Posts Tagged ‘Securities and Exchange Commission’

Law Week Colorado, February 18, 2105




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Denver CO, April 22, 2015 – In the last year I have seen proposals for clients to go public through a reverse merger with a public operating company that was really a shell or “blank-check” company. In both cases during the listing process the SEC commented that the registering company appeared not to have any real assets or operations, appeared to be a shell or blank-check company, and the SEC asked whether the company intended to do a reverse merger in the near future. The companies responded that they did too have a real business (they didn’t), and they had no intention of merging with any company in the future. Almost as soon as the company was registered they were trying to sell a reverse merger / back-door-listing to my client.

A “shell company” is prohibited from taking advantage of many favorable SEC rules for three years after it is no longer a shell, and has extensive 8-K filing requirements. In addition, “blank check” companies are subject to restrictive escrow and use of funds requirements, along with clear risk and disclosure obligations. I advised my client that it would likely bear substantial costs from the previous founders’ lies to the SEC, since the original promoters would be cashed-out and long gone when it came time to pay the piper. We walked away.

Last week the SEC charged 10 people with fraud for lying to the SEC about the shell or “blank-check” status of registered companies bound for reverse mergers.

The SEC announced the charges in a press release on April 16, 2015, stating it brought fraud charges “against 10 individuals involved in a scheme to offer and sell penny stock in undisclosed “blank check” companies bound for reverse mergers while misrepresenting to the public that they were promising startups with business plans. Blank check companies generally have no operations and no value other than their status as a registered entity, which makes them attractive targets for unscrupulous individuals seeking reverse mergers with clean shells ripe for pump-and-dump schemes.”

According to the SEC, the group created undisclosed blank check companies, installed figurehead officers, falsely claimed in registration statements and other SEC filings that the companies were pursuing real business ventures, and concealed from the public that the sole purpose of the companies was entering into reverse mergers so they could profit from the sales.

The SEC is seeking disgorgement of approximately $ 6 million in ill-gotten gains plus prejudgment interest, financial penalties, and permanent injunctions as well as officer-and-director bars and penny stock bars.

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According to the SEC, in 2012 companies raised $173 billion through direct private placements, and pooled funds raised $725 billion. These offerings were conducted without public advertising. After September 23, 2013 companies and hedge funds offering their securities in private placements can now advertise the offering to the public, so long as (1) all purchasers are “accredited investors” and (2) they take “reasonable steps” to verify that each purchaser is “accredited.” However, the new rules also increase the risk and likelihood of losing your private placement exemption, and should be used with caution.


The basic foundation of securities laws in the United States is that every offering and sale of a security must be either registered with the SEC and applicable state commissions, or qualify for an exemption from registration. The primary exemption from registration is §4(2) of the Securities Act of 1933 (“Securities Act”), which exempts “transactions by an issuer not involving any public offering.” In the decades after 1933, court rulings and SEC guidance added a confusing and formidable crazy-quilt of rules about what made a “private placement” under §4(2). To address this problem, in 1983 the SEC issued Regulation D; private placements that meet one of the three Reg D requirements are deemed exempt from registration, and thus Reg D provides issuers with a “safe harbor” so they know their private placement is exempt, instead of having to deal with the uncertainty of §4(2).

The details of Reg D offerings are beyond the scope of this article, but nearly all private placements by issuers are conducted under Rule 506 of Reg D, because there is no limit on the amount raised or the number of accredited investors (now known as Rule 506(b)). There are several specific requirements that must be met to comply with a Reg D exemption, and Form D must be filed with the SEC and the relevant state commissions – more on that later. But until now, it was a requirement of every Reg D private placement that it not involve any public offering.

That means no advertising, no Internet webpages about your offering, no hosted breakfast meetings at the retirement home about an “investment opportunity,” no facebook postings, no windshield flyers at the mall – until now.

