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What is an Activist Investor?

Monday, March 6th, 2017

!!!What is an Activist Investor?

T. Boone Pickens, Jr., Kirk Kerkorian, Carl Icahn, Nelson Peltz, Bill Ackman, David Einhorn, Dan Loeb… Financial newspapers regularly report on these people. But, who are they? What do they do to earn their living? ”Are they really corporate raiders or agitators for the shareholders?”

These people have been called __activist investors__ or corporate raiders, depending on the perspective of the commentator. What kind of change do they want to bring about and for whom?

Activist investors are individuals or institutional investors (such as hedge funds and private equity funds) that purchase a significant amount stocks in a public company. They do so to instigate changes within that company. The goal of an activist investor may ultimately be to gain a seat on the board of the target company.

Typically, a company can become the target for activist investors if the company has excessive cash reserves or wasteful operating costs that could be distributed as dividends to shareholders, or the company could be run more efficiently as a private company. Activist investors do not usually manage the corporations in which they invest. Instead, they rely on the support of external institutional investors to exert friendly pressure as they exercise shareholder rights.

Activist investor tactics can be anything from collaborative to contentious. They can include negotiating with management, public campaigns, shareholder resolutions, proxy contests, and even litigation. Proxy fights and litigations can be costly and time consuming so few activist investor campaigns proceed to that level.

A good indicator of a company becoming a target for activist investors is the filing of SEC Schedule 13D (beneficial ownership report). When an activist investor or institutional investor purchases beneficial ownership of more than 5 percent of a voting class of the target company’s stocks registered under Section 12 of the Securities Exchange Act of 1934, they are required to file a Schedule 13D or 13G. Once a company becomes a target, they may also want an amicable settlement in an effort to avoid a costly battle due to the changing attitudes of institutional investors.

!!!Examples of Activist Investors

!Carl Icahn

Carl Icahn started as a stockbroker in 1961 on Wall Street. In 1978, he began to act as an activist investor by taking controlling positions in individual firms. Companies such as Trans World Airlines, U.S. Steel, Yahoo Inc., Netflix Inc., Xerox, and the Clorox Company became the targets. One of Icahn’s more notable investments was in Apple Inc. and Xerox Corporation.

!Bill Ackman

Bill Ackman is the founder and chief executive officer (CEO) of the Pershing Square Capital Management, a hedge fund management company. Pershing has taken positions in Target Corporation, Wendy’s Company, Valeant Pharmaceuticals, and Chipotle Mexican Grill. Ackman’s notable investments and positions include Valeant Pharmaceuticals International Inc. and a short position in Herbalife Ltd.

!Dan Loeb

Dan Loeb is the founder of the $10.8 billion hedge fund Third Point Partners, a hedge fund based in New York. Third Point has sizable positions in Baxter International Inc. and Ligand Pharmaceuticals Inc. He also gained a seat on the Yahoo board of directors in 2012. Loeb’s strategy is to purchase companies that are in trouble, replace the management, and attempt to restore profitability.

!Activist Investment Funds

Examples of activist investment funds include the California Public Employees’ Retirement System (CalPERS) and the State Board of Administration of Florida.

!!!Lesson Summary

Whenever the management of public companies lacks appropriate incentives to maximize shareholder value, __activist investors__ jump in to make the company more valuable. Without activist investors, the complacent managers incur agency costs, maintaining their position regardless of performance while receiving excessive executive compensation and fringe benefits.

Term Structure of Interest Rates

Friday, March 3rd, 2017

!!!Interest Rates

What is a common thread going through the whole macroeconomic system, linking all the separate players such as the government, businesses, and consumers? It is the interest rate. It acts as a signal in moving funds among these players. This is true in the international arena, too, through foreign exchange rates. In a perfect market, the interest rates over different maturity should be the same given the same risk since these interest rates are affected by the risk only. In reality, however, this is not true.

In economics, the relationship between different terms or maturities (for instance, 1 month, 1 year, or 10 years), and the interest rates for risk-free debt is called the __Term Structure of Interest Rates__. In real life, the term structure of interest rate is rarely horizontal over the time. As you can see, the benchmark interest rates either rise or decline as the maturity of debt increases. In other words, the flat yield curve (b) is a theoretical behavior of the interest rate in the perfect capital market and this rarely happens.

[{Image src=’fd17598d-4952-48ca-9b6e-fd5a7d815b54_rising-yield-curve1.jpg’ alt=’Term Structure’}]

Now, we need to come up with some explanations to account for the difference between the theoretical flat term structure and real (either increasing or decreasing) term structures.


In general terms, the following observations of interest rates over time are made in reality.

1. Interest rates for different terms move together.

2. Interest rates on short-term debts fluctuate more than those on long-term debts.

3. The term structure of interest rates usually slopes upward in most cases.

To account for these facts, we will introduce three existing theories of the Term Structure of Interest Rates: Expectations Theory, Segmented Market Theory, and Liquidity Premium Theory.

!!Expectations Theory

The underlying premise of this theory is that investors are indifferent to the maturity of bonds. So, they can switch bonds if their interest rates are not competitive with other maturities. In economics, these bonds are called perfect substitutes. According to this theory, therefore, all the long-term rates are simply the averages of expected future short-term rates.

!!Segmented Markets Theory

The underlying assumption of this theory is that markets for different maturity bonds have their own set of supply and demand, thus completely insulated from each other. The interest rate for each bond with a different maturity is determined by their own supply and demand set of the segmented market.

!!Liquidity Premium Theory

Throughout our discussion of the term structure of interest rate theories, we have assumed that average investors are risk averse and demand a premium for longer maturity bonds because of inflation and interest rate risk. The longer the term of the bond, the greater the bond market price changes due to a given change in interest rates. The buyer of long-term bonds, therefore, require higher premiums for the higher risks (inflation & interest rate risks) of long-term bonds.

!!!Lesson Summary

Interest rates are the only common thread linking all the different players in the macro economy. The relationship between different terms and the interest rates for risk-free debt is called the __Term Structure of Interest Rates__. The behavior of this fundamental benchmark of interest rates is very carefully followed by all the economic agents to use the rate as their basis for decision making and to predict what is in store in the future in terms of economic activity. The term structure and the direction of interest rates are also often used to judge the overall credit market condition.


Friday, March 3rd, 2017


Sub-prime mortgage and the collateralized mortgage obligations (CMOs) that packaged them were singled out for precipitating the financial crisis of 2008.

What is a collateralized mortgage obligation (CMO) that bundles these sub-prime mortgages? It is the product of financial engineering that transforms a group of illiquid financial assets into a security. For instance, there are special bonds backed by financial receivables such as credit card receivables, auto loans, leases and home-equity loans.

These are called asset backed securities (ABS). This special debt market is relatively new but expanding fast. When a pool of residential mortgages are used in the place of these other financial receivables, this particular asset backed security (ABS) is called a mortgage backed security (MBS). Finally, a type of mortgage backed security (MBS) is called a collateralized mortgage obligation when the mortgage backed security (MBS) is divided into portions of the debt based on maturity and/or risks of the pool.

!!!Mechanics of a Collateralized Mortgage Obligation (CMO)

Firstly, an investment bank buys mortgages from retail mortgage banks and brokers, that originated residential mortgage loans to the property owners.Then, different slices of IOUs are sold by the investment bank to satisfy different tastes of risk/return combination of investors. Investors (banks, hedge funds, pension funds, insurance companies, mutual funds, and governmental agencies including central banks) in a collateralized mortgage obligation (CMO) buy these IOUs to receive payments from the income generated by the pool of underlying home mortgages.

!!!Types of CMOs

In accordance to pre-defined and complicated rules, a collateralized mortgage obligation (CMO) pools and re-directs the payments of principal and interest from large pools of home mortgages to different types and maturities of CMOs. These different types of collateralized mortgage obligations (CMOs) are known as ”tranches”. This French word ”tranche” means __a portion of money__. Each type of a collateralized mortgage obligation (CMO) may have different principal balances, coupon rates, maturity dates, and other details of the rights and risks of ownership of any bonds.

The most simple form of CMO is composed of classes that are retired in a strict sequence. In other words, all the outstanding classes of collateralized mortgage obligation (CMO) receive regular interest payments, but principal payments are made to the first class exclusively until it gets paid fully. This is called __Sequential Pay__.

There also are more complicated types such as Planned Amortization Class, Targeted Amortization Class, Companion Tranches, Principal-Only, Interest-Only, Floating-Rate, etc. that are all beyond the scope of this lesson.

!!!__History of CMOs__

A collateralized mortgage obligation (CMO) was first created in 1983 by two investment banks (Salomon Brothers and First Boston) for the U.S. Federal Home Loan Mortgage Corporation whose main function is to provide liquidity for the U.S. home mortgage loans. The value of CMOs peaked in 2007 just before the global financial crisis.

The CMOs were singled out in the mass media for starting the global financial crisis in 2008. Even though the underlying mortgages went bad rapidly, investors for whatever reasons got fixated on the income streams generated by the CMOs instead. Rating agencies and other esoteric financial models failed to pick up increasing foreclosure and payment default rates in the middle of rising housing prices.

!!!__Risks of CMOs__

When Freddie Mac guaranteed the payment of principal and interest on the underlying pool of mortgages in 1983, the collateralized mortgage obligation (CMO) posed essentially no credit risk. This was true since government agencies such as Fannie Mae, Freddie Mac, or Ginnie Mae, at least implicitly, have the full backing of the US Government. Investors took prepayment, interest, market and liquidity risks, however, for which they were compensated with higher yields.

__Private label collateralized mortgage obligations (CMOs)__ were soon issued by investment banks with underlying mortgages that were not guaranteed by Fannie, Freddie or Ginnie. These unconventional collateralized mortgage obligations (CMOs) re-introduced credit risk to the collateralized mortgage obligations (CMOs) market. Credit insurance was mainly used to deal with the credit risk of private label non-conforming collateralized mortgage obligations (CMOs).

With the banks starting to pass more of the credit risk on to investors, collateralized mortgage obligations (CMOs) became absurdly complicated game among three parties of investment banks, mortgage brokers, and credit rating agencies. Soon, therefore, each tranche had to receive its own credit rating from a rating agency.

!!!__Lesson Summary__

Collateralized mortgage obligations (CMOs) provided enormous amount of liquidity into the secondary residential mortgage loan market; thereby enabling various mortgage originators to make more home loans to more property owners. Mortgage banks originated mortgages that the investment banks re-packaged into collateralized mortgage obligations (CMOs) that the investors devoured with the blessings of the rating agencies. The added liquidity quickened the pace of mortgage origination in turn.

However, there were limited numbers of houses and qualified borrowers to finance; credit standards had to fall to keep up with the profitable business. Many mortgage lenders eventually got involved in falsifying loan applications. Credit rating agencies did not adequately reflected the underlying fraud going on in the front line. With investment banks shopping the bond ratings, the real estate market inevitably ended up in a huge ”bubble”. The market started to lose momentum in 2007; in the following year, it collapsed in the worst financial crisis since the Great Depression of the 1930s.

What is a Federal Tax Lien?

Wednesday, March 1st, 2017

!!! What is a Federal Tax Lien?


You can either fail to pay your tax in full on time or you can assessed after tax audit. In either case, you are supposed to pay in full within 10 business days. If you cannot make arrangements to settle your delinquent taxes after the ”notice and demand” letter, the Internal Revenue Service (IRS) of the United States Treasury has a right to rectify the situation by filing a federal tax lien which is the ”legal claim” against non-compliant taxpayer’s properties.


!!! How to Get Rid of a Federal Tax Lien


The best policy is to pay the delinquent federal debt in full as promptly as possible.  The Internal Revenue Service (IRS) will remove the lien within 30 days of full payment. When you cannot pay in full, however, you can apply for the payment plan and/or submit ”offer in compromise”.


!! Payment Plan (Installment Agreements)


You can set up a monthly payment plan with the IRS by filing Form 9465. If you satisfy all the prerequisites of payment plan of the IRS, you may even be able to use an online payment arrangement, depending upon the delinquent tax amount. However, the Internal Revenue Service (IRS) will not consider your installment payment application until you file all the required tax returns. Once you get on the payment plan, you should avoid default by paying at least minimum amount you agreed upon. If the payment plan defaults, you might have to pay reinstatement fee to get back on the plan or have to start the process from the scratch.


!! Offer in Compromise


Like the payment plan with the IRS, you must be current with all filing requirements before you apply for an offer in compromise. An __offer in compromise__ allows you to settle your tax debt for less than the full amount you owe. It may be a legitimate option if you can’t pay your full tax liability along with the installment plan above. The Internal Revenue Service will consider your unique personal factors and circumstances such as the assets, ability to pay, current and prospective income, current age, living expenses, family problems, etc.  __Offer in Compromise Pre-Qualifier__ in the IRS web site can give you  preliminary proposal amount. If the accepted amount is paid, the taxpayer should initiate to request the release of the lien. The IRS oftentimes do not follow through with the removal of the lien voluntarily.


!! Effect of a Federal Tax Lien


A federal tax lien affects your properties, businesses, credit, and sometimes your employment. The federal tax lien attaches to all of your assets. Your ”Notice of Federal Tax Lien” usually continue after the bankruptcy if the IRS recorded the tax lien before your filing fro bankruptcy. In the case of business, the lien attaches to all business property.


!!! The Statute of Limitations and Federal Tax Liens


The IRS has ten years from the date of a tax assessment to collect a debt from the taxpayer for taxes assessed on or after November 6th of 1990. When this date passes, the IRS is barred from attempting to collect your tax debt unless you waive the enforcement of the statute. Released taxpayer must obtain a Certificate of Release of Federal Tax Lien to expunge the record of the lien from the local and/or state office of records.


There are, however, many exceptions that extend the collection time period. Signing of a waiver, bankruptcy proceedings, offer in compromise, and the filing of a Collection Due Process, Innocent Spouse Relief and any other forms of relief extends the statute of limitations.


!!! Summary


The Internal Revenue Service has a right to file the __Notice of Federal Tax Lien__ with a proper authority to claim their interests with your current and/or future properties once you become delinquent with them. You need to pay them in full as soon as possible to remove the lien. The IRS is supposed to remove the lien within thirty days of the full payment. If you cannot pay in one lump sum, you can opt for either an installment plan or offer in compromise.


The statute of limitations on the collection of the federal tax lien is usually ten years from the date of assessment. Due to many exceptions to this statute of limitations, it behooves you to consult with qualified accountant and/or attorney before you sign any documents with the IRS.

Financial Audit Success

Monday, February 6th, 2017

There are a variety of reasons why private companies need to subject themselves to the often-bemoaned financial audit. Whether it’s to provide reporting for investors, lenders, or creditors or to make better decisions on regulatory actions or succession planning, conducting a financial audit is an effective way to get a better understanding of your firm.

However, the process can be helped or hindered by a company’s preparation leading up to the actual audit, and the outcome depends on a combination of adequate preparation and knowing what you need to know going into it.

When it comes to financial audits, making it a seamless process — or a tiring uphill slog — is largely up to you.


What Can Go Wrong?

There are some common mistakes when it comes to financial audits. The first, and perhaps most damaging one, is engaging the “wrong” auditor, or one who doesn’t have a nuanced understanding of the business.


With that comes the risk of auditors asking for unnecessary or incorrect information, increasing the number of adjustments and control deficiencies, which results in a qualified audit report — not exactly a gold star for potential investors or lenders.

A second risk is tied to inadequate audit preparation on the part of the firm. Without the proper preparation, even the right auditor will struggle to get the information it needs, leading to delays, increased costs, and a higher risk of business disruption.


10 Steps to Success

Whether you are preparing for your first or fiftieth, there are 10 steps that can help you ensure a successful, headache-free financial review.


Engage “the right” audit firm. The first and most important step is to find and engage the right audit firm. There is no one-size-fits-all. The right audit firm not only understands the business and industry, but also has years of experience auditing similar companies. Have you met the team? What is their approach to the audit? What is the company’s objective in obtaining the audit? The audit process is a collaborative effort. Choosing a firm that aligns closely with the business is key. And, of course, cost factors into this — make sure the price is right in light of the questions above.

