Category: Securities Law

Rulemaking Petition Seeks SEC Guidance on NFTs

A recent rulemaking petition to the SEC requests that the agency issue a concept release on nonfungible tokens, or NFTs. The petition is hopeful that an SEC rulemaking paired with an opportunity for public input will resolve regulatory uncertainty for parties looking to create NFTs and facilitate their sale.

The petition opens by noting that the federal securities laws, first written in the 1930s, “provide a crude mechanism for the regulation of NFTs.” It then uses the SEC’s Howey guidance to consider whether NFTs should be deemed securities for purposes of the federal securities laws. The petition observes that if NFTs are deemed securities, platforms facilitating their sale and secondary trading may be deemed exchanges, broker-dealers or alternative trading systems under SEC rules. However, consistent with the market’s current approach to the issue, the petition also posits that if an NFT “relates to an existing asset and is marketed as a collectible with a public assurance of authenticity on the blockchain, it should not be deemed a security.”

To allay any potential uncertainty in the future, the petition urges the SEC to issue a concept release (which is the SEC’s term for an advance notice of proposed rulemaking under the Administrative Procedure Act) on the status and regulation of NFTs under the federal securities laws. Because NFTs do not typically function as traditional securities, the petition advocates that the SEC provide guidance that defines when an NFT is a security and what type of registration is required by firms facilitating the trading of NFTs. Doing so will, according to the petition, stimulate innovation and promote market integrity, capital formation, and protection of investors.

As we have previously noted, new SEC Chairman Gary Gensler brings a deep understanding of blockchain and digital assets to the agency. The crypto community has been hopeful that he will also bring a more progressive attitude towards the regulation of digital asset securities. Mr. Gensler is scheduled to testify for the first time as SEC chairman before the full House Financial Services Committee on May 6, 2021, but his prepared testimony does not address digital assets. As NFTs continue to proliferate, weighing in on this asset class will provide a great deal of insight to Chairman Gensler’s broader approach to the crypto space in his new role.

Copyright © 2021, Hunton Andrews Kurth LLP. All Rights Reserved.

ARTICLE BY Scott H. Kimpel of Hunton Andrews Kurth
For more articles on NFTs, visit the NLR Corporate & Business Organizations

How a CEO Can Be Liable for a Noncompliant Business

Your company is being targeted in a civil lawsuit. A whistleblower has filed a complaint with the U.S. Securities and Exchange Commission (SEC). The Internal Revenue Service’s Criminal Investigations Division (IRS-CI) is investigating your company for tax fraud. As the company’s chief executive, are you at risk for personal liability exposure?

Maybe. While most corporate liabilities reside exclusively at the corporate level, there are circumstances in which CEOs can be held liable for their companies’ noncompliance. In certain circumstances, CEOs can face personal civil, or criminal liability for acts taken by, or on behalf of, their companies. Litigation and investigations targeting businesses’ noncompliance can also lead to the discovery of wrongs committed by CEOs in their individual capacities, and these discoveries can lead to personal liability as well.

“CEOs can potentially face personal liability in a broad range of circumstances. As a result, CEOs need to take adequate steps to mitigate their risk, and they must be prepared to defend themselves during (and in some cases after) corporate investigations, litigation, and enforcement proceedings. ” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C. 

3 Types of Scenarios in Which CEOs Can Face Personal Liability Arising Out of Corporate Noncompliance

There are three main types of scenarios in which CEOs can face personal liability arising out of corporate noncompliance. However, within each of these three broad areas, there are numerous possible examples; and, as discussed below, CEOs need to implement appropriate measures to mitigate their personal risk. The three main types of scenarios in which CEOs can face personal liability are:

  • Piercing the corporate veil
  • Acts and omissions in the CEO’s corporate capacity
  • Acts and omissions in the CEO’s personal capacity

1. Piercing the Corporate Veil

Even outside of the legal and corporate environments, it seems that most people are familiar with the phrase, “piercing the corporate veil.” However, few people (including people in the legal and corporate environments) have a clear understanding of what this phrase actually means.

Piercing the corporate veil refers to the act of holding a company’s owners and executives liable for the company’s debts. This can include either debts owed to commercial creditors, debts owed to judgment creditors, or both.

Corporations, limited liability companies (LLCs), and certain other types of business entities insulate owners and executives from personal financial responsibility for corporate debts. Owners and executives enjoy “limited liability” based on the existence of the business entity, which itself is classified as a “person” for most legal purposes. If the company gets sued, the limited liability protection afforded to its owners and executives means that they are not at risk for facing judgments in their personal capacities—in most cases.

