Laura Anthony

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

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    Regulation A+ Continues To Grow

    Tuesday, April 17, 2018, 8:48 AM [General]
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    The new Regulation A/A+, which went into effect on June 19, 2015, is now three years old and continues to develop and gain market acceptance. In addition to ongoing guidance from the SEC, the experience of practitioners and the marketplace continue to develop in the area. Nine companies are now listed on national exchanges, having completed Regulation A+ IPO’s, and several more trade on OTC Markets. The NYSE even includes a page on its website related to Regulation A+ IPO’s. As further discussed herein, most of the exchange traded companies have gone down in value from their IPO offering price, which I and other practitioners attribute to the lack of firm commitment offerings and the accompanying overallotment (greenshoe) option.

    On March 15, 2018, the U.S. House of Representatives passed H.R. 4263, the Regulation A+ Improvement Act, increasing the Regulation A+ Tier 2 limit from $50 million to $75 million in a 12-month period. 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 change the entire marketplace is advocating for. See HERE. On June 8, 2017, the U.S. House of Representatives passed the Financial Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs Act (the “Financial Choice Act 2.0”), which also included a provision increasing the Tier 2 offering limit to $75 million. See HERE. The SEC has included Regulation A amendments on its long-term legislation action list as of December 2017.

    This firm has been deep in the Regulation A space. A February 2018 Audit Analytics report named our firm one of the top three Regulation A firms in the country, and we are working on multiple new offerings that have yet to be filed. Furthermore, we are working on Regulation A+ offerings that will include an equity security in the form of a token based on blockchain or distributed ledger technology, an exciting new development in the field.

    This blog will provide a comprehensive overview of Regulation A+, including updates based on experience and guidance in the industry.

    Summary of Regulation A/A+

    I’ve written about Regulation A+ on numerous occasions, including detailing the history and intent of the rules. Title IV of the JOBS Act, which was signed into law on April 5, 2012, set out the framework for the new Regulation A and required the SEC to adopt specific rules to implement the new provisions. The new rules came into effect on June 19, 2015. For a refresher on such history and intent, see my blog HERE.

    Importantly, as discussed further below, Tier 2 of Regulation A (Regulation A+) preempts state blue sky law, and securities issued in a Regulation A+ offering are “covered securities.” In addition to the federal government, every state has its own set of securities laws and securities regulators. Unless the federal law specifically “preempts” or overrules state law, every offer and sale of securities must comply with both the federal and the state law. There are 54 U.S. jurisdictions, including all 50 states and 4 territories, each with separate and different securities laws. Even in states that have identical statutes, the states’ interpretations or focuses under the statutes differ greatly. On top of that, each state has a filing fee and a review process that takes time to deal with. It’s difficult, time-consuming and expensive.

    However, as I will discuss below, this does not include preemption of state law related to broker-dealer registration. Five states (Florida, New York, Texas, Arizona and North Dakota) do not have “issuer exemptions” for public offerings such as a Regulation A offering. Companies completing a Regulation A offering without a broker-dealer will need to register as an “issuer dealer” in those states. Although each state has differing requirements, they all require certain uniform information and the process has not been overly cumbersome.

    Two Tiers of Offerings

    Regulation A is divided into two offering paths, referred to as Tier 1 and Tier 2. A Tier 1 offering allows for sales of up to $20 million in any 12-month period. Since Tier 1 does not preempt state law, it is really only useful for offerings that are limited to one but no more than a small handful of states. Tier 1 does not require the company to include audited financial statements and does not have any ongoing SEC reporting requirements. Tier 1 is generally not used for an initial going public transaction. Tier 1 is most often used by existing public companies that are not subject to the SEC reporting requirements.

    Both Tier I and Tier 2 offerings contain minimum basic requirements, including issuer eligibility provisions and disclosure requirements. Resales of securities by affiliate selling security holders are limited to no more than $6,000,000 for a Tier 1 offering and $15,000,000 for a Tier 2 offering. Resales of securities by non-affiliate selling security holders are limited to 30% of the aggregate offering amount for the company’s first Regulation A offering or subsequent offering that is completed within one year of the first offering. Although no company has yet completed a second Regulation A offering after the one-year period, such offering would not have a limit on non-affiliate resales.

    For offerings up to $20 million, an issuer can elect to proceed under either Tier 1 or Tier 2. Both tiers will allow companies to submit draft offering statements for non-public SEC staff review before a public filing, permit continued use of solicitation materials after the filing of the offering statement and use the EDGAR system for filings.

    Tier 2 allows a company to file an offering circular with the SEC to raise up to $50 million in a 12-month period. Tier 2 preempts state blue sky law. A company may elect to either provide the disclosure in Form 1-A format or the disclosure in a traditional Form S-1 when conducting a Tier 2 offering. The Form S-1 format is a precondition to being able to file a Form 8-A to register under the Exchange Act. Either way, the SEC review process is a little shorter, and a company can market in a way that it cannot with a traditional IPO. However, we have noticed that as more and more issuers are using the process, the reviewers have become busier and the review time has extended accordingly.

    Both Tiers of Regulation A have specific company eligibility requirements, investor qualifications and associated per-investor investment limits. Also, the process is not inexpensive. Attorneys’ fees, accounting and audit fees and, of course, marketing expenses all add up. A company needs to be organized and ready before engaging in any offering process, and especially so for a public offering process. Even though a lot of attorneys, myself included, will provide a flat fee for parts of the process, that flat fee is dependent on certain assumptions, including the level of organization of the company.

    In a CD&I, the SEC confirmed that a company may withdraw a Tier 2 offering after qualification but prior to any sales or the filing of an annual report, by filing an exit report on Form 1-Z, and thereafter be relieved of any further filing requirements.

    Eligibility Requirements

    Regulation A is available to companies organized and operating in the United States and Canada. A company will be considered to have its “principal place of business” in the U.S. or Canada for purposes of determination of Regulation A eligibility if its officers, partners, or managers primarily direct, control and coordinate the company’s activities from the U.S. or Canada, even if the actual operations are located outside those countries.

    The following issuers are not eligible for a Regulation A offering:

    • Companies currently subject to the reporting requirements of the Exchange Act;
    • Investment companies registered or required to be registered under the Investment Company Act of 1940, including BDC’s. However, a company that operates investments that are exempt from the registration requirements under the 1940 Act would qualify, such as REIT’s and companies that transact in certain loans such as small business loans, student loans, auto loans, and personal loans.
    • Blank check companies, which are companies that have no specific business plan or purpose or whose business plan and purpose is to engage in a merger or acquisition with an unidentified target; however, shell companies are not prohibited, unless such shell company is also a blank check company. A shell company is a company that has no or nominal operations; and either no or nominal assets, assets consisting of cash and cash equivalents; or assets consisting of any amount of cash and cash equivalents and nominal other assets. Accordingly, a start-up business or minimally operating business may utilize Regulation A;
    • Issuers seeking to offer and sell asset-backed securities or fractional undivided interests in oil, gas or other mineral rights;
    • Issuers that have been subject to any order of the SEC under Exchange Act Section 12(j) denying, suspending or revoking registration, entered within the past five years. Accordingly, a company that is deregistered for delinquent reporting would not be eligible for Regulation A;
    • Issuers that became subject to Regulation A reporting requirements, such as through a Tier 2 offering, and did not file required ongoing reports during the preceding two years; and
    • Issuers that are disqualified under the Rule 262 “bad actor” provisions.

    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 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. 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.

    Unfortunately, in what is clearly a legislative miss, companies that are already publicly reporting – that is, are already required to file reports with the SEC – are not eligible. OTC Markets has petitioned the SEC to eliminate this eligibility criterion, and pretty well everyone in the industry supports a change here, but for now it remains. 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. Also, as discussed at the beginning of this blog, the House has now passed the Improving Access to Capital Act, which would allow companies subject to the reporting requirements under the Exchange Act to use Regulation A.

    Regulation A can be used for business combination transactions, but is not available for shelf SPAC’s (special purpose acquisition companies).

    Eligible Securities

    Regulation A is limited to equity securities, including common and preferred stock and options, warrants and other rights convertible into equity securities, debt securities and debt securities convertible or exchangeable into equity securities, including guarantees. If convertible securities or warrants are offered that may be exchanged or exercised within one year of the offering statement qualification (or at the option of the issuer), the underlying securities must also be qualified and the value of such securities must be included in the aggregate offering value. Accordingly, the underlying securities will be included in determining the offering limits of $20 million and $50 million, respectively.

    Recently our firm, and several others that I am aware of, are using Regulation A to create equity digital tokens using blockchain technology. For my most recent blog on that subject, see HERE.

    Asset-backed securities are not allowed to be offered in a Regulation A offering. REIT’s and other real estate-based entities may use Regulation A and provide information similar to that required by a Form S-11 registration statement.

    General Solicitation and Advertising; Solicitation of Interest (“Testing the Waters”)

    Other than the investment limits, anyone can invest in a Regulation A offering, but of course they have to know about it first – which brings us to marketing. All Regulation A offerings will be allowed to engage in general solicitation and advertising, at least according to the SEC. Tier 1 offerings are also required to comply with applicable state law related to such solicitation and advertising, including any prohibitions of same.

    Marketing in the Prequalification Period

    Regulation A allows for prequalification solicitations of interest in an offering, commonly referred to as “testing the waters.” Issuers can use “test-the-waters” solicitation materials both before and after the initial filing of the offering statement, and by any means. A company can use social media, Internet websites, television and radio, print advertisements, and anything they can think of prior to qualification of the offering. Marketing can be oral or in writing, with the only limitations being certain disclaimers and antifraud. Although a company can and should be creative in its presentation of information, there are laws in place with serious ramifications requiring truth in the marketing process. Investors should watch for red flags such as clearly unprovable statements of grandeur, obvious hype or any statement that sounds too good to be true – as they are probably are just that.

    When using “test-the-waters” or prequalification marketing, a company must specifically state whether a registration statement has been filed and if one has been filed, provide a link to the filing. Also, the company must specifically state that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC. Any investor indications of interest during this time are 100% non-binding – on both parties. That is, the potential investor has no obligation to make an investment when or if the offering is qualified with the SEC and the company has no obligation to file an offering circular or if one is already filed, to pursue its qualification. In fact, a company may decide that based on a poor response to its marketing efforts, it will abandon the offering until some future date or forever.

    Solicitation material used before qualification of the offering circular must contain a legend stating that no money or consideration is being solicited and none will be accepted, no offer to buy securities can be accepted and any offer can be withdrawn before qualification, and a person’s indication of interest does not create a commitment to purchase securities.

    For a complete discussion of Regulation A “test-the-waters” rules and requirements, see my blog HERE.

    All solicitation material must be submitted to the SEC as an Exhibit under Part III of Form 1-A. This is a significant difference from S-1 filers, who are not required to file “test-the-waters” communications with the SEC. There is no requirement that the materials be filed prior to use—only that they be included as an exhibit to the final qualified offering circular. In a CD&I the SEC has also confirmed that the requirement under Industry Guide 5 that sales material be submitted to the SEC before use, does not apply to Regulation A offerings. Industry Guide 5 relates to registration statements involving interests in real estate limited partnerships.

    A company can use Twitter and other social media that limits the number of characters in a communication, to test the waters as long as the company provides a hyperlink to the required disclaimers. A company can use a hyperlink to satisfy the disclosure and disclaimer requirements in Rule 255 as long as (i) the electronic communication is distributed through a platform that has technological limitations on the number of characters or amount of text that may be included in the communication; (ii) including the entire disclaimer and other required disclosures would exceed the character limit on that particular platform; and (iii) the communication has an active hyperlink to the required disclaimers and disclosures and, where possible, prominently conveys, through introductory language or otherwise, that important or required information is provided through the hyperlink.

    Unlike the “testing of the waters” by emerging growth companies that are limited to QIB’s and accredited investors, a Regulation A company can reach out to retail and non-accredited investors. After the public filing but before SEC qualification, a company may use its preliminary offering circular to make written offers.

    Of course, all “test-the-waters” materials are subject to the antifraud provisions of federal securities laws.

    Like registered offerings, ongoing regularly released factual business communications, not including information related to the offering of securities, is allowed and is not considered solicitation materials.

    Post-qualification Marketing

    Once an offering has been qualified by the SEC and a company is soliciting the purchase of the securities, and not merely an indication of interest, the company has offering circular delivery requirements. That is, the company must deliver the qualified Final Offering Circular to all purchasers and prospective purchasers. This delivery requirement can be satisfied by providing an active hyperlink to the URL where the Final Offering Circular is filed on EDGAR. Accordingly, once an offering has been qualified with the SEC, a company cannot solicit the sale of securities using print, TV, radio or other forms of advertising that do not allow for the inclusion of an active hyperlink.

    Continuous or Delayed Offerings

    Continuous or delayed offerings (a form of a shelf offering) are allowed only if the offering statement pertains to: (i) securities to be offered or sold solely by persons other than the issuer (however, note that under the rules, this is limited to 30% of non-affiliates for first-time offerings and by dollar limit for affiliates for any offering); (ii) securities that are offered pursuant to a dividend or interest reinvestment plan or employee benefit plan; (iii) securities that are to be issued upon the exercise of outstanding options, warrants or rights; (iv) securities that are to be issued upon conversion of other outstanding securities; (v) securities that are pledged as collateral; or (vi) securities for which the offering will commence within two days of the offering statement qualification date, will be made on a continuous basis, will continue for a period of in excess of thirty days following the offering statement qualification date, and at the time of qualification are reasonably expected to be completed within two years of the qualification date.

    Under this last continuous offering section, issuers that are current in their Tier 2 reporting requirements may make continuous or delayed offerings for up to three years following qualification of the offering statement. Moreover, in the event a new qualification statement is filed for a new Regulation A offering, unsold securities from a prior qualification may be included, thus carrying those unsold securities forward for an additional three-year period. When continuously offering securities under an open Regulation A offering, a company must update its offering circular, via post-qualification amendment, to disclose material changes of fact and to keep the financial statements current.

    Where a company seeks to qualify an additional class of securities via post-qualification amendment to a previously qualified Form 1-A, Item 4 of Part I, which requires “Summary Information Regarding the Offering and Other Current or Proposed Offerings,” need only include information related to the new class of securities seeking qualification.

    Additional Tier 2 Requirements; Ability to List on an Exchange

    In addition to the basic requirements that apply to all Regulation A offerings, Tier 2 offerings also require: (i) audited financial statements (though I note that the majority of state blue sky laws require audited financial statements, so this federal distinction does not have a great deal of practical effect); (ii) ongoing reporting requirements, including the filing of an annual and semiannual report and periodic reports for current information (Forms 1-K, 1-SA and 1-U, respectively); and (iii) a limitation on the number of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth.

    The investment limitations for non-accredited investors resulted from a compromise with state regulators that opposed the state law preemption for Tier 2 offerings. It is the obligation of the issuer to notify investors of these limitations. Issuers may rely on the investors’ representations as to accreditation (no separate verification is required) and investment limits.

