At an open meeting on May 23, the SEC took several significant actions involving internal control requirements, the capital formation process, and resales of restricted securities and securities issued in registered business combination transactions. The SEC: 

  • Adopted interpretive guidance and related rules regarding management’s assessment of internal control over financial reporting that are intended to reduce the time and expense required for this assessment; 
  • Approved the issuance of rule proposals designed to modernize capital formation requirements, including proposals to (1) ease the registration and disclosure requirements for offerings by smaller companies, (2) broaden the class of issuers eligible for shelf registration of primary offerings to include certain companies with a public float below $75 million, (3) expand the class of accredited investors to whom sales can be made in unregistered offerings under Securities Act Regulation D, (4) exempt from registration under Section 12 of the Exchange Act compensatory stock options issued by non-reporting companies, and (5) limit the application