First SEC Staff Comments on Recent Non-GAAP CDIs

As many of us have noticed, the first comment letters from the staff in the SEC’s Division of Corporation Finance, following Corp Fin’s recent issuance of new CDI guidance on the presentation of non-GAAP financial measures, have become available publicly.  The comment letters shed additional useful light on Corp Fin’s views concerning non-GAAP presentations.

One of the comment letters sent to Alexandria Real Estate Equities, Inc. on June 20, 2016, provides a particularly helpful glimpse into Corp Fin’s views about the use of non-GAAP information in the executive summary of MD&A.  The staff’s letter includes the following comment in reference to MD&A in the registrant’s 2015 Form 10-K:

We note that in your executive summary you focus on key non-GAAP financial measures and not GAAP financial measures which may be inconsistent with the updated Compliance and Disclosure Interpretations issued on May 17, 2016 (specifically Question 102.10). We also note issues related to prominence within your earnings release filed on February 1, 2016. Please review this guidance when preparing your next earnings release.

Indeed, the executive summary portion of the MD&A – when initially conceptualized in the SEC’s 2003 release providing interpretive guidance in the preparation of MD&A – was supposed to include an overview to facilitate investor understanding.  The overview was intended to reflect the most important matters on which management focuses in evaluating operating performance and financial condition.  In particular, the overview was not supposed to be duplicative, but rather more of a “dashboard” providing investors insight in management’s operation and management of the business.

Looking back at the release to write this blog entry, I note references, with regard to Commission guidance on preparation of the MD&A overview, explaining that the presentation should inform investors about how the company earns revenues and income and generates cash, among other matters, but should not include boilerplate disclaimers and other generic language.  The Commission even acknowledged that the overview “cannot disclose everything and should not be considered by itself in determining whether a company has made full disclosure.”

Many companies have presented in their MD&A overview those non-GAAP measures used by management to operate the business and otherwise manage the company.  Where appropriate, references typically are made to the information appearing elsewhere in the document, presented to enable compliance with applicable rules and guidance for non-GAAP presentations.  Interestingly, the staff, in its comment, questions the “prominence” of the non-GAAP presentation in the context of the earnings release (noting that the staff provides less specificity in the portion of its comment relating to the MD&A overview).  This focus on prominence – to the extent the staff’s concerns relate to the MD&A overview – is worth further consideration in preparing MD&A disclosure.   In this connection, query whether the staff – in questioning prominence – could be expressing a view that when management analyzes for investors the measures on which it focuses in managing the business, if management relies on non-GAAP measures, it necessarily must focus on (and explain) – with no less prominence – the corresponding GAAP measures.

David N. Feldman

SEC Proposes Expansion of Those Eligible For Scaled Reporting as “Smaller Reporting Companies”

On June 27, 2016, the SEC released a proposal that would increase the number of companies eligible to be “smaller reporting companies.” SRCs get the benefits of reduced disclosure over other public companies, such as two years of financial statements instead of three. To be an SRC, currently you have to have a public trading float value below $75 million, or if your float is zero, then revenues less than $50 million. The SEC is proposing increasing these thresholds to either a public float of less than $250 million, or if no float, then revenues of less than $100 million.

The JOBS Act created “emerging growth companies” (EGCs) which get some of the same benefits as SRCs. But EGC benefits go away with time whereas the SRC benefits do not. Plus, companies that went public before the JOBS Act generally cannot be EGCs. So why is all this cool? Because it was recommended multiple times at the annual SEC small business conference by folks like your humble blogger, and also by the SEC’s advisory committee on small and emerging companies.

Why else is it cool? Because the pool of SRCs has dropped from 42% to 32% of all public companies since the SRC rules were set up. So fewer companies get the benefit. With these proposed changes the SEC projects it would go back to 42%.

David N. Feldman

Analysis of Court Ruling Upholding SEC Regulation A+ Rules

I have now had a chance to read the 23-page, very well-written, clear and concise DC Circuit court opinion on the Reg A+ challenge brought by two states (see entry below). The ruling started with a brief history of securities law, how it started with the states but moved to add federal oversight after the 1929 market crash. Offerings exempt from full SEC registration for smaller companies have been around for a long time, and Reg A actually was first adopted in 1936. In 1996, Congress preempted state oversight of offerings involving “covered securities,” at first essentially those to trade on national exchanges such as Nasdaq or the NYSE. The JOBS Act in 2012 expanded covered securities to include those issued in Reg A+ offerings to “qualified purchasers,” a term the Act said was to be defined by the SEC. The SEC said everyone is qualified because of additional investor protections in the new rules.

