Laura Anthony

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    • Title:Founding Partner
    • Organization:Legal & Compliance, LLC
    • Area of Expertise:Securities Law
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    The SEC Has Provided Guidance On Ether and Bitcoin, Sort Of

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    Forum Recommendations

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

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

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    Online Platforms Trading Cryptocurrencies; Continued Uncertainty In Crypto Space

    Tuesday, June 5, 2018, 7:55 AM [General]
    0 (0 Ratings)

    I have been writing often about the cryptocurrency marketplace and the SEC and other regulators’ statements and concerns about compliance with the federal securities laws. On July 25, 2017, the SEC issued a Section 21(a) Report on an investigation related to an initial coin offering (ICO) by the DAO, concluding that the ICO was a securities offering.  In that Report the SEC stated that securities exchanges providing for trading must register unless an exemption applies. In its numerous statements on cryptocurrencies since then, the SEC has consistently reminded the public that exchanges that trade securities, including cryptocurrencies that are securities, must be licensed by the SEC.

    The SEC has also stated that as of today, no such licensed securities cryptocurrency exchange exists. However, a few CFTC regulated exchanges have now listed bitcoin futures products and, in doing so, engaged in lengthy conversations with the CFTC, ultimately agreeing to implement risk mitigation and oversight measures, heightened margin requirements, and added information sharing agreements with the underlying bitcoin trading platforms.

    The topic of the registration of exchanges for trading cryptocurrencies is not new to regulators. Years before the Section 21(a) DAO Report and crypto craze, on December 8, 2014, the SEC settled charges against BTC Virtual Stock Exchange and LTC-Global Virtual Stock Exchange, which traded securities using virtual currencies, bitcoin or litecoin. According to the SEC release on the matter, “the exchanges provided account holders the ability to use bitcoin or litecoin to buy, sell, and trade securities of businesses (primarily virtual currency-related entities) listed on the exchanges’ websites. The venues weren’t registered as broker-dealers despite soliciting the public to open accounts and trade securities. The venues weren’t registered as stock exchanges despite enlisting issuers to offer securities for the public to buy and sell.” The exchanges charged and collected transaction-based compensation for each executed trade on the platforms.

    Since the Section 21(a) DAO Report, most of the statements from the SEC and other regulators have focused on ICOs and the issuance of cryptocurrencies as opposed to focusing on the exchanges that trade cryptos. On March 7, 2018, the SEC finally issued a public statement directed specifically to online platforms for the trading of digital assets – i.e., cryptocurrencies. This blog will summarize that statement. Also, at the end of this blog is a list with links to my numerous other blogs on the topic of distributed ledger technology (blockchain), cryptocurrencies and ICOs.

    SEC Statement on Potentially Unlawful Online Platforms for Trading Digital Assets

    Online trading platforms have become prevalent for the buying and selling of coins and tokens, including new cryptocurrencies offered in initial coin offerings (ICOs). Many platforms bring buyers and sellers together in one place and offer investors access to automated systems that display priced orders, execute trades, and provide transaction data. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.  As mentioned above, no such SEC-registered platform exists as of today.

    In its statement, the SEC cautions investors that “[T]o get the protections offered by the federal securities laws and SEC oversight when trading digital assets that are securities, investors should use a platform or entity registered with the SEC, such as a national securities exchange, alternative trading system (‘ATS’), or broker-dealer.”

    The SEC is concerned that online platforms have the appearance of regular licensed securities exchanges, including using the word “exchange” when they are not. The SEC does not review the standards these “exchanges” use to pick or vet digital assets and cryptocurrencies, the trading protocols used to determine how orders interact and are executed, nor any internal controls or procedures of these platforms. Furthermore, the SEC warns that data provided by these trading platforms, such as bid and ask prices and execution information, may lack integrity.

    The SEC provides a list of questions for investors to ask when considering trading on an online platform, including:

    • Do you trade securities on this platform? If so, is the platform registered as a national securities exchange (see our link to the list below)?
    • Does the platform operate as an ATS? If so, is the ATS registered as a broker-dealer and has it filed a Form ATS with the SEC (see our link to the list below)?
    • Is there information in FINRA’s BrokerCheck ® about any individuals or firms operating the platform?
    • How does the platform select digital assets for trading?
    • Who can trade on the platform?
    • What are the trading protocols?
    • How are prices set on the platform?
    • Are platform users treated equally?
    • What are the platform’s fees?
    • How does the platform safeguard users’ trading and personally identifying information?
    • What are the platform’s protections against cybersecurity threats, such as hacking or intrusions?
    • What other services does the platform provide? Is the platform registered with the SEC for these services?
    • Does the platform hold users’ assets? If so, how are these assets safeguarded?

    Registration or Exemption of an Exchange

    Section 5 of the Exchange Act of 1934, as amended (“Exchange Act”) makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange or is exempted from such registration. A national securities exchange registers with the SEC under Section 6 of the Exchange Act.

    Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood….” Exchange Act Rule 3b-16 further defines an exchange to mean “an organization, association, or group of persons that: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.” The SEC has also stated that “an exchange or contract market would be required to register under Section 5 of the Exchange Act if it provides direct electronic access to persons located in the U.S.”

    According to the SEC website, as of today there are 21 licensed exchanges registered with the SEC. Exchanges that trade securities futures are registered with the SEC through a notice filing under Section 6(g) of the Exchange Act. There are 5 such registered exchanges. There are two exchanges that the SEC has exempted from registration on the basis of limited volume transactions.

    Continued Uncertainty

    Although the SEC is certainly correct that an online trading platform that trades securities must be licensed by the SEC, that would not be the case if the asset being traded is not a security. In fact, if the asset is a currency (and not a security) or a “thing” such as loyalty points, no US federal agency would regulate its trading. The SEC only regulates the trading of securities and security-related products. 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.

    Likewise, no federal regulator has direct jurisdiction over “exchanges” that trade loyalty points such as converting airline points to use for hotels, cars, consumer goods and services, or cash.  Online platforms such as www.points.com and www.webflyer.com operate using contractual partnerships with entities that issue loyalty points. In fact, points.com is owned by Points International Ltd., which trades on the TSX and Nasdaq and refers to itself as “the global leader in loyalty currency management.” Certainly, today there is a vast difference in the trading of loyalty points versus those looking to make profits in cryptocurrency trading, but there are also analogies, especially with the “currency” side.  In a recent 6-K, Points has this to say about the loyalty industry:

    Year-over-year, loyalty programs continue to generate a significant source of ancillary revenue and cash flows for companies that have developed and maintain these loyalty programs. According to the Colloquy group, a leading consulting and research firm focused on the loyalty industry, the number of loyalty program memberships in the US increased from 3.3 billion in 2014 to 3.8 billion in 2016, representing an increase of 15% (source: 2017 Colloquy Loyalty Census Report, June 2017). As the number of loyalty memberships continues to increase, the level of diversification in the loyalty landscape is evolving. While the airline, hotel, specialty retail, and financial services industries continue to be dominant in loyalty programs in the US, smaller verticals, including the restaurant and drug store industries are beginning to see larger growth in their membership base. Further, newer loyalty concepts, such as large e-commerce programs, daily deals, and online travel agencies, are becoming more prevalent. As a result of this changing landscape, loyalty programs must continue to provide innovative value propositions in order to drive activity in their programs.

    Companies that believe that their crypto is truly a utility with currency value may feel they have more in common with a loyalty point than a security, and regulators have yet to be able to give any level of firm ground on which to stand.

    In a hearing before the House Financial Services Committee on May 16, 2018, Stephanie Avakian, co-director of the SEC Division of Enforcement, told lawmakers that the SEC will continue to look at each case involving a cryptocurrency on a facts-and-circumstances basis. Ms. Avakian and co-director Steven Peiken both gave testimony and sat in the hot seat. The Financial Services Committee members were pushing for more definitive input on how ICOs should be defined and regulated, without result. The hearing became contentious, with Committee members becoming frustrated with the lack of direction and lack of certainty from the SEC as to how they define and view cryptocurrencies, other than “on a case-by-case basis” and using the same federal securities principles that already exist – a mantra that has been repeated.

    However, the SEC enforcement division could rightfully feel they are being put in an unfair position with this line of questioning.  Commissioner Hester M. Peirce warned against rulemaking by enforcement in a recent speech. Ms. Peirce has strong opinions on the subject.  She states, “[D]ue process starts with telling individuals in advance what actions constitute violations of the law.” She continues with “[A] related issue to which I am paying attention is the degree to which our enforcement process is being used to push the bounds of our authority. Congress sets the parameters within which we may operate, and we ought not to stray outside those boundaries through, for example, overly broad interpretations of  ‘security’ or extraterritorial impositions of the law. Our canons of ethics specifically caution us against exceeding ‘the proper limits of the law’ and argue for us remaining ‘consistent with the statutory purposes expressed by the Congress.’”

