Securities Registration

Last week, the Securities and Exchange Commission announced that effective October 1, 2015, filing fees that public companies and other issuers pay to register their securities with the Commission will be reduced to $100.70 per million dollars (from money and calculator$116.20 per million dollars).  The reduction applies to fees paid under Section 6(b) of the Securities Act of 1933 and Sections 13(e) and 14(g) of the Securities Exchange Act of 1934, which the SEC is required to annually adjust.  According to the National Law Review, this year’s decrease of approximately 13% is up from last year’s 10% reduction of registration statement filing fees.  This is obviously a nice trend that saves public companies money, which will hopefully continue annually.

Business development company representatives petitioned the SEC to “modernize” its rules pertaining to such entities.  BDCs are a type of private company that invests in small and mid-sized businesses.

The SEC has long disfavored BDCs, but none of these representatives want the SEC to allow BDCs to operate under rules that apply to traditional public companies, such as the ability to file automatic shelf registration statements, and to release factual and forward-looking business information through free-writing prospectuses, among other things.

In all likelihood, this petition is going nowhere given the SEC’s long standing animosity towards BDCs.

Investors in certain condominium units asked the United States Supreme Court to review a federal appeals court’s conclusion that the sale of the units, when coupled with a separate rental-management agreement, were not securities under state or federal law.  See Salameh v. Tarsadia Hotel, U.S., No. 13-763, 12/24/13.  The plaintiffs believe this was an “investment contract” security.  The SEC agrees with the investors.

The plaintiffs purchased condominium units, and signed a rental-management agreement, required under the terms of the purchase contract.  The plaintiffs alleged that these contracts were an investment contract security since they had no control over their units and expected a profit only through the efforts of others.  However, both the district court and the United States Court of Appeals for the Ninth Circuit rejected this argument.

In short, this question needs to be addressed by the Supreme Court, and we will continue to monitor it.

Brokers may finally see the light at the end of the expungement tunnel.  Over the last month, registered representatives have received some surprisingly good news relating to their CRD licensing records. 

In August 2012, the United States District Court for the Northern District of California granted a motion by E-Trade Securities LLC to expunge an employee’s CRD records relating to an investor dispute where he had no involvement.  The court stated that there is a FINRA Rule 2080, relating to the expungement of information from the CRD system, provides that a court of competent jurisdiction may direct and order such an expungement, providing that FINRA may participate in the judicial proceeding.  Nonetheless, the court found that there was no substantive legal standard to determine if such a challenge was or was not appropriate.  As a result, the court adopted the standard for expungement that SEC guidance provided, as well as, from case law, Reinking v. FINRA, Western District of Texas, #A-11-CA-813 (Dec. 1, 2011). 

Applying these standards, the court found that the broker’s case easily meets the regulatory purpose standard found in Reinking case some of the allegations were false in that there was no regulatory value in keeping the records active.  As such, the court determined that the records should be expunged from this broker’s record.  See Bridge v. E-Trade Securities LLC, et al., N.D. Cal. No. C-11-2521 E.M.C. (Aug. 7, 2012). 

Additionally, in another California case, this time at the state court level, a California Appeals Court held that a court could erase past public disclosure reports for a broker that were old or irrelevant since it unfairly hurt his livelihood.  The appeals court, thus, allowed the lower court to possibly invoke unusually broad authority to erase details on this broker’s record involving more than a dozen arbitration cases.  The court determined that this was simply the fair thing to do, and that the court did not have to follow any rigorous standards imposed by FINRA.  See Lickiss v. Financial Industry Regulatory Authority, __ Cal. Rptr. 3d __, 2012 WL 3605785 (August 23, 2012).  Although this was a victory for the broker, in that he could proceed with his case, his case must now proceed before the trial court to determine if this information should, in fact, be expunged.  As a result, at least in California, brokers now have the opportunity to ask a Judge to rule that such disclosures on CRD licensing records are simply not fair. 

