SEC Approves Rules to Improve Small Business Regulation | Publications

Introduction.

On November 15, 2007, the Securities and Exchange Commission (the “SEC”) adopted rules designed to modernize and improve the reporting, capital-raising and disclosure requirements for small companies. These rules include, among other changes:

shortening the holding periods under Rule 144 of the Securities Act of 1933 (the “Securities Act”) for restricted securities of public companies from one year to six months;
expanding eligibility for scaled disclosure regulations with reduced disclosure obligations to “smaller reporting companies”; and
creating two new exemptions for compensatory employee stock options, so that the registration requirements of the Securities Exchange Act of 1934 (the “Exchange Act”), will not be triggered solely by a company’s compensation decisions.

The rules are intended mainly to enable smaller companies to raise capital more effectively, ease some of the burdens of the SEC’s reporting and disclosure requirements and increase the number of smaller companies eligible to comply with the scaled disclosure requirements.

This client alert will summarize each of the three new rules.

Part I – Revisions to Securities Act Rule 144 and Rule 145.

While the revisions to Rule 144 and Rule 145 will apply to both larger and smaller companies, these revisions are primarily designed to benefit smaller companies and enhance their access to the private markets. The adoption of the amendments is expected to reduce the cost to issuers of raising capital through private placements by making restricted securities more liquid. The impact of the increased liquidity may be a reduction in the so-called “liquidity discount” that investors receive to purchase equity securities in private placements.

The SEC’s adopting release that sets forth the final rules may be found at http://www.sec.gov/rules/final/2007/33-8869.pdf. For a more detailed summary of these amendments by Morrison & Foerster LLP, please see http://www.mofo.com/news/updates/files/13257.html.

A. Rule 144 Holding Period Requirements.

1. Background.

Rule 144 provides selling securityholders with a safe harbor exemption under Section 4(1) of the Securities Act for the resale of their securities, so that – if the resale satisfies certain criteria – the holders are not deemed to be engaged in a distribution of securities. As a result, the selling securityholder is not classified as an “underwriter” and may sell the securities without registration. Rule 144 applies to the resale of restricted securities, including securities purchased in a private placement, or prior to an issuer’s initial public offering. In 1997, the SEC amended Rule 144 to reduce the required holding period for both affiliates and non-affiliates under Rule 144(d) from two years to one year, and the required holding period for non-affiliate holders to sell an unlimited amount of securities under Rule 144(k) was reduced from three years to two years.

As a general rule, Rule 144 currently requires that before restricted securities may be resold, there must be a holding period of one year, beginning on the date the full purchase price or other consideration is paid by the purchaser. This holding period helps ensure that the purchaser of securities in a private placement has assumed the economic risks of investment and is not acting as a conduit for a sale to the public of unregistered securities on behalf of an issuer.

2. New Rules Shorten Holding Period Requirements.

Based on its observations since the implementation of the 1997 amendments, the SEC is now satisfied that a holding period of six months for restricted securities of public companies held by affiliates and non-affiliates constitutes a reasonable indication that an investor has assumed the economic risk of investment in Rule 144 securities. The SEC’s decrease of the holding period from one year to six months is designed to prevent the required holding period from being longer than necessary and imposing unnecessary costs or restrictions on capital formation. This shortening of the holding period may have the practical effect of (a) making it less burdensome to issue securities in private placements and (b) potentially reducing the discount to market price that investors pay to purchase securities in private placements, due to the so-called “liquidity discount.” This amendment was principally designed to benefit smaller companies with capital needs, but will also benefit larger companies as well, as the new rules will also be available to their investors.

For issuers that are not Exchange Act reporting companies at the time of the relevant private placement, the new rules – consistent with current Rule 144 – will continue to require that the holding period for the restricted securities will be one year for both affiliates and non-affiliates. However, after satisfying the one-year holding period, non-affiliates of these companies will not be subject to any other conditions under Rule 144.

B. Other Revisions to Rule 144.

1. Revised Volume Limitations for Debt Securities.

Under existing Rule 144, sales of both debt and equity securities were limited to the greater of 1% of the outstanding class or the average weekly trading volume during any three month period. Many observed that these limitations effectively precluded the resale of debt securities in reliance upon the Rule. Accordingly, under the amendments, the volume limitations for debt securities have been increased to 10% of the relevant tranche during any three-month period.

2. Manner of Sale Requirements.

a. Background.