Ensure an upfront understanding of the business. If the audit team achieves a deep understanding of the subtleties of the business at the onset of the audit process, it will be able design a better risk assessment and audit framework. This can ultimately reduce audit hours and fees.

Understand the audit plan. Ensure auditors are focusing on the high-risk areas and businesses with more complex structures, including various revenue streams, locations, and segments. Meet with the auditors during the planning phase to discuss their understanding of high-risk areas. Auditors typically develop a prepared-by-client (PBC) list to request information. Scrutinize the PBC list to identify items that are not applicable, and don’t be afraid to challenge the auditor’s assessment.

Designate a point person. This is typically the controller or other finance executive who has a deep understanding of both finance and business operations. They can and should leverage members of their team as necessary to gather information and execute specific PBC list items, but the majority of communication and information should flow through this individual. Doing so ultimately streamlines workflow and eliminates version control challenges.

Have information readily available. Delayed transfer of information leads to a longer audit process and can increase cost. Call up necessary documents from the archive center. Obtain documents from third parties (like banks or vendors). Provide as much information as you can to the audit team prior to kickoff.

Non-standard or unusual transactions. If the company enters into any non-standard transactions (e.g. purchase or sale of business, change in segment reporting, significant impairment), it’s crucial to involve auditors at the time of the transaction. To avoid year-end surprises, it is best practice to have these transactions audited when they occur.

Audit before audit. Review information before submitting to auditors, and ask yourself if it looks correct. Perform your own risk assessment, and test samples of high-risk accounts on your own. Set up a robust finance process that identifies errors and issues in real time. Errors discovered during the audit will result in additional testing, delaying the overall audit process and increasing the cost. Additionally, finding significant errors can result in additional reporting requirements to the board. If the business is planning an exit event or has potential investors analyzing it, they will want to know that the right systems, processes, and internal controls are in place and that the audit report is clean and unqualified.

Be proactive and treat auditors as trusted partners. Treat your auditors as your trusted business partners. You are helping yourself when you are proactive and forthcoming. This includes raising and discussing potential issues as early as possible. Make yourself and your team available to answer questions throughout the audit.

Keep track of audit. Establish a weekly update call to discuss the status of the audit, open items, and potential issues. Frequent status meetings with the auditors will steer the audit process in the right direction. These meetings will help management and the auditors understand if additional resources or time is needed to complete the audit.

Reoccurrence of audit. Lastly, reoccurring annual audits help determine if controls are effective and the information produced for decision-making is relevant and reliable. An important benefit of a reoccurring audit is that instances of error and fraud are significantly reduced, operational efficiency is increased, and bottom-line results are improved through a combination of cost savings and a reduction in overpayments. As an added bonus, the more you conduct audits, the more seamless it gets year after year.

At the end of the day, an audit is necessary, even if painful. With preparation and a dose of patience, however, it can turn into a streamlined, if not enjoyable, process.

New C&DI Guidance On Regulation A+

Tuesday, January 24th, 2017

On November 17, 2016, the SEC Division of Corporation Finance issued three new Compliance and Disclosure Interpretations (C&DI) to provide guidance related to Regulation A/A+. Since the new Regulation A+ came into effect on June 19, 2015, its use has continued to steadily increase.  In my practice alone I am noticing a large uptick in broker-dealer-placed Regulation A+ offerings, and recently, institutional investor interest.

Following a discussion on the CD&I guidance, I have included some interesting statistics, practice tips, and thoughts on Regulation A+, and a refresher summary of the Regulation A+ rules.

New CD&I Guidance

In the first of the new CD&I, the SEC has clarified that where a company seeks to qualify an additional class of securities via post-qualification amendment to a previously qualified Form 1-A, Item 4 of Part I, which requires “Summary Information Regarding the Offering and Other Current or Proposed Offerings,” need only include information related to the new class of securities seeking qualification.

In a reminder that Regulation A+ is technically an exemption from the registration requirements under Section 5 of the Securities Act, the SEC confirms that under Item 6 of Part I, requiring disclosure of unregistered securities issued or sold within the prior year, a company must disclose all securities issued or sold pursuant to Regulation A in the prior year.

New question 182.13 clarifies the calculation of a 20% change in the price of the offering to determine the necessity of filing a post-qualification amendment which would be subject to SEC comment and review, versus a post-qualification supplement which would be effective immediately upon filing. In particular, Rule 253(b) provides that a change in price of no more than 20% of the qualified offering price, may be made by supplement and not require an amendment. An amendment is subject to a whole new review and comment period and must be declared qualified by the SEC. A supplement, on the other hand, is simply added to the already qualified Form 1-A, becoming qualified itself upon filing. The 20% variance can be either an increase or decrease in the offering price, but if an increase, cannot result in an offering above the respective thresholds for Tier 1 ($20 million) or Tier 2 ($50 million).

In the third CD&I, the SEC confirms that companies using Form 1-A benefit from Section 71003 of the FAST Act.  In particular, the SEC interprets Section 71003 of the FAST Act to allow an emerging growth company (EGC) to omit financial information for historical periods if it reasonably believes that those financial statements will not be required at the time of the qualification of the Form 1-A, provided that the company file a pre-qualification amendment such that the Form 1-A qualified by the SEC contains all required up-to-date financial information. Interestingly, Section 71003 only refers to Forms S-1 and F-1 but the SEC has determined to allow an EGC the same benefit when filing a Form 1-A. Since financial statements for a new period would result in a material amendment to the Form 1-A, potential investors would need to be provided with a copy of such updated amendment prior to accepting funds and completing the sale of securities.

Regulation A+ Statistics; Practice Tip; Further Thoughts

Regulation A+ Statistics

According to The Vintage Group, through November 30, 2016, there were a total of 165 Regulation A+ filings, 16 of which were subsequently withdrawn.  Of these, 130 have been qualified by the SEC, with the average time to receive qualification being 101 days.  Some companies have filed multiple Regulation A+ offerings. The 130 qualified offerings represent 94 different companies.  Thirty eight (38) of the 94 companies completed Tier 1 offerings and 56 completed Tier 2. The average offering size of Tier 1 offerings is $9.5 million and $28.9 million for Tier 2 offerings. As reported by The Vintage Group, the average cost of a Tier 1 offering has been $120,000 and of a Tier 2 offering has been $920,000.  I am assuming this includes marketing costs.

Regulation A/A+ – Private or Public Offering?

Although a complete discussion is beyond this blog, the legal nuance that Regulation A/A+ is an “exempt” offering under Section 5 has caused confusion and the need for careful thought by practitioners and the SEC staff alike. So far, it appears that Regulation A/A+ is treated as a public offering in all respects except as related to the applicability of Securities Act Section 11 liability.  Section 11 of the Securities Act provides a private cause of action in favor of purchasers of securities, against those involved in filing a false or misleading public offering registration statement. Any purchaser of securities, regardless of whether they bought directly from the company or secondarily in the aftermarket, can sue a company, its underwriters, and experts for damages where a false or misleading registration statement had been filed related to those securities.  Regulation A is not considered a public offering for purposes of Section 11 liability.

Securities Act Section 12, which provides a private cause of action by a purchaser of securities directly against the seller of those securities, specifically imposes liability on any person offering or selling securities under Regulation A. The general antifraud provisions under Section 17 of the Securities Act, which apply to private and public offerings, of course apply to Regulation A/A+.

When considering integration, in addition to the discussion in the summary below, the SEC has now confirmed that a Regulation A/A+ offering can rely on Rule 152 such that a completed exempt offering, such as under Rule 506(b), will not integrate with a subsequent Regulation A filing. Under Rule 152, a securities transaction that at the time involves a private offering will not lose that status even if the issuer subsequently makes a public offering. The SEC has also issued guidance that Rule 152 applies to prevent integration between a completed 506(b) offering and a subsequent 506(c) offering, indicating that the important factor in the Rule 152 analysis is the ability to publicly solicit regardless of the filing of a registration statement.

However, Regulation A/A+ is definitely used as a going public transaction and, as such, is very much a public offering. Securities sold in a Regulation A+ offering are not restricted and therefore are available to be used to create a secondary market and trade such as on the OTC Markets or a national exchange.

Tier 2 issuers that have used the S-1 format for their Form 1-A filing will be permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements. A Form 8-A is a simple registration form used instead of a Form 10 for issuers that have already filed the substantive Form 10 information with the SEC.  Upon filing a Form 8-A, the issuer will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A+ reporting will automatically be suspended. With the filing of a Form 8-A, the issuer can apply to trade on a national exchange.

This marks a huge change and opportunity for companies that wish to go public directly and raise less than $50 million. An initial or direct public offering on Form S-1 does not preempt state law. By choosing a Tier 2 Regulation A+ offering followed by a Form 8-A, the issuer can achieve the same result – i.e., become a fully reporting trading public company, without the added time and expense of complying with state blue sky laws.

Also, effective July 10, 2016, the OTCQB amended their rules to allow a Tier 2 reporting entity to qualify to apply for and trade on the OTCQB; however, unless the issuer has filed a Form 8-A or Form 10, they will not be considered “subject to the Exchange Act reporting requirements” for purposes of benefiting from the shorter 6-month Rule 144 holding period.

Practice Tip

In light of the fact that Regulation A/A+ is technically an exemption from the Section 5 registration requirements, it might not be included in contractual provisions related to registration rights. In particular, the typical language in a piggyback or demand registration right provision creates the possibility that the company could do an offering under Regulation A/A+ and take the position that the shareholder is not entitled to participate under the registration rights provision because it did not do a “registration.” As an advocate of avoiding ambiguity, practitioners should carefully review these contractual provisions and add language to include a Form 1-A under Regulation A/A+ if the intent is to be sure that the shareholder is covered.  Likewise, if the intent is to exclude Regulation A/A+ offerings from the registration rights, that exclusion should be added to the language to avoid any dispute.

Further Thoughts

Tier 2 offerings in particular present a much-needed opportunity for smaller companies to go public without the added time and expense of state blue sky compliance but with added investor qualifications. Tier 2 offerings preempt state blue sky laws. To compromise with opponents to the state blue sky preemption, the SEC included investor qualifications for Tier 2 offerings. In particular, Tier 2 offerings have a limitation on the amount of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth.

However, as companies continue to learn about Regulation A+, many still do not understand that it is just a legal process with added benefits, such as active advertising and solicitation including through social media. There is no pool of funds to tap into; it is not a line of credit; it is just another process that companies can use to reach out to the investing public and try to convince them to buy stock in, or lend money to, their company.

As such, companies seeking to complete a Regulation A/A+ offering must consider the economics and real-world aspects of the offering.  Key to a successful offering are a reasonable valuation and rational use of proceeds. A company should demonstrate value through its financial statements and disclosures and establish that the intended use of proceeds will result in moving the business plan ahead and hopefully create increased value for the shareholders. Investors want to know that their money is being put to the highest and best use to result in return on investment. Repayment of debt or cashing out of series A investors is generally not a saleable use of proceeds. Looking for $50 million for 30% of a pre-revenue start-up just isn’t going to do it!  The company has to be prepared to show you, the investor, that it has a plan, management, vision and ability to carry out the business proposition it is selling.

From the investors’ perspective, these are risky investments by nature. Offering materials should be scrutinized. The SEC does not pass on the merits of an offering – only its disclosures. The fact that the registration statement has been qualified by the SEC has no bearing on the risk associated with or quality of the investment. That is for each investor to decide, either alone or with advisors, and requires really reviewing the offering materials and considering the viability of the business proposal. At the end of the day, the success of the business, and therefore the potential return on investment, requires the company to perform – to sell their widgets, keep ahead of the competition, and manage their business and growth successfully.

Refresher:  The Final Rules – Summary of Regulation A+

History of Regulation A+; Goals and Purpose

The original Regulation A was adopted in the 1960s as a sort of short-form registration process with the SEC. However, since Regulation A still required a lengthy and expensive state review and qualification process, known as “blue sky registration,” over the years it was used less and less until it was barely used at all. Literally years would go by with only a small handful, if any, Regulation A filings; however, the law remained on the books and the authors and advocates behind the JOBS Act saw potential to use Regulation A to democratize the IPO process by implementing some changes.

Without going down a rabbit hole on “blue sky laws” from a high level, in addition to the federal government, every state has its own set of securities laws and securities regulators. Unless the federal law specifically “pre-empts” or overrules state law, every offer and sale of securities must comply with both the federal and the state law. There are 54 U.S. jurisdictions, including all 50 states and 4 territories, each with separate and different securities laws. Even in states that have identical statutes, the state’s interpretations or focus under the statutes differs greatly. On top of that, each state has a filing fee and a review process that takes time to deal with.  It’s difficult, time-consuming and expensive.

Title IV of the JOBS Act that was signed into law on April 5, 2012, set out the framework for the new Regulation A and required the SEC to adopt specific rules to implement the new provisions, which it did. The new rules quickly became known as Regulation A+ and came into effect on June 19, 2015.  Regulation A+ has a path to pre-empt state law, and allows for unlimited marketing – as long as certain disclaimers are used, and of course, subject to antifraud laws – you have to be truthful.

As with all of the provisions in the JOBS Act, Regulation A+ was created to provide a less expensive and easier method for smaller companies to access capital. One of the biggest impediments to reaching potential investors has always been strict prohibitions against marketing offerings – whether the offerings were registered with the SEC or under a private placement. Historically, companies wishing to sell securities could only contact people they know and have a business relationship with – which was a small group for anyone. Even the marketing of non-Regulation A registered offerings and IPO’s have been strictly limited. The use of a broker-dealer would be helpful because a company could then access that broker’s client base and contacts, but broker-dealers are not always interested in helping smaller companies raise money.

The JOBS Act made the most dramatic changes to the landscape for the marketing and selling of both private and public offerings since the enactment of the Securities Act of 1933, one of which is the overhaul of Regulation A.

In essence, Regulation A+ has given companies a mechanism and tools to empower them to reach out to the masses in completing an IPO and has concurrently put protections in place to prevent an abuse of the process.

Specifics of Regulation A+ – How Does it Work?

The new Regulation A+ actually divided Regulation A into two offering paths, referred to as Tier 1 and Tier 2. Tier 1 remains substantially the same as the old pre-JOBS Act Regulation A but with a higher offering limit and allowing more marketing. The old Regulation A was limited to offerings of $5 million or less in any 12-month period. The new Tier 1 has been increased to up to $20 million. Since Tier 1 does not pre-empt state law, it is really only useful for offerings that are limited to one but no more than a small handful of states.  Tier 1 does not require the company to include audited financial statements and does not have any ongoing SEC reporting requirements.  Tier 1 will likely not be used for a going public transaction.

On June 23, 2015, the SEC updated its Division of Corporation Finance C&DI to provide guidance related to Regulation A/A+ by publishing 11 new questions and answers and deleting 2 from its forms C&DI which are no longer applicable under the new rules.  This summary includes that guidance.

Both Tier I and Tier 2 offerings have minimum basic requirements, including issuer eligibility provisions and disclosure requirements.  In addition to the affiliate resale restrictions, resales of securities by selling security holders are limited to no more than 30% of a total particular offering for all Regulation A+ offerings. For offerings up to $20 million, an issuer can elect to proceed under either Tier 1 or Tier 2. Both tiers will allow companies to submit draft offering statements for non-public SEC staff review before a public filing, permit continued use of solicitation materials after the filing of the offering statement and use the EDGAR system for filings.

Tier 2 allows a company to file a registration statement with the SEC to raise up $50 million in a 12-month period. Tier 2 pre-empts state blue sky law. The registration statement is a little less lengthy than a traditional IPO registration, the SEC review process is a little shorter, and a company can market in a way that it cannot with a traditional IPO. The trade-off is that Regulation A+ is limited in dollar amount to $50 million, there are specific company eligibility requirements, and there are investor qualifications and associated per-investor investment limits.

Also, the process is not inexpensive. Attorneys’ fees, accounting and audit fees and, of course, marketing expenses all add up. A company needs to be organized and ready before engaging in any offering process, and especially so for a registered offering process. Even though a lot of attorneys, myself included, will provide a flat fee for the process, that flat fee is dependent on certain assumptions, including the level of organization of the company.

