Laura Anthony

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    • Member Type(s): Expert
    • Title:Founding Partner
    • Organization:Legal & Compliance, LLC
    • Area of Expertise:Securities Law
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    SEC and NASAA Statements on ICOs and More Enforcement Proceedings

    Tuesday, January 16, 2018, 8:43 AM [General]
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    The message from the SEC is very clear: participants in initial coin offerings (ICO’s) and cryptocurrencies in general need to comply with the federal securities laws or they will be the subject of enforcement proceedings. This message spreads beyond companies and entities issuing cryptocurrencies, also including securities lawyers, accountants, consultants and secondary trading platforms. Moreover, the SEC is not the only watchdog. State securities regulators and the plaintiffs’ bar are both taking aim at the crypto marketplace. Several class actions have been filed recently against companies that have completed ICO’s.

    After a period of silence, on July 25, 2017, the SEC issued a Section 21(a) Report on an investigation and related activities by the DAO, with concurrent statements by both the Divisions of Corporation Finance and Enforcement. On the same day, the SEC issued an Investor Bulletin related to ICO’s. For more on the Section 21(a) Report, statements and investor bulletin, see HERE. Since that time, the SEC has engaged in a steady flow of enforcement proceedings and statements on the subject.

    The DAO report centered on a traditional analysis to determine whether a token is a security and thus whether an ICO is a securities offering. In particular, the nature of a digital asset (“coin” or “token”) must be examined to determine if it meets the definition of a security using established principles, including the Howey Test. See HERE for a discussion on the Howey Test. The report also pointed out that participants in ICO’s are subject to federal securities laws to the same extent they are in other securities offerings, including broker-dealer registration requirements, and that securities exchanges providing for trading must register unless an exemption applies.

    On November 1, 2017, the SEC issued a warning to the public about the improper marketing of certain ICO’s, token offerings and investments, including promotions and endorsements by celebrities. Celebrities, like any other promoter, are subject to the provisions of Section 17(b) of the Securities Act, including the requirement to disclose the nature, scope, and amount of compensation received in exchange for the promotion. For more on Section 17(b) and securities promotion in general, see HERE.

    On December 11, 2017, SEC Chairman Jay Clayton issued a statement on cryptocurrencies and initial coin offerings. In that statement, Clayton drilled down on the sudden rise of “non-security” ICO’s, now being referred to as “utility tokens,” clearly conveying the message that if a token has attributes of a security, it will be governed as a security. To make the message even clearer, also on December 11, 2017, the SEC halted the ICO by Munchee, Inc., disagreeing with Munchee’s statements and conclusions that its token was a “utility token” and not a security.

    This was not the first ICO halt.  On December 4, 2017, the SEC halted the ICO by PlexCorps, including outright fraud with the claims of an unregistered offering. The SEC has also taken aim at companies that are in the crypto space in general, having halting the trading of The Crypto Company on December 19, 2017 after a 2,700% stock price increase. This was not the first trading halt, either. Others include American Security Resources Corp, halted on August 24, 2017; First Bitcoin Capital, halted on August 23, 2017; CIAO Group, halted on August 9, 2017; and Sunshine Capital on June 7, 2017.

    More recently, on January 5, 2018, the SEC halted the trading of UBI Blockchain Internet, Ltd. citing questions regarding the accuracy of information in SEC filings and concerns about market activity, which was the epitome of an unexplained stock surge.

    On August 28, 2017, the SEC issued an investor alert warning about public companies making ICO-related claims. The alert specifically mentioned the trading suspensions and warned that ICO claims could be a sign of a pump-and-dump scheme.

    On January 4, 2018, Chair Clayton issued another statement, this time joined by Commissioners Kara Stein and Michael Piwowar, commenting on the North American Securities Administrators Association (NASAA) statement made the same day. The NASAA is a group comprised of state securities regulators, which, among other functions, acts as a communication arm for the individual state regulators on important marketplace topics.

    Jay Clayton’s December 11, 2017 Statement

    Jay Clayton begins his December 11, 2017 statement with an acknowledgement of the “tales of fortunes made and dreamed to be made,” which is a perfect description of ICO mania.  Keeping with the SEC theme under Clayton, he then addresses ICO considerations for Main Street investors. In addition to warning of fraud and misrepresentations, ICO’s and cryptocurrency trading is a national marketplace; invested funds may quickly move overseas. Furthermore, the SEC may not be able to gain jurisdiction or pursue bad actors or lost funds in other countries.

    The fact is that as of today, no cryptocurrency offerings have been registered with the SEC.  Although Jay Clayton doesn’t talk about what registration will really mean for an ICO, I note that, since registration is the process of ferreting out disclosures, it will force an entity issuing an ICO to be clear about the usefulness of its token, if any, and the risk factors not only associated with its token, but the marketplace as a whole. My firm is currently working on registration statements as well as private offering documents for ICO’s and blockchain technology entities and the complexity of this new industry and technology, and uncertainty associated with legalities (including not only securities matters, but the implication of swap and commodity transactions, tax ramifications, intellectual property matters, etc.) is confounding to even the best and brightest.

    The importance of the involvement and efforts by market professionals is not lost on the SEC.  In the beginning, many ICO’s, believing that this new investment vehicle was somehow not a security and therefore outside the parameters of the securities laws and SEC jurisdiction, forewent the advice of legal counsel and other professionals. Now that this belief has been rectified, in his statement, Jay Clayton reminds market professionals of their gatekeeping duties. Chair Clayton states, “[I] urge market professionals, including securities lawyers, accountants and consultants, to read closely the investigative report we released earlier this year (the “21(a) Report”) and review our subsequent enforcement actions.”

    He continues: “[F]ollowing the issuance of the 21(a) Report, certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance.  Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security….. On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements:  investor protection and, in particular, the protection of our Main Street investors.” The bold emphasis was from the SEC, not added by me.  The message could not be clearer.

    Attorneys and other professionals are not the only groups that the SEC is taxing with gatekeeper responsibilities.  Jay Clayton adds: “[I] also caution market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions. Selling securities generally requires a license, and experience shows that excessive touting in thinly traded and volatile markets can be an indicator of ‘scalping,’  ‘pump and dump’ and other manipulations and frauds.  Similarly, I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934.” Again, the bold emphasis is not mine.  Although Jay Clayton does not indicate so, I am unaware of any properly licensed secondary market or exchange for the trading of cryptocurrencies at this time.  TZero is properly licensed, but not up and functioning as of the date of this blog.