But, there are various circumstances in which the veil of limited liability can be pierced (or, in plain English, in which a CEO can be held financially responsible for a company’s debts). Three of the most common circumstances that allow for piercing are:

  • Commingling – If a CEO commingles his or her personal assets with the assets of the business, a court may find that there is an insufficient distinction between the two. For example, if a small business owner/CEO deposits payments for accounts receivable into his or her personal account, a judge might determine that since the business owner/CEO is not respecting the company’s existence, the court should not respect it, either.
  • Failure to Observe Corporate Formalities – In addition to commingling, failure to observe other corporate formalities can lead to piercing as well. This includes failure to observe formalities such as preparing meeting minutes and resolutions, making annual filings, and separately purchasing assets for personal and business use.
  • Insufficient Corporate Assets – Judges have also allowed piercing in circumstances in which companies are grossly undercapitalized. Essentially, if a company is undercapitalized and takes on more debt or risk than it can reasonably handle, then a judge might hold the company’s owner and/or CEO personally liable as a result of failing to endow the company with the funds it needed to operate in good faith.

In piecing cases, CEOs can face full liability for debts incurred at the corporate level. Theoretically, this is true even if the CEO did not personally participate in the conduct that gave rise to the liability. The CEO’s personal liability attaches not as a result of the underlying wrong, but as a result of the CEO’s failure to observe and respect the requirements for securing limited liability protection.

2. Personal Liability for Acts and Omissions Committed in the CEO’s Corporate Capacity

Even when piercing is not warranted, CEOs can still face personal liability if they commit certain wrongful acts in their corporate capacity. CEOs can also face criminal culpability for crimes committed in their corporate capacity (including crimes purportedly committed for or in the name of the company).

For example, this has come up multiple times recently in federal Paycheck Protection Program (PPP) loan fraud investigations. In these investigations, companies are facing penalties for fraudulently obtaining (or even just applying for) PPP loans during the pandemic. But, in many cases their CEOs are facing personal liability as well. Typically, this liability is the result of either (i) the CEO submitting a fraudulent PPP loan on the company’s behalf, or (ii) simply being at the helm of an organization that fraudulently applied for and/or obtained federally-backed funds from a financial institution.

In most cases, in order for a CEO to be held liable for an act or omission committed in the CEO’s corporate capacity, the act or omission must either:

  • Have been committed intentionally;
  • Constitute gross negligence;
  • Constitute a criminal act; or
  • Fall outside of the CEO’s actual or apparent authority.

In addition to federal law enforcement investigations, this type of liability exposure frequently arises in civil litigation (where plaintiffs will often pursue claims against multiple related parties and individuals) and in shareholder derivative cases. If a plaintiff or group of shareholders believe that a CEO is directly responsible for the company’s conduct or performance, then the CEO will need to engage his or her own defense counsel for the litigation.

3. Investigations and Litigation Targeting CEOs in Their Personal Capacity

The third main type of scenario in which CEOs will face personal liability for business noncompliance is when litigation or an investigation at the corporate level leads to scrutiny of the CEO’s conduct in his or her personal capacity. For example, if IRS-CI investigates a company for tax fraud and there is evidence to suggest that the CEO may have been embezzling funds or withholding income from his or her own returns, then the CEO could face an investigation as well.

What Can CEOs Do to Protect Themselves from Personal Liability?

Given the risk of facing personal liability, what can – and should – CEOs do to protect themselves? Just as CEOs need to manage their companies’ risk effectively, they need to manage their own risk as well. Similar to corporate risk mitigation strategies, CEOs’ risk mitigation strategies should focus on (i) understanding their risks, (ii) understanding what it takes to maintain compliance, (iii) purchasing adequate insurance coverage, and (iv) knowing what to do in the event that a liability risk arises.

  • Understanding CEOs’ Risks – Mitigating risk starts with understanding the risks that need to be mitigated. For CEOs, while some of these risks mirror those that exist at the corporate level, others do not. While CEOs don’t necessarily need to implement risk mitigation practices that are on par with those of their companies, they do need to ensure that they have a clear understanding of the acts and omissions that have the potential to lead to trouble.
  • Understanding and Maintaining Compliance – CEOs need to have a clear understanding of what it takes to maintain compliance in both their corporate and individual capacities. At the corporate level, this ensures that CEOs don’t make mistakes that have the potential to be classified as criminal, intentional, or grossly negligent conduct. At the individual level, this helps mitigate against the risk of facing personal liability as a follow-on to a corporate-level lawsuit or investigation.
  • Purchasing Insurance Coverage – CEOs can purchase directors and officers (D&O) liability insurance coverage to mitigate against the risk of facing personal financial responsibility for noncompliance. However, CEOs also need to understand the limitations of D&O coverage. Policies often exclude claims based on gross negligence or failure to exercise the duties of a CEO’s office in good faith—and this means that lawsuits often target allegations based on gross negligence and bad-faith conduct so that plaintiffs can seek damages beyond CEOs’ D&O policy limits.
  • Knowing How to Respond to Liability Risks – Finally, CEOs need to know how to respond to liability risks. Just as companies should have policies and procedures for responding to lawsuits and investigations, CEOs should have discussions with their personal legal counsel so that they know what to do when a claim or inquiry arises. While there is certainly the possibility that a reactive response could be too little too late, when coupled with the other mitigation strategies discussed above, acting quickly in response to a threat can help reduce the likelihood of facing a civil judgment and/or criminal charges.

