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

The SEC has issued final rules that reflect self-executing provisions of the JOBS Act. Because they were self-executing provisions of the JOBS Act, they do not change existing practice and were already well known. In addition, the rules reflect inflation adjusted amounts for determining “emerging growth company” status under the JOBS Act and other amounts related to Regulation Crowdfunding.  The rules will be effective upon publication in the Federal Register.

For the compliance minded individual, maybe the most important changes are the changes to Securities Act Forms S-1, S-3, S-4, S-8, S-11, F-1, F-3 and F-4 and Exchange Act Forms 10, 8-K, 10-Q, 10–K, 20–F and 40-F. Broadly speaking the cover page has been revised to include a “check the box” item to indicate that the person filing the report is an “emerging growth company” and an additional box to check as follows:  “If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 7(a)(2)(B) of the Securities Act.”

In remarks at a conference, CFTC Acting Chairman J. Christopher Giancarlo announced the CFTC’s intent to comply with an Executive Order which requires each agency to designate a Regulatory Reform Officer and establish a Regulatory Reform Task Force. Chairman Giancarlo noted that the CFTC’s initiative was named Project KISS, standing for Keep It Simple Stupid.  It is an agency-wide review of CFTC rules, regulations and practices to make them simpler, less burdensome and less costly.

On its face, the Executive Order is fuzzy as to whether it applies to independent agencies, but apparently the CFTC wants to play ball in any event.

It’s interesting to compare the Executive Order to Chairman Giancarlo’s objectives. Chairman Giancarlo stated “Project KISS is NOT about identifying rules for repeal or even rewrite. What it IS about is taking our existing rules as they are and applying them in ways that are simpler, less burdensome and less of a drag on the economy” (emphasis in original).  The Executive Oder directs the Regulatory Reform Task Force to evaluate existing regulations and make recommendations to the agency head regarding their repeal, replacement, or modification, consistent with applicable law.

The opinion of the SEC in KCD Financial Inc. upholds a FINRA disciplinary action against a FINRA member broker-dealer that sold securities in a private placement when no exemption from registration was available.  KCD’s Dallas office also did business under the name Westmount Realty Finance LLC. Testimony indicated that Westmount Realty Finance had an “issuer side” that put together offerings and a “FINRA sales side” comprised of a “captive” team of registered representatives who sold no securities other than those offered by Westmount Realty Finance.

Westmount Realty Finance sponsored an offering of the WRF Distressed Residential Fund 2011, LLC (the “WRF Fund” or the “Fund”). The PPM stated that the offer and sale of interests in the Fund were being offered only to persons who were accredited investors as set forth in Regulation D.  In a Notice of Exempt Offering of Securities it filed with the SEC, the WRF Fund claimed that the offering was exempt pursuant to Rule 506 under Regulation D.  After the PPM and associated documents were completed, KCD sent e-mails to approximately 1,200 individual accredited investors and registered investment advisors in KCD’s database of preexisting investors, informing them that the new offering was available.

Before KCD’s registered representatives had sold any interests in the WRF Fund, two Dallas newspapers published articles about the WRF Fund, based on a press release issued by Westmount Realty Finance. Both articles were generally available without restriction on the websites of the respective newspapers. The attorney that drafted the PPM learned of the newspaper articles, and contacted the Senior Vice-President of capital markets for Westmount Realty Finance, who was also the branch manager of the Dallas office.  The attorney advised the Senior Vice-President that the articles were a “breach of the prohibition against general solicitation.” The attorney also warned the Senior Vice President not to post the Dallas Business Journal article on “the Westmount website,” apparently referring to a website maintained by Westmount Realty Capital, LLC (“WRC”), an affiliate of Westmount Realty Finance.

The Senior Vice-President promptly telephoned the Chief Compliance Officer to tell him about the attorney’s concerns. Rather than terminating the offering, the Senior Vice-President and the Chief Compliance Officer decided to tell the representatives that if anyone who did not have a prior business relationship with Westmount Realty Finance or KCD contacted them about the WRF Fund, they should ask how that person learned about the offering. If the potential investor learned of the offering from a newspaper article, the representatives were not to let that person invest. At least one potential investor who had learned about the offering from a news article was told by a representative that he could not participate in the offering.

The newspaper articles were published on an unrestricted portion of the WRC website. During a FINRA examination of KCD in the fall of 2011, a FINRA examiner found that the articles were still posted on the WRC website.  KCD registered representatives first sold interests in the WRF Fund on May 5, 2011, nine days after the newspaper articles were published. Sales continued until at least October 2011.