Rule 144(f) previously required that securities be sold in “brokers’ transactions” (as the term is defined in Section 4(4) of the Securities Act) or that securities be sold with a “market maker” (as the term is defined in Section 3(a)(38) of the Exchange Act). Rule 144(f) also previously prohibited a seller from (a) soliciting or arranging for the solicitation of orders to buy securities in anticipation of, or in connection with, a Rule 144 transaction or (b) making any payment in connection with the offer or sale of the securities to any person other than the broker who executes the order to sell the securities.

The SEC indicated in its 1997 proposing release that it contemplated eliminating the manner of sale requirements entirely. However, the proposal was not adopted at that time. The June 2007 proposing release for the new rules articulated the SEC’s original position that brokers, as financial intermediaries, serve an important function as gatekeepers for promoting compliance with Rule 144, and states the SEC’s concern that “eliminating the manner of sale limitations for equity securities may lead to abusive transactions.” Some of the comments to the proposed amendments indicated that the manner of sale requirements should be eliminated completely because, among other things, (a) the holding period requirements of Rule 144 should generally suffice to achieve the non-distribution purposes of the rule, (b) these requirements limit the form of offerings and the development of market practices, and reduce liquidity and (c) Rule 144 compliance can be achieved by using certificates bearing restrictive legends, rather than by brokers serving a “gatekeeper” function.

In contrast to its concerns regarding equity securities, the SEC indicated in its June 2007 proposing release that fixed income securities, including asset-backed securities, do not raise the same concerns as equity securities, and that the manner of sale provisions with respect to the resale of fixed income securities are unduly burdensome. The SEC noted that fixed income securities are traded in dealer transactions in which the dealer seeks buyers for securities to fill sell orders, instead of through the means prescribed in Rule 144(f). For these reasons, the SEC stated in its June 2007 proposing release that the manner of sale restrictions should be eliminated as to fixed income securities.

b. Revision of Manner of Sale Requirements for Equity Securities;
Elimination of Manner of Sale Requirements for Debt Securities.

Affirming its stance in its June 2007 proposing release, the SEC’s new rules will eliminate entirely the manner of sale limitations for debt securities. Additionally, because the SEC was persuaded to a greater degree by the comments it received in response to the June 2007 proposing release regarding equity securities, the new rules will revise the manner of sale provisions relating to affiliates’ sales of equity securities. For example, sales of equity securities may be made through “riskless principal transactions,” where trades are executed at the same price, regardless of any markup or markdown, commission equivalent or other fee. Similarly, several technical amendments have been made to the definition of “brokers’ transactions.”

3. Form 144 Filing Thresholds.

a. Background.

The current Rule 144(h), which requires notice filings of proposed sales, has been in place since Rule 144’s initial adoption in 1972. Rule 144(h) currently requires a notice on Form 144 to be submitted to the SEC if a selling securityholder intends to sell securities under Rule 144 that exceed 500 shares or an aggregate sale price of $10,000 within a three-month period.

b. Adoption of Higher Thresholds for Form 144 Filings.

In accordance with its June 2007 proposing release, the SEC has amended Rule 144(h) to increase the Form 144 filing threshold amount to trades of 1,000 shares or $50,000 within a three-month period. Only affiliates of issuers will be required to file this notice when relying on Rule 144, and these requirements will no longer apply to non-affiliates. The SEC expects that this amendment will substantially reduce the Form 144 filing requirements for affiliates of public companies.

4. Simplification of Preliminary Note and Codification of Certain SEC Staff Interpretations.

In addition to the new rules noted above, the new amendments will also amend Rule 144 to:

streamline the introductory note to Rule 144 to clarify in “plain English” that any
person who sells restricted securities – and any affiliate or person who sells restricted securities on behalf of an affiliate – will not be deemed to be engaged in a distribution of the securities, and therefore will not be deemed an underwriter with respect to the transaction in which the securities are sold if the sale is made in accordance with the provisions of Rule 144; and
codify certain staff interpretations of the SEC’s Division of Corporation Finance to facilitate market participants’ understanding and compliance with Rule 144.

C. “Tolling Provisions” Relating to Holding Period for Hedging Transactions Not Adopted.

1. Background.

In its June 2007 proposing release, the SEC expressed its concern about hedging transactions with respect to resales of restricted securities, insofar as these transactions are designed to transfer the economic risk of investment away from the securityholder and to a third party shortly after that securityholder acquires the security. Due to these concerns, the SEC proposed adding a new paragraph to Rule 144 that would toll the holding period for restricted securities of reporting companies while an affiliate or non-affiliate is engaged in certain hedging transactions. This proposal met with a substantial level of opposition, with commentators noting, among other things, the significant operational and compliance difficulties that would arise from attempting to track (a) securities subject to hedging transactions in a DTC environment or other environment where securities are fungible and positions are netted or (b) hedged securities positions that change daily or more frequently at certain financial institutions.