    A company completing a Tier 2 offering that has used the S-1 format for their offering circular may file a Form 8-A with the qualification of the Form 1-A as long as it is filed no later than 5 days following qualification, to register under the Exchange Act, and may make immediate application to a national securities exchange. A Form 8-A is a simple (generally 2-page) registration form used instead of a Form 10 for companies that have already filed the substantive Form 10 information with the SEC (generally through an S-1).

    The Form 8-A will only be allowed if it is filed within five (5) days of the qualification of the Form 1-A or a post-qualification amendment to the initial qualified Form 1-A As with any SEC filings based on calendar days, where the fifth day falls on a Saturday, Sunday or federal holiday, the certification may be received on the next business day.

    For registration under Section 12(g) of the Exchange Act, the 8-A becomes effective upon the later of the filing of the Form 8-A or the qualification of the Regulation A offering statement.

    Where the securities will be listed on a national exchange, the accredited investor limitations will not apply. When the Form 8-A is for registration with a national securities exchange under Section 12(b) of the Exchange Act, the 8-A becomes effective on the later of the day the 8-A if filed, the day the national exchange files a certification with the SEC confirming the listing, or the qualification of the offering circular.

    Upon effectiveness of the Form 8-A, the company will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A reporting will automatically be suspended. Accordingly, upon effectiveness of the Form 8-A, a company no longer qualifies to use Regulation A as an offering method and as such, the company would need to discontinue future sales under the qualified offering circular. As a result of this, most companies file a post-qualification amendment to their Form 1-A when all sales have been completed, and then file a Form 8-A in conjunction with that post-qualification amendment.

    In their September 14, 2017 CD&I, the SEC confirmed that an issuer may also file a Form 8-A concurrently (i.e., within five days) with the qualification of a post-qualification amendment to a Form 1-A. Financial statements in any qualified Form 1-A must be current at the time of qualification, and the same holds true for a post-qualification amendment. The SEC notes that the reason a Form 8-A may only be filed concurrently with qualification is to ensure that financial statements are current at the time a company becomes registered under the Exchange Act and subject to its reporting requirements.

    The SEC has clarified the timing of an annual report on Form 10-K once an 8-A has been filed. In particular, in the event that a qualified Form 1-A did not contain an audit of the last full fiscal year, the SEC will allow the company to file its annual report within 90 days of effectiveness of a Form 8-A. A Form 8-A is usually effective as of its filing, but can be preconditioned on certain events, such as a certification of a national exchange as described above. For example, if a company with a calendar year-end qualifies a Form 1-A on March 30, 2018 and files an 8-A on April 4, 2018, it would be required to file a Form 10-K for fiscal year-end December 31, 2017 (with the 2016 comparable period) within 90 calendar days from the effectiveness of the Form 8-A.

    Likewise, the SEC provided guidance on the timing of a quarterly report on Form 10-Q following effectiveness of a Form 8-A. Generally, a company must file its 10-Q within 45 days of the effectiveness of a registration statement, or on the due date of its regular 10-Q if the company was already subject to the Exchange Act reporting requirements. The SEC has confirmed that it will allow a 10-Q to be filed within 45 days of effectiveness of a Form 8-A filed in connection with a Form 1-A qualification. Moreover, a company may actually have to file two Form 10-Q’s in that time period. A Form 1-A does not require (or allow for) the filing of quarterly stub periods; rather, a stub period must be for a minimum of a six-month financial period. Accordingly, it is possible that a company would need to file two Form 10-Q’s for two stub periods, within 45 days of effectiveness of its Form 8-A.

    For example, let’s say a company with a calendar year-end qualifies a Form 1-A on August 10, 2018 and files a Form 8-A, which goes effective on the same day. The qualified Form 1-A contains an audit for fiscal year-end December 31, 2016 and 2017, but does not contain any stub period financial statements for 2018 (note that the 2017 year-end audit would not go stale for purposes of Regulation A until September 30, 2018 in this example). In this case, the company would need to file its Form 10-Q’s for both quarters ending March 31, 2018 and June 30, 2018 by September 24, 2018.

    Nine companies are now listed on national exchanges having completed Regulation A+ IPO’s and several more trade on OTC Markets. Most of the exchange traded companies have gone down in value from their IPO offering price, which I and other practitioners attribute to the lack of firm commitment offerings and the accompanying overallotment (greenshoe) option. An overallotment option, often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing, is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position. A covered short position is one in which a seller sells securities it does not yet own, but does have access to.

    A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).

    The federal securities laws only allow overallotment options in “firm commitment offerings. In a firm commitment offering, the underwriter firmly commits to buying a certain number of shares” from the company and then resells those shares into the market, either directly or through a syndicate of other underwriters. As of now, all Regulation A offerings have been on a “best-efforts basis.” In a best-efforts offering, the underwriter does not commit to any sales but merely uses its best efforts to sell the offering into the market (either directly or through a syndicate).

    As Regulation A grows in use and popularity, and attracts more institutional players and higher-quality deals, I would expect firm commitment offerings and the use of the overallotment option. In a Regulation A offering, the overallotment would need to be considered in determining the maximum allowable offering amounts ($20 million for Tier 1 and $50 million for Tier 2).


    The final rules include a limited-integration safe harbor such that offers and sales under Regulation A will not be integrated with prior or subsequent offers or sales that are (i) registered under the Securities Act; (ii) made under compensation plans relying on Rule 701; (iii) made under other employee benefit plans; (iv) made in reliance on Regulation S; (v) made more than six months following the completion of the Regulation A offering; or (vi) made in crowdfunding offerings exempt under Section 4(a)(6) of the Securities Act (Title III crowdfunding–Regulation CF).

    The SEC has confirmed that a Regulation A offering can rely on Rule 152 such that a completed exempt offering, such as under Rule 506(b), will not integrate with a subsequent Regulation A offering. Under Rule 152, a securities transaction that at the time involves a private offering will not lose that status even if the company subsequently makes a public offering. The SEC has also issued guidance that Rule 152 applies to prevent integration between a completed 506(b) offering and a subsequent 506(c) offering, indicating that the important factor in the Rule 152 analysis is the ability to publicly solicit. As Rule 506(c) is considered a public offering for this analysis, there would be nothing preventing a company from completing a Rule 506(c) offering either before, concurrently or after a Regulation A offering.

    In the absence of a clear exemption from integration, companies would turn to the five-factor test. In particular, the determination of whether the Regulation A offering would integrate with one or more other offerings is a question of fact depending on the particular circumstances at hand. The following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

    Offering Statement – General

    A company intending to conduct a Regulation A offering must file an offering circular with, and have it qualified by, the SEC. The offering circular is filed with the SEC using the EDGAR database filing system. Prospective investors must be provided with the filed, prequalified offering statement 48 hours prior to a sale of securities. Once qualified, investors must be provided with the final qualified offering circular. Like current registration statements, Regulation A rules provide for an “access equals delivery” model, whereby access to the offering statement via the Internet and EDGAR database will satisfy the delivery requirements. As discussed above, this access must be via an active hyperlink.

    There are no filing fees for the process. The offering statement is reviewed, commented upon and then declared “qualified” by the SEC with an issuance of a “notice of qualification.” The notice of qualification can be requested or will be issued by the SEC upon clearing comments. The SEC has been true to its word in that the review process has been lighter than that normally associated with an S-1 or other Securities Act registration statement. However, I have noticed over time that offering circulars are being reviewed more in line with an S-1 than when the process first started.

    Issuers may file offering circular updates after qualification in lieu of post-qualification amendments similar to the filing of a post-effective prospectus for an S-1. In a CD&I, the SEC clarified the calculation of a 20% change in the price of the offering to determine the necessity of filing a post-qualification amendment which would be subject to SEC comment and review, versus a post-qualification supplement which would be effective immediately upon filing. Rule 253(b) provides that a change in price of no more than 20% of the qualified offering price, may be made by supplement and not require an amendment. An amendment is subject to a whole new review and comment period and must be declared qualified by the SEC. A supplement, on the other hand, is simply added to the already qualified Form 1-A, becoming qualified itself upon filing. The 20% variance can be either an increase or decrease in the offering price, but if it is an increase, it cannot result in an offering above the respective thresholds for Tier 1 ($20 million) or Tier 2 ($50 million).

    To qualify additional securities, a post-qualification amendment must be used. In a CD&I the SEC has clarified that where a company seeks to qualify an additional class of securities via post-qualification amendment to a previously qualified Form 1-A, Item 4 of Part I, which requires “Summary Information Regarding the Offering and Other Current or Proposed Offerings,” need only include information related to the new class of securities seeking qualification.

    In a reminder that Regulation A is technically an exemption from the registration requirements under Section 5 of the Securities Act, the SEC confirmed that under Item 6 of Part I, requiring disclosure of unregistered securities issued or sold within the prior year, a company must disclose all securities issued or sold pursuant to Regulation A in the prior year.

    Offering Statement – Non-public (Confidential) Submission

    The rules permit a company to submit an offering statement to the SEC on a confidential basis. The rule provides that only companies that have not previously sold securities under a Regulation A or a Securities Act registration statement may submit the offering confidentially.

    Confidential submissions will allow a Regulation A issuer to get the process under way while soliciting interest of investors using the “test-the-waters” provisions without negative publicity risk if it alters or withdraws the offering before qualification by the SEC. The confidential filing, SEC comments, and all amendments must be publicly filed at least 15 calendar days before qualification.

    Confidential submissions to the SEC are completed by choosing a “confidential” setting in the EDGAR system. To satisfy the requirement to publicly file the previous confidential information, the company can file all prior confidential information as an exhibit to its non-confidential filing, or change the setting in the EDGAR system on its prior filings, from “confidential” to “public.” In the event the company chooses to change its EDGAR setting to “public,” it would not have to re-file all prior confidential material as an exhibit to a new filing.

    If a company wants to keep certain information confidential, even after the required time to make such information public, it will need to submit two confidential requests, one as part of the offering review process and one when prior confidential filings are made public. During the confidential Form 1-A review process, the company should submit a request under Rule 83 in the same manner it would during a typical review of a registered offering. Once the company is required to make the prior filings “public” (15 days prior to qualification), the company would make a new request for confidential treatment under Rule 406 in the same manner other confidential treatment requests are submitted. For a confidential treatment request under Rules 83 and 406, a company must submit a redacted version of the document via EDGAR with the appropriate legend indicating that confidential treatment has been requested. Concurrently, the company must submit a full, unredacted paper version of the document to the SEC using the ordinary confidential treatment procedure (such filings are submitted via a designated fax line to a designated person to maintain confidentiality).

    Offering Statement – Form and Content

    An offering statement is submitted on Form 1-A. Form 1-A consists of three parts: Part I – Notification, Part II – Offering Circular, and Part III – Exhibits. Part I calls for certain basic information about the company and the offering, and is primarily designed to confirm and determine eligibility for the use of the Form and a Regulation A offering in general. Part I includes issuer information; issuer eligibility; application of the bad-actor disqualifications and disclosures; jurisdictions in which securities are to be offered; and unregistered securities issued or sold within one year. As Regulation A is technically an unregistered offering, all Regulation A securities sold within the prior year must be included in this section.

    Part II is the offering circular and is similar to the prospectus in a registration statement. Part II requires disclosure of basic information about the company and the offering; material risks; dilution; plan of distribution; use of proceeds; description of the business operations; description of physical properties; discussion of financial condition and results of operations (MD&A); identification of and disclosure about directors, executives and key employees; executive compensation; beneficial security ownership information; related party transactions; description of offered securities; and two years of financial information.

    The required information in Part 2 of Form 1-A is scaled down from the requirements in Regulation S-K applicable to Form S-1. Issuers can complete Part 2 by either following the Form 1-A disclosure format or by including the information required by Part I of Form S-1 or Form S-11 as applicable. Note that only issuers that elect to use the S-1 or S-11 format will be able to subsequently file an 8-A to register and become subject to the Exchange Act reporting requirements or to trade on a national exchange.

    Companies that had previously completed a Regulation A offering and had thereafter been subject to and filed reports with the SEC under Tier 2 can incorporate by reference from these reports in future Regulation A offering circulars.

    Form 1-A requires two years of financial information. All financial statements for Regulation A offerings must be prepared in accordance with GAAP. Financial statements of a Tier 1 issuer are not required to be audited unless the issuer has obtained an audit for other purposes. Audited financial statements are required for Tier 2 issuers. Audit firms for Tier 2 issuers must be independent and PCAOB-registered. An offering statement cannot be qualified if the date of the balance sheet is more than nine months prior to the date of qualification. Financial statements do not go stale for nine months, as opposed to 135 days for other filings under Regulation S-X. Interim financial statements should be for a minimum period of six months following the date of the fiscal year-end.

    A recently created entity may choose to provide a balance sheet as of its inception date as long as that inception date is within nine months before the date of filing or qualification and the date of filing or qualification is not more than three months after the entity reached its first annual balance sheet date. The date of the most recent balance sheet determines which fiscal years, or period since existence for recently created entities, the statements of comprehensive income, cash flows and changes in stockholders’ equity must cover. When the balance sheet is dated as of inception, the statements of comprehensive income, cash flows and changes in stockholders’ equity will not be applicable.

    In a CD&I the SEC confirmed that companies using Form 1-A benefit from Section 71003 of the FAST Act. The SEC interprets Section 71003 of the FAST Act to allow an emerging growth company (EGC) to omit financial information for historical periods if it reasonably believes that those financial statements will not be required at the time of the qualification of the Form 1-A, provided that the company file a prequalification amendment such that the Form 1-A qualified by the SEC contains all required up-to-date financial information. Section 71003 only refers to Forms S-1 and F-1, but the SEC has determined to allow an EGC the same benefit when filing a Form 1-A. Since financial statements for a new period would result in a material amendment to the Form 1-A, potential investors would need to be provided with a copy of such updated amendment prior to accepting funds and completing the sale of securities.

    Part III requires an exhibits index and a description of exhibits required to be filed as part of the offering statement. A tax opinion is not required to be filed as an exhibit to Form 1-A, but a company may do so voluntarily.

    Offering Price

    All Regulation A offerings must be at a fixed price. That is, no offerings may be made “at the market” or for other than a fixed price. This applies to all aspects of the Regulation A offering. For example, a company could not complete an offering whereby a purchaser exercises an option or warrant at a variable price with the resale of such securities being registered at a fixed price. As a result of this, and the inability to obtain any prequalification commitment from a purchaser whatsoever, a Regulation A offering is not conducive for use in equity line transactions.

    Ongoing Reporting

    Both Tier I and Tier 2 issuers must file summary information after the termination or completion of a Regulation A offering. A Tier I company must file certain information about the Regulation A offering, including information on sales and the termination of sales, on a Form 1-Z exit report no later than 30 calendar days after termination or completion of the offering. Tier I issuers do not have any ongoing reporting requirements.

