Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

In a recent speech, CFPB Director Richard Cordray gave his views that  the law specifies that the CFPB generally does not have jurisdiction over auto dealers and their practices, but the CFPB does have jurisdiction over the largest auto lenders and their lending programs.  Director Cordray reminded the audience that the CFPB had issued a bulletin to clarify the boundaries of the CFPB’s authority over auto lending and to provide guidance to indirect auto lenders about compliance with the law.

Director Cordray noted that lender mark-up policies, which allow dealers to exercise discretion over the interest rates they charge consumers and provide direct financial incentives for charging higher prices, may lead to fair lending violations. His belief is that when lenders provide this type of discretion and incentives the CFPB believes it creates significant risk of illegal pricing disparities based on factors like race or national origin.

Director Cordray discussed steps auto lenders might consider taking to ensure they are in compliance with the Equal Credit Opportunity Act and Regulation B. One approach is to develop robust fair lending compliance management systems to monitor for disparate impact and promptly remedy consumer harm on an ongoing basis when it is identified. He noted the bulletin also stated that lenders could take steps to comply with the law by adopting some other pricing mechanism that fairly compensates dealers for their work but avoids the fair lending risks that are inherent in pricing by discretionary markup.

According to Director Cordray, there may be several such mechanisms that would work in practice: a flat fee per transaction, or a fixed percentage of the amount financed, or other nondiscretionary approaches that market participants may devise that would work to address these concerns. The precise details of any such approach bear further analysis, but the central points are twofold. First, Director Cordray noted the CFPB recognizes that auto dealers play a valuable role in much auto lending that occurs in this country, and they deserve to be compensated fairly for the work they do. Second, he also offered that the CFPB is aware that the structure of indirect auto lending programs can greatly affect the risks of discrimination that harms consumers and violates the law.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The integration doctrine must be considered when an issuer conducts multiple offerings in a short period of time.  If applicable, multiple offerings are collapsed to determine if a safe harbor or exemption still applied.  Under the JOBS Act, integration becomes important in the following situations:

  • An issuer uses general solicitation under Rule 506(c) and a short time later attempts to do an offering under 506(b) or Section 4(a)(2).
  • An issuer uses general solicitation under Rule 506(c) and also commences a public offering within a short period of time.
  • Completed Rule 506(b) or Section 4(a)(2) private offerings are followed by offerings using general solicitation under Rule 506(c) or are attempted concurrently.

Little is known about the position the SEC will ultimately take about integration of offerings under the JOBS Act but some clues can be gleaned from studying existing pronouncements set forth below.

Regulation D Safe Harbor

Securities Act Rule 502 provides a safe harbor for integration.  All sales that are part of the same Regulation D offering must meet all of the terms and conditions of Regulation D. Offers and sales that are made more than six months before the start of a Regulation D offering or are made more than six months after completion of a Regulation D offering will not be considered part of that Regulation D offering, so long as during those six month periods there are no offers or sales of securities by or for the issuer that are of the same or a similar class as those offered or sold under Regulation D, other than those offers or sales of securities under an employee benefit plan as defined in Rule 405 under the Securities Act.

If the issuer offers or sells securities for which the foregoing six-month safe harbor is unavailable, the determination as to whether separate sales of securities are part of the same offering (i.e., are considered integrated) depends on the particular facts and circumstances.  The following factors should be considered in determining whether offers and sales should be integrated for purposes of the exemptions under Regulation D:

  • Whether the sales are part of a single plan of financing;
  • Whether the sales involve issuance of the same class of securities;
  • Whether the sales have been made at or about the same time;
  • Whether the same type of consideration is being received; and
  • Whether the sales are made for the same general purpose.