Oberheiden P.C. © 2021

ARTICLE BY Dr. Nick Oberheiden of Oberheiden P.C.
For more articles on compliance, visit the NLR Corporate & Business Organizations Section.

Oops: NASDAQ Seeks to Correct a 2009 Error Re: ADR Listing Requirements

On Wednesday, April 7, 2021, the U.S. Securities and Exchange Commission (“SEC”) issued Release No. 34-91492 publishing a Proposed Rule Change by NASDAQ to amend the requirements for listing ADRs on each of NASDAQ’s Global Select AND Global Markets.

American Depository Receipts

“ADRs” are American Depository Receipts. They have a long history in the U.S. capital markets, having been invented by J.P. Morgan in 1927 to facilitate access to the American stock market by Selfridges, an iconic British department store organized and managed by an American expatriate as the second-largest (after Harrod’s) department store in the UK in 1909 (and featured in a BBC TV series of that name about both the store and Mr. Selfridge). ADRs are depository receipts issued by an American bank when the underlying securities are deposited in a foreign depository bank. There are some interesting complexities about ADR’s depending on whether the ADR is a Level 1 ADR, or whether it is a Level 2 Sponsored ADR, which requires filing a separate registration statement with the SEC. And then there are Level 3 ADRs that require the foreign company to not only file a Form F-1 with the SEC but to adhere either to U.S. GAAP accounting standards OR IFRS as published in the IASB. The April 7 NASDAQ Proposal does not directly impact any of these ADR complexities.

Listing requirements are just that: the conditions a company must meet in order to have its securities traded on NASDAQ. NASDAQ has three market tiers: the Global Select Market, the Global Market, and the Capital Market. The Capital Market is the trading tier with the least stringent requirements for listing. The NASDAQ Global Market requires that the companies seeking to list on it must have some international attributes and substantially higher financial and governance features. The NASDAQ has the most rigorous listing requirements and is the tier for leading international companies.

NASDAQ Listing Requirements

Until 2009, NASDAQ required that at least 400,000 ADRs be issued in order to be listed on any of the three NASDAQ tiers, insure that there would be sufficient liquidity and “depth in the market” to support public trading. Then in 2009, as part of a “housekeeping,” NASDAQ moved the listing requirements for ADRs on the Global Market AND the Global Select Market to a new section of NASDAQ listing requirements that had NO minimum number of ADRs in order to be listed on those tiers. Ironically, the least restricted trading tier RETAINED the 400,000 ADR requirement. Recently, someone at NASDAQ noticed the disparity. Fortunately, NO issue with fewer than 400,000 ADRs has been listed on either the Global Select or Global Market tiers in the 12 years since 2009. Now, NASDAQ seeks to reimpose the 400,000 minimum ADR requirement for ALL NASDAQ tiers. As this proposed change to the listing requirements is a simple reinstatement of a condition accidentally omitted in the 2009 “housekeeping,” and as no present listing will be adversely affected, NASDAQ requested, and the SEC granted, a waiver of the normal 30-day period before a change might take effect.

While, as Alexander Pope wrote: “To err is human, to forgive, divine;” to correct may even be better.

©2021 Norris McLaughlin P.A., All Rights Reserved

ARTICLE BY Peter D. Hutcheon of Norris McLaughlin P.A.
For more articles on the SEC, visit the NLR Securities & SEC section.

SEC Ventures Into The Dark Web, But Can It Establish A Connection?

In March, the Securities and Exchange Commission announced its first securities enforcement action involving the “dark web”.  The SEC’s complaint describes the “dark web” as referring to “a subset of the deep web that is intentionally hidden, requiring specific software to access content”.   The SEC states that the “deep web” refers to “anything on the internet that is not indexed by, or accessible via, a search engine like Google”.

The SEC’s complaint alleges that the defendant “offered and sold on one of the dark web marketplaces various purported
‘insider tips’ that he falsely described as material, nonpublic information from the insider trading forum or corporate insiders”.  I found this interesting because the SEC wasn’t charging the defendant with insider trading but with selling false insider tips.  This may be fraudulent, but is it it a securities law violation?  Stock tips, whether false or true, are not themselves securities.  How does the SEC bring the defendant’s allegedly fraudulent conduct under the securities laws?