    Tier 2 companies are also required to file certain offering termination information and have the choice of using Form 1-Z or including the information in their first annual report on Form 1-K. In addition to the offering summary information, Tier 2 issuers are required to submit ongoing reports including: an annual report on Form 1-K, semiannual reports on Form 1-SA, current event reports on Form 1-U and notice of suspension of ongoing reporting obligations on Form 1-Z.

    A Tier 2 issuer may file an exit form 1-Z and relieve itself of any ongoing requirements if no securities have been sold under the Regulation A offering and the Form 1-Z is filed prior to the company’s first annual report on Form 1-K.

    The ongoing reporting for Tier 2 companies is less demanding than the reporting requirements under the Securities Exchange Act. In particular, there are fewer 1-K items and only the semiannual 1-SA (rather than the quarterly 10-Q) and fewer events triggering Form 1-U (compared to Form 8-K). Companies may also incorporate text by reference from previous filings. In a CD&I, the SEC confirmed that it will not object if an auditor’s consent is not included as an exhibit to an annual report on Form 1-K, even if the report contains audited financial statements. The report would still need to contain the auditor’s report, but a separate consent is not required.

    The annual Form 1-K must be filed within 120 calendar days of fiscal year-end. The semiannual Form 1-SA must be filed within 90 calendar days after the end of the semiannual period. The current report on Form 1-U must be filed within 4 business days of the triggering event. Successor issuers, such as following a merger, must continue to file the ongoing reports.

    The rules also provide for a suspension of reporting obligations for a Regulation A issuer that desires to suspend or terminate its reporting requirements. Termination is accomplished by filing a Form 1-Z and requires that a company be current over stated periods in its reporting, have fewer than 300 shareholders of record, and have no ongoing offers or sales in reliance on a Regulation A offering statement. Of course, a company may file a Form 10 to become subject to the full Exchange Act reporting requirements.

    The ongoing reports will qualify as the type of information a market maker would need to support the filing of a 15c2-11 application. Accordingly, an issuer that completes a Tier 2 offering could proceed to engage a market maker to file a 15c2-11 application and trade on the OTC Markets. The OTC Markets allows Regulation A reporting companies to apply for any of its tiers of listing, including the OTCPink, OTCQB or OTCQX, depending on which tier the company qualifies for.

    A company that reports under the scaled-down Regulation A requirements is not considered to be subject to the Exchange Act reporting requirements, and therefore shareholders that have purchased restricted securities in exempt offerings (including 506(b) or 506(c) offerings in advance of the Regulation A) will need to satisfy the longer one-year holding period under Rule 144. Shares purchased in the Regulation A offering itself are freely tradable.

    Freely Tradable Securities

    Securities issued to non-affiliates in a Regulation A offering are freely tradable. Securities issued to affiliates in a Regulation A offering are subject to the affiliate resale restrictions in Rule 144, except for a holding period. The same resale restrictions for affiliates and non-affiliates that apply to Regulation A offerings also apply to securities registered in a Form S-1.

    Since neither Tier 1 nor Tier 2 Regulation A issuers are subject to the Exchange Act reporting requirements (unless a Form 8-A is filed), the Rule 144 holding period for shareholders that have purchased restricted securities in exempt offerings (including 506(b) or 506(c) offerings in advance of the Regulation A) will need to satisfy the longer one-year holding period under Rule 144. Shareholders would not be able to rely on Rule 144 at all if the company has been a shell company at any time in its history. For more information on Rule 144 as it relates to shell companies, see HERE.

    Treatment under Section 12(g)

    Exchange Act Section 12(g) requires that an issuer with total assets exceeding $10,000,000 and a class of equity securities held of record by either 2,000 persons or 500 persons who are not accredited, register with the SEC, generally on Form 10, and thereafter be subject to the reporting requirements of the Exchange Act.

    Regulation A exempts securities in a Tier 2 offering from the Section 12(g) registration requirements if the issuer meets all of the following conditions:

    • The issuer utilizes an SEC-registered transfer agent. Such transfer agent must be engaged at the time the company is relying on the exemption from Exchange Act registration;
    • The issuer remains subject to the Tier 2 reporting obligations;
    • The issuer is current in its Tier 2 reporting obligations, including the filing of an annual and semiannual report; and
    • The issuer has a public float of less than $75 million as of the last business day of its most recently completed semiannual period or, if no public float, had annual revenues of less than $50 million as of its most recently completed fiscal year-end.

    Moreover, even if a Tier 2 issuer is not eligible for the Section 12(g) registration exemption as set forth above, that issuer will have a two-year transition period prior to being required to register under the Exchange Act, as long as during that two-year period, the issuer continues to file all of its ongoing Regulation A reports in a timely manner with the SEC.

    State Law Preemption

    Tier I offerings do not preempt state law and remain subject to state blue sky qualification. The SEC encourages Tier 1 issuers to utilize the NASAA-coordinated review program for Tier I blue sky compliance. For a brief discussion on the NASAA-coordinated review program, see my blog HERE. However, in practice, I do not think this program is being utilized; rather, when Tier 1 is being used, it is limited to just one or a very small number of states and companies are completing the blue sky process independently.

    Tier 2 offerings are not subject to state law review or qualification – i.e., state law is preempted. State law can still require a notice filing. Securities sold in Tier 2 offerings were specifically added to the NSMIA as federally covered securities. Federally covered securities are exempt from state registration and overview. Regulation A provides that “(b) Treatment as covered securities for purposes of NSMIA… Section 18(b)(4) of the Securities Act of 1933… is further amended by inserting… (D) a rule or regulation adopted pursuant to section 3(b)(2) and such security is (i) offered or sold on a national securities exchange; or (ii) offered or sold to a qualified purchaser, as defined by the Commission pursuant to paragraph (3) with respect to that purchase or sale.” For a discussion on the NSMIA, see my blogs HERE and HERE.

    State securities registration and exemption requirements are only preempted as to the Tier 2 offering and securities purchased pursuant to the qualified Tier 2 Form 1-A offering circular. Subsequent resales of such securities are not preempted. However, securities traded on a national exchange are covered securities. Moreover, the OTCQB and OTCQX levels of OTC Markets are becoming widely recognized as satisfying the manual’s exemption for resale trading in most states.

    State law preemption only applies to the securities offering itself and not to the person or persons who sell the securities. Unfortunately, not all states offer an issuer exemption for issuers that sell their own securities in public offerings such as a Regulation A offering. In particular, Arizona, Florida, Texas, New York and North Dakota require issuers to register with the state as issuer broker-dealers to qualify to sell securities directly. Each of these states has a short-form registration process in that regard. In addition, Alabama and Nevada require that the selling officers and directors of issuers register with the state.

    Federally covered securities, including Tier 2 offered securities, are still subject to state antifraud provisions, and states may require certain notice filings. In addition, as with any covered securities, states maintain the authority to investigate and prosecute fraudulent securities transactions.

    Broker-dealer Placement

    Broker-dealers acting as placement or marketing agents are required to comply with FINRA Rule 5110 regarding filing of underwriting compensation, for a Regulation A offering.

    Regulation A – Private or Public Offering?

    The legal nuance that Regulation A is an “exempt” offering under Section 5 has caused confusion and the need for careful thought by practitioners and the SEC staff alike. Regulation A is treated as a public offering in almost all respects except as related to the applicability of Securities Act Section 11 liability. Section 11 of the Securities Act provides a private cause of action in favor of purchasers of securities, against those involved in filing a false or misleading public offering registration statement. Any purchaser of securities, regardless of whether they bought directly from the company or secondarily in the aftermarket, can sue a company, its underwriters, and experts for damages where a false or misleading registration statement had been filed related to those securities. Regulation A is not considered a public offering for purposes of Section 11 liability.

    Securities Act Section 12, which provides a private cause of action by a purchaser of securities directly against the seller of those securities, specifically imposes liability on any person offering or selling securities under Regulation A. The general antifraud provisions under Section 17 of the Securities Act, which apply to private and public offerings, of course apply to Regulation A.

    As mentioned above, the SEC has now confirmed that a Regulation A offering can rely on Rule 152 such that a completed exempt offering, such as under Rule 506(b), will not integrate with a subsequent Regulation A filing. Under Rule 152, a securities transaction that at the time involves a private offering will not lose that status even if the issuer subsequently makes a public offering. Along the same lines, as Rule 506(c) is considered a public offering for this analysis, there would be nothing preventing a company from completing a Rule 506(c) offering either before, concurrently or after a Regulation A offering.

    Regulation A is definitely used as a going public transaction and, as such, is very much a public offering. Securities sold in a Regulation A offering are not restricted and therefore are available to be used to create a secondary market and trade, such as on the OTC Markets or a national exchange.

    Tier 2 issuers that have used the S-1 format for their Form 1-A filing are permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements and to register with a national exchange. The Form 8-A must be filed within 5 days of the qualification of the Form 1-A or any post-qualification amendments. A Form 8-A is a simple registration form used instead of a Form 10 for issuers that have already filed the substantive Form 10 information with the SEC. Upon filing a Form 8-A, the issuer will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A+ reporting will automatically be suspended. A form 8-A can also be used as a short-form registration to list on a national exchange under Section 12(b) of the Exchange Act. Registration under 12(g) occurs automatically; however, Registration under 12(b) requires that the applicable national securities exchange certify the registration within five calendar days. As with any SEC filings based on calendar days, where the fifth day falls on a Saturday, Sunday or federal holiday, the certification may be received on the next business day.

    A Regulation A process is clearly the best choice for a company that desires to go public and raise less than $50 million. An initial or direct public offering on Form S-1 does not preempt state law. By choosing a Tier 2 Regulation A offering followed by a Form 8-A, the issuer can achieve the same result – i.e., become a fully reporting trading public company without the added time and expense of complying with state blue sky laws. In addition to the state law preemption benefit, Regulation A provides relief from the strictly regulated public communications that exist in an S-1 offering.

    Practice Tip on Registration Rights Contracts

    In light of the fact that Regulation A is technically an exemption from the Section 5 registration requirements, it might not be included in contractual provisions related to registration rights. In particular, the typical language in a piggyback or demand registration right provision creates the possibility that the company could do an offering under Regulation A and take the position that the shareholder is not entitled to participate under the registration rights provision because it did not do a “registration.” As an advocate of avoiding ambiguity, practitioners should carefully review these contractual provisions and add language to include a Form 1-A under Regulation A if the intent is to be sure that the shareholder is covered. Likewise, if the intent is to exclude Regulation A offerings from the registration rights, that exclusion should be added to the language to avoid any dispute...

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    The Division of Corporation Finance’s Disclosure Review And Comment Process

    Tuesday, April 10, 2018, 8:17 AM [General]
    0 (0 Ratings)

    Those that regularly read my blog know that I sometimes like to go back to basics. This blog will revisit and discuss the SEC’s Division of Corporation Finance (“CorpFin”) comment and review process. Back in March 2016, I wrote about the SEC comment and review process, including a description of the internal review process, review levels and breakup of industry sector reviewers. That blog can be read HERE.  Since that time, the SEC has eliminated the Tandy Letter requirement. See HERE. Furthermore, on March 22, 2018, CorpFin updated its “Filing Review Process” page on the SEC website.

    At the end of each calendar year, the big four accounting firms generally publish studies on CorpFin’s Comment Priorities. Their studies, and other recent publications, uniformly found that the number of comments, especially in a registration process, has dramatically declined.  I have noticed this trend as well in my practice.

    Also consistent in reports is a list of recent comment priorities, including: (i) non-GAAP financial measures (see HERE for more information on this topic; (ii) application of the new revenue recognition standards; (iii) disclosure of cyber risks and cyber incidents; (iii) management, discussion and analysis presentation and disclosures, including segment reporting and income taxes; (iv) disclosures of intangible assets and goodwill; (v) state sponsors of terrorism; (vi) related to acquisitions, mergers and business combinations; and (vii) signatures, exhibits and agreements.

    This past year, in September 2017, the SEC Office of Inspector General published an Evaluation of the Division of Corporation Finance’s Disclosure Review and Comment Letter Process (the “September 2017 Report”). The purpose of the Inspector General’s examination and report was to review CorpFin’s process for issuing, tracking and facilitating public access to comment letters and related correspondence.

    In addition to summarizing the September 2017 Report, this blog includes information on the updated CorpFin Filing Review Process page and general commentary and information on the process.


    The SEC Division of Corporation Finance (CorpFin) reviews and comments upon filings made under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”).  The purpose of a review by CorpFin is to ensure compliance with the disclosure requirements under the federal securities laws, including Regulation S-K and Regulation S-X, and the general anti-fraud provisions which require disclosure of material information necessary to make required disclosures, not misleading. The standard for required disclosure is generally the materiality of the information. 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.

    CorpFin selectively reviews filings, although generally all first-time filings, such as an S-1 for an initial public offering or Form 10 registration under the Exchange Act, are fully reviewed.  The Sarbanes-Oxley Act of 2002 requires that CorpFin review all public companies at least once every three years. Section 408 of the Sarbanes-Oxley Act requires CorpFin to focus on companies that have the largest market capitalization. Section 508 of the Sarbanes-Oxley Act specifies certain factors that the SEC should consider when scheduling reviews, including market capitalization, financial restatements, volatility of the company’s stock price and the price/earnings ratio.

    There are three basic levels of review. A review by CorpFin can be a “full review” in which CorpFin will review a filing from cover to cover, including both legal and accounting aspects and basic form for compliance with the federal securities laws. A partial review may include either legal or accounting, but generally a partial review is related to financial statements and related disclosures, including Management Discussion and Analysis of Financial Condition and Results of Operations, and is completed by CorpFin accounting staff. A review may also be a targeted review in which CorpFin will examine the filing for one or more specific items of disclosure. Moreover, although not a designated level of review, CorpFin sometimes “monitors” a filing, which is a term used for a light review.

    Reviewers are appointed files based on industry sectors. CorpFin has broken down its reviewers into the following 11 broad industry sectors: healthcare and insurance; consumer products; information technologies and services; natural resources; transportation and leisure; manufacturing and construction; financial services; real estate and commodities; beverages, apparel and mining; electronics and machinery and telecommunications.  Each industry office is staffed with an assistant director and approximately 25 to 35 professionals, primarily accountants and lawyers.  Each filing has more than one reviewer with a frontline contact person and supervisor.  A full review file will have an accounting and legal reviewer as well as a supervisor.

    Internally at CorpFin, a file will have a reviewer and an examiner. The examiner conducts an initial review and recommends comments to the reviewer. The reviewer may accept the examiner’s work, add comments or remove proposed comments. In addition, other CorpFin support offices may propose comments for a particular company. Each participant in the process is required to keep detailed notes and reports and upload the information into an internal workstation.

    Neither the SEC nor the CorpFin evaluates the merits of any transaction or makes an assessment or determination as to whether a transaction or company is appropriate for any particular investor or the marketplace as a whole.  The purpose of a review is to ensure compliance with the disclosure requirements of the securities laws.  In that regard, CorpFin may ask for increased risk factors and clear disclosure related to the merits or lack thereof of a particular transaction, but they do not assess or comment upon those merits beyond the disclosure.

