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SEC targets capital formation reform

Last year the Security and Exchange Commission’s Advisory Committee on Smaller Public Companies proposed sweeping changes in two areas – SOX 404 and capital formation. Who would have guessed that the capital formation proposals would end up as the revolutionary part of that Committee proposal?
At the height of the public furor over excessive SEC regulation destroying American capital markets, the SEC Advisory Committee issued a report on April 23, 2006 that focused primarily on SOX 404. The key recommendation was to exempt smaller companies from SOX 404 coverage. The SEC immediately rejected such an exemption, and instead launched a concentrated program to recast SOX 404 in more user friendly terms. And just last month, the SEC issued a guidance designed to lessen the costs and burden on smaller companies in complying with SOX 404. (See related news article on page one.)
Almost lost at the back of the Advisory Committee’s report was an extensive list of 13 separate proposals to relax the regulatory noose around capital formation. When the SEC brushed aside the Committee’s SOX 404 suggestions in May 2006, the agency said not a word about these other proposals.
But one year later, the SEC on May 23 proposed for public discussion a series of six “New Proposals” to “modernize and improve its capital raising and reporting requirements for smaller companies,” acknowledging that much of the New Proposals were based upon the earlier Committee report. These seemingly technical recommendations foretell substantial alterations in the manner of capital formation in the United States.
The same pressures that drove the report recommendations were cited in the May SEC press release disclosing the New Proposals: “As we all recognize, smaller companies are critical players for our capital markets and for the U.S. economy more broadly. By proposing to rationalize the regulations that apply to capital raising and public reporting by smaller companies, . . . the Commission has again confirmed its commitment to the health and robustness of this important segment of our markets.”

Significant proposed changes
The New Proposals seek to abolish what is in effect the present two-tier disclosure system under the ’34 Act. Companies with a public float below $25 million qualify for using Regulation S-B. The New Proposals would abolish the disclosure forms under S-B, combining disclosure requirements for S-B companies into disclosure for all companies with less than $75 million in public float. In the future, all such companies would share a single, less rigorous disclosure scheme generally involving: (i) less detailed business descriptions; (ii) elimination of ancillary financial information; (iii) only two years of financial information; and (iv) presumably the elimination of certain other disclosures required of larger enterprises.
The report noted that S-B filers presently suffered a “possible stigma” in the marketplace by reason of that status, which stigma presumably would be abolished by treating such companies together with others with less than $75 million of public float. The report further noted that these changes would reduce cost and simplify disclosure “while not adversely impacting investor protection in any significant way.” This leaves one to speculate why such disclosure requirements were ever imposed on any company in the first instance.
Larger public companies (with a float above $75 million) enjoy the ability to issue additional shares on simplified SEC Form S-3. The New Proposals would open up Form S-3 for all companies, regardless of float, provided they had timely filed their ’34 Act reports for at least one year (subject to certain technical limitations, including unavailability of this procedure for shell companies).
Interestingly, the New Proposals do not adopt the Report’s suggestion that S-3 be available for companies that are currently timely in their ’34 Act reporting. The Proposals instead retain the punitive requirement that timely filing has been maintained for an entire prior year.
The New Proposals will not afford to smaller companies the automatic effectiveness of Form S-3 registrations, which were afforded to well-known seasoned issuers under the SEC’s Securities Act Reform rules promulgated in 2005. S-3 registration statements for these smaller companies would be subject to SEC review before they became effective.
Another New Proposal would exempt employee stock options from the requirement to register those options as a separate class of securities under the ’34 Act. Presently, public companies must register each class of securities held by at least 500 shareholders. Expanding technology companies are long famous for incentivizing their employees with compensatory stock options (although there is a current trend, for a variety of reasons, towards restricted stock).
The SEC proposals would affect two kinds of expanding companies. Non-reporting issuers (smaller companies) would never have to register stock options issued under employee stock option plans, no matter how many optionees receive them. And public companies with an underlying class of securities already registered under Section 12 of the ’34 Act would not have to register separately the stock options exercisable into such underlying registered class.
The commission has also proposed amendments to Regulation D, the most frequently used exemption from federal registration requirements when issuers raise private capital.
Numerous proposals in this area include:

  • Establishing a new Rule 507 that would permit limited advertising for offerings to “qualified purchasers”;
  • Defining securities sold pursuant to new Rule 507 as “covered securities” under Section 18 of the Securities Act, which would generally exempt issuance of those securities from registration under state securities laws;
  • Adjusting for inflation after five years the definition of “accredited investor” (accredited investors must meet minimum financial standards and, if they do, they become permitted purchasers under Regulation D without numerical limit;
  • Shortening from six months to 90 days the integration Safe Harbor (the period of time when Regulation D offerings will be aggregated for regulatory purposes with other similar offerings of the same issuers); and
  • Requiring electronic filing of the Form D, which the SEC mandates for all Regulation D offerings.
    Of equal interest is the New Proposal to revise SEC Rules 144 and 145 designed to ease the ability of investors to resell securities purchased in unregistered transactions. Rule 144 generally requires an unaffiliated investor to hold securities for at least 12 months before resale. The proposal is to shorten the holding period to six months and, seemingly, to permit resale with “no additional requirements” (presumably, without restriction as to amounts sold or manner of resale, present requirements under Rule 144).
    The commission also will solicit comments on whether to permit affiliates of issuers (who already file under the insider trading provisions of Section 16 of the 1934 Act) to satisfy their obligation of filing Form 144 after resales by instead filing only Form 4 (which is already required under Section 16 to disclose insider sales).
    Rule 145 regulates merger and acquisition transactions, and the ultimate resale of securities obtained in such transactions. Presumably substantial loosening of resale limitations will be proposed, because the SEC’s press release promises to eliminate “the presumptive underwriter provision” which is the single most troublesome regulatory impediment to free resale of acquisition-based securities.
    Whether the new proposals will move us back to old Rule 133, which generally allowed immediate resale of securities obtained in acquisition transactions, under a “no sale” theory, remains to be seen. The original promulgation of Rule 145 was a radical, 180-degree repudiation of prior practice under Rule 133.

    What happens next?
    The SEC’s May 23 press release (www.sec.gov/news/press/2007/2007-102.HTM) promises publication of the specific New Proposals, followed by a 60-day period for comment. At the writing of this article, the specifics (which will be complex as many SEC rules are implicated) have yet to be published in the Federal Register.
    No doubt significant industry and consumer-protection comment will be elicited. The degree to which comments reflecting investor fears can divert the SEC from its drive to establish flexibility in U.S. capital formation markets remains to be seen. Clearly the commission has gotten the message that it must do its part in trying to promote domestic capital formation as a driver of the U.S. economy.
    And, will there be a “third shoe”? Additional intriguing suggestions from the report are not incorporated in the SEC’s New Proposals. They would significantly loosen the regulatory noose as well.
    The New Proposals are silent on suggestions to:

  • encourage the dissemination of research on smaller public companies, including allowing the circulation of company-sponsored research;
  • provide a streamlined NASD registration process for finders and M&A advisors, which registration would end the “gray market” of unregistered business finders and investment bankers often used by smaller companies;
  • address the manner by which shareholders are counted under the Exchange Act for purposes of requiring registration of classes of securities, which could have substantial impact on the manner, or even the viability, of going private efforts;
  • foster trading in the very smallest of public companies (including publication of broker/dealer information on OTC companies under ’34 Act Rule 15c2-11);
  • adopt the “access equals delivery” concept, recently implemented in connection with amendments to public offering and proxy regulation, which would make Internet posting the universal equivalent of the actual delivery of anything filed with the SEC; and
  • define “qualified purchaser” under the NSMIA of 1996, which is the reform legislation that removed many capital formation activities from the reach of state regulation.
    The SEC is walking a tightrope between its investor protection mandate, on the one hand, and pressure from business and government to insure the primacy of American entrepreneurship and venture capital, on the other.
    Unanswered is the broader question of whether the SEC can effectively impact the trends weakening the American capital formation marketplace.
    When telephone calls to American companies are being answered in India, where most of our consumables are made in places like China and Vietnam, and in light of the rise of stock markets around the world, could it be that the SEC’s efforts to centralize capital formation within the physical geography of the United States is doomed to failure by broader trends unrelated to regulatory limitations?
    Stephen M. Honig is a member of Duane Morris’s corporate department in the firm’s Boston office. You can reach him at smhonig@duanemorris.com.

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