Concurrent Public Offerings

The filing of a registration statement may be viewed as a general solicitation of investors.  The SEC announced in August 2007 that its view is that, while there are many situations in which the filing of a registration statement could serve as a general solicitation or general advertising for a concurrent private offering, the filing of a registration statement does not, per se, eliminate a company’s ability to conduct a concurrent private offering, whether it is commenced before or after the filing of the registration statement. Further, the SEC’s view is that the determination as to whether the filing of the registration statement should be considered to be a general solicitation or general advertising that would affect the availability of the Section 4(a)(2) exemption for such a concurrent unregistered offering should be based on a consideration of whether the investors in the private placement were solicited by the registration statement or through some other means that would otherwise not foreclose the availability of the Section 4(a)(2) exemption. This analysis should not focus exclusively on the nature of the investors, such as whether they are “qualified institutional buyers” as defined in Securities Act Rule 144A or institutional accredited investors, or the number of such investors participating in the offering; instead, the SEC believes the companies and their counsel should analyze whether the offering is exempt under Section 4(a)(2) on its own, including whether securities were offered and sold to the private placement investors through the means of a general solicitation in the form of the registration statement.

For example, according to the SEC, if a company files a registration statement and then seeks to offer and sell securities without registration to an investor that became interested in the purportedly private offering by means of the registration statement, then the Section 4(2) exemption would not be available for that offering. On the other hand, if the prospective private placement investor became interested in the concurrent private placement through some means other than the registration statement that did not involve a general solicitation and otherwise was consistent with Section 4(2), such as through a substantive, pre-existing relationship with the company or direct contact by the company or its agents outside of the public offering effort, then the prior filing of the registration statement generally would not impact the potential availability of the Section 4(2) exemption for that private placement and the private placement could be conducted while the registration statement for the public offering was on file with the Commission. The SEC also believes if the company is able to solicit interest in a concurrent private placement by contacting prospective investors who (1) were not identified or contacted through the marketing of the public offering and (2) did not independently contact the issuer as a result of the general solicitation by means of the registration statement, then the private placement could be conducted in accordance with Section 4(a)(2) while the registration statement for a separate public offering was pending.

Abandoned Offerings

Rule 155 provides a non-exclusive safe harbor from integration of private and registered offerings. Under Rule 155 a private offering of securities will not be considered part of an offering for which the issuer later files a registration statement if:

  • No securities were sold in the private offering;
  • The issuer and any person(s) acting on its behalf terminate all offering activity in the private offering before the issuer files the registration statement;
  • The preliminary and final prospectuses used in the registered offering disclose specified information about the abandoned private offering;
  • The issuer does not file the registration statement until at least 30 calendar days after termination of all offering activity in the private offering, unless the issuer and any person acting on its behalf offered securities in the private offering only to persons who were (or who the issuer reasonably believes were):
    • Accredited investors (as that term is defined in §230.501(a)); or
    • Persons who satisfy the knowledge and experience standard of Rule 506(b)(2)(ii).

In addition, under Rule 155, an offering for which the issuer filed a registration statement will not be considered part of a later commenced private offering if:

  • No securities were sold in the registered offering;
  • The issuer withdraws the registration statement in accordance with SEC rules;
  • Neither the issuer nor any person acting on the issuer’s behalf commences the private offering earlier than 30 calendar days after the effective date of withdrawal of the registration statement under SEC rules;
  • The issuer notifies each offeree in the private offering that:
    • The offering is not registered under the Act;
    • The securities will be “restricted securities” (as that term is defined in §230.144(a)(3)) and may not be resold unless they are registered under the Act or an exemption from registration is available;
    • Purchasers in the private offering do not have the protection of Section 11 of the Securities Act (15 U.S.C. 77k); and
    • A registration statement for the abandoned offering was filed and withdrawn, specifying the effective date of the withdrawal; and
  • Any disclosure document used in the private offering discloses any changes in the issuer’s business or financial condition that occurred after the issuer filed the registration statement that are material to the investment decision in the private offering.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

In General

Growing companies need to be aware of the requirements of Section 12(g) of the Exchange Act.  If the thresholds of Section 12(g) are crossed, which look principally to the number of shareholders, the company must generally begin filing the same reports under the Securities Exchange Act of 1934 as any company listed on the NYSE or Nasdaq.  Therefore the issue needs to be considered when raising capital and granting employees equity, and is especially important to venture funded and other entities that use employee equity as a significant component of compensation.