    Comment Letters and Responses

    Comment letters are based on a company’s filings and other public information about the company. For instance, CorpFin will review press releases and a company’s website, management communications and speeches, and conference presentations in addition to the company’s filings with the SEC. In comment letters, CorpFin may ask that a company provide additional supplemental information to the staff (such as backup materials to justify factual information such as reference to reports, statistics, market or industry size, etc.), revise disclosure in the document, provide additional disclosure in the reviewed filing or provide additional or different disclosure in future filings. Where a change is requested in future filings, intended disclosures may be provided in the comment letter response for SEC advance approval.

    A company generally responds to the particular comment letter with a responsive letter that addresses each comment and, where appropriate, amended filings on the particular report(s) being commented upon. The response letter may refer to changes made in a filing in response to the comment or provide reasoning or explanations as to why a change was not made or in support of a particular disclosure.  CorpFin then may issue additional comment letters either on the same question or issue, or additional questions or issues as it continues its review, and analyze the company’s responses.  Where a comment letter asks for additional disclosure in future filings, proposed language should be provided to avoid an additional comment once the disclosure is made.

    Each comment response should clearly present the company’s position on the pertinent issue in a way that will persuade CorpFin that it is the correct position. Comment responses should cite applicable SEC rules and guidance, and accounting authority (as the comments themselves most often do). Responses should explain how the company’s approach serves to satisfy the SEC’s requirements while providing good disclosure to investors. Responses should address the company’s unique facts and circumstances, and should avoid conclusory or argumentative statements. If it is the company’s position that the technical application of the rule will place too large of a burden on the company, the company should explain how it is burdened and how the alternative provided by the company will provide adequate disclosure for investors.

    The comment-and-response process continues until the staff has resolved all comments. No sooner than 20 business days after completion of its review, the SEC will upload all comment letters and responses to the EDGAR database. These comment letters and responses are searchable but are organized by company, not topic, making particular topic searches difficult. When generally searching for comments and responses on a specific topic, third-party advanced searching software is helpful.

    Although the basic process involves letters and responses, the CorpFin staff is available to discuss comments with a company and its legal, accounting and other advisors. The process can and often does involve such conversations. CorpFin will not give legal or accounting advice, but it will talk through comments and responses and discuss the analysis and adequacy related to disclosures. The initial comment letter received from CorpFin will have the reviewer’s direct contact information. The back-and-forth process does not require a formal protocol other than the required written response letter. That is, a company or its advisors may engage in conversations regarding comments, or request the staff to reconsider certain comments prior to putting pen to paper.

    Moreover, CorpFin encourages this type of conversation, especially where the company or its advisors do not understand a particular comment.  The staff would rather discuss it than have the company guess and proceed in the wrong direction. Where the staff suggests that a company should revise its disclosure or its financial statements, the company may, and should as appropriate, provide the staff with a written explanation of why it provided the disclosure it did. This explanation may resolve the comment without the need for the requested amendment. A CorpFin review is not an attack and should not be approached as such. My experience with CorpFin has always been pleasant and involves a type of collaboration to improve company disclosures.

    A company may also “go up the ladder,” so to speak, in its discussion with the CorpFin review staff.  Such further discussions are not discouraged or seen as an adversarial attack in any way. For instance, if the company does not understand or agree with a comment, it may first talk to the reviewer.  If that does not resolve the question, they may then ask to talk to the particular person who prepared the comment or directly with the legal branch chief or accounting branch chief identified in the letter. A company may even then proceed to speak directly with the assistant director, deputy director, and then even director. Matters of legal disclosure or application of GAAP accounting principles are not an exact science, and discussions are encouraged such that the end result is an enhanced disclosure by the company and consistent disclosures across different companies. The SEC provides all of these individuals contact information on its website and will willingly engage in productive conversations with a company.

    When responding to comment letters and communicating with SEC staff, it is important that a person who understands the process, such as SEC counsel, take the lead in communication. Responses should be consistent, both related to a particular comment letter and over time. A company that flip-flops on accounting treatment or disclosures will lose credibility with the SEC and invoke further review and comments.

    CorpFin is also willing to provide a reasonable amount of extra time to respond to comment letters when requested. Most comment letters request a response within 10 days. CorpFin is usually willing to give an extra 10 days but will balk at much longer than that without a very good reason by the company for the delay.

    If the reviewed filing is a Securities Act registration statement, such as an S-1, the CorpFin staff will verbally inform the company that it has cleared comments and the company may request that the SEC declare the registration statement effective. Where the reviewed filing is an Exchange Act filing that does not need to be declared effective, CorpFin will provide the company with a letter stating that it has resolved all of its comments.

    September 2017 Report

    The September 2017 Report reveals that CorpFin is developing a new system to improve and streamline certain aspects of the disclosure review process. The new system is called the System for Workflow Activity Tracking, which is referred to as SWAT. SWAT will automate certain aspects of the review process such as providing notifications of filing review status to other review team members. In addition, SWAT will generate a draft comment letter based on comments input into and approved within the system. The reviewer or another designated member of the relevant assistant director’s staff will review and revise the draft letter to ensure that it meets CorpFin’s policies for format, tone, and content. Once the draft letter is approved, a final comment letter will be generated within SWAT.

    In its examination, the Office of Inspector General found that: (i) examiners and reviewers did not always properly document comments before issuing comment letters to companies; (ii) some case files were incomplete as of the date CorpFin issued a comment letter to a company; and (iii) examiners and reviewers inconsistently documented oral comments to companies.

    As a result, the Office of Inspector General made three recommendations for CorpFin to improve its internal process. In particular, CorpFin should: (i) establish a mechanism or control for staff members to trace all comments provided to companies for inclusion in examiner and reviewer reports before issuing comment letters; (ii) establish a mechanism or control that ensures the staff follows policies to upload all examiner and reviewer reports to the internal workstation before issuing comment letters; and (iii) establish detailed guidance on how examiners and reviewers should document oral comments provided to companies during disclosure reviews. The recommendations were agreed to and will be closed upon verification that the corrective measures have been implemented. It is anticipated that the full implementation of the SWAT process will effectively resolve these issues as well.


    A company can stay prepared for comment letters, and responses, by making sure it has adequate internal controls and procedures for reporting.  The company should also stay on top of SEC guidance on disclosure matters, which can be accomplished by ensuring that the company has experienced SEC counsel that, in turn, stays up to date on all SEC rules, regulations and guidance. Likewise, the company should retain an accountant that monitors up-to-date accounting pronouncements and guidance. The company should maintain a file with backup materials for any disclosures made, including copies of reference materials for third-party disclosure items. In responding to comments, it is helpful to review other companies’ comment response letters and disclosures on particular issues. Where the SEC has requested changes in future filings, the company and its counsel must be sure to continuously monitor to be sure those changes are included.  As mentioned, the SEC reviews public information on the company, including websites and press releases and accordingly, these materials should be reviewed for consistency in SEC reports.

    Although a full discussion of confidential treatment and requests is beyond the scope of this blog, a company may seek confidential treatment of materials and responses to comments under Rule 83. Rule 83 requires the company to respond to comments with two separate letters: one containing the confidential information, and the other not. Unlike confidential treatment requests under Rules 406 and 24b-2, a confidential treatment request for a comment response letter does not require that the company provide a justification for such confidential treatment.  However, if a Freedom of Information Act (FOIA) request is submitted by a third party related to such comment letter response, the SEC will inform the company and request justification for continued confidential treatment. Confidential treatment under Rule 83 expires after 10 years unless a renewal is requested. Both Rule 83 and other confidential treatment rules require very specific transmittal procedures, and the documents must all clearly indicate that confidential treatment is requested.

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    The SEC’s 2018 Flex Regulatory Agenda

    Tuesday, April 3, 2018, 8:11 AM [General]
    0 (0 Ratings)

    In December 2017, the SEC posted its latest version of its semiannual regulatory agenda and plans for rulemaking with the U.S. Office of Information and Regulatory Affairs. Prior to issuing the agenda, SEC Chair Jay Clayton had promised that the SEC’s regulatory agenda’s would be “more realistic” and he seems to have been true to his word.

    The agenda is separated into two categories: (i) Existing Proposed and Final Rule Stages; and (ii) Long-term Actions. The Existing Proposed and Final Rule Stages are intended to be completed within the next 12 months and Long-term Actions are anything beyond that. The semiannual list published in July 2017 only contained 33 legislative action items to be completed in a 12-month time frame, and the newest list is down to 26 items, whereas the prior fall 2016 list had 62 items.

    The Unified Agenda of Regulatory and Deregulatory Actions

    The Office of Information and Regulatory Affairs, which is an executive office of the President, publishes a Unified Agenda of Regulatory and Deregulatory Actions (“Agenda”) with actions that 60 departments, administrative agencies and commissions plan to issue in the near and long term. The Agenda is published twice a year, though the fall edition contains statements of regulatory priorities and additional information about the most significant regulatory activities planned for the coming year. Interestingly, the SEC did not include a statement on regulatory priorities, letting the list speak for itself.

    The Office of Information and Regulatory Affairs, under the current administration, has stated that the Agenda “represents the beginning of fundamental regulatory reform and a reorientation toward reducing unnecessary regulatory burden on the American people.” Furthermore, the Office states, “[B]y amending and eliminating regulations that are ineffective, duplicative, and obsolete, the Administration can promote economic growth and innovation and protect individual liberty.”

    Executive Orders 13771 and 13777 require agencies to reduce unnecessary regulatory burden and to enforce regulatory reform initiatives.  Each agency was requested to carefully consider the costs and benefits of each regulatory or deregulatory action and to prioritize to maximize the net benefits of any regulatory action. The SEC is not the only agency with a reduced Agenda. In total, agencies withdrew 1,579 actions that were initially proposed in the fall 2016 Agenda.  Agencies moved 700 actions to either long-term or inactive. Also, adding transparency for those of us who like to stay up on these matters, the agencies will now post and make public their list of “inactive” rules.

    SEC Flex Regulatory Agenda

    On the agenda in the final rule stages are Regulation S-K disclosure updates and simplification rule changes we have all expected. The proposed rule change was issued in October 2017, a summary of which can be read HERE.  Included in the final rule stage is amendments to smaller reporting company definition (see HERE), and regulation of NMS Stock Alternative Trading Systems. Amendments to the interactive data (XBRL) program have been moved up from proposed to final rule stage since July 2017.

    Also included for final rules are the treatment of communications involving security-based swaps, modernization of property disclosure for mining companies, investment company reporting modernization and amendments to the investment advisor act, disclosure handling information, amendments to covered securities under Section 18 of the Securities Act and amendments to municipal securities rules.

    Items of interest in the proposed rule stage include amendments to financial disclosures about entities other than the registrant (see HERE), implementation of FAST Act report recommendations (see HERE), disclosure of payments by resource extraction issuers, amendments to the financial disclosure for registered debt security offerings, auditor independence with respect to loans or debtor-creditor relationships, various rules related to the Investment Company Act and Investment Advisors Act, and amendments to the Whistleblower Program Rules.

    Rule on exchange traded products, personalized investment advice standard of conduct, and disclosures of payments by resource extraction issuers were moved from long-term to the proposed rule stage.

    Removed from the July 2017 Existing Proposed and Final Rule Stages list and added to long-term actions are rules related to business and financial disclosure required by Regulation S-K, reporting on proxy votes on executive compensation (i.e., say-on-pay – see HERE), transfer agents (see HERE), Form 10-K summary, and revisions to audit committee disclosures.

    Items on the long-term agenda which were also on the July 2017 long-term list include registration of security-based swaps, universal proxy, corporate board diversity, investment company advertising, stress testing for large asset managers, prohibitions of conflicts of interest relating to certain securitizations, definitions of mortgage-related security and small-business-related security, standards for covered clearing agencies, and risk mitigation techniques.

    Other items of interest on the long-term action list include Regulation Crowdfunding amendments, business, financial and management disclosure required by Regulation S-K, hedging disclosures, several securities-based swaps regulatory actions, conflict minerals amendments, amendments to Guide 5 on real estate offerings and Form S-11, extending testing-the-waters provisions to non-emerging growth companies, and incentive-based compensation arrangements.

    Regulation A amendments are on the long-term action list. I am hopeful that these amendments may include an increase in the offering limits and opening up Regulation A to reporting issuers.  See HERE.

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

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

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    The SEC Has Issued New Guidance On Cybersecurity Disclosures

    Tuesday, March 27, 2018, 9:34 AM [General]
    0 (0 Ratings)

    On February 20, 2018, the SEC issued new interpretative guidance on public company disclosures related to cybersecurity risks and incidents. In addition to addressing public company disclosures, the new guidance reminds companies of the importance of maintaining disclosure controls and procedures to address cyber-risks and incidents and reminds insiders that trading while having non-public information related to cyber-matters could violate federal insider-trading laws.

    The prior SEC guidance on the topic was dated, having been issued on October 13, 2011. For a review of this prior guidance, see HERE. The new guidance is not dramatically different from the 2011 guidance.


    The topic of cybersecurity has been in the forefront in recent years, with the SEC issuing a series of statements and creating two new cyber-based enforcement initiatives targeting the protection of retail investors, including protection related to distributed ledger technology (DLT) and initial coin or cryptocurrency offerings (ICO’s). Moreover, the SEC has asked the House Committee on Financial Services to increase the SEC’s budget by $100 million to enhance the SEC’s cybersecurity efforts. See my two-part blog series, including a summary of the recent speeches and initiatives, HERE and HERE.

    The SEC incorporates cybersecurity considerations in its disclosure and supervisory programs, including in the context of its review of public company disclosures, its oversight of critical market technology infrastructure, and its oversight of other regulated entities, including broker-dealers, investment advisors and investment companies. Considering rapidly changing technology and the proliferation of cybersecurity incidents affecting both private and public companies (including a hacking of the SEC’s own EDGAR system and a hacking of Equifax causing a loss of $5 billion in market cap upon disclosure), threats and risks, public companies have been anticipating a needed update on the SEC disclosure-related guidance.

    SEC Commissioner Kara Stein’s statement on the new guidance is grim on the subject, pointing out that the risks and costs of cyberattacks have been growing and could result in devastating and long-lasting collateral affects. Commissioner Stein cites a Forbes article estimating that cyber-crime will cost businesses approximately $6 trillion per year on average through 2021 and an Accenture article citing a 62% increase in such costs over the last five years.

    Commissioner Stein also discusses the inadequacy of the 2011 guidance in practice and her pessimism that the new guidance will properly fix the issue.  She notes that most disclosures are boilerplate and do not provide meaningful information to investors despite the large increase in the number and sophistication of, and damaged caused by, cyberattacks on public companies in recent years. Commissioner Stein includes a list of requirements that she would have liked to see in the new guidance, including, for example, a discussion of the value to investors of disclosing whether any member of a company’s board of directors has experience, education, expertise or familiarity with cybersecurity matters or risks.