To succeed in their challenge, the states would have had to prove 1) that the Act “unambiguously foreclosed” the opportunity for the SEC to write the rules the way they did or 2) that the rules were “arbitrary and capricious” and serving no valid economic purpose. The states actually tried to argue that the JOBS Act was not clear in preempting state review of Reg A+ offerings. The Court clearly and strongly disagreed and made clear it was Congress, not the SEC, preempting the states. They also stated firmly that the SEC was given very broad power in the Act to write the definition of qualified purchaser almost entirely as they wished, regardless of prior proposals on other matters and even regardless of the plain meaning of the words. And it also noted that they added further protections such as the limit on investments by non-accredited investors and the enhanced disclosure and reporting obligations, as well as clearly demonstrating the economic benefits of the new rules (um it’s called the JOBS Act!). So, said the Court, they were not foreclosed by the law to act as they did and they did not act in an arbitrary or capricious fashion.

There is a broader legal discussion about the breadth of powers of administrative agencies to implement statutory edicts, but that is for another day and probably a legal journal in any event. Let us hope that the states that brought this and their supporters accept the ruling, take their licks and move on. One assumes they would not want to appeal just to be even further rebuked by a full appeals panel. So….let’s do some deals!

David N. Feldman

Flash: Court Shoots Down State Challenge to Reg A+ Rules

Very good news: the DC Circuit today rejected the effort by two states (Massachusetts and Montana) to invalidate the SEC’s rules enacted to implement Regulation A+ and Title IV of the Jumpstart Our Business Startups (JOBS) Act of 2012. We are waiting to review the actual decision, but the court’s decision, written by Judge Karen L. Henderson, said the SEC made rules that were not arbitrary or capricious, the grounds on which they were being challenged.

As I understand it, the states’ only choice at this point would be to appeal directly to the US Supreme Court. The Supremes take a very small percentage of cases seeking their involvement, though one cannot predict what MA and MO will seek to do. As we know, the states were supported and backed by the North American Securities Administrators Association (NASAA) which represents the securities regulators of all the states.

More to come after we review the decision. But this is a critically positive development for the continuing acceptance, growth and use of new Regulation A+ to help smaller companies grow, raise capital and create jobs.

David N. Feldman

How to Modernize “Accredited”?

The SEC’s Advisory Committee on Small and Emerging Companies, co-led by Sara Hanks, met the other day to talk about how to update the definition of “accredited investor” following a detailed report issued by the SEC back in December. As we know, only accrediteds are permitted to invest in certain types of securities offerings.

The 1982 thresholds in SEC Regulation D say you’re accredited with $200,000 annual income or a $1 million net worth (now excluding your primary residence). I know my friends will be mad at me, but if you go to www.dollartimes.com, it tells you that $200,000 in 1982 dollars is worth $503,244 today after inflation. Luckily it doesn’t appear anyone at the SEC is proposing increasing the amount that much. And they are also considering letting you be accredited if you have certain types of licensing, such as an accountant or financial planner. They also are considering not increasing the thresholds but limiting the amount you can invest if you make over $200,000 but less than some other level. They’re even considering developing an exam to show you are sophisticated regardless of income.

So I don’t think it’s whether but when these changes will be made, and how severe they will be. I like expanding it to knowledgeable folks even if not meeting income standards. Reg D offerings have been the bulwark of the investment community for decades. Let’s hope the staff and Commissioners (including the two new ones who are coming, having been approved by the Senate Banking Committee today) don’t jigger with it too much.

David N. Feldman

SEC Completes JOBS & FAST Act Rulemakings

Last week the SEC proudly announced the completion of its rulemaking obligations under the Jumpstart Our Business Startups (JOBS) Act of 2012 and the mini-JOBS Act 2.0 tacked onto the Fixing America’s Surface Transportation (FAST) Act. The last rules had to do with implementing the increase in the number of shareholders triggering an obligation to become a full SEC reporting company. They also spent lots of time on the Regulation A+ rules and new Regulation CF for “statutory” crowdfunding which are also complete. CF is just days away from being effective, the Reg A+ rules have been in effect almost a year now.

There is other work still pending under JOBS. For example, the SEC recently put out a 300+ page concept release talking about ideas to modernize some of the disclosure requirements in SEC Regulation S-K. The JOBS Act mandates that they examine this and hopefully implement some changes. One of the most interesting, which I’ve been pushing for years: let’s allow smaller public companies to eliminate burdensome disclosure requirements if they are not material to an investor’s understanding of the company. This is similar to SEC rules for disclosure in private companies to non-accredited investors. But this is still developing.