The JOBS Act

Section 201(a) of The Jumpstart Our Business Startups Act, (the “JOBS Act”)(April 5, 2012) directed the SEC to issue rules allowing “general solicitation” in connection with a private placement. Earlier this year the SEC issued new Rule 506(c), which went into effect on September 23, 2013 and provides a new “safe harbor” exemption from registration for securities offerings marketed using general advertising if:

  • all investors are “accredited investors” at the time of investment, and
  • the issuer takes reasonable steps to verify that each purchaser is an accredited investor.

How It Works

New Rule 506(c) under Regulation D allows issuers and their agents to advertise and offer to the public their securities, without having to register the offering or the securities under the Securities Act, if (1) all investors are “accredited investors” at the time of investment, (2) the issuer takes reasonable steps to verify that each purchaser is an accredited investor, and (3) they otherwise comply with Reg D. Note that the definition of “accredited investor” under Reg D has not changed, which means that an “accredited investor” includes persons that the issuer reasonably believes to be an accredited investor. Therefore, the issuer will not lose the exemption if an unaccredited investor sneaks in, so long as the issuer reasonably believed the investor was accredited.

Securities issued under new Rule 506(c) will still be “covered securities” under federal securities laws, and therefore preempt the “Blue Sky” laws of the 50-states; state registration will not be necessary, but the issuer must still file Form D with the SEC and the states where securities are sold. Form D has been amended, and the issuer must now check-the-box to state whether the offering is conducted under new Rule 506(c), or traditional Rule 506(b) with no public offering.

One of the key compliance requirements will be taking “reasonable steps to verify each purchaser is an accredited investor.” The SEC has provided guidance. First, the traditional method of requiring investors to “self-certify” that they are accredited by checking a box on their stock purchase agreement will not be acceptable for public offerings under new Rule 506(c). Second, rather than a “bright line” test, the SEC has adopted a “principals-based approach” to whether the issuer takes reasonable steps – a “common sense” test, depending on the facts of each offering. At one end of the spectrum, if the issuer sells its shares to JP Morgan Chase, Bank of America and Goldman Sachs, very little effort will be required to establish that the purchasers are “accredited,” it is readily confirmed in the public record. On the other end of the spectrum, verifying the accredited status of natural persons will require some effort (and record-keeping).

Natural persons may be accredited based on (1) income (alone or with spouse), or (2) their net worth. The SEC provided a few safe-harbor methods for satisfying that investors are “accredited,” which are not exclusive.


An issuer will be deemed to have satisfied the verification requirement for the income of a natural person by reviewing the investor’s IRS income forms for the two most recent years, such as Form W-2, Schedule K-1, Form 1099, and Form 1040. The issuer must also get a written representation from the investor that he expects to reach the required income level again in the current year. If the income requirement is based on joint income with the investor’s spouse, the IRS forms and representation must pertain to both the investor and spouse.

Net Worth

An issuer will be deemed to have satisfied the verification requirement for the net worth of a natural person by reviewing one or more of the investor’s bank statements, brokerage statements, securities account statements, certificates of deposit, tax assessments and appraisal reports for assets, and a consumer credit report for liabilities from one of Experian, Equifax, or Trans Union. The investor’s written representations described above are required.

Third-Party Verification

An issuer will be deemed to have satisfied the verification requirement by getting a written confirmation from the investor’s registered securities broker or investment adviser, CPA or licensed attorney.

Bad-Actor Disqualifications

Concurrent with issuing the new Rule 506(c), the SEC also issued the long awaited “Bad Actor” disqualification rules, disqualifying felons and other “bad actors” from participating in Rule 506 offerings. The issuer will lose its private placement exemption and be subject to rescission (discussed below) if the issuer, a director or officer, a 20% owner, a promoter, or a finder has had a “disqualifying event” such as a criminal conviction, a securities related injunction or restraining order, a banking regulator order, or any of a number of other disqualifying events. These will be discussed in more detail in a companion article.

The Big Risk – Claims for Rescission, Damages and Enforcement Action

The penalty for violating the registration or antifraud provisions of the securities laws is that, at a minimum, investors can rescind their purchase and receive a refund of their investment.  Some states, such as Colorado, provide for attorney’s fees in these types of cases. Additionally, the state and federal regulatory agencies have enforcement rights and, in extreme and aggravated circumstances, may fine and enforce criminal penalties.