    In fairness, Ms. Peirce was talking in the context of enforcement as a whole. Not once did she mention cryptocurrencies, ICOs or blockchain in that speech.  However, in light of the prevalence of the topic and many industry leaders, politicians and market participants looking to the SEC for guidance on the question of “what is a cryptocurrency” and “how should it be regulated,” I can’t help but think the SEC is looking back at Congress with the same question.

    Further Reading on DLT/Blockchain and ICOs

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

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

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

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

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

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

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

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

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

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

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

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    Multiple Classes of Stock and the Public Company

    Tuesday, June 5, 2018, 7:54 AM [General]
    0 (0 Ratings)

    In March 2017, Snap Inc. completed its IPO, selling only non-voting Class A common shares to the investing public and beginning an ongoing discussion of the viability and morality of multiple classes of stock in the public company setting. No other company has gone public with non-voting stock on a U.S. exchange.  Although Facebook and Alphabet have dual-class stock structures, shareholders still have voting rights, even though insiders hold substantial control with super-voting preferred stock.

    Snap’s stock price was $10.79 on May 7, 2018, well below is IPO opening price of $17.00. Certainly the decline has a lot to do with the company’s floundering app, Snapchat, which famously lost $1.3 billion in value when reality star Kylie Jenner tweeted that she no longer used the app, but the negativity associated with the share structure has made it difficult to attract institutional investors, especially those with a history of activism. Although there was a net increase of $8.8 million in institutional ownership in the company for the quarter ending March 2018, the approximate 20% total institutional ownership is below average for the Internet software/services industry and the increase in the quarter resulted from purchases by 2 institutions where 8 others decreased their holdings.

    Moreover, many institutions, including pension funds, have holdings in Snap because they buy index funds, including ETFs, and Snap is in the S&P 500. The Council of Institutional Investors has even sent Snap a letter urging it to reconsider its share structure.

    The discussion has gained regulatory attention as well. On February 15, 2018, SEC Commissioner Robert J. Jackson Jr. gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” in which he talked about the detriments of closely held perpetual control stock in a public company.

    Days prior to Commissioner Jackson’s speech, Commissioner Kara Stein gave a speech at Stanford University about the role of corporate shareholders.  Commissioner Stein posits that the relationship between a company and its shareholders should be mutual, including in areas involving cyber threats, board composition, shareholder activism and dual-class capital structures. Stein sees dual-class structures as purposefully disenfranchising shareholders and being inherently undemocratic.

    Perhaps feeling the pressure, on May 2, 2018, Zynga founder Mark Pincus announced he will convert his super-voting preferred stock into common stock, eliminating the company’s dual-class structure.  As a result of the conversion, Pincus’ voting power was reduced from 70% to 10%. His prior 10% economic stake remains unchanged.

    SEC Commissioner Robert J. Jackson Jr.’s Speech: Perpetual Dual-Class Stock: The Case Against Corporate Royalty

    On February 15, 2018, SEC Commissioner Robert J. Jackson Jr., gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” at the University of California, Berkley campus.  Commissioner Jackson began the substantive portion of his speech with a summary background of a dual-class stock structure.  I’ve supplemented his explanation with additional information.

    Dual-class voting typically involves two more or more classes of stock, with one class having significantly more voting power than the others. The higher voting shares are often called “super-voting.” Typically, in a dual-class structure, the equity issued to the public is common equity with one vote per share and equity issued to insiders would be super-voting preferred stock. A company may also have other classes of preferred stock with various rights issued to different investors.  Snap’s issuance of non-voting common stock to the public takes this structure one step further.

    Historically, the NYSE did not allow companies to go public with dual-class voting structures. However, the takeover battles in the 1980s resulted in a change in the rules to allow for insider and management anti-takeover voting protection. Today, it is common for companies to go public with dual classes of voting stock.  Public companies using dual-class are today worth more than $5 trillion, and more than 14% of the 133 companies that listed on U.S. exchanges in 2015 have dual-class voting. That compares with 12% of firms that listed on U.S. exchanges in 2014, and just 1% in 2005. Nearly half of the companies with dual-class shares give corporate insiders super-voting rights in perpetuity.

    Commissioner Jackson acknowledges the reasons for a dual-class structure, and the desire by entrepreneurs and founders to go public while retaining control; however, he also quickly asserts that such a structure undermines accountability. Prior to accessing public markets, management control is beneficial in that it allows visionaries and entrepreneurs to innovate and disrupt industries without the short-term pressure of a loss of control over their efforts. However, perpetual outsized voting rights not only provide ultimate control to founders and entrepreneurs, but to their heirs as well, who may or may not be strong managers, entrepreneurs and visionaries.

    Although many market players are recently strongly advocating for a change in rules to prohibit companies from going public with a dual-class structure, Commissioner Jackson advocates a change such that a dual-class structure has a time limit or expiration date. There may be benefits to management control for a period of time, but that benefit ultimately runs out after a company is public and certainly once the founding management retires, leaves, passes away or otherwise ceases their entrepreneurial run. He suggests that the exchanges propose amended rules in this regard.

    Commissioner Jackson waxes philosophical pointing out the foundation of the United States origins, the Constitution and government structure, all of which are designed to allow for a change in regime and a vote by the masses. Even in public markets, power is not meant to continue in perpetuity, which is one of the reasons that the U.S. requires public companies to report and provide disclosure to investors and shareholders. Jackson likens perpetual super-voting stock as creating corporate royalty.

    However, for the sake of the debate, I note that in the free market system, it is likely that if management that holds super-voting shares does not perform, the underlying business will lose value, consumers will stop buying the product, and institutions will stop owning the stock and investing. The corporate royalty would then be under self-preserving pressure to be acquired by a stronger competitor with a better management team.

    In fact, Jackson continues his speech with analytics indicating that companies with super-voting insider control, do not perform as well as their counterparts. A recent study by Martijn Cremers, Beni Lauterbach, and Anete Pajuste entitled The Life-Cycle of Dual-Class Firms (Jan. 1, 2018) shows that the costs and benefits of dual-class structures change over time, with such companies trading at a premium shortly after the IPO, but decreasing over time.

    Jackson’s staff studied 157 dual-class IPOs that occurred within the past 15 years.  Of the 157 companies, 71 had sunset provisions or provisions that terminated the dual-class structure over time, and 86 gave insiders control forever. Whereas the companies traded relatively equally for the first few years, after seven years, those with a perpetual dual-class structure traded at a substantial discount to the others. Furthermore, when a company with a perpetual dual-class structure voluntarily eliminated the second control class, there was a significant increase in valuation.

    As mentioned, institutional investors and market participants have vocally opposed dual-class structures for public companies. In December 2017, the Investor as Owner Subcommittee of the SEC’s Investor Advisory Committee published a report entitled Discussion Draft: Dual Class and Other Entrenching Governance Structures in Public Companies strongly opposing the structure. In addition to its letter to Snap, the Council of Institutional Investors has published a page on its website discussing and advocating for one-share equal voting rights for public companies.

    Furthermore, the FTSE Russell index will now exclude all companies whose float is less than 5% of total voting power, the S&P Dow will now exclude all dual-class companies and the MSCI will reduce dual-class companies from its indexes. Commissioner Jackson is concerned that excluding dual-class stock companies from indexes does more harm than good. Many Main Street investors own public equities through funds or ETFs that in turn either own or mirror indexes. By removing dual-class companies from index funds, Main Street investors lose the opportunity to invest in these companies, some of which are the most innovative in the country today.

    Commissioner Jackson’s suggestion of finding a middle ground whereby a company could complete an IPO with a dual-class structure and allow its visionaries to build without short-term shareholder pressure, but then limiting that sole control to a defined period, was met with praise and approval. Several market participants, including the SEC’s Investor Advisory Committee and the Council of Institutional Investors, made comments supporting the suggestion.

    More on Preferred Equity

    Although the topic of super-voting features in dual-class stock structures has been hotly debated recently, it is not the only feature that may be in preferred stock.  Preferred stock is the most commonly used investment instrument due to its flexibility. Preferred stock can be structured to offer all the characteristics of equity as well as of debt, both in financial and non-financial terms. It can be structured in any way that suits a particular deal. The following is an outline of some of the many features that can be included in a preferred stock designation:

    1. Dividends a dividend is a fixed amount agreed to be paid per share based on either the face value of the preferred stock or the price paid for the preferred stock (which is often the same); a dividend can be in the form of a return on investment (such as 8% per annum), the return of investment (25% of all net profits until the principal investment is repaid) or a combination of both. Although a dividend can be structured substantially similar to a debt instrument, there can be legal impediments to a dividend payment and a creditor generally takes priority over an equity holder. The ability of an issuer to pay a dividend is based on state corporate law, the majority of which require that the issuer be solvent (have the ability to pay creditors when due) prior to paying a dividend. Accordingly, even though the issuer may have the contractual obligation to pay a dividend, it might not have the ability (either legally or monetarily) to make such payments;

    – As a dividend may or may not be paid when promised, a dividend either accrues and cumulates (each missed dividend is owed to the preferred shareholder) or not (we didn’t get the dividend this quarter, but hopefully next);