To establish a violation of Rule 10b-5, the SEC must prove that the defendant’s activities were “in connection with” the purchase or sale of a security.  Here, the defendant’s deception did not relate to securities that he sold to investors.  The SEC’s complaint attempts to connect the defendant’s activities to securities transactions by alleging  that traders paid for the tips using Bitcoin, and used the fake insider information to purchase and sell stock of various publicly traded companies.  In SEC v. Zandford, 535 U.S. 813 (2002), the U.S. Supreme Court found that the person deceived do not have to be counterparties to the person committing the fraud.  However, the defendant in this case might argue that his fraud was complete when he sold the false tips and therefore the SEC cannot establish the requisite connection.  I will be interested to learn whether this becomes a contested issue at trial.

© 2010-2020 Allen Matkins Leck Gamble Mallory & Natsis LLP

ARTICLE BY Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP
For more articles on the SEC, visit the NLR Securities & SEC section.

Three Critical Questions That Will (Hopefully) be Answered by the SEC’s Lawsuit against Ripple

Late last year, the SEC filed a litigated action in the U.S. District Court for the Southern District of New York against Ripple Labs Inc. and two of its executive officers (collectively, “Ripple”), alleging that Ripple raised over $1.3 billion in unregistered offerings of the digital asset known as XRP. Ripple opted not to file a motion to dismiss the complaint, and based on recent filings it appears that the parties do not believe a pre-trial settlement is likely. The SEC’s complaint alleges that, beginning in 2013, Ripple raised funds through the sales of XRP in unregistered securities offerings to investors in the U.S. and abroad. Ripple also allegedly exchanged billions of XRP units for non-cash consideration, including labor and market-making services. The SEC’s complaint also named as defendants two executives of Ripple who allegedly effected personal, unregistered sales of XRP totaling approximately $600 million. According to the SEC, during all of this, Ripple failed to register its offers and sales of XRP, or satisfy any exemption from registration, in violation of Section 5 of the Securities Act of 1933.

The SEC’s case rests on the proposition that XRP is a security – if it is not, the SEC lacks jurisdiction. In SEC v. Howey, the Supreme Court provided a framework for determining whether certain assets are “investment contracts,” and therefore, are securities (Section 3(a)(10) of the Securities Act defines the term “security” to include an “investment contract”). In what is now known as the “Howey Test,” the Court explained that an asset is a security if it represents an investment in a common enterprise with the expectation of profits derived solely from the efforts of others. In its complaint, the SEC argues that XRP is a security because investors who purchased XRP anticipated that profits would be dependent upon Ripple’s efforts to manage and develop the market for XRP. Ripple has disputed the SEC’s allegations, arguing that XRP is a “fully functioning currency that offers a better alternative to Bitcoin.”

The Ripple case raises three very important questions regarding digital assets, and may provide a vehicle for the SEC or the court to offer answers to those questions:

  1. When does a digital asset transition from a security to a currency (or something else)? At one end of the spectrum, the SEC has made it clear that it views almost any initial coin offering (ICO) to involve the offer of securities. At the other end, there is Ether, which today relies on a distributed ledger without a centralized administrator. In 2018, then Director of the SEC’s Division of Corporation Finance, William Hinman, stated publicly that “putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” XRP probably falls somewhere in between those two extremes. Because of that, this case may present a unique opportunity for the SEC or the court to shed further light on how and where to draw the line between a security and a currency.
  2. How will President Biden’s administration approach digital assets? Under Chairman Clayton’s leadership, the SEC took a deliberate approach towards digital assets and, as reflected by the Ripple case, was not hesitant to bring enforcement actions in this space. President Biden has nominated Gary Gensler to the be the next SEC Chair. For the past few years, Mr. Gensler has been a Professor at MIT, teaching courses on blockchain and crypto assets. He will almost certainly have strong views on how the SEC should approach digital assets. As this litigation progresses, we may gain some insight into those views.
  3. How should disgorgement be calculated for a violation of Section 5 (and only Section 5) after the Supreme Court’s decision last year in Liu? In the Ripple case, the SEC has alleged that the company raised over $1.3 billion from sales of XRP, and the two individual defendants sold approximately $600 million of XRP. In the past, the SEC has often argued that all proceeds of an offering made in violation of Section 5 were subject to disgorgement as ill-gotten gains. In Liu, however, the Supreme Court explained that courts should deduct “legitimate expenses” when calculating disgorgement. The Ripple case could provide the SEC or the court the opportunity to explain how to calculate legitimate expenses, particularly in this case, where there are no allegations that the company or executives engaged in fraud, and it looks like the company will be able show substantial expenses from operating its business and the executives will be able to show that they provided legitimate employment services to Ripple.

Hopefully, the Ripple case will provide answers to one or more of these questions. Stay tuned.

© 2020 Proskauer Rose LLP.
For more, visit the NLR Securities & SEC section.

Stumbling Through Securities Law Challenges for COVID-19 Vaccine Developers

As the world waits to overcome the COVID-19 pandemic, publicly traded pharmaceutical companies waging in that fight are facing the multifaceted challenge of developing COVID-19 responses, informing the public of their progress, and managing legal challenges related to their efforts. Enter AstraZeneca.