    Jay Clayton’s statement is not all negative. He recognizes that ICO’s can be an effective method to raise capital and fund projects. He also recognizes that not all cryptocurrencies are securities. A specific example would be an in-app game with token purchases that can only be used to reach another level. However, Clayton points out that “[B]y and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”

    The Division of Enforcement has been instructed to vigorously police the ICO marketplace. Finally, the SEC encourages investors to conduct thorough due diligence before making an ICO investment. In that regard, he provides a list of basic questions that should be asked and considered before making any investment.

    January 4, 2018 Statements by Chair Clayton and Commissioners Kara Stein and Michael Piwowar

    On January 4, 2018, Chair Clayton, Commissioners Kara Stein and Michael Piwowar issued a statement commending the North American Securities Administrators Association’s (NASAA) own statement made the same day addressing concerns with ICO’s and cryptocurrencies. The NASAA is a group comprised of state securities regulators.

    The SEC’s top brass specifically point out that cryptocurrencies are not, in fact, currencies in that they are not backed or regulated by sovereign governments and seem to be focused on a method of capital raising as opposed to mediums of exchange. Reiterating its other messaging, the SEC reminds the public that offerings and their participants must comply with the state and federal securities.

    NASAA Statement on Cryptocurrencies and ICO’s

    NASAA begins its statement with a consistent theme to the SEC, warning Main Street investors to be cautious about investments involving cryptocurrencies. NASAA, also like the SEC, encourages potential investors to conduct due diligence and ask questions before making an ICO (or any) investment.

    NASAA includes a laundry list of risks and issues with ICO’s and crypto-related investments. NASAA points out that unlike FIAT or traditional currencies, cryptocurrencies have no physical form and typically are not backed by tangible assets (though I note that this is a void that is quickly being addressed by new tokens backed by physical assets and commodities).

    Furthermore, cryptocurrencies are not insured, not controlled by a central bank or other governmental authority, are subject to very little if any regulation, and cannot be easily exchanged for other commodities. Cryptocurrencies are susceptible to breaches, hacking and other cybersecurity risks, including on both the ICO issuer side and the investor side through direct breaches into a wallet or other digital storage. ICO’s are a global investment vehicle and, as such, US regulators may have no ability to recover lost funds or pursue bad actors.  Likewise, private civil proceedings could prove futile.

    Moreover, the high volatility and high risk of cryptocurrency investments make them unsuitable for most investors. In both its statement and a very simple investor-directed animated video on the subject, NASAA clearly states that investors could lose all of their money in a crypto-related investment.

    Regulators almost unanimously believe that cryptocurrencies involve a high risk of fraud. NASAA includes a list of obvious red flags, including guaranteed high returns, unsolicited offers, sounds too good to be true, pressure to buy immediately, and unlicensed sellers.

    NASAA now lists ICO’s and cryptocurrency-related investment products as an emerging investor threat for 2018.

    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.

    The SEC’s 2017 Enforcement Priorities And Results

    Tuesday, January 9, 2018, 8:29 AM [General]
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    No more broken windows!  In a series of speeches by various top brass at the SEC followed by the publication of the SEC Enforcement Division 2017 Report on results and priorities, the SEC has confirmed both directly and through its actions that the era of “broken windows” enforcement is over. The broken windows policy was first shepherded by Mary Jo White in 2013 and was one in which the SEC committed to pursue infractions big and small and to investigate, review and monitor all activities. The idea was that small infractions lead to bigger infractions, and the securities markets have had the reputation that minor violations are overlooked, creating a culture where laws were treated as meaningless guidelines.

    Michael Piwowar has been a critic of broken windows since its inception. In a speech to the Securities Enforcement Forum in 2014, Mr. Piwowar stated, “[I]f every rule is a priority, then no rule is a priority.” He continued, “[I]f you create an environment in which regulatory compliance is the most important objective for market participants, then we will have lost sight of the underlying purpose for having regulation in the first place. Rather than enabling vital and important economic activity, we will have unnecessarily shackled it – and our country will be far worse off from the absence of such activity.”

    Given the power to make a change, Commissioner Michael Piwowar and Chair Jay Clayton have signaled an adjustment in enforcement priorities throughout the year. In February 2017, then acting Chair Michael Piwowar revoked the subpoena authority from SEC staff, leaving the Division of Enforcement with the sole authority to approve a formal order of investigation and issue subpoenas. Mr. Piwowar had been a vocal critic of both the staff subpoena power and the manner in which the power was created since its inception. He has also been a vocal critic of the SEC’s investigative power, believing it has too much power and too little oversight. For more on the SEC subpoena power, Mr. Piwowar’s views, and the early stage setting for the current enforcement priorities, see HERE.

    In his October 4, 2017 testimony on the SEC’s Agenda, Operations and Budget before the Committee on Financial Services, Chair Jay Clayton reiterated his commitment to rooting out bad actors and fraud, including pump-and-dump schemes, insider trading, and serious reporting and disclosure violations. Certainly, a review of published enforcement proceedings has illustrated that commitment. Mr. Clayton also laid the groundwork for more focused enforcement, stating, “I have asked the Division of Enforcement to evaluate regularly whether we are focusing appropriately on retail investor fraud and investment professional misconduct, insider trading, market manipulation, accounting fraud and cyber matters. I believe our Main Street investors would want us to focus on these areas.”

    In July 2017, Chair Clayton announced a top priority and philosophy of protecting “Main Street investors,” which buzzwords are now repeated often in SEC communications, including press releases and speeches.

    On October 26, 2017, Steven Peikin, co-director of the SEC Division of Enforcement, confirmed the death knell for the broken windows policy. In a speech, Mr. Peiken told conference attendees that the SEC would “have to be selective and bring a few cases to send a broader message rather than seep the entire field.” Mr. Peiken also suggested stronger communication between the Division of Enforcement and investigative targets, and an environment that fosters cooperation. In that regard, the SEC should communicate the benefits of cooperation and specifically how a company can merit cooperation credit. In that regard, the SEC will again encourage self-reporting and remediation, a prior policy that lost its wind in the 2001 Enron crisis.

    Clearly, the change is driven by more than philosophy. The SEC budget has effectively been frozen, and more money needs to be spent on cybersecurity matters than ever before. See HERE. The SEC Division of Enforcement could have at least 100 fewer investigators and supervisors over the next year, as those lost to attrition will not be replaced.

    Mary Jo White’s policy of forcing admissions of guilt in enforcement settlements may also have reached its pinnacle. In June 2013, the SEC announced that it would require that a settling party admit wrongdoing as part of a settlement to act as a further deterrent and bolster public accountability. In addition to reputational damage, this policy had legal evidentiary significance that could be used in civil matters, including shareholder lawsuits. For more on this, see HERE.