The last rule change? Per the SEC release, “As a result of JOBS Act and FAST Act changes, an issuer that is not a bank, bank holding company or savings and loan holding company is required to register a class of equity securities under the Exchange Act if it has more than $10 million of total assets and the securities are ‘held of record’ by either 2,000 persons, or 500 persons who are not accredited investors.  An issuer that is a bank, bank holding company or savings and loan holding company is required to register a class of equity securities if it has more than $10 million of total assets and the securities are ‘held of record’ by 2,000 or more persons.” This is good.

David N. Feldman

And So it Goes…The Year in Smallcap Regulation

What a year this was! So much has happened in our smallcap world this year. Here are my top 10 highlights (and lowlights):

•Regulation A+ rules were finalized, dramatically improving the range of options for capital formation for smaller companies. Unfortunately, two states challenging the new requirements have led some to hold off on utilizing the new rules.

•The FAST Act got us easier transfers of interests in private companies, S-1 forward incorporation by reference, reducing financial disclosure and a longer confidentiality period for IPOs.

•The SEC made it easier to demonstrate a pre-existing substantive relationship with an investor in a Regulation D offering.

•Proposed changes to Rule 504 under Regulation D could offer expanded crowdfunding opportunities.

•One well known smallcap attorney goes to jail for 18 months for pump and dump schemes, another arrested in an alleged market manipulation scheme, the same alleged scheme in which yet a third attorney in our space was arrested in 2014.

•The SEC approved final Title II JOBS Act crowdfunding rules, with hope to help start-up companies raise money from large numbers of folks. In-state crowdfunding has also become more and more popular.

•The Supreme Court made proving insider trading more difficult, leaving many in jail to seek release.

•The SEC still does not seem ready to act on allowing private placement broker/finders to act without or with limited SEC registration as they have for M&A brokers. Same with allowing smaller companies the right to opt out of XBRL, even though the House passed it.

•PIPE funds are resurfacing and raising money. And..

•I joined the awesome firm of Duane Morris LLP as a partner in NY!

Too all a happy, healthy and prosperous 2016!!!

David N. Feldman

OTCQX Strengthens Listing and Governance Requirements

The OTCQX, owned by OTC Markets, Inc., announced last week that they are increasing their listing and governance requirements effective January 1. The QX is the highest tier of trading among the OTC options. There will now be a higher initial bid price of $0.25 to trade on the OTCQX U.S. tier.  US companies on the QX will have to keep a price above $0.10. International companies will be required to meet new initial and ongoing minimum bid prices of $0.25 and $0.10 to trade on the OTCQX International tier. Both US and international companies will have higher initial and ongoing market capitalizations of $10 million and $5 million, respectively.  All companies now will be required to have at least two market makers.

In addition, there are new minimum corporate governance requirements for American companies on the QX. These are: a minimum of two independent directors on the board of directors; an audit committee composed of a majority of independent directors; and they must conduct annual shareholders’ meetings and submit annual financial reports to shareholders at least 15 calendar days prior to such meetings. They also added even more stringent new requirements for the higher level “premier” tier on the QX.

In their announcement, OTC Markets CEO Cromwell Coulson acknowledged the purpose of these changes is to strengthen the legitimacy of the QX and get more attention from investors, Wall Street firms and analysts for these companies. My take: good stuff!

David N. Feldman

Flash: Obama Signs New Small Business Initiatives Into Law

They got tucked into a transportation bill (Fixing America’s Surface Transportation Act or the FAST Act), but with a deft set of amendments the Reforming Access for Investments in Startup Enterprises Act of 2015 (or the RAISE Act) and other small business initiatives were signed by the President on December 4, 2015 and are now law. The new law also includes a direction to the SEC to change Form S-1 to allow forward incorporation by reference in filings by smaller reporting companies. This is a big and positive change for companies not eligible to use short form registration on Form S-3.

The RAISE Act assures an exemption from SEC registration for a resale of a security to an accredited investor who has access to certain information from the company, no bad actors or shells allowed, no general solicitation or advertising, no start-up companies and the class of stock being sold has to have existed for at least 90 days. This eliminates the old awkward invented Securities Act Section 4(1-1/2) exemption which was used in practice and accepted by the SEC but actually nowhere in the statute. This could help add comfort to secondary market folks who help people buy pre-IPO stocks like Facebook and Twitter before they go public. It could also help PIPE (private investment in public equity) investors who wish to transfer their shares more confidently in a private transaction before they would otherwise be eligible to sell the shares publicly.