AstraZeneca partnered with Oxford University to develop a COVID-19 vaccine in April 2020, which it later called “AZD1222.” On May 21, 2020, the company announced that the United States government was providing more than $1 billion for the development, production and delivery of the vaccine. Over the course of the next six months, the company continued to make public announcements on further financial support agreements and interim development results on its vaccine progress.

On January 26, 2021, an institutional holder of AstraZeneca’s American depositary shares (“ADSs”)” filed a putative securities class action complaint in the United States District Court for the Southern District of New York. The plaintiff claims that between May 21, 2020, and November 20, 2020, AstraZeneca failed to disclose certain alleged errors and flaws in AZD1222’s clinical trials.  According to the complaint, analysts and industry experts began to raise questions after AstraZeneca’s November 23, 2020 disclosure of an interim analysis of two smaller scale trials of the vaccine in disparate locales with two different dosing regimens. This disclosure purportedly resulted in a decline of nearly $2 per ADS during the trading day on November 23, 2020.

The complaint goes on to allege that post-class period reports revealed that AstraZeneca failed to disclose (i) that initial AZD1222 clinical trials had suffered from a critical manufacturing error, resulting in a substantial number of trial participants receiving half the designed dosage; (ii) that clinical trials for AZD1222 consisted of a patchwork of disparate patient subgroups, each with subtly different treatments, undermining the validity and import of the conclusions that could be drawn; (iii) that certain clinical trial participants for AZD1222 received the second dose up to several weeks after the dose had been scheduled to be delivered according to the original trial design; (iv) that AstraZeneca had failed to include a substantial number of patients over 55 years of age in its clinical trials for AZD1222; and (v) that AstraZeneca’s clinical trials for AZD1222 had been hamstrung by widespread flaws in design, errors in execution, and a failure to properly coordinate and communicate with regulatory authorities and the general public.  Based on these purported problems, the complaint contends that the data and conclusions that could be derived from the clinical trials were of limited utility, and AZD1222 was unlikely to be approved for commercial use in the United States in the short term. The complaint also alleges that AstraZeneca’s disclosures undermined confidence in AZD1222 and may have eroded public trust in the COVID-19 vaccine development process.

Interestingly, this complaint was filed the day after Merck & Co., Inc. announced its discontinuation of development of its own SARS-Cov-2/COVID-19 vaccines, following review of Phase 1 clinical trials  As of the date of this post, Merck’s stock price trades at $75.60 as compared to $80.98 on January 22, 2021.

Nevertheless, on February 10, 2021, the World Health Organization published interim recommendations for use of the AZD1222 vaccine developed by AstraZeneca and Oxford University, concluding that “the known and potential benefits of AZD1222 outweigh the known and the potential risks” and recommends “an interval of 8 to 12 weeks between the doses.” That announcement came after the complaint against AstraZeneca was filed, but may alter the course of the litigation as it moves forward.

© 2020 Proskauer Rose LLP.
ARTICLE BY Mee (Rina) Kim of Proskauer Rose LLP

SEC Adopts Final Rules to Modernize Financial Disclosure Requirements

On November 19, 2020, the Securities and Exchange Commission (SEC) adopted final rules to update the core financial disclosure requirements of Regulation S-K – relating to Selected Financial Data, Supplementary Financial Information and Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) – to efficiently provide investors with material financial information and ease the compliance burden for registrants.1 As noted in our client alert on the proposed rules earlier this year, these final rules are part of the broader initiative by the SEC to modernize and simplify disclosure requirements.

Highlights of the rules include the following:

Eliminate Item 301 (Selected Financial Data)

  • Registrants will no longer be required to provide five years of selected financial data.

Simplify Item 302(a) (Supplementary Financial Information)

  • Replace the current requirement in Item 302(a) to provide two years of tabular selected quarterly financial data with a principles-based requirement for material retrospective changes.
  • Specifically, disclosure will only be required under Item 302(a) when there are one or more retrospective changes to the statements of comprehensive income for any of the quarters within the two most recent fiscal years or any subsequent interim periods for which financial statements are included or required to be included that are, individually or in the aggregate, material.

Restructure and Streamline Item 303 (MD&A) 

