United States: SEC/SRO Update

SEC Revises Timeline for Adopting Rules Implementing Dodd-Frank

The Securities and Exchange Commission (SEC) has revised its proposed timeline¹ for adopting rules implementing The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Below is a planned schedule of certain Dodd-Frank SEC rulemakings:

• As it stands now, the SEC plans on adopting final rules during the August-December 2011 time period relating to disclosure by institutional investment managers of votes on executive compensation (§ 951 of Dodd-Frank); exchange listing standards regarding compensation committee independence and factors affecting compensation adviser independence and disclosure rules concerning compensation consultant conflicts (§ 952 of Dodd-Frank); and revising the "accredited investor" standard (§ 413 of Dodd-Frank).
• The SEC now plans on issuing proposed rules relating to disclosure of pay-for-performance, pay ratios and hedging by employees and directors (§§ 953 and 955 of Dodd-Frank) and clawback of executive compensation (§ 954 of Dodd-Frank) in the August-December 2011 time period and adopt final rules relating to these matters in the January-June 2012 time period.
• Also in the January-June 2012 time period, the SEC plans to propose and adopt rules (jointly with others) relating to disclosure of, and prohibitions of certain executive compensation structures and arrangements (§ 956 of Dodd-Frank).
• In the July-December 2012 time period, the SEC plans to report to Congress on its study and review of use of compensation consultants and effects of such use (§ 952 of Dodd- Frank).
• The SEC has not yet determined when it will issue proposed rules on definition of "other significant matters" for purposes of exchange standards regarding broker voting of uninstructed shares (§ 957 of Dodd-Frank).

Given this revised timetable, it is unlikely that all of the rules relating to pay-for-performance, pay ratios and hedging by employees and directors, claw back of executive compensation and disclosure of, and prohibitions of certain executive compensation structures and arrangements will be effective for the 2012 proxy season.

NASDAQ, NYSE and NYSE AMEX Propose Rules Making It More Difficult for Companies to List after Effecting a Reverse Merger

In response to the alleged widespread fraudulent behavior of reverse merger companies, the three major U.S. stock exchanges—the NASDAQ Stock Market LLC (NASDAQ), the New York Stock Exchange LLC (NYSE) and NYSE Amex LLC (NYSE Amex)—have proposed rules making it more difficult for a reverse merger company to list its securities on each of these exchanges. Generally, a reverse merger company exists when a public shell company merges with a private operating company in a transaction in which the shell company is the surviving legal entity.

The exchanges are proposing to adopt a "seasoning" period which, according to the NYSE filing, "should provide greater assurance that the company's operations and financial reporting are reliable, and will also provide time for its independent auditor to detect any potential irregularities, as well as for the company to identify and implement enhancements to address any internal control weaknesses. The seasoning period will also provide time for regulatory and market scrutiny of the company... ."²

Under the NASDAQ proposed rules a reverse merger company will be eligible to submit an application for initial listing only if the combined entity has, immediately preceding the filing of the initial listing application: (1) traded for at least six months in the U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange, following the filing with the SEC or other regulatory authority of all required information about the transaction, including audited financial statements for the combined entity; and (2) maintained a bid price of $4 per share or higher on at least 30 of the most recent 60 trading days. In addition, such a company may only be approved for listing if, at the time of approval, it has timely filed, in the case of a domestic issuer, its most recent two required periodic financial reports with the SEC or other regulatory authority (Forms 10-Q or 10-K) containing at least six months of information about the combined entity, or, in the case of a foreign private issuer, comparable information on Forms 6-K, 20-F or 40-F.