    In his October 2017 speech, Mr. Piekin talked about the admissions policy, stating, “I think when people resolve cases with the commission [and] neither admit nor deny but agree to all the points of relief, I don’t think most people in the world say, ‘Boy, they really got away with that.’” That doesn’t mean the policy will disappear, but it may revert to its prior reiteration, where only those with related criminal cases will be asked for a guilt admission.

    Division of Enforcement Annual Report on Results and Priorities

    On November 15, 2017, the Division of Enforcement issued its annual report (Annual Report) on results and priorities, reiterating the mission and focus on the protection of Main Street investors. The Annual Report cites five core principles, including: (i) focus on Main Street (retail) investors, including accounting fraud, sales of unsuitable products, pursuit of unsuitable trading strategies, pump-and-dump schemes and Ponzi schemes; (ii) focus on individual accountability to maximize deterrence and prevent recidivists from continuing improper activities; (iii) keeping pace with technological changes, including all cybersecurity matters; (iv) imposing sanctions that support enforcement goals; and (v) constantly assessing the allocation of resources.

    The Annual Report reiterates initiatives announced earlier this year, including the new Cyber Unit and Retail Strategy Task Force (see HERE), while confirming its commitment to long-standing enforcement goals. The top current goals include risks posed by cyber-related misconduct; issues raised by the activities of investment advisers, broker-dealers, and other registrants; financial reporting and disclosure issues involving public companies; and insider trading and market abuse.

    During fiscal year ended (FYE) September 2017, the SEC brought 754 enforcement proceedings,  returned $1.07 billion to harmed investors and obtained judgment and orders for more than $3.789 billion in disgorgement and penalties. During FYE ended September 2016, the SEC brought 868 actions and obtained judgements and orders for more than $4 billion in disgorgement and penalties. For more on the 2016 report, see HERE.

    Broken down by type of case, the most cases were brought related to issuer reporting violations including audit and accounting problems, followed by securities offerings, then investment advisor or investment company violations, then broker-dealer violations, followed by insider trading, then market manipulation. A number of cases were also brought for public finance abuse, FCPA violations and transfer agent issues.

    Interestingly, the SEC suspended trading in 309 companies in FYE 2017, a 55% increase from 2016. Trading suspensions are generally related to market manipulation and microcap fraud, and are a very successful tool to stop these problems in their tracks. Asset freezes were pretty even in both years, with 35 court-ordered asset freezes in 2017 and 33 in 2017. Likewise, the imposition of bars and suspensions has remained a constant, with 625 in 2017 and 650 in 2016...

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    Violations by Investment Advisers Who Advertise

    Thursday, January 4, 2018, 3:48 PM [General]
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    Which violations occur most when investment advisers decide to advertise their services to potential clients?

    A September 14, 2017, risk alert from the Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) identifies the top six infringements, according to Laura Anthony, founder of Legal and Compliance, LLC, a national corporate, securities and business transactions law firm in West Palm Beach, FL.

    Most of the violations involve misleading information or claims, while the others include failure to report complete information, especially around such issues as investor fees and provision of a full and balanced picture of past performance, both good and bad, Ms. Anthony notes.

    Writing in the Securities Law Blog, Ms. Anthony points out that the violations originate from the Investment Advisers Act of 1940, which prohibits investment advisers from directly or indirectly disseminating information that is untrue or misleading. The law applies specifically to advertising or claims that investors might rely on to decide when to buy or sell any security, or which one to buy or sell.

    The most common violations identified in the OCIE are:

    · Misleading performance results: An adviser provides misleading information about past performance (e.g., omits fees, relies on benchmarks or comparisons that are materially different, fails to provide information on how returns were derived).

    · Misleading one-on-one presentations: An adviser fails to disclose all information when reporting results.

    · Misleading claim of compliance: An adviser falsely claims to be voluntarily compliant with SEC standards.

    · Cherry-picked profitable stock selections: An investor claims results that do not include a balanced picture of both profitable and unprofitable selections.

    · Misleading selection of recommendations: An investor focuses inordinately on successful holdings or stock picks without divulging an equal number of poor performers.

    · Inadequate advertising procedures: An investor does not have adequate processes and internal checks in place for reviewing, approving and confirming advertisements that meet all legal standards.

    OCIE also provided a summary of “touting,” the practice by which investors promote their business acumen by mentioning awards, rankings or other types of third-party recognition. Such phraseology must be factual as to the date, selection criteria and creator of the information, and must indicate that the investor did not pay to be included or mentioned, Ms. Anthony notes.

    New SEC Compliance Alert Identifies Most Common Violations by Investment Advisers Who Advertise

    Thursday, January 4, 2018, 3:48 PM [General]
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    Which violations occur most when investment advisers decide to advertise their services to potential clients?

    A September 14, 2017, risk alert from the Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) identifies the top six infringements, according to Laura Anthony, founder of Legal and Compliance, LLC, a national corporate, securities and business transactions law firm in West Palm Beach, FL.

    Most of the violations involve misleading information or claims, while the others include failure to report complete information, especially around such issues as investor fees and provision of a full and balanced picture of past performance, both good and bad, Ms. Anthony notes.

    Writing in the Securities Law Blog, Ms. Anthony points out that the violations originate from the Investment Advisers Act of 1940, which prohibits investment advisers from directly or indirectly disseminating information that is untrue or misleading. The law applies specifically to advertising or claims that investors might rely on to decide when to buy or sell any security, or which one to buy or sell.

    The most common violations identified in the OCIE are:

    · Misleading performance results: An adviser provides misleading information about past performance (e.g., omits fees, relies on benchmarks or comparisons that are materially different, fails to provide information on how returns were derived).

    · Misleading one-on-one presentations: An adviser fails to disclose all information when reporting results.

    · Misleading claim of compliance: An adviser falsely claims to be voluntarily compliant with SEC standards.

    · Cherry-picked profitable stock selections: An investor claims results that do not include a balanced picture of both profitable and unprofitable selections.

    · Misleading selection of recommendations: An investor focuses inordinately on successful holdings or stock picks without divulging an equal number of poor performers.

    · Inadequate advertising procedures: An investor does not have adequate processes and internal checks in place for reviewing, approving and confirming advertisements that meet all legal standards.

    OCIE also provided a summary of “touting,” the practice by which investors promote their business acumen by mentioning awards, rankings or other types of third-party recognition. Such phraseology must be factual as to the date, selection criteria and creator of the information, and must indicate that the investor did not pay to be included or mentioned, Ms. Anthony notes.