    – Although a dividend payment can be structured to be paid at any interval, payments are commonly structured to be paid no more frequently than quarterly, and often annually;

    – Dividends on preferred stock are generally preferential, meaning that any accrued dividends on preferred stock must be fully paid before any dividends can be paid on common stock or other junior securities;

    1. Voting Rights as discussed, preferred stock can be set up to establish any level of voting rights from no voting rights at all, voting rights on certain matters (sole vote on at least one board seat; voting rights as to the disposition of a certain asset but otherwise none), or super-voting rights (such as 10,000 to 1 or 51% of all votes);
    2. Liquidation Preferences a liquidation preference is a right to receive a distribution of funds or assets in the event of a liquidation or sale of the company issuer.  Generally creditors take precedence over equity holders; however, preferred stock can be set up substantially similar to a debt instrument whereby a liquidation preference is secured by certain assets, giving the preferred stockholder priority over general unsecured creditors vis-à-vis that asset.  In addition, a liquidation preference gives the preferred stockholder a priority over common stockholders and holders of other junior equities. The liquidation preference is usually set as an amount per share and is tied into the investment amount plus accrued and unpaid dividends;

    – In addition to a liquidation preference, preferred stockholders can partake in liquidation profits (for example, preferred stockholder gets entire investment back plus all accrued and unpaid dividends, plus 30% of all profits from the sale of the company issuer; or preferred stockholder gets entire investment back plus all accrued and unpaid dividends and then participates pro rata with common stockholders on any remaining proceeds (known as a participating liquidation preference);

    1. Conversion or exchange rights a conversion or exchange right is the right to convert or exchange into a different security, usually common stock;

    – Conversion rights include a conversion price which can be set as any mathematical formula, such as a discount to market (75% of the average 7-day trading price immediately prior to conversion); a set price per share (preferred stock with a face value of $5.00 converts into 5 shares of common stock thus $1.00 per share of common stock); or a valuation (converts at a company valuation of $30,000,000);

    – Conversion rights are generally at the option of the stockholder, but the issuer can have such rights as well, generally based on the happening of an event such as a firm commitment underwriting (the issuer has the right to convert all preferred stock at a conversion price of $10.00 per share upon receipt of a firm commitment for the underwriting of a $50,000,000 IPO);

    – The timing of conversion rights must be established (at any time after issuance; only between months 12 and 24; within 90 days of receipt of a firm commitment for a financing in excess of $10,000,000);

    – conversion rights usually specify whether they are in whole or in part and, for public companies, limits are often set (conversion limited such that cannot own more than 4.99% of outstanding common stock at time of conversion);

    1. Redemption/put rights a redemption right in the form of a put right is the right of the holder to require the issuer to redeem the preferred stock investment (to “put” the preferred stock back to the issuer); the redemption price is generally the face value of the preferred stock or investment plus any accrued and unpaid dividends; redemption rights generally kick in after a certain period of time (5 years) and provide an exit strategy for a preferred stock investor;
    2. Redemption/call rights a redemption right in favor of the issuer is a call option (the issuer can “call” back the preferred stock); generally when the redemption right is in the form of a call a premium is placed on the redemption price (for example, 125% of face value plus any accrued and unpaid dividends or a pro rata share of 2.5 times EBITDA);
    3. Anti-dilution protection anti-dilution protection protects the investor from a decline in the value of their investment as a result of future issuances at a lower valuation.  Generally the issuer agrees to issue additional securities to the holder, without additional consideration, in the event that a future issuance is made at a lower valuation such as to maintain the investors overall value of investment; an anti-dilution provision can also be as to a specific percent ownership (the holder will never own below 10% of the total issued capital of the issuer);
    4. Registration rights registration rights refer to SEC registration rights and can include demand registration rights (the holder can demand that the issuer register their equity securities) or piggyback registration rights (if the issuer is registering other securities, it will include the holder’s securities as well);
    5. Transfer restrictions preferred stock can be subject to transfer restrictions, either in the preferred stock instrument itself or separately in a shareholder’s or other contractual agreement; transfer restrictions usually take the form of a right of first refusal in favor of either the issuer or other security holders, or both;
    6. Co-sale or tag along rights co-sale or tag-along rights are rights of holders to participate in certain sales of stock by management or other key stockholders;
    7. Drag-along rights drag-along rights are the rights of the holder to require certain management or other key stockholders to participate in a sale of stock by the holder;
    8. Other non-financial covenantspreferred stock, either through the instrument itself or a separate shareholder or other contractual agreement, can contain a myriad of non-financial covenants, the most common being the right to appoint one or more persons to the board of directors and to otherwise assert control over management and operations; other such rights include prohibitions against related party transactions; information delivery requirements; non-compete agreements; confidentiality agreements; limitations on management compensation; limitations on future capital transactions such as reverse or forward splits; prohibitions against the sale of certain key assets or intellectual property rights; in essence non-financial covenants can be any rights that the preferred stockholder investor negotiates for.

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    SEC Continues to Review, And Delay, Crypto Funds

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

    On January 18, 2018, the SEC issued a letter to the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) explaining why the SEC could not approve a cryptocurrency-related exchange traded fund (ETF) or mutual fund. The letter, authored by SEC Division of Investment Management director Dalia Blass, explains the SEC’s reservations and concerns about approving a crypto-related mutual fund or ETF. The letter advised against seeking registration of funds that invest heavily in cryptocurrency-related products until the raised questions and concerns can be properly addressed.

    The SEC letter comes a year after the SEC rejected a proposal by Cameron and Tyler Winklevoss, famously linked to the founding of Facebook, to create a bitcoin-tracking ETF. Since that time the SEC has privately rejected several similar requests. Many in the industry appreciate the SEC letter as it offers specific guidance and concrete issues to be addressed as the march towards the eventual approval of a crypto-related fund continues.

    Since the January 18 letter, the SEC has been reviewing and conducting proceedings on a New York Stock Exchange (NYSE) proposal to list and trade five bitcoin-related ETFs. The proceedings are expected to go on for a few months. This blog will begin with an explanation of what exactly is an ETF and then address the SEC’s concerns related to the clearance of crypto-related ETFs.

    What is an ETF?

    Exchange traded funds or ETFs are funds that track indexes. Historically, exchange traded funds have tracked big-board indexes such as the Nasdaq 100, S&P 500 or Dow Jones; however, as ETFs have risen in popularity, there are now funds that track lesser-known indexes or specially created indexes to feed the ETF market. There are indexes based on market sectors, such as tech, healthcare, financial; foreign markets; market cap (micro-, small-, mid-, large-, and mega-cap); asset type (small-growth, large-growth, etc.); and commodities. The primary difference between an ETF and other index funds is that an ETF does not try to outperform the corresponding index, but rather tries to track and replicate the performance.

    An ETF allows an investor the advantage of copying an index with a single stock trade, without the risk associated with a fund manager trying to outperform the market.  Since the fund manager is simply copying and mirroring the particular index, the management style is referred to as “passive management.”

    Passive management reduces the administrative costs from an actively managed portfolio, and that savings can be passed down to the investors. A typical private hedge fund charges 2% per annum for administrative fees. That fee is reduced to 1% for mutual or registered funds. The typical fee for an ETF is less than .20% per year. Moreover, since an ETF does not trade as actively as typical funds, it has fewer capital gain events and therefore lower taxes.

    An ETF trades just like a stock, with continuous trading throughout a day. ETFs are generally margin-eligible and accordingly can be sold short. Conversely, mutual funds are generally only priced once a day after market closings and are not margin-eligible.

    ETFs have become increasingly popular over the years, especially with investors that are interested in market sectors, regions or asset types. It is not surprising that investors are interested in crypto-related ETFs and that fund creators are likewise trying to meet this investor demand.

    SEC Position on Crypto-related Mutual Funds and ETFs

    As mentioned, On January 18, 2018, the SEC Division of Investment Management issued a letter to the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) explaining why the SEC could not approve a cryptocurrency-related exchange traded fund (ETF) or similar investment product such as a mutual fund.

    The SEC begins with its commitment to fostering innovation and the development of new types of investment products, ETFs being a primary example, but quickly continues with the assertion that multiple investor protection issues need to be resolved before a crypto-related fund could be offered.  The primary issues are valuation, liquidity, custody, arbitrage, potential manipulation and other risks.

    The concerns and questions raised by the SEC will also impact future changes to exchange listing standards by the Division of Corporation Finance, the Division of Trading and Markets and the Office of the Chief Accountant. The SEC foresees needed changes to accounting, auditing and reporting requirements for crypto-related funds and ETFs.

    Valuation

    Mutual funds and ETFs must value their assets on each business day in order to reach a net asset value (“NAV”). NAV is used to determine fund performance, what investors pay for mutual funds and what authorized participants pay for ETFs as well as what they receive when they redeem or sell. The SEC is concerned that a fund or ETF would not have the necessary information to value a cryptocurrency as a result of their volatility, fragmentation, lack of regulation, nascent state and current trading volume (or lack thereof) in the cryptocurrency futures markets.

