Governance & Compliance Insider

On Tuesday, July 25, as many practitioners probably expected, the SEC issued a warning that offers and sales of digital assets (virtual coins or tokens) by organizations using blockchain or distributed ledger technology (often referred to, among other things, as Initial Coin Offerings (“ICOs”) or Token Sales) are subject to the requirements of the federal securities laws. Depending on the offering, investors may use an established currency (e.g., U.S. dollars) or virtual currency (e.g., Bitcoin or Ether) to buy the virtual coins or tokens being offered. After they are issued, the virtual coins or tokens may be resold to others in a secondary market on virtual currency exchanges or other platforms. A blockchain or distributed ledger is an electronic ledger, or list of entries, maintained by participants in a computer network who use cryptography to process and verify transactions on the ledger, providing comfort to users and potential users that entries are secure. Examples of blockchains are Bitcoin and Ethereum, which are used to create and track transactions in the tokens known as Bitcoin and Ether, respectively. ICOs have captured significant attention recently as several enterprises, often start-up or development stage businesses, have attracted substantial investments through internet-based offerings, in some cases generating proceeds in the tens and hundreds of millions of dollars. Promoters of ICOs may tell investors that their investments will fund development of a digital platform, software, or similar projects and that the virtual tokens or coins offered may be used to access the platform, use the software, or otherwise participate in the project. Additionally, promoters and issuers may lead potential investors to expect a return on their investment or to participate in a share of the profits expected from the project. The SEC warned that, depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities under U.S. law. If so, the offer and sale of these virtual coins or tokens in an ICO are subject to U.S. federal securities laws. Furthermore, promoters and issuers participating in unregistered ICOs may be liable for securities law violations, and any exchange providing for trading in these virtual coins or tokens may need to register as a securities exchange with the SEC. The SEC's warning was made in a Report of Investigation stemming from an Enforcement Division inquiry into whether an organization known as “The DAO” violated federal securities laws with unregistered offers and sales of “DAO Tokens” in exchange for the Ether virtual currency. By the time the offering by The DAO closed, The DAO had raised Ether valued at approximately US$150 million. The DAO has been described as a “crowdfunding contract,” but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and FINRA. In its report, the SEC concluded that the tokens offered and sold by The DAO were securities offered and sold in the United States and therefore subject to the U.S. federal securities laws. Under the circumstances, however, the SEC decided not to bring charges or make findings of violations, but rather to caution industry and market participants to be cognizant that U.S. federal securities laws apply to anyone who offers and sells securities in the United States, whether the issuer is a traditional company or a decentralized autonomous organization and regardless of whether purchases are made using U.S. dollars or virtual currencies. Moreover, the report confirms that the use of distributed ledger technology does not affect the determination whether virtual coins or tokens are securities. The SEC's Office of Investor Education and Advocacy also issued an investor bulletin to provide information to investors about ICOs. The bulletin explains that new technologies may be used to perpetrate investment schemes that don’t comply with federal securities laws and highlights several red flags of investment fraud.

In Henry v. Phixios Holdings, Inc., C.A. No. 12504-VCMR,the Delaware Court of Chancery held that pursuant to Section 202 of the General Corporation Law, in order for a stockholder to be bound by stock transfer restrictions that are not “noted conspicuously on the certificate or certificates representing the security,” he must have actual knowledge of the restrictions before he acquires the stock. If the stockholder does not have actual knowledge of the stock transfer restrictions at the time he acquires the stock, he can become bound by the stock transfer restrictions after the acquisition of the stock only if he affirmatively assents to the restrictions, either by voting to approve the restrictions or by agreeing to the restrictions. The Chancery Court concluded that the plaintiff did not have actual knowledge of the restrictions, though the restrictions were contained in the company's bylaws provided to the plaintiff prior to his purchase of the company's stock, and that as a result, the company could not rescind his shares pursuant to the restrictions contained in the bylaws. Since it can be challenging to prove "actual knowledge,"  issuers are reminded to place appropriate legends on their restricted securities prior to sale.  With regard to book-entry shares, versus certificated shares, issuers should provide notice of such restrictions pursuant to Section 151(f) of the General Corporation Law.  Issuers may also obtain an agreement, a vote or other evidence that purchasing securityholders accepted the applicable restrictions on transferability prior to sale. Under the Securities Act, issuers are required to take steps to prevent distribution to the public of securities that are neither registered nor exempt from registration.  Restrictions on transfer may also be required under an issuer's charter documents or in an agreement with a stockholder. Common types of legends include: a "'33 Act" legend that indicates that securities have not been registered under the Securities Act and may not be resold unless they are either registered or exempt from registration, an "affiliate" legend for control shares held by directors, executives or large stockholders, and a "lockup" legend that indicates that a contract prohibits the stockholder from selling the shares for a period of time.  