Eligibility Requirements

Regulation A+ will be available to companies organized and operating in the United States and Canada. The following issuers will not be eligible for a Regulation A+ offering:

  • Companies currently subject to the reporting requirements of the Exchange Act;
  • Investment companies registered or required to be registered under the Investment Company Act of 1940, including BDC’s;
  • Blank check companies, which are companies that have no specific business plan or purpose or whose business plan and purpose is to engage in a merger or acquisition with an unidentified target; however, shell companies are not prohibited, unless such shell company is also a blank check company. A shell company is a company that has no or nominal operations; and either no or nominal assets, assets consisting of cash and cash equivalents; or assets consisting of any amount of cash and cash equivalents and nominal other assets.  Accordingly, a start-up business or minimally operating business may utilize Regulation A+;
  • Issuers seeking to offer and sell asset-backed securities or fractional undivided interests in oil, gas or other mineral rights;
  • Issuers that have been subject to any order of the SEC under Exchange Act Section 12(j) denying, suspending or revoking registration, entered within the past five years;
  • Issuers that became subject to Exchange Act reporting requirements, such as through a Tier 2 offering, and did not file required ongoing reports during the preceding two years; and
  • Issuers that are disqualified under the “bad actor” rules and, in particular, Rule 262 of Regulation A+.

A company will be considered to have its “principal place of business” in the U.S. or Canada for purposes of determination of Regulation A/A+ eligibility if its officers, partners, or managers primarily direct, control and coordinate the company’s activities from the U.S. or Canada, even if the actual operations are located outside those countries.

A company that was once subject to the Exchange Act reporting obligations but suspended such reporting obligations by filing a Form 15 is eligible to utilize Regulation A/A+. A company that voluntarily files reports under the Exchange Act is not “subject to the Exchange Act reporting requirements” and therefore is eligible to rely on Regulation A/A+. A wholly owned subsidiary of an Exchange Act reporting company parent is eligible to complete a Regulation A/A+ offering as long as the parent reporting company is not a guarantor or co-issuer of the securities being issued.

Unfortunately, in what is clearly a legislative miss, companies that are already publicly reporting – that is, are already required to file reports with the SEC – are not eligible. OTC Markets has petitioned the SEC to eliminate this eligibility criteria, and pretty well everyone in the industry supports a change here, but for now it remains. For more information on the OTC Markets petition and discussion of the reasons that a change is needed in this regard, see my blog HERE.

Regulation A/A+ can be used for business combination transactions, but is not available for shelf SPAC’s (special purpose acquisition companies).

Eligible Securities

The final rule limits securities that may be issued under Regulation A+ to equity securities, including common and preferred stock and options, warrants and other rights convertible into equity securities, debt securities and debt securities convertible or exchangeable into equity securities, including guarantees. If convertible securities or warrants are offered that may be exchanged or exercised within one year of the offering statement qualification (or at the option of the issuer), the underlying securities must also be qualified and the value of such securities must be included in the aggregate offering value.  Accordingly, the underlying securities will be included in determining the offering limits of $20 million and $50 million, respectively.

Asset-backed securities are not allowed to be offered in a Regulation A+ offering. REIT’s and other real estate-based entities may use Regulation A+ and provide information similar to that required by a Form S-11 registration statement.

General Solicitation and Advertising; Solicitation of Interest (“Testing the Waters”)

Other than the investment limits, anyone can invest in a Regulation A+ offering, but of course, they have to know about it first – which brings us to marketing. All Regulation A+ offerings will be allowed to engage in general solicitation and advertising, at least according to the SEC. However, Tier 1 offerings will be required to review and comply with applicable state law related to such solicitation and advertising, including any prohibitions related to same.

Regulation A+ allows for pre-qualification solicitations of interest in an offering, commonly referred to as “testing the waters.”  Issuers can use “test the waters” solicitation materials both before and after the initial filing of the offering statement and by any means. A company can use social media, internet websites, television and radio, print advertisements, and anything they can think of. Marketing can be oral or in writing, with the only limitations being certain disclaimers and truth. Although a company can and should be creative in its presentation of information, there are laws in place with serious ramifications requiring truth in the marketing process. Investors should watch for red flags such as clearly unprovable statements of grandeur, obvious hype or any statement that sounds too good to be true – as they are probably are just that.

When using “test the waters” or pre-qualification marketing, a company must specifically state whether a registration statement has been filed and if one has been filed, provide a link to the filing. Also, the company must specifically state that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC. Any investor indications of interest during this time are 100% non-binding – on both parties. That is, the potential investor has no obligation to make an investment when or if the offering is qualified with the SEC and the company has no obligation to file a registration statement or if one is already filed, to pursue its qualification. In fact, a company may decide that based on a poor response to its marketing efforts, it will abandon the offering until some future date or forever.

As such, solicitation material used before qualification of the offering circular must contain a legend stating that no money or consideration is being solicited and none will be accepted, no offer to buy securities can be accepted and any offer can be withdrawn before qualification, and a person’s indication of interest does not create a commitment to purchase securities.

For a complete discussion of Regulation A/A+ “test the waters” rules and requirements, see my blog HERE.

All solicitation material must be submitted to the SEC as an Exhibit under Part III of Form 1-A.  This is a significant difference from S-1 filers, who are not required to file “test the waters” communications with the SEC.

A company can use Twitter and other social media that limit the number of characters in a communication, to test the waters as long as the company provides a hyperlink to the required disclaimers. In particular, a company can use a hyperlink to satisfy the disclosure and disclaimer requirements in Rule 255 as long as (i) the electronic communication is distributed through a platform that has technological limitations on the number of characters or amount of text that may be included in the communication; (ii) including the entire disclaimer and other required disclosures would exceed the character limit on that particular platform; and (iii) the communication has an active hyperlink to the required disclaimers and disclosures and, where possible, prominently conveys, through introductory language or otherwise, that important or required information is provided through the hyperlink.

Unlike the “testing of the waters” by emerging growth companies that are limited to QIB’s and accredited investors, a Regulation A+ company could reach out to retail and non-accredited investors. After the public filing but before SEC qualification, a company may use its preliminary offering circular to make written offers.

Of course, all “test the waters” materials are subject to the antifraud provisions of federal securities laws.

Like registered offerings, ongoing regularly released factual business communications, not including information related to the offering of securities, will be allowed and will not be considered solicitation materials.

Continuous or Delayed Offerings

Continuous or delayed offerings (a form of a shelf offering) will be allowed if (i) they commence within two days of the offering statement qualification date, (ii) are made on a continuous basis, (iii) will continue for a period of in excess of thirty days following the offering statement qualification date, and (iv) at the time of qualification are reasonably expected to be completed within two years of the qualification date.

Issuers that are current in their Tier 2 reporting requirements may make continuous or delayed offerings for up to three years following qualification of the offering statement. Moreover, in the event a new qualification statement is filed for a new Regulation A+ offering, unsold securities from a prior qualification may be included, thus carrying those unsold securities forward for an additional three-year period.

Continuous or delayed offerings are available for all securities qualified in the offering, including securities underlying convertible securities, securities offered by an affiliate or other selling security holder, and securities pledged as collateral.

Additional Tier 2 Requirements; Ability to List on an Exchange

In addition to the basic requirements that will apply to all Regulation A+ offerings, Tier 2 offerings will also require: (i) audited financial statements (though I note that state blue sky laws almost unilaterally require audited financial statements, so this federal distinction may not have a great deal of practical effect); (ii) ongoing reporting requirements including the filing of an annual and semiannual report and periodic reports for current information (new Forms 1-K, 1-SA and 1-U, respectively); and (iii) a limitation on the number of securities non-accredited investors can purchase to no more than 10% of the greater of the investor’s annual income or net worth.

It is the obligation of the issuer to notify investors of these limitations. Issuers may rely on the investors’ representations as to accreditation (no separate verification is required) and investment limits.

This third provision provides additional purchaser suitability standards and the Regulation A+ definition of “qualified purchaser” for purposes of allowing state law pre-emption. During the proposed rule comment process many groups, including certain U.S. senators, were very vocal about the lack of suitability standards of a “qualified purchaser.” Many pushed to align the definition of “qualified purchaser” to the current definition of “accredited investor.” The SEC’s final rules offer a compromise by adding suitability requirements to non-accredited investors to establish quantitative standards for non-accredited investors.

The new rules allow Tier 2 issuers to file a Form 8-A to be filed concurrently with a Form 1-A, to register under the Exchange Act, and the immediate application to a national securities exchange. Where the securities will be listed on a national exchange, the accredited investor limitations will not apply.

Although the ongoing reporting requirements will be substantially similar in form to a current annual report on Form 10-K, the issuer will not be considered to be subject to the Exchange Act reporting requirements. Accordingly, such issuer would not qualify for a listing on the OTCQB or national exchange, but would also not be disqualified from engaging in future Regulation A+ offerings.

Tier 2 issuers that have used the S-1 format for their Form 1-A filing will be permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements. A Form 8-A is a simple (generally 2-page) registration form used instead of a Form 10 for issuers that have already filed the substantive Form 10 information with the SEC (generally through an S-1). The Form 8-A will only be allowed if it is filed concurrently with the Form 1-A. That is, an issuer could not qualify a Form 1-A, wait a year or two, then file a Form 8-A.  In that case, they would need to use the longer Form 10.

Upon filing a Form 8-A, the issuer will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A+ reporting will automatically be suspended.


The final rules include a limited-integration safe harbor such that offers and sales under Regulation A+ will not be integrated with prior or subsequent offers or sales that are (i) registered under the Securities Act; (ii) made under compensation plans relying on Rule 701; (iii) made under other employee benefit plans; (iv) made in reliance on Regulation S; (v) made more than six months following the completion of the Regulation A+ offering; or (vi) made in crowdfunding offerings exempt under Section 4(a)(6) of the Securities Act (Title III crowdfunding, which is not yet legal).

In the absence of a clear exemption from integration, issuers would turn to the five-factor test. In particular, the determination of whether the Regulation A+ offering would integrate with one or more other offerings is a question of fact depending on the particular circumstances at hand. In particular, the following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

Offering Statement – General

A company intending to conduct a Regulation A+ offering must file an offering statement with, and have it qualified by, the SEC.  The offering statement will be filed with the SEC using the EDGAR database filing system. Prospective investors must be provided with the filed pre-qualified offering statement 48 hours prior to a sale of securities. Once qualified, investors must be provided with the final qualified offering circular. Like current registration statements, Regulation A+ rules provide for an “access equals delivery” model, whereby access to the offering statement via the Internet and EDGAR database will satisfy the delivery requirements.

There are no filing fees for the process. The offering statement will be reviewed much like an S-1 registration statement and declared “qualified” by the SEC with an issuance of a “notice of qualification.” The notice of qualification can be requested or will be issued by the SEC upon clearing comments. The SEC has indicated that reviewers will be assigned filings based on industry group.

Issuers may file offering circular updates after qualification in lieu of post-qualification amendments similar to the filing of a post-effective prospectus for an S-1. To qualify additional securities, a post-qualification amendment must be used.

Offering Statement – Non-Public (Confidential) Submission

As is allowed for emerging growth companies, the rules permit an issuer to submit an offering statement to the SEC on a confidential basis. However, only companies that have not previously sold securities under a Regulation A or a Securities Act registration statement may submit the offering confidentially.

Confidential submissions will allow a Regulation A+ issuer to get the process under way while soliciting interest of investors using the “test the waters” provisions without negative publicity risk if it alters or withdraws the offering before qualification by the SEC. However, the confidential filing, SEC comments, and all amendments must be publicly filed as exhibits to the offering statement at least 21 calendar days before qualification. When an S-1 is filed confidentially, the offering materials need be filed 21 calendar days before effectiveness, but the SEC comment letters and responses are not required to be filed.  This, together with the requirement to file “test the waters” communications, are significant increased pre-offering disclosure requirements for Regulation A+ offerings.

Confidential submissions to the SEC are completed by choosing a “confidential” setting in the EDGAR system. To satisfy the requirement to publicly file the previous confidential information, the company can file all prior confidential information as an exhibit to its non-confidential filing, or change the setting in the EDGAR system on its prior filings, from “confidential” to “public.” In the event the company chooses to change its EDGAR setting to “public,” it would not have to re-file all prior confidential material as an exhibit to a new filing.

If a company wants to keep certain information confidential, even after the required time to make such information public, it will need to submit two confidential requests, one as part of the registration review process and one when prior confidential filings are made public.  During the confidential Form 1-A review process, the company should submit a request under Rule 83 in the same manner it would during a typical review of a registered offering. Once the company is required to make the prior filings “public” (21 days prior to qualification), the company would make a new request for confidential treatment under Rule 406 in the same manner other confidential treatment requests are submitted. In particular, for a confidential treatment request under Rules 83 and 406, a company must submit a redacted version of the document via EDGAR with the appropriate legend indicating that confidential treatment has been requested.  Concurrently, the company must submit a full, unredacted paper version of the document to the SEC using the ordinary confidential treatment procedure (such filings are submitted via a designated fax line to a designated person to maintain confidentiality).

Offering Statement – Form and Content

The rules require use of new modified Form 1-A.  Form 1-A consists of three parts: Part I – Notification, Part II – Offering Circular, and Part III – Exhibits. Part I calls for certain basic information about the issuer and the offering, and is primarily designed to confirm and determine eligibility for the use of the Form and a Regulation A offering in general.  Part I will include issuer information; issuer eligibility; application of the bad actor disqualification and disclosure; jurisdictions in which securities are to be offered; and unregistered securities issued or sold within one year.

Part II is the offering circular and is similar to the prospectus in a registration statement. Part II requires disclosure of basic information about the issuer and the offering; material risks; dilution; plan of distribution; use of proceeds; description of the business operations; description of physical properties; discussion of financial condition and results of operations (MD&A); identification of and disclosure about directors, executives and key employees; executive compensation; beneficial security ownership information; related party transactions; description of offered securities; and two years of financial information.

The required information in Part 2 of Form 1-A is scaled down from the requirements in Regulation S-K applicable to Form S-1.  Issuers can complete Part 2 by either following the Form 1-A disclosure format or by including the information required by Part I of Form S-1 or Form S-11 as applicable. Note that only issuers that elect to use the S-1 or S-11 format will be able to subsequently file an 8-A to register and become subject to the Exchange Act reporting requirements.

Moreover, issuers that had previously completed a Regulation A offering and had thereafter been subject to and filed reports with the SEC under Tier 2 could incorporate by reference from these reports in future Regulation A offering circulars.

Form 1-A requires two years of financial information. All financial statements for Regulation A offerings must be prepared in accordance with GAAP. Financial statements of a Tier 1 issuer are not required to be audited unless the issuer has obtained an audit for other purposes. Audited financial statements are required for Tier 2 issuers. Audit firms for Tier 2 issuers must be independent and PCAOB-registered. An offering statement cannot be qualified if the date of the balance sheet is more than nine months prior to the date of qualification.

A recently created entity may choose to provide a balance sheet as of its inception date as long as that inception date is within nine months before the date of filing or qualification and the date of filing or qualification is not more than three months after the entity reached its first annual balance sheet date. The date of the most recent balance sheet determines which fiscal years, or period since existence for recently created entities, the statements of comprehensive income, cash flows and changes in stockholders’ equity must cover. When the balance sheet is dated as of inception, the statements of comprehensive income, cash flows and changes in stockholders’ equity will not be applicable.

Part III requires an exhibits index and a description of exhibits required to be filed as part of the offering statement.

Offering Price

All Regulation A+ offerings must be at a fixed price. That is, no offerings may be made “at the market” or for other than a fixed price.

Ongoing Reporting

Both Tier I and Tier 2 issuers must file summary information after the termination or completion of a Regulation A+ offering. A Tier I company will need to file certain information about the Regulation A offering, including information on sales and the termination of sales, on a new Form 1-Z exit report, no later than 30 calendar days after termination or completion of the offering. Tier I issuers will not have any ongoing reporting requirements.

Tier 2 companies are also required to file certain offering termination information and would have the choice of using Form 1-Z or including the information in their first annual report on new Form 1-K.  In addition to the offering summary information, Tier 2 issuers are required to submit ongoing reports including: an annual report on Form 1-K, semiannual reports on Form 1-SA, current event reports on Form 1-U and notice of suspension of ongoing reporting obligations on Form 1-Z (all filed electronically on EDGAR).