The SEC found that the newspaper articles published on WRC’s website were designed to arouse public interest in the WRF Fund offering and therefore constituted offers. The articles were based on a press release issued by Westmount Realty Finance, the promoter of the WRF Fund, and sought to draw attention to the Fund. They cast the Fund’s objective in a favorable light, stating that the United States was “experiencing record-level foreclosure activity” and predicting a bright future for the Fund.

KCD argued that the articles were “not even aimed at investors, but at owners of distressed residential properties from whom the WRF Fund sought to purchase investment properties.” The SEC found that even if the articles were designed in part to alert potential sellers of distressed properties to the WRF Fund’s possible interest, that did not preclude the articles from also constituting offers.

KCD also argued that it did not use the articles to offer or sell securities because it took steps to insure that all sales were to accredited investors with whom the firm had a prior relationship. The SEC found that whether the purchasers were accredited or had a prior relationship to the firm is irrelevant to whether or not the newspaper articles constituted a general solicitation for purposes of Regulation D.

Finally, KCD argued that a letter from Commission staff stating that the staff did not intend to recommend enforcement action against Westmount Realty Capital after an investigation that allegedly encompassed the WRF Fund offering suggested that the staff determined that the WRF Fund investors were accredited and had a pre-existing relationship with KCD or Westmount Realty Finance. The Commission’s opinion states whether the investors were accredited or had such a pre-existing relationship was irrelevant because Rule 506 was not available where, as here, there was a general solicitation. In any case, staff letters advising that an investigation has been terminated without recommending enforcement action do not establish that no violations of the securities laws occurred.

The SEC has denied a proposed rule change by NYSE Arca to permit the listing and trading of shares of the SolidX Bitcoin Trust. The reasons were substantially similar to the reasons the SEC denied a proposed rule change submitted by Bats BZX Exchange designed to permit the listing and trading of the Winklevoss Bitcoin Trust.  The reasons are that the Commission believes that, in order to meet standards set forth in the Exchange Act, an exchange that lists and trades shares of commodity-trust exchange-traded products, or ETPs, must, in addition to other applicable requirements, satisfy two requirements which were not met.  First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated

Meanwhile, Bats BZX Exchange filed a petition for review of the denial of the Winklevoss Bitcoin Trust. The petition for review argues the standard applied by the SEC staff was inconsistent with prior approval orders and was not required by the Exchange Act, and that the manipulation concerns in the order were overstated and largely theoretical.  In support, the petition argues that the Exchange believes that the geographically diverse and continuous nature of bitcoin trading makes it difficult and prohibitively costly to manipulate the price of bitcoin.  In fact, the Exchange believes the bitcoin market generally is less susceptible to manipulation than the equity, fixed income, and commodity futures markets for a number of reasons:

  • there is not inside information about revenue, earnings, corporate activities, or sources of supply;
  • it is generally not possible to disseminate false or misleading information about bitcoin in order to manipulate its price;
  • a substantial over-the-counter market provides liquidity and shock-absorbing capacity;
  • bitcoin’s 24/7/365 nature means that there is no single market-close event to manipulate; and
  • it is unlikely that any one actor could obtain a dominant market share.

Traditionally, there has been no guidance in US GAAP about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern or to provide related footnote disclosures. It has been a matter considered by the auditors, and auditors would include an explanatory paragraph in the audit opinion if the auditor concluded that substantial doubt existed about an entity’s ability to continue as a going concern. This changed in August 2014 when FASB issued an Accounting Standards Update captioned “Presentation of Financial Statements—Going Concern (Subtopic 205-40).” ASC 205-40 is effective for annual periods ending after December 15, 2016, and for annual periods and interim periods thereafter.

Now, an entity’s management should evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Substantial doubt about an entity’s ability to continue as a going concern exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued.

When management identifies conditions or events that raise substantial doubt about an entity’s ability to continue as a going concern, management should consider whether its plans that are intended to mitigate those relevant conditions or events will alleviate the substantial doubt. The mitigating effect of management’s plans should be considered only to the extent that (1) it is probable that the plans will be effectively implemented and, if so, (2) it is probable that the plans will mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern.

If conditions or events raise substantial doubt about an entity’s ability to continue as a going concern then disclosures are required. The disclosure requirements vary depending on whether the substantial doubt is or is not alleviated as a result of consideration of management’s plans.

Sears Holdings Corporation’s disclosures in its Form 10-K under the new standard appear to have attracted the most attention in the press so far. Press reports indicated “Sears warned investors that it has “substantial doubt” it will stay in business.”  But is that the whole story?