    I have read numerous media articles and blogs related to the disclosure of cyber-matters in SEC reports. One such blog was written by Kevin LaCroix and published in the D&O Diary. Mr. LaCroix’s blog points out that according to a September 19, 2016, Wall Street Journal article, cyber-attacks are occurring more frequently than ever but are rarely reported. The article cites a report that reviewed the filings of 9,000 public companies from 2010 to the present and found that only 95 of these companies had informed the SEC of a data breach.

    As reported in a blog published by Debevoise and Plimpton, dated September 12, 2016, (thank you,, a review of Fortune 100 cyber-reporting practices revealed that most disclosures are contained in the risk-factor section of regular periodic reports such as Forms 10-Q and 10-K, as opposed to interim disclosures in a Form 8-K. Moreover, only 20 incidents were reported at all in the period from January 2013 through the third quarter of 2015.

    However, as Commissioner Stein notes, the SEC only has so much authority or power through guidance, as opposed to rulemaking.  Commissioner Stein strongly advocates for new rulemaking in this regard. I do not think in the current environment advocating for fewer rules, that rulemaking related to cybersecurity disclosurewill be made a priority. Moreover, I would not advocate for in-depth or robust further rules.  Disclosure is based on materiality, and a company has an ongoing obligation to disclose any material information, including that which is related to cybersecurity matters. I think the SEC can question principals-based specific disclosures, and whether they are robust enough, through review and comment on public company filings.  Certainly, the SEC staff, who reviews thousands of filings, has the knowledge of a lack of cybersecurity disclosure and can comment. In fact, if the SEC wrote a few standard cybersecurity-related disclosure comments and included them in a lot of comment letters, the marketplace would respond accordingly and beef up disclosure to avoid the comments.

    Although I do not generally advocate for additional rules, Commissioner Stein makes one suggestion that I would support and that is adding the disclosure of cybersecurity event to the Form 8-K filing requirements. Although the new SEC guidance does not specifically require a Form 8-K, in light of the importance of these events, it seems it would be appropriate and the guidance itself requires “timely disclosure.”  However, without a specific requirement, a company could elect to disclose via a press release and/or the filing of a Form 8-K under Item 7.01 Regulation FD disclosure. When disclosing using a press release and Regulation FD item in a Form 8-K, a company may elect for the information to be “furnished, not filed.” Section 18 of the Exchange Act imposes liability for material misstatements or omissions contained in reports and other information filed with the SEC. However, reports and other information that are “furnished” to the SEC do not impose liability under Section 18. The antifraud provisions under Rule 10b-5 would still apply to the disclosure, but the stricter Section 18 liability would not.

    New Guidance on Public Company Cybersecurity Disclosures

    The new guidance begins with an introduction describing the importance of cybersecurity in today’s business world, driving the point home by comparing it to the importance of electricity. Cyber-incidents can take many forms, both intentional and unintentional, and commonly include the unauthorized access of information, including personal information related to customers’ accounts or credit information, data corruption, misappropriating assets or sensitive information or causing operational disruption. Attacks use increasingly complex methods, including malware, ransomware, phishing, structured query language injections and distributed denial-of-service attacks. A cyber-attack can be in the form of unauthorized access or a blocking of authorized access.

    The purpose of a cyber-attack can vary as much as the methodology used, including for financial gain such as the theft of financial assets, intellectual property or sensitive personal information on the one hand, to a vengeful or terrorist motive through business disruption on the other hand. Perpetrators may be insiders and affiliates, or third parties including cybercriminals, competitors, nation-states and “hacktivists.”

    When victim to a cyber-attack or incident, a company will have direct financial and indirect negative consequences, including but not limited to:

    • Remediation costs, including liability for stolen assets, costs of repairing system damage, and incentives or other costs associated with repairing customer and business relationships;
    • Increased cybersecurity protection costs to prevent both future attacks and the potential damage caused by same. These costs include organizational changes, employee training and engaging third-party experts and consultants;
    • Lost revenues from unauthorized use of proprietary information and lost customers;
    • Litigation;
    • Increased insurance premiums;
    • Damage to the company’s competitiveness, stock price and long-term shareholder value; and
    • Reputational damage.

    Whereas the 2011 disclosure guidance was conservative in its tone, trying to strike a balance between satisfying the disclosure mandates of providing material information related to risks to the investing community with a company’s need to refrain from providing disclosure that could, in and of itself, provide a road map to the very breaches a company attempts to prevent, the new guidance is more blunt in the critical need to inform investors about material cybersecurity risks and incidents when they occur.

    A company’s ability to timely and properly make any required disclosure of cybersecurity risks and incidents requires the company to implement and maintain disclosure controls and procedures that provide an appropriate method of discerning the impact that such matters may have on the company and its business, financial condition, and results of operations, as well as a protocol to determine the potential materiality of such risks and incidents.

    Insider Trading

    It is also important that public company officers, directors and other insiders respect the importance and materiality of cybersecurity risk and incident knowledge and not trade a company’s security when in possession of non-public information related to cybersecurity matters.  In that regard, companies should include cybersecurity matters in their insider trading policies and procedures. These insider trading policies should (i) guard against trading in the period between when a company learns of a cybersecurity incident and the time it is made public; and (ii) require the timely disclosure of such non-public information.


    Public companies have many disclosure requirements, including through periodic reports on Forms 10-K, 10-Q and 8-K, through Securities Act registration statements such as on Forms S-1 and S-3 and generally through the antifraud provisions of both the Exchange Act and Securities Act, which requires a company to disclose “such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.” The SEC considers omitted information to be material if there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision or that disclosure of the omitted information would have been viewed by the reasonable investor as having significantly altered the total mix of information available.

    As with all disclosure requirements, the disclosure of cybersecurity risk and incidents requires a materiality analysis. Although there continues to be no specific disclosure requirement or rule under either Regulation S-K or S-X that addresses cybersecurity risks, attacks or other incidents, many of the disclosure rules encompass these disclosures indirectly, such as risk factors, internal control assessments, management discussion and analysis, legal proceedings, disclosure controls and procedures, corporate governance and financial statements. As mentioned, as with all other disclosure requirements, an obligation to disclose cybersecurity risks, attacks or other incidents may be triggered to make other required disclosures not misleading considering the circumstances.

    A company has two levels of cybersecurity disclosure to consider. The first is its controls and procedures and corporate governance to both address cybersecurity matters themselves and to address the timely and thorough reporting of same. The second is the reporting of actual incidents.  In determining the materiality of a particular cybersecurity incident, a company should consider (i) the importance of any compromised information; (ii) the impact of an incident on company operations; (iii) the nature, extent and potential magnitude of the event; and (iv) the range of harm such incident can cause, including to reputation, financial performance, customer and vendor relationships, litigation or regulatory investigations.

    Of course, the new guidance is also clear that a company would not need to disclose the depth of information that could, in and of itself, provide information necessary to breach cyber-defenses. A company would not need to disclose specific technical information about cybersecurity systems, related networks or devices or specific devices and networks that may be more susceptible to attack due to weaker systems.

    The new guidance also reminds companies that they have a duty to correct prior disclosures that the company determines were untrue at the time material information was made or omitted, and to update disclosures that become inaccurate after the fact.

    Like the prior guidance, the new guidance provides specific input into areas of disclosure.

    Risk Factors

    Obviously, where appropriate, cybersecurity risks need to be included in risk factor disclosures. The SEC guidance in this regard is very common-sense. Companies should evaluate their cybersecurity risks and take into account all available relevant information, including prior cyber-incidents and the severity and frequency of those incidents. Companies should consider the probability of an incident and the quantitative and qualitative magnitude of the risk, including potential costs and other consequences of an attack or other incident.  Consideration should be given to the potential impact of the misappropriation of assets or sensitive information, corruption of data or operational disruptions. A company should also consider the adequacy of preventative processes and plans in place should an attack occur.  Actual threatened attacks may be material and require disclosure.

    As with all risk-factor disclosures, the company must adequately describe the nature of the material risks and how such risks affect the company. Likewise, generic risk factors that could apply to all companies should not be included. Risk factor disclosure may include:

    • Discussion of the company’s business operations that give rise to material cybersecurity risks and the potential costs and consequences, including industry specific risks and third-party and service-provider risks;
    • The costs associated with maintaining cybersecurity protections, including insurance coverage;
    • The probability of an occurrence and its potential magnitude;
    • Potential for reputational harm;
    • Description of past incidents, including their severity and frequency;
    • The adequacy of preventative actions taken to reduce cybersecurity risks and the associated costs, including any limits on the company’s ability to prevent or mitigate risks;
    • Existing and pending laws and regulations that may affect the companies cybersecurity requirements and the associated costs; and
    • Litigation, regulatory investigation and remediation costs associated with cybersecurity incidents.

    Management Discussion and Analysis (MD&A)

    In MD&A a company should consider all the same factors that it would consider in its risk factors.  A company would need to include discussion of cybersecurity risks and incidents in its MD&A if the costs or other consequences associated with one or more known incidents or the risk of potential future incidents result in a material event, trend or uncertainty that is reasonably likely to have a material effect on the company’s results of operations, liquidity or financial condition, or could impact previously reported financial statements. The discussion should include any material realized or potential reduction in revenues, loss of intellectual property, remediation efforts, maintaining insurance, increase in cybersecurity protection costs, addressing harm to reputation and litigation and regulatory investigations.  Furthermore, even if an attack did not result in direct losses, such as in the case of a failed attempted attack, but does result in other consequences, such as a material increase in cybersecurity expenses, disclosure would be appropriate.

    Business Description; Legal Proceedings

    Disclosure of cyber-related matters may be required in a company’s business description where they affect a company’s products, services, relationships with customers and suppliers or competitive conditions. Likewise, material litigation would need to be included in the “legal proceedings” section of a periodic report or registration statement. The litigation disclosure should include any proceedings that relate to cybersecurity issues.

    Financial Statements

    Cyber-matters may need to be included in a company’s financial statements prior to, during and/or after an incident. Costs to prevent cyber-incidents are generally capitalized and included on the balance sheet as an asset. GAAP provides for specific recognition, measurement and classification treatment for the payment of incentives to customers or business relations, including after a cyber-attack.  Cyber-incidents can also result in direct losses or the necessity to account for loss contingencies, including those related to warranties, direct loss of revenue, providing customers with incentives, breach of contract, product recall and replacement, indemnification or remediation. Incidents can result in loss of, and therefore accounting impairment to, goodwill, intangible assets, trademarks, patents, capitalized software and even inventory.  Financial statement disclosure may also include expenses related to investigation, breach notification, remediation and litigation, including the costs of legal and other professional service providers.

    Broad Risk Oversight

    A company must disclose the extent of its board of directors’ role in the risk oversight of the company, such as how the board administers its oversight function and the effect this has on the board’s leadership structure. To the extent cybersecurity risks are material to a company’s business, this discussion should include the nature of the board’s role in overseeing the management of that risk. Information should also be included on how the board engages with management on cybersecurity risk management.

    Controls and Procedures

    The new guidance clearly provides that companies should adopt comprehensive policies and procedures related to cybersecurity and to assess their compliance regularly, including policy/procedure compliance related to the sufficiency of disclosure controls and procedures.  Procedures must address a company’s ability to record, process, summarize and report financial and other information in SEC filings.  Additionally, any deficiency in these controls and procedures should be reported.

    The SEC reminds companies that their principal executive officer and principal financial officer must make individual certifications regarding the design and effectiveness of disclosure controls and procedures. These certifications should take into account cybersecurity-related controls and procedures.

    Furthermore, as discussed above, a company should have proper policies and procedures preventing officers, directors and other insiders from trading on material nonpublic information related to cybersecurity risks and incidents.

    Regulation FD and Selective Disclosure

    Companies may have disclosure obligations under Regulation FD related to cybersecurity matters. Under Regulation FD, “when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons it must make public disclosure of that information.” The SEC reminds companies that these requirements also relate to cybersecurity matters and that, along with all the other disclosure requirements, policies and procedures should specifically address any disclosures of material non-public information related to cybersecurity...

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    OTC Markets Issues Comment Letters On FINRA Rules 6432 And 5250; The 15c2-11 Rules

    Tuesday, March 20, 2018, 8:23 AM [General]
    0 (0 Ratings)

    January 8, 2018, OTC Markets Group, Inc. (“OTC Markets”) submitted a comment letter to FINRA related to FINRA Rule 6432.  Rule 6432 requires that a market maker or broker-dealer have the information specified in Securities Exchange Act Rule 15c2-11 before making a quotation in a security on the over-the-counter market. Although I summarize the salient points of the OTC Markets comment letter, I encourage those interested to read the entire letter, which contains an in-depth analysis and comprehensive arguments to support its position. On February 8, 2018, OTC Markets submitted a second comment letter to FINRA, this one related to FINRA Rule 5250.  Rule 5250 prohibits companies from compensating market makers in connection with the preparation and filing of a Form 211 application.

    Rule 6432 – Compliance with the Information Requirements of SEA Rule 15c2-11

    Subject to certain exceptions, including the “piggyback exception” discussed below, Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange traded company security prior to resuming or initiating a quotation of that security.  Generally, a non-exchange traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA. Although the rule requires that the Form 211 be filed at least three days prior to initiating a quotation, in reality FINRA reviews and comments on the filing in a back-and-forth process that can take several weeks or even months.

    The specific information required to be maintained by the broker-dealer is delineated in Securities Exchange Act (“Securities Act”) Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace.  The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or under Regulation A and quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv).

    In addition, Rule 6432 requires the submittal of specified information about the security being quoted (for example, common stock, an ADR or warrant), the quotation medium (for example, OTCQB) and if priced, the basis upon which the price was determined.

    Rule 6432 requires a certification confirming that the member broker-dealer has not accepted any payment or other consideration in connection with the submittal of the Form 211 application as prohibited by Rule 5250.

    Rule 15c2-11(f)(2) allows a member firm to quote or process an unsolicited order on behalf of a customer without compliance with the information requirements. In such case, the member must document the name of the customer, date and time of the unsolicited order and identifying information on the security.

    Rule 5250 – Payments for Market Making

    Rule 5250 specifically prohibits a market maker from accepting any payments or other consideration, directly or indirectly, in association or connection with publishing a quotation, acting as a market maker or submitting an application in connection therewith. In other words, a market maker cannot accept any consideration whatsoever for preparing and submitting a Form 211 application with FINRA.

    However, the fact is that putting together the information required by the Form 211 and responding to FINRA comments takes administrative time and effort, and I would advocate that a broker-dealer should be able to accept some form of compensation to cover this internal expense. Moreover, the Form 211 process has changed over time, becoming much more arduous for the submitting market maker. I remember when a Form 211 could actually be submitted three days prior to a quotation and based on the market maker’s assertion that they were in possession of the required information, the Form was processed, oftentimes in 24 hours.

    Today, a Form 211 goes through an extensive review, comment and response process similar to an SECreview of a filing. The comment and review process is completed when FINRA either clears the Form 211 or refuses to clear the Form. The market maker is required to provide FINRA with a copy of all information and documents in their possession, and FINRA reviews the information and challenges the market maker’s position that the information is adequate. This process takes weeks at a minimum and oftentimes much longer.