    State Distributed Ledger Technology and Blockchain Regulations

    Tuesday, January 2, 2018, 8:33 AM [General]
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    In a time of rapidly changing regulations and policies on all securities industry and corporate finance topics, and the development of distributed ledger technology (DLT or blockchain) and associated initial cryptocurrency offerings (ICO’s), I have never had so many topics in the queue to write about. With a once-a-week blog, I will just keep working through the list, reporting on all developments, some quicker than others.  In this blog, I am circling back to DLT with a synopsis of state law developments and the Uniform Law Commission’s (ULC) approved Uniform Regulation of Virtual Currency Business Act (Uniform VCBA).

    Uniform Regulation of Virtual Currency Business Act (Uniform VCBA)

    On July 19, 2017, the Uniform Law Commission (ULC) approved Uniform Regulation of Virtual Currency Business Act (Uniform VCBA) to be used as a model for states seeking to adopt such legislation. The VCBA is a money-transmitting or payment-processing-based legislation. The VCBA defines a money transmitter in an effort to provide clarity on what businesses are required to be licensed. The VCBA also provides an anti-money laundering (AML) framework that mirrors FinCEN requirements.

    The VCBA focuses on control over the currency and transaction and requires licensing by any business that has the “power to execute unilaterally or prevent indefinitely a virtual currency transaction.” This definition is meant to distinguish virtual wallets that merely hold an individual’s virtual currency and process a transaction at the behest of such owner, without any additional powers.

    Delaware

    The Delaware Blockchain Initiative is the state’s program to welcome and encourage blockchain businesses and to establish regulatory clarity for their operations and the use of blockchain technology overall, including DLT.

    The August 1, 2017 amendments to the Delaware General Corporation Law (DGCL) Section 219, 224 and 232 will allow Delaware private companies to use DLT to maintain shareholder records, including authorized, issued, transferred, and redeemed shares, on a DLT system. As of now, the amendments to the DGCL are limited to private companies; however, the state of Delaware is in talks with the SEC related to implementing the technology for public companies.

    DGCL Sections 219 and 224 have been amended to permit corporations to rely on a DLT as a stock ledger itself, potentially eliminating a separate transfer agent for private companies. Section 219(c) defines a “stock ledger” to include “one or more records administered by or on behalf of the corporation.” Section 224 provides that any records “administered by or on behalf of the corporation” could include “one or more distributed electronic networks for databases.”

    A ledger must also: (i) be convertible into clearly legible paper form within a reasonable time; (ii) be able to be used to prepare the list of stockholders specified in Sections 219 and 220 (related to stockholder demands to inspect corporate books and records); (iii) must be able to record information and maintain records for various statute sections related to shareholdings, including those related to consideration for partly paid shares, the transfer of shares for collateral, pledged shares and voting trusts; and (iv) be able to records transfers of shares in compliance with the Delaware Uniform Commercial Code.

    Delaware is currently working in collaboration with a private company, Symbiont, to put together “smart securities,” which are allegedly impossible to counterfeit. The ledger could be maintained by either a closed or open group of participants.  The ledger and any transfers would be updated instantaneously, effectively allowing for T+0 settlement of trades.

    Nevada

    Preceding Delaware by a month, on June 5, 2017, Nevada’s governor signed Senate Bill 398 into law, confirming that blockchain records have legally binding status. Unlike Delaware, Nevada’s regulations do not amend its corporate statutes (i.e., Chapter 78, Nevada’s Private Corporation Law), but rather, similar to Arizona, amends Chapter 719, Nevada’s Uniform Electronic Transactions Act.

    Nevada’s statute defines blockchain as an electronic record of transactions or other data which is: (i) uniformly ordered; (ii) redundantly maintained or processed by one or more computers or machines to guarantee the consistency or nonrepudiation of the recorded transactions or other data; and (iii) validated by the use of cryptography.

    The Nevada statute prohibits local governments from imposing taxes or fees on the use of a blockchain; requiring a certificate, license or permit to use a blockchain; or imposing any other requirement related to the use of blockchain. Moreover, the Nevada statute provides “written” status to blockchain records.  In particular, “if a law requires a record to be in writing, submission of a blockchain which electronically contains the record satisfies the law.”

    Arizona

    Prior to both Nevada and Delaware, in March 2017 Arizona passed House Bill 2417 into law, confirming the legal status of blockchain records. Like Nevada, Arizona gives smart contracts and blockchain signatures legal binding status. In addition, the Arizona statute confirms that a smart contract has legally binding status, as would any other legal form of contract. Also like Nevada, Arizona’s provision is an amendment to its electronic transactions statute and not its corporate governance provisions.

    Arizona defines “blockchain technology” as “distributed ledger technology that uses a distributed decentralized, shared and replicated ledger, which may be public or private, permissioned or permissionless, or driven by tokenized crypto economics or tokenless. The data on the ledger is protected with cryptography, is immutable and auditable and provides an uncensored truth.”

    Arizona defines a “smart contract” as “an event driven program, with state, that runs on a distributed decentralized, shared and replicated ledger and that can take custody over and instruct transfer of assets on that ledger.”

    Vermont

    Vermont defines “blockchain technology” as “a mathematically secured, chronological and decentralized consensus ledger or database, whether maintained via Internet interaction, peer-to-peer network, or otherwise.” The Vermont statute confirms that blockchain records will be considered regular business records and makes blockchain records admissible as evidence under the Vermont rules of evidence.

    Miscellaneous Virtual Currency Provisions

    Multiple states, including Connecticut, New York, Oregon and Tennessee, have enacted legislations defining virtual currency and requiring money transmitters or payment processors which exchange virtual currency for U.S. dollars, to be licensed. The New York statute (the BitLicense Regulation) has received a lot of pushback, with many claiming it is vague or overly difficult to comply with, causing many in the business to avoid New York jurisdiction.

    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 summary on a report on an investigation related to the DAO’s ICO, 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.

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    Newly Established SEC Office and Advisory Committee Will Advocate for Small Business Capital Formation

    Thursday, December 28, 2017, 9:58 AM [General]
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    A two-year federal effort to modernize regulations and policies governing small and emerging growth companies (EGCs) will result in new a Securities and Exchange Commission (SEC) Office of Advocate for Small Business Capital Formation and an accompanying advisory committee, according to Laura Anthony, a securities and investment specialist, blogger and founder of Legal and Compliance, LLC, in West Palm Beach.

    Based on a September 13, 2017, final report from the SEC’s Advisory Committee on Small and Emerging companies, the federal agency that oversees securities and investments is proposing new guidance and definitions for emerging privately held businesses and small publicly traded companies, Ms. Anthony writes in the Securities Law Blog.

    The newly formed advocacy office will oversee the updated policies and regulations; members are currently being sought for its advocacy advisory committee, according to Ms. Anthony.

