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SEC updates and expands Regulation A to help smaller companies raise capital

3/25/2015

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The Securities and Exchange Commission today adopted final rules to facilitate smaller companies’ access to capital.  The new rules provide investors with more investment choices.  The new rules update and expand Regulation A, an existing exemption from registration for smaller issuers of securities.  The rules are mandated by Title IV of the Jumpstart Our Business Startups (JOBS) Act.  The updated exemption will enable smaller companies to offer and sell up to $50 million of securities in a 12-month period, subject to eligibility, disclosure and reporting requirements.

The final rules, often referred to as Regulation A+, provide for two tiers of offerings:  Tier 1, for offerings of securities of up to $20 million in a 12-month period, with not more than $6 million in offers by selling security-holders that are affiliates of the issuer; and Tier 2, for offerings of securities of up to $50 million in a 12-month period, with not more than $15 million in offers by selling security-holders that are affiliates of the issuer. Both Tiers are subject to certain basic requirements while Tier 2 offerings are also subject to additional disclosure and ongoing reporting requirements.

The final rules also provide for the preemption of state securities law registration and qualification requirements for securities offered or sold to “qualified purchasers” in Tier 2 offerings.  Tier 1 offerings will be subject to federal and state registration and qualification requirements, and issuers may take advantage of the coordinated review program developed by the North American Securities Administrators Association.

The rules will be effective 60 days after publication in the Federal Register.

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A level playing field for all?

2/11/2015

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The mission of the Securities and Exchange Commission as stated on its website is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

A recent study is questioning the "fair orderly and efficient markets" aspect of the agency’s mission.  The study, available here, was conducted by two academics from the University of Chicago’s Booth School of Business and one from the University of Colorado at Boulder and is entitled “Run EDGAR run: SEC Dissemination in a high-frequency world.” 

The study, complete with detailed tables and graphs, reviewed a large number of Form 4 filings (disclosing changes in beneficial ownership of securities owned by corporate insiders) during 2012 and 2013.  It found that the SEC electronic filing system, or EDGAR, processes filings quickly with a time lag of around 40 seconds from the moment a document is submitted for filing and the moment it becomes available to the public.  Subscribers who pay for direct access to EDGAR through commercial services receive filings typically 10 seconds before the public.  It also shows that around 30 seconds prior to public availability, prices, volumes, and spreads are impacted by  filing news.  This would support the theory that some market participants are taking advantage of the posting delay.

In the words of the study’s authors: “These results raise questions about whether the SEC dissemination process is really a level playing field for all investors.”

I couldn’t have said it better, except by adding that some market participants may find the playing field more level than others.

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DTC withdraws proposed rule change

8/25/2014

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On August 15, 2014, the DTC withdrew its proposed rule change to Specify Procedures Available to Issuers of Securities Deposited at DTC for Book Entry Services when DTC Imposes or Intends to Impose Restrictions on the Further Deposit and/or Book Entry Transfer of Those Securities.  No reason for the withdrawal was given.  However, it is fair to assume that the withdrawal was prompted by the comments, many of them negative, on the proposed rule change.  The SEC had hinted earlier that it was less than thrilled by the DTC’s efforts. 

The blogs below described my own reservations on the proposals.  Of course, the DTC is still required to design new rules to address the SEC’s concerns expressed in International Power.

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...and now for something completely counter-intuitive

6/18/2014

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According to a new study, foreign-based companies provide higher quality disclosures than their U.S. based counterparts.  In fact, firms based in far away countries that have disclosure laws that are vastly different often have the best disclosures as evidenced by clearer writings included in their annual reports and press releases.  Language differences also appear to have a positive impact on a foreign company’s disclosures.

The report suggests that foreign based companies are compensating for their perceived struggle to articulate their operations in a clear and concise fashion.  This results in business descriptions and discussions of financial results that are easier to understand than those presented by U.S. companies.  The report also concludes that efforts to make disclosures more readable are generally successful in that these companies often enjoy greater U.S. institutional investor participation.

The study entitled Restoring the tower of Babel: How foreign firms communicate with U.S. investors will be published in the July 2014 edition of The Accounting Review.  The University of British Columbia’s Sauder School of Business study reviewed corporate disclosure documents during the period from 2000 to 2012 and compared the Management Discussion and Analysis section of 10-Ks of almost 3,500 foreign companies listed in the U.S. with their U.S. based competitors.