Other very exciting changes in the law:

  • mandating the SEC look to ease disclosure burdens on smaller companies, to study ways to improve and simplify disclosure rules, and reduced disclosure for emerging growth companies.
  • lengthening the time you can keep your IPO filing confidential under the JOBS Act to 15 days before the first road show (from 21 days)
  • permitting a JOBS Act IPO filing to exclude financials that are likely to go stale by the time of the actual offering.
  • allowing an emerging growth company to still be treated like one through its JOBS Act IPO even if it stops being an EGC during the process.

Thanks House Financial Services Committee for pushing these through the “I’m Just a Bill” process!

Dell/EMC Merger Highlights the Return of Tracking Stock and the Associated Corporate Governance and Shareholders Rights Issues

Tracking Stocks Are Now Relics,” declared the Wall Street Journal in January 2008.  Tracking stocks had been the hot trend during the dot-com boom of the late 1990s, when companies sought to take advantage of wild valuations of internet business that they owned.  Recently, however, tracking stock has returned to the news due to its role in the Dell/EMC merger.  Dell, to help pay for the merger, plans to issue tracking stock to track EMC’s interest in VMWare.  Because that tracking stock will be a form of Dell common stock, Dell in essence is returning to the public markets, as noted by UC Berkeley professor Steven Davidoff Solomon in this NYTimes DealBook column.

A tracking stock is a form of common stock that “tracks” or depends on the financial performance of a specific business unit or operating division of a company – rather than the operations of the company as a whole.  Tracking stocks trade as separate securities. Thus, if the unit or division fares poorly, the value of the tracking stock would fall, even if the company at large was doing well.  And vice versa.

Interesting corporate governance and shareholders’ rights issues arise in connection with tracking stock as a result of the limitations inherent to tracking stock:

  • Tracking stock does not entail ownership of the tracked entity’s assets. Rather, for financial reporting purposes the company allocates consolidated assets, liabilities, revenue, expenses and cash flow between the entire company and the tracked entity.  That allocation, however, does not change the legal title to any assets, which remain with the company.
  • It does not confer voting rights on its shareholders, typically.
  • The tracked entity does not have its own board of directors. The board of directors operates the entire company, of which the tracked entity is but one division or business.  The board could make decisions which are good for the company overall, but not necessarily for the owners of the tracking stock.  As a result, conflicts may arise between the board of the company and the shareholders of the tracked entity
  • The tracking stock holders have no right to participate in a tender offer for the common shares of the company (unless the tender also was directed to the tracking shareholders).
  • As a result of the foregoing, owners of tracking stock may lose out on takeover bids and other activity by activist investors. In that sense, a tracking stock resembles the stock of a spinoff with a permanent anti-takeover provision.

A case arising out of the dot com era illustrates some of these issues.  In Sedighim v. Donaldson, Lufkin & Jenrette, Inc., 167 F. Supp. 2d 639, 644-45 (S.D.N.Y. 2001), DLJ had offered tracking stock in its online brokerage business, DLJdirect, in 1999.  The following year, Credit Suisse made a tender for all outstanding common shares of DLJ – but not for DLJdirect.  So while the DLJ shareholders obtained a nice premium, the DLJdirect shareholders missed out.

DLJdirect shareholders asserted claims under Sections 11 and 12 of the Securities Act of 1933, alleging the DLJdirect prospectus misrepresented the rights that DLJdirect shareholders would have in a merger.  They claimed, for instance, that statements such as that “DLJdirect shareholders would be subject to all the risks of an investment in DLJ” suggested DLJdirect shareholders would be entitled to participate in the tender for DLJ common shares.  The plaintiffs also asserted they were entitled to participate in Credit Suisse’s tender under the SEC’s “All Holders, Best Price” rule (Rule 14d-10), which requires that a bidder make its tender available to all holders of the same “class” of securities subject to the tender.  DLJdirect shareholders asserted that because the prospectus described the tracking stock as a part of the common stock of DLJ, they were entitled to participate along with DLJ’s common shareholders. The court rejected this argument, holding that the DLJdirect shares were “vastly different securities with different rights, and trade at significantly different prices in the market.” Id. at 651.  The rule could not be used to “erase distinctions of different types of securities.” Id.

The Sedigham decision highlights the different rights of tracking stock.  In essence, DLJ’s board could properly ignore the interest of the shareholders of DLJdirect in the context of the merger between DLJ and Credit Suisse.  These issues were spelled out in the IPO prospectus for the DLJdirect tracking stock, and despite claims to the contrary its shareholders had no reasons to believe otherwise.  The court granted defendants’ motion to dismiss.

It will be interesting to see whether tracking stocks return in any significant number, and any corporate governance issues that develop – in particular, the nature and scope of the duties owed by a company’s board of directors to owners of tracking stock.