The ongoing reporting for Tier 2 companies is less demanding than the reporting requirements under the Securities Exchange Act. In particular, there are fewer 1-K items and only the semiannual 1-SA (rather than the quarterly 10-Q) and fewer events triggering Form 1-U (compared to Form 8-K). The SEC anticipates that companies would use their Regulation A+ offering circular as the groundwork for the ongoing reports, and they may incorporate by reference text from previous filings.

The annual Form 1-K must be filed within 120 calendar days of fiscal year-end. The semiannual Form 1-SA must be filed within 90 calendar days after the end of the semiannual period. The current report on Form 1-U must be filed within 4 business days of the triggering event.  Successor issuers, such as following a merger, must continue to file the ongoing reports.

The rules also provide for a suspension of reporting obligations for a Regulation A+ issuer that desires to suspend or terminate its reporting requirements. Termination is accomplished by filing a Form 1-Z and requires that a company be current over stated periods in its reporting, have fewer than 300 shareholders of record, and have no ongoing offers or sales in reliance on a Regulation A+ offering statement. Of course, a company may file a Form 10 to become subject to the full Exchange Act reporting requirements.

The ongoing reports will qualify as the type of information a market maker would need to support the filing of a 15c2-11 application. Accordingly, an issuer that completes a Tier 2 offering could proceed to engage a market maker to file a 15c2-11 application and trade on the OTC Pink tier of the OTC Markets. Such issuer, however, would not be deemed to be “subject to the Exchange Act reporting requirements” to support a listing on the OTCQB or OTCQX levels of the OTC Markets.

Freely Tradable Securities

Securities issued to non-affiliates in a Regulation A+ offering will be freely tradable. Securities issued to affiliates in a Regulation A+ offering will be subject to the affiliate resale restrictions in Rule 144, except for a holding period. The same resale restrictions for affiliates and non-affiliates apply to securities registered in a Form S-1.

However, since neither Tier 1 nor Tier 2 Regulation A+ issuers are subject to the SEC reporting requirements, the shareholders of issuers would not be able to rely on Rule 144 for prior shell companies. Moreover, the Tier 2 reports do not constitute reasonably current public information for the support of the use of Rule 144 for affiliates in the future.

Treatment under Section 12(g)

Exchange Act Section 12(g) requires that an issuer with total assets exceeding $10,000,000 and a class of equity securities held of record by either 2,000 persons or 500 persons who are not accredited register with the SEC, generally on Form 10, and thereafter be subject to the reporting requirements of the Exchange Act.

The new Regulation A+ exempts securities in a Tier 2 offering from the Section 12(g) registration requirements if the issuer meets all of the following conditions:

  • The issuer utilizes an SEC-registered transfer agent. Such transfer agent must be engaged at the time the company is relying on the exemption from Exchange Act registration;
  • The issuer remains subject to the Tier 2 reporting obligations;
  • The issuer is current in its Tier 2 reporting obligations, including the filing of an annual and semiannual report; and
  • The issuer has a public float of less than $75 million as of the last business day of its most recently completed semiannual period or, if no public float, had annual revenues of less than $50 million as of its most recently completed fiscal year-end.

Moreover, even if a Tier 2 issuer is not eligible for the Section 12(g) registration exemption as set forth above, that issuer will have a two-year transition period prior to being required to having to register under the Exchange Act, as long as during that two-year period, the issuer continues to file all of its ongoing Regulation A+ reports in a timely manner with the SEC.

State Law Pre-emption

Tier I offerings do not pre-empt state law and remain subject to state blue sky qualification. The SEC, in its press release, encouraged issuers to utilize the NASAA-coordinated review program for Tier I blue sky compliance. For a brief discussion on the NASAA-coordinated review program, see my blog HERE. However, in practice, I do not think this program is being utilized; rather, when Tier 1 is being used, it is limited to just one or a very small number of states and the company is completing the blue sky process independently.

Tier 2 offerings are not subject to state law review or qualification – i.e., state law is pre-empted.  State securities registration and exemption requirements are only pre-empted as to the Tier 2 offering and securities purchased pursuant to the qualified Tier 2 for 1-A offering circular. Subsequent resales of such securities are not pre-empted.

The text of Title IV of the JOBS Act provides, among other items, a provision that certain Regulation A securities should be treated as covered securities for purposes of the National Securities Markets Improvement Act (NSMIA). Federally covered securities are exempt from state registration and overview. Regulation A provides that “(b) Treatment as covered securities for purposes of NSMIA… Section 18(b)(4) of the Securities Act of 1933… is further amended by inserting… (D) a rule or regulation adopted pursuant to section 3(b)(2) and such security is (i) offered or sold on a national securities exchange; or (ii) offered or sold to a qualified purchaser, as defined by the Commission pursuant to paragraph (3) with respect to that purchase or sale.” For a discussion on the NSMIA, see my blogs HERE and HERE.

The definition of “qualified purchaser” became the subject of debate and contention during the comment process associated with the initially issued Regulation A+ proposed rules. In a compromise, the SEC has imposed a limit on Tier 2 offerings such that the amount of securities non-accredited investors can purchase is to be no more than 10% of the greater of the investor’s annual income or net worth. In light of this investor suitability limitation, the SEC has then defined a “qualified purchaser” as any purchaser in a Tier 2 offering.

Federally covered securities, including Tier 2 offered securities, are still subject to state antifraud provisions, and states may require certain notice filings. In addition, as with any covered securities, states maintain the authority to investigate and prosecute fraudulent securities transactions.

Broker-dealer Placement

Broker-dealers acting as placement or marketing agent will be required to comply with FINRA Rule 5110 regarding filing of underwriting compensation, for a Regulation A+ offering.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys

Report On Regulation S-K

Tuesday, January 3rd, 2017

As required by Section 72003 of the Fixing America’s Surface Transportation Act (the “FAST Act”), on November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K (the “Report”) including detailed recommendations for changes.

The Report continues the ongoing review and proposed revisions to Regulations S-K and S-X as related to reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”). Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act. Regulation S-X contains specific financial statement preparation and disclosure requirements.

The Disclosure Effectiveness Initiative began in December 2013, when the SEC, as required by the JOBS Act, issued its first report on the Regulation S-K disclosure requirements. The Disclosure Effectiveness Initiative is intended to evaluate the rules related to disclosure, how information is presented and disclosed and how technology can be utilized in the process and to implement changes to improve the current disclosure-related rules and regulations.

Since the initiative began, the SEC has been issuing reports, an in-depth concept release, and proposed rule changes as part of the Disclosure Effectiveness Initiative. However, as of the date of this blog, none of the proposed changes have been implemented. I have included a summary of the various proposals and SEC publications at the end of this blog. I suspect that following the change in administration, and re-staffing of the SEC, including the as of yet to be announced replacements for SEC Chair Mary Jo White, Division of Corporation Finance Director Keith Higgins, and Trading and Markets Director Stephen Luparello, there will be significant progress in many of the outstanding proposals as well as new and different proposals on the subject.  It is my belief that the new leadership will take a pro-business viewpoint and that we will see that flow through to the disclosure requirements, especially as it impacts smaller reporting companies and emerging-growth companies.

The Report

The FAST Act, passed in December 2015, contains two sections requiring the SEC to modernize and simplify the requirements in Regulation S-K.  Section 72002 requires the SEC to amend Regulation S-K to “further scale or eliminate requirements… to reduce the burden on emerging growth companies, accelerated filers, smaller reporting companies, and other smaller issuers, while still providing all material information to investors.” In addition, the SEC was directed to “eliminate provisions… that are duplicative, overlapping, outdated or unnecessary.” In accordance with that requirement, On July 13, 2016, the SEC issued proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded. The S-K and S-X Amendments also seek comment on certain disclosure requirements that overlap with U.S. GAAP and possible recommendations to FASB, the regulatory body that drafts and implements GAAP, for conforming changes. See my blog on the proposed rule change HERE. The proposal remains pending.

Section 72003 required the SEC to conduct a study on Regulation S-K and, in that process, to consult with the SEC’s Investor Advisory Committee (the “IAC”) and the Advisory Committee on Small and Emerging Companies (the “ACSEC”) and then to issue a report on the study findings, resulting in the Report issued on November 23, 2016. As required, the SEC consulted with the IAC and ACSEC as part of the process.

Section 72003 specifically requires that the Report include: (i) the finding made in the required study; (ii) specific and detailed recommendations on modernizing and simplifying the requirements in Regulation S-K in a manner that reduces the costs and burdens on companies while still providing all material information; and (iii) specific and detailed recommendations on ways to improve the readability and navigability of disclosure documents and to reduce repetition and immaterial information.

The SEC Report includes a high level review of the rule proposals issued by the SEC specifically in response to their mandate under the FAST Act. In particular, the proposed rule changes related to mining companies, proposed amendment to the definition of a smaller reporting company, the July 13, 2016 proposed amendments to Regulation S-K and the August 31, 2016 proposed amendment to Item 601 were all required by the FAST Act. In the Further Reading section below, I have included links to my blogs on these proposals.

Specific SEC Staff Recommendations

A. Item 10(d) Related to Incorporation by Reference

The SEC staff recommends revising Item 10(d) to permit incorporation by reference to documents that have been filed with the SEC for at least 5 years, but require a detailed description of and hyperlink to such documents. Currently the rule specifically prohibits incorporation of documents that have been filed more than five years prior.

The SEC staff recommends allowing incorporation by reference to financial statement footnotes where such disclosures satisfy other Regulation S-K item requirements. For example, disclosures related to related party transactions (Item 404), selected financial data (Item 301) and off-balance-sheet arrangements (Item 303) are all repeated in financial statement footnotes. The SEC staff notes that allowing incorporation by reference from financial statements to other documents would increase audit costs and burdens and accordingly specifically recommends disallowing outside incorporation from the financial statements.

In addition, currently incorporation-by-reference rules are not consistent. For example, Rule 411 related to Securities Act registration statements has different requirements than Rule 12b-23 related to Exchange Act registration statements. Different forms also have different rules and requirements. The SEC recommends consolidating all the incorporation-by-reference rules into Item 10(d) and that such rules apply to all filings under the both the Securities Act and Exchange Act.

B. Business Information

The SEC staff recommends revising Item 102 to clarify that a description of property is only required to the extent that physical properties are material to the company’s business. Currently, Item 102 requires companies to “state briefly the location and general character of the principal plants, mines and other materially important physical properties of the registrant and its subsidiaries.” The SEC could also streamline the disclosure requirement by adding a description of material property to the Item 101 business description as opposed to leaving it as a stand-alone item.

C. Management Discussion and Analysis

The SEC staff recommends revising Item 303 to clarify that a company need only provide a period-to-period comparison for the two most recent years and that it may hyperlink to the prior year’s annual report for prior comparisons. The SEC staff also recommends considering requiring a discussion of material changes and known trends and uncertainties that impacted those changes, as opposed to the current granular line-item comparisons. In that regard, the MD&A focus would shift to longer-term trends and how those trends impacted the reported financial statements and may impact future results.

The SEC staff also recommends eliminating the requirement to provide a tabular disclosure of contractual obligations. I note that smaller reporting companies are not required to provide this disclosure. The staff recommends that instead of the table, a company should provide a hyperlink to financial statement footnotes and a liquidity discussion that describes material changes to contractual obligations and the ability to pay and perform such obligations.

D. Management, Security Holders, Corporate Governance

The SEC staff recommends clarifying the rules as to when and where the business experience of executive officers is required in proxy statements. In particular, the rules should clarify that the information is not required in a proxy statement when it is otherwise contained in a Form 10-K.

The SEC staff recommends allowing a company to simply review EDGAR filings to determine compliance with Section 16. Currently a Section 16 filer is required to also furnish a company with their filings. Similarly, the staff recommends eliminating the Section 16 disclosure requirement altogether where there are no delinquencies to report.

The SEC staff makes multiple recommendations to clarify and clean up certain corporate governance reporting requirements including further aligning the smaller reporting company and emerging-growth company requirements.

E.Registration Statements

As related to registration statements, the SEC staff makes several recommendations to clean up redundancies, allow for hyperlinks, and add consistencies to the requirements related to registration statements. The following is a brief description of some of those recommendations.

The SEC staff recommends eliminating the provision of Item 501 related to the name of the company. In particular, the SEC rules have provisions related to the use of a name that is the same as a “well-known” company or could be misleading.  The concept is already covered by intellectual property laws and it is not necessary for the SEC to have a specific regulation addressing same.

The staff recommends eliminating the requirement to provide an explanation of the method of determining the price of an offering in a registration statement from the cover page and allowing a hyperlink to the same disclosure elsewhere in the document.

The staff recommends adding a disclosure to specify if the company already trades on the OTC Markets and to provide the trading symbol. Currently the disclosure is only required for exchange-traded companies. In practice, OTC-traded companies already do this.

The staff recommends reducing the length of the “subject to completion” disclaimer on the front page by eliminating reference to state law where it is not applicable, such as when the offering pre-empts state law under the National Securities Market Improvement Act (NSMIA).

The staff recommends eliminating several of the Item 512 undertakings provisions as duplicative, redundant or obsolete.

F. Exhibits

The staff recommends adding a description of the company’s outstanding securities as an exhibit to Form 10-K. The staff also recommends adding the requirement that a subsidiaries legal entity identifier number (LEI) be included in the subsidiary list exhibit.

The staff recommends permitting the omission of attachments and schedules from exhibits unless the schedule or attachment has material information that is not disclosed elsewhere.

G. Manner of Delivery Requirements

The staff recommends adding XBRL tagging to the cover page of reports.  The staff also recommends allowing the use of hyperlinks to websites when a disclosure of such website URL is required.

Further Reading

The following is a recap of the ongoing Disclosure Effectiveness Initiative-related reports and proposals. The Disclosure Effectiveness Initiative began in December 2013, when the SEC, as required by the JOBS Act, issued its first report on the Regulation S-K disclosure requirements. The Disclosure Effectiveness Initiative is intended to evaluate the rules related to disclosure, how information is presented and disclosed and how technology can be utilized in the process and to implement changes to improve the current disclosure-related rules and regulations.

On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes. The proposal remains pending.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K.  Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.  The changes remain pending.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. The proposal remains pending.

On June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

On June 16, 2016, the SEC proposed revisions to Item 102 of Regulation S-K and Industry Guide 7 related to the property disclosure requirements for mining companies. The revisions are intended to modernize the disclosure obligations to be better aligned with current industry and global regulatory practices. The SEC also proposed rescinding Industry Guide 7 and including the substantive provisions in a new subpart in Regulation S-K.

On April 15, 2016, the SEC issued a concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements.  See my two-part blog on the S-K Concept Release HERE and HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

As part of the Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

Reg CF

Thursday, December 8th, 2016

SEC Adopts Regulations Implementing “Regulation Crowdfunding” Under Section 4(a)(6) Of The Securities Act

On October 30, 2015, the Securities and Exchange Commission voted to adopt “Regulation Crowdfunding” (Regulation CF). Regulation CF is the set of rules and forms that will implement securities crowdfunding in the United States. The SEC was required to adopt these rules under the provisions of Title III of the JOBS Act of 2012. The final rules come after the SEC reviewed and considered over 485 comment letters from professional trade associations, investor organizations, law firms, investment companies and investment advisers, broker-dealers, potential funding portals, members of Congress, the SEC’s Investor Advisory Committee, state securities regulators, government agencies, potential issuers, accountants, and other interested parties. The rules will go into effect on May 16, 2016, although entities that wish to act as broker-dealers and “crowdfunding portals” under Regulation CF will be able to start the application process from the end of January. The changes from the SEC’s proposed rules originally published in October 2013 are limited, and almost all those changes fall on the side of reducing burdens on the issuer. Of particular note is the fact that first-time issuers under the new rules will not be required to have their financial statements audited, and ongoing reports are not required even to be reviewed by an accountant. Additionally, the rules increase the ability of crowdfunding portals to use subjective criteria in deciding which companies’ offerings to host on their sites, and also to invest in those offerings. From a technical perspective, the fact that the SEC has made it possible to file documents in PDF form will reduce the logistical burden on issuers. On the negative side, individual investment limits were reduced to be based on the lesser of a person’s income or net worth. Additionally, the exclusion of crowdfunding shareholders from the “shareholder of record” count that triggers full registration with the SEC has become conditional.

