SEC Proposes Amendments To Capital Raising & Reporting Rules For Smaller Companies & Approves Guidance On Compliance With Section 404 Of SOX

On May 23, 2007, the U.S. Securities and Exchange Commission ("SEC") proposed a series of measures aimed at modernizing and improving certain requirements with respect to the capital raising and reporting requirements for smaller companies. On the same day, the SEC unanimously approved interpretive guidance for compliance with Section 404 of the Sarbanes-Oxley Act of 2002 ("SOX"). The proposed measures and interpretive guidance confirm the SEC’s commitment to minimizing the regulatory burden imposed upon, and facilitating capital formation by, smaller companies. The text of the interpretive guidance, and proposed regulations are not yet available yet. The descriptions provided in this Alert are based on SEC press releases and statements made by the Commissioners and SEC staff at the open meeting.

SMALLER COMPANY REGULATION IMPROVEMENT

The measures proposed by the SEC incorporate many of the recommendations the SEC Advisory Committee on Smaller Public Companies (the "Committee"), as well as in the recommendations of the 25th Annual SEC Government-Business Forum On Small Business Capital Formation.1

The goal of the proposed rulemaking (the "Proposals") is to ease the burdens that smaller companies face in raising capital and complying with SEC reporting requirements. The "focus on capital formation and the removal of obstacles to the growth of smaller companies goes hand-in-hand with [the SEC’s] responsibility to protect investors," according to SEC Chairman Christopher Cox. Chairman Cox explained that "[i]t’s investors who are injured and whose money is lost when the small businesses in which they invest can’t get affordable access to new capital."

The Proposals would:

• Implement a new system of securities regulation for smaller public companies that would make scaled regulation available to a much larger number of smaller public companies;
• Modify eligibility requirements of certain securities offering registration forms to allow companies with a public float below $75 million to take advantage of the benefits of shelf registration;
• Add a new exemption from Securities Act of 1933 ("Securities Act") registration requirements for sales of securities to a newly defined category of "qualified purchasers" in which limited advertising would be permitted;

• Shortened holding periods under Securities Act Rules 144 and 145 for restricted securities to reduce the cost of capital and to increase access to capital;

• Add new exemptions for compensatory employee stock options so that the Securities Exchange Act of 1934 ("Exchange Act) registration requirements would not be triggered solely by a company’s compensation decisions; and

• Provide for the electronic filing of Form D, the form filed by companies making private or limited offerings in connection with Regulation D offerings, to ease burdens for filers and make the information more readily available.

Scaled Disclosure and Reporting Requirements

Under the Proposals, all companies with up to $75 million in public float would be eligible for scaled disclosure and reporting. At the present time only companies that have a public float of common equity of less than $25 million are eligible to utilize Regulation S-B, the "SB" public report forms and Form SB-2 registration statement (the "SB Forms"). If adopted this change would significantly expand the number of issuers entitled to provide disclosure under the less stringent requirements applicable to smaller issuers. Additionally, the Proposals would simplify the disclosure and reporting requirements by combining, for most purposes, the categories of small business issuers and non-accelerated filers into one new category called "smaller reporting companies." In order to simplify the disclosure and reporting requirements even further, the Proposals contemplate the integration of the current Regulation S-B disclosure requirements into the Regulation S-K disclosure requirements. Finally, all "SB" forms would be abolished.

Shelf Registration Eligibility

The Proposals would permit companies that do not meet the current requirement for eligibility for use of Forms S-3 or F-3 to nevertheless register primary offerings of securities on such forms, subject to a restriction on the amount of securities that the company may sell in any one-year period. As proposed, a company with less than $75 million in public float could register a primary offering on Form S-3 or F-3, provided that it:

• does not sell more than the equivalent of 20% of its public float in primary offerings registered on Form S-3 or F-3 over any one-year period;
• meets the other eligibility conditions for the use of Form S-3 or F-3; and
• is not a shell company and has not been a shell company for at least 12 months prior to filing the registration statement.

New Offering Exemption

The Proposals would create new Rule 507 under Regulation D, which would provide an exemption from Securities Act registration for sales of securities to a new category of qualified purchasers, namely "Rule 507 Qualified Purchasers." This exemption would allow issuers to engage in limited advertising akin to a "tombstone" addressed to Rule 507 Qualified Purchasers in connection with the sale of its securities (the existing limitation against general solicitations would otherwise remain in effect). Rule 507 Qualified Purchasers will be defined to include purchasers with either $2.5 million in investments or individual annual income of at least $400,000 ($600,000 in the aggregate with a spouse). Institutions holding $10 million in investments generally would qualify as Rule 507 Qualified Purchasers. Directors, executive officers and general partners of the issuer would qualify as Rule 507 Qualified Purchasers without having to satisfy the monetary requirements.