The federal antifraud provisions arise primarily from Section 10(b) and rule 10b-5 of the Securities Exchange Act of 1934 (“Exchange Act”), as well as the lesser known Section 12(2) of the Securities Act. States have similar or identical antifraud provisions in their “Blue Sky” laws. Failure to comply with these provisions can result in civil liabilities (i.e., money damages). The liability can be, and often is, personal as to corporate officers, directors, principal shareholders and promoters. These antifraud laws prohibit any person in connection with the purchase or sale of any security from misrepresenting or omitting a material fact or engaging in any act or practice that constitutes a “fraud” or deceit upon any other person. Fraud, for securities law purposes, is much broader than the average person thinks of “fraud”. It includes omissions in disclosure (sometimes even unintentional ones) rather than just deliberate misrepresentations. Therefore, regardless of whether you intend to defraud an investor, if you fail to disclose a material fact, you may be liable.

If an issuer loses its exemption, or, fails to disclose important facts or makes mistakes in disclosures, it is at risk for claims by investors seeking to get their money back, and the directors and officers who participated in the offering may be personally liable. None of the antifraud damages or rescission rights were removed by these new rules.

 Risk #1 – Lose The Exemption, No Fall-Back Exemption

Lawyers commonly help their clients design and conduct private placements so that they comply with both old Rule 506 of Reg D (now Rule 506(b)), and §4(2) of the Securities Act. Rule 506 has a number of specific requirements that, if not met, will cause you to lose the exemption. For example, it is not uncommon for an issuer to restrict its offering to accredited investors, thereby decreasing its disclosure obligations, but then decided to let in Uncle John and Aunt Jane, who are not accredited. Since it hasn’t met the disclosure obligations for non-accredited investors required by Rule 506, the issuer has lost the benefit of that exemption. However, if the placement also complied with the §4(2) requirements, and Uncle John and Aunt Jane meet the “sophisticated investor” requirements of §4(2), the issuer has not lost its private placement exemption – the offering is still exempt.

But, if the offering includes general solicitation and advertising to the public under new Rule 506(c), there is no fallback exemption. Remember, the §4(2) registration exemption applies only to offerings “not involving any public offering,” and therefore will not be available as a fallback if you fail to meet the formal requirements of new Rule 506(c). A private placement with public advertising under new Rule 506(c) is all-or-nothing – you are on the trapeze without a net.

Risk #2 – Commit Securities “Fraud”

“Oops, we forgot to mention, that one guy is suing us about that one thing!”

“Did we tell the investors about that note coming due next year?”

Generally speaking, liability for securities fraud arises when the investor makes his investment decision. While there is no specific disclosure requirement under Rule 506 for offerings made only to accredited investors, without a disclosure document like a private placement memorandum or offering circular, the issuer will be in a tough spot if an investor claims securities fraud, which will be all the more difficult if the offering was advertised. First, a disgruntled investor could claim that he decided to invest based on the public advertising that he saw, before he even saw any investment documents – a risk that did not exist before. An issuer would have little evidence to defend that claim without a robust offering disclosure document with comprehensive risk factor disclosures, and a well-controlled investment acceptance procedure.

Second, securities “fraud” includes the failure to disclose a material fact, which is a fact that a reasonable investor would consider important to an investment decision. The courts have consistently held that generic or “blanket” risk disclosures, such as “this investment is risky and you could lose all your money,” are not sufficient to protect issuers from liability for securities fraud. Fact and risk disclosures must be well considered and specific to each issuer and each offering. In the author’s opinion, public advertising of private offerings will increase the already considerable tension between an issuer’s desire to make its stock attractive, and the lawyer’s desire to disclose all “bad facts” and potential risks. Absent the regulatory scheme of SEC review and comment for public offerings, and specific and very detailed disclosure rules, issuers making public offerings of private placements under new Rule 506(c) may “sales pitch” their stock, and pay the price for inaccurate and incomplete advertisements and solicitations at a later date.