    Her coverage of the committee’s two-year effort and final report covers five main topics:

    · Updated definitions that would identify “smaller reporting companies” as those with public floats up to $250 million (up from less than $75 million), and would identify “accelerated filers” as those with public floats of $250-$700 million. According to Ms. Anthony, “This will increase the class of companies benefiting from a broad range of benefits,” including exemption from several pay, auditor and compensation requirements.

    · Updated definitions of “accredited investors” with an emphasis on simplicity, acceptable levels of non-financial sophistication, a “do-no-harm” philosophy and other factors.

    · A recommendation to amend Rule 701’s requirement that financial consultants be “natural persons,” a nod to the increasing use of employees or employee rental services by fund-raising entities and a recognition of “the realities of today’s business operations.”

    · Greater clarity at state and federal levels around broker-dealer regulations, including broker registration, compensation, exemptions and solicitation. The committee reiterated its support for a joint, coordinated and transparent FINRA-North American Securities Administrators Association effort focused on small business capital regulations at the state level.

    · Board diversity disclosure and definitions, which the advisory committee believes should be left to qualifying companies but should include information covering race, gender and ethnicity.

    · A new U.S. equity market for smaller company securities trading by accredited investors, as well as other measures to increase investment opportunities for small and mid-cap investors.

    Left unaddressed are auditor attestation requirements that arise from the Sarbanes-Oxley Act. Proponents favor the inclusion of auditor-originated reports on companies’ effectiveness regarding financial reporting, while critics call the requirements burdensome and costly. The Advisory Committee indicated that its updated definition of “accelerated filers” would include a higher threshold for compliance and reporting.

    The Investment Adviser Advertising Rule

    Wednesday, December 27, 2017, 9:44 AM [General]
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    On September 14, 2017, the SEC Office of Compliance Inspections and Examinations (“OCIE”) issued a risk alert identifying the most frequent compliance violations to the investment adviser’s advertising rule.

    The Advertising Rule

    The “Advertising Rule” found in Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “Advisers Act”) prohibits an adviser from directly or indirectly publishing, circulating or distributing any advertisement that contains any untrue statement of material fact, or that is otherwise false or misleading.  “Advertising” includes any “notice, circular, letter or other written communicated addressed to one or more persons or any notice or other announcement published or made by radio or television  which offers (1) any analysis, report, or publication concerning securities, or which is to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (2) any graph, chart, formula, or other device to be used in making any determination as to when to buy or sell any security, or which security to buy or sell, or (3) any other investment advisory service with regard to securities.”

    The Advertising Rule specifically prohibits: (i) any advertisement that directly or indirectly refers to any testimonial concerning the adviser or any report or service rendered by the adviser; (ii) an adviser from advertising past specific recommendations that were profitable to any person; (iii) any advertisements claiming that any graph, chart or formula can by itself determine whether to buy or sell a security; and (iv) advertisements that offer purportedly free reports, analysis or services.

    In addition to the Advertising Rule itself, guidance on adviser advertising can be found in SEC-issued guidance updates, opinions and no-action letters, and settled or adjudicated court and administrative proceedings.

    Most Frequent Advertising Rule Violations

    The OCIE risk alert identified the following most frequent violations of the Advertising Rule:

    • Misleading Performance Results. The OCIE often observed advertisements with misleading performance results.  As an example, any advertisement of results that do not deduct the advisory fee from the presented performance, is deemed misleading.  As another example, advertisements that compared results from a particular benchmark were often misleading as the parameters or strategies involved in the two comparisons were often materially different.  Finally, hypothetical and back-tested performance results could be misleading where information on how returns were derived or other material information was not included.
    • Misleading One-on-One PresentationsAn example of a misleading one-on-one presentation would be where the adviser advertised performance results gross of fees without necessarily additional material disclosures.  Again, the mere failure to disclose that advisory fees had not been deducted from an advertisement would also be misleading.
    • Misleading Claim of Compliance with Voluntary Performance StandardsThe OCIE staffobserves cases in which an adviser claims compliance with voluntary performance standards, when in fact, they were not compliant.
    • Cherry-Picked Profitable Stock Selections. An advertisement that cherry-picks profitable stock selections without a balanced presentation, including disclosure related to unprofitable selections, is misleading.
    • Misleading Selection of Recommendations. The OCIE staff often finds adviser advertisements that include past specific investment recommendations in a misleading way. In the TCW Group no-action letter, the SEC specifically found that it was not misleading to include five or more best-performing holdings or stock picks, as long as an equal number of worst performers were also disclosed.  Moreover, an adviser would have to also include other materially relevant information about its strategy.  In the Franklin no-action letter, the SEC staff allowed advertisements including past specific performance results that used consistently applied, objective, non-performance based selection criteria, as long as the adviser included certain disclosures such as that the included results were not all results or all securities purchased or sold, and did not include profits related to specific recommendations.  Many advisers fail to follow the guidance in these no-action letters.
    • Compliance Policies and Procedures. Many advisers do not have adequate compliance policies and procedures to prevent deficient advertising practices.  Adequate procedures would include a process for reviewing and approving advertisement materials prior to publication or dissemination; determining parameters for inclusion in performance calculations; and confirming the accuracy of performance results.

    OCIE Touting Initiative

    In 2016 the OCIE launched a Touting Initiative to examine adviser advertisements that touted awards, ranking lists or professional designations and accolades in their marketing materials.  Where an adviser includes third-party rankings or awards in their advertisements, they must include material facts related to the award or ranking, so as not to be misleading, including the date of the award, selection criteria, who created or gave the award or ranking, and whether the adviser paid to be included.  Furthermore, the OCIE found that advisers sometimes obtained a ranking or award by providing false information in their application or nomination for the award in the first place.  Finally, another commonly found touting violation involved improper client testimonials.

    Read More

    Hefty SEC Report on Impact of Regulatory Reform Finds Increased Private Offerings and Small Company IPOs Amid Mixed Results

    Thursday, December 21, 2017, 10:52 AM [General]
    0 (0 Ratings)

    A sizable U.S. Securities and Exchange Commission (SEC) report on the impact of regulatory reforms enacted after the 2008 financial crisis finds gains for some sectors of the investment marketplace, no discernible impact on others, and positive movement for small company initial public offerings (IPOs), emerging growth companies (EGCs) and private offerings.

    West Palm Beach attorney Laura Anthony, a securities investment specialist and founder of Legal and Compliance, LLC, notes in her Securities Law Blog that the report – all 315 pages of it – found “no empirical evidence that U.S. Treasury market liquidity deteriorated after regulatory reforms,” specifically the Dodd-Frank Act and the 2012 JOBS Act.

    However, the report by the SEC Division of Economic and Risk Analysis (DERA) finds that total market securities increased after the implementation of the JOBS Act, as did the number of small company IPOs (less than $30 million), up from 17% of all to 22% of all IPOs.