Ignoring special accommodations for bank holding companies, the JOBS Act amended Section 12(g) and Section 15(d) of the Exchange Act as follows:

  • The holders of record threshold for triggering Section 12(g) registration for issuers (other than banks and bank holding companies) has been raised from 500 or more persons to either (1) 2,000 or more persons or (2) 500 or more persons who are not accredited investors.
  • In calculating the number of holders of record for purposes of determining whether Section 12(g) registration is required with respect to a class of equity security, issuers (including banks and bank holding companies) may exclude persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of Section 5 of the Securities Act.

As a result, we discuss the following critical issues in depth:

  • How do you count the number of holders, and do you need to look beyond the share register?
  • What can an issuer do to make sure its shareholders remain accredited investors?
  • What is important to maintain an exemption for securities issued pursuant to an employee benefit plan?

Counting Holders

While seemingly straightforward, numerous complexities can arise.  Exchange Act Rule 12g5-1, which addresses the definition of “held of record” provides among other things, the following counting rules:

  • Securities identified as held of record by a corporation, a partnership, a trust whether or not the trustees are named, or other organization shall be included as so held by one person.
  • Securities identified as held of record by one or more persons as trustees, executors, guardians, custodians or in other fiduciary capacities with respect to a single trust, estate or account shall be included as held of record by one person.
  • Securities held by two or more persons as co-owners shall be included as held by one person.
  • Securities registered in substantially similar names where the issuer has reason to believe because of the address or other indications that such names represent the same person, may be included as held of record by one person.

Packing multiple holders into a special purpose vehicle to hold the securities and the hoped for ability to count them as one holder probably doesn’t work.  The rule provides that notwithstanding the foregoing points, securities held, to the knowledge of the issuer, subject to a voting trust, deposit agreement or similar arrangement shall be included as held of record by the record holders of the voting trust certificates, certificates of deposit, receipts or similar evidences of interest in such securities, provided, however, that the issuer may rely in good faith on such information as is received in response to its request from a non-affiliated issuer of the certificates or evidences of interest.

The SEC has confirmed in CDIs that institutional custodians, such as Cede & Co. and other commercial depositories, are not single holders of record for purposes of the Exchange Act’s registration and periodic reporting provisions. Instead, each of the depository’s accounts for which the securities are held is a single record holder.  The SEC has also confirmed in CDIs that securities held in street name by a broker-dealer are held of record under the rule only by the broker-dealer. The SEC originally proposed a version of the rule that would have looked through to the beneficial owners of the street-name securities, but adopted the rule in a form that does not produce this result.

Employee Benefit Plans

It is important to understand that options and other benefit plan securities can potentially trigger Exchange Act registration.  See Exemption Of Compensatory Employee Stock Options From Registration Under Section 12(g) Of The Securities Exchange Act Of 1934 (Release No. 34-56887).  However, the SEC has confirmed in CDI’s the directives in the JOBS Act that that an issuer may exclude persons who received securities pursuant to an employee compensation plan in Securities Act-exempt transactions whether or not the person is a current employee of the issuer. Although Section 503 of the JOBS Act directs the Commission to adopt “safe harbor” provisions that issuers can follow when determining whether holders of their securities received the securities pursuant to an employee compensation plan in transactions that were exempt from the registration requirements of Section 5 of the Securities Act of 1933, the lack of a safe harbor does not affect the application of Exchange Act Section 12(g)(5).

Crowdfunding

The SEC has proposed in Regulation Crowdfunding, as directed by the JOBS Act, that securities issued pursuant to the crowdfunding exemption are not counted when determining whether Exchange Act Thresholds are crossed. The JOBS Act requires the SEC to exempt securities issued under Section 4(a)(6) from the registration requirements of the Exchange Act.  Proposed Rule 12g-6 provides that securities issued pursuant to an offering made under Section 4(a)(6) would be permanently exempted from the record holder count under Section 12(g). An issuer seeking to exclude a person from the record holder count would have the responsibility for demonstrating that the securities held by the person were initially issued in an offering made under Section 4(a)(6).