Risk #3 – Lose the Broker-Dealer Exemption

In addition to the registration exemption, a private placement must also comply with the broker-dealer registration or exemption requirements of the Exchange Act. That is, securities may not be sold in the United States except by a person registered as a broker-dealer (or their agents), unless an exemption applies – the persons selling the securities must be registered or exempt. The “issuer exemption” is most commonly used for a private placement. The issuer exemption allows the directors and officers of a company to sell its securities without registering (1) so long as they do not sell more often than once every 12 months, (2) the selling persons are officers, directors, or full-time employees who perform substantial duties for the Company other than selling these securities, and (3) the selling persons are not paid compensation for their sales efforts – they can continue to receive their normal compensation, but no commissions or bonuses for selling the stock. Issuers must be mindful that these rules still apply, even with a publicly advertised private placement. If advertising an offering generates excessive calls and inquiries to the company, the company must be very careful that the persons taking the calls understand their roles and limitations in the context of the broker-dealer exemption, and don’t cause the issuer to lose its “issuer exemption.”

Risk #4 – Hedge Funds May Get Special Attention

In addition to the registration exemption and the broker-dealer exemption, private pooled investment funds, such as hedge funds, private equity funds and venture capital must, must be registered as an investment company under the Investment Company Act of 1940, unless an exemption applies. Most private funds rely on one of two exemptions from the 1940 Act, both of which are not available if they make a public offering of their securities. Because the new rules allowing general solicitation would be of no value to private funds if advertising caused them to lose their 1940 Act registration exemption, the SEC has determined that private funds can make public offerings under Rule 506(c) without losing their 1940 Act registration exemption. Specifically, the SEC ruled that since the JOBS Act provided that offers and sales under new Rule 506(c) shall not be deemed public offerings “under the Federal securities laws,” and the 1940 Act is a “Federal securities law,” then, offerings by private funds under Rule 506(c) shall not be deemed public offerings.

However, the SEC indicated it may be paying particular attention to advertising and disclosures by private funds. Investment advisers to private funds are subject to additional rules under the Advisers Act, and in its issuing release the SEC said “we intend to employ all of the broad authority Congress provided us ….. and direct it at adviser conduct” affecting investors in private funds. The SEC provided this pointed reminder: “Recently, for example, we have brought enforcement actions against private funds advisers and others for material misrepresentations to investors and prospective investors regarding fund performance, strategy, and investment, among other things.” It is probable that the SEC will be carefully scrutinizing advertising and sales materials of private funds for potential misrepresentations.

The Early Fallout

The SEC, and particularly state securities regulators, did not support allowing “public advertising of private placements” (and yes, that is a direct contradiction in terms – a fact not lost on the SEC). However, the JOBS Act required this rule-making, and it does not come without a cost. First, the SEC finally issued the “Bad Actor” rules, prohibiting persons with a relevant bad history from participating. That will be discussed in a different article. At the same time, the SEC issued new proposed rules regarding Form D and filing requirements. Until now, Form D has been a mere formality and an information gathering tool for the SEC. Failure to timely file Form D had little or no real consequences. The SEC is proposing to add real enforcement and penalties behind the Form D filing requirement, and to require issuers making public offerings under new Rule 506(c) to file their offering materials with the SEC.  While these new Form D and reporting requirements are only proposed for comment at this time, and the final regulations remain to be seen, it is clear that the SEC intends to keep a close eye on issuers using advertising for their private placements. State securities commissions will be doing the same.

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The Securities and Exchange Commission announced today that companies can use social media outlets like Facebook and Twitter to make news announcement in compliance with Regulation FD (Fair Disclosure), if investors have previously been told which social media the company will be using, and who’s feed to monitor. Regulation FD requires companies to distribute important news in a manner designed to get that information out to the general public, so that all investors have the ability to get important news at the same time. Today the SEC confirmed that social media can meet that requirement, if certain conditions are met.