  • Add a new Item 303(a) to clarify the objective of MD&A and streamline the instructions.
    • The objective clarifies that the disclosure is to provide material information relevant to an assessment of the financial condition and results of operations of the registrant, including an evaluation of the amounts and certainty of cash flows from operations and from outside sources. The disclosure is expected to better allow investors to view the registrant from management’s perspective.
  • Amend current Item 303(a)(1) and (2) (amended Item 303(b)(1)) to enhance disclosure requirements for liquidity and capital resources.
    • The amended rules elicit enhanced analysis, by encouraging registrants to provide a more meaningful discussion of the reasons underlying material changes in line items (and discouraging registrants from simply reciting amounts of changes).
    • Registrants will need to provide material cash requirements, including commitments for capital expenditures, as of the latest fiscal period, the anticipated source of funds needed to satisfy such cash requirements, and the general purpose of such requirements.
  • Amend current Item 303(a)(3) (amended Item 303(b)(2)) to simplify disclosure requirements for results of operations.
    • Registrants will need to disclose known events that are reasonably likely to cause a material change in the relationship between costs and revenues, such as known or reasonably likely future increases in costs of labor or materials or price increases or inventory adjustments.
    • Registrants will also need to discuss material changes in net sales or revenue (as opposed to just material increases).
    • Although the specific disclosure requirement with respect to the impact of inflation and price changes (Item 303(a)(3)(iv)) will be eliminated, registrants will still be required to discuss these topics if they are part of a known trend or uncertainty that had, or is reasonably likely to have, a material impact on net sales, revenue, or income from continuing operations.
  • Add a new Item 303(b)(3) to clarify and codify SEC guidance on critical accounting estimates.
    • Registrants will also be required to disclose, to the extent that the information is material and reasonably available, how much an estimate and/or assumption has changed over a relevant period, and the sensitivity of the reported amount to the methods, assumptions and estimates underlying its calculation.
  • Replace current Item 303(a)(4) regarding off-balance sheet arrangements with an instruction to discuss such obligations in the broader context of MD&A.
    • Registrants will be required to discuss commitments or obligations, including contingent obligations, arising from arrangements with unconsolidated entities or persons that have, or are reasonably likely to have, a material current or future effect on the registrant’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements, or capital resources even when the arrangement results in no obligation being reported in the registrant’s consolidated balance sheets.
  • Eliminate current Item 303(a)(5) regarding tabular disclosure of contractual obligations.
    • Registrants must still disclose material contractual obligations as part of an enhanced principles-based liquidity and capital resources requirement focused on material short- and long-term cash requirements from known contractual and other obligations.
  • Amend Instruction 4 to Item 303(a) (amended Item 303(b)) to clarify disclosure of material changes in line items.
    • Where there are material changes in a line item, including where material changes within a line item offset one another, registrants must disclose the underlying reasons for these material changes in quantitative and qualitative terms.
  • Amend current Item 303(b) (amended Item 303(c)) to allow for flexibility in the comparison of interim periods.
    • Registrants will be permitted to compare their most recently completed quarter to either the corresponding quarter of the prior year or to the immediately preceding quarter to provide a more tailored and meaningful analysis that is relevant to their specific business cycles.

What’s Next?

The final rules will become effective 30 days after they are published in the Federal Register, and registrants will be required to comply with the rules beginning with the first fiscal year ending on or after the date that is 210 days after such publication date. Following the effective date, however, registrants may provide disclosure consistent with the final amendments, as long as registrants provide disclosure responsive to an amended item in its entirety. For example, following the effective date, a registrant with a calendar year-end may omit disclosure to comply with Item 301 in its Annual Report on Form 10-K to be filed in early 2021, and may provide disclosure to comply with amended Item 303 in such report, if the registrant provides disclosure pursuant to each provision of amended Item 303 in its entirety in such report.

1 See “Management’s Discussion and Analysis, Selected Financial Data, and Supplementary Financial Information,” SEC Release No. 33-10890 (Nov. 19, 2020), available here.

Copyright © 2020 Womble Bond Dickinson (US) LLP All Rights Reserved.

SEC Proposes to Modernize Fund Shareholder Reports and Disclosures

The SEC has proposed modifications to the disclosure framework for mutual funds and exchange-traded funds (ETFs). The proposal sets forth a layered disclosure approach to highlight key information for retail investors. If adopted, the proposed modifications would:

  • require streamlined shareholder reports that would include fund expenses, performance, illustrations of holdings and material fund changes;
  • encourage the use of graphics or text features to promote effective communications; and
  • promote a layered and comprehensive disclosure framework by continuing to make available online certain information that is currently required in shareholder reports but may be less relevant to retail shareholders. Highlights from the proposal include the following: Tailored Shareholder Reports. Under proposed Rule 498B, new investors would receive a fund prospectus in connection with their initial investment, as they currently do, but funds would not deliver annual prospectus updates to shareholders thereafter.

Instead, funds would keep existing shareholders informed through streamlined annual and semi-annual reports, as well as timely notifications of material fund changes as they occur. Certain changes to a registration statement, such as updates to existing risk disclosures, may be deemed not to be material and therefore not subject to the timely notification requirements under proposed Rule 498B. Proposed Rule 498B would not prohibit a fund from continuing to satisfy its prospectus delivery obligations by delivering a copy of the summary prospectus and any supplements to the summary prospectus to existing shareholders. Current versions of the prospectus, which must include any material fund changes, would remain available online and would be delivered upon request in paper or electronically, consistent with the shareholder’s delivery preference. Funds would continue to be subject to the same prospectus and registration statement liability and anti-fraud provisions for fund documents required to be made available online but not required to be delivered to existing shareholders (the summary and statutory prospectus and information required to be incorporated into those documents). The proposal would require a fund company to prepare separate reports for each of its series but not for each class of a multi-class fund. The proposal also would provide additional flexibility for funds to add tools and features to annual reports that appear on their websites or are otherwise provided electronically. This could include video or audio messages, mouse-over windows, pop-up definitions, chat functionality and expense calculators. A link to a hypothetical streamlined shareholder report issued by the SEC in connection with the proposal is available here.

