Laura Anthony

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    • Member Type(s): Expert
    • Title:Founding Partner
    • Organization:Anthony L.G., PLLC
    • Area of Expertise:Securities Law
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    The SEC’s Strategic Hub For Innovation And Financial Technology

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

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

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

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

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

                    Blockchain/Distributed Ledger 

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

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

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

    Digital Marketplace Financing

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

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

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

    Automated Investment Advice

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

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

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

    Artificial Intelligence/Machine Learning

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

    Further Reading on DLT/Blockchain and ICOs

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    Proposed Rule Changes To Simplify Registered Debt Offerings

    Tuesday, December 4, 2018, 7:03 AM [General]
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    This summer the SEC proposed rule changes to simplify disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, as well as for affiliates whose securities collateralize a company’s securities. The proposed amendments apply to Rules 3-10 and 3-16 of Regulation S-X and are aimed at making the disclosures easier to understand and to reduce the cost of compliance for companies. The proposed rules follow the September 2015 SEC request for comment related to the Regulation S-X financial disclosure obligations for certain entities other than the reporting entity. The September 2015 request for comment specifically discussed Rules 3-10 and 3-16, which comment responses were considered in the current proposed rules. For more on the September 2015 comment request, see HERE.

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

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

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

    Rule 3-10

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

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

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

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

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

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

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

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

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

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

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

    Rule 3-16

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

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

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

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

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    Financial Statement Disclosure Relief Under Rule 3-13

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

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

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

    Rule 3-13 of Regulation S-X

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

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

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

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

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

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

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

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

    How to Seek Relief

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

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

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

    Further 

    Background on SEC Disclosure Effectiveness Initiative

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

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

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

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

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

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

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

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

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

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

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

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

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

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    SEC Adopts Amendments to Simplify Disclosure Requirements

    Tuesday, October 16, 2018, 5:14 AM [General]
    0 (0 Ratings)

    n August the SEC voted to adopt amendments to certain disclosure requirements in Regulations S-K and S-X (the “S-K and S-X Amendments”) as well as conforming changes throughout the federal securities laws and related forms. The amendments are intended to simplify and update disclosure requirements that are redundant, duplicative, overlapping, outdated or superseded with the overriding goal of reducing compliance burdens on companies without reducing material information for investors. The new amendments finalize and adopt the proposed rules that had previously been issued on July 13, 2016. See my blog on the proposed rule change HERE. The final rule changes were substantially, but not entirely, as proposed.

    The Regulation S-X and S-K Amendments come as a result of the Division of Corporation Finance’s Disclosure Effectiveness Initiative and as required by Section 72002 of the FAST Act. The proposing release also requested public comment on a number of disclosure requirements that overlap with, but require information incremental to, U.S. GAAP to determine whether further changes should be made.

    The S-K and S-X Amendments cover:

    • Duplicative requirements, including duplications between financial footnote requirements and disclosures in the body of a registration statement or report;
    • Overlapping requirements which may not be completely duplicative. The S-K Amendments consider whether to delete certain disclosure requirements that are covered in GAAP or other financial reporting or integrate such disclosures into a single rule source;
    • Outdated requirements which have become obsolete due to the passage of time or changes regulations, business or technology; and
    • Superseded requirements which are inconsistent with recent legislation or updated rules and regulations.

    The amendments are set to go effective thirty (30) days after publication in the federal register. As of the date of this blog, the amendments have not been published. There have been a few blogs and some commentary as to the reason for the delay, but regardless of the reason, the delay has caused some question as to whether certain changes will need to be implemented in the upcoming 10-Q’s to be filed for companies with a September 30 quarter-end. In particular, the new amendments will require companies to present a change in shareholders’ equity as part of its quarterly financial statements, which statement was previously only required in annual reports.

    Responding to the marketplace questions, on September 25, 2018, the SEC published a new Compliance and Disclosure Interpretation (C&DI) on the matter. New question 105.09 clarifies that the amendments are effective for all filings made 30 days after publication in the federal register. However, despite this effective date, the SEC would not object if the first quarterly statement of changes in shareholder’s equity is included in a company’s Form 10-Q filed for the quarter that begins after the effective date of the amendments.

    Disclosure Location

    Some of the amendments change the location of information in a filing which can have a material impact.  Location changes involve:

    • Prominence Considerations – the location of a disclosure may provide for a certain level of prominence of the information.
    • Financial Statement Considerations – some amendments relocate disclosure from outside to inside the financial statements, thus subjecting the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Furthermore, forward-looking statement safe-harbor protection is not available for information inside the financial statements. Conversely, some amendments relocate disclosures from inside to outside the financial statements.
    • Bright-line Disclosure Threshold Considerations – some amendments removed bright-line disclosure requirements.