Footnote 1 to the financial statements, under a section captioned “Uses and Sources of Liquidity”, discusses a series of actions taken to mitigate liquidity concerns, including new financing arrangements, restructuring programs intended to generate costs savings, and the sale of the Craftsman brand to Stanley Black & Decker.

The footnote continues noting that “Our historical operating results indicate substantial doubt exists related to the Company’s ability to continue as a going concern. We believe that the actions discussed above are probable of occurring and mitigating the substantial doubt raised by our historical operating results and satisfying our estimated liquidity needs 12 months from the issuance of the financial statements. However, we cannot predict, with certainty, the outcome of our actions to generate liquidity, including the availability of additional debt financing, or whether such actions would generate the expected liquidity as currently planned.”

The footnote also notes that “In August 2014, the FASB issued an accounting standards update which requires management to assess whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the financial statements are issued. If substantial doubt exists, additional disclosures are required. This update was effective for the Company’s annual period ended January 28, 2017. The Company’s assessment of our ability to continue as a going concern is further discussed in the “Uses and Sources of Liquidity” paragraph above. The adoption of the new standard did not have a material impact on the Company’s consolidated financial position, results of operations, cash flows or disclosures.”

So while it is true that management believes substantial doubt exists as to Sears’ ability to continue as a going concern, the press did not report or emphasize that management believed it has taken action probable of occurring and mitigating the substantial doubt raised. In addition, the audit report did not include an explanatory paragraph that the auditor concluded that substantial doubt existed about Sears’ ability to continue as a going concern.

Other examples of application of ASC 205-40 include ImmunoGen, Inc. (mitigating actions are not considered probable), Omeros Corporation (mitigating actions are not considered probable) and Hooper Holmes, Inc. (mitigating actions are not considered probable).

Myomo, Inc. has had an offering statement qualified by the SEC in which it discloses an intent to apply to list its common stock on the NYSE MKT LLC. The offering seeks to raise $15 million on a “best efforts” basis without any minimum offering amount.

Myomo is a medical device company in the medical robotics industry, specializing in myoelectric braces (orthotics) for people with neuromuscular disorders. According to the offering statement it is developer of the MyoPro® product line, which is a myoelectric-controlled upper limb brace (orthosis). The orthosis is a rigid brace used for the purpose of supporting a patient’s weak or deformed arm to enable and improve functional activities of daily living (“ADLs”) in the home and community that is available only on a physician’s order.

The offering statement states in order to complete the listing process, the company will be required to, among other things, file with the SEC a post-qualification amendment to the offering statement, and then file a Form 8-A in order to register its shares of Common Stock under the Exchange Act. The post-qualification amendment of the offering statement is subject to review by the SEC. Of course, the listing qualification standards must be met as well.

The offering statement also says that upon completion of the offering, the company expects to elect to become a public reporting company under the Exchange Act, and thereafter publicly report on an ongoing basis as an “emerging growth company” under the reporting rules set forth under the Exchange Act.

Update:  You can find the final judgment here.

Pursuant to a court order, the parties to the conflict minerals case have filed a proposed judgment after they advised the court no further proceedings were necessary. The text of the proposed judgment is as follows:

(1) The Court DECLARES pursuant to 28 U.S.C. § 2201 that Section 1502 of the Dodd-Frank Act, 15 U.S.C. § 78m(p)(1)(A)(ii) and (E) (“the Statute”), and Securities and Exchange Commission Rule 13p-1 and Form SD, Conflict Minerals, 77 Fed. Reg. 56,274, 56,362-65 (Sept. 12, 2012) (“the Rule”), violate the First Amendment to the extent that the Statute and the Rule require regulated entities to report to the Commission and to state on their websites that any of their products “have not been found to be ‘DRC conflict free.’”

(2) Pursuant to the Administrative Procedure Act, 5 U.S.C. § 706(2), the Court HOLDS UNLAWFUL AND SETS ASIDE the Rule, 77 Fed. Reg. at 56,632-65, only to the extent that it requires regulated entities to report to the Commission and to state on their websites that any of their products “have not been found to be ‘DRC conflict free.’”

(3) In all other respects, the Court DENIES summary judgment to Plaintiffs, GRANTS summary judgment to Defendants and Defendant-Intervenors, and REMANDS to the Commission.

The Department of Justice has filed an amicus brief in the case of PHH Corp. v. Consumer Financial Protection Bureau pending before the United States Court of Appeals for the District of Columbia Circuit and is scheduled for en banc oral argument on May 24, 2017.  The primary issue discussed in the brief is the fact that the CFPB is headed by a single Director who is appointed by the President, with the advice and consent of the Senate, for a term of five years, and who may be removed by the President only for “inefficiency, neglect of duty, or malfeasance in office.”