Three weeks prior to the SEC adopting its final rules, FINRA, which is the self-regulatory organization for broker-dealers and which will also oversee the new “funding portals,” submitted its final Funding Portal Rules to the SEC for final approval.

Section 4(a)(6) of the Securities Act, the “crowdfunding exemption”

Offers of securities to the public (which includes offers made over the internet) must be registered with the SEC under the Securities Act of 1933, unless an exemption from registration is available. The JOBS Act added a new exemption to the Securities Act, Section 4(a)(6), to permit securities crowdfunding without registration. The exemption is subject to the following statutory conditions: The aggregate amount sold to “all investors,” including any amount sold in reliance on the new exemption, may not exceed $1 million in any 12-month period. The language of the statute (the JOBS Act) suggests that offerings made under other exemptions (Regulation D, for example) might count towards the $1 million limit, but the SEC’s view is that since Congress intended crowdfunding to be an additional source of funds for small companies, the limit applies solely to sales under Section 4(a)(6), and that amounts sold under other exemptions will not affect the limit. As discussed below, the SEC will permit crowdfunding offerings to be made concurrently with other exempt offerings, effectively permitting unlimited sizes of offerings to be made without registration.

An investor is limited in the amount he or she may invest in crowdfunding securities in any 12-month period:

  • If either the annual income or the net worth of the investor is less than $100,000, the investor is limited to the greater of $2,000 or 5% of the lesser of his or her annual income or net worth.
  • If the annual income and net worth of the investor are both greater than $100,000, the investor is limited to 10% of the lesser of his or her annual income or net worth, to a maximum of $100,000.

For calculating an investor’s net worth, Regulation CF uses the same method as used in Regulation D, which excludes the value of the investor’s primary residence. Investors may include their spouse’s income for the purposes of the income test. The “lesser of” standard is a change from the proposed rules, which took a “greater of” approach to calculating the investment limit based on income or net worth. This change will significantly limit the funds available from non-accredited investors. However, the SEC’s rules permit concurrent offerings under Section 4(a)(6) and Rule 506(b) or (c), which may effectively result in accredited investors not being subject to any limit on their investment.

The transaction must be made through a broker, or through a “funding portal” (a new designation under the Securities Exchange Act of 1934) that meets the requirements set out below. The issuer must comply with the disclosure and other requirements set out below. Note that compliance with each of these requirements is a condition to availability of the exemption from registration. If these conditions are not met and the relief for “insignificant deviations” discussed below is not available, then the issuer will have violated the Securities Act by making an unregistered offering of securities to the public.

Requirements for issuers

Incorporation and eligibility

The issuer must be incorporated or organized under the laws of a state or territory of the United States, or the District of Columbia. It may not be an “investment company” as defined under the Investment Company Act of 1940, and cannot be an SEC-reporting company. “Blank check” companies formed for unspecified purposes or to acquire other companies cannot make offerings under Regulation CF. Additionally, the exemption is not available to any issuer that is disqualified by reason of the bad actor disqualification, or if the issuer (or any entities controlled by or under common control with the issuer) has previously offered securities under Regulation CF and failed to file its ongoing reports with the SEC.

Many commentators urged the SEC to allow issuers to be able to issue securities through the use of single purpose funds. This would avoid the “messy cap table” problem identified by some angel and venture capital investors who do not want to have to deal with numerous small investors in a company. However, the SEC declined to create such an exemption, citing Congressional intent and the language of the statute, which specifically excludes investment companies from being able to rely on Section 4(a)(6).

When determining issuer eligibility for the amount of funds to be raised and financial statements requirements, the SEC has clarified the language contained in the statutory text of Section 4(a)(6) that the definition of issuer includes all entities controlled by or under common control with the issuer and any predecessors of the issuer. For example, a single real estate developer that is raising funds for multiple issuers is subject to a 12-month cap of $1 million raised under Regulation CF aggregated across all issuing companies. Additionally, if an issuer controlled by that developer had made a previous offering under Regulation CF, then all future offerings in any company controlled by the
developer in excess of $500,000 would be required to include audited financial statements.

The definition of common control may also have an impact on franchisees. If the franchise agreement controls the issuer and all other franchisees (i.e., has the power to direct or cause the direction of the management and policies of the entity), then all franchisees would be aggregated together when determining amounts offered and sold under Regulation CF and the financial statements to be required.


The SEC requires that issuers provide certain information to investors through the intermediaries’ platforms and to the SEC directly via a filing of Form C on EDGAR, the SEC’s data handling system. Form C will consist of XML-fillable fields in the front portion of the Form and then “Exhibits” which will include the rest of the information required to be filed. Some information is mandatory, but the issuer may include other information in the Form. The mandatory information for each issuer includes:

  • The name, legal status (i.e., form, state, and date of organization), physical address, and website address.
  • The names of the directors and officers (and any persons occupying a similar status or performing a similar function), the positions and offices held by those persons, how long they have served in those positions, and the business experience of those persons over the past three years.
  • The name of each person who is a beneficial owner of 20% or more of the issuer’s outstanding voting equity securities. These are the same shareholders covered by the “Bad Actor” disqualification provisions discussed below.
  • A description of the business of the issuer and anticipated plan of business.
  • The current number of employees of the issuer.
  • A discussion of the material risk factors that make an investment in the issuer speculative or risky.
  • The target offering amount and the deadline to reach the target amount, including a statement that if the sum of the investment commitments does not equal or exceed the target offering amount at the offering deadline, no securities will be sold in the offering, investment commitments will be cancelled and committed funds will be returned.
  • Statement with respect to whether the issuer will accept investment in excess of the target amount and the maximum it will it accept. If the issuer accepts investments above the stated target, it must state the method it will use to allocate oversubscriptions.
  • A description of the purpose and intended use of the offering proceeds. The SEC elaborates that it expects issuers to provide a detailed description of the intended use of proceeds with enough information to allow investors to understand how the offering proceeds will be used. If an issuer is uncertain how the proceeds will be used, it should identify the probable uses and the factors impacting the selection of each use. Similarly, if the issuer accepts proceeds above the target amount, it should indicate the purpose and intended use of those excess funds.
  • A description of the process to complete the transaction or to cancel an investment commitment.
  • The price of the securities or the method for determining the price. If the issuer has not set a price at start of the campaign, it must provide a final price prior to any sale of securities.

A description of the ownership and capital structure of the issuer. This requirement also includes:

  • Disclosure of the terms of the securities being offered as well as each other class of security of the issuer;
  • Any rights held by principal shareholders;
  • Name and ownership level of any 20% beneficial owner;
  • How the securities being offered are valued and how the securities may be valued in the future;
  • Risks to purchasers of the securities relating to minority ownership and the risks associated with corporate actions like the additional issuance of shares, issuer repurchases, and the sale of the issuer or issuer assets to related parties; and
  • Description of the restrictions on the transfer or the securities.
  • The name, SEC file number and Central Registration Depository number of the intermediary conducting the offering.
  • A description of the intermediary’s financial interests in the issuer’s transaction, including the amount of compensation paid to the intermediary for conducting the offering and the amount of any referral or other fees associated with the offering.
  • A description of the material terms of any indebtedness of the issuer. Material terms include the amount, interest rate, maturity date, and any other terms a purchaser would deem material.
  • A description of any exempt offering conducted within the past three years. The description should include the date of the offering, the offering exemption relied upon, the type of securities offered, the amount of securities sold, and the use of proceeds.
  • A description of any completed or proposed transaction involving the issuer or any entity under common control with the issue for value exceeding five percent of the amount raised under Section 4(a)(6) within the past 12 months, including the current offering, when a control person, promoter, or family member had a direct or indirect material interest.
  • A description of the financial condition of the issuer, including discussion of liquidity, capital resources, and historical results of operations covering each period for which financial statements are provided.
  • The tax information and financial statements certified by the principal executive officer, reviewed financial statements, or audited financial statements of the issuer, depending on the level of the raise and raises within the previous 12 months, or whether this is the first offering of the issuer under Regulation CF.
  • A description of any events that would have triggered disqualification under the Bad Actor disqualification had they occurred after the effective date of the final rule.
  • Updates on progress towards meeting the target offering amount.
  • A statement regarding where on the issuer’s website investors will be able to find the issuer’s annual report, and the date by which the annual report will be available.
  • A statement regarding whether the issuer or any of its predecessors failed to comply with the ongoing reporting requirements of Regulation CF.
  • Any other material information necessary in order to make previous statements not misleading.

Other than the information about the issuer that is required to be entered into the XML portion of the Form C (which is covers things like name, address, size of offering, etc.), the SEC does not specify the format or medium in which the mandatory disclosure must be presented, leaving flexibility for crowdfunding issuers to present some information in written offering documents, some in videos, and other information by graphic means.

In response to suggestions made in the comment process, the SEC includes an optional Question and Answer (“Q&A”) format that an issuer can follow in order to provide the mandatory disclosure not covered by the XML portion of the Form. While this might assist some issuers who have not sought professional advice to make sure that they do not miss any important items, the Q&A itself is quite technical, and uses securities concepts such as “beneficial owner” and “material terms of outstanding classes of securities” which may be confusing to non-lawyers.

All information about an offering posted on an intermediary’s site must be filed with the SEC via its electronic EDGAR data-handling system. The wording of the SEC’s original proposals suggested that while the mandatory disclosure would have to be filed on Form C, it might be possible to post on the intermediary’s website additional information that did not have to be filed. The SEC has made it clear that this is not the case. Online offerings, currently normally made in reliance on the exemption from registration provided by Regulation D, use a variety of offering materials, including offering memoranda, slide decks, videos and other materials. All these will need to be filed, but the SEC has made that process easier by permitting the filing of data in PDF format (not permitted in other types of SEC filing). Video and audio cannot be filed through EDGAR; a transcript must be filed instead. Not only must all these optional materials be filed, but the issuer (and in some circumstances the intermediary, as discussed in “Liability” below) is liable for any misstatements made in them.

Financial statements

Issuers of securities under Regulation CF are required to provide financial statements prepared in accordance with US Generally Accepted Accounting Practices (U.S. GAAP) covering the two most recently completed fiscal years (or shorter period since inception). The type of review that these financial statements have to undergo depends on the amount sought, the amount of securities that the issuer has already sold in reliance on Regulation CF in the preceding 12 months, and whether the issuer has previously sold securities in an offering under Regulation CF:

  • If current offer plus previous raises amounts to $100,000 or less, the financial statements must be certified by the principal executive officer and accompanied by information from the company’s tax returns (but not the tax returns themselves).
  • If current offer plus previous raises amounts to $100-500,000, the financial statements will be required to be reviewed by a CPA.
  • If current offer plus previous raises amounts to $500,000 or more, the financial statements must be audited by a CPA. However, if the issuer has not previously sold securities under Regulation CF, the financial statements will only be required to be reviewed by a CPA.

The financial statements are not permitted to be more than 18 months old. If more than 120 days has passed since the end of the most recently-ended fiscal year, the issuer will have to produce financial statements for that most recent year, but until that point could use financial statements from the preceding year. No interim financials are required. The review standards to be used by the accountant are the Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. While there has been widespread applause at the more flexible position taken by the SEC in the final rules with respect to audit requirements, issuers should realize that the review process is a substantive one and that if they have been using simple financial statement software like QuickBooks, the reviewing CPA is likely to require them to revise, reformat and expand their financial statements in order to meet GAAP requirements. One issue that startups with revenue should pay particular attention to is their revenue recognition policies.

The SEC does not exempt very early-stage companies from these requirements. The SEC reiterated its position in the Proposing Release that “financial statements prepared in accordance with U.S. GAAP are generally self-scaling to the size and complexity of the issuer, which reduces the burden of preparing financial statements for many early stage issuers.” Thus, even companies at the business plan stage seeking $500,000 would have to produce financial statements reviewed by a CPA.

Issuer Filing Requirements and Form C

The Form C must be filed and made public prior to the start of the offering. This means that no “exclusive first look,” either by the issuer or any intermediary, will be permitted. All potential investors must have access to the offering at the same time. Regulation CF creates a new XML-based fillable form, Form C, for use in allowing issuers to provide required information. There are several variants of Form C:

  • Form C: used for the original offering statement to provide the required disclosures.
  • Form C/A: used for amendments to a previously filed Form C.
  • Form C-U: used by issuers at the end of the offering to disclose the total amount of securities sold.
  • Form C-AR: used by issuers to provide the required annual reports.
  • Form C-AR/A: used for amendments to a previously filed Form C-AR.
  • Form C-TR: used by issuers who are terminating their reporting.

Form C will be used for the provision of some of the mandatory information in XML format, with other required disclosures being submitted as an attachment to Form C. Those attachments can be in PDF form, which is a new and very welcome development for the EDGAR filing process. (The attachments can also be in “EDGAR HTML” or ASCII.) As discussed above, so long as all the mandatory information is filed and presented to investors, the media used to present that disclosure are not specified by the SEC.

When information is presented in the form of video, the text of the video script must be filed; the EDGAR system does not handle video files.

Regulation CF requires issuers to file Form C with the SEC via EDGAR, as well as providing the Form C to the intermediary, investors, and potential investors; however, it allows issuers to satisfy this latter requirement by providing the intermediary with a copy of the disclosures provided to the SEC and directing investors to the intermediary via email or the issuer’s website. To file a Form C the issuer must have EDGAR filing codes and a Central Index Key (CIK) code. If an issuer does not already have these codes it can obtain them from the SEC. The issuer may also work with an intermediary to prepare the disclosures and have the intermediary submit the Form C.

The SEC does not review, comment on or in any way approve the disclosure. It would be foolish, however, to assume that the SEC will not read information that is on EDGAR. An investor protection agency cannot be expected to look the other way if it sees information that it finds troubling, and issuers should operate on the assumption that the SEC staff and the state regulatory authorities will be scouring the Forms C that are filed for potentially misleading statements.

Ongoing disclosure requirements

Issuers that have sold securities in reliance on Section 4(a)(6) must file information with the SEC and post it on their websites on an annual basis. The annual filing must be made within 120 days of the issuer’s fiscal year-end. The information included in the annual report is similar to that required in the initial filing, except that, in response to numerous objections to the burden of ongoing reporting as originally proposed, no accountants’ audit or review of the financial statements will be necessary.

Regulation CF provides for five ways in which a company is able to cease filing ongoing reports with the SEC. Annual filing requirements continue until:

  • The issuer becomes a fully-reporting registrant with the SEC;
  • The issuer has filed at least one annual report, but has no more than 300 shareholders of record;
  • The issuer has filed at least three annual reports, and has no more than $10 million in assets;
  • The issuer or another party purchases or repurchases all the securities sold in reliance on Section 4(a)(6); or
  • The issuer ceases to do business.

The ability for an issuer to cease filing if it has 300 or fewer holders of record, or assets not exceeding $10 million, is a modification from the proposed rule. These changes mitigate some of the compliance cost for small companies that have issued securities under Regulation CF, as does the elimination of the requirements for CPA review or audit.

Advertising and publicity

Pursuant to Section 4A(b)(2) of the Securities Act, an issuer may “not advertise the terms of the of the offering, except for notices which direct investors to the funding portal or broker.” Under the new rules, an issuer and any person acting on behalf of the issuer may publish a limited notice (sometimes called a “tombstone”) that advertises the terms of an offering so long as the notice includes the address of the intermediary’s platform on which information about the issuer and offering may be found. While acknowledging that the statute restricts the ability of potential issuers to advertise, the SEC has explained that restrictions on advertising the terms of the offering are meant to direct the investors to the intermediary’s platform. Once at the intermediary platform, the investors will have access to the information that will allow them to make an informed decision about the offering. Under the rules, a notice advertising the terms of an offering may contain no more than the following (it can contain less):

  • A statement that the issuer is conducting an offering, the name of the intermediary conducting the offering and a link to the intermediary’s platform;
  • The terms of the offering (the amount of the securities being offered, the nature of the securities, the price of the securities, and the closing date of the offering period); and
  • Factual information about the legal identity and the business location of the issuer. This information is limited to the name of the issuer of the security, the address, phone number and the website of the issuer, an email address for a representative of the issuer, and a brief description of the issuer’s business.