Under the NYSE proposed rules a reverse merger company would not be eligible for listing unless the combined entity had, immediately preceding the filing of the initial listing application: (1) traded for at least one year in the U.S. over-the-counter market, on another national securities exchange or on a regulated foreign exchange following the consummation of the reverse merger and, in the case of a domestic issuer, filed with the Commission a Form 8-K including all of the information required by Item 2.01(f) of Form 8-K, including all required audited financial statements, or, in the case of a foreign private issuer, filed comparable information on Form 20-F; (2) maintained on both an absolute and an average basis for a sustained period a minimum stock price of at least $4; and (3) timely filed with the SEC all required reports since the consummation of the reverse merger, including the filing of at least one annual report containing audited financial statements for a full fiscal year.

The NYSE Amex proposed rules are the same as the NYSE proposed rules except that rather than a sustained minimum stock price of $4, the reverse merger company must maintain on both an absolute and an average basis for a sustained period a minimum closing stock price equal to the stock price requirement, including all requirements based on stock price, applicable to the initial listing standard under which the reverse merger company was qualifying to list. Even if a company meets the foregoing criteria, an exchange could still choose not to list a reverse merger company's securities. Under the proposed rules, the exchanges will conduct risk-informed reviews of reverse merger companies seeking to list on the exchange using broad discretion.

SEC Replaces Credit Ratings with New Criteria to Determine Form S-3 or Form F-3 Eligibility

On July 27, as required by § 939A of Dodd- Frank, the SEC adopted rules to remove references to credit ratings in forms and rules promulgated under the Securities Act of 1933 (Securities Act) and Securities Exchange Act of 1934.³ This article focuses on the rules that, effective September 2, 2011, replaced credit ratings criteria with a new test, which must be satisfied by a public company planning to use Form S-3 or Form F-3 to register a primary offering of nonconvertible securities for cash. To ease transition to new rules, the SEC also adopted a three-year grandfather provision.

Generally, to be eligible to use a registration statement on Form S-3 or Form F-3, a company must meet the form's eligibility requirements related to the registrant (General Instruction I.A.) and at least one of the form's transaction requirements in General Instruction I.B.

Prior to September 2, 2011, Instruction I.B.2 permitted public companies to register primary offerings of nonconvertible investment grade securities for cash, which meant that, at the time of sale, at least one nationally recognized statistical rating organization rated the security in one of its generic rating categories which signified investment grade.

New Instruction I.B.2 includes four criteria focused on whether the company using Form S-3 or Form F-3 is widely followed in the marketplace. Instruction I.B.2 provides that a primary offering of non-convertible securities, other than common equity, for cash is eligible to be registered on Form S-3 or Form F-3 if one of the following conditions is satisfied:

• the company has issued (as of a date within 60 days prior to the filing of the registration statement) at least $1 billion in nonconvertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Securities Act, over the prior three years;
• the company has outstanding (as of a date within 60 days prior to the filing of the registration statement) at least $750 million of nonconvertible securities, other than common equity, issued in primary offerings for cash, not exchange, registered under the Securities Act;
• the company is a wholly owned subsidiary of a well-known seasoned issuer (WKSI);⁴ or
• the company is a majority-owned operating partnership of a real estate investment trust (REIT) that qualifies as a WKSI.

The SEC noted in the adopting release that none of the foregoing criteria should be viewed as a standard of credit worthiness. Rather, the SEC was trying to preserve short-form eligibility for companies that have a wide following in the marketplace and viewed these criteria as an indication of wide market following. The SEC has included a wholly owned subsidiary of a WKSI in this list because the SEC believes that such subsidiary is likely to be widely followed by the same analysts who follow the parent company's operations. The SEC has added a majority-owned operating partnership of a REIT that qualifies as a WKSI to this list based on the SEC's analysis of a REIT's structure and the likelihood that followers of a REIT would also review the operations of its operating partnership.

In calculating the $1 billion or the $750 million amounts, a company can include the principal amount of any nonconvertible debt and the greater of liquidation preference or par value of any nonconvertible preferred stock issued in primary registered offerings for cash. Parent company issuers can include in their calculations the principal amount of their full and unconditional guarantees of nonconvertible securities, other than common equity, of their majority-owned subsidiaries issued in registered primary offerings for cash over the prior three years or outstanding as of a date within 60 days prior to the filing of the registration statement.