    Since a market maker cannot even cover their internal costs for this labor-intensive process, fewer market makers are willing to engage in the process at all.

    The “Piggyback” Exception

    The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted on at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed and approved by FINRA by a market maker and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted.

    As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.

    The OTC Markets Comment Letter on Rule 6432

    The opening paragraph of OTC Markets’ comment letter sets the tone for the entire letter, stating, “[W]e continue to believe that the cumbersome operational processes around Rule 6432, and the related Rule 15c2-11… under the… Exchange Act, unnecessarily impede capital formation by small issuers.” They continue, and I agree, that the process creates an unnecessary difficulty on smaller companies seeking to access public markets in the U.S.

    OTC Markets suggests that the recent boom in ICO’s is a natural response to the difficulties with navigating the capital and secondary markets for smaller companies, including the Form 211 process, DTC eligibility,  depositing non-exchange traded securities (see HERE, which factors have only intensified since publication of that blog), and market liquidity. A re-working of Rule 6432 and the interaction with the 45-year-old Rule 15c2-11 would help improve the marketplace dramatically.

    Rule 15c2-11 was enacted in 1970 to ensure that proper information was available prior to quoting a security in an effort to prevent microcap fraud.  At the time of enactment of the rule, the Internet was not available for access to information. The premise of the rule was to require broker-dealers, who would be quoting the securities, to maintain information and provide that information to investors upon request. Rule 6432 requires FINRA member firms to comply with Rule 15c2-11 by filing a Form 211 with FINRA. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Moreover, since enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures.

    The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through. OTC Markets proposes the following changes to Rule 6432 and its administration:

    (i) Make the Form 211 review process more objective and efficient. FINRA’s role should be changed from a subjective gatekeeper to an objective administrator, only ensuring that the market maker has the required information. FINRA should not review the merits of the information itself. Furthermore, FINRA should be bound by the three-day requirement set forth in Rule 15c2-11 such that a market maker can proceed with a quote (and receive a ticker symbol where necessary) within the mandated three days. The goal should be to ensure a market maker has the information mandated by Rule 15c2-11, that such information is publicly available for the investing community, and that an issuer has the responsibility for the accuracy of the information.

    I agree with this suggestion. FINRA can adequately address its gatekeeper role in its annual or biannual audit and review of member firms.  Moreover, if FINRA believes that a member firm has violated its requirements under Rule 6432, as a self-regulatory organization, it has the authority and ability to institute an investigation into such member firm. By performing subjective reviews of the information itself and merits of such information, FINRA is asserting substantive control over issuers for which it lacks jurisdiction and for which such issuer has no due process rights or recourse. The same overreaching of authority relates to Rule 6490 and the processing of corporate actions. See HERE. The SEC itself, who has direct jurisdiction over a company, does not review the merits of a company’s operations, business model or capital structure, but rather only the proper disclosure of same such that an investor can make an informed decision. FINRA, who does not have direct jurisdiction or governing authority over a company, has found a way to exert subjective influence, without due process, or even published rules or information as to the criteria used in their subjective analysis.

    (ii) Form 211 materials should be made public and issuers should be liable for any misrepresentations. Currently, Form 211 materials are not publicly available. Making the information publicly available would further the clear objective of SEC Rule 15c2-11.

    In practice, as part of its review process, FINRA not only requests additional information, but often material non-public information, which is not only beyond the scope of Rule 15c2-11, but which information has no reasonable expectation of being made public. Clearly, if information is important for the marketplace and investors to make informed investment decisions, it should be required by the rules and should be publicly available.

    (iii) Outsource Form 211 processes to IDQS’s.  A broker-dealer should file a Form 211 directly with the interdealer quotation system (IDQS) on which it plans to quote the security. The IDQS should review such information for completeness and submit the package to FINRA within the three-day rule time frame. Also, FINRA member IDQS’s should be allowed to submit their own Form 211 application for issuers that meet certain lower risk criteria, such as those already trading on a Qualified Foreign Exchange.

    (iv) Allow IDQS’s to monitor ongoing disclosure and institute trading halts. FINRA member IDQS’s should be responsible for developing a system that ensures ongoing disclosure of Rule 15c2-11 information for quoted securities, including the power to respond to indications of fraud and institute trading halts.

    This seems so obvious to me.  Where FINRA exercises subjective merit reviews of initial Form 211 applications, it then takes no action whatsoever to ensure ongoing current information. I have seen stocks trade large volumes that have been completely dark or devoid of current information for years. By allowing an IDQS to require ongoing public information by an issuer for the privilege of having market makers make markets, the SEC and FINRA would add a layer of gatekeeping responsibility that does not exist today. Separately, I note that OTC Markets does have a system and regime that responds to certain issues, such as improper stock promotion (see HERE), but has no power to institute a trading halt.

    (v) Allow broker-dealer compensation for Form 211 filing. See more discussion on this topic below. I agree that allowing compensation for a Form 211 filing is not only advisable but if structured properly, has no downside. The compensation can be capped and subject to specific disclosure and reasonableness rules, including compliance with Section 17(b) of the Securities Act (see HERE).

    (vi) Allow multiple market makers to quote a security after a Form 211 is cleared. This would replace the current rules of only allowing one market maker to quote a security for the first 30 days. Moreover, I would go further and suggest that the piggyback exception only be allowed if there is publicly available current information.

    Encouraging Capital Markets

    Following its discussion on the rules and suggested changes, the OTC Markets comment letter turns to the need to encourage secondary trading of securities as an important aspect of encouraging capital formation for smaller companies as a whole. Investors are much more likely to participate in capital raising if they have an exit strategy such as a liquid secondary marketplace where they can reasonably deposit and re-sell freely tradeable securities.

    The costs and burdens of being public on a national exchange are a huge disincentive for smaller companies.  The decline in the US IPO markets is a constant discussion by SEC top brass, other regulators and politicians (for example, see HERE and HERE). As the OTC Markets comment letter points out, a small company seeking to raise $10 million to finance a promising new software, is in no position to shoulder the costs and burdens of a national exchange listing, but is also stifled by the inability to properly access liquidity for its investors on IDQS’s such as OTC Markets due to antiquated and improperly administered rules such as Rule 6432.

    In fact, as of today OTC Markets is the only viable operating secondary marketplace for the trading of non-exchange traded public securities. OTC Markets is comprised of three tiers: the OTCQX; the OTCQB and the Pink Open Market. For a review of the OTCQX standards, see HERE. For a review of the OTCQB standards, see HERE. For more information on the Pink Open Market, see HERE.

    By implementing OTC Markets suggested changes to Rule 6432 and its implementation and administration, more small companies would access public markets, better information would be made available to investors and the marketplace, and secondary market liquidity would improve.

    The OTC Markets Comment Letter on Rule 5250

    On February 8, 2018, OTC Markets group submitted a second comment letter to FINRA related to Exchange Act 15c2-11 and its implementation by FINRA. The second letter directly addresses Rule 5250, which prohibits a market maker from accepting any payments or other consideration, directly or indirectly, in association or connection with publishing a quotation, acting as a market maker or submitting an application in connection therewith.

    As discussed above, a Form 211 goes through an extensive review, comment and response process similar to an SEC review of a filing. The comment and review process is completed when FINRA either clears the Form 211 or refuses to clear the Form. The market maker is required to provide FINRA with a copy of all information and documents in their possession, and FINRA reviews the information for completeness but also the merits of the information using undisclosed subjective standards. In response to comments, a market maker must work with a company to provide information, which can often involve material non-public information that is not, and may never be, made public. The process takes weeks at a minimum and oftentimes much longer.

    As a basic premise for the market maker, it must conduct adequate due diligence on the company and properly gather and analyze information prior to submittal to FINRA. The process can be labor-intensive for the market maker.

    Furthermore, part of the process involves the market maker’s analysis and backup for the requested pricing of the security in its initial quotation. When a company goes public on a national exchange, a market maker is not restricted from charging for its investment banking services, including the part of the service that involves a valuation and determination of initial offering price. The process of determination valuation for an initial quote on the OTC Markets is substantially similar. The inability to charge for such service acts as a disincentive for a market maker to give adequate thought and attention to the process.

    Since a market maker cannot even cover their internal costs for this labor-intensive process, fewer market makers are willing to engage in the process at all. Moreover, market makers have no incentive to engage with issuers in completing due diligence or creating on ongoing relationship which ensures access to information, that is made public to the investing community. In addition to assisting investors and the market place in making informed decisions, market maker/company engagement will help detect red flags and indicia of fraud, facilitating the purpose of the rules and benefiting the markets as a whole.

    A responsible rule could be put into place that allows a market maker to charge for their services and encourages productive engagement and communication between a market maker and their client company. The rule should require public disclosure of a market makers fee (as well as the application itself as discussed above). In addition, market makers should be allowed to receive reimbursements for actual out-of-pocket expenses associated with preparing and filing a Form 211. Again, this amount should be fully disclosed to the investment community.

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

    Tuesday, March 13, 2018, 8:16 AM [General]
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    On November 30, 2017, the SEC held its annual Government-Business Forum on Small Business Capital Formation (the “Forum”). It will be several months until the final report with recommendations from the forum is published, but the opening remarks from SEC Chair Jay Clayton and Commissioners Kara Stein and Michael Piwowar provide ongoing and consistent guidance as to the current focus of the SEC. For a review of the recommendations by last year’s forum, see HERE.

    As expected, the topics of cryptocurrency and ICO’s were front and center at the Forum. In his opening remarks at the Forum, Division of Corporation Finance Director William Hinman confirmed that the SECbelieves that ICO’s generally involve securities offerings and that the securities laws must be complied with. Hinman continued that the SEC is providing guidance through enforcement and public statements on the topic.

    As with other statements and speeches, the SEC hedges by pointing out the validity of an ICO as a capital raising tool, and of course, the innovation potential of blockchain. The SEC is not trying to discourage ICO’s or blockchain innovation; they are trying to discourage ICO’s that fail to comply with securities laws, and the unfortunate, multiple frauds being perpetuated as a result of the frenzy surrounding this new technology.

    Remarks by Chairman Jay Clayton

    Chair Clayton is consistent with the theme he has been putting forth since taking office: The SEC is committed to helping Main Street investors. The Forum provides a key opportunity for the small-cap marketplace to have their voices heard regarding issues and desired changes to federal securities regulations and the regulatory system.

    Chair Clayton reiterates the SEC’s three-part mission to (i) protect investors; (ii) maintain fair, orderly and efficient markets; and (iii) facilitate capital formation. Furthermore, although capital formation is important for all businesses, small and medium-sized businesses contribute the most to U.S. job creation, generating 62% of new jobs. Along the same lines, the SEC wants to open more investment opportunities into small businesses for Main Street investors. In that regard, Jay Clayton points out the Regulation A public offering process. As an aside, I was happy to see him recognize Regulation A as an IPO, whereas when he first took office, he seemed to view Regulation A as outside the IPO realm.

    Remarks by Commissioner Michael Piwowar

    Michael Piwowar’s statement was short and pointed. As anyone that follows my blog knows, I am a fan of Piwowar, agreeing with most of his views, and more so his willingness to express those views, even when contrary to other SEC chiefs or the legislature. Mr. Piwowar has been vocal about his disagreement with the pay ratio disclosure requirements mandated by the Dodd-Frank Act and uses his statement as an opportunity to reiterate that view, while pointing out that the recent interpretative guidance on the subject will help with the compliance burden. I have not written about that guidance as of yet, but my prior blog on the pay ratio rules can be read HERE.

    Commissioner Piwowar also points out other SEC actions to assist with small businesses and capital formation, including the newest proposed rules to modernize and simplify disclosures (see HERE) and the SEC’s action to allow all companies to file confidential registration statements (see HERE).

    Commissioner Piwowar ends his statement by promising that he will personally give careful consideration to this year’s recommendations of the Forum. I hope so, as the recommendations are always on point to assist the small-cap marketplace.

    Remarks by Commissioner Kara Stein

    Commissioner Stein began with the usual niceties regarding the forum and its importance for communication between regulators and the small-cap market. Adding her own perspective, Commissioner Stein points out that a lot of the SEC’s effort and rules are “designed to facilitate trust between… market participants – the small businesses seeking to raise capital, the investors who wish to support their growth, and their service providers.”  Continuing to add her own unique voice, Ms. Stein talked about the need for diversity of companies and investors and bringing capital raising (and a voice in the process) to different parts of the country.

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    The Senate Banking Committee’s Hearing On Cryptocurrencies

    Tuesday, March 6, 2018, 8:52 AM [General]
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    On February 6, 2018, the United States Senate Committee on Banking Housing and Urban Affairs (“Banking Committee”) held a hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission.” Both SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo testified and provided written testimony. The marketplace as a whole had a positive reaction to the testimony, with Bitcoin prices immediately jumping up by over $1600. This blog reviews the testimony and provides my usual commentary.

    The SEC and CFTC Share Joint Regulatory Oversight

    The Banking Committee hearing follows SEC and CFTC joint statements on January 19, 2018 and a joint op-ed piece in the Wall Street Journal published on January 25, 2018 (see HERE). As with other areas in capital markets, such as swaps, the SEC and CFTC have joint regulatory oversight over cryptocurrencies. Where the SEC regulates securities and securities markets, the CFTC does the same for commodities and commodity markets.

    Bitcoin has been determined to be a commodity and as such, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Nevertheless, the CFTC does NOT have regulatory jurisdiction over markets or platforms conducting cash or “spot” transactions in virtual currencies or other commodities or over participants on such platforms. These spot virtual currency or cash markets often self-certify or are subject to state regulatory oversight. However, the CFTC does have enforcement jurisdiction to investigate fraud and manipulation in virtual currency derivatives markets and in underlying virtual currency spot markets.

    The SEC does not have jurisdiction over currencies, including true virtual currencies. However, many, if not all, token offerings have been for the purpose of raising capital and have involved speculative investment contracts, thus implicating the jurisdiction of the SEC, in the offering and secondary trading markets.

    Chair Clayton repeated that “every ICO I’ve seen is a security,” and added, “[T]hose who engage in semantic gymnastics or elaborate re-structuring exercises in an effort to avoid having a coin be a security are squarely in the crosshairs of our enforcement division.” Chair Clayton is very concerned that Main Street investors are getting caught up in the hype and investing money they cannot afford to lose, without proper (if any) disclosure, and without understanding the risks.  He also reiterates previous messaging that to date no ICO has been registered with the SEC and that ICO’s are international in nature such that the SEC may not be able to recover lost funds or effectively pursue bad actors. Cybersecurity is also a big risk associated with ICO investments and the cryptocurrency market as a whole. Chair Clayton cites a study that more than 10% of total ICO proceeds, estimated at over $400 million, has been lost to hackers and cyberattacks.

