SEC Disclosure Matters

New York Relents on Form D Filings

Form D FilingsAs of December 2, 2020, New York has joined other states in requiring that Form Ds filed with the SEC for securities offerings be submitted to the state via the EFD electronic system, replacing the state’s previously-required Form 99.

New York has long been a holdout on this front since 1996 when Congress passed the National Securities Market Improvement Act, which was intended to rationalize the crazy quilt patchwork of individual state “blue sky” laws to be complied with wherever securities were sold. NSMIA expressly preempted any requirements from a state beyond filing a copy of the Form D along with a filing fee and a consent to service of process. Most states quickly amended their blue sky laws to require only what NSMIA permitted. New York, however, continued to require the filing of a Form 99, which clearly required more disclosure from issuers than was permitted under NSMIA. …

The SEC is Enforcing Accredited Investor Verification Rules

The SEC is Enforcing Accredited Investor Verification RulesThe SEC recently brought an enforcement action against a fund investing in digital assets for a failure to register a sale of securities under Section 5 of the Securities Act. The fund had filed a Form D with the SEC that, in itself, offers no clue as to what went wrong. The form reports the sale of fund interests under the exemption provided by Rule 506(b) of Regulation D. This is the common exemption used for private placements of securities, and by complying with the applicable rules under Regulation D, there would be a safe harbor protecting the issuer against a registration violation.

Does It Matter that Few Investors Read SEC Disclosure?

Jason Zweig, writing in the Wall Street Journal, discusses efforts to make securities disclosure more understandable to the typical investor. He quotes the Nobel-laureate behavioral economist Richard Thaler as saying that “nobody reads” the dense disclosure mandated by the SEC. This is clearly a bit of hyperbole, but I think we can all agree that a majority of investors don’t read a prospectus cover to cover before making their investment decision. The question is what to do about it.

The SEC Expands the Pool of Smaller Reporting Companies

The SEC Expands the Pool of Smaller Reporting CompaniesThe SEC has greatly expanded the number of public companies that can take advantage of the “scaled disclosure” provisions of Regulation S-K. Under these rules, smaller reporting companies have less onerous requirements that apply to their periodic filings. For example, smaller reporting companies do not need to include the lengthy Compensation Discussion and Analysis disclosure that larger companies do. Following the SEC’s recent action, the definition of “smaller reporting company” includes registrants with a public float of less than $250 million (up from $75 million), as well as registrants with annual revenues of less than $100 million for the previous year and either no public float or a public float of less than $700 million (previously, less than $50 million of annual revenues with no public float).

What We Can Learn from Changes in Public SEC Filings

Title III CrowdfundingPeter R. Orszag, writing in Bloomberg View, highlights a study of public SEC-filed Form 10-K annual reports, which found that companies that make changes to the disclosure in their 10-Ks from one year to the next tend to have lower stock returns than average after publication of those changes. The study found that a significant majority of the changes constituted disclosure of negative information, so the resulting decline in performance is not surprising.

The Presumed Sophistication of Accredited Investors

The Presumed Sophistication of Accredited InvestorsA recent Wall Street Journal article highlighted how sketchy brokers have been marketing problematic private placements to accredited investors. While the article focused on the brokers, I was struck by the identity of one of the investor victims noted in the article as having lost a lot of money: George Stephanopoulos, the ABC News anchor and former Clinton Administration official. I don’t mean to cause Mr. Stephanopoulos any further embarrassment by highlighting this here (though I’m guessing that the readership of my blog is far less than that of the Journal), but the fact that he was scammed is a useful illustration of the misguidedness of the accredited investor definition and associated rules.

The current definition of “accredited investor” under SEC rules essentially uses wealth as a proxy for sophistication, as an individual can qualify by either having an annual income of $200,000 or a net worth of $1 million not including the value of one’s primary residence. An offering made to all accredited investors does not have an information requirement, meaning the investors do not need to be provided with a similar level of disclosure that would be associated with a registered public offering.

A Possible Change to the “Accredited Investor” Definition

Accredited InvestorSecurities offerings that are exempt from the SEC’s registration requirements often hinge on whether some or all of the investors are “accredited investors.” There are various categories of accredited investors for business entities, but for individuals, the categories relate to the investor’s annual income, net worth or whether the individual is a director or executive officer of the issuer.

The underlying policy of the current definition of accredited investors is that rich people (a term not used in the actual rules, obviously) can be assumed to have a level of financial sophistication such that they would conduct adequate due diligence before making an investment. Accordingly, accredited investors require less disclosure about proposed securities offerings. This assumption is, shall we say, not attuned to human reality. The obvious group of accredited investors that are not necessarily sophisticated is heirs and spouses of wealthy business people, who may have no background at all in finance and investment matters. But even for those accredited investors who have directly earned the money that grants them that status, plenty are in fields such as sports and entertainment where the particular skill that is remunerative to them has nothing to do with investing. Additionally, many white collar professionals such as doctors, engineers and even some attorneys may be highly educated, but they are not able to make heads or tails of a balance sheet and income statement. …

The Pitfalls of Being an OTC Public Company

Title III CrowdfundingThe SEC’s Division of Economic and Risk Analysis (DERA) recently issued a paper about over-the-counter stocks, i.e., stocks of publicly traded companies that are not listed on a national securities exchange like the New York Stock Exchange or Nasdaq. While the main subject of the paper is on the inadvisability of individual investors purchasing OTC stocks, my focus here, briefly addressed in the paper, is on whether the companies themselves should consider transactions that result in them having OTC stock. For example, companies that are not in a position to complete a traditional IPO may be able to go public via a backdoor method such as merger with a SPAC or a reverse merger.

For these companies, the usual plan is not to remain an OTC company forever, with thinly traded stock and low institutional ownership. Rather, the hope is that, with the capital usually raised concurrently with the transaction that made the company public, it can successfully execute its business plan such that it can meet the listing standards for admission on the NYSE or Nasdaq at a later date. However, this scenario rarely plays out in practice. Studies cited in the DERA paper find that, over a nine-year period, less than 9% of OTC companies became listed on an exchange, and even those that do have a poor average investment return.

Accordingly, any company planning to go public by alternative means has to consider the possibility of remaining in OTC status indefinitely. There are some advantages to being public. It may be easier to attract employees with equity compensation packages, since there is an easier path to eventually selling shares than would be the case with a private company. Also, public company stock can be used to acquire other companies (though a target company may be skeptical about receiving OTC stock). Finally, there are forms of financing like PIPEs that are available only to public companies (though the terms of those transactions are not necessarily any more company-favorable than investments that private companies can secure).

The SEC Proposes Expanding the Pool of Smaller Reporting Companies

The SEC recently proposed greatly expanding the definition of “smaller reporting company” applicable to public companies that file reports under the Securities Exchange Act of 1934 (10-Ks, 10-Qs, etc.). As someone who has done most of my public company work for smaller reporting companies, I can confirm that this will be a huge regulatory relief for those companies who now fall under the definition. …

The SEC’s Discussion of Risk Factors

The SEC's Discussion of Risk FactorsThe SEC recently issued a long concept release seeking public comment on ways to modernize Regulation S-K, the set of disclosure requirements used both for Securities Act registration statements like Form S-1 and Exchange Act reports like Form 10-K. (As a side note, the term “concept release” invariably brings to my mind concept albums by bands like Pink Floyd.) Given my (self-imposed) limit on the length of my blog posts, I will confine my discussion of the release for now to just one point: the SEC’s solicitation of comment on the suggestion that companies provide, in the Risk Factors section, estimated probabilities of the relevant event occurring and the magnitude of the effect on the company if it does occur.