2. Rationale for Not Adopting “Tolling Provisions” for Hedging Transactions.

Reacting to the strong public criticism of the proposed tolling provisions, the SEC was persuaded that these provisions would unduly complicate Rule 144 and that there was not strong evidence that hedging activity resulted in abuses in the context of Rule 144. Consequently, the SEC did not adopt these provisions. The SEC will continue to monitor hedging activities of holders of restricted securities and, if necessary, will revisit this issue.

D. Revisions to Rule 145: “Presumptive Underwriter” Provisions.

Rule 145 provides that exchanges of securities in connection with reclassifications of securities, mergers or consolidations, or transfers of assets that are subject to shareholder vote, constitute sales of these securities. Rule 145(c) and Rule 145(d) are known as the “presumptive underwriter” provisions. Rule 145(c) deems a person who is a party to these transactions (other than the issuer or any person who is an affiliate of the issuer when the transaction is submitted for vote or consent) and who publicly offers or sells securities of the issuer acquired in connection with the transaction to be an “underwriter” within the meaning of Section 2(11) of the Securities Act. Rule 145(d) sets forth the restrictions on the resale of these securities by persons and parties deemed to be underwriters. The practical effect of these rules is to decrease the liquidity of securities held by securityholders of parties that have been subject to merger transactions.

The SEC originally proposed to eliminate the “presumptive underwriter” provisions in its 1997 proposing release. In its June 2007 proposing release, the SEC re-affirmed its belief that the Rule 145 presumptive underwriting provisions were unnecessary. However, based on abusive sales of securities that have resulted from business combinations involving shell companies, the SEC still finds it necessary to apply the presumptive underwriter provisions to shell companies, their affiliates and their promoters. Accordingly, the new rules eliminate the presumed underwriter status provisions in Rule 145(c), except with regard to transactions involving shell companies.

Part II – Smaller Reporting Company Regulatory Relief and Simplification Provisions.

In its new rules, the SEC extended the benefits of its optional disclosure reporting requirements for smaller companies to a larger group of public companies. The SEC’s adopting release that sets forth the final rules may be found at http://www.sec.gov/rules/final/2007/33-8876.pdf.

A. Replacement of “Small Business Issuer” Category with “Smaller Reporting Company.”

1. Background.

Currently, the term “small business issuers” refers to companies with both a public equity float and annual revenues of less than $25 million. “Non-accelerated filers” (companies that do not qualify as “large accelerated filers” or “accelerated filers” under Exchange Act Rule 12b-2) have a public equity float of less than $75 million. According to the SEC, of the approximately 12,000 companies that filed annual reports under the Exchange Act in 2006, approximately 4,000 of these companies had a public equity float of less than $25 million and qualified as small business issuers, and approximately 5,000 had a public equity float of less than $75 million. The new rules create a new category called “smaller reporting company,” which will include companies with a public float of less than $75 million and which will benefit from a series of reduced disclosure requirements.

2. New “Smaller Reporting Company” Definition; Combination of Two Groups of Scaled Requirements.

The new term “smaller reporting company” will refer to companies that are not investment companies or asset-backed issuers, and have a public equity float of $75 million or less. For companies that do not have a public equity float as defined, or are unable to calculate this item (for example, because the company had no significant public common equity outstanding or no market price for its common equity), these companies will be eligible to use the scaled disclosure if their respective annual revenues were less than $50 million during their most recently completed fiscal year. As a result, the new term “smaller reporting company” will include two formerly separate groups – “small business issuers” (companies currently eligible to use the Regulation S-B disclosure requirements) and most non-accelerated filers.

The new rules provide for movements in and out of the scaled disclosure system, based upon changes in market capitalization over time. Smaller reporting companies will be required to exit the scaled disclosure system in the fiscal year after their individual public float rises above $75 million as of the last business day of their second fiscal quarter. A company of this kind attempting to re-enter the scaled disclosure system would need to determine that its public float was less than $50 million as of the last business day of its second fiscal quarter, and would be able to use scaled disclosure in the next fiscal year after that determination, beginning with its initial Form 10-Q of that year.

Notably, the SEC did not adopt its “inflation indexing” proposal, which would have adjusted the $75 million and $50 million ceilings every five years to account for inflation. However, the SEC is currently undertaking a larger project to examine inflation indexing across a wider range of existing rules – a project that will also include examining the definitions of large accelerated filers, accelerated filers and non-accelerated filers.