    “Although I do not believe that emerging growth companies are necessarily small companies, more than 75% of IPOs were by ECGs in 2016,” Ms. Anthony points out.

    Other key findings from the DERA report:

    · Capital formation totaled $20.2 trillion from the time Dodd-Frank was signed in 2010 through 2016; of the total, $8.8 trillion was raised through registered offerings, and the remainder through private offerings.

    · IPO capital reached highs in 1999, 2007 and 2014, and lows in 2003, 2008 and 2016.

    · The market liquidity of the U.S. Treasury did not deteriorate after regulatory reform, while corporate bond trading activity improved or remained flat.

    · Factors in addition to regulatory legislation have also affected market liquidity, including the impact of electronic markets, macroeconomic changes and post-crisis charges in dealer risk preferences.

    The DERA analysis looked at five broad considerations, including the link between primary market capital raising and secondary market liquidity; the impact of alternative credit risk products and bond market liquidity; capital market liquidity; smaller market behaviors; and other regulations that affect different investment groups disproportionately.

    SEC Advisory Committee On Small And Emerging Companies Holds Final Meeting

    Tuesday, December 19, 2017, 8:20 AM [General]
    0 (0 Ratings)

    On September 13, 2017, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) held its final meeting and issued its final report. The Committee was organized by the SEC for a two-year term to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”

    As the two-year term is expiring, Congress has determined to establish an Exchange Act-mandated, perpetual committee to be named the Small Business Capital Formation Advisory Committee. The SEC is also setting up a new Office of Advocate for Small Business Capital Formation and is actively seeking to fill both the advocate and Committee positions.

    The September 13, 2017 Advisory Committee meeting discussed: (i) the auditor attestation report under Section 404(b) of the Sarbanes Oxley Act (“SOX”); (ii) the proposed amendments to the definition of a “smaller reporting company”; (iii) amendments to the definition of an “accredited investor”; (iv) potential updates to modernize Securities Act Rule 701 of the Securities Act related to employee stock compensation from private companies; (v) finders in private placement transaction; (vi) disclosure of board diversity; and (vii) the creation of a new secondary market for accredited investors to trade small-cap equities.

    Amendment to Smaller Reporting Company Definition

    The Advisory Committee believes that public company disclosure requirements disproportionately burden smaller reporting companies. In July 2015 the Advisory Committee made specific recommendations to the SEC for changes to the definition of a “smaller reporting company” (see HERE). Under the current rules a “smaller reporting company” is defined as one that, among other things, has a public float of less than $75 million in common equity, or if unable to calculate the public float, has less than $50 million in annual revenues.  Similarly, a company is considered a non-accelerated filer if it has a public float of less than $75 million as of the last day of the most recently completely second fiscal quarter. The Advisory Committee has made the following recommendations:

    • The SEC should revise the definition of “smaller reporting company” to include companies with a public float of up to $250 million. This will increase the class of companies benefiting from a broad range of benefits to smaller reporting companies, including (i) exemption from the pay ratio rule; (ii) exemption from the auditor attestation requirements; and (iii) exemption from providing a compensation discussion and analysis.  I note that the SEC proposed rules conforming to this recommendation and in the most recent meeting urged the SEC to finalize the rule. For more on the SEC proposed rule change, see HERE.
    • The SEC should revise its rules to align disclosure requirements for smaller reporting companies with those for emerging-growth companies. These include (i) exemption from the requirement to conduct shareholder advisory votes on executive compensation and on the frequency of such votes; (ii) exemption from rules requiring mandatory audit firm rotation; (iii) exemption from pay versus performance disclosure; and (iv) allow compliance with new accounting standards on the date that private companies are required to comply.  For more information on the differences between a smaller reporting company and an EGC, please see HERE.
    • The SEC should revise the definition of “accelerated filer” to include companies with a public float of $250 million or more but less than $700 million. As a result, the auditor attestation report under Section 404(b) of the Sarbanes-Oxley Act would no longer apply to companies with a public float between $75 million and $250 million.

    As an aside, one of the recommendations flowing from the 2016 SEC Government-Business Forum on Small Business Capital Formation is that the definition of smaller reporting company and non-accelerated filer should be revised to include an issuer with a public float of less than $250 million or with annual revenues of less than $100 million, excluding large accelerated filers; and to extend the period of exemption from Sarbanes 404(b) for an additional five years for pre- or low-revenue companies after they cease to be emerging-growth companies.

    Amendment to Definition of an Accredited Investor

    Previously on June 19, 2016, and in early 2015, the Advisory Committee made specific recommendations for changes to the definition of an “accredited investor.”  See here for my prior blog on the subject HERE. The Advisory Committee has reiterated its prior recommendations, including:

    (i) The core of prior recommendations remain the same with the added statement that “the overarching goal of any changes the Commission might consider should be to ‘do no harm’ to the private offering ecosystem.”

    (ii) The SEC should not change the current financial thresholds in the definition except to adjust for inflation on a going-forward basis.

    (iii) The definition should be expanded to take into account measure of non-financial sophistication, regardless of income or net worth, thereby expanding rather than contracting the pool of accredited investors.

    (iv) “Simplicity and certainty are vital to the utility of any expanded definition of accredited investor.  Accordingly, any non-financial criteria should be able to be ascertained with certainty”; and

    (v) The SEC should continue to gather data on this subject and, in particular, what “attributes best encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.”

    Amendment to Rule 701

    The Advisory Committee heard presentations and made recommendations to the SEC to amend Rule 701. Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Exchange Act. The Rule 701 exemption  is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.

    Rule 701 exempts the offers and sales of securities under a written compensatory plan. The plan can provide for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors. However, under the rule consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.

    Securities issued under Rule 701 are restricted securities for purposes of Rule 144; however, 90 days after a company becomes subject to the Exchange Act reporting requirements, securities issued under a 701 planbecome available for resale. In addition, non-affiliates may sell Rule 701 securities after the 90-day period without regard to the current public information or holding period requirements of Rule 144.

    The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. Rule 701 issuances do not integrate with the offer and sales of any other securities under the Securities Act, whether registered or exempt.

    Rule 701(e) contains specific disclosure obligations scaled to the amount of securities sold. In particular, for all issuances under Rule 701 a company must provide a copy of the plan itself to the share recipient. Where the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the company must provide the following disclosures to investors within a reasonable period of time before the date of the sale: (i) a copy of the plan itself (ii) risk factors; (iii) financial statement as required under Regulation A; (iv) if the award is an option or warrant, the company must deliver disclosure before exercise or conversion; and (v) for deferred compensation, the company must deliver the disclosure to investors within a reasonable time before the date of the irrevocable election to defer is made.