The SEC commenced an investigation last year after Netflix CEO Reed Hastings posted on his personal Facebook page on July 3, 2012 that Netflix’s monthly online viewing for June 2012 had exceeded one billion hours for the first time. Netflix did not report that information to investors through a press release or Form 8-K filing, and a Netflix press release later that day did not include the information. The announcement represented a nearly 50% increase in streaming hours from Netflix’s January 25, 2012 report, and was clearly important news to the market. Hastings and Netflix had not previously used Facebook to announce company metrics, and they had never told investors to watch Hastings’ personal Facebook page for Netflix news. Netflix’s stock price increased from $70.45 at the time of the post, to $81.72 at the close of the following trading day.

According to the SEC press release: “The SEC did not initiate an enforcement action or allege wrongdoing by Hastings or Netflix. Recognizing that there has been market uncertainty about the application of Regulation FD to social media, the SEC issued the report of investigation pursuant to Section 21(a) of the Securities Exchange Act of 1934.”

The SEC’s report of investigation, available here, confirms that Regulation FD applies to social media used by public companies the same way it applies to company websites. As a result, reporting issuers cannot use social media as the sole method to report material, non-public information, unless the issuer has previously notified investors and the public to look to a specific site, page or feed for that type of information. Failure to comply could constitute selective disclosure and a violation of Regulation FD.

In particular, the report of investigation notes that the personal social media site of an individual corporate officer would not ordinarily be assumed to be a method  “reasonably designed to provide broad, non-exclusionary distribution of the information to the public” as required by Regulation FD, even if the officer is a business celebrity and has a large number of subscribers, friends or contacts.  “Personal social media sites of individuals employed by a public company would not ordinarily be assumed to be channels through which the company would disclose material corporate information”, and may not be used for that purpose unless the public is given advance notice that the site may be used to distribute company information.



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Last year the SEC announced it was adopting new procedures to encourage greater cooperation in its enforcement investigations, including the use of cooperation agreements, non-prosecution agreements and deferred prosecution agreements. Non-prosecution agreements and deferred prosecution agreements are typically used in criminal proceedings to encourage cooperation by important witnesses and provide fair and specific treatment of cooperating witnesses.  To understand their use by the SEC it is helpful to understand how these tools developed under federal practice.

The Department of Justice has used these agreements for years in corporate fraud cases.  The infamous “Thompson Memorandum”, written by Larry Thompson of the DOJ in 2003 to help federal prosecutors decide whether to charge a company with criminal offenses, required that a company must

  1. turn over materials from internal investigations,
  2. waive attorney-client privilege, and
  3. not provide targeted executives with company-paid lawyers,

before the company could claim credit for cooperating with the DOJ.   In other words, a company might provide extensive cooperation to the DOJ, but would not get any credit for that cooperation unless it expressly gave up its rights and breached its indemnification contracts.  Nearly every public company has indemnification agreements with its directors and officers, and indemnification is provided in the corporation statutes of Delaware, Colorado, and most other states. While eviscerating the constitutional rights to counsel and against self-incrimination, and the statutory right and contractual obligation to indemnification, the Thompson Memo also provided for the use of non-prosecution agreements for companies that waived their constitutional rights.

The Thompson Memorandum was replaced in December 2006 by the more reasonable “McNulty Memorandum”, which provided some relief from the most offensive portions of the Thompson Memorandum by requiring prosecutors to go through certain procedural requirements and obtain approval from senior supervisors before demanding a waiver of the attorney-client privilege.

The McNulty Memorandum was revised in 2008 (the “Filip Memo”) to prohibit the Department of Justice from coercing companies to breach their indemnification agreements with their directors and officers, to allow credit for cooperation to companies that do not waive the attorney-client privilege or do not disclose attorney-client work product, and to prohibit prosecutors from demanding attorney-client communications or attorney work product.