One of the more utilized provisions of the Jumpstart Our Business Startups Act (JOBS Act) has been the confidential submission of IPO registration statements by Emerging Growth Companies (EGCs) to the Securities and Exchange Commission. The nonpublic nature of the SEC review process has allowed EGCs to submit IPO registration statements and respond to SEC comments outside the public eye and without having to alert the market of their intention to go public. As of July 10, 2017, all issuers will now have the ability to submit draft registration statements to the SEC on a confidential basis. Read more in our recent eUpdate here: www.dorsey.com/newsresources/publications/client-alerts/2017/07/all-issuers-eligible-to-submit-draft-ipo.

Companies frequently wrestle with perks in their proxy executive compensation disclosure. Whether an item constitutes a perk often requires judgment based on the facts and circumstances,¹ and disclosure may elicit intense, public scrutiny over what amounts to a relatively small percentage of an executive’s total compensation package.² From time to time, the SEC issues a cautionary tale that perks need to be accounted for and reported with care. The SEC recently announced that Miles Nadal, the former CEO of marketing company MDC Partners, has agreed to pay $5.5 million to settle charges that his perks were not properly disclosed to shareholders. While MDC Partners disclosed certain perks received by Mr. Nadal, including an annual allowance of $500,000, it failed to disclose payments for personal use of private airplanes, charitable donations in Mr. Nadal’s name, yacht and sports car expenses, cosmetic surgery, and a wide range of other perks totaling an additional $11.285 million from 2009 through 2014. The SEC order notes that MDC Partners, which agreed to a $1.5 million settlement of the matter earlier this year, understated Mr. Nadal’s perks by an average of almost 300% each year. While MDC Partners’ example is an egregious one, companies should verify that they have implemented internal controls that are capturing the full range of perks and potential perks, particularly where there is temptation to omit or mischaracterize these items, and that they have implemented disclosure controls that ensure the accurate reporting of these items. 1  In its adopting release for the “Executive Compensation and Related Person Disclosure,” Release Nos. 33-8732A, 34-54302A, File No. S7-03-06 (Aug. 29, 2006), the SEC established a two-step analysis for whether an item constitutes a perk: An item is not a perquisite if it is “integrally and directly related” to the performance of the executive’s duties, even if there is an element of personal benefit, so no disclosure would be required. If an item is not integrally and directly related to the performance of the executive’s duties, and it confers a direct or indirect benefit that has a personal aspect, then the item is a perquisite, unless it is generally available on a non-discriminatory basis to all employees. It does not matter whether the item may be provided for some business reason or for the convenience of the company. 2  Under Item 402(c)(2)(ix) of Regulation S-K, perquisites or other personal benefits paid to the named executive officers in the proxy statement must be disclosed in the summary compensation table, unless their total value is less than $10,000. Each perquisite or personal benefit must be identified by type, and each one that exceeds the greater of $25,000 or 10% of the total amount of perquisites and personal benefits must be quantified and disclosed in a footnote. Perquisites and other personal benefits are to be valued based on their aggregate incremental cost to the company.  