The rules do not place restrictions on how the issuer distributes these notices, the format of the notice, or its medium. Issuers can use social media, audio, video or street theater, so long as only the permitted content is included. An issuer could place these notices on various social media sites to attract potential investors and the notice would direct them to the intermediary page where they could access the information necessary to make an informed investment decision.

No other public communications about the offering are permitted. Posts on Facebook, tweets on Twitter, LinkedIn updates and the like that do not follow these limitations would all likely result in the issuer’s violation of Section 5 of the Securities Act.

Under the rules, an issuer is allowed to communicate with investors and potential investors about the terms of the offering through communication channels provided by the intermediary through its platform, so long as the issuer identifies itself as the issuer in all communications. Anyone acting on behalf of the issuer must identify their affiliation with the issuer on all communications on the intermediary’s platform. The SEC has clarified that the restrictions apply only to persons acting on behalf of the issuer. If a person whose only connection to the issuer was that she loved the company’s product were to tweet that she intended to invest because the company was sure to succeed, this would be unlikely to be a problem for the issuer.

Issuers may engage third-parties to promote the offering in two contexts – through the communication channels provided by the intermediary, and through tombstone notices.
Intermediaries are required to create communication channels on their platforms to facilitate discussion between prospective investors and the issuer (see below). Regulation CF anticipates instances where the issuer will have paid a promoter to respond to investors through those communication channels. In that situation, such compensation must be disclosed by the promoter with any communication on the platform. The second context involves payments to third-parties for publishing tombstone notices that direct to the intermediary’s offering page.

Regulation CF states that an issuer may not pay a third party to do what it cannot do itself. Paid promoters should consider whether the disclosure requirements of Section 17(b) of the Securities Act apply to them. An issuer would not be prohibited from disseminating other information about the company in the normal course of its business that does not relate to the terms of the offering, such as general business advertising.

Requirements for intermediaries

The following requirements apply to both broker-dealers and funding platforms; funding platforms will be subject to some limitations on their activities discussed in “Special limitations on funding portals” below.


A person acting as an intermediary in a transaction involving the sales of securities for someone else pursuant to Section 4(a)(6) must:

  • Register with the SEC as a broker or as a funding portal. Regulation CF creates a streamlined registration process for funding portals. Non-U.S. funding portals are only be allowed to register with the SEC if the funding portal is based in a jurisdiction that has an information sharing agreement with the SEC, and the funding portal is registered in that jurisdiction.
  • Register with a self-regulatory organization, or SRO (the only eligible SRO at present being FINRA).

Obligations with respect to fraud prevention and compliance

The statute requires intermediaries to take risks to reduce the risk of fraud, and Regulation CF requires intermediaries to take positive action in several areas: Intermediaries must have a “reasonable basis for believing” that the issuer has met the disclosure and process requirements described below. An intermediary may rely on issuer representations to form that reasonable basis for belief. However, the SEC emphasized that an intermediary has a responsibility to assess whether reliance on representations is reasonable, given its course of interactions with potential issuers. This means that the representation must be detailed enough to evidence a reasonable awareness by the issuer of its obligations and its ability to comply with those obligations. As a result, this requirement cannot be met with a simple representation (“checking the box”) that the issuer has complied with Regulation CF, but requires an inquiry into the issuer and the steps it has taken to comply with Regulation CF.

Intermediaries must have a “reasonable basis for belief” that the issuer has established a way to keep accurate records of the holders of securities. Similarly with the reasonable basis for belief as to issuer compliance, the SEC provides that an intermediary may accept representations from an issuer that it has established a means to keep track of securityholders. However, any such representation from the issuer must detail record keeping functions such as:

  • Monitoring the issuance of securities through the intermediary’s platform;
  • Maintaining a master security holder list;
  • Maintaining a transfer journal or other such log;
  • Effecting the exchange or conversion of any securities;
  • Maintaining a control book demonstrating historical registration of those securities; and
  • Countersigning and legending physical certificates.
  • If the issuer has engaged a registered transfer agent, the intermediary will be deemed to have met the requirement of establishing a reasonable basis for belief.

The intermediary must deny access to its platform if it has a reasonable basis to believe that any specified person is subject to a “Bad Actor” disqualification. This requirement is tied to the statutory mandate under Section 4A(a)(5) of the Securities Act that an intermediary conduct a background and securities enforcement regulatory history check on the issuer and its covered persons. In order to meet this requirement, the intermediary must conduct these checks on the issuer, predecessors of the issuer, officers and directors (or any person occupying a similar status or performing a similar function), and any 20 percent beneficial owner of the issuer.

The intermediary must deny access to its platform if it has a reasonable basis to believe that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection. Here, the intermediary must be able to adequately and effectively assess the risk of fraud from the issuer or its offering, and may not ignore facts about the issuer that indicate fraud or investor protection concerns. If it cannot adequately assess the issuer or resolve concerns, the intermediary must deny access to its platform. This may occur, for example, where an issuer’s directors are foreign nationals whose country of origin does not allow for third parties to review criminal or regulatory enforcement background information. If it becomes aware of the potential for fraud after granting access to its platform, it must cancel the offering. The SEC does not further define what constitutes “concerns about investor protection,” and creates some ambiguity as to what is required of intermediaries.

Opening of investor accounts

An intermediary may not accept any investment commitment from investors in a transaction under Regulation CF, until that investor has opened an account with the intermediary and consented to electronic delivery of materials. The SEC does not specify the exact information that the intermediary must obtain from an investor, and leaves it to intermediaries to determine what they will require for business purposes and compliance purposes. The requirements that investors consent to electronic delivery of information is important for the functioning of securities crowdfunding. As almost all activity related to the offering and ongoing reporting will be delivered electronically via email, by being directed to a URL, and through the intermediary’s portal, investors are required to consent to such delivery of information in lieu of paper mailings.

Notices regarding promoters of the issuer

At the time that an investor opens an account with an intermediary, the intermediary must inform the investor that anyone who promotes an offering in exchange for compensation, or who is a founder or an employee of an issuer promoting the issuer through the communication channels on the platform must disclose the fact that he or she is engaging in promotional activities on behalf of the issuer. The SEC believes this requirement will assist investors by alerting them at the outset about the promotional activities of issuers or representatives of issuers.

Compensation disclosure

An additional notice requirement for intermediaries when establishing an account for an investor includes disclosure of the manner in which they will be compensated in connection with offerings and sales made in reliance on Section 4(a)(6). For a platform that will accept a range of compensation types from issuers (e.g., flat fee, commission, equity interest, etc.), each type of compensation that it will accept must be disclosed. The SEC determined that this requirement is better suited to the time of an investor’s account opening rather than prior to the point when an investor makes an investment commitment because it will help investors make better-informed decisions when reviewing offerings on the platform.

Provision of educational materials

As part of the statutory requirements for offerings under Section 4(a)(6), intermediaries are required to provide disclosures and investor educational materials. Regulation CF requires these educational materials to be provided to investors at the time they open accounts with intermediaries. Regulation CF further requires that the materials be written in plain language and otherwise designed to communicate effectively specified information. These materials are required to cover:

  • The process for investing on the intermediary’s platform.
  • The risks associated with crowdfunding securities.
  • The types of securities that may be offered on the intermediary’s platform and the risks associated with each, including dilution (note that the intermediary may be deemed not to have met this criterion if an issuer sells a securities product not previously explained in its education materials).
  • Restrictions on resale.
  • The type of information that an issuer is required to deliver annually, and that such information may cease to be provided in the future.
  • Investor limit amounts.
  • The limitation’s on an investor’s right to cancel an investment commitment and circumstances in which an issuer may cancel and investment commitment.
  • The need for an investor to consider whether crowdfunding securities are appropriate for him or her.
  • That at the end of the offering, there might not be any ongoing relationship between the issuer and the intermediary.

The circumstances under which an issuer may cease to publish annual reports and the corresponding absence of current financial information about the issuer.
The SEC declined to develop its own investor educational materials for the purpose of this requirement, instead leaving it to each platform to determine the best means to educate their investors. These educational materials must be made continuously available. Should the intermediary make material revisions to its educational materials, it must provide the updated materials to all investors prior to accepting any additional investment commitments or effecting any further transactions.

Acknowledgement of risk

Prior to accepting any investor commitments for any particular offering, Regulation CF requires that intermediaries receive a representation from the investor that the investor has reviewed the educational materials and understands that the entire amount of the investment is at risk and may be lost. Additionally, intermediaries must require investors to complete a questionnaire that demonstrates the investor’s understanding that:

  • There are restrictions on the investor’s ability to cancel an investment commitment and obtain a return of the commitment.
  • It may be difficult to resell securities acquired in an offering of securities under Section 4(a)(6).

Investing in securities sold under Section 4(a)(6) involves risk and that the investor should not invest any funds unless the investor is able to bear the entire loss of the investment. The SEC declined to develop such a questionnaire and instead left it to the discretion of intermediaries. The SEC stated that this flexibility will allow intermediaries to tailor questionnaires to the business and likely investor base of the intermediary. Intermediaries may require additional information in these questionnaires, such as information concerning the investor’s level of investment experience, where the investor acquired any information about the offering, and the percentage of the investors liquid net worth represented by the proposed investment.

Whatever format the process may take, the intermediary will be required to receive the representation and questionnaire responses from the investor each time an investor makes an investment commitment even if the investor has previously made investments through the intermediary. Requirements for intermediaries with respect to transactions The SEC sets out the methods by which an intermediary must comply with the statutory requirements for managing offerings taking place under Section 4(a)(6) in in Rules 303 and 304. Intermediary must make issuer information available During the course of an offering, the intermediary must make the issuer’s required disclosure information publicly available on the intermediary’s website. This information must be available for at least 21 days prior to any sale of securities and displayed in a manner that allows for any visitor, including regulators, to access, download, and save. This rule poses compliance challenges for intermediaries. First, it is unclear how an issuer’s amendment to its disclosure information impacts the 21-day availability requirements prior to sale. Second, it is possible an intermediary will be liable for allowing sales to occur if the issuer has not supplied the complete set of information it is required to disclose. As such intermediaries must ensure that issuer’s disclosures are complete. The intermediary is not required to ascertain whether investors have reviewed the disclosure material.

Investor qualifications

Intermediaries are responsible for ensuring an investor stays within the annual investment limit. To comply with this requirement, intermediaries must have a reasonable basis for believing that the investor satisfies his or her annual investment limit. An intermediary may rely on investor representations concerning the investor’s annual income, net worth, and the amount of the investor’s other investments made under Section 4(a)(6). Additionally, for each transaction, intermediaries are required to obtain a representation from an investor that the investor has reviewed the educational materials and require the investor to complete a questionnaire covering the restrictions on the ability of the investor to cancel the investment commitment, the limitations on resale of securities, and the riskiness of transactions under Section 4(a)(6).

Communication channels for issuers and investors

Regulation CF is designed on the premise that crowdfunding requires the crowd to be able to communicate with each other and with the issuer to evaluate the investment opportunity. As such, the final rules require that the intermediary establish communication channels on the intermediary’s platform to provide a centralized and transparent means for members of public to asset the investment offering. Specifically, the intermediary must:

  • Permit public access to view the discussions made in the communication channels;
  • Restrict posting of comments to those persons who have opened an account with the intermediary on its platform;
  • Require that any person posting a comment in the communication channels clearly and prominently disclose with each posting whether he or she is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or is otherwise compensated, whether in the past or prospectively, to promote the issuer’s offering; and

If a funding portal, not participate in the communications other than to establish guidelines for communications and remove abusive or potentially fraudulent communication. The SEC leaves open to intermediaries whether to allow their registered users to post under their real names or under aliases. Either choice will affect the quality of communications presented. For example, real names might limit participation, but aliases could encourage inaccurate or abusive posts. Other considerations for intermediaries when establishing communication channels include objective enforcement of communications. For instance, promotion of a positive comment or removal of a negative comment that is not abusive may be considered the provision of investment advice.

Providing notices to prospective purchasers

Upon receipt of an investment commitment, the intermediary must provide the investor with a notification disclosing:

  • The dollar amount of the investment commitment;
  • The price of the securities, if known;
  • The name of the issuer; and
  • The date and time by which the investor may cancel the investment.

Transmission or maintenance of funds from investors

The rules pertaining to transmission of funds under Regulation CF vary based on the status of the intermediary as a registered broker-dealer or funding portal. Broker-dealers must comply with existing regulations set out in Rule 15c2-4. Under the regulation, funds must be promptly deposited into a separate bank account until the close of the offering when it is promptly transmitted to the issuer. Funding portals, which are prohibited from handling funds or securities, must:

  • Direct funds to a qualified third-party that has agreed to hold the funds in escrow, with qualified third-parties including a registered broker-dealer, bank or credit union; and
  • Direct the qualified third party to transmit funds to the issuer or return funds to the investor depending on the result of the offering under Section 4(a)(6).

Confirmation of transactions

Intermediaries are responsible for sending notice to investors confirming the completion of the transaction. Those notices must disclose pertinent details of the transaction, including:

  • The date of the transaction;
  • The type of security that the investor is purchasing;
  • The identity, price, and number of securities purchased by the investor, as well as the
  • number of securities sold by the issuer in the transaction and the price(s) at which the securities were sold;
  • If a debt security, the interest rate and the yield to maturity calculated from the price paid and date of maturity;
  • If a callable security, the first date that the securities can be called by the issuer; and
  • The source, form and amount of any remuneration received or to be received by the intermediary in connection with the transaction, including any remuneration to be received by the intermediary from persons other than the issuer.

Intermediary responsibility for cancellations and reconfirmations

At various times during an offering, the intermediary may be responsible for reconfirming an investment commitment with investors or cancelling the investment commitment. In the event than an issuer makes a material change to the terms of an offering or to the information provided by the issuer, intermediaries are required to contact investors that have made a commitment and request the investor re-commit to the investment in light of the new information. This confirmation must be received within five days or else the investment commitment must be cancelled by the intermediary. If the intermediary was required to cancel the investment commitment, it must then send a notice of the cancellation to the investor and direct a refuse of the investor’s funds. In the case of a material change occurring within five days of the target end of the offering established by the issuer, the officer must be extended to allow five full business days for the investor to re-commit to the investment. If an issuer does not raise the target funds by the deadline it established, the intermediary has five days to provide investors with notice of the cancellation of the investment commitment, direct the refund of investor funds, and prevent investors from committing any additional funds to the offering.

Protect the privacy of information collected from investors

The statutory language of Section 4A(a)(9) of the Securities Act requires that intermediaries protect the privacy of information collected from investors. Rather than creating new privacy rules, the SEC adopted rules to clarify that broker-dealers and funding portals are required to comply with Regulation S-P, Regulation S-ID, and Regulation S-AM. Taken together, these regulations obligate intermediaries to have policies and procedures in place to protect nonpublic information about investors, prevent identify theft, and limit the information shared with affiliates.

Limitation on payments to finders

An intermediary in an offering under Section 4(a)(6) is prohibited from compensating finders or any person for providing personally identifiable information on any investor or potential investors.

Financial interest in issuers

By statute, the directors, officers, or partners of an intermediary are prohibited from having a financial interest in an issuer using its services. The SEC clarified the way in which this prohibition applies to the intermediary itself. An intermediary may receive a financial interest in the issuer as a form of compensation for the services performed by the intermediary; the financial interest must be of the same class and at the same terms as the securities being sold under Section 4(a)(6).

Special limitations on funding portals

Under the Securities Exchange Act and Regulation CF, funding portals are limited purpose brokerdealers that may assist issuers in the offering and sale of securities subject to certain limitations on their activities. The statutory prohibitions on funding portals include:

  • Paying for finding potential investors;
  • Giving investment advice or recommendations;
  • Soliciting offers or sales to buy the securities offered on its portal
  • Compensating anyone for such solicitation or based on the sale of securities on its portal;
  • Holding or managing funds; and
  • Permitting their officers, directors or partners to have a financial interest in an issuer using their services.
  • The SEC provided additional clarification of the statutory limitations by creating a conditional safe harbor for funding portals.