    It is becoming increasingly certain that the U.S. will impose a new regulatory regime over those tokens that are not a true cryptocurrency, which would likely include all tokens issued on the Ethereum blockchain for capital raising purposes. Clayton made the distinction between Bitcoin, which is decentralized, on a public Blockchain and mined or produced by the public and other “securities tokens” which are the cryptocurrencies that developed by an organization and created and issued primarily for capital formation and secondary trading.

    Many tokens are being fashioned that outright and purposefully resemble equity in an enterprise as a new way to represent equity and capital ownership. Clearly this falls directly within the SEC jurisdiction, and state corporate regulatory oversight as well. Furthermore, there are instances where a token is issued in a capital-raising securities offering and later becomes a commodity, or instances where a token securities offering is bundled to include options or futures contracts, implicating both SEC and CFTC compliance requirements.

    In the Banking Committee testimony, the SEC and CFTC presented a united front, confirming that they are cooperating and working together to ensure effective oversight. Both agencies have established virtual currency task forces and their respective enforcement divisions are cooperating and sharing information. Also, both agencies have launched efforts to educate the public on virtual currencies, with the CFTC publishing numerous articles and creating a dedicated “Bitcoin” webpage.

    In addition to cooperating with each other, they are also cooperating and communicating with the NASAA, the Consumer Financial Protection Bureau, FinCen, the IRS, state regulators and others.

    The Technology

    Consistent with all statements by the regulators, both the SEC and CFTC agree that that blockchain technology is disruptive and has the potential to, and likely will, change the capital markets. Moreover, both agencies consistently reiterate their support of these changes and desire to foster innovation.  In fact, the new technology has the potential to help regulators better monitor transactions, holdings and obligations and other market activities.

    Chair Giancarlo’s testimony states that “DLT is likely to have a broad and lasting impact on global financial markets in payments, banking, securities settlement, title recording, cyber security and trade reporting and analysis. When tied to virtual currencies, this technology aims to serve as a new store of value, facilitate secure payments, enable asset transfers, and power new applications.” In addition, smart contracts have the ability to value themselves in real time and report information to data repositories.

    However, regulation and oversight need to be fashioned that properly address the new technology and business operations. Both agencies are engaging in discussions with industry participants at all levels. A few of the key issues that will need to be resolved include custody, liquidation, valuation, cybersecurity at all levels, governance, clearing and settlement, and anti-money laundering and know-your-customer matters.

    Overall, Chair Giancarlo seemed more positive and excited about blockchain and Bitcoin, pointing out current uses including a recent transaction where 66 million tons of American soybeans were handled in a blockchain transaction to China. Chair Clayton, while likely also very enthusiastic about the technology, is currently more focused on the fraud and misuse that has consumed this space recently.

    Current Regulations and Needed Change

    While the agencies investigate and review needed changes to the regulatory environment, both maintain that current regulations can be relied upon to address the current state of the market. On the SEC side, Chair Clayton walked the Banking Committee through previous SEC statements and the DAO Section 21(a) report issued in July 2017. He again confirmed that the Howey Test remains the appropriate standard for determining whether a particular token involves an investment contract and the application of the federal securities laws. The current registration and exemption requirements are also appropriate for ICO offerings. An issuer can either register an offering, or rely on exemptions such as Regulation D for any capital-raising transaction, including those involving tokens.

    Conversely, the current regulatory framework related to exchange traded fund products (ETF’s) needs some work before a virtual currency product could be approved. Issues remain surrounding liquidity, valuation, custody of holdings, creation, redemption and arbitrage. In that regard, in a coming blog, I will review an SEC letter dated January 18, 2018 entitled “Engaging on Fund Innovation and Cryptocurrency-related Holdings” outlining why a crypto-related ETF would not be approved at this time.  Senator Mark Warner was quick to point out that there seems to be a regulatory disconnect where an SEC governed ETF is not approved, but a CFTC-governed Bitcoin future is allowed.

    The current federal broker-dealer registration requirements remain the best test to determine if an exchange or other offering participant is required to be registered and a member of FINRA. Chair Clayton repeats his warning shot to gatekeepers such as attorneys and accountants that are involved in ICO’s and the crypto marketplace as a whole. Chair Clayton expresses concern that crypto markets often look similar to regulated securities markets and even are called “exchanges”; however, “investors transacting on these trading platforms do not receive many of the market protections that they would when transacting through broker-dealers on registered exchanges or alternative trading systems (ATSs), such as best execution, prohibitions on front running, short sale restrictions, and custody and capital requirements.”

    CFTC Chair Giancarlo reiterated that current regulations related to futures, options, and derivatives contracts, and the registration (or lack thereof through self-certification) of spot currency exchanges are being utilized in the virtual currency market. However, the part of the regulatory system that completely defers to state law may need change. In particular, check cashing, payment processing and money transmission services are primarily state regulated. Many of the Internet-based cryptocurrency trading platforms have registered as payment services and are not subject to direct oversight by the SEC or the CFTC, and both agencies expressed concern about this jurisdictional gap.

    Giancarlo was especially critical of this state-by-state approach and suggested new federal legislation, including legislation related to data reporting, capital requirements, cybersecurity standards, measures to prevent fraud, price manipulation, anti-money laundering, and “know your customer” protections. “To be clear, the CFTC does not regulate the dozens of virtual currency trading platforms here and abroad,” Giancarlo said, clarifying that the CFTC can’t require cyber-protections, platform safeguards and other things that consumers might expect from traditional marketplaces.

    Chair Clayton expressed the same concerns, especially the lack of protections for Main Street investors. Chair Clayton stated, “I think our Main Street investors look at these virtual currency platforms and assume they are regulated in the same way that a stock is regulated and, as I said, it’s far from that and I think we should address that.”

    I am always an advocate of federal oversight of capital markets matters that cross state lines. A state-by-state approach is always inconsistent, expensive, and inefficient for market participants.

    Both agencies are clear that regardless of the technology and nomenclature, they are and will continue to actively pursue cases of fraud and misconduct. Current regulations or questions related to needed changes do not affect this role. However, Chair Clayton did impress upon the Banking Committee that the current hiring freeze and budgetary restraints are an impediment. The SEC specifically needs more attorneys in their enforcement and trading and markets divisions.

    Further Reading on DLT/Blockchain and ICO’s

    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 ICO’s, see HERE.

    For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s 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 ICO’s 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 Journalop-ed article and information on the International Organization of Securities Commissions statement and warning on ICO’s, see HERE.

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

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    The Treasury Department Report To The President On Capital Markets

    Tuesday, February 27, 2018, 4:53 PM [General]
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    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 was issued in response to an executive order dated February 3, 2017. 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; this one on capital markets discusses and makes specific recommendations related to the federal securities laws.

    The Core Principles 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 232-page report that directly affect the small and lower middle equity markets. In addition to the areas discussed in this blog, the report covers business development and investment companies, Title III crowdfunding, the bond and treasury markets, securitization, derivatives and multiple other topics. 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 by category.

    Summary of Recommendations and Findings

    The U.S. equities market represents $29 trillion in publicly traded U.S. stocks, with an average daily volume of over $270 billion. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), together with state securities regulators, are responsible for regulating U.S. markets. Further self-regulatory organizations such as the Financial Industry Regulatory Authority (FINRA) oversee parts of the markets and its participants.

    Encouraging Going Public Transactions

    There are many benefits to a going public transaction. As summarized by the Treasury Report:

    Access to the public equity markets means obtaining a source of permanent capital, usually at a cost lower than other alternatives. Proceeds from IPOs can be used to hire employees, develop new products and technologies, and expand operations. Furthermore, IPOs give institutional and other early stage investors an exit, allowing them to reallocate their capital and talent to other ventures. IPOs also have important implications for employees, who may have accepted pre-IPO compensation in the form of options and stock grants. After an IPO, an employee can monetize his or her compensation by selling into the market. This feature can incentivize employee job performance and work commitment.

    As I’ve written about several times, the U.S. economy has experienced an extremely slow recovery since the latest financial crisis, though fortunately, that seems to be improving dramatically over the last year. However, over the last 20 years, the number of public companies in the U.S. has declined by nearly 50%. Many factors have been cited for the decrease in IPO’s, including: (i) compliance costs and risk related to regulations, including Sarbanes-Oxley and Dodd-Frank; (ii) changes in equity market structure, such as decimalization, fragmentation of the market and a decline in small and mid-sized investment banks; (iii) nonfinancial disclosure requirements based on social and political issues; (iv) shareholder litigation risk; (v) shareholder pressure to prioritize short-term returns over long-term growth; (vi) inadequate oversight and accountability of proxy advisor firms; and (vii) lack of research coverage for smaller public companies. At the same time, the availability of private equity funds has increased.

    The Treasury Department’s recommendations include numerous measures to encourage IPO’s, including eliminating duplicative requirements, liberalizing pre-initial public offering communications (testing the waters), and removing non-material disclosure requirements.  he Report makes several recommendations to assist all public companies, including amending the $2000 holding requirement for shareholder proposals and amending resubmission thresholds for repeat shareholder proposals.

    Removal of Non-Material Disclosure Requirements

    Materiality is an objective standard meant to provide disclosure that would be important to a “reasonable investor” as opposed to a subjective standard meant to serve varied special interest groups. However, Dodd-Frank added special interest disclosure requirements, including those related to conflict minerals, mine safety, resource extraction and pay ratio. The Treasury Report notes that the securities laws are not equipped to deal with social issues and that requiring such disclosures for public companies and not private companies not only undermines the overall social aspect of the goals but creates an incentive to remain private.

    The Treasury Report recommends eliminating each of these disclosure requirements (conflict minerals, mine safety, resource extraction and pay ratio). I note that the Financial Choice Act eliminates these provisions as well.  See HERE.

    Eliminate Duplicative Disclosures

    The Treasury Report recommends that the SEC proceed to amend Regulation S-K to eliminate duplicative, overlapping, outdated or unnecessary disclosures. The Report mentions that the SEC has been working on this, but doesn’t give real credit to the progress made. I’ve written about the SEC Disclosure Effectiveness Initiative on numerous occasions, including a review of the October 11, 2017 proposed rule amendment to simplify and modernize disclosure requirements (see HERE).

    Permit Additional Pre-IPO Communications

    Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. Communications made by the company during the IPO process, beginning with the pre-registration filing period, depending on the mode and content, result in violations of Section 5 of the Securities Act. Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.” For a more complete discussion of allowable communications during the IPO process, see HERE.

    In April 2012, the JOBS Act was enacted which created emerging growth companies (EGC’s) and provided provisions to allow EGC’s to communicate with qualified institutional buyers (QIB’s) and institutional accredited investors during the pre-filing period. The JOBS Act also allows EGC’s to file confidential registration statements with the SEC. It is thought that testing the waters, together with the ability to file a confidential registration statement, reduces the risk of an IPO by allowing a company to gauge investor interest without having exposed its financial and business information to the public and competitors.

    On June 19, 2017, the SEC expanded to the ability to file confidential registration statements to all companies completing an IPO and for some follow-on secondary offerings (see HERE). The Treasury Report recommends that all companies be allowed to test the waters with QIB’s and institutional accredited investors.

    Not only do I agree with this recommendation, but I think it should be taken one step further and that testing the waters, to the extent allowed in a Regulation A offering, should be allowed for all companies completing an initial IPO under a certain dollar limit such as $100 million. Regulation A allows for pre-filing and pre-qualification indications of interest as long as no funds are solicited or accepted and proper disclaimers are provided.  Regulation A does not limit solicitation recipients and all forms of solicitation and advertising are permitted, subject to the disclaimer requirements and antifraud provisions.

    One of the SEC and regulator concerns with gun jumping is that it will create an illusory market interest or prime the market in an unsustainable fashion. One of the reasons why such solicitation is allowed in a Regulation A offering is that it is thought that companies engaging in such offerings, with a high end limit of $50 million, will be smaller and less likely to create overwhelming market interest. In addition, with the offering limitation, it is less likely that the offering marketing will result in an unsustainable initial market price.

    Just as all companies can now file confidential registration statements, I think all companies should be allowed to engage in public test-the-waters communications, subject to investor protections through disclaimers, rules against accepting funds, requiring the delivery of a filed prospectus once filed, and subject to offering dollar limitations.

    Shareholder Rights and Dual Class Stock

    Generally corporate governance and shareholder rights are a matter of state law. Under state law, a corporation may have multiple classes of stock with differing rights, including voting rights. A class of stock may have voting control, regardless of the number of shares or holders of public or common stock.

    The Treasury Report recommends that corporate governance, including stock classes, remain under state law.  I agree. In fact, I think the Report only addresses this topic because it has been debated recently, especially following the Snapchat IPO, whose public offering only included non-voting stock.

    Shareholder Proposals

    Exchange Act Rule 14a-8 allows shareholders to include proposals in a company’s proxy materials. The rule requires the company to include the proposal unless it falls within a list of allowable exclusions and provided that the shareholder follow the procedural requirements. To submit a proposal, a shareholder must have held, for at least one year, either (i) company securities with a value of $2,000 or more, or (ii) at least 1% of the outstanding voting securities.

    The Treasury Report states that “According to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.”

    Shareholder proposals are an oft-debated topic as they cost companies tens of millions of dollars and significant time and management resources. The SEC often issues guidance on proposals, including recently in November 2017, about which I will write more in the future. Prior guidance was published in January 2015 (see HERE).

    The Treasury Report recommends that the $2,000 holding requirement, which was instituted over 30 years ago, be substantially increased, and adding additional eligibility requirements. The Treasury Report also recommends substantial changes to the resubmission thresholds.

    Smaller Public Companies

    Smaller public companies face additional challenges, including just by virtue of complying with regulatory requirements with fewer economic and human resources. Furthermore, institutional investors generally favor invest larger companies.

    The Treasury has identified opportunities to ease challenges for smaller public companies, including amending the definition of a “smaller reporting company” to increase the public float threshold from $75 million to $250 million and increasing scaled disclosure requirements. Moreover, the Report recommends extending the length of time a company may be considered an emerging growth company (EGC) to up to ten (10) years based on revenue and public float thresholds.

    The Treasury Department also recognizes that liquidity remains an issue for smaller public companies. In that regard, the Report recommends increasing “tick size” and making changes to the practices at ATS’s (which would include OTC Markets).

    Amend the Definition of a Smaller Reporting Company

    Currently a smaller reporting company (SRC) is defined as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available. SRC’s have the benefit of scaled disclosure requirements and are not required to comply with Sarbanes-Oxley Section 404(b), requiring independent auditor attestation of management’s assessment on internal controls.

    Consistent with SEC proposals, the Treasury Report recommends increasing the threshold for an SRC to $250 million of public float. The Report does not mention the revenue threshold. The SEC has proposed rules to amend the definition of a SRC, which rule change is slated for action this year. For a review of the proposed rule amendment, see HERE.

    Increase Time to Qualify for Emerging Growth Company Status

    An EGC is defined as a company with total annual gross revenues of less than $1,070,000,000 during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. An EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1,070,000,000 in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO; (iii) the date on which it has issued more than $1,070,000,000 in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more).