    The Advisory Committee made the following recommendations related to Rule 701:

    (i) Eliminate the Requirement that consultants be natural persons. The original limitation was intended to prevent Rule 701 from being used for capital-raising transactions; however, many smaller companies use outside employees or employee rental services that are run through entities. The Advisory Committee believes that this change will bring Rule 701 more in line with the realities of today’s business operations and that other provisions of the rule adequately address the prohibition against improper use of the Rule, such as for capital-raising transactions.

    (ii) Remove the Rule 701 limits of the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. The Advisory Committee believes that the analysis required by these limits outweigh any benefits.

    (iii)  Increase the $5 million disclosure requirement cap to at least $10 million. Note that bills have now passed both the House and Senate that would increase the cap to $10 million and are expected to be signed by the President in the near future.

    (iv) Exclude “material amendments” from the calculation of the limits in the Rule. Currently SEC CD&I on the Rule require repriced options to be counted as new grants or sales. However, it is argued that repricing merely keeps options within the intended use of the Rule, i.e., as compensation. Moreover, it is thought that companies avoid repricing when it would be beneficial, to avoid reaching the Rule limits.

    (v) Clarify the application of the Rule to Restricted Stock Units (RSU’s). RSU’s are not currently addressed in the Rule. It is recommended that they be treated the same as options. In addition, it is recommended that any disclosure obligations be triggered by exercise or settlement and not the grant itself. Note, however, that a CD&I does include RSU’s under Rule 701 and requires disclosure, and limit analysis, as of the date of grant.

    (vi) Require disclosure only after the threshold has been exceeded. Currently, expanded disclosure must be provided to any person who receives securities under Rule 701 during the 12-month period in which the company sells securities under Rule 701 with a value over $5 million. As disclosure is required prior to a grant, a company could inadvertently fail to comply with the Rule when it did not properly predict it would reach the cap, or future amendments result in reaching the cap. This is another reason that amendments should be excluded from the cap calculation. Moreover, it was recommended that the disclosure requirements be simplified to require only a current balance sheet and income statement, and only requiring updates upon a material change or once a year.

    (vii) Clarify timing and delivery requirements for disclosure documents.  Currently disclosure is required to be delivered “a reasonable period of time prior to the sale.” It is recommended that disclosure be clearly allowed to be delivered at any time prior to the sale and that “access equals delivery” satisfy deliver requirements. Since Rule 701 only applies to private companies, companies sometimes do, and could be formally allowed to set up data rooms accessible to equity recipients. Note that on November 6, 2017, the SEC issued a new CD&I on the subject which specifically allows a company to implement cyber security safeguards when electronically transmitting or providing disclosure in accordance with Rule 701.

    For more on Rule 701, see my blog HERE.

    Private Placement Finders

    In a repeated and ongoing theme, the Advisory Committee once again recommended that the SEC take action to provide regulatory certainty to finders in private placement transactions. The Advisory Committee has previously made recommendations to the SEC and sought regulatory action on May 15, 2017 and on September 23, 2015. In addition to a plea for any guidance and support, in 2015 the Advisory Committee had made the following specific recommendations:

    (i) The SEC take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Exchange Act;

    (ii) The SEC exempt intermediaries on a federal level that are actively involved in the discussions, negotiations and structuring, and solicitation of prospective investors for private financings as long as such intermediaries are registered on the state level;

    (iii) The SEC spearhead a joint effort with the North American Securities Administrators Association (NASAA) and FINRA to ensure coordinated state regulation and adoption of measured regulation that is transparent, responsive to the needs of small businesses for capital, proportional to the risks to which investors in such offerings are exposed, and capable of early implementation and ongoing enforcement; and

    (iv) The SEC should take immediate steps to begin to address this set of issues incrementally instead of waiting for the development of a comprehensive solution.

    For a review of my ongoing discussion on finder’s fees, see my blog HERE.

    Board Diversity

    The Advisory Committee believes that board diversity improves competitiveness and creates greater access to capital, more sustainable profits and better shareholder relationships. As such, the Advisory Committee recommends that the SEC amend its current very broad rule on board diversity disclosure to require companies to describe their policies with respect to diversity and to disclose the extent to which their boards are diverse. As with the current rule, the definition of diversity can be left to the company; however, disclosure should include information regarding race, gender and ethnicity.

    Market Structure – Secondary Trading

    The Advisory Committee recognizes that liquidity is an issue for smaller companies. The Advisory Committeeadvocates for a new U.S. equity market for the trading by accredited investors in smaller company securities. The Advisory Committee also advocates for federal law preemption over the secondary trading of Tier 2 Regulation A securities. Moreover, the Advisory Committee recommends that the SEC allow for smaller exchange-listed companies to voluntarily choose larger trading increments or tick sizes.  It is thought that widening spreads from the current one-penny increments could provide economic incentives that would encourage the provision of trading support to the equity securities of small and mid-cap companies.  More flexibility and larger tick sizes could also encourage IPO’s for small companies. For more on the SEC tick size pilot program, see HERE.

    Sarbanes-Oxley Section 404(b)

    The Advisory Committee has heard presentations on the Sarbanes-Oxley Section 404(b) requirement for an auditor attestation and report on management’s assessment of internal control over financial reporting. Among other things, Section 404(b) of SOX requires companies to include in their annual reports filed with the SEC, an accompanying auditor’s attestation report on the effectiveness of the company’s internal control over financial reporting. In other words, reporting companies must employ their auditor to audit and attest upon their financial internal control process, in addition to the financial statements themselves.

    Section 404(b) has been a hot topic recently, with those already or soon to be required to comply almost unilaterally requesting relief, and those that benefit from its application, including accountants and auditors, almost unilaterally touting its benefits.  The Financial Choice Act, which is not likely to pass in its complete form, includes a provision that would increase the Rule 404(b) compliance threshold from a $250 million public float to $500 million.

    In one Advisory Committee presentation, a representative from a large accounting firm supported Section 404(b) and touted improvements in accounting quality. According to studies, companies that have control audits have fewer restatements, higher valuations and lower costs of debt.

    However, in the second presentation by the CEO of a relatively small pre-revenue biotech company, the reality of the onerous cost and effort involved to comply with Section 404(b) was illustrated. The cost of 404(b) compliance took away from R&D, growth, and additional employees, and could add 1% or more to the company’s overall burn rate. That CEO advocated for an exemption from 404(b) for all companies with either a public float under $250 million or annual revenues under $100 million.

