SEC Disclosure Matters

The SEC’s SPAC Proposal and Projections

The SEC has issued its long-expected proposed rules regarding SPACs. Here are the proposing rule release and the shorter press release. The SEC has always been skeptical of SPACs, and the rules are generally designed to impose new disclosure requirements on SPACs that make the rules more aligned with those applicable to traditional IPOs. One of the reasons SPACs had their moment in the sun recently is that they are easier to complete than IPOs, so the rules, if enacted, could have the effect of severely dampening the market for SPACs, even if they do nothing to directly restrict them from being done. In fact, the general expectation that rules like these were coming down the pike has, anecdotally, been a factor in the SPAC market slowing down recently.

One of the key areas in the proposed rules relates to projections. Under current rules, companies merging with a SPAC can include projections about the company’s future expected results and can benefit from a safe harbor protecting it from litigation if the projections don’t come to pass, as long as the projections are accompanied by a disclaimer and the companies don’t have actual knowledge that they won’t come true. In contrast, companies going public the traditional way don’t have the benefit of this safe harbor. The proposed rules would eliminate the safe harbor in the SPAC context, which would have the practical effect of precluding most projections from being presented.

There are exceptions, but companies doing traditional IPOs are generally more mature than those seeking to go public via SPAC, which are often pre-revenue (or at least pre-profit). This doesn’t mean the companies are inherently dodgy; rather, there are hurdles to meet, like further research and development, regulatory approvals, etc., before they can actually realize a profit. In a way, it makes sense that these early-stage companies would want to include projections to give potential investors a picture of how an investment could perform, since the historical financial statements don’t provide much useful information about where the company is going. However, trying to project future financial results for companies before they are fully doing the thing that they’re hoping to do is an inherently imprecise undertaking.

Suppose a company projects that its revenues will increase twenty-fold over the next five years, which could be a completely legitimate, good-faith estimate in particular contexts (though laughably unrealistic in others). If this company actually ends up achieving a fifteen-fold increase, most early investors would be happy with that result and wouldn’t feel aggrieved, but the projection would have been off by hundreds of percentage points.

I’m not a regular investor in early-stage companies, just an advisor and observer, but from my perch I can see that there is high demand for projections – investors want to see them to inform their go/no-go decisions and companies want to make them to attract investment with blowout return scenarios. But making a decision based on whether the projected numbers reach an exact threshold you have in mind seems misguided, whether it’s the company or the investor making the projection. The whole point of equity investing versus debt is that you have theoretically unlimited gains, paired with a higher risk of losses. If you’re going to be in the business of investing in early-stage companies, the general strategy is to diversify: do whatever due diligence you can, but accept that success is inherently uncertain and hope that by spreading the investments to a wide number of ventures, the outsized gains from the hits will more than offset the failures. Trying to artificially impose precision on this by distinguishing between a projection of 10X or 50X or whatever doesn’t seem to be to be a productive use of an MBA.

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. …