Availability of Information on Form N-CSR and Online. Information currently required in shareholder reports that is not included in the streamlined shareholder report would be available online, delivered free of charge upon request, and filed on a semi-annual basis with the SEC on Form N-CSR. Such information includes the schedule of investments and other financial statements, while a graphical representation of a fund’s holdings would be retained in the streamlined shareholder reports.

Exclusion of Open-End Funds from Scope of Rule 30e-3. The proposal would also amend the scope of Rule 30e3, the optional internet availability of shareholder reports, to exclude open-end funds. The proposal would not affect the availability of Rule 30e-3 for closed-end funds. The SEC’s rationale for narrowing the scope of this rule is based on its preliminary belief that the direct transmission of tailored reports represents a more effective means of improving investors’ access to and use of fund information, and reducing funds’ printing and mailing expenses, than allowing open-end funds to rely on Rule 30e-3.

Amended Prospectus Disclosure of Fund Fees and Risks. The proposal would amend prospectus disclosure requirements and related instructions to provide greater clarity and more consistent information regarding fees, expenses, and principal risks. The proposed amendments would: (1) replace the existing fee table in the summary section of the statutory prospectus with a simplified fee summary, (2) move the existing fee table to the statutory prospectus, and (3) replace certain terms in the current fee table with terms intended to be clearer to investors. The proposed amendments would also permit funds that make limited investments (up to 10% of net assets) in other funds to disclose acquired fund fees and expenses (AFFE) in a footnote to the fee table and summary instead of requiring AFFE to be presented as a line item in the table. The amendments would preclude a fund from disclosing non-principal risks in the prospectus. An additional new instruction would require that funds describe principal risks in order of importance, with the most significant risks appearing first, and tailor risk disclosure to how the fund operates rather than rely on generic, standard risk disclosures. Proposed instructions would also prohibit the presentation of principal risks in alphabetical order.

Fee and Expense Information in Investment Company Advertisements. The proposed amendments would require that presentations of investment company fees and expenses in advertisements and sales literature be consistent with relevant prospectus fee table presentations and reasonably current. The proposed amendments to the advertising rules would affect all registered investment companies and business development companies. The amendments would require fees and expenses in advertisements to include timely and prominent information about a fund’s maximum sales load (or any other non-recurring fee) and gross total annual expenses. Next Steps. The SEC has proposed an 18-month transition period. Accordingly, if adopted, the compliance date would be 18 months after the amendments’ effective date. Comments on the SEC’s proposal are due within 60 days after publication in the Federal Register.

Copyright © 2020 Godfrey & Kahn S.C.
For more artices on the SEC, visit the National Law Review Securities & SEC section.

SEC Publishes New Whistleblower Rules; Deadlines Impact Thousands of Cases

The Federal Register published the Whistleblower Program Rule changes approved by the U.S. Securities and Exchange Commission (“SEC” or “Commission”) on September 23, 2020. The changes published today not only impact the requirements governing the whistleblower program, but they establish new deadlines relevant to thousands of current or future cases.

While the effective date of the rules changes is listed as December 7, 2020, each rule’s applicability date should be examined as many are retroactive.

In Section III of the published rules, the SEC carefully explains the applicability of each provision. Highlighted below are rules that can impact pending cases.

Among the new deadlines established by the SEC are:

  • Rule 21F-4(e) defining “monetary sanctions.” This rule change will be applied retroactively and has a significant impact on the amount of an award a whistleblower may be entitled to under pending cases and in cases related to non-prosecution agreements. The rule applies “calculating any outstanding payments to be made to meritorious whistleblowers.” This means the rule covers all pending cases. It also covers sanctions obtained in cases resolved by non-prosecution agreements where the SEC never published a Notice of Covered Action.
  • Rule 21F-6 concerns the SEC’s discretion in small cases where sanctions obtained by the SEC are $5 million or less that rewards should be paid at the highest amount (i.e., 30% of sanctions obtained), barring the existence of negative factors that would justify a reduction. This rule applies to “all award claims still pending” on December 7, 2020. Thus, the applicability of this rule is retroactive.
  • Rule 21F-9 requires whistleblowers to file complaints using the TCR form to qualify for a reward. Whistleblowers have 30-days from an initial contact with the SEC to file the TCR. The 30-day requirement is tolled until a whistleblower obtains actual or constructive knowledge of the TCR filing requirement. However, the thirty day requirement can be triggered when a whistleblower hires an attorney to file a reward claim. This provision applies “to all award claims still pending” as of December 7, 2020, and all future filings. All persons contacting the SEC with information on potential violations need to be aware of this 30-day filing deadline, along with all attorneys who represent whistleblowers in SEC proceedings.
  • Rule 21F-13 relates to the administrative record on appeal of Whistleblower Award Applications. Under this rule, any WB-APP award application filed with the SEC after December 7, 2020, may not be supplemented. Therefore, whistleblowers must be careful to include the entire basis for an award claim in their WB-APP application. This rule applies “only to covered-action and related-action award applications that are connected to a Notice of Covered Action” posted on or after December 7, 2020.
  • Rule 21F-18 established a new summary disposition process. This rule applies to “any whistleblower award application for which the Commission has not yet issued a Preliminary Determination” as of December 7, 2020, as well as to any future award applications that might be filed. Therefore, this rule impacts pending reward claims.
  • Interpretive guidance on the meaning and application of the term “independent analysis” in Rule 21F-4. The SEC intends to rely on the principles articulated in the guidance for “any whistleblower claims that are still pending at any stage.” Thus, any person who has already filed a TCR complaint or a WB-APP application based on the “independent analysis” rules should examine this new guidance and determine whether they need to amend or supplement their filings.

The SEC whistleblower program has been extremely successful. As of today, the Commission has collected over $2 billion in sanctions from whistleblower cases, paid to harmed investors well over $750 million, and paid 112 whistleblowers over $719 million in rewards.

Copyright Kohn, Kohn & Colapinto, LLP 2020. All Rights Reserved.
For more articles on whistleblowers, visit the National Law Review Securities & SEC section.

SEC Adopts Expansion of “Accredited Investor” Definition

On August 26, 2020, the U.S. Securities & Exchange Commission (SEC) adopted amendments to Rule 501, Rule 144A and other related rules (the Amendments) to expand the definition of “accredited investor” under the Securities Act of 1933 (the Securities Act). The amendments were adopted largely as proposed and broaden the scope of natural persons and entities that may qualify to participate in private offerings of securities that are exempt from registration under the Securities Act.

In particular, the “accredited investor” designation will now include the following:

  • Natural persons holding certain professional certification and designations. The SEC will periodically issue orders designating those professional certificates, designations or credentials that, when held by a natural person, would qualify such person as an accredited investor. Contemporaneously with the Amendments, the SEC designated holders in good standing of the Series 7, Series 65 and Series 82 licenses as qualifying for accredited investor status. In evaluating additional professional designations for qualifying status, the SEC will consider a non-exhaustive list of attributes established by the Amendments.
  • “Knowledgeable Employees” of private funds as defined under the Investment Company Act, but only with respect to investment in such private fund. A Knowledgeable Employee’s spouse will also be considered an accredited investor with respect to joint investments in the private fund.
  • Certain enumerated entities, including:
    • federal- or state-registered investment advisers and exempt reporting advisers, regardless of the level of assets under management;
    • rural business investment companies (RBICs), as defined in Section 384A of the Consolidated Farm and Rural Development Act;
    • limited liability companies that have total assets in excess of $5 million and were not formed for the purpose of acquiring the securities offered1 ; and
    • any entity with at least $5 million in investments (as defined under the Investment Company Act of 1940) that has not been formed for the purpose of investing in the securities offered, in order to encompass entities such as Indian tribes, foreign entities and local government bodies that were not previously covered by Rule 501.
  • “Family offices” and their “family clients,” each as defined under the Advisers Act, provided the family office has at least $5 million in assets under management, was not formed for the purpose of acquiring the securities offered and was directed to make the investment by a person who has such knowledge and experience in financial and business matters such that the family office is capable of evaluating the merits and risks of the investments.

The Amendments would also clarify that spousal equivalents can pool finances when determining qualification as an accredited investor and update the definition of “qualified institutional buyer” under the Securities Act to conform with the new accredited investor definition.

The expansion of the accredited investor definition has many implications for asset managers, including updates to offering and subscription documents and questionnaires, consideration of expanded options for funding GP commitments via the expanded pool of knowledgeable employees and affiliated professionals and evaluation of fund-raising opportunities. Commissioners adopted the amendments on a 3-2 vote, with commenters disagreeing with the SEC’s decision not to index the wealth thresholds, which were initially adopted in 1982, for inflation.

The Amendments will go effective 60 days after publication in the Federal Register.

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1 While Rule 501 did not explicitly include LLCs meeting these requirements prior to the Amendments, the SEC historically has taken the position that such LLCs qualify as accredited investors.

© 2020 Vedder Price
ARTICLE BY Robert M. Crea, Joseph M. Mannon, and Adam S. Goldman of Vedder Price.
For more SEC news, visit the National Law Review Securities, SEC, & Financial Institution Law News section.