Practical Implications

Given the foregoing, issuers that anticipate having numerous shareholders should consider the following:

  • Organizational documents should prohibit transfers to transferees that are not accredited investors.  Prior to permitting any such transfer, the issuer should require the proposed transferee to submit data that confirms the transferee is an accredited investor.
  • Organizational documents should require accredited investors to annually recertify that they remain accredited investors and if not perhaps a redemption right at an agreed value should exist.
  • Any securities issued pursuant to benefit plans should scrupulously comply with Securities Act exemptions and documentation of compliance should basically be maintained “forever” so that the exemption from Exchange Act registration can be proved.
  • Resist the urge to encourage investors to use special purpose entities to aggregate investors to avoid Exchange Act registration but if it happens make sure there are procedures in the special purpose entities’ organizational documents to maintain exemptions as set forth above.
  • Have procedures to track securities issued under Regulation Crowdfunding so that initial holders and transferees can be excluded when calculating Exchange Act registration thresholds.

For other information on the JOBS Act, see JOBS Act and Other Securities Law Essentials for Growing Companies.

Check jobs-act-info.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC has released its 2013 Annual Report to congress on the Dodd-Frank Whistleblower Program.  Setting aside the SEC chest pounding, this is the first year for which the SEC has year-over-year data concerning the nature of the tips and complaints the SEC receives through its whistleblower program. It appears to us that it has stabilized at around a little more than 3,000 complaints per year.  Fiscal 2013 drew 3,238 complaints compared to 3,001 in 2012, an 8% increase.  So by our calculations that’s almost 9 complaints a day in 2013.

The most common complaint categories reported by whistleblowers in the 2013 fiscal year were Corporate Disclosures and Financials (17.2%), Offering Fraud (17.1%), and Manipulation (16.2%). By comparison, in Fiscal Year 2012, the most common complaint categories reported by whistleblowers also were Corporate Disclosures and Financials (18.2%), Offering Fraud (15.5%), and Manipulation (15.2%).

The whistleblower office  reviews every submission by a whistleblower to the SEC. During the evaluation process, the staff examines each tip to identify those that are sufficiently specific, credible, and timely to warrant the additional allocation of Commission resources. When the whistleblower office determines a complaint warrants deeper investigation, the staff assigns the complaint to one of the SEC’s 11 regional offices, a specialty unit, or to an Enforcement Associate Director in the home office. Complaints that relate to an existing investigation are forwarded to the staff working on the existing matter. Tips that could benefit from the specific expertise of another Division or Office within the SEC generally are forwarded to staff in that Division or Office for further analysis.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

When evaluating internal control over financial reporting, Exchange Act Rule 13a-15(c) requires the evaluation to be based on a framework that is “a suitable, recognized control framework that is established by a body or group that has followed due-process procedures.”  Public companies have historically used the 1992 COSO framework.  In May of 2013, COSO updated the framework and announced that COSO will consider the 1992 framework superseded on December 15, 2014.

In a meeting between SEC officials and the Center for Audit Quality (CAQ) SEC Regulations Committee, the SEC stated that the SEC staff plans to monitor the transition for issuers using the 1992 framework to evaluate whether any SEC action becomes necessary or appropriate at some point in the future.  The staff indicated that the longer issuers continue to use the 1992 framework, the more likely they are to receive questions from the staff about whether the issuer’s use of the 1992 framework satisfies the SEC’s requirement to use a suitable, recognized framework (particularly after December 15, 2014 when COSO will consider the 1992 framework to have been superseded by the 2013 framework).

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

We have updated our publication, The JOBS Act and Other Securities Law Essentials for Growing Companies, to incorporate the proposed crowdfunding rules as well as the new insights revealed in the SEC’s FAQs released yesterday that we blogged about earlier today.

The materials are a resource for growing companies to assist them in navigating the securities laws, which have been changing in the last few years at a breakneck pace.  There are lots of articles floating around on the internet about the JOBS Act, crowdfunding, and general solicitation, and it can be difficult for small businesses to know what is hyperbole and what is accurate and legitimate.  Our materials are a comprehensive guide to private placements and the impact of the JOBS Act on private placements, as well as offerings with and without the use of general solicitation, liability arising from private placements, issues arising from the use of finders, and common mistakes made by issuers and lawyers.