On March 31, 2017, the Securities and Exchange Commission (SEC) issued final rules regarding inflation adjustments and other technical amendments under Title I and III of the Jumpstart Our Business Startups (JOBS) Act. Under the inflation adjustments, the SEC adjusted the gross revenue threshold for an issuer to lose its status as an Emerging Growth Company (EGC) from $1.0 billion to $1.07 billion, a $70 million dollar increase. Further, the SEC adjusted the Regulation Crowdfunding thresholds, increasing among other thresholds the maximum amount an issuer can raise under Regulation Crowdfunding from $1 million to $1.07 million. In relation to the various exemptions and scaled disclosure permitted to EGCs under the JOBS Act, the SEC also adopted technical amendments to certain rules and to certain forms, adding check boxes to the cover pages for companies to indicate if they are an EGC and whether they have elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Securities Exchange Act of 1934 (the Exchange Act). Forms and rules amended include Forms C, S-1, S-3, S-4, S-8, S-11, F-1, F-3 and F-4 under the Securities Act of 1933; Rule 12b-2, Rule 14a-21 and Forms 10, 8-K, 10-Q, 10-K, 20-F and 40-F under the Exchange Act; Rule 2-02 and Rule 3-02 of Regulation S-X; Rule 100 and Rule 201 of Regulation Crowdfunding; and Items 301, 303, 308, 402 and 1101 of Regulation S-K to reflect these reporting accommodations. The new rules and changes in the forms will take effect upon publication in the Federal Register, which is currently scheduled to take place on April 12, 2017. Issuers should take note of these changes in the form cover pages in preparing their next periodic reports to the SEC.

We get asked from time-to-time whether it is advisable for issuers to pay fees to unregistered “finders” for introducing potential investors in the United States to the issuer in connection with securities offerings. The short answer is “no.” Most finders are engaged by issuers under finder’s, advisory, or other arrangements, which typically require payment of “success fees” upon completion of a financing transaction. While these arrangements are sometimes structured to try to hide or disguise the true intent of the arrangement, payment of transaction-based compensation is treated by U.S. securities regulators as a nearly-conclusive indication that a person is engaged in the securities business and should be registered as a broker-dealer. The relevant U.S. federal broker-dealer laws that should be of concern to an issuer using an unregistered finder include: Section 15(a)(1) of the Securities Exchange Act of 1934 (Exchange Act), which makes it unlawful for a person to “effect a transaction in securities” or “attempt to induce the purchase or sale of, any security” unless they are registered as a broker or dealer under the rules and regulations of the Financial Industry Regulatory Authority, Inc. (FINRA). FINRA is the regulatory organization designated by the Securities and Exchange Commission (SEC) to license and regulate broker-dealers. Section 29(b) of the Exchange Act, which provides that every contract made in violation of any provision of the broker-dealer registration requirements “shall be void” as to rights of persons who made or engaged in the performance of such contract. It results in the underlying purchase of securities becoming a voidable transaction that gives the investor a right of rescission, effectively granting a put right to the investor or purchaser. Section 20(e) of the Exchange Act, under which the SEC may impose aiding-and-abetting liability on any person that knowingly or recklessly provides substantial assistance in a violation of the Exchange Act. The theory behind broker-dealer registration is to provide a gatekeeper to protect investors in the marketplace. FINRA members are required to “observe high standards of commercial honor and just and equitable principles of trade” in the conduct of its business, including determining if an investment is "suitable" for its customer. Finders assisting in transactions rarely make such determinations and view themselves simply as middlemen in making introductions to potential investors. Because unregistered broker-dealers may not adhere to these high commercial standards, the SEC broadly construes the broker-dealer laws and narrowly construes the few permitted exceptions. Under SEC guidance derived from no-action letters, the SEC requires all intermediaries effecting transactions in securities to be licensed, subject to a few limited exceptions. Effecting a securities transaction may include, among other factors, receiving transaction-based compensation, recommending a company or the purchase of its securities, negotiating terms of a securities offering or purchase, attending meetings or presentations where the merits of the investment are discussed, performing or accommodating due diligence efforts, providing valuations or estimates of value, and other activities that facilitate a securities transaction. The consequences of engaging an unlicensed finder can be troublesome: Finder Risks:  Any unlicensed person engaging in activities designed to effect a transaction in securities may violate broker-dealer laws. The SEC or state securities regulators may seek to enjoin the unlawful activities or seek monetary penalties or criminal sanctions. Issuer Risks:  Retaining and permitting an unlicensed intermediary to effect a securities transaction may be a violation of federal and many state laws, and may subject the issuer to possible civil and criminal penalties. Any person that knowingly or recklessly provides substantial assistance in a violation of the Exchange Act may be subject to aiding-and-abetting liability. Rescission Risks:  A violation of broker-dealer laws creates a right of rescission under federal and/or state securities law. The SEC or state securities regulators may require the issuer to offer investors rescission rights, and the issuer may be required to return the investment. State Securities Violations:  Many states have begun reviewing state notice filings on Form D (which report transactions exempt from registration under Regulation D) and actively monitoring finder’s fees paid in connection with securities transactions. Some states have required issuers to provide additional information related to unlicensed broker-dealers and, in some cases, to certify that finder’s fees or commissions have only been paid in compliance with broker-dealer laws. Accounting Liability Risk:  Auditors may raise accounting issues resulting from paying finder’s fees to unregistered broker-dealers and may require an issuer to account for potential liability arising from rescission rights. Bad Actor Consequences:  An issuer or finder that is convicted of any felony or misdemeanor, is subject to any order, judgment, or decree of any court, or is subject to any order of certain regulators may be ineligible to participate in certain types of securities offerings, including Rule 506 of Regulation D offerings and Regulation A offerings. Using an unlicensed finder can result in broker-dealer law violations. Many times the issue arises in the context of state notice filings and direct inquiries from state securities regulators where finder’s fees or commissions are paid in connection with an offering. Other times, they arise from a failed investment where the investor may assert claims related to broker-dealer law violations to establish a right of rescission. Issuers should use caution in determining whether to engage a finder to assist in financing transactions.