Intriguingly, Reuters also reports that the number of broker requests for expungement to date nearly matches the total number filed last year.  This is indicative of the overall trend by brokers to clean their records. 

In sum, these two cases represent a watershed for brokers seeking to clean up their CRD disclosures.  Although some commentators are suggesting that this may open up the flood gates and possibly provide for other states to follow suit, we believe that the more appropriate approach would be for FINRA to propose new rules and regulations to streamline the process so that such information would be removed from the public disclosure files, especially when it is old and irrelevant.

Yesterday, the SEC proposed rules to implement Section 201(a) of the JOBS Act, which mandates the elimination of the prohibition against general solicitation in Rule 506 and Rule 144A offerings.  The proposed rule answered the major questions securities professionals were asking about these reforms:  would the new Rule 506 replace the old (no), would “reasonable steps to verify” require issuers to comply with strict guidelines (no again), and would it take the SEC over 60 pages to answer those two questions (yes!). 

First, a quick review: Section 4(a)(2) of the Securities Act of 1933 exempts transactions “not involving any public offering” from the pricey and time-consuming registration requirements of Section 5 of the Securities Act.  Rule 506 was (and still is) a safe harbor under Regulation D under Section 4(a)(2) of the Securities Act, meaning that if an issuer met its requirements, it could safely assume that the offering was not public. 

Among other things, Rule 506 prohibited “general solicitation and general advertising” which is exactly what it sounds like.  In addition, an issuer relying on Rule 506 could sell to an unlimited number of accredited investors (basically: investment companies, funds, and wealthy people) and no more than 35 “sophisticated” non-accredited investors (basically: normal people who arguably have some idea of what an investment is).  A Bizarro Kanye might say, “the SEC doesn’t care about rich people” (that’s not exactly true, but remember: Bizarro isn’t that smart).  After those 35, an issuer had to “reasonably believe” that the investors were accredited.

That was the old Rule 506, hereby known as Rule 506(b).  The new Rule 506, or Rule 506(c), removes the ban on general solicitation, but issuers can only sell to accredited investors – no more 35 sophisticated non-accredited guys.  It also requires that issuers “take reasonable steps to verify” that the investors are accredited.  When the JOBS Act passed, some worried that its mandate to amend Rule 506 meant that the old version would be lost.  We can all rest easy: now issuers have a choice – stick with the stricter advertising rules if you want to offer securities to non-accredited investors, or advertise like crazy and take reasonable steps to verify that everyone you sell to is accredited. 

Rule 506(c) may be a huge benefit to a lot of start ups who have had trouble finding accredited investors to fund their ideas.  If so, this would come at the expense of the “finders” industry, although few entrepreneurs will cry over that side effect. 

The “reasonable steps to verify” also made some fear that Rule 506(c) would lead to mandatory tests or necessary documents to prove accredited-investor status.  There was a concern that issuers would need to undergo much more rigorous due diligence under this new rule.   (These securities professional types are real worry warts.)  Relax: “we [the SEC] anticipate that many practices currently used by issuers in connection with existing Rule 506 offerings would satisfy the verification requirement proposed for offerings pursuant to Rule 506(c).”  The SEC is proposing an objective standard that weighs both the type of information and the amount of information an issuer has about a possible investor.  For example, if that investor claims to be a registered broker-dealer, you could just go to FINRA’s BrokerCheck website to check and be set.  Or if the minimum investment was $1 Million and an investor could provide that (unfinanced) in cash, you could safely assume a personal wealth of over $1 Million (and, also, that he’s a drug kingpin).  The SEC even suggested that a third party verification, such as an affidavit by an investment advisor, accountant or attorney attesting to the investor’s accredited status, would suffice.  That said, the SEC made it clear that simply asking “are you accredited?” ain’t gonna cut it – some due diligence will be required. 