We will continue to update these materials to account for new developments. Check back at dodd-frank.com frequently to stay abreast of the latest news affecting private capital raising.

On November 13, 2013, the SEC released new compliance and disclosure interpretations (which we’re calling FAQs) aimed at addressing common questions relating to private offerings that make use of general solicitation under new Rule 506(c) and Rule 144A. 

Rule 144A / Regulation S Clarifications

Regulation S provides an exemption for offers and sales of securities outside the United States.  One condition to Regulation S is “no directed selling efforts are made in the United States by the issuer, a distributor, any of their respective affiliates, or any person acting on behalf of any of the foregoing.”  Directed selling efforts are defined to be any activity undertaken for the purpose of, or that could reasonably be expected to have the effect of, conditioning the market in the United States for any of the securities being offered in reliance on this Regulation S. Such activity includes placing an advertisement in a publication “with a general circulation in the United States” that refers to the offering of securities being made in reliance upon this Regulation S.  The new FAQs clarify that: 

  • In a Rule 144A offering in which securities were sold to financial intermediaries in exempt transactions pursuant to Section 4(a)(2) or Regulation S, general solicitation may be conducted by the initial purchasers in the Section 4(a)(2) or Regulation S transactions as well as by the issuer.
  • Rule 144A offerings are often conducted in tandem with Regulation S offerings.  According to the FAQs the amendments to Rule 144A permitting the use of general solicitation do not change how directed selling efforts under Regulation S are analyzed in concurrent Rule 144A and Regulation S offerings.

Issuer Verification Methods and Conclusions Trump Actual Circumstances

  • When it comes to the status of purchasers as accredited investors, the Rule 506(c) exemption hinges on whether the issuer took reasonable steps to verify the accredited investor status of purchasers and formed a reasonable belief that the purchasers met that standard, rather than whether the purchasers are actually accredited investors.  If a purchaser turns out to not, in fact, be an accredited investor, the Rule 506(c) exemption is still valid as long as the issuer made a reasonable inquiry and formed a reasonable belief as to the purchaser’s accredited status within the meaning of Rule 506(c).  Conversely, if an issuer fails to make the necessary inquiry, the Rule 506(c) exemption will not be available to the issuer, even if it turns out that each purchaser is in fact an accredited investor.

Clarifications Regarding the Non-Exclusive Safe Harbors for Verification

  • Rule 506(c) provides a non-exclusive list of four methods of verifying accredited investor status that will be deemed reasonable under the rule.  The SEC makes a distinction between relying on one of these enumerated safe harbors and relying on the general principles-based approach of Rule 506(c), in which the question of whether an inquiry was reasonable depends on evaluation of all of the facts and circumstances.  For example, if an issuer is relying on the review of financial records method for verifying accredited investor status, but, at the time of the purchase of securities, the financial records the issuer reviewed are older than 3 months, the issuer will be unable to rely on the financial records method and will instead need to fall back on the principles-based general approach.
  • The verification method that relies on written certification by attorneys or other licensed professionals does not require that the professional be licensed in the U.S.
  • The safe harbor for existing investors in the issuer does not extend to affiliates of the issuer or common sponsors; if NewCo and OldCo are both sponsored by Investment Fund, a purchaser of NewCo securities will not fall within the existing investor safe harbor by reason of being an existing investor in OldCo.

Issuers Can Convert Ongoing Traditional Private Offerings to Rule 506(c) Offerings

  • If an issuer sets out to conduct a Rule 506(b) offering may subsequently determine to change the offering to take advantage of Rule 506(c) and general solicitation.  The key question is whether all of the requirements of Rule 506(c) are met with respect to all sales in the offering – including sales made prior to the determination to transition to a Rule 506(c) offering.  If the issuer filed a Form D before undertaking general solicitation, that Form D would need to be amended to indicate that the issuer was relying on Rule 506(c).  This same concept applies in the case of an issuer that began a Rule 506 offering before new Rule 506(c) went effective in September and wants to transition to a generally solicited offering.