On March 22, 2017, the Securities and Exchange Commission adopted an amendment to Rule 15c6-1(a) to shorten by one business day the standard settlement cycle for most broker-dealer securities transactions.  Currently, the standard settlement cycle for these transactions is three business days, known as T+3.  The amended rule shortens the settlement cycle to two business days, T+2. The amended rule will take effect on September 5, 2017. The SEC stated that the amended rule is “designed to enhance efficiency, reduce risk, and ensure a coordinated and expeditious transition by market participants to a shortened standard settlement cycle.” To assist in the preparation for the implementation of the new, shortened settlement cycle, the SEC has established an e-mail address – T2settlement@sec.gov – for the submission of inquiries to SEC staff.  Issuers will want to consider and be prepared for the impact of the shortened settlement cycle in relation to closing and settlement of public securities offerings.

On March 9, 2017, the Senate Banking Committee passed a series of four bills focused on deregulation, including one that would make it easier for privately held companies to issue stock awards through equity compensation plans. Each of the bills was a bipartisan effort. One bill eases certain restrictions on reporting on exchange traded funds (ETFs). The bill would address securities laws and regulations that discourage broker-dealers from publishing research on ETFs by directing the Securities and Exchange Commission (SEC) to provide a safe harbor for research reports that cover ETFs. The second bill proposes to ease reporting thresholds for privately held corporations when issuing stock awards. Currently, under Item 701 under the Securities Act of 1933, as amended, if the sales price or amount of securities sold in any 12-month period under a private company’s equity compensation plans exceeds $5 million, then the company must provide certain information to the holders of the equity compensation securities, which many companies consider onerous and inappropriate for a privately held corporation. The bill would increase that threshold to $10 million and have it adjusted for inflation. A third bill would raise to 250 from 100 the number of investors venture capital funds can acquire before triggering SEC registration requirements under the Investment Company Act of 1940, as amended. The final bill would credit stock exchanges for any fees they have overpaid the SEC. The bills have been reported to the Senate, placed on the Senate legislative calendar and are awaiting further action by the Senate. Companion bills in the House are moving through the House Finance Committee.