    The SEC has requested that the industry evaluate and provide information as to how valuations would be conducted. Furthermore, the SEC has asked how funds would develop and implement policies and procedures related to crypto-related valuations to ensure that the requirements as to fair value are met. Likewise, the SEC would need satisfaction that a fund or ETF could adequately address the accounting and valuation impacts of “forks” such as when a cryptocurrency diverges into two separate currencies with different prices.

    The SEC questions the policies a fund would implement to identify and determine eligibility and acceptability for newly created cryptocurrencies. The SEC has concern as to how a fund would consider the impact of market information and manipulation in the underlying cryptocurrency markets as related to the determination of the settlement price of cryptocurrency futures.

    Liquidity

    Investments in open-ended funds such as mutual funds and ETFs are redeemable on a daily basis and as such, the funds must maintain sufficient liquid assets to satisfy redemptions.  Rule 22e-4 promulgated under the Investment Company Act of 1940 (the “1940 Act”) requires funds to implement liquidity risk management programs. Under the rule, funds must classify their investments into one of four liquidity categories and limit their investments in illiquid securities to 15% of the fund’s assets.

    The SEC is concerned with the steps a fund or ETF that invests in cryptocurrencies or crypto-related products would take to ensure that it would have sufficient liquidity to meet daily redemptions. Moreover, the SEC raises questions as to how such funds would satisfy Rule 22e-4 and in particular, how could any crypto-related investment be classified as anything other than illiquid under the rule.

    The SEC specifically asks how such funds would take into account the trading history, price volatility and trading volume of cryptocurrency futures contracts, and would funds be able to conduct a meaningful market-depth analysis in light of these factors.  Similarly, given the fragmentation and volatility in the cryptocurrency markets, would these funds need to assume an unusually sizable potential daily redemption amount in light of the potential for steep market declines in the value of underlying assets.

    Custody

    The 1940 Act provides for certain requirements related to the custody of securities held by funds, including who may act as a custodian and when funds must verify holdings. The SEC questions how a fund or ETF could satisfy the custody requirements for cryptocurrency-related products. The SEC notes that there are currently no custodians providing fund custodial services for cryptocurrencies. Likewise, although currently all bitcoin future contracts are cash-settled, if physical settlement contracts develop, the SEC questions how a fund will custody the bitcoin to make delivery.

    The SEC further questions how a fund will validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records.  Another issue for cryptocurrencies is cybersecurity and the threat of hacking.  The SEC has concerns about how custodians can satisfy their requirements for the safekeeping of crypto assets.

    Arbitrage for ETFs

    ETFs obtain SEC orders that enable them to operate in a specialized structure that provides for both exchange trading of their shares throughout the day at market-based prices, and “creation unit” purchases and redemptions transacted at NAV by authorized participants. In order to promote fair treatment of investors, an ETF is required to have a market price that would not deviate materially from the ETF’s NAV. The SEC questions how an ETF could comply with the terms of an order considering the fragmentation, volatility and trading volume in the cryptocurrency marketplace.

    The SEC would like funds to engage with market makers and authorized participants to understand the feasibility of the arbitrage for ETFs investing substantially in cryptocurrency and cryptocurrency-related products. The SEC also questions how trading halts or the shutdown of a cryptocurrency exchange would affect the market price or arbitrage.

    Potential Manipulation and Other Risks

    The SEC believes that the current cryptocurrency markets have substantially fewer investor protections than traditional securities markets. Moreover, the SEC, other federal regulators, and state regulators have found considerable fraud in the cryptocurrency marketplace. The SEC is concerned about how a fund would address fraud concerns in the underlying markets when offering investments in the fund to retail investors. Similarly, the SEC is concerned about the disclosure of, and ability for a retail investor to understand, the risks of an investment in a crypto-related fund.

    Likewise, the SEC would like funds to engage in discussions with broker-dealers who may distribute the funds, as to how the broker-dealer will satisfy their suitability requirements. The SEC is also concerned with how an investment advisor will satisfy their fiduciary obligations when recommending a crypto-related fund.

    Further Reading on DLT/Blockchain and ICOs

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

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

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

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

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

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

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

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

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

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    OTC Markets Makes Several Regulatory Recommendations

    Tuesday, May 15, 2018, 8:35 AM [General]
    0 (0 Ratings)

    On March 8, 2018, Cromwell Coulson, CEO of OTC Markets Group, made a presentation to the SEC’s Investor Advisory Committee (“IAC”) as part of a panel on “Discussion of Regulatory Approaches to Combat Retail Investor Fraud.” During the meeting, Mr. Coulson discussed the most serious market risks and presented a list of 14 OTC Market’s regulatory recommendations to improve disclosure and combat these market risks.

    A review of OTC Markets website on April 24, 2018 shows 10,469 traded securities, $1.1 billion volume, 7.2 billion share volume and 174,268 trades. In his remarks to the IAC, Mr. Coulson points out that 98% of the traded dollar volume of companies on OTC Markets make current information available. Echoing the SEC’s “Main Street investor” focus, he states that “[W]e have many stocks on our markets that are completely appropriate to be part of a diversified, long term, investment portfolio, of a main street investor; we also have speculative securities that are only appropriate for risk tolerant trader.”

    However, certainly the trading in all equity securities, and especially small-cap securities, has risk. Mr. Coulson identifies what he believes are the three biggest risks to retain investors. In particular: (i) manipulative online promotion, including fraudulent and misleading information; (ii) share dilution, including through equity line financings, toxic convertible instruments and illegal share distributions; and (iii) bad actors, with a suggestion to allow for a speedy trading freeze to prevent ongoing frauds. I note that in its recent comment letters to FINRA related to the 15c2-11 process, OTC Markets suggested that it be given the power to institute short-term trading halts in response to improper activity and/or a lack of proper disclosure (see).

    As part of OTC Markets’ recently adopted stock promotion policy and best practices guidelines to improve investor transparency (see HERE), OTC Markets conducted an investigative initiative to track promotion activities. Coulson indicates that data reveals that 70% of dollar volume of securities impacted by promotional activities are listed and trade on national exchanges. Moreover, promoted securities usually have significant share dilution and are rarely suspended by the SEC. Although OTC Markets stock promotion policies are helpful, Mr. Coulson suggests that regulatory modernization is also needed to require increased disclosure of online paid stock promotion and the people behind such promotions.

    Coulson also addressed the issue of short selling. Internet-based forums, especially anonymous forums that are used for stock manipulation, misinformation and fraudulent promotions, proclaim that short selling in small-cap securities is rampant and the cause of downward pricing pressure. The reality is that short selling in small-cap securities is generally minimal due to the high cost of borrow interest and coverage requirements. Most short selling is small companies is completed by market makers with a requirement to close out within 2 days. Coulson actually suggests that in addition to greater transparency and reporting of short selling activity, regulatory changes should be made to encourage heathy short selling and price stabilization efforts by market makers.

    Another topic of concern and interest involves the illegal issuance of securities and affiliate trading. Coulson suggests transparency and information can help this issue.  In particular, Coulson advocates for increasing the role of transfer agents as record keepers. I note that he did not use the words “gate keepers” and it is unclear from the transcript if that implication was there. On December 22, 2015, the SEC issued an advance notice of proposed rulemaking and concept release on proposed new requirements for transfer agents and requesting public comment. See HERE. No further action has been taken since that time, and rules related to transfer agents have been moved from the SEC short-term agenda to long-term actions.

    Also to further transparency related to illegal issuances and affiliate trading, Coulson suggests ending anonymous Objecting Beneficial Owner (OBO) accounts for affiliates of issuers. Likewise, Coulson suggests adding a reporting requirement similar to Forms 3, 4 and 5 under Section 16 for non-SEC reporting companies.  For more on Section 16, see HERE.

    To help combat fraud and provide a deterrent to bad actors, Coulson supports increased cooperation and communication between market operators, such as OTC Markets, and regulators. Using the analogy of real-time monitoring for credit card fraud, Coulson suggests real-time monitoring and responses by market operators to red flags and indicia of fraud. In order to make preventative responses feasible, there would have to be a system to allow for a relatively quick investigation and re-onboarding of trading for affected companies.

    Coulson notes that much of the fraud in smaller public company trading emanates from unregulated intermediaries that have acquired shares in the private financing markets and are seeking to stimulate investor buying interest, so they can sell their shares. Although Coulson does not talk about regulating finders as a response to this problem, he does talk about stimulating financing options for smaller companies. I am a champion of a workable regulatory regime for finders and, as such, cannot pass this opportunity to raise the issue. For more on the current state of the law and my views, see HERE.

    To stimulate financing options, Coulson suggests allowing SEC reporting companies to utilize Regulation A+ and increasing shelf registration options. I’ve written many times about my support for an amendment to Regulation A+ to allow SEC reporting companies to complete offerings. For more on Regulation A+ in general, see HERE and particularly related to the OTC Markets comment letter and arguments for allowing reporting companies to be eligible to use the offering, see HERE.