In contrast to the Department of Justice, the SEC does not have criminal enforcement powers, only civil enforcement powers, and must refer criminal cases to the Department of Justice.  However, over the years the SEC has sought greater cooperation from companies and people under SEC civil investigation.  For example, the SEC’s equivalent of the Thompson/McNulty/Filip Memorandums is the 2001 “Seaboard Report” describing the criteria it will consider in determining whether, or how much, credit it will give to companies who self-police, self-report, take corrective action or cooperate with the SEC.  Never mind that the “Seaboard Report” is neither about “Seaboard” nor a “report”, it stated that cooperation can result in reduced charges, lighter sanctions or mitigating language in settlements.

Despite the SEC’s more reasonable approach to the rights of companies under investigation, the Seaboard Report, and the SEC’s approach to giving credit for cooperation, were vague, and often applied after-the-fact.  In many cases, a company never really knows where it stands with the SEC, and whether it is actually receiving credit for cooperation, until after the investigation is complete.  While the Justice Department’s rules were originally offensive, at least a defendant signing a non-prosecution or deferral agreement knows exactly what to do, and exactly what treatment it will receive in return for cooperation.

To encourage the type of cooperation the SEC wants, it needs to provide the same type of certainty and fairness to potential witnesses as the DOJ, and so last year the SEC adopted new procedures for rewarding cooperation.

The SEC entered its first non-prosecution agreement in December 2010 with Carter’s Inc. In the Carter’s case the EVP of Sales, Joe Elles, allegedly gave substantial discounts to the company’s largest customer and hid them from the company.  Because the company didn’t know, it did not recognize the discounts until later reporting periods, which caused the company’s results for the quarters in which the discounts were given to be artificially inflated.  The SEC brought an action against Elles, but entered into a non-prosecution agreement with Carter’s. The SEC identified the following factors as relevant to its decision not to bring an action against Carter’s: (1) the “relatively isolated nature” of the unlawful conduct; (2) the company’s “prompt and complete” self-reporting of the misconduct to the SEC; and (3) the company’s “exemplary and extensive” cooperation in the inquiry, including a “thorough and comprehensive” internal investigation.  The SEC did not require Carter’s to waive its attorney-client privilege.

The SEC recently announced its first use of a deferred prosecution agreement, with Tenaris S.A., a manufacturer of steel pipe products from Luxemburg, listed on the New York Stock Exchange.  A world-wide internal investigation conducted by Tenaris’ outside counsel revealed Foreign Corrupt Practices Act violations in Uzbekistan, where Tenaris allegedly bribed Uzbek officials and made $5 million in profits from pipeline contracts.  The company self-reported to the SEC and the Department of Justice, cooperated with the government, and made extensive efforts at correcting the violations.

The SEC said that Tenaris was an appropriate candidate for the first deferred prosecution agreement because of its “immediate self-reporting, thorough internal investigation, full cooperation with SEC staff, enhanced anti-corruption procedures, and enhanced training.”

Under the deferred prosecution agreement, the SEC will not bring civil charges against Tenaris unless the SEC determines that the company has not complied with its obligations under the agreement.  Although Tenaris shared the results of its internal investigation with the government, the agreement does not require it to waive the attorney-client privilege.  Tenaris agreed to pay $5.4 million in disgorgement and interest.

By eliminating the Hobson’s choice of either cooperating and not knowing what will happen, or not cooperating and not knowing what will happen, the certainty provided by deferment and non-prosecution agreements will allow lawyers to better advise their clients on the consequences of self-reporting and corrective actions, and should make it easier for the SEC to secure cooperation from companies and individuals on a fair and reasonable basis.

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This is the second in a series analyzing important changes to capital markets and securities laws by the Dodd-Frank Wall Street Reform and Consumer Protection Act. On July 21, 2010 President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act.  While the Act is 2,319 pages long, it has very little immediate effect on the financial markets. Rather, the Dodd-Frank Act empowers a variety of financial regulators and government agencies to conduct studies, take testimony, publish reports and promulgate rules and regulations to enforce the various provisions of the Act.  Not unlike Twilight (New Moon), nothing much happens in the Dodd-Frank Act, but it lets you know there’s more to come.