The SEC recently issued a no-action letter to Morgan Stanley that will streamline the process for its wealth management clients to participate in IPOs. The SEC said it would not object to Morgan Stanley’s proposed use of conditional offers to buy shares (“COBs”) prior to the effectiveness of IPO registration statements under specific conditions. The no-action request and the SEC’s letter confirm that COBs, if properly implemented, may be used in registered offerings, and when read together, outline detailed procedures to follow in order to use COBs. Read more in our eUpdate here: https://www.dorsey.com/newsresources/publications/client-alerts/2016/12/sec-endorses-use-of-conditional-offers

On November 18, 2016, the SEC’s Division of Corporation Finance issued a set of compliance and disclosure interpretations (“C&DIs”) pertaining to abbreviated debt tender offers, which were the subject of an SEC no-action letter in early 2015. The new C&DIs offer important clarifications regarding abbreviated debt tender offers and the previous no-action letter guidance. Read more in our full summary here: https://www.dorsey.com/newsresources/publications/client-alerts/2016/11/guidance-provided-by-sec

On November 17, 2016, the SEC issued a new interpretation stating that a company may conduct a generally solicited offering of securities under Rule 506(c) immediately following a completed securities offering made in reliance upon Rule 506(b), without invalidating the prior offering.  The SEC’s new interpretation will give companies more flexibility in their financing plans, allowing them to potentially take advantage of the best of both exemptions.  Many investors and companies prefer to participate in Rule 506(b) offerings, because these offerings do not require the investor to provide the company with detailed tax or other financial information in order to verify that the investor is an accredited investor, and do not require the company to due diligence the investor’s claim of accredited investor status.  However, companies may not always be able to raise sufficient funds from investors that are already known to the company.  Under the new interpretation, a company could complete tranche 1 of a financing with known investors, without engaging in general solicitation, in reliance upon Rule 506(b), relying on representations from the investors that they are accredited investors, and then following the closing of that tranche, begin to generally solicit investors that are not already known by the company, for tranche 2 of the financing in reliance upon Rule 506(c), requiring only the investors in tranche 2 to provide the more detailed tax or financial information required to verify their claim of accredited investor status.  The company would still need to satisfy the other requirements of Rule 506(c), and would need to consider whether any offerings subsequent to the Rule 506(c) offering could potentially be “integrated” with the Rule 506(c) offering. The full text of the SEC’s interpretation is provided below: Question 256.34 Question: An issuer has been conducting a private offering in which it has made offers and sales in reliance on Rule 506(b). Less than six months after the most recent sale in that offering, the issuer decides to generally solicit investors in reliance on Rule 506(c). Are the factors listed in the Note to Rule 502(a) the sole means by which the issuer determines whether all of the offers and sales constitute a single offering? Answer: No. Under Securities Act Rule 152, a securities transaction that at the time involves a private offering will not lose that status even if the issuer subsequently decides to make a public offering. Therefore, we believe under these circumstances that offers and sales of securities made in reliance on Rule 506(b) prior to the general solicitation would not be integrated with subsequent offers and sales of securities pursuant to Rule 506(c). So long as all of the applicable requirements of Rule 506(b) were met for offers and sales that occurred prior to the general solicitation, they would be exempt from registration and the issuer would be able to make offers and sales pursuant to Rule 506(c). Of course, the issuer would have to then satisfy all of the applicable requirements of Rule 506(c) for the subsequent offers and sales, including that it take reasonable steps to verify the accredited investor status of all subsequent purchasers. [November 17, 2016]

The Securities and Exchange Commission ("SEC") recently issued a new compliance and disclosure interpretation (the "New C&DI") in Question 116.25 regarding the availability of Form S-3 for the registration and sale of shares by companies with public float less than $75 million. Instruction I.B.6(a) to Form S-3 states that if a registrant has a public float of less than $75 million, the registrant may only register and sell securities via Form S-3 if the aggregate market value of the securities sold by or on behalf of the registrant during the 12-month period immediately prior to and including the date of the sale is no more than one-third of all common voting and nonvoting equity held by non-affiliates of the registrant. This instruction and accompanying rules and interpretive guidance are often referred to as the "Baby Shelf Rules." The new C&DI puts a stop to certain practices that were being used by registrants to work around the Baby Shelf Rules. Read more: https://www.dorsey.com/newsresources/publications/client-alerts/2016/11/sec-clarifies-baby-shelf-rules