Under the conditional safe harbor, funding portals may:

  • Determine whether and under what terms to allow an issuer to offer securities on the funding portal’s platform;
  • Apply objective criteria to highlight offerings on the platform;
  • Provide search functions for investors to search and sort offerings based on objective criteria;
  • Provide communication channels that allow the issue to communicate with investors and potential investors;
  • Advise issuers on the structure and content of the offering;
  • Compensate third parties for referring persons to the portal and other services, so long as the referral does not include personally identifiably information of any potential investor and the compensation is not transaction based unless the party is a registered broker-dealer;
  • Pay or offer to pay compensation to a registered broker-dealer for services;
  • Receive compensation from a registered broker-dealer;
  • Advertise the existence of the funding portal and identify one or more issuers using objective criteria to determine which issuers to identify;
  • Deny access to the funding portal’s platform if the funding portal has a reasonable basis for believing that the issuer presents the potential for fraud;
  • Direct investors where to transmit funds for the purchase of securities; and
  • Direct third-parties to release funds to issuers or return funds to investors.

Curation of offerings by funding portals

In its proposed rules, the SEC expressly prohibited funding portals from “curating” offerings, as such subjective curation would be investment advice — an activity prohibited to funding portals by statute. In the final rules, the SEC relaxed this requirement by providing funding portals the ability to determine whether and under what terms to allow issuers onto their platforms so long as curation does not result in the provision of investment advice. This requirement is connected with the advertising restrictions discussed below. For instance, curation by the funding portal may not support a claim that the issuers on the platform “are safer or better investments”. Instead, the curation should be a back-office type activity that helps portals bring forward the types of issuers they want without that activity becoming a selling point for the platform of the issuers.

Highlighting issuers and offerings

In keeping with the prohibition on providing investment advice, funding portals are only permitted to highlight specific issuers or offerings through the application of objective criteria that is reasonably designed to highlight a broad selection of issuers. The objective criteria must be applied consistently to all issuers and offerings and may not highlight issuers and offerings based on the advisability of investing, whether implicitly or explicitly. Some of the objective criteria noted by the SEC are: the type of securities being offered; the geographic location of the issuer; and the number or amount of investment commitments made. Funding portals may not use the objective criteria in such a way that it highlights or promotes a specific offering, as that would not be designed to highlight a broad selection of issuers. Funding portals are further prohibited from receiving special or additional compensation for identifying or highlighting (or offering to highlight) an issuer or offering on the platform.

Providing search functions

Funding portals may provide search functions that allow investors to sort through offerings based on objective criteria. The search function may allow for the search to be based on multiple criteria that would result in investors only viewing a limited number of offerings. The SEC identifies examples of acceptable search criteria that include the percentage of the target offering amount that has been met, geographic proximity to the investor, and days remaining before the offering deadline. Any criteria chosen by the funding portal must not cross into advisability of investing.

Providing communication channels

In providing communication channels as required by all intermediaries in offerings under Section 4(a)(6), funding portals have limitations on their participation in those communication channels. Funding portals, and their associated persons, may not participate in the communications through the communication channels. They may only establish guidelines about communication through the provided channels and may remove abusive and fraudulent communications. Funding portals are required to make these communication channels open to the public and only allow potential investors with accounts to post on these channels. Funding portals must require any commenter posting in the channels to disclose if he or she is receiving compensation for promoting an issuer. The SEC clarifies that any communication channel can include ratings of the offering by investors and potential investors (e.g., up-votes, down-votes, likes, dislikes). Any rating system used must provide for both positive and negative ratings. If the funding portal only allows for positive ratings, that may be considered investment advice.

Advising Issuers

Funding portals are permitted to advise an issuer about the structure or content of the offering, which includes preparing the offering documentation. The SEC noted that a funding portal could provide predrafted templates or forms to the issuers, and provide advice on the types of securities the issuer can offer, the terms of those securities and crowdfunding regulations.

Paying for referrals

Funding portals may compensate a third party for referring potential investors to the portal so long as the third party does not provide the funding portal with any personally identifiable information about any of the potential investors. This might include hyperlinks from third parties’ sites. Compensation for such referrals may not be based on the purchase or sale of a security on the portal’s platform unless the third party is a registered broker-dealer.

Compensation arrangements with registered broker-dealers

Funding portals may enter into certain agreements with registered broker-dealers where they can pay each other for services. The proposed rules permit a funding portal to pay or offer to pay a registered broker-dealer for services in connection with an offering made in reliance on Section 4(a)(6). In addition, the SEC allows funding portals to provide services and be paid by a registered broker-dealer in connection with the funding portal’s offer or sale of securities in reliance on Section 4(a)(6). However, the final rules do not allow a funding portal to receive compensation for referrals of investors in offerings made other than in reliance on Section 4(a)(6). This is relevant to the financial considerations for funding portals offering securities of an issuer pursuing concurrent offerings under Section 4(a)(6) and Rule 506(c). The funding portal may not receive commissions for referring accredited investors to a broker-dealer managing the offering under Rule 506(c).

Advertising the funding portal and offerings

Funding portals are subject to limitations on publicity that do not apply to broker-dealers (which have pre-existing and strict rules about advertising and the use of social media). Under the final rules, a funding portal is:

  • Permitted to advertise its own existence;
  • Permitted to identify issuers or offerings in its advertisements based on objective criteria that would identify a large selection of issuers, so long as the criteria used do not implicitly endorse one issuer or offering over others and are consistently applied to all issuers and offerings; and
  • Prohibited from receiving special or additional compensation for identifying or highlighting an issuer or offering in its advertisements.

The rule does not restrict the media formats that funding portals may use to advertise, and is solely focused on the content.

Denying potential issuers access to the platform

To stay within the safe harbor established by the SEC, funding portals may engage in the required activity for all intermediaries to deny access to potential issuers where the funding portal has a reasonable basis for believing that the issuer or the offering presents the potential for fraud, or otherwise raises concerns about investor protection. To meet this requirement, the funding portal must deny access if it reasonably believes that it is unable to adequately or effectively assess the risk of fraud of the issuer or its potential offering. This obligation also applies to issuers or offerings that have been accepted to the platform and the funding portal later becomes aware of the potential for
fraud. In that case, the funding portal must promptly remove the offering from the platform.

Accepting investor commitment and directing the transmission of funds

While funding portals are explicitly prohibited from handling customer funds and securities by statute, they may accept investment commitments on behalf of issuers and direct those funds to be deposited with a qualified third party. The funding portal is permitted to instruct the qualified third party to deliver funds to the issuer upon completion of the offering, or return funds to investors in the event the offering is cancelled. Qualified third parties include registered broker-dealers, and banks or credit unions that have agreed to hold the funds in escrow.

Compliance issues

Funding portals are required to implement written policies and procedures for complying with the various statutory and regulatory requirements for financial intermediaries. In the proposed rules, the SEC noted that funding portals would be required to register as brokers but for the specific exemption from registration that applies to registered funding portals. In the final rules, the SEC determined that funding portals must put in place customer privacy protections of 17 CFR § 248 as they apply to broker-dealers, and the provisions relating to examination and inspection of books and records and facilities by the SEC and FINRA. Of note, the SEC determined that the compliance policies of funding portals do not need to include anti-money laundering provisions. The SEC notes that other parties involved in transactions facilitated by funding portals, such as broker-dealers and banks holding funds, continue to have their own anti-money laundering procedures.

How investors will pay for securities

The statutory authority for crowdfunding and the requirements for intermediaries does not limit or require a particular payment mechanism by investors. The SEC declined to impose any restrictions on the form of payment that intermediaries may accept. For instance, investors will be able to transmit funds to intermediaries (or their escrow agents) by bank transfer, debit card or PayPal accounts linked to debit cards or funds deposited with Paypal. The SEC leaves intermediaries to use their own discretion in determining whether to accept certain payment methods, like credit cards. In the case of credit cards, there are regulatory issues involved in the purchase of securities using credit (“on margin”) and this is likely to be an area where credit card companies may have to deal with a large number of disputes and potential “charge-backs.” For these reasons, credit card companies may decline to provide their services to this industry altogether, and individual intermediaries may choose not to accept credit cards, for either regulatory or economic reasons.

FINRA requirements

On October 9, 2015 FINRA filed with the SEC for approval its rules for funding portals. Under FINRA’s rules, funding portals would not be subject to some of the more onerous obligations of full broker-dealers, such as capital requirements, and FINRA has not proposed that funding portal personnel be required to pass examinations on securities markets and law, although they will be required to demonstrate that they understand and are capable of compliance with securities regulations. Funding portals will be subject to FINRA’s rules relating to their conduct during offerings taking place under Section 4(a)(6). Specifically, funding portals will be required to adhere to “high standards of commercial honor and just and equitable principles of trade”. Additionally, funding portals may not effect any transactions by their own manipulative or deceptive conduct, or by aiding and abetting such conduct of another person, including any issuer. Further, funding portals will be responsible for the content of any “funding portal communication”, which includes all written or electronic communications distributed by or made available by a funding portal, which may include issuer-created content.

Why intermediaries need to check that the issuer has met the conditions of the exemption

The filing of the information set out above to the SEC is one of the conditions of the exemption from registration for an offering by an issuer. As mentioned above, if an issuer does not comply with all of the SEC’s filing requirements, and the omission is not so small that it can fit within the “insignificant deviation” rule, the conditions for the Section 4(a)(6) exemption are not met, and the offer violates the registration requirements of Section 5 of the Securities Act. The remedy for this violation is rescission (i.e., giving the investors their money back; it is like the investors having an ongoing right to “put” the securities back to the issuer). If an intermediary were to host on its platform an offering to which a rescission right applied, and no mention were made of that fact, this would almost certainly be an “omission of a material fact” that the intermediary would be responsible for. Intermediaries should therefore check to make sure the issuers have complied with Regulation CF’s requirements, or have a third party do so.

Simultaneous accredited and crowdfunding offerings

The SEC makes clear its position that that an offering made in reliance on Section 4(a)(6) should not be integrated with another exempt offering. “Integration” means treating two different offerings made at the same time as if they were one offering, subject to all the conditions of both offerings. Because the SEC will not automatically integrate Section 4(a)(6) offerings with other offerings, an issuer may make a Section 4(a)(6) offering that occurs simultaneously with, or is closely preceded or followed by an offering made under Regulation D. While the offers will not be integrated, an issuer must take care that if the Regulation D exemption prohibits general solicitation (e.g. Rule 506(b)), purchasers in that offering may not be solicited by the Section 4(a)(6) offering. Similarly, if the other exemption allows for general solicitation (e.g., Rule 506(c)), then those general solicitations may not include advertisements prohibited under Section 4(a)(6).

It seems likely that “side-by-side” offerings, made to “accredited” investors under Rule 506(b) or 506(c) alongside offerings to unaccredited friends and family in reliance on Section 4(a)(6), will become popular. Rule 506 does not mandate specific disclosure, but the mandatory information requirements would be relatively easy to comply with for most issuers making a Rule 506 offering, and the modest additional costs would be more than offset by the goodwill engendered by including customers and early supporters. In particular, the disclosure requirements under Regulation CF are easier to comply with than the requirements that apply if non-accredited investors are included in an offering under Rule 506(b).

Side-by-side offerings of this type may be most easily undertaken by fully registered broker dealers, who would be able to charge commissions for both the accredited and nonaccredited investors. Funding portals may need to act as “bulletin boards” (platforms that do not solicit investors and do not charge commission) or form a relationship with a fully-registered broker with respect to the Rule 506 portion of the offering. This should not be done without the advice of experienced securities law counsel.

The ability to make concurrent offerings means that, when structured properly from a regulatory point of view, a crowdfunding offering can include an accredited investor component increasing the overall size significantly beyond $1 million and not imposing any investment limitations on accredited investors.

Relief for insignificant deviations

The statutory and regulatory requirements for crowdfunding issuers and intermediaries are complex and extensive, and inexperienced issuers may innocently fail to comply with them. The SEC has adopted a three-prong test that would provide issuers a safe harbor for insignificant deviations from a term, condition, or requirement of Regulation CF. In order to qualify for the safe harbor under proposed Rule 502, the issuer relying on the exemption in Section 4(a)(6) must show:

  • The failure to comply with a term, condition, or requirement was insignificant with respect to the offering as a whole;
  • The issuer made a reasonable and good faith effort to comply with all terms, conditions, and requirements of Regulation CF; and
  • The issuer did not know of the failure to comply, where the failure to comply with a term, condition or requirement was the result of the failure of the intermediary to comply with the requirements of Section 4A(a) and the related rules, or such failure by the intermediary occurred solely in offerings other than the issuer’s offering.

So long as the issuer acted in good faith while attempting to comply with the rule, the issuer should not lose the Section 4(a)(6) exemption just because there was a failure to comply with the rule that was insignificant in light of the offering as a whole. The third prong of the safe harbor provision should prevent an issuer from losing the exemption in Section 4(a)(6) because an intermediary violated Section 4A(a). If the issuer knows of the intermediary’s failure to comply with a term, condition, or requirement of Regulation CF, and does nothing to correct it, the issuer will lose the exemption.


The statutory language expressly set out the liability imposed on issuers for making false or misleading statements and omissions. Section 4A(c) of the Securities Act, added by the JOBS Act, provides that an issuer, including its officers and directors, will be liable to the purchaser of its securities in a transaction under Section 4(a)(6) if the issuer makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which there were made, not misleading. The company and its officers and directors bear the burden of proof with this respect to this liability: they must show that they did not know, and in the exercise of reasonable care, could not have known of the misleading statement or omission. The statutory language applies this liability to “any person who offers or sells the security in such offering.” The SEC (applying interpretation set out in a Supreme Court case) originally noted that on the basis of this definition, intermediaries, including funding portals, would be subject to this liability.

While many commenters objected to this interpretation, the SEC declined to retract the statement or to create an exemption from liability for funding portals (or any intermediaries). The SEC states that the status of an intermediary as “issuer” will depend on a facts and circumstances analysis. The SEC points out that there are appropriate steps that intermediaries might take in order to rely on the “reasonable care” defense provided by Congress. These steps may include establishing policies and procedures reasonably designed to achieve compliance with Regulation CF, conducting a review of the issuer’s offering documents before posting them to the platform, to evaluate whether they containmaterially false or misleading information. CrowdCheck can help with these processes.

Issuers and intermediaries should be aware that the JOBS Act and Regulation CF do not limit liability associated with other anti-fraud rules and statutes of the securities laws that already exist. For instance, issuers will continue to face liability for manipulative or deceptive practices or misleading statements under Rule 10b-5. Additionally, intermediaries, issuers, and anyone who “willfully participates” in an offering could be liable for false or misleading statements made to induce a securities transaction under Section 9(a)(4) of the Exchange Act.

It is to be hoped that the issue never comes up because no intermediaries find themselves defending allegations of misleading statements, but it is interesting that there has been no discussion of the impact of the Supreme Court 2010 Janus decision on potential intermediary liability. This decision examined what it means to “make” a misleading statement under Rule 10b-5, which has many common elements with Section 4A(c). In addition to SEC liability for securities law violation, FINRA imposes liability on funding portals and broker-dealers that violate the FINRA rules of conduct. Under FINRA Rules 2010, 2020, and funding portal Rule 200, brokers and funding portals are required to observe high standards of commercial honor and not to engage in manipulative, deceptive, or other fraudulent devices. Additionally, funding portal Rule 200 prohibits a funding portal from including on its website information from an issuer that the portal knows or has reason to know contains any untrue or misleading statement.

State law

Under the JOBS Act, the states are pre-empted from requiring registration of Section 4(a)(6) offerings, but there is no restriction of their ability to take enforcement action with respect to fraud or deceit by issuers, brokers or funding portals. States may impose fees if they are the principal place of business of the issuer or if more than half the purchasers of a crowdfunding offering are in that state. A funding portal’s home state may regulate the portal, but cannot impose different or additional rules. The SEC declined to mandate that the issuer provide any information directly to state securities regulators on the assumption that state securities regulators would be able to access the issuer’s mandatory disclosures on EDGAR.

Resale restrictions

Securities issued pursuant to Section 4(a)(6) are not freely transferrable by the purchaser for one year after the date of purchase. The statutory text outlines four situations in which a transfer may be made prior to the end of the one-year period; the SEC did not significantly alter these provisions in its Rule 501. Prior to the end of one year, transfers may be made:

  • To the issuer of the securities;
  • To an accredited investor;
  • As part of an offering registered with the SEC; or
  • To a member of the family of the purchaser or the equivalent, to a trust controlled by the purchaser, to a trust created for the benefit of a member of the family of the purchaser, or in connection with the death or divorce of the purchaser.