The Dodd-Frank Act was primarily crafted to reduce the exposure of the U.S. banking system to a repeat of the 2008 melt-down, and end the potential for “too big to fail” government bail outs.  However, the Act goes well beyond the initial intent, addressing broad changes in securities laws, capital markets, banking and consumer finance.

47 Studies (or is it 67 Studies?)

Depending on whom you ask, and how you count parts and sub-parts, the exact number of studies commissioned by the Dodd-Frank Act varies.  The best estimate may be “scads”.  Studies will be conducted and reports published by the Financial Stability Oversight Council, the FDIC, the GAO, the FTC, the Federal Reserve, Treasury, the new Bureau of Consumer Financial Protection, and the SEC, among others.  In particular, the SEC will have one of the biggest roles in implementing Dodd-Frank.   The SEC has begun ramping-up to implement its role.  Compliance Week reports that the SEC will hire roughly 800 new employees, create five new offices, and revamp its internal reporting and technology processes in implementation of its broader reporting and enforcement role.

The following studies may be of interest to our clients:

  • Accredited Investors. The GAO will study and report on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.  As I reported recently, the Dodd-Frank Act already increased the asset value required for individual investors to be “accredited” by excluding the value of the investor’s primary residence.  This report is due in 3 years.
  • Short Selling and Swaps. The SEC must report on several studies on different aspects of short selling and swap transactions.  Particularly, reporting and regulation of certain aspects of short selling are likely to be forthcoming.  While selling stock you don’t own, gambling that the price will go down, can be an effective hedge (insurance) strategy for persons with substantial and complex stock positions, short selling for speculation often vexes public companies.  Management of public companies who watch their stock go down for no apparent reason in the face of growing short positions often believe that speculators are conducting a “short and distort” campaign – taking a short position, then spreading negative rumors or false information about the company to insure a profit from the short position, or that the existence of the short position itself causes other investors to sell their stock, driving the price down and hurting the company.
  • Information on Broker-Dealers, Investment Advisers and Registered Reps. The SEC must study and recommend ways to improve investor access to registration information (including disciplinary actions, regulatory, judicial, and arbitration proceedings, and other information) about registered and previously registered investment advisers, associated persons of investment advisers, brokers and dealers and their associated persons.  This report is due by January 21, 2011.
  • Aiding and Abetting Violations of Securities Laws. The GAO must study and report on the impact of authorizing a private right of action against any person who aids or abets another person in violation of the securities laws. This is of particular interest to securities lawyers, accounting firms, and their insurers.  At common law, aiding and abetting occurs through “knowing participation” in the illegal conduct. Although knowing participation is required, wrongful intent by the defendant is not necessary.  Nor is it necessary that the plaintiff establish that an agreement existed between the defendant and the guilty party.  There is a fine evidentiary line between participating in someone else’s conduct, and knowing the conduct was illegal. Thus, when a fraudster commits securities fraud and heads for the border with the money, the aggrieved investors look for people to sue – the lawyers who prepared the offering documents, the accountants who prepared the financial statements, the financial printer, the broker dealer who sold the securities, the investment banker who advised on the deal.

Under current law the SEC may bring action against aiders and abettors, but individuals may not. In addition, the Dodd-Frank Act provides for the SEC to impose aiding and abetting liability on persons who “recklessly” provide substantial assistance to someone who violates the Exchange Act.  Previously, the SEC was required to show that such assistance was provided “knowingly.”  Private plaintiffs have been unable to bring such claims since the Supreme Court’s Central Bank of Denver decision in 1994, and the 2008 decision in Stoneridge Investment Partners blocked plaintiffs from bringing similar “scheme” liability claims.

The Dodd-Frank Act also extends aiding and abetting liability for the first time to the Securities Act, the Investment Company Act and the Investment Advisers Act. The Act also clarifies that the SEC may pursue enforcement actions against so-called “control” persons – those found to “directly or indirectly control” a violator – unless they acted in “good faith” and did not “directly or indirectly induce” the violative conduct.  This report is due in 1 year.