    Coulson completed his presentation by talking about another topic that has been oft debated and for which I have strong opinions, and that is venture exchanges. The OTC Markets has worked hard to position itself as a venture exchange, but unfortunately has not received legislative support.  In fact, OTC Markets does not always receive due regard at all from the SEC and Wall Street. Back in December 2016, the SEC issued a white paper on penny stocks in which it inaccurately, albeit implicitly, lumped all OTC Markets securities together as penny stocks and as providing limited disclosure. See HERE. To the contrary, one of the requirements to trade on the OTCQX tier of OTC Markets is that the security not be a penny stock. See HERE. Both the OTCQB and OTCQX require fairly robust disclosure, including audited financial statements. OTC Markets also has a flag which appears on a company’s quote page to identify if a particular security is exempt from the definition of a penny stock.

    Mr. Coulson points out that in 2017, 61 companies graduated from the OTC Markets to a national exchange, illustrating the venture function of OTC Markets.  Furthermore, realizing the need for legislation, Coulson states that any venture legislation should follow the European SME growth market model, be disclosure-driven, and include exchanges and ATS’s that already serve smaller companies (such as OTC Markets).  For more on the importance of venture exchanges and specifics on how they should operate, see HERE.

    Coulson rightfully adds, “[E]xchange listing is not a clear solution to solving the problems at hand. We need a more holistic approach, focusing on better investor information, rather than the hard-and-fast assertion that every exchange-traded security is safe, while all other securities are risky.”

    Complete List of OTC Markets Regulatory Recommendations

    The following is the full list of the 14 regulatory recommendations by OTC Markets.

    1. Increase Paid Promoter Disclosure – OTC Markets recommends amending Securities Act Section 17(b) to require additional disclosures related to paid stock promotion and the people involved in such promotions. For more on stock promotion and Section 17(b), see HERE.
    2. Provide More Disclosures from Affiliates, Insiders and Institutions – As discussed above, OTC Markets suggests limiting anonymous Objecting Beneficial Owner accounts for affiliates. Moreover, insider and affiliate trading should be reported by all publicly traded companies and not just those subject to the Exchange Act reporting requirements. The reporting requirements should be similar to those under Section 16 for reporting companies. OTC Markets also suggests expanding Exchange Act Section 13(f) to OTC traded securities, requiring institutional investment managers to disclosure their holdings in all publicly traded securities, including short positions.
    3. Improve Share Issuance Compliance – OTC Markets suggest that transfer agent regulations be modernized to provide broker-dealers with reliable information on the issuance, ownership and transfer history of shares.

    4, Enable More Real-time SEC Enforcement – Interdealer quotation systems (IDQS) (like OTC Markets) should monitor ongoing disclosure by companies and have the ability to monitor and label late or deficient disclosures (such as OTC Markets does now).  Furthermore, the SEC should work with these market operators to take quick action where there are indications of fraud, including with trading halts and suspensions.

    1. Short Sale Reform – Require the timely disclosure of short sale positions and of aggregate industry activity. Also, allow more market maker short selling activity by amending Regulation SHO to extend the close-out time for short positions in OTC equity securities to 6 days as is current allowed for exchange traded securities.
    2. Allow SEC Reporting Companies to Use Regulation A+ – See discussion above. In addition, 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.
    3. Allow Companies to Sell Shares Directly into the Market – Allow companies that trade on an exchange or an established public market to easily sell their shares directly in the market.
    4. Facilitate Competition in Venture Exchange Legislation – A monopoly venture exchange should be avoided. As discussed above, any venture legislation should follow the European SME growth market model, be disclosure-driven, and include exchanges and ATS’s that already serve smaller companies (such as OTC Markets).
    5. Adopt Investor Suitability Standards Based on Experience and Risk Tolerance – Broker-dealers should be allowed to establish risk profiles based on trading experience and overall risk tolerance. Similar to this suggestion, I would suggest a modification to the accredited investor definition in line with the SEC Advisory Committee on Small and Emerging Companies’ prior recommendations, including expanding the definition to take into account trading experience.  See HERE.
    6. Allow Payments for Market Making – FINRA Rule 5210 should be amended to allow broker-dealers to be compensated for out-of-pocket expenses associated with preparing and submitting a Form 211 to FINRA. For more, see HERE.
    7. Bring Back the Federal Reserve OTC Margin List – Non-penny stock OTC securities should be marginable. OTC Markets suggests two possible solutions: (i) give the SEC, rather than the Federal Reserve Board, oversight of margin eligibility, or (ii) the margin list that was historically published by the Federal Reserve under Regulation T should be reinstated to make margin-eligible all non-penny stocks that are actively traded on “established public markets.”
    8. Allow Small Companies to Effectively Provide Employee Stock Ownership Plans (ESOPs) – IRS regulations limit the ability for non-exchange traded companies to effectively offer ESOP’s to employees. The definition of an “established securities market” contained in IRS regulations should be updated to include securities quoted on OTC Markets Group’s OTCQX and OTCQB markets.
    9. Allow Trading Venues to Review and/or Submit FINRA Form 211 Filings – Currently only market makers may submit a Form 211 to FINRA. Trading venues registered with the SEC and FINRA should also be allowed to do so. For more on this, see HERE.
    10. Update the SEC Definition of Penny Stocks (Exchange Act Rule 3a51-1) – Currently, biotech and other research-heavy companies may not meet the net tangible assets exemption (Subsection (g)(1)) from the definition of a penny stock. The review standard for net tangible assets (Subsection (g)(3)) should be updated to take into account interim capital raises for these types of companies. For more on the penny stock rules, see HERE...

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    Going Public Without An IPO

    Tuesday, May 8, 2018, 10:19 AM [General]
    0 (0 Ratings)

    On April 3, 2018, Spotify made a big board splash by debuting on the NYSE without an IPO. Instead, Spotify filed a resale registration statement registering the securities already held by its existing shareholders. The process is referred to as a direct listing. As most of those shareholders had invested in Spotify in private offerings, they were rewarded with a true exit strategy and liquidity by becoming the company’s initial public float.

    In order to complete the direct listing process, NYSE had to implement a rule change. NASDAQ already allows for direct listings, although it has historically been rarely used. To the contrary, a direct listing has often been used as a going public method on the OTC Markets and in the wake of Spotify, may gain in popularity on national exchanges as well.

    As I will discuss below, there are some fundamental differences between the process for OTC Markets and for an exchange. In particular, when completing a direct listing onto an exchange, the exchange issues a trading symbol up front and the shares are available to be sold by the selling stockholders at prevailing market prices at any time. In an OTC Markets direct listing, a company must work with a market maker to file a 15c2-11 application with FINRA to obtain a trading symbol. For more on the 15c2-11 process, see HERE. Moreover, the registered securities may only be sold by the listed selling shareholders at the registered price, regardless of prevailing market price. However, once a company is trading on the OTCQB or OTCQX tier of OTC Markets, and as long as the offering is not considered an indirect primary offering, the company could amend the registration statement to allow shares to be sold at market price. Generally an offering will be considered indirect primary if more than 30% of the float is being registered for resale.

    In a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors. Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary. A benefit to the company is that it has received funds much earlier in the process, rather than after a registration statement has cleared the SEC.  The cost of completing an audit and legal fees associated with the registration process is expensive and is usually borne up front prior to receiving investor funds in a traditional IPO process.

    Where a broker-dealer assists in the private placement, the commission for the private offering may be slightly higher than the commissions in a public offering.  One of the reasons is that FINRA regulates and must approve all public offering compensation, but does not limit or approve private offering placement agent fees.  For more on FINRA Rule 5110, which regulates underwriting compensation, see HERE. A second reason a broker-dealer may charge a higher commission is that there is higher risk to investors in a private offering that does not have an immediately available public exit.

    The investors take a greater risk because the shares they have purchased are restricted and may only be resold if registered with the SEC or in accordance with an exemption from registration such as Rule 144. Generally a company offers a registration rights agreement when conducting the private offering, contractually agreeing to register the shares for resale within a certain period of time. Due to the higher risk, private offering investors generally are able to buy shares at a lower valuation than the intended IPO price. The pre-IPO discount varies but can be as much as 20% to 30%.

    Furthermore, most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors. As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. Rule 506(c) allows for general solicitation and advertising of the offering.

    Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round. Main Street investors will not be able to participate until the company is public and trading. Although this raises debate in the marketplace, a debate which has resulted in increased offering exemptions for non-accredited investors such as Regulation Crowdfunding, the fact remains that the early investors take on greater risk and as such need to be able to financially withstand that risk. For more on the accredited investor definition, see HERE.

    The private offering, or private offerings, can occur over time. Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round. Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages. In a direct listing, a company can register all these shareholdings for resale in the initial public market.

    Although Spotify’s shares increased in value since debuting on the NYSE, in a direct listing there is a chance for an initial dip, as without an IPO and accompanying underwriters, there will be no price stabilization agreements. Usually price stabilization and after-market support is achieved by using an overallotment or 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).