    Redundant or Duplicative Requirements

    The Regulation S-K and S-X Amendments eliminate a laundry list of 25 redundant and duplicative disclosures. Most of these changes are technical and nuanced related to particular Regulation S-X GAAP and other financial statement disclosures—for example, foreign currency, financial statement consolidation, income tax disclosures, contingencies and interim accounting adjustments. As these eliminations are duplicative, they will not change the financial reporting or disclosure requirements.

    Overlapping Requirements

    Similar to redundant and duplicative disclosures, the SEC has identified numerous disclosure requirements that are related to, but not exactly the same as, GAAP, IFRS and other SEC disclosure obligations. The Regulation S-K and S-X Amendments delete, scale back or integrate the overlapping disclosures to eliminate the overlap.

    The proposed rule release categorized changes as either deleting a disclosure requirement or integrating a requirement with another rule. Some of the proposed changes involved a change in disclosure location, with considerations outlined above in my discussion of disclosure location.

    A complete detail of all the Regulation S-K and S-X Amendments related to overlapping disclosures is beyond the scope of this blog; however, a few items deserve discussion.

    In general, many of the changes proposed by the SEC relate to interim financial reporting. In some cases where items are fully required to be reported in a Form 8-K, annual report or management discussion and analysis (MD&A), the SEC has eliminated the same or similar requirement from interim financial statements. For example, the SEC eliminated significant business combination pro forma financial statement requirements from interim financial statements for smaller reporting companies and Regulation A filers. The pro forma financial statements are already sufficiently required by Item 9.01 of Form 8-K.  However, at this time the SEC retained the financial reporting in interim reports for a significant business disposition or discontinued operation.

    In some cases, the SEC eliminated disclosures in financial statements, leaving only the disclosure in the body of the filing. For example, the SEC eliminated segment financial information from the footnotes, leaving it only in the MD&A.

    In other cases, the SEC eliminated disclosure in the body of a document in favor of a financial statement disclosure. For example, the SEC eliminated a discussion of warrants, rights and convertible instruments from the body of a Form 10 or S-1, noting that a complete disclosure, including dilution, is required in financial statements.

    Not all of the proposed amendments were included in the final S-K and S-X Amendments. For example, rules related to the financial disclosure requirements related to repurchase and reverse repurchase agreements have overlapping provisions. However, the comments to the proposed elimination of these overlapping requirements prompted the SEC to retain the provisions as is, and refer the requirements to FASB for potential incorporation into U.S. GAAP.  Similarly, although most of the proposed amendments related to derivative accounting were included in the final rule release, the requirement to disclose where in the statement of cash flows the effect of derivative financial instruments is reported remains, again with a referral to FASB to consider incorporation with U.S. GAAP. Likewise, disclosures related to equity compensation plans remain unchanged but were referred to FASB for potential incorporation with U.S. GAAP.

    Outdated Requirements

    The SEC has identified disclosure requirement that have become obsolete as a result of time, regulatory, business or technological changes. The Regulation S-K and S-X Amendments amend and sometimes add, but not delete, disclosure as a result of outdated requirements.

    Again, most of the outdated requirements are technical (for example, income-tax disclosures) in nature and beyond the scope of this blog. Some are common sense; for example, a reference to information being available in the SEC public reference room has been amended to include only a reference to the SEC Internet address for EDGAR filings. Another common-sense change is the elimination of the requirement to post the high and low bid or trading prices for each quarter for the prior two fiscal years in an annual 10-K. The SEC reasons that the daily market and trading prices of a security are readily available on a number of websites. Moreover, these websites allow for the download and collation of trading prices over periods of time and provide much more robust information than currently contained in a 10-K.

    Superseded Requirements

    The constant change in accounting and disclosure requirements and regulations have created inconsistencies in Regulation S-K and S-X. The SEC has effectuated amendments to eliminate such inconsistencies. For example, certain provisions in Regulation S-X still refer to development-stage companies, a concept that was eliminated by FASB in June 2014.

    The SEC also took this opportunity to clean up some nonexistent or incorrect references that resulted from regulatory changes over time.

    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.

    On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE.  The initial proposed amendments were published on June 27, 2016, (see HERE).

    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. For a review of that letter and recommendations, see HERE.

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

    On October 11, 2017, the SEC published proposed rule amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The proposed rule amendments implement a mandate under the Fixing America’s Surface Transportation Act (“FAST Act”).  The proposed amendments would: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See my blog HERE.. 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. Final amendments were approved on August 17, 2018.

    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.

    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.