    The primary benefits of an EGC include scaled-down disclosure requirements both in an IPO and periodic reporting, relief from the auditor attestation requirements in Section 404(b) of the Sarbanes-Oxley Act, confidential filings of registration statements, certain test-the-waters rights in IPO’s, and an ease on analyst communications and reports during the EGC IPO process. The first of emerging growth companies (“EGC’s”) will begin losing EGC status as the five-year anniversary of the creation of an EGC has now passed.  For a discussion of EGCs and the impact of losing EGC status, see HERE.

    The Treasury Report recommends increasing the time a company may be considered an EGC to up to 10 years.

    Research Analyst Rules

    In 2003 and 2004, SEC enforcement settlements with some of the major broker-dealers and investment banks required the firms to separate their research analysts from investment banking. The JOBS Act eased restrictions on research analyst communications during the IPO process. In addition, several changes in legislation have been proposed, with many passing either the House or Senate, but not becoming law. Included in that is the Financial Choice Act, which recommended expanding the exclusion of research reports from the definition of an offer for or to sell securities under the Securities Act.

    The Treasury Report recommends a complete overhaul of the rules related to research reports, including harmonizing the 2003 and 2004 enforcement settlements within those new rules.

    Regulation A/A+ Amendments

    Like research reports, multiple changes in legislation have been proposed, and passed either the House or Senate, including the Financial Choice Act, which would increase the limits for Regulation A to $75 million. Additionally, there have been many proponents, including myself, who advocate for allowing companies that are subject to the Exchange Act reporting requirements to use Regulation A. See HERE for a discussion on efforts in this regard.

    Supporting Regulation A, the Treasury Report recommends expanding the eligibility to use Regulation A to include Exchange Act reporting companies and increasing the Tier 2 offering limits to $75 million.

    Encouraging Private Funding

    Being public is not the right choice for all companies, especially earlier-stage entities, and as such, the Treasury Report discusses the state of private equity and ways to encourage private funding and access to capital for these vital companies as well. In an effort to support private capital-raising efforts, the Report makes recommendations for the modification of the “accredited investor” definition, creating a regulatory structure for finders, and modifying rules for private equity funds, including allowing more investments by unaccredited investors under Rule 506.

    Regulation of Finders

    The regulation of finders, or lack thereof, has been a topic I have written about many times, and is one of the most deficient areas of guidance in the federal securities laws. I have been vocal about my recommendations, including that I would recommend a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. For a review of the SEC Advisory Committee on Small and Emerging Companies recommendations related to finders, and a discussion of my own views, see HERE.

    The Treasury Report recommends that the SEC, FINRA and states propose a new regulatory structure for finders and other intermediaries in capital-forming transactions. The report generally suggests a “broker-dealer lite” structure; however, it makes no specific recommendations and anything broker-dealer-related will likely not resolve the issues or fix this broken area of the system.

    Increase Eligible Investors in Regulation D Offerings

    The definition of an accredited investor is another relevant topic to our private (and public) capital markets. On December 18, 2015, the SEC issued a report on the definition of an “accredited investor” and it is expected that new proposed rules amending the definition will be issued this year. For a review of the SEC report and more information on the background of the definition of an accredited investor, see HERE.

    The definition of “accredited investor” has not been comprehensively re-examined by regulators since its adoption in 1982; however, in 2011 the Dodd-Frank Act amended the definition to exclude a person’s primary residence from the net worth test of accreditation. Generally, natural persons can qualify as an accredited investor if they have a net worth of at least $1 million, excluding their primary residence, or have income of at least $200,000 ($300,000 together with a spouse) for each year for the last two years with a reasonable expectation to continue such income in the current year. Certain legal entities with over $5 million in assets are accredited investors, while certain regulated entities such as banks, broker-dealers, registered investment companies, BDC’s, and insurance companies are automatically designated as accredited investors.

    The Treasury Report recommends expanding the definition of an accredited investor to include additional sophisticated investors, including, for example, registered representatives working with broker-dealers, investment advisors, financial professionals, and investors that are advised as to the merits and risks by a licensed individual.

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    The CFTC And Cryptocurrencies

    Tuesday, February 20, 2018, 9:15 AM [General]
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    The SEC and U.S. Commodity Futures Trading Commission (CFTC) have been actively policing the crypto or virtual currency space. Both regulators have filed multiple enforcement actions against companies and individuals for improper activities including fraud. On January 25, 2018, SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo published a joint op-ed piece in the Wall Street Journal on the topic.

    Backing up a little, on October 17, 2017, the LabCFTC office of the CFTC published “A CFTC Primer on Virtual Currencies” in which it defines virtual currencies and outlines the uses and risks of virtual currencies and the role of the CFTC. The CFTC first found that Bitcoin and other virtual currencies are properly defined as commodities in 2015. Accordingly, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing. Rather, these “exchanges” are regulated as payment processors or money transmitters under state law.

    The role of the CFTC is substantially similar to the SEC with a mission to “foster open, transparent, competitive and financially sound markets” and to “protect market users and their funds, consumers and the public from fraud, manipulation and abusive practices related to derivatives and other products subject to the Commodity Exchange Act (CEA).” The definition of a commodity under the CEA is as broad as the definition of a security under the Securities Act of 1933, including a physical commodity such as an agricultural product, a currency or interest rate or “all services, rights and interests in which the contracts for future delivery are presently or in the future dealt in” (i.e., futures, options and derivatives contracts).

    Where the SEC regulates securities and securities markets, the CFTC does the same for commodities and commodity markets. At times the jurisdiction of the two regulators overlaps, such as related to swap transactions (see HERE). Furthermore, while there are no SEC licensed securities exchanges which trade virtual currencies or any tokens, there are several commodities exchanges that trade virtual currency products such as swaps and options, including the TeraExchange, North American Derivatives Exchange and LedgerX.

    The Commodity Exchange Act would prohibit the trading of a virtual currency future, option or swap on a platform or facility not licensed by the CFTC. Moreover, the National Futures Association (NFA) is now requiring member commodity pool operators (CPO’s) and commodity trading advisors (CTA’s) to immediately notify the NFA if they operate a pool or manage an account that engaged in a transaction involving a virtual currency or virtual currency derivative.

    The CFTC refers to the IRS’s definition of a “virtual currency” and in particular:

    A virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments it operates like real currency but it does not have legal tender status in the U.S. Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as a convertible virtual currency.  Bitcoin is one example of a convertible virtual currency.

    I note that neither the CFTC’s definition of Bitcoin as a commodity, nor the IRS’s definition of a virtual currency, conflicts with the SEC’s position that most cryptocurrencies and initial cryptocurrency offerings today are securities requiring compliance with the federal securities laws. The SEC’s position is based on an analysis of the current market for ICO’s and the issuance of “coins” or “tokens” for capital raising transactions and as speculative investment contracts. In fact, a cryptocurrency which today may be an investment contract (security) can morph into a commodity (currency) or other type of digital asset. For example, an offering of XYZ token for the purpose of raising capital to build a software or blockchain platform or community where XYZ token can be used as a currency would rightfully be considered a securities offering that needs to comply with the federal securities laws. However, when the XYZ token is issued and can be used as a form of currency, it would become a commodity. Furthermore, the bundling of a token securities offering to include options or futures contracts may implicate both SEC and CFTC compliance requirements.

    The CFTC primer gives a little background on Bitcoin, which was created in 2008 by a person or group using the pseudonym “Satoshi Nakamoto” as an electric payment system based on cryptographic proof allowing any two parties to transact directly without the need for a trusted third party, such as a bank or credit card company. Bitcoin is partially anonymous, with individuals being identified by an alphanumeric address. Bitcoin runs on a blockchain-decentralized network of computers and uses open-source software and “miners” to validate transactions through solving complex algorithmic mathematical equations.

    A virtual currency can be used as a store of value; however, virtual currencies are not a yield asset in that they do not generate dividends or interest. Virtual currencies can generally be traded with resulting capital gains or losses. The CFTC, like all regulators, points out the significant speculation and volatility risk. The CFTC reiterates the large incidents of fraud involving crypto marketplaces. Furthermore, there is a significant cybersecurity risk. If a “wallet” holding cryptosecurities is hacked, they are likely gone without a chance of recovery.

    Although many virtual currencies, including Bitcoin, market themselves as a payment method, the ability to utilize Bitcoin and other virtual currencies for everyday goods and services has not yet come to fruition. In fact, the trend toward Bitcoin being a regularly accepted payment has seemed to have gone the other way, with payment processor Stripe, tech giant Microsoft and gaming platform Steam discontinuing Bitcoin support due to lengthy transaction times and increased transaction failure rates.

    Further Reading on DLT/Blockchain and ICO’s

    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 ICO’s, see HERE.

    For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s 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 ICO’s and updates on enforcement proceedings as of January 2018, see HERE.

    To read about the SEC and CFTC joint statements and the Wall Street Journal op-ed article, see HERE.

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    The New Auditor Report

    Tuesday, February 13, 2018, 8:32 AM [General]
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    In October 2017, the SEC approved a new rule by the Public Company Accounting Oversight Board (PCAOB) requiring significant changes to public company audit reports. Among other additions, an audit report will need to include critical audit matters (CAMs) and disclosure the tenure of the auditor. The new rule and requirements related to audit reports are significant as the audit report is the document in which the auditor itself communicates to the public and investors.

    The new standard will require auditors to describe CAMs that are communicated to a company’s audit committee. Critical audit matters are those that relate to material financial statement entries or disclosures and require complex judgment. One of the purposes of the proposed change is to require the auditor to communicate to investors, via the audit report, those matters that were difficult or thought-provoking in the audit process and that the auditor believes an investor would want to know.

    The new audit report standard also adds information related to the audit firm tenure, and the auditor’s role and responsibilities. Tenure can be an important factor in an audit, including an auditor’s experience and thus understanding of a company’s business and audit risks.

    The process in finalizing the rule has been lengthy, having begun in 2010 in response to investor- and public-initiated comments. Once proposed, the rule went through three rounds of public solicitation for comment. Of particular concern is whether the new requirements will result in increased nuisance shareholder litigation, costing the company and its investors, and whether it will result in a chill on auditor-company communications. In a statement related to the new auditor report, SEC Chairman Jay Clayton expressly addressed this concern, stating:

    “I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.

    I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”

    As an aside, as with any rule making, SEC rules and regulations can and do result in unintended consequences. This is an issue I’ve raised many times over the years in my blogs, including, for example, the multitude of differences between requirements for smaller reporting companies and emerging growth companies, a topic the SEC is now working on addressing and rectifying. It is great to see Chair Clayton discuss this phenomenon directly and for the rule itself to take measures to monitor and initiate changes based on implementation analysis.

    There are certain carve-outs from some of the rule requirements, including the CAM requirements. In particular, the CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans; however, they do specifically apply to smaller reporting companies.  Moreover, the rule requires extensive post-implementation review, in light of the potential for negative unintended consequences, and such review could result in changes to the rule itself and its implementation schedule.

    The New Audit Report Rules

    The new rules have broken old AS 3101, which covered all audit reports, into two parts: (i) AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, and (ii) AS 3105, Departures from Unqualified Opinions and Other Reporting Circumstances. From a high level, audit reports have a pass/fail standard—i.e., they are either qualified or unqualified. The new rules clarify the auditor’s report standards in each case.

    The new rules require an auditor to communicate critical audit matters (CAMs) in the audit report, or affirmatively state that there were no CAMs. A CAM is defined as “any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the financial statements; and (ii) involved especially challenging, subjective or complex auditor judgment.”

    For clarity, the rules provide a list of considerations when determining whether a matter was especially challenging, subjective or complex. These considerations include: (i) the auditor’s assessment of the risks of material misstatement; (ii) the degree of auditor judgment in areas that involved a high degree of judgment or estimation by management, including any measurements with significant uncertainty; (iii) the nature and timing of significant unusual transactions and audit effort and judgment involved; (iv) the degree of auditor subjectivity in applying audit procedures; (v) the nature and extent of audit effort, including specialized skill or knowledge or need for outside consultation; and (vi) the nature of audit evidence.

    The SEC rule release and PCAOB release stress that CAMs should not be boilerplate disclosures carried in each report, which would then lessen their impact and usefulness. Rather, a CAM should only be a material event that has required thought and complexity to the auditor and company. Furthermore, a CAM only includes those matters that meet each element of the definition, including materiality, requirement to communicate with the audit committee, and matters involving especially challenging, subjective or complex judgment.

    Each audit report must: (i) identify the CAM; (ii) describe the considerations that led the auditor to determine that the matter is a CAM; (iii) describe how the CAM was addressed in the audit; and (iv) refer to the relevant financial statement accounts or disclosures. That is, an auditor must articulate “why” a matter is a CAM and how it was addressed.  The auditor must keep documentation and thorough records on the process, including how any particular issue was determined to be a CAM or not.

    The CAM reporting does not apply to emerging growth companies (EGCs), broker-dealers, investment companies, business development companies or employee stock plans. Although EGCs are exempt, smaller reporting companies are not. The SEC comment process concluded that CAMs could provide new information about smaller reporting companies, and in fact may be even more critical since these smaller companies generally have less analyst coverage and other reliable outside information sources. Auditors for smaller reporting companies have an additional 18 months to comply with the new rules.

    In addition to CAM discussions, the new rules require the following additions to the audit report: (i) a disclosure of the auditor tenure, including the year the auditor began serving the company; (ii) a statement regarding the auditor independence requirement; (iii) addressing the report to both the company’s shareholders and board of directors; (iv) adding particular standardized language, phrases and qualifiers, including adding the phrase “whether due to error or fraud” when describing the auditor’s responsibility under PCAOB standards to obtain reasonable assurance about whether the financial statements are free of material misstatement; and (v) standardizing the form of the report, including adding sections and titles to guide the reader.

    All other changes in the audit report rules, including tenure reporting, as well as guidelines pertaining to form (headers, etc.), apply to all companies, including EGCs.

    The new rules make various conforming changes to related rules, including requiring the engagement quality reviewer to evaluate the determination, communication and documentation of CAMs. Moreover, the auditor will be required to prevent a draft of the report to the company’s audit committee and engage in discussions on the report contents.

    The rule changes also conform an auditors Section 404(b) report to the new report format. As a reminder, Section 404(a) of the Sarbanes-Oxley Act requires companies to include in their annual reports on Form 10-K a report of management on the company‘s internal control over financial reporting (“ICFR”) that: (i) states management‘s responsibility for establishing and maintaining the internal control structure; and (ii) includes management‘s assessment of the effectiveness of the ICFR. Section 404(b) requires the independent auditor to attest to, and report on, management‘s assessment.

    Effective Dates

    All changes other than CAM-related requirements go into effect for audits beginning with the fiscal year ending on or after December 15, 2017. CAM requirements go into effect for large accelerated filers beginning with the fiscal year ending on or after June 20, 2019 and for all other companies beginning with the fiscal year ending on or after December 15, 2020.

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