Securities sold pursuant to Rule 506(c) offerings will remain restricted securities.  None of the changes to Rule 506 are meant to imply changes to Section 4(a)(2) or the other rules under Regulation D. 

The SEC is now requesting comments, and has a series of questions that it wants public feedback on.  The majority focus on the verification issue, but I don’t foresee many changes.  The SEC’s proposed approach offers flexibility.  More flexibility also means more uncertainty, but most of that uncertainty will only happen along the margins.  A company performing a decent level of due diligence should be safe.  And, as before, if an investor provides falsified documents and lies convincingly, the issuer will still have reasonable belief and will have taken reasonable steps.  

The SEC also proposed rules to allow general solicitation for Rule 144A re-sales of restricted securities.  This is less interesting, because Rule 144A restricts sales to Qualified Institutional Buyers (QIBS), which are generally investors with over $100 million in assets.  Rule 144A is usually used in initial offerings exempt from registration pursuant to Section 4(a)(2) or Regulation S (a safe harbor for the sale of securities made outside the US).  I’m not sure what this change to Rule 144A is supposed to accomplish, because there isn’t exactly a large target market of QIBS.  If you are planning on making a Rule 144A offering, and your investment banker says something like “well, I don’t know any QIBS, so why don’t we take out a subway ad?” you should fire him. As the SEC said, “Although Rule 144A doe not include an express prohibition against general solicitation, offers of securities under Rule 144A currently must be limited to QIBS, which has the same practical effect.”  That’s diplomatic bureaucrat speak for “we have no clue why Congress made us do this.”

These are just proposed rules, meaning the public has 30 days to comment. 

It’s a rare day when I can say, with unadulterated smugness, “I was right.”  So today is doubly rare, as I can say it twice.

Manchester United – the world’s most valuable sports team, adored by estimated 659 million fans, winner of numerous Premiership titles, FA Cups, and Championship League titles– is going public.  In America.  As an Emerging Growth Company.

And I called it.  Back in May, I said that European companies would increasingly turn to America to do their IPOs, given the EU’s push towards greater shareholder accountability.   Before that, I noted that the definition of an Emerging Growth Company as any company with under $1 billion in revenue meant damn near every company doing an IPO would be an EGC.   

There’s nothing emerging or growing about Man U.  It was founded in 1878.  To grow its fan base, Man U would need to find the lost tribes of the Amazon.  This isn’t even Man U’s first time going public (nothing initial about this IPO) – it was previously listed on the London Stock Exchange until Malcolm Glazer privatized in an leveraged buyout a few years back.  If  Manchester United is an EGC, the JOBS Act needs be amended to rename Emerging Growth Companies as “Pretty Much Anyone Not Already Public In America Company” or PMANAPIAC for short.   

Now, there are more reasons why the devilish denizens of Old Trafford are setting up shop on the NYSE.  In America, unlike Europe, dual-class share structures are perfectly fine and popular with massive companies controlled by its founders (Facebook has a dual-class structure).  Dual-class shares give some shareholders voting preferences over others.  In the Man U deal, the Glazer family will get 10 votes for each of their stocks, whereas the participants in this IPO will get 1 vote per share.  That way, control of the company remains private, despite it being nominally public.  Normally NYSE rules require listed companies to have boards with a majority of independent directors, but that rule is waived for controlled companies, like Man U.

Man U isn’t the only famous, venerable brand that has recently announced its emergence and growth:  Fender, as in the bad-ass guitars, announced its EGC IPO in May.  Keep in mind that Fender’s been around longer than the Rolling Stones, yet it’s still emerging. 