The Justice Department agrees with the original appellate panels holding that the “for cause” removal provision violates constitutional separation of powers. While for cause removal provisions have been upheld for multiple-member regulatory commissions, the Justice Department views single-headed agency differently.  The brief notes that a single-headed agency lacks critical structural attributes that have been thought to justify “independent” status for multi-member regulatory commissions. Moreover, because a single agency head is unchecked by the constraints of group decision-making among members appointed by different Presidents, there is a greater risk that an “independent” agency headed by a single person will engage in extreme departures from the President’s executive policy.

The Justice Department also believes that the unconstitutional nature of the CFPB organizational structure does not render the CFPB’s entire enabling statute invalid. Rather, the proper remedy for the constitutional violation is to sever the provision limiting the President’s authority to remove the CFPB’s Director.  The brief notes that when confronting a constitutional flaw in a statute, courts generally try to limit the solution to the problem, severing any problematic portions while leaving the remainder intact.  According to the brief, there is no evidence that Congress would have preferred no Bureau at all to a Bureau whose Director was removable at will.

Perhaps echoing the politics behind the Justice Department’s position, House Financial Services Committee Chairman Jeb Hensarling (R-TX) issued the following statement:

“Republicans have said for years that the Bureau is unconstitutionally structured. Its lack of accountability and the unparalleled authority placed in the hands of the Bureau’s unaccountable sole director make the CFPB arguably the most powerful and least accountable bureaucracy in American history.  Owing to its unconstitutional structure, the Bureau’s sole unaccountable director, unlike bipartisan commissions, can act unilaterally to eliminate access to credit options and increase consumer costs.  In addition, the Bureau does not recognize core constitutional principles like the right to due process.  Instead, it relies almost exclusively on its vague or undefined enforcement authority to practice regulation by enforcement.  The Bureau’s consumer protection mission is important, but no government agency – no matter how well-intentioned – should be able to evade common sense checks and balances that are necessary for accountability.  I applaud the Department of Justice for recognizing this unconstitutional CFPB must not stand and must not continue to harm the very consumers it is supposed to protect.”

The Trump administration has published its budgetary Blueprint. The Blueprint notes the 2018 Budget is being unveiled sequentially in that the Blueprint provides details only on discretionary funding proposals. The full Budget will be released later this spring and will include the administration’s specific mandatory and tax proposals, as well as a full fiscal path.

The Blueprint does not provide details for the SEC’s or the CFTC’s budget.

According to the Trump administration, the Blueprint eliminates and reduces hundreds of programs and focuses funding to redefine what the administration believes is the proper role of the Federal Government.

The Budget proposes to eliminate funding for independent agencies, including: the African Development Foundation; the Appalachian Regional Commission; the Chemical Safety Board; the Corporation for National and Community Service; the Corporation for Public Broadcasting; the Delta Regional Authority; the Denali Commission; the Institute of Museum and Library Services; the Inter-American Foundation; the U.S. Trade and Development Agency; the Legal Services Corporation; the National Endowment for the Arts; the National Endowment for the Humanities; the Neighborhood Reinvestment Corporation; the Northern Border Regional Commission; the Overseas Private Investment Corporation; the United States Institute of Peace; the United States Interagency Council on Homelessness; and the Woodrow Wilson International Center for Scholars.

According to the Blueprint, the administration will take action to ensure that by 2020 it will be able to say the following:

  • Federal agencies are managing programs and delivering critical services more effectively.
  • Federal agencies are devoting a greater percentage of taxpayer dollars to mission achievement rather than costly, unproductive compliance activities.
  • Federal agencies are more effective and efficient in supporting program outcomes.
  • Agencies have been held accountable for improving performance.

The Corporate Council of The Corporation Law Section of the Delaware State Bar Association has prepared proposed amendments to the Delaware General Corporation Law to facilitate the use of block chain technology for stockholder records. Blockchain, also known as distributed ledger technology and typically associated with the use of Bitcoin currency, relies on an algorithm which can be used to track the exchange of stocks, bonds and other financial securities without a centralized ledger. Blockchain technology is based on a distributed “open ledger” using consensus-based authentication methods that depart from the current methods of securities settlement process.  The technology works by storing information in blocks that record all transactions ever done through the network and allows for independent validation of both the existence of assets to be traded and ownership.

The proposed legislation addresses the differences between a distributed technology and traditional stockholder records, including that:

  • Stockholder records need not be administered solely by the corporation.
  • Electronic networks are a permissible method of record keeping.
  • Certain notices may be given by electronic transmission.