    Direct Listing on OTC Markets

    There are some fundamental differences between the direct listing process for OTC Markets and for an exchange. In particular, when completing a direct listing onto an exchange, the exchange issues a trading symbol upfront and the shares are available to be sold by the selling stockholders at prevailing market prices at any time. In an OTC Markets direct listing, a company must work with a market maker to file a 15c2-11 application with FINRA to obtain a trading symbol.  For more on the 15c2-11 process, see HERE.

    When completing a direct listing onto OTC Markets, the registered securities may only be sold by the listed selling shareholders at the registered price, regardless of prevailing market price. However, once a company is trading on the OTCQB or OTCQX tier of OTC Markets, and as long as the offering is not considered an indirect primary offering, the company could amend the registration statement to allow shares to be sold at market price. Generally an offering will be considered indirect primary if more than 30% of the float is being registered for resale.

    Overall the direct listing process is a little less expensive and little quicker than a direct IPO process. The reason for this is that the company can work with a market maker to apply for a trading symbol immediately upon effectiveness of the S-1 as opposed to having to wait until after an offering has been sold and closed out.

    The following is a summary of the direct listing process for an OTC Markets listing. To begin, a company should retain its team including legal, accounting and auditor. The company will also need a transfer agent and EDGAR agent. Our firm often makes referrals and recommendations as to various other service providers. Moreover, a company may use a broker-dealer placement agent in the private offering phase.

    Generally, counsel will prepare a full transaction checklist including who is responsible for what items from the beginning until completion of the direct listing.  The beginning of the process includes gathering due diligence and completing any corporate cleanup or reorganization that may be necessary in advance of a public listing. All companies need some level of cleanup, which can include amending articles of incorporation and bylaws to make them public company-friendly; creating employee stock option plans; entering into employment contracts with key officers; ensuring that licensing agreements and intellectual property rights are secure; adding board members and committees such as an audit committee; and establishing corporate governance including an insider trading policy.

    While the company’s accounting and auditing are being completed, legal counsel will complete corporate cleanup and begin to draft the private offering documents, if the company is completing a new private offering round (sometimes a company begins the process after several prior rounds of offerings and will not need to complete another). In addition, legal counsel, together with the investment bankers if any, and other advisors will work with the company to determine valuation and the best structure for the private offering and the registration statement pricing. The final registration statement pricing will not need to be determined until the final pre-effective amendment is filed with the SEC.

    Ultimately a company will be registering common stock and that common stock will trade on the OTC Markets, but the private placement investment itself can take many forms, including convertible preferred stock, units consisting of current equity in the form of common and/or preferred stock and options or warrants, or units consisting of any combination of debt and equity. For more on the form of an investment and various options, see HERE. Furthermore, private offerings often include registration rights agreements to require the company to file a resale registration statement within a certain period of time.

    In structuring the private offering(s) and subsequent resale registration statement, thought must be given to the public trading markets, including obtaining a trading symbol, qualifying for various tiers of OTC Markets, and hopefully, having an active trading market. Part of this process includes planning for the Form 211 Application, which will be filed by a market maker after effectiveness of the S-1 registration statement.

    When reviewing a market maker’s Form 211 application for the issuance of a trading symbol, FINRA conducts an in-depth review of the company, its shareholders and capitalization. See HERE. One matter which FINRA reviews in determining whether to grant a trading symbol is “concentration of ownership.” FINRA will not grant a trading symbol unless there are enough non-affiliated shareholders holding freely tradeable shares, to establish a public float. Although there is no rule on this, my experience indicates that an initial float must be comprised of a minimum of 30 shareholders with more being better. FINRA will also consider the percentage of the company owned by these non-affiliated shareholders.  Again, although there is no hard rule, in order to obtain a trading symbol, at least 20% or greater of the company’s common stock, on a fully diluted basis, should be in the hands of the public float.

    Likewise, OTC Markets now considers concentration of ownership in determining whether to grant an application to trade on the OTCQB or OTCQX tiers. OTC Markets generally follows the same parameters as FINRA, though if other red flags or negative factors exist, such as recent shell company status, at least 25%-30% of the company common stock, on a fully diluted basis, will need to be in the hands of the public float in order to trade on these higher tiers.

    Furthermore, counsel must be sure to assist with any blue sky compliance in the process. For more on blue sky compliance, see my two-part blog HERE  and HERE.

    Once all private offerings are completed and the company has its intended capital structure and number of shareholders, and the company audit is completed, the S-1 registration statement will be drafted and filed with the SEC. A company can choose to file confidentially but will need to make all filings public at least 15 days prior to the registration statements effectiveness. For more on confidential filings, see HERE.

    Within 30 days of filing the S-1 registration statement, the company will receive initial comments from the SEC. The comment and review process will continue with the SEC for approximately 3-4 months, at which time the SEC will clear the S-1 to be declared effective. When a company is trading on a national exchange, they have generally timed the application with the exchange so that the shares begin trading shortly after the S-1 is declared effective and in particular, upon filing and effectiveness of a Form 8-A to complete the full registration process for the company. A Form 8-A is discussed further below.

    In an OTC Markets listing, a Form 211 Application must be filed with FINRA to receive a ticker symbol and begin trading. The Form 211 is filed by a market maker.  Generally, a company will begin to speak with a market maker shortly before the filing. The FINRA process will take a minimum of two weeks and can go on for several months. Preparation of an organized and complete file will make a big difference in the timing of the process.

    Concurrent with the Form 211 process, the company will apply to OTC Markets and determine which tier it qualifies for. Once FINRA issues a ticker symbol, the company can trade; however, to gain liquidity the company will also need to obtain DTC eligibility. The market maker that assists with the Form 211 Application can submit the DTC application as well. The stockholders listed in the S-1 registration statement are free to sell their registered shares at the price registered with the SEC.

    Direct Listing on NASDAQ

    NASDAQ has allowed for a direct listing although historically it has rarely been used. The process to achieve a direct listing on NASDAQ is substantially the same as OTC Markets with some key differences. This section will only discuss the differences. The biggest difference is that when completing a direct listing onto an exchange, the exchange issues a trading symbol upon effectiveness of the registration statement and filing of an 8-A, and the shares are then available to be sold by the selling stockholders at prevailing market prices.

    An S-1 registration statement is a registration statement filed under the Securities Act of 1933.  In order to qualify to trade on a national exchange, a company must also be registered under the Securities Exchange Act of 1934. This is not a requirement for OTC Markets. A Form 8-A is a simple (generally 2-page) Exchange Act 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).  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 effective date of the S-1 registration statement.

    Direct Listing on NYSE

    An NYSE direct listing follows the same process on NASDAQ; however, previously NYSE rules required an underwriter to determine or at least sign off on valuation in connection with an initial public offering. On February 2, 2018, the SEC approved a proposed rule change by the NYSE to allow a company that had not previously been registered with the SEC and which is not being listed as part of an underwritten initial public offering, to apply for and if qualified, trade on the NYSE.  The amended rules modify the provisions relating to qualification of companies listing without a prior Exchange Act registration in connection with an underwritten initial public offering and amend Exchange rules to address the opening procedures on the first day of trading of such securities.

    The rule amendments modify the determination of market value such that the NYSE has discretion to determine that a company meets the minimum market value requirements for a listing based on an independent third-party valuation...

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    ABA Comment Letter On Disclosures Under Regulation S-K

    Tuesday, May 1, 2018, 9:17 AM [General]
    0 (0 Ratings)

    In December 2017, the American Bar Association (“ABA”) submitted its fourth comment letter to the SEC related to the financial and business disclosure requirements in Regulation S-K.  Like the SEC’s ongoing Disclosure Effectiveness Initiative, the ABA has a Disclosure Effectiveness Working Group as part of its Federal Regulation of Securities Committee (of which I am a member) and its Law and Accounting Committee.

    The ABA comment letter begins with a general discussion of the materiality concept, which is the underlying basis of disclosure, and then provides input on various specific areas of disclosure under Regulation S-K.  The ABA comment letter specifically responded to the SEC concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016.  See my two-part blog on the S-K Concept Release HERE  and HERE.

    I’ve been writing about Regulation S-K and the SEC Disclosure Initiative since at least early 2015.  Although consistently a priority, with the finalization of proposed rule changes on the SEC short-term agenda (see HERE), a complete overhaul of Regulation S-K (and Regulation S-X) is a fluid, ongoing process that will likely continue for years to come.

    Materiality

    Materiality is a concept I’ve written about several times (see HERE, for example,).  Regulation S-K and Regulation S-X provide specific disclosure requirements that are measured and supplanted by the materiality concept.  Specific disclosure requirements generally involve objective quantitative or bright-line-rule-based standards.  In addition, to those specific disclosure requirements, a company must disclose any other material information necessary to make required disclosures not misleading.  Materiality requires a facts-and-circumstances analysis.  In TSC Industries, Inc. v. Northway, Inc., the U.S. Supreme Court defined materiality as information that would have a substantial likelihood of being viewed by a reasonable investor as having significantly altered the total mix of information available.