Issuers May Be Unable to Fall Back on Section 4(a)(2)

  • In a traditional Rule 506 offering (now a Rule 506(b) offering), the exemption in Section 4(a)(2) of the Securities Act provided a safety net of sorts; even if an issuer blew the 506 exemption by failing to comply with a specific requirement of the rule, the issuer could always fall back on the exemption provided in Section 4(a)(2).  In a Rule 506(c) offering, this may not be the case. If an issuer attempts to comply with Rule 506(c) but fails to fulfill the requirements of the rule, the Section 4(a)(2) exemption will not be available to the issuer if the issuer has conducted general solicitation in connection with the offering. 

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

In Pruett v BlueLinx Holdings, Inc., decided by the United States District Court for the Northern District of Georgia (1:13-cv-02607), the court held that a whistleblower suing under Dodd-Frank’s non-retaliation provisions was not entitled to a jury trial.  The reason is Dodd-Frank provides for the doubling of back pay, which is an automatic calculation and there is nothing for a jury to decide.  The court also noted that Congress amended similar provisions of the Sarbanes-Oxley Act to provide for a jury trial, but no similar provision was included in Dodd-Frank which was considered at the same time.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

 

Last week current and former supervisory personnel in the Enforcement Divisions of the Commodity Futures Trading Commission and Federal Energy Regulatory Commission spoke – at an Energy Bar luncheon – about (1) the “red flags” of possible manipulation and (2) effective compliance programs in this more aggressive federal enforcement environment.

These red flags do not necessarily mean that the trading is manipulative. But given that any determination of whether trading is manipulative is fact specific, if present these trades should be discussed with legal and compliance departments. The red flags they cited include:

  1. “Unprofitable trading”
  2. Trading to move price or protect a position that is flattering
  3. Taking advantage of flaws/glitches in the market rules
  4. You are the only entity doing this type of trade
  5. Trading in markets with little liquidity
  6. Trading inconsistent with market fundamentals
  7. Doing business off recorded lines or suggesting that conversations be off recorded lines

For more information, read our PDF: Red Flags

Further, they offered tips for effective compliance programs:

  1. Placing a compliance officer on the trading floor to interact with the traders
  2. Trading limits for trading group and for individuals
  3. Upper management must consider compliance work a profit center (rather than a drain on profits)
  4. Testing — prior to being in the middle of an investigation — document retention and document retrieval systems so the any investigation target does not end up providing information in “drips and drabs,” i.e., providing information to the agencies and then later finding additional information relevant to the investigation

For more information, read our PDF: Developing an Effective Compliance Program

The SEC announced a deferred prosecution agreement, or DPA, with a former hedge fund administrator who helped the agency take action against a hedge fund manager who allegedly stole investor assets.  According to the SEC’s DPA with Scott Herckis – the agency’s first with an individual – he served as administrator for Connecticut-based Heppelwhite Fund LP, which was founded and managed by Berton M. Hochfeld.  With voluntary and significant cooperation from Herckis, the SEC filed an emergency enforcement action against Hochfeld in November 2012 for misappropriating more than $1.5 million from the hedge fund and overstating its performance to investors.  The SEC’s action halted the fraud and froze the hedge fund’s assets and Hochfeld’s personal assets, which are now being used to compensate defrauded investors.

According to the DPA, Herckis served as the fund’s administrator from December 2010 to September 2012, when he resigned and contacted government authorities with his concerns about Hochfeld’s conduct and certain discrepancies in Heppelwhite’s accounting records.  Herckis voluntarily produced voluminous documents and described to the SEC how Hochfeld was able to perpetrate his fraud.  As a result, the SEC was able to file the emergency action within weeks.

Under the terms of the DPA, which states that Herckis aided and abetted Hochfeld’s securities law violations, Herckis must comply with certain prohibitions and undertakings.  Herckis cannot serve as a fund administrator or otherwise provide any services to any hedge fund for a period of five years, and he also cannot associate with any broker, dealer, investment adviser, or registered investment company.  The DPA requires Herckis to disgorge approximately $50,000 in fees he received for serving as the fund administrator, which will be added to the Fair Fund that has been created to help compensate Heppelwhite investors. 

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.