The SEC clarified that the restrictions on transfer apply to all holders during the one-year period, whether they purchased their securities from the issuer or in a secondary transaction. The SEC did not provide guidance or structure with respect to subsequent trading of crowdfunding securities. However, it should be noted that the JOBS Act pre-emption of state regulation applies only to the initial offer and sale of securities by the issuer. After the end of the statutory restriction on transfer, investors would likely be able to transfer their securities to someone else without registration at the federal level, in reliance on Section 4(a)(1) of the Securities Act. However, subsequent trades must also be made in accordance with state law (which is only preempted when the issuer is a full SEC-reporting company), and the law varies widely from state to state with respect to how securities of non- public companies can be resold. Crowdfunding securities will thus be extremely illiquid. Any entity providing an exchange or market or liquidity facility for the resale of crowdfunding securities would need to be registered with the SEC as a stock exchange or alternative trading system.

Crowdfunding securities and registration under the Exchange Act

The Exchange Act typically requires companies to become reporting companies under the Exchange Act when their shares are held of record by 2,000 persons or 500 persons who are not accredited investors. Recognizing that offers under Section 4(a)(6) are likely to bring in many shareholders, the JOBS Act exempts Section 4(a)(6) securities from the shareholder threshold. The SEC interpreted the statute in Rule 12g-6 to provide that all securities issued pursuant to a Section 4(a)(6) offering would be exempted from the holders-of-record count under the Exchange Act. In other words, the exemption follows the security, not the purchaser. So if a purchaser resells Section 4(a)(6) securities to another person after one year, there is no change to the number of holders of record. Issuers will have to make sure their securities sold under Section 4(a)(6) bear clear identification as such. In a change from the proposed rules, the exemption from record holder count is conditional upon:

  • The issuer being current in its ongoing reporting obligations;
  • The issuer not having assets more than $25 million; and
  • The issuer engaging a transfer agent registered with the SEC to keep its books.

This conditionality may prove problematic to issuers whose operations (and thus assets) grow rapidly, although the SEC grants them a two-year period in which to transition to full reporting status. Crowdfunding issuers will have to make very sure that they file their annual Form C-ARs on time.

PCAOB’s Role in Enhancing Public Trust and Integrity in Audits

Monday, December 5th, 2016

DATE Dec. 5, 2016

SPEAKER James R. Doty, Chairman

EVENT AICPA Conference on SEC and PCAOB Developments

LOCATION Washington

Let me begin by stating that the views I express are my own and should not be attributed to the PCAOB as a whole or any other members or staff. It is a pleasure to join you for the 44th year of this conference. In addition to the technical training on current and emerging issues the conference provides, it is an important opportunity for those who care about the accounting profession to reflect on the profession’s future in our markets. I believe the profession has a bright future. Society’s needs for assurance are expanding, and I believe the profession is now well-positioned to meet them. But it is not a routine business opportunity. It depends on the profession’s continuing to attend to society’s needs. Since the dark days of Enron and the many other accounting scandals that followed it, both the profession and the PCAOB have worked hard to reestablish the profession’s footing solidly in the public interest. The PCAOB is founded on an idea that is as compelling today as it was in 2002. Establishing an independent, expert, dedicated audit oversight organization – outside the government but overseen by the SEC – would shore up the critical role of the audit in our markets. In my time today, I will cover four themes underlying this idea, to explain how the PCAOB helps provide the profession that solid footing needed to maintain and grow public trust. First, investor protection is enhanced by an independent process that promotes the integrity of audits. Second, the PCAOB plays a vital role as a mechanism for not only managing that process but making a real difference. Third, forging a constructive relationship with firms, albeit a somewhat adversarial one, benefits our economic system, protects investors, provides clarity on essential standards, helps companies stay on track and contributes to capital formation. Finally, the PCAOB can be a catalyst to help the profession achieve the full potential of its role in our capital markets. We know a rapidly changing landscape will require the PCAOB to sustain its investment in innovation, in order to meet the needs of investors and enable public companies in our markets to benefit from a lower cost of capital. In all this, the wisdom of the great English conservative thinker, Edmund Burke, comes to mind – “He that wrestles with us strengthens our nerves and sharpens our skills.” I think Burke would have understood the critical role the PCAOB plays, through independent oversight and review, in strengthening the profession. Before I talk about these themes in more detail, let me tell you about the priorities we addressed in 2016, a very busy year. We continue to do more in the way of outreach, especially to audit committees, with a view to help raise awareness of audit risks and challenges. We issued a report on inspection observations since 2013 related to audit firms’ communications with audit committees. We’ve met with preparers and auditors to understand challenges they have faced in audits of internal control over financial reporting. We have worked with audit firms to implement our new standard on disclosure of the name of the engagement partner and other firms involved in an audit. Those disclosures will begin to be available to investors and markets in 2017. In April, we proposed a new standard on using the work of other auditors. In May, we issued a revised proposal on improvements to the auditor’s reporting model, reflecting changes in light of comments received on the original proposal. All the while, we’ve made significant strides in developing and implementing an improved standard-setting process, providing for deeper research before embarking on new projects as well as enhancing outreach at all stages. In this regard, we’ve held public meetings with our advisory groups on the auditor’s reporting model, audit committee interaction, use of non-GAAP measures, and on various performance standards such as the use of other auditors, specialists, estimates and fair value measurements. We’ve also devoted considerable effort to build our capabilities in research and economic analysis, through our Center for Economic Analysis. Center economists are using economic analysis to judge the impact of new rules and standards, both ex ante and ex post, by applying empirical skills to data collected both publicly and through our inspection program. By improving our economic analysis of standards under development, we can have greater confidence that the benefits of those new standards will justify their costs. We issued a request for public comment on the Center’s first-ever post-implementation review of a standard we issued several years ago to improve engagement quality reviews. Center economists are also evaluating many of the potential audit quality indicators that we vetted publicly in a concept release last year, by aggregating firm data obtained in inspections and conducting empirical tests across firms. We have also posted working versions of eight research papers by distinguished Center scholars on our website. They are undergoing rigorous peer review and may be subject to some change. But they give you a sense of what the PCAOB can, and I believe must, do to understand the motivations and impediments to audit quality. We have issued staff inspection briefs previewing 2015 inspection findings and the scope and objectives of the 2016 inspection cycle. We issued a fifth annual inspection report on our temporary broker-dealer program. We’ve used the growing body of information accumulated in these inspections, and the insights they’ve afforded, to develop a proposal for a permanent program for public comment. Internationally, we secured renewal of the European Commission’s adequacy determination, which allows us to continue to conduct joint inspections of PCAOB-registered firms with European audit oversight bodies. The renewal runs for another six years – double the period of previous such determinations. Last week, we announced a protocol for joint inspections with Italian authorities. There remain just a handful of jurisdictions where we need to but can’t yet inspect PCAOB-registered firms – Ireland, Belgium, Portugal and China. We are well along in achieving protocols in the first three, and we continue dialogue with authorities in China. Where appropriate, we have commenced deeper investigations and disciplinary proceedings. We have experienced a significant increase in enforcement matters relating to potential violations by registered non-U.S. firms. The PCAOB announced settled actions in two of these matters today: one involving materially false audit reports by the Brazil office of a large firm network, the other involving an audit failure by the same network’s Mexican office. In addition to the cases announced today, we made public 47 settled disciplinary proceedings, which exceeds the number of actions announced in 2015. Our litigated proceeding are non-public, but I would like to note that the United States Securities Exchange Commission earlier this fall upheld the PCAOB’s sanction against an audit partner for failing to address deficiencies in his audit of the U.S. subsidiary of an Israeli-based foreign private issuer. We continue to have an active docket of non-public matters involving a range of issues and firms. Addressing the conduct of bad apples not only protects investors, but it protects you as well. Who among you hasn’t, at some point in your career, worked for or along with, or observed, someone you felt put you at risk through careless work or, worse, by simply acceding to aggressive reporting for a career or economic benefit. The heads of several of the PCAOB’s divisions and offices will speak in detail about this work over the course of the next three days: Chief Auditor Marty Baumann, Director of Inspections Helen Munter, and Enforcement Director Claudius Modesti. You’ll also hear from my colleague on the Board, Jay Hanson. None of it would be possible, though, without the support and counsel of the SEC Chair and commissioners, as well as staff in the Office of the Chief Accountant, particularly Chief Accountant Wes Bricker and Deputy Chief Accountant Marc Panucci, who spoke to many of these initiatives this morning. And I know I speak for all of the PCAOB in wishing former Chief Accountant Jim Schnurr well in his continuing recovery. The work I described reinforces the four, fundamental themes I referred to at the beginning. Theme number 1: Investor protection matters, and it is enhanced by auditor oversight It is the flow of certified information in the marketplace that, when perceived as both reliable and relevant to investment decisions, gives uninformed and dispersed investors the confidence to participate in a market as great as that which we enjoy in the U.S. The U.S. federal securities laws emanated from our strategic desire, as a nation, to bolster public confidence in our capital markets for the purpose of restoring and enhancing our ability to form capital for private enterprise. Without concerted effort to maintain and champion a vigilant system of validating the financial information provided to the market, our businesses pay more than they need to for funding. The long term stability of our capital markets and the audit profession’s important role in those markets depends on uncompromising trust. That trust, once lost, cannot be easily regained. If long-term investors don’t have a basis for trust in a company’s statements about its position and plans, short-termism may become the dominant market mentality, stifling innovation and job creation, and, ultimately, hindering economic growth. The PCAOB protects against such erosion. Theme 2: The vital role the PCAOB plays as a mechanism for managing that process is making a real difference In my view, our independent oversight has changed the landscape for the better. Inspections have improved audits, and changed firms’ attitudes and execution. Some of that emerging research I mentioned indicates that when we find deficient audits, the engagement teams raise their game – without a commensurate increase in fees but with a statistically significant reduction in restatements. Issuance of regular inspection reports provides meaningful information that didn’t exist before, and that helps all parties, including investors, audit committees, and companies, make better decisions. Enforcement has helped root out bad apples, and fosters trust in the system. Boards can use our published cases to gravitate to better auditors and better audit practices. We have issued better and clearer audit standards related to the performance of audits. We have also made progress in improving the relevance and transparency of audits. Awareness of our role and mission is now firmly established, and emerging academic research suggests this is helping build public confidence in investing. It is my belief that the PCAOB has a unique and indispensable role in helping companies maintain investor trust, avoid financial reporting failures, and in turn has helped our economy and capital markets remain resilient and grow. Theme 3: Our intent is to forge a constructive relationship with the profession that benefits our economic system, protects investors, provides clarity on essential standards, helps companies stay on track In the PCAOB’s 14 years, our inspectors have examined many thousands of audits and found numerous examples of high quality auditing, including evidence of auditors requiring companies to adjust their accounting or improve their internal controls over financial reporting. These auditors are the unsung heroes who avert the scandals that don’t happen. But our inspectors have also found and reported numerous instances in which firms’ audit reports should not have been issued. No one likes a restatement, but when a material misstatement is identified, an early correction is better for both the company’s investors as well as the company’s reputation, and related cost of capital. The more audits we can review, the more likely the prospect of scrutiny will deter the kind of audit failures that led to the Sarbanes-Oxley Act. This was the organizing principle underlying the creation of the PCAOB, but now we’ve put it to the test and demonstrated that it’s true. Theme 4: As a catalyst to help the profession achieve the full potential of its role in our capital markets, we know a rapidly changing landscape will require the PCAOB to sustain our investment in innovation. That informs our analysis of the work that lies ahead There are four topics under research in our new standard-setting process. None should be surprises, for they have all been on our agenda for some time. They include potential improvements to our quality control standards. Audits also need to take advantage of technology to glean more insights about risks and help focus resources on important areas for follow up. We will study how new tools can best advance investor protection. We will also continue to monitor the auditor’s association with non-GAAP data, especially data purportedly derived from the audited financial statement. And we will give focused attention to the auditor’s responsibilities under the Private Securities Litigation Reform Act of 1995 related to potential illegal acts. The PCAOB is also nearing completion of a project to make the auditor’s report more useful and informative to investors and other financial statement users. This project emanated from Treasury Secretary Paulson’s Advisory Committee on the Audit Profession, which published a number of recommendations in the fall of 2008, including that the PCAOB improve the usefulness of the auditor’s report. Through PCAOB outreach, investors have confirmed the importance of retaining the binary, pass-fail opinion. But in today’s complex economy, and particularly in light of lessons learned after the financial crisis, users of the audit report also want a better understanding of the judgments that go into an opinion. After reflecting on public comment received on a concept release, in 2013, the PCAOB proposed a framework for auditors to report such “critical audit matters.” In the intervening years, there has been promising experimentation with similar frameworks abroad, including by the profession itself through the International Auditing and Assurance Standards Board, which in 2015 adopted requirements similar to those we proposed – to elucidate “key audit matters” in the audit report. There has been positive reaction to these changes from a broad range of market participants, including securities issuers themselves, who have seen expanded audit reports as a tool to signal commitment to high quality and reliable financial reporting. Investors have also welcomed the more insightful reports. One experienced institutional investor said there’s finally “an audit report worth reading.” Auditors, too, enjoy renewed relevance and vitality. The head of one large U.K. firm’s audit practice testified at a PCAOB hearing that in “20-odd years of auditing,” he had never seen so much “interest from investors in what I’m doing.” The change, he said, was “a real positive.” Those are strong testimonials. Earlier this year, we refined our proposal, in light of public comment as well as a robust economic analysis. Although more modest than some other jurisdictions’ requirements, it is a step that will allow companies to distinguish themselves by retaining auditors with track records for more insightful and reliable reports, and will allow auditors to compete to serve such clients on the basis of the quality demonstrated in their reports. In closing, underlying all the PCAOB’s initiatives is the goal to help the profession meet increasing demands in a responsible way that preserves integrity, inspires investor trust and promotes economic vitality.

New Federal Overtime Rules: Do They Matter in California?

Friday, October 21st, 2016

You might recall our post on how California’s new minimum wage plan will be affecting overtime.  Well, now there’s a new set offederal overtime rules that kick in December 1, 2016.  The Obama administration just published the Final Rule that effectively extends overtime eligibility to millions more in the work force.

Here are the two major provisions of the new regulation:

  • Increases the Federal overtime exemption threshold: Salaried employees making less than $47,476 (formerly $23,660) annually are guaranteed overtime pay for any hours worked above 40/week.
  • Increases the threshold for the “highly compensated employee” exemption: Salaried employees making more than $134,004 (formerly $100,000) annually are exempt from overtime provisions (as long as they regularly do administrative, executive, or professional work, and not manual labor)
  • Automatically adjusts every three years: The numbers will be readjusted to match the 40th percentile income level of full-time salaried workers of the US’s poorest region (currently the south).

How Does This Affect Me?

New Federal Overtime Law Chart

If you’re in California… not a whole lot.

As it currently stands, California employees are subject to overtime laws by default.  As we discussed in an earlier post, the employer has to prove that an employee fits a specific exemption in order to not pay overtime.  Probably the most common is for workers who 1) are primarily doing intellectual/creative/managerial work and 2) make at least twice the minimum wage.  For salaried employees, that means they must make more than $41,600/year to be subject to that state exemption.  Factoring in the new minimum wage plan, that number will increase to $43,680 on January 1, 2017 (just 31 days after the federal regulation kicks in), and will surpass the new federal regulation on January 1, 2019 (at $49,920/year).

That means that for those using just this exemption, the only impact is for employees salaried between twice the state minimum wage and $47,476/year, and even that will last for just over two years (see the above chart).

For California employers, the most significant change is for those currently using other state overtime exemptions, like the sheepherder exemption (yeah, it’s on the list).  If your sheepherder is salaried at $25,000/year, then they were exempt from both federal and state overtime provisions in 2015, but will no longer be exempt federally after December 1, 2016.  Pay close attention the the exemptions you’re using so that this doesn’t sneak up on you, and, as always, keep meticulous records of your employees’ hours!


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