    The ABA comment letter discusses the materiality standard’s application to specific Regulation S-K disclosure requirements.  As noted by the ABA, the SEC recognizes that it has “adopted different approaches to guide registrants in evaluating materiality for purposes of disclosure, including in some cases using quantitative thresholds to address uncertainty in the application of materiality.”  In some cases, Regulation S-K is “principles-based” in that it directs the company to apply the materiality standard directly to the facts at hand.  A principles-based approach requires the company to “rely on a registrant’s management to evaluate the significance of information in the context of the registrant’s overall business and financial circumstances” and to “exercise judgment” in determining whether disclosure is required.

    The ABA comment letter notes the necessity of balancing rule-based disclosures with those that require a materiality analysis.  There is a degree of uncertainty in a materiality analysis and coupled with situations with a potential conflict of interest, such as disclosures related to officers and directors, or those that have a social application such as conflict minerals, the SEC leans towards a more specific rule-based approach.  However, with ever-lengthening disclosure documents filled with irrelevant and non-material information, the principles-based materiality standard is gaining favor.

    To balance the approaches, the ABA suggests subjecting almost all Regulation S-K disclosure items to a materiality analysis.  A company would be required to evaluate each Item in Regulation S-K , thereby preserving the rigor of a rules-based system, but would be permitted to omit information, even if disclosure would otherwise be specifically required, if such information is not material and the inclusion of the information is not necessary to make any required statements not materially misleading.  Exceptions to this approach would include disclosures involving conflicts of interest such as related party transactions and executive compensation.

    The ABA specifically recommend amending Item 10 of Regulation S-K to add the following subsection (g):

    (g) In addition to the information expressly required to be disclosed, the registrant shall disclose such additional material information, if any, as may be necessary to make the required statements in the light of the circumstances under which they are made not misleading. Issuers may omit information otherwise called for by a line item, except for Items 402 and 404, if such information is not material, as long as the effect of omitting the information would not be materially misleading. It shall be presumed, in the absence of facts to the contrary, that the omission of any disclosure called for by a Regulation S-K line item was an intentional omission by the registrant in reliance upon this sub-section (g) and not a failure to provide the disclosure called for by such line item.

    Known Trends or Uncertainties

    Known trends and uncertainties is a category of discussion included in Management Discussion and Analysis of Financial Conditions (MD&A).  Item 303(a) requires a company to discuss their financial condition, changes in financial condition, and results of operations using year-to-year comparisons.  The discussion is required to cover the period of the financial statements in the report (i.e., 2 years for smaller reporting companies and emerging growth companies and 3 years for others).  The SEC proposed rule change published on October 11, 2017 would allow a company to eliminate the earliest year in its discussion as long as (1) the discussion is not material to an understanding of the current financial condition; and (ii) the company has filed a prior Form 10-K with an MD&A discussion of the omitted year.  The proposed amendment would also eliminate the reference to a five-year look-back in the instructions, but rather a company would be able to use any presentation or information that it believes will enhance a reader’s understanding.  The amendments will flow through to foreign private issuers as well with conforming changes to the instructions for Item 5 of Form 20-F.

    Item 303(a) also requires a discussion of known trends or uncertainties that have had or that the company reasonably expects will have a material effect, either positive or negative, on its liquidity, capital resources or results of operations.  A discussion of trends is forward-looking, related to potential future performance.  Although the ABA believes the information is relevant and important, it expresses concerns about the SEC’s interpretations and guidance on the disclosure requirement.

    The SEC guidance on trends (SEC Release 33-6385, published in 1989) states that where a trend, demand, commitment, event or uncertainty is known, management must: (i) assess whether the trend is reasonably likely to come to fruition, and if not disclosure is not required; (ii) if unsure, management should assume it is reasonably likely and then determine the impact on the company financial condition and if such impact is material.  Unless the impact is not material, disclosure is required.

    The ABA advocates replacing the SEC’s current guidance with an analysis based on the Supreme Court case of Basic, Inc. v. Levinson, which created a probability vs. magnitude test for materiality.  In Basic the Supreme Court set the standard as “Under such circumstances, materiality ‘will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’”

    The ABA also notes recent uncertainty in the law on the question of whether a failure to disclose is necessarily a violation of the antifraud provisions under Section 10(b) and Rule 10(b)(5).  In particular, different federal circuit courts have reached different conclusions on the subject, and the U.S. Supreme Court has recently refused to review the matter to provide clarity.  The ABA would like the SEC to address this discrepancy in rule making by affirmatively asserting that whether a failure to disclose is a violation of antifraud provisions depends on a facts-and-circumstances analysis.

    Critical Accounting Estimates

    MD&A also requires a discussion of critical accounting estimates.  The ABA suggests that the SEC amend Item 303 to specifically require a discussion of the judgements and assumptions that management must make in order to prepare, and that have the most significant impact on, the company financial statements.  The ABA suggests that the SEC clarify that the discussion should not just be a cut-and-paste of the critical accounting footnote in the financial statements, as is often the case now.  Rather, the MD&A discussion should supplement the more technical footnote disclosure to help investors have a better understanding of the impact these assumptions have on the company’s financial disclosure.  The discussion could even provide examples of what the financial statements might contain if different assumptions were made.

    The SEC has made inroads into eliminating duplicative disclosure, including requesting comment and raising the issue of whether items duplicated in financial statement footnotes and other parts of a report should be maintained in only one or the other section or incorporated by reference from the footnotes to another section such as MD&A.  Several important factors affect this dialogue, including that (i) an auditor must audit and therefore has responsibility for the contents in the financial statement footnotes, including any related discussion in the audit report (see HERE related to the new audit report requirements) which could increase audit costs and burdens; and (ii) items in the financial statement footnotes are not protected by the forward-looking statements’ safe harbors.  As such, the ABA recommends any enhanced disclosure related to accounting estimates and judgments only be included in the MD&A section of a report.

    Strategy

    Although SEC rules do not require a disclosure of business strategy, many companies include a stand-alone discussion, especially in an IPO context.  The ABA suggests adding business strategy as a required category under Item 101 Description of Business.  The ABA also suggests leaving the category undefined instead letting companies look to generally accepted understandings and their own business ideas.  I do not agree with this suggestion from the ABA.  I am generally not an advocate of additional requirements and would suggest leaving it as is with voluntary discussion where appropriate.

    Intellectual Property Rights

    The SEC has discussed expanding the intellectual property disclosures in Item 101.  The ABA advocates protection of intellectual property and trade secret information.  Among many issues is the loss of protection afforded trade secret or confidential information once published and in the public, the ability to identify copyright information created by employees, and identifying which distinctive marks are subject to common law trademark protection. As such, it recommends that the SEC not expand its current requirements.

    Sustainability

    The topic of social disclosure has been much debated over the past few years.  In a report issued in October 2017, the U.S. Department of the Treasury recommended eliminating special interest and social disclosure from the SEC disclosure rules, including those related to conflict minerals, mine safety, resource extraction and pay ratio.  The Financial Choice Act would eliminate these provisions as well.  See HERE.  Climate change disclosure is another area of debate.  On the other hand, institutional investors have asserted a social agenda, and disclosure of same, in the proxy process and voting on directors.  The power of these funds and investors is not one a company can ignore.

    The ABA supports the SEC’s guidance related to social issues, which is principles-based and generally would be included in MD&A or risk factor disclosures.  The ABA includes sustainability, public policy, environmental, social and governance matters in this broad category.  The comment letter supports a materiality analysis related to disclosure.  However, I note that materiality would require an analysis as to whether such disclosure is important to a “reasonable investor.”  As noted above, many institutional investors push their own social agenda, and thus disclosures related to same, even if a reasonable investor may not find the information material.

    Disclosure of these social issues breeds emotional arguments and extreme viewpoints.  Those that advocate for eliminating the disclosure requirements do so strongly, and those that believe there is not enough disclosure or enforcement in the area, believe so fervently.  The ABA comment letter suggests adding rules that will assist companies in determining the level of disclosure, but qualifying those rules with a materiality standard.  However, the ABA notes the complexity in this area and the need for careful evaluation, as well as the probability of a fluid, changing investor environment and thus a changing view of the “reasonable investor.”

    Litigation

    Item 103 requires disclosure of material pending private civil and governmental regulatory legal proceedings and certain other specified pending or contemplated legal proceedings to which an issuer or its property is subject.  Legal proceeding disclosures may also be appropriate in MD&A, risk factors and financial footnotes.  Although Item 103 puts all matters in one location, it often does not include any important information beyond factual information about the proceedings.  The ABA suggests even further reducing the disclosure in Item 103 to a catalogue with cross-references to more robust disclosures in other sections of a report.  Finally, the ABA recommends reevaluating the requirement related to disclosure of “contemplated” governmental proceedings to those that have been asserted or have a probability of being asserted.

    Risk Factors

    The disclosure of risk factors is complex enough that I once wrote a blog on just that topic.  See HERE.  Almost all SEC guidance on disclosure matters includes a discussion of risk factors, such as the recent guidance on cybersecurity disclosure (see HERE).