    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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    Securities Token Or Not? A Case Study – Part III

    Tuesday, October 9, 2018, 5:22 AM [General]
    3.2 (1 Ratings)

    This is the third part in my three-part series laying out fact patterns and discussing whether a specific digital asset is a security, a utility, currency, commodity or some other digital asset. In Part 1 of the series, I examined a decentralized token that had been issued without any concurrent capital raise and was able to conclude such token was not a security. Part 1 can be read HERE. In Part 2 I examined a token that was issued with the intent of being a utility token, but as a result of the clear speculative motivation for purchasers, and the lack of decentralization, concluded it was a security. Part 2 can be read HERE.

    In this Part 3 of the series, I examine the issuance of the Free Token as a dividend and its cousin the Bounty Token. Unlike the prior blogs in this series, which examined the question of whether a particular token is a security, this blog will analyze the definition of a “sale” under Section 2(a)(3) of the Securities Act of 1933, as amended (the “Securities Act”).  As part of this analysis, I will review the SEC action In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”).

    The Free Token

    Facts

    Acme Insurance is building a blockchain-based community for the development of blockchain applications to revolutionize the insurance industry. Acme Insurance intends for the community to ultimately be decentralized and the code to be entirely open-source. Acme Insurance is a regional, top-tier insurance company that hopes to grow in the national marketplace and believes that if it can start and assist in the creation of a community that fosters technological developments in the industry, it will be able to capitalize on those developments to improve its market share. It also fundamentally believes in the improvement and advancement of the industry as a whole, which is defragmented and has a very large incidence of fraud. Prior to launching the Insurance Blockchain, Acme donated 2% of its net profits to educational projects which could benefit the insurance industry and has now committed to donating that 2% to the Insurance Blockchain community.

    Acme is launching the Free Token to facilitate its plans. Acme is forming a Foundation to oversee the Insurance Blockchain project. An initial team of international developers is creating the platform. Acme has created 15 million Free Tokens, half of which it will distribute as a dividend to all Acme Insurance shareholders, on a pro rata basis. Acme has 900 shareholders. Acme will not receive any consideration for the issuance. Future Free Tokens will be issued through Proof of Work, and later Proof of Stake, mining efforts and as compensation for website maintenance, code updates, developing and other contributions to the project. All software developments will remain open-source, with no royalty or profit-sharing-type rights.

    It is anticipated that the Free Token will trade on cryptocurrency exchanges, and Acme hopes they will increase in value to motivate efforts on the project.

    Although Acme believes that ultimately the Free Token would not be considered a security, rather than test its analysis, it intends to sidestep the question and issue the token as a dividend by airdropping the token to all shareholders, without compliance with the registration and exemption requirements of the federal securities laws. Acme has asked me to confirm that it is able to do so.

    Legal Analysis

    As I’ve written about many times, Section 5 of the Securities Act stipulates that the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration.  Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the resale of a security by an existing security holder must either be registered or exempt from registration. The registration statement or offering circular is subject to review by the SEC before it can be used for the offer and sale of a security. The process can be both time-consuming and expensive.

    Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

    The registration requirements, or necessity to utilize an exemption, apply to the “offer” or “sale” of a security. Section 2(a)(3) of the Securities Act defines the terms “sale” and “offer” in pertinent part as:

    The term “sale” or “sell” shall include every contract of sale or disposition of a security or interest in a security, for value. The term “offer to sell”, “offer for sale”, or “offer” shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value… Any security given or delivered with, or as a bonus on account of, any purchase of securities or any other thing, shall be conclusively presumed to constitute a part of the subject of such purchase and to have been offered and sold for value.

    Section 2(a)(3), by its own terms, hinges on the receipt of value. The issuance of a dividend to all shareholders or the issuance of broad-based stock options to all employees has long been viewed as not involving the sale of securities.  This theory is often referred to as the “no sale” theory. In a Letter of General Counsel Discussing Question of Whether a Sale of a Security is Involved in the Payment of a Dividend, Securities Act Release No. 33-929, the SEC stated that the distribution of a cash or stock dividend to an issuer’s existing shareholders does not constitute a “sale” under Section 2(3)(a) of the Securities Act, and therefore such distribution does not require a Securities Act registration statement.  This guidance was issued in 1936 and has been reiterated on multiple occasions ever since.

    Question 103.01 of the SEC Division of Corporation Finance’s Compliance and Disclosure Interpretations, published in November, 2008 confirmed the SEC’s long-standing position.  In particular:

    Question 103.01

    Question: If a company declares a dividend that is payable in either cash or securities at the election of the recipients, does the declaration of the dividend need to be registered under the Securities Act?