Whether they are large or small, foreign private issuers that satisfy the criteria will be able to qualify as “smaller reporting companies.” Accordingly, these companies could have the choice of taking advantage of the scaled standards for smaller reporting companies, or providing disclosure based on the requirements of the SEC’s forms for foreign private issuers. However, in order for a foreign private issuer to use the smaller reporting company rules, it must (a) file its periodic reports on U.S. forms and (b) prepare its financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”).

B. Scaled Disclosure Item Requirements from Regulation S-B Merged into Regulation
S-K.

Regulation S-B, which is currently available only to U.S. and Canadian issuers, was designed to provide small business issuers with a single source for their SEC disclosure requirements. The SEC’s objectives in adopting a new disclosure system for smaller companies were principally to reduce compliance costs, while maintaining adequate investor protection. The new rules will integrate Regulation S-B’s substantive scaled disclosure items into the related items of Regulation S-K. As a result of these amendments, smaller reporting companies:

will not be required to include financial information about segments in their “Description of Business” discussion;
will only be required to disclose business development activities for three years, as opposed to five;
will not be required to provide “selected financial data” or “supplementary financial information”;
will only be required to present a comparison of two years, and will not be required to provide tabular disclosure of their contractual obligations in their MD&A disclosure;
will not be required to include the “Quantitative and Qualitative Disclosures about Market Risk” section;
will have reduced reporting requirements relating to executive compensation, including that they will not be required to present the new “CD&A” section, and will be required to disclose compensation information relating to a smaller number of executive officers;
will have reduced disclosure obligations relating to related party transactions and corporate governance matters;
will not be required to provide a stock performance graph; and
will not be required to include risk factor disclosure in their Form 10-K and Form 10-Q filings.

C. Integration of Individual Regulation S-B Disclosure Provisions into Regulation S-K;
“A La Carte” Compliance Option.

The new rules integrate individual Regulation S-B disclosure items (other than Item 310, as discussed below) into Regulation S-K. To accomplish this, each relevant item of Regulation S-K will be amended to contain separate disclosure standards for smaller reporting companies. Each new paragraph have a heading “Smaller Reporting Companies” for ease of reference.

The new rules will allow each smaller reporting company to select on an item-by-item, or “a la carte” basis, whether it will comply with the new scaled disclosure requirements in Regulation S-K for smaller reporting companies, or whether it will comply with the more rigorous disclosure requirements in Regulation S-K that apply to other companies. These new rules will give each smaller reporting company both the flexibility to determine at its option whether it takes advantage of one, some or all of Regulation S-K’s new scaled disclosure requirements, and the ability to tailor the proper balance of disclosure for its investors.

Whether or not they choose to rely on the scaled disclosure provisions, smaller reporting companies will need to check the new “smaller reporting company” box on the cover page of their reports, in order to enable market participants to easily determine whether or not a company may be basing its disclosure on these rules.

D. Amended Financial Statement Requirements for Smaller Reporting Companies.

One of the most important provisions of Regulation S-B is Item 310, which governs the form, content and preparation of financial statements for small business issuers. Currently, the requirements in Item 310 are less detailed than those that appear in Regulation S-X, the regulation that governs the financial statements of most public companies that do not rely on Regulation S-B. Item 310 also bases the requirements for form, content and preparation of financial statements solely on GAAP, as opposed to the requirements of SEC Regulation S-X. Additionally, while Regulation S-X requires an audited balance sheet for the last two fiscal years and audited statements of income, cash flows and changes in stockholders’ equity for each of the last three fiscal years, Item 310 allows smaller companies to provide only an audited balance sheet for the latest fiscal year and audited statements of income, cash flows and changes in stockholder’s equity for each of the latest two fiscal years. In the new rules, the SEC has added provisions to Regulation S-X which replace Item 310 of Regulation S-B and will extend many of the scaled disclosure requirements for small business issuers to smaller reporting companies.

2. New Financial Statement Requirements.

There are several substantive changes that will distinguish the new Regulation S-X requirements for smaller reporting companies from the current Item 310. First, because “smaller reporting companies” can include all foreign companies under amended Regulation S-X, foreign issuers who elect to use the scaled reporting rules will be required to file U.S. GAAP financial statements with the SEC. For this reason, a foreign issuer will need to weigh the benefits of filing on the forms for a “smaller reporting company” (rather than on the SEC’s forms for foreign private issuers) against the burdens of having to prepare U.S. GAAP financials. Second, under the new rules, smaller reporting companies will need to provide two years – rather than one year – of audited balance sheet data in annual reports and registration statements.