Finally, to go wonky for a second, the popularity of EGC status, which allows companies to disclose less information for 5 years, proves that the theory that investors will discount based on less disclosure is bumpkis.  Some finance nerds have argued that companies that take advantage of weaker disclosure rules end up hurting their stock price because investors will avoid them.  It’s one of those theories that sounds really good until you remember that the only people who read prospectuses and 10-Ks are the lawyers who drafted them.  For every one investor who will avoid Man U because it’s registration statement will report the last two years of audited financial statements instead of three there will be another dozen who buy Man U because WAYNE ROONEY IS A BEAST.  The dual-share voting structure will deter serious investors, though, who won’t like the idea of being unable to toss out management if they don’t perform well (management, by the way, means Glazer’s two sons).

Personally, I will not be buying stock in Man U.  Not because they are using most of the IPO proceeds to pay down the huge debt from the LBO.  Not because I’ll be stuck with Americans running an English football team.  Not even because the soccer labor market pays players unsustainable and ludicrious sums of money.  No.  I won’t buy Man U because I’m a gooner.

In its never ending quest to find suitable ways to address capital formation issues in the United States, the SEC’s Division of Corporation Finance is looking to see if foreign jurisdictions handle some of these issues better and if it could be applied in the United States. 

For example, the SEC is looking to see if other jurisdictions handle solicitations and advertising of private offerings differently.  Coupled with this item, Corporation Finance is also reviewing the regulation of private issuers as well.  In particular, Corporation Finance is looking at private placements and general solicitation bans in light of the new age of social media, and 24 hour news coverage.  One consideration is if the current regulatory scheme of a registered offering regime is relevant when one considers the way information is received in this type of market and the attempts to encourage investors through these communications.

The SEC is intrigued at the way foreign private issuers handle these matters overseas and if its current system should remain in place.  Historically, foreign private issuers in the United States ahd been the traditional large cap companies.  However, this model is changing, and it is unclear if the SEC’s current regulatory framework has adapted.

Finally, the SEC should be applauded for its efforts in realizing not all regulation needs to be addressed from an American standpoint, but that certain goals could be achieved by following an overseas model.

Fox Rothschild just issued another Corporate Alert on Crowdfunding.  The first was written by Michael Harrington, and I helped him with our latest.  These are just a few in a series we have planned on the JOBS Act, so stay tuned.  I’ll post links to all of them on the Securities Compliance Sentinel here.  Unlike most coverage of crowdfunding (including most of mine), we gave a little thought as to what crowdfunding might look like.

So take a look at it.  You won’t be disappointed.  Unless you thought that crowdfunding was going to upend the way we think of early stage finance and be a truly awesome paradigm-shifter that changes everything.  Then you’ll be really disappointed… like a Penguins fan‘s level of disappointment. 

And here is one more link for good measure: Power to the Crowd!  The Promise (and Pitfalls) of Crowdfunding!

Recently, the SEC announced that it would take steps to bar felons and bad actors from any Regulation D offering. 

This rule was mandated by the Dodd-Frank Act, and the SEC issued the proposal last May 2011.  This new rule may be in place before the end of this year, but there is no certainty on timing at this point.  This new rule is part of an overall effort by the SEC to attempt to remove bad actors from early stage offerings since these offerings usually involve raising capital for small companies.

In an intriguing case out of the United States District Court for the Western District of Missouri, a plaintiff’s purchase of condominium units with an option to participate in the rental program did not involve an investment contract under either the federal or Missouri securities laws.  The court, thus, dismissed the plaintiff’s securities claims. 

The court believed that the purchases of these condos with rental options did not rise to the level of an investment contract requiring adherence to the securities laws.  In particular, the court considered if the transaction qualified as an investment contract, analyzing if there was an investment of money, common enterprise, and the reasonable expectation of profits to be derived from the efforts of others, among others things.  The court focused on the uncertainties of both vertical and horizontal commonality required under the common enterprise element test.  In determining that there was a lack of horizontal commonality, the court found that the plaintiffs were not sold securities.  The court also noted that there was no requirement to participate in the rental program as well.

As such, this interesting case has effects in both the real estate and securities markets that have suffered greatly during the recession.  This decision may lead to an increased use of these types of programs.