The Proposals would also amend the qualifications for "accredited investors" as used in Regulation D by adding an investments-owned test to the existing total assets and net worth requirements. Specifically it has been proposed that the definition of "accredited investor" be revised to include individual investors that own investments of $750,000 and institutional investors that own investments of $5 million. It has also been suggested that the list of entities that could qualify as "accredited investors" would be expanded, but no definitive guidance has been issued as of the date of this Alert. Finally, it was proposed that beginning September 1, 2012, the monetary thresholds for qualifying as an "accredited investor" would be periodically adjusted to reflect inflation.

The Proposals would change Regulation D further by shortening the integration safe harbor from six months to ninety days and applying uniform "bad boy" disqualification provisions to all Regulation D offerings.

Rules 144 and 145

The Proposals would amend Rule 144 to shorten the holding period for restricted securities of reporting companies from 1 year to 6 months. Under the Proposals the holding period would be tolled for up to 6 months while a security holder is engaged in certain hedging transactions, such as the commonly-used "collar".

The Proposals would permit the resale of restricted securities by non-affiliates of reporting companies after they satisfy a 6 month holding period (or 12 months if hedging occurs). Nonaffiliates could resell restricted securities of non-reporting companies after satisfying a 12 month holding period.

The Proposals also would raise the Form 144 filing requirement threshold for affiliates’ sales and eliminate the manner of sale limitations with respect to debt securities.

Finally, in an effort to simplify compliance, the Proposals would streamline certain parts of Rule 144, including the Preliminary Note thereto, and codify certain staff interpretations relating to the rule.

The SEC is seeking public comment on whether to permit affiliates of issuers that are subject to the filing requirements of Section 16 of the Exchange Act to satisfy their Form 144 filing requirements by filing a Form 4.

With respect to Rule 145, the Proposals would eliminate the presumptive underwriter provision except in the case of transactions involving blank check or shell companies. The Proposals also would revise the resale provisions of subsection (d) of Rule 145 to mirror the requirements in revised Rule 144.

Registration Exemption for Compensatory Employee Stock Options

Under existing law stock options constitute a separate class of an issuer’s securities, are required to be registered under Section 12(g) of the Exchange Act and therefore subject an otherwise non-reporting company to the reporting requirements of the Exchange Act if the registration thresholds set forth in Section 12(g) are met. The SEC approved a proposal for two new exemptions from the registration requirements of Section 12(g) of the Exchange Act. The first would apply to compensatory employee stock options issued by non-reporting issuers, provided that the options are issued pursuant to a written plan; eligible recipients are limited to employees, directors, consultants and advisors; the transferability of the shares received upon exercise of the options and shares of the same class as those underlying the options is restricted; and certain risk and financial information is provided to the option holders and holders of shares received upon exercise of the options (akin to that required if securities are sold in reliance on Rule 701 exceeded $5 million in a 12-month period). The second exemption would apply to compensatory employee stock options issued by issuers that are subject to Section 12(g) reporting.

Form D Filings

The Proposals would require that Form D be filed electronically using a new online system. Moreover, the Proposals would simplify and update the form itself. The full text of the Proposals will be made available on the SEC’s website as soon as possible.

SECTION 404 OF SOX

The SEC unanimously approved interpretative guidance (the "Guidance") aimed at helping public companies strengthen their internal control over financial reporting while reducing unnecessary costs, particularly for smaller companies through a risk-based approach. The SEC worked closely with the Public Company Accounting Oversight Board ("PCAOB") to align the Guidance with the PCAOB’s newly-proposed auditing standard number 5.

The goal of the Guidance is to focus companies’ management on the internal controls that best protect against the risk of a material financial misstatement. According to Chairman Cox, by using the Guidance, "companies of all sizes will be able to scale and tailor their evaluation procedures according to the facts and circumstances. And investors will benefit from the reduced compliance costs."

In addition to the Guidance, the SEC approved rule amendments to:

• provide that a Company that performs an evaluation of internal control in accordance with the Guidance satisfies the annual evaluation required by Exchange Act Rules 13a-15 and 15d-15;
• define "material weakness" as "a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis;"
• revise the requirements for the auditor’s attestation report on the effectiveness of internal control over financial reporting to more clearly convey that the auditor should opine directly on internal control, rather than on management’s evaluation process.

The Guidance and the rule amendments will become effective 30 days from their publication in the Federal Register.

Footnote

The Cozen O’Connor Securities Practice Group, consisting of lawyers from the firm’s Washington, D.C., Philadelphia, and West Conshohocken offices, offers expertise in a broad range of securities matters, including transactional, regulatory and compliance matters, litigation in federal and state courts, as well as before administrative agencies, and criminal defense. The Securities Practice Group is involved in all types of public and private equity and debt offerings, structuring M & A transactions, assisting our public clients comply with ongoing securities law obligations, and representing broker-dealers in a full range of regulatory issues. Cozen O'Connor's securities attorneys, several of whom held significant positions at the Securities and Exchange Commission and continue to maintain frequent contact with the SEC, take pride in leading our diverse clientele through the labyrinth of federal and state securities law issues in an efficient and cost-effective manner. The Securities Practice Group works closely with many other practice groups in the firm, including those that concentrate in the areas of corporate, banking, public finance, real estate, and tax law, to provide our clients with integrated solutions to their legal issues.

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