In connection with the amendments to the financial reporting rules for smaller reporting companies, these companies will be required to file financial statements that conform to GAAP, but generally will not be required to comply with other provisions of Regulation S-X. Additionally, these companies will also enjoy a somewhat more permissive set of rules in the event that their financial statements “go stale” for purposes of filing a registration statement, as well as for purposes of determining when the company must include financial statements for a business that it proposes to acquire.

E. Elimination of Current “SB” Forms.

Under the new rules, smaller reporting companies will no longer use SB forms such as Form SB-1 or Form 10-KSB. Instead, these companies will use the forms for larger U.S. companies, such as Form S-1 and Form 10-K. There will be a phase-out period, described below, for current small business issuers transitioning to smaller reporting companies. As a practical matter, the elimination of all other “SB” Forms will likely result in regulatory simplification by having only one set of disclosure requirements, and is expected to make smaller reporting company filers more “mainstream” through their integration into the Regulation S-K framework.

During the phase-out period, current small business issuers will have the option to file their next annual report for a fiscal year ending on or after December 15, 2007 on either Form 10-KSB or Form 10-K. Such an issuer may continue to file its periodic reports using Regulation S-B and the SB forms until its next annual report is filed. Thereafter, all of its periodic reports must be filed on a form that does not have the SB designation.

As to registration statements, all companies filing a registration date after the effective date of the new rules will be required to file on the appropriate form without an SB designation.

Part III – Exemption of Compensatory Employee Stock Options from Registration Under Section 12(g) of the Exchange Act.

A. Background.

For many years, private, non-reporting issuers have used compensatory stock options as a form of non-cash compensation to attract, motivate and retain employees. Since 1990, certain private, non-reporting companies have granted compensatory employee stock options to 500 or more people. Currently, under Section 12(g) of the Exchange Act, a company with 500 or more holders of record of a class of equity securities and assets in excess of $10 million at the end of its most recently ended fiscal year must register that class of securities with the SEC, unless there is an available exemption from registration. Although there is an exemption under Section 12(g) for interests in other employee compensation plans involving securities, there is no exemption for compensatory employee stock options. Consequently, numerous private non-reporting companies that issued compensatory stock options have sought registration relief from the SEC’s Division of Corporation Finance. In the past, when certain specified conditions were present, the SEC issued no action letters to provide these companies with the requested relief.

In its July 2007 proposing release, the SEC proposed two exemptions from Exchange Act Rule 12h-1 (which currently lists exemptions from the provisions of Section 12(g) for interests in employee stock bonus, stock purchase or similar plans) to provide Section 12(g) registration relief to issuers of compensatory employee stock options. The first exemption was intended to provide non-Exchange Act reporting companies with certainty that their decisions with respect to compensatory employee stock options issued under stock option plans would not subject them to Exchange Act reporting and registration requirements before they became public companies. The second exemption was intended to provide Exchange Act reporting companies with registration relief for only the options (and not the equity securities underlying those options) issued under a stock option plan when (a) the class of equity securities underlying those options has already been registered under Exchange Act Section 12 and (b) the class of persons eligible to receive or hold the options is limited appropriately.

B. Adoption of the Two Proposed Exemptions Relating to Compensatory Employee Stock Options.

Determining that the existing statutory provisions and rules provide holders of employee stock options with appropriate protections under federal securities laws, the SEC adopted two new exemptions to Rule 12h-1, as follows:

private non-reporting companies will be exempt from Section 12(g) registration for compensatory employee stock options issued under employee stock option plans; and
companies that are reporting companies under Section 13 or Section 15(d) of the Exchange Act will be exempt from Section 12(g) registration for compensatory employee stock options.

The SEC’s adopting release that sets forth the final rules may be found at http://www.sec.gov/rules/final/2007/34-56887.pdf.

These new exemptions will benefit private companies by preventing them from becoming subject to the Exchange Act’s reporting requirements as a result of their granting equity rewards to their employees in the form of employee stock options. Public companies will also benefit from these new exemptions, as they will have enhanced certainty that they need not register their stock options once they have registered the underlying class of equity securities. These new exemptions will also reduce the SEC’s administrative burden, as they will have the practical effect of streamlining and reducing the reporting process for the relevant companies.

* * *

Effectiveness of New Amendments.

The new rules have different effective dates:

the amendments of Rule 144 and Rule 145 will become effective on February 15, 2008;
the amendments with respect to smaller reporting companies will become effective in January 2008, and will be effective for annual reports on Form 10-K for companies with a fiscal year end on or about December 31 for purposes of the filings due in 2008; and
the amendments exempting compensatory employee stock options from registration became effective on December 7, 2007.