    Risk factor disclosures are entirely principles-based.  That is, there are no bright-line prescriptive rules that require a specific risk disclosure.  Although the SEC consistently suggests only including risk factors that actually impact a company, and not boilerplate disclosures that could impact all businesses, most companies include the boilerplate disclosures.  Companies are more concerned with the plaintiff’s bar and potential shareholder lawsuits for the failure to include a risk factor than the SEC guidance in this regard.  Likewise, an SEC suggestion to limit the number of risk factor disclosures, or to order these disclosures in terms of management’s view of their priority or assessment of probability and magnitude of the potential impact, was met with strong issuer opposition—again, likely from a fear of shareholder litigation.

    The ABA comment letter makes a number of specific recommendations related to risk factor disclosures.  Despite opposition, the ABA suggests that the SEC consider limiting the number of risk factors and require that they be listed in order of priority.  Similarly, the ABA suggests a specific requirement that companies omit generic risk factors from their reports and registration statements.  Although it does not suggest disclosing the probability of a particular risk, the ABA does advise that companies conduct a probability/magnitude assessment in its risk factor disclosures.

    Further Background on SEC Disclosure Effectiveness Initiative

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

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

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

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

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

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

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

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

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

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

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

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

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    What is a SAFT?

    Tuesday, April 24, 2018, 8:16 AM [General]
    0 (0 Ratings)

    A Simple Agreement for Future Tokens (“SAFT”) is an investment contract originally designed to provide a compliant alternative to an initial coin offering (ICO).  A SAFT as used today was intended to satisfy the U.S. federal securities laws, money services and tax laws and act as an alternative to an ICO when the platform and other utilization for the cryptocurrency or token was not yet completed. The form of the SAFT is the result of a joint effort between the Cooley law firm and Protocol Lab as detailed in the white paper released on October 2, 2017 entitled “The SAFT Project: Toward a Compliant Token Sale Framework.” As discussed in this blog, the SAFT’s compliance with federal securities laws has now come into question by both the SEC and practitioners.

    SAFT’s are offered and sold to accredited investors as an investment to fund the development of a business or project in a way not dissimilar to the way equity changes hands in traditional venture capital. A SAFT was developed from the oft-used simple agreement for future equity (SAFE) contract in the venture capital setting. In a SAFT sale, no coins are ever offered, sold or exchanged. Rather, money is exchanged for traditional paper documents that promise access to future product. Fundamentally, a SAFT has been relying on the premise that the future product is not in and of itself a security.

    Although the SEC had been looking at ICO’s for a while, on July 25, 2017 it issued a Section 21(a) Report on an investigation related to an initial coin offering (ICO) by the DAO concluding that the ICO was a securities offering. The Section 21(a) Report established that the Howey Test is the appropriate standard for determining whether a particular token involves an investment contract and the application of the federal securities laws. SEC Chair Jay Clayton has confirmed this standard in several public statements and in testimony before the United States Senate Committee on Banking Housing and Urban Affairs (“Banking Committee”). For a review of the Howey Test, see HERE.

    Following the Section 21(a) Report, in a slew of enforcement proceedings by both the SEC and state securities regulators, and in numerous public statements, it is clear that regulators have viewed most, if not all, ICO’s as involving the sale of securities. At the same time, the SAFT grew in popularity as an attempt to comply with the 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.

    SAFT users rely on the premise that a cryptocurrency which today may be an investment contract (security) can morph into a commodity (currency) or other type of digital asset. The SAFT would delay the issuance of the cryptocurrency until it has reached its future utility. Investors in a SAFT automatically receive the cryptocurrency when it is publicly distributed in an ICO. The SAFT investors generally receive the crypto at a discount to the public offering price. However, this premise is taking a direct hit lately. Although I’ll lay out more on the SAFT history and why it was thought of as a solution further in this blog, I’ll jump right to the current analysis, and why a SAFT might not provide the intended protections.

    The SAFT Problem

    Although everyone, including regulators, agree that the state of the law in the area of cryptocurrencies and tokens is unsettled, regulators, including both the CFTC and SEC, have increasingly taken positions that would bring cryptocurrencies within their jurisdiction. I believe regulators are reacting to overarching fraud and therefore a necessity to take action to protect investors. Without congressional rule making and definitive guidance, regulators have no choice but to make the current law fit the circumstances. In some cases that works fine, but in others it does not and I suspect continuing changes in interpretations, enforcement premises and ultimately rule making will occur.

    As I’ve previously discussed, the CFTC first found that Bitcoin and other virtual currencies were 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. See HERE.

    The SEC has also taken the stance that ICO’s involve the sale of securities, and that exchanges providing for the after-market trading of cryptocurrencies must register unless an exemption applies. The SEC is now taking it one step further, postulating that the tokens or cryptocurrencies underlying the SAFT could also be a security (and when I say “could” I mean “are”), in which case the SAFT structure is nothing more than a convertible security and fails to comply with the federal securities laws and makes it even more likely that it would result in an enforcement proceeding, or private litigation.

    A SAFT is a type of pre-ICO investment with the investors automatically receiving the crypto when the company completes its public ICO. If the underlying token is a security, then the future ICO fails to comply with the federal securities laws and the original SAFT also fails to comply.

    Getting ahead of this issue, many companies have structured a SAFT such that the future ICO is also labeled a security, and the SAFT investor will receive the crypto when the future ICO is registered with the SEC. However, this results in a private pre-public security sale, which in and of itself is prohibited by the securities laws.

    In particular, Securities Act CD&I 139.01 provides:

    Question: Where the offer and sale of convertible securities or warrants are being registered under the Securities Act, and such securities are convertible or exercisable within one year, must the underlying securities be registered at that time?

    Answer: Yes. Because the securities are convertible or exercisable within one year, an offering of both the overlying security and underlying security is deemed to be taking place. If such securities are not convertible or exercisable within one year, the issuer may choose not to register the underlying securities at the time of registering the convertible securities or warrants. However, the underlying securities must be registered no later than the date such securities become convertible or exercisable by their terms, if no exemption for such conversion or exercise is available. Where securities are convertible only at the option of the issuer, the underlying securities must be registered at the time the offer and sale of the convertible securities are registered since the entire investment decision that investors will be making is at the time of purchasing the convertible securities. The security holder, by purchasing a convertible security that is convertible only at the option of the issuer, is in effect also deciding to accept the underlying security. [Aug. 14, 2009] (emphasis added)

    In a Crowdfund Insider article published March 26, 2018, one practitioner (Anthony Zeoli) has had discussions with the SEC on the subject. As reported in the article, the SEC has stated that if the SAFT investor will automatically receive tokens in the future when and if the tokens are registered, without any further action on the part of the investor, then the tokens must be registered as of the date of the SAFT investment.

    Of course, the future ICO or token offering could be completed in a private offering in compliance with the federal securities laws, such as using Rule 506(c) and limiting all sales to accredited investors (see HERE on Rule 506(c)). However, assuming the token or coin really is designed to create a decentralized community or to have utility value that can be widely used by the public, limiting sales to accredited investors does not meet the needs of the issuers. Moreover, even if the future offering is structured as a private securities offering, the SAFT sale disclosure documents would need to include full disclosure on the future coin or token such that the investor could make an informed investment decision at the time of the SAFT investment.

    In the same article, Zeoli delves into a more nuanced issue, which is the rising difference in the meaning of a “coin” vs a “token.” A SAFT is a simple agreement for future “tokens” but is being used to pre-sell initial “coin” offerings. If a coin and a token are two very different things (as Zeoli suggests—think stock vs. LLC interest), then the underlying contract has systemic problems beyond the registration and exemption provisions of the federal securities laws and may be a misrepresentation resulting in fraud claims.

    More On SAFT; Background

    As mentioned, the current form of a SAFT was created by a joint effort between the Cooley law firm and Protocol Lab as detailed in the white paper released on October 2, 2017 entitled “The SAFT Project: Toward a Compliant Token Sale Framework.” The SAFT was intended to comply with the federal securities, money transmittal and tax laws. Also, as discussed, the SAFT relies on the premise that a cryptocurrency which today may be an investment contract (security) will tomorrow be a non-security digital asset satisfying the Howey Test.  The SAFT would delay the issuance of the cryptocurrency until it has reached its future utility.

    The original SAFT white paper states:

    The SAFT is an investment contract. A SAFT transaction contemplates an initial sale of a SAFT by developers to accredited investors. The SAFT obligates investors to immediately fund the developers. In exchange, the developers use the funds to develop genuinely functional network, with genuinely functional utility tokens, and then deliver those tokens to the investors once functional. The investors may then resell the tokens to the public, presumably for a profit, and so may the developers.

    The SAFT is a security. It demands compliance with the securities laws. The resulting tokens, however, are already functional, and need not be securities under the Howey test. They are consumptive products and, as such, demand compliance with state and federal consumer protection laws.

    Despite its good intentions, as of today, the model SAFT no longer works.

    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 Journal op-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.

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

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    Regulation A+ Continues To Grow

    Tuesday, April 17, 2018, 8:48 AM [General]
    0 (0 Ratings)

    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).

    Integration

    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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