  • Lessen Impact of Sarbanes-Oxley on Medium-Sized Companies. The SEC will study how the SEC could reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act for companies whose market capitalization is between $75,000,000 and $250,000,000 while maintaining investor protections for such companies, including whether any such methods of reducing the compliance burden or a complete exemption for such companies from compliance with such section would encourage companies to list on exchanges in the United States in their initial public offerings.  See Sarbanes-Oxley discussion below. This study is due in 9 months.

  • Core and Brokered Deposits.  The FDIC will conduct a one year study to evaluate:

– the definition of core deposits for the purpose of calculating the insurance premiums of banks;

– the potential impact on the Deposit Insurance Fund of revising the definitions of brokered deposits and core deposits to better distinguish between them;

– an assessment of the differences between core deposits and brokered deposits and their role in the economy and banking sector of the United States;

– the potential stimulative effect on local economies of redefining core deposits; and

– the competitive parity between large institutions and community banks that could result from redefining core deposits.

Current FDIC policy strongly discourages acceptance of brokered deposits by charging an FDIC insurance premium if brokered deposits exceed a specified percentage, and by very broadly interpreting the definition of brokered deposit.

What the Dodd-Frank Act Does Today

  • Makes it Harder to Qualify as an Accredited Investor.  As detailed in my earlier article, effective immediately, the definition of an individual accredited investor under the SEC’s Regulation D for private placements now excludes the value of the investor’s primary residence. This reduces the number of people eligible to participate in many private placements, which are often offered only to accredited investors.

  • Sarbanes-Oxley Relief. After six compliance extensions by the SEC, including a couple of “final extensions”, the matter is taken out of the SEC’s hands.  The Dodd-Frank Act provides immediate relief from the onerous Sarbanes-Oxley internal control audit provisions for approximately 5,000 smaller public companies.  Smaller public companies, (non-accelerated filers – companies with a market cap less than $75 million) are now exempt from Sarbanes-Oxley 404(b) compliance. Sarbanes-Oxley 404(a) requires a management report on internal controls, which smaller public companies must still provide – 404(b) requires external audit of internal controls. Based on a 2007 study by Financial Executives International, the average filer incurred outside audit and legal fees associated with Sarbanes-Oxley compliance of $846,000. The costs of compliance with 404(b) were clearly beyond the reasonable reach of smaller public companies.  Smaller public companies comprise approximately 50% of all public companies in the United States.

Stay tuned – the real financial reform will be published over the next few months and years.

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This is the first in a series that will analyze important changes to capital markets and corporate finance laws, enacted by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Most U.S. based companies seeking to raise money from investors do so through a “private placement” authorized under Regulation D of the Securities and Exchange Commission.  Reg D provides several exemptions from SEC registration of a securities offering, the most popular of which (Rule 506) allows unlimited investment and participation by “accredited investors”.  If the offering includes non-accredited investors, the issuer must meet required disclosure obligations by providing information of the same kind that would be provided in a registration statement for a public offering.  If only accredited investors participate in the offering, there are no specific disclosure requirements mandated by Reg D (although thorough disclosure is still recommended as a risk management practice).  Therefore, many issuers chose to limit their offerings only to “accredited investors”.

With the enactment of Dodd-Frank, effective July 21, 2010, and for at least the next four years, the definition of “accredited investor” has changed.  The net worth part of the accredited investor test, which specifies that a natural person is an accredited investor if his or her net worth is at least $1 million, now excludes the value of that person’s primary residence.   Before July 21, the net worth test included the investor’s primary residence.

There was no transition period or future effective date, so that issuers conducting private placements on July 21, 2010 had to amend and re-document their private placements in process to comply with the change.   Fortunately, the other portions of the accredited investor definition, including the net income tests for natural persons, remain unchanged for now.

The Comptroller General is required to study the appropriate criteria for accredited investor status and report back to Congress within three years.  On July 20, 2014 and every four years thereafter the SEC must review the definition of accredited investor as it applies to natural persons and make adjustments in the rules if appropriate.

The Race to the Bottom has a discussion of the history of the definition of accredited investor, as well as some thoughts about the SEC’s role in developing the standards in the past and the future.

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