    Answer: No, as there is no sale of the dividend shares under the Securities Act. [Nov. 26, 2008]

    The analysis is based in part on the lack of investment decision by the recipient of the dividend.  If the recipient is not bargaining for the dividend and is not giving up anything of value, there is no risk, and therefore no sale of securities has occurred.

    Accordingly, without more, even if the Free Token is a security, Acme Insurance can issue it as a dividend without compliance with the registration or exemption requirements under the federal securities laws.

    The Bounty Token

    Facts

    To increase distribution of the Free Token, Acme will create a bounty program whereby initial users receive Free Tokens for (i) signing up to the Insurance Blockchain project; (ii) sharing certain white papers and other information documents on the project; or (iii) writing and creating educational and informational documents on the project.

    Bounty programs are also often referred to as airdrop programs, though an airdrop can be used for a dividend release as well. An airdrop involves a controlled and periodic release of “free” tokens to people that meet a specific set of requirements, such as user ranking or activity. Generally the goal of an airdrop is to promote the new cryptocurrency. Bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Bounty programs are a means of advertising and have gained in popularity in ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as registering at a website, reading and sharing materials, or marketing and making improvements to aspects of the cryptocurrency framework. In an airdrop, however, the issuer does not assign any tasks to the recipients; they need only meet some effortless requirements.  In a bounty program, however, individuals must execute assigned tasks before receiving the tokens.

    Legal Analysis

    Tokens issued in a bounty program generally involve the sale of securities that must either be registered or exempt from registration. The concept behind a bounty token program is not new. In the Internet bubble of the ’90s, companies were issuing free stock to gain website traffic and the SEC took notice. In a series of no-action letters, the SEC shut down the practice.

    In Vanderkam & Sanders (January 27, 1999), an unnamed operator of an Internet-based auto referral service proposed to issue free stock to anyone who registered at the company’s website or who referred others to it. Visitors would complete a simple registration form and would not be required to provide cash, property or services for their shares. The SEC ruled that “the issuance of securities in consideration of a person’s registration on or visit to an issuer’s Internet site would be an event of sale” and would be unlawful unless “the subject of a registration statement or a valid exemption from registration.”

    In Simplystocks.com (February 4, 1999), a web-based provider of financial information proposed to distribute free stock from a pool of entrants who logged in to the company’s website and provided their name, address, Social Security number, phone number and email address and then chose a log-in name and password. Visitors would receive one entry in the stock pool for each day they logged in to the website. After 180 days, the stock would be randomly allocated among the entrants in the stock pool. The SEC stated that the Simplystocks.com stock giveaway would be unlawful unless registered or exempt from registration.

    In Andrew Jones (June 8, 1999), the promoter proposed to issue free stock to the first one million people who signed up or referred others to sign up. Shares would be claimed either by sending a self-addressed stamped envelope to the company along with the person’s name, address and email address, or by visiting the company’s website and providing the same information. The company said the information provided by shareholders would be used solely for corporate purposes and would not be sold or given to others or used for advertising purposes. The SEC ruled that “the issuance of securities in consideration of a person’s registration with the issuer, whether or not through the issuer’s Internet site, would be an event of sale” and would be unlawful unless registered or exempt from registration.

                    In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”)

    On August 14, 2018 the SEC obtained a judgment against Tomahawk Exploration LLC and its principal for engaging in a fraudulent ICO.  According to the SEC, Tomahawk attempted to complete an ICO using fraudulent and misleading sales materials. However, the ICO failed to raise any money and so Tomahawk “gave away” its tokens as part of a bounty program involving online promotional services.

    The bounty program, like the ICO sales materials, were misleading on their face and clearly an effort to promote the token.  Tomahawk featured the program prominently on its ICO website, offering between 10 and 4,000 tokens for activities such as making requests to list TOM on token trading platforms, promoting tokens on blogs and other online forums, and creating professional picture file designs, YouTube videos or other promotional materials.

    The SEC Order found that Tomahawk’s issuance of tokens under the Bounty Program constituted an offer and sale of securities because the company provided tokens to investors in exchange for services designed to advance Tomahawk’s economic interests and foster a trading market for its securities. In other words, the services required in the bounty program were a valid consideration. It has long been established that value for securities can be in the form of services, cash, property, or anything that a board of directors reasonably determines as valuable. Tomahawk received value in the form of online marketing and promotion, and by the creation of a secondary public trading market for its token.  In the case of SEC vs. Sierra Brokerage Servs, Inc., the court specifically found that “where a ‘gift’ disperses corporate ownership and thereby helps to create a public trading market it is treated as a sale.”

    Although the Insurance Blockchain bounty program does not require outright promotional activity, at this point, I would still recommend that the bounty program be discontinued or comply with the registration or exemption requirements of the federal securities laws...

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