    The Advisory Committee seems to agree that 404(b) is not necessary or helpful for smaller companies but did not make a specific recommendation as suggested by the biotech CEO. Rather, the Advisory Board has recommended a change in the definition of “accelerated filer” as noted above, which would include a higher threshold for Section 404(b) compliance.

    Read More 

    SEC Publishes Report on Access to Capital and Market Liquidity

    Tuesday, December 12, 2017, 8:52 AM [General]
    0 (0 Ratings)

    On August 8, 2017 the SEC Division of Economic and Risk Analysis (DERA) published a 315-page report describing trends in primary securities issuance and secondary market liquidity and assessing how those trends relate to impacts of the Dodd-Frank Act, including the Volcker Rule. The report examines the issuances of debt, equity and asset-backed securities and reviews liquidity in U.S. treasuries, corporate bonds, credit default swaps and bond funds. Included in the reports is a study of trends in unregistered offerings, including Regulation C and Regulation Crowdfunding.

    This blog summarizes portions of the report that I think will be of interest to the small-cap marketplace.

    Disclaimers and Considerations

    The report begins with a level of disclaimers and the obvious issue of isolating the impact of particular rules, especially when multiple rules are being implemented in the same time period. Even without the DERA notes that noted trends and behaviors could have occurred absent rule changes or reforms. The financial crisis that resulted in the implementation of Dodd-Frank, necessarily resulted in changes in market trends in and of itself, as did post crisis changes other than Dodd-Frank such as much lower interest rates. Furthermore, observed changes could be a result of numerous other factors such as various regulations (besides the studies Dodd-Frank and JOBS Act), non-regulatory market structure changes and technological advances.

    Moreover, five broad economic considerations shaped the DERA analysis. First, capital raising in primary markets and liquidity in secondary markets are inextricably intertwined. There is a direct correlation between the ability to exit investments on the secondary market and the inflow of new investments for primary issuances. Second, alternative credit risk products impact activity and liquidity in bond markets. Third, liquidity is an important characteristic of capital markets, impacting the ability of investors to execute trades of different sizes, quickly and at a low cost. Fourth, although large sample analysis is used to study the markets, this information may not reflect the behaviors of smaller market segments. For example, since the sample size and offering size for companies relying on the JOBS Act provisions is relatively small, and its time of use is relatively short, the DERA declines to reach conclusions regarding future trends related to these offerings.  Fifth, regulations that affect one group over another, affect the ability to observe overall changes in market indicators and links to such regulations.

    Changes and Trends in Primary Issuance

    As I reiterate in many of my blogs, all offers and sales of securities must be either registered with the SEC under the Securities Act of 1933 (the “Securities Act”) or conducted under an exemption from registration. All offerings require disclosure to potential investors with registered offerings requiring detailed disclosures and financial information delineated by regulations, including Regulations S-K and S-X.  Companies completing registered offerings become subject to ongoing reporting requirements under the Securities Exchange Act of 1934 (the “Exchange Act”). For more information on Exchange Act reporting requirements, see HERE.

    One of the purposes of exempt offerings is to reduce the burden on companies during the capital-raising process and thereafter. Certainly not all companies can afford, nor should take on the expense of, a registered offering and ongoing SEC reporting requirements. Since exempt offerings require fewer disclosures and have far less regulatory oversight, they are subject to investor limitations, such as accreditation, and for some, offering limits. The investor protection provisions of the exemption claimed must be met to qualify for the exemption from registration.

    The JOBS Act, enacted in 2012, was designed to promote registered and exempt offerings. The JOBS Actcreated emerging growth companies (EGC’s), expanded Rule 506 of Regulation D by creating Rule 506(c) allowing general solicitation and advertising in exempt offerings limited to accredited investors, amended Rule 144A to allow general solicitation and advertising, revamped Regulation A completely and created Regulation CF (Title III Crowdfunding). The DERA notes that these changes would be expected to have important effects on the amount of capital being raised and personally, I think that the changes have had a dramatic impact on primary issuances and especially for smaller companies.

    As noted above, the DERA is reluctant to directly tie increases in primary market issuances to the JOBS Act because it involves relatively newer regulations (the provisions were enacted over time from 2012 through 2016), and smaller sample sizes for analysis, but the report can’t deny the uptick, noting the increase in activity around its implementation.

    The DERA analyzed the primary issuance of debt, equity and asset-backed securities. The DERA reviewed changes in IPO’s, seasoned follow-on offerings, Regulation A and exempt offerings of debt and equity under Regulation D. Total capital formation from the signing of Dodd-Frank into law in 2010 through the end of 2016 was $20.20 trillion, of which $8.8 trillion was raised through registered offerings and the balance through private offerings. The DERA did not find a decrease in total primary market security issuances as a result of Dodd-Frank, though it did find that there was an increase around the implementation of the JOBS Act in 2012.

    The DERA did note several trends, including that capital raised through initial public offerings (IPO’s) ebbs and flows over time, reaching highs in 1999, 2007 and 2014 and lows in 2003, 2008 and 2016. The number of small company IPO’s has increased in recent years. IPO’s of less than $30 million increased from 17% of total IPO’s to 22% following passage of the JOBS Act. Although I do not believe that emerging growth companies (EGC’s) are necessarily small companies, more than 75% of IPO’s were by EGC’s in 2016.  The use of Regulation A also continues to increase.

    In addition, private offerings have increased substantially over the years. The amount raised through private offerings in the period from 2012 through 2016 was more than 26% higher than the amount raised in registered offerings in the same time period.

    Changes and Trends in Market Liquidity

    The DERA found it more difficult to tie changes in market liquidity to regulatory reform, citing other factors such as the electronification of markets, changes in macroeconomic conditions, and post-crisis changes in dealer risk preferences as influencers.

    The report focused on treasuries, corporate bonds, single-name credit default swaps and funds in its liquidity analysis, devoting 191 pages to these topics. A discussion of this areas is beyond the scope of this blog.

    The DERA does state that it found no empirical evidence that U.S. Treasury market liquidity deteriorated after regulatory reforms. Trading activity in corporate bond markets has generally improved or remained flat. Furthermore, transaction costs have decreased over the years on whole. Dealers in corporate bond markets have reduced their capital commitment since 2007, which is consistent with the Volcker Rule.

    The Author

    Laura Anthony, Esq.
    Founding Partner
    Legal & Compliance, LLC
    Corporate, Securities and Going Public Attorneys
    330 Clematis Street, Suite 217
    West Palm Beach, FL 33401
    Phone: 800-341-2684 – 561-514-0936
    Fax: 561-514-0832
    LAnthony@LegalAndCompliance.com
    www.LegalAndCompliance.com
    www.LawCast.com

    Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

    Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

    Follow me on FacebookLinkedInYouTubeGoogle+Pinterest and Twitter.

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