In order to facilitate the transition to the new rules, the SEC is permitting companies that reasonably believed (and disclosed the basis for such belief) that they would have been eligible to use a registration statement on Form S-3 and Form F-3 prior to September 2, 2011, (i.e., the date of effectiveness of new rules) to continue to use these forms and to file a final prospectus for an offering of nonconvertible securities pursuant to such registration statement until September 2, 2014, even if such issuers would not be eligible to do so under the new rules.

The SEC indicated that the following factors could serve as non-exclusive grounds for the company's reasonable belief of eligibility: (i) an investment grade security rating; (ii) a previous investment grade credit rating on a security issued in an offering similar to the type the company seeks to register that has not been downgraded or put on a watch-list since its issuance; or (iii) a previous assignment of a preliminary investment grade rating.

FINRA Issues Investor Alert Warning about Chasing Returns in Structured Products, High-Yield Bonds and Floating-Rate Loan Funds

On July 25, the Financial Industry Regulatory Authority (FINRA) issued an Investor Alert, entitled The Grass Isn't Always Greener—Chasing Returns in a Challenging Investment Environment, that warns investors that investments promising higher returns often have greater risk and that investors should not invest based solely by looking at an investment's return, whether historical or projected.

In the Investor Alert, FINRA pointed out that recently there has been an increase in several types of investments that promise higher returns including, among other things, high-yield bonds, floating-rate loan funds, structured retail products and leveraged products. FINRA noted that there are several questions an investor should ask prior to making an investment in these higher return products, including:

• Does the higher return from the investment come with increased risk? Does the investor understand how the investment operates? If an investor does not fully understand how an investment functions, the investor could be surprised by unexpected outcomes, such as illiquidity, exit fees, loss of principal, or the return of investment in a form other than cash.
• What are the costs and fees associated with the new investment? Many higher return products have higher costs. FINRA notes as an example that hedge funds and structured products can be very costly, and since some of the costs are built into their return, it can be difficult to know what an investor is paying.
• Is the product callable? If a product is callable, the issuer can redeem the investment prior to the investment reaching maturity. In such an instance, the investor may not be able to find another investment that will have as favorable returns as the called investment.
• Could the new investment be fraudulent? FINRA emphasizes that an investor should always independently verify who the investor is dealing with and whether the seller of the investment is licensed to do business with the investor. The status of individual brokers or firms can be checked using FINRA's Broker Check, and the status of an investment adviser or firm can be checked using the Investment Adviser Public Disclosure database.

SEC Issues Order Raising Dollar Thresholds in Qualified Client Rule

The Investment Advisers Act of 1940 (Advisers Act) generally prohibits a registered investment adviser from charging performance-based fees to clients. However, Rule 205-3 under the Advisers Act permits registered investment advisers to charge a performance-based fee to "qualified clients."

Since 1998, qualified clients under Rule 205-3 have included clients who have assets under management with the adviser of $750,000 or more, and clients who have a net worth of $1.5 million or more. Dodd-Frank, signed into law on July 21, 2010, directed the SEC to adjust the dollar thresholds included in the qualified client definition for inflation within one year of the date of enactment, and every five years thereafter. Accordingly, on July 12, 2011, the SEC issued an order approving adjustments to the dollar thresholds in Rule 205-3 under the Advisers Act. Pursuant to such order, the $750,000 million assets under management test was increased to $1 million and the $1.5 million net worth test was increased to $2 million. The order is effective as of September 19, 2011.

SEC Makes a Statement on Well-Known Seasoned Issuer (WKSI) Waivers

On July 8, the Division of Corporation Finance of the SEC issued a statement on WKSI waivers.⁵ Public companies that violated antifraud provisions of federal securities laws or that are the subject of a judicial or administrative decree or order (including a settled claim or order) prohibiting certain conduct or activities regarding antifraud provisions of federal securities laws, become "ineligible issuers" and cannot qualify as a WKSI for three years, which may affect their capital raising capabilities.⁶

Under Securities Act Rule 405, the SEC may grant waivers of ineligible issuer status "upon a showing of good cause, that it is not necessary under the circumstances that the issuer be considered an ineligible issuer." The SEC statement clarifies what constitutes "a showing of good cause" for purposes of an ineligible issuer waiver request and outlines the framework the SEC will follow in considering whether to grant a waiver.

In evaluating the appropriateness of granting a waiver from ineligible issuer status, the SEC focuses on whether the anti-fraud violation (i) stems from the company's disclosures about itself, and (ii) is based on scienter.

If the antifraud violation involves the company's own disclosures and the company's conduct in making material misstatements or omissions involved scienter, then the likelihood of its future disclosures being unreliable may be greater than if the company's conduct was not intentional or reckless. Therefore, generally, a waiver request involving an anti fraud violation that is scienter-based and stems from the company's own disclosures would likely not be granted. If the antifraud violation does not involve the company's own disclosures (for example, the company is a broker-dealer, and the anti-fraud violation stems from its broker-dealer activity), then the SEC is less likely to be concerned with the reliability of the company's current and future disclosures and a waiver request would likely be granted, even if the anti fraud violation is scienter-based. If the antifraud violation is not scienter-based and stems from the company's own disclosures, then the SEC considers the following factors in deciding whether to grant the waiver (no single factor is determinative):

• Remedial Steps Taken by the Company—The SEC considers remedial measures the company has taken to prevent a recurrence of the misconduct, including changes in key personnel, undertakings specifically designed to prevent future fraudulent disclosures, improvements to internal controls and disclosure controls, and procedures and disclosures about those improvements.
• Pervasiveness and Timing of the Misconduct—The SEC examines the seriousness and pervasiveness of the misconduct by the company and its officers, directors and employees, including the culpability of individuals and the age of the misconduct. Fraudulent conduct and disclosures resulting from the actions of a few individuals not in positions of authority or leadership could create fewer questions about the reliability of a company's future disclosures than would a pattern or history of misconduct by senior management, or a culture or tone at the top demonstrating a lack of commitment to good disclosure. Changes in personnel would also be relevant to this factor.
• Impact on the Company if the Waiver Request Is Denied—The SEC assesses whether, in light of the nature of the company's misconduct, the loss of WKSI status would be a disproportionate hardship for the company. The SEC also evaluates whether the company's loss of WKSI status could have harmful effects for markets as a whole, the company's significance to the markets, and its connectedness to other market participants.

Footnotes

1. The entire planned timeline of SEC rule making under Dodd-Frank can be found on the SEC's Web site as follows: http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#08-12-11 .

2. SEC Release No. 34-65034, Self-Regulatory Organizations; New York Stock Exchange LLC; Notice of Filing of Proposed Rule Change Amending §§102.01 and 103.01 of the Exchange's Listed Company Manual to Adopt Additional Listing Requirements for Companies Applying to List After Consummation of a "Reverse Merger" with a Shell Company at pages 4-5.

3. See Security Ratings, SEC Release No. 33-9245 (July 27, 2011), at http://www.sec.gov/rules/final.shtml.

4. Generally, WKSI is an issuer that, as of a date within 60 days of determination date, (i) has a worldwide market value of its outstanding voting and nonvoting common equity held by nonaffiliates of $700 million or more; or (ii) has issued in the last three years at least $1 billion aggregate principal amount of nonconvertible securities, other than common equity, in primary offerings for cash, not exchange, registered under the Securities Act.

5. See Statement on Well-Known Seasoned Issuer Waivers, dated July 8, 2011, at http://www.sec.gov/divisions/corpfin/guidance/wksi-waiversinterp.htm.

6. WKSIs can register securities offerings on a shelf registration statement that becomes

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