Go figure!
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Delaware Court Validates Fee-shifting Bylaw

5/21/2014

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On May 8, 2014, the Delaware Supreme Court ruled on a question of law posed by a United States District Court that so-called fee-shifting bylaw provisions are permissible under Delaware law.  These types of provisions require a stockholder suing a Delaware corporation to pay for the corporation’s legal fees if the stockholder loses the suit. 

In general, Delaware follows the American Rule that requires each party to a litigation to pay its own attorneys’ fees and costs.  However, in ATP Tour, Inc. et al. v. Deutscher Tennis Bund et al., the Court observed that it is long settled law that contracting parties may agree to modify the American Rule and obligate the losing party to pay the prevailing parties’ fees.  It further stated that bylaws are contracts among a corporation’s shareholders.  Therefore, a fee-shifting bylaw would not be prohibited under Delaware law.

The Court added that the enforceability of a fee-shifting bylaw depends on the manner in which it was adopted and the circumstances under which it was invoked. Bylaws that may otherwise be facially valid will not be enforced if adopted or used for an inequitable purpose.  This may occur for example when the purpose of the provision is to obstruct the legitimate efforts of a shareholder to call a corporation to task for its actions.  Think adoption of the bylaw after a shareholder’s suit has been commenced.

The effect of the ruling is subject to debate.  Some regard the ruling as having a potentially negative impact on shareholders’ rights because it will cause shareholders to think twice before challenging corporate misconduct out of concern that they may have to pay the corporation's legal bills.  Others believe that companies will be reluctant to adopt a fee-shifting provision as it will cause prospective investors to stay away from a company that curtails their rights.  See the Wall Street Journal’s article for a neat summary of the pros and cons of the Court’s decision.

It appears to me that the Court merely built on long settled law that previously validated such bylaw provisions as choosing the Delaware courts as the exclusive forum for disgruntled stockholders who want to bring an action against the corporation.
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DTC's latest attempt at recreating new rules still leaves many small issuers in the cold

4/11/2014

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As I indicated in an earlier blog, newly proposed DTC rules designed to create a system based on fair procedures for issuers affected by a DTC deposit chill or global lock will still leave many smaller issuers gasping for air, especially those issuers whose securities have been subjected to a deposit chill or a global lock that predates the SEC;'s opinion in In the Matter of the Application of International Power Group, Ltd., SEC Rel. 66611, March 15, 2012 .

The attempted DTC rewrite of the rule proposal unfortunately does nothing to address the issues raised in my comment letter to the SEC.  The idea is simple: issuers and the markets need a written rule that addresses the predicament of issuers affected by pre-International Power DTC sanctions while at the same time acknowledging that these issuers have been punished enough by the length of time the DTC sanctions have been in place.  DTC refuses to characterize service interruptions as penalties or sanctions.  The unfortunate reality is however, that these DTC actions have major consequences for the relevant issuers in terms of their inability to raise additional capital.  In many cases it will lead to a slow corporate death.

The rules should provide considerations of fairness that weigh the perceived benefits of a continuing DTC  service interruption, whether in the form of a deposit chill or a global lock, against the often irreparable harm done to the issuer.  This is especially true when the service interruption has been in effect for extended periods of time.  To slap another one year or six month global lock, as the case may, on an issuer that has already been in the penalty box for years as the DTC seems to  imply in its response letter to commenters here is just unconscionable.  Read my comment letter here for a more detailed analysis as to what is wrong with the rewritten draft rule.
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Are SEC staff members involved in insider trading?

3/10/2014

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A fascinating discussion has been raging in the academic and the not so academic communities as to whether SEC staff members have been making profits from stock sales by taking advantage of nonpublic information.  An absolute no-no for agency staffers charged with enforcing insider trading violations.

The debate was triggered by a draft study authored by an accounting professor at Emory University Business School with the help of a doctoral student at Georgia State University.  The study finds that over the years 2009-2011, SEC employees realized abnormal returns from securities sales ahead of a decline in stock prices.  The authors suggest three explanations for these higher than normal returns: (i) luck; (ii) skill of the traders; and (iii) access to non-public information.

The authors claim to have found that at least some of these profits are information based, as staffers tended to sell in the run-up to six SEC enforcement actions.  In addition, trades allegedly took place in the interim period between a corporate insider’s paper-based filing of the sale of restricted stock with the SEC (Form 144) and the online disclosure of such sale.  The authors do acknowledge that their findings are subject to severe limitations based on the short time period covered by the study.  They also report that the SEC has responded to the findings by stating that each of the scrutinized trades had been approved and that staff assigned to an enforcement action is required to sell stock he or she holds in the subject company.

Broc Romanek does a thorough job discrediting the study in this online post based on his knowledge of SEC internal policies as well as his understanding of the workings of the securities markets.  Others are less charitable in their opinion concerning the righteousness of the SEC staff as evidenced in this angry blog by Professor Bainbridge emphasizing the hypocrisy of SEC enforcement actions.  A more balanced analysis of the study’s findings may be found in The New York Times DealBook.  It concludes that SEC staffer’s gains are likely more attributable to luck than anything else.

I find Broc’s strong arguments against the study pretty compelling.  Nevertheless, this study and its findings present some serious food for thought.

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SEC continues to crack down on microcap fraud

2/5/2014

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Operation Shell-Expel

On February 3, 2014, the SEC announced the latest actions in its microcap fraud-fighting initiative known as Operation Shell-Expel, suspending trading in 255 dormant shell companies ripe for pump and dump abuse in the over-the-counter market.  The SEC started the initiative in 2012 to clean up the microcap marketplace by scrutinizing penny stocks nationwide and identifying clearly inactive companies.

The SEC is to be commended for continuing to fight fraud in the microcap world.

Operation Comic Relief

On the same day, the SEC announced, under what should be called Operation Comic Relief,
that it had commenced stop order proceedings against twenty issuers that had filed resale S-1s.  All issuers purported to be mining companies, they all filed their S-1 on the same day in January 2013, each showing a different CEO but other than that virtually identical.  The SEC claims that all issuers are controlled by the same undisclosed individual, a lawyer with previous SEC troubles.

Really, what were these folks thinking.


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Newly proposed DTC rule leaves many small issuers in the cold

1/16/2014

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On December 5, 2013, The Depository Trust Company filed with the SEC proposed rules to modify its rules and procedures relating to deposit and transfer restrictions imposed or to be imposed by the DTC on an issuer’s securities.  The aim of the rule change is to create greater transparency and an opportunity for an issuer to be heard.  Click here for the complete text of the SEC release and here for the actual text of the amended rule.  
No DTC service means no trading
DTC is the nation’s central securities depository.  It performs services and maintains securities accounts for its participants, primarily banks and broker dealers, including the deposit with DTC of so-called eligible securities (i.e. “freely tradable" as substantiated by a legal opinion by the issuer’s outside counsel) for credit to a participant’s securities account.  This process enables the electronic trading of securities so that investors and their brokers no longer have to handle physical certificates.  These days, electronic trading is virtually the only way to transfer stock and other securities; brokers will only rarely accept certificates.
DTC may decline (additional) deposits of an issuer’s securities or refuse to perform all services including transfers if there is concern regarding a security’s eligibility based on suspicions that the particular security was issued without registration or a valid exemption.  DTC restrictions may be categorized as follows:
  • A Deposit Chill is typically imposed when the DTC detects large volume deposits of low-priced or thinly traded securities and its monitoring otherwise suggests that an issue may not be freely tradable; and
  • A Global Lock is typically imposed when (i) the DTC becomes aware of law-enforcement or regulatory proceeding alleging the unregistered distribution of securities in violation of the federal securities laws, or (ii) an issuer fails to respond adequately to DTC’s imposition of a deposit chill.
Traditionally, DTC did not communicate directly with issuers or their shareholders.  Therefore, if there was an eligibility question regarding a particular security, neither the issuer nor the holder of the security would find out about DTC’s refusal to transfer until much later, often long after the transactional opportunity had passed.  In 2012 the SEC opined that if the DTC refuses to perform certain services, it must notify the issuer affected by such refusal and provide it with an opportunity to be heard.  It must also adopt procedures that meet certain fairness requirements.  In the Matter of the Application of International Power Group, Ltd., SEC Rel. 66611, March 15, 2012.  It was against this backdrop that DTC drafted this rule proposal. 

What’s the problem?
Although the proposed rule is a promising start in the process of righting DTC procedural wrongs, the rule leaves much to be desired.  I want to highlight one aspect of the proposal that impacts many small companies that have been the subject of a deposit chill for an extended period of time. 

The rule proposes that restrictions be lifted automatically after a certain period of time in analogy to the holding periods of Rule 144 under the Securities Act of 1933.  Specifically, it allows for a global lock removal within six months (in the case of a reporting issuer) or one year (in the case of a non-reporting issuer) after the disposition of the enforcement proceeding, or, if the global lock was the result of the issuer’s failure to respond adequately to the DTC, six months or one year, as the case may be, after the imposition of the global lock.
The proposed rule provides for the automatic lifting of global locks but not of deposit chills.  The problem with that approach is that issuers whose securities have been the subject of a deposit chill will not be able to benefit from an automatic lifting of that deposit chill following the Rule 144 holding period time lapse.  This can be especially painful for a smaller issuer whose securities have been under a deposit chill that predates International Power without making it into the big league of global lock subjects.  They will now need the additional imposition of a global lock followed by a six month or one year waiting period, as the case may be, before the lock is released automatically.  By that time, it may be too late to salvage what is left of the company’s business.  Note that a deposit chill can be almost as draconian as a global lock as it effectively bars an issuer from raising additional financing.  Both sanctions represent a sort of securities purgatory that could seriously imperil a small company’s continued existence. 

In addition, from the perspective of the small issuer subjected to a pre-International Power deposit chill, differentiating between the removal of a deposit chill and a global lock as proposed by the rule has the bizarre effect that a global lock which is typically imposed as a result of law-enforcement or enforcement proceedings is easier to remedy than a deposit chill which is usually imposed based on mere concerns regarding a security’s eligibility.

Issuers of low-priced or thinly traded securities are the most likely targets of a DTC service suspension.  A portion of those issuers lack real businesses and their securities are the most easily manipulated.  I am not advocating for the rescue of microcap corporate trash that produces nothing more than “blue sky” type promises of eternal peace on earth, global cooling and total reforestation of the Amazon rainforest.  However, there are many small companies that offer real goods and services; that are growing, and that need capital to expand.  Their prospects are greatly diminished because of the yoke of a long term deposit chill. 

To be clear, based on DTC's requirement that securities held in its inventory must be fungible (click here for an explanation of that concept), we can understand the argument that only a global lock lends itself to a free-up analogous to Rule 144 since the only way to ensure that a person has held his shares for the requisite six-month or one-year period is through a global lock which makes it impossible to transfer a security.  No such assurance exists under a deposit chill since securities that were already in the system at the time of the imposition of the chill may be freely transferred.  Nevertheless, it seems fundamentally unfair to treat chilled shares more severely than locked shares for the reasons expressed above.

What to do
In the spirit of jumpstarting business startups (JOBS Act, anybody?), it would serve the public interest and the investment community to have a deposit chill lifted automatically after a period of time, just like a global lock, at least for those chills imposed prior to the International Power ruling when DTC did not bother to advise issuers of a service suspension.  Alternatively, the rule should allow for a fairness determination based on the facts and circumstances of the particular case that enough time has passed for the pre-International Power deposit chill to be lifted and allow the company to move on.  Facts that may weigh in favor of a lifting of the chill should include the existence of a legitimate business; the length of time the chill has been in effect (especially if the chill predates the SEC’s International Power ruling); the minor nature of the alleged violations that resulted in the issuance of the securities as to which there exists concern (including a finding that the alleged violations were committed by persons not affiliated with the issuer); and the small number of issuer’s shares as to which there exists a concern as a proportion of the total number of shares outstanding.
The comment period for the proposal has now ended.  Based on the small number of comment letters submitted to the SEC, this proposal does not appear to have created much buzz.  That is unfortunate because DTC's actions have a potentially significant and negative impact on many small companies at a time when they need all the help they can get from regulators and SRO's such as DTC. 

Bottom line: the proposed rule was not written in the spirit of the JOBS Act




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SEC proposes new Regulation A+

1/7/2014

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On December 18, 2013, the Securities and Exchange Commission issued a release proposing new rules for the purpose of implementing Section 401 of the Jumpstart Our Business Startups Act, or JOBS Act for short.  It amends and greatly expands current Regulation A, which exempts from SEC registration offerings of securities of up to $5 million within a 12-month period; hence its nickname Regulation A+.  For all you intrepid readers of regulatory promulgating literature, click here for the SEC release in all its 387 page glory.  Following is a short summary of the background and the main features of the proposed rule.

By enacting the JOBS Act, Congress sought to enable smaller companies to raise capital without the burdensome registration requirements of the federal and state securities laws.  Section 401 of the JOBS Act added a new Section 3(b)(2) to the Securities Act of 1933, which directs the SEC to adopt rules exempting offerings of up to $50 million of securities annually from the registration requirements of the Securities Act.  The near worthlessness of the existing Regulation A exemption is illustrated by the SEC's observation in the release that from 2009 through the end of 2012 there had been 19 qualified offerings under the rule for a total offering amount of approximately $73 million.  By contrast, during the same period more than 27,000 offerings of up to $5 million each claiming other exemptions were conducted for a total offering amount of approximately $25 billion. 

The proposed rule creates two tiers of exemption:

 Tier 1: annual offering limit of $5,000,000, including no more than $1,500,000 on behalf of selling securityholders; and

Tier 2: annual offering limit of $50,000,000, including no more than $15,000,000 on behalf of selling securityholders.

As proposed, some of the more significant Regulation A+ provisions include the following:
  • Issuers may raise up to $50,000,000 publicly during a twelve month period;
  • Only non-public issuers organized in the U.S. and Canada are eligible to rely on the exemption;
  • Securities issued in the offering are not restricted;
  • Tier 2 offerings are exempt from state blue sky registration and qualification requirements;
  • Issuers may test the waters for potential interest in the offering prior to filing offering documents with the SEC;
  • Issuers are required to submit an offering statement with the SEC (initially, at the option of the issuer, confidentially for staff review, followed by an electronic filing via the EDGAR system);
  • Tier 2 issuers will be required to electronically file annual reports that include audited financial statements as well as semi-annual and current event reports;
  • Issuers subject to certain enforcement (so called “bad boy” provisions) and other regulatory problems may not rely on the exemption;
  • Issuers who fail to comply with the ongoing reporting requirements under the proposed rule are not eligible for the exemption;
  • Anyone may invest in under the proposed rule, subject to a cap of 10% of the greater of the investor’s annual income and net worth as represented by the investor to the issuer;
  • The rule creates a variety of new forms that are synched with the SEC’s EDGAR electronic filing system.
The SEC is continuing to solicit comments on such matters as possibly limiting the size of the issuers eligible to rely on the exemption; the status of shell companies and business development companies; whether to allow other non-domestic companies to rely on the exemption; and whether to exclude certain types of securities (such as asset backed securities).  Individual SEC Commissioners also left open the possibility of creating an additional third tier exempting annual raises of between $10-15 million.  The proposals will remain open for public comment for a 60-day period.

The proposed rule requires that offering materials be filed with and qualified by the SEC prior to use.  Such qualification is subject to a review of the offering materials by the SEC, a process similar to the comment process in registered offerings (IPO lite maybe?).  I for one will be curious to see whether the new rule strikes the right balance between such benefits as higher exempt offering limits and state securities law pre-emption on the one hand and the transactional costs associated with ongoing issuer reporting and compliance requirements on the other.  Nevertheless, I believe that if adopted, the new rule has the potential to radically transform the way smaller issuers raise capital.

Bottom line: it remains to be seen whether or not the proposed rule deserves an A+. 
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    Here I present my views on the world in general and the world of corporate law in particular.  I report on the latest developments affecting legal entities, such as rules and regulations adopted by the Securities and Exchange Commission and other regulators impacting on capital formation and reporting and disclosure requirements.  I show how I can help you navigate the increasingly complex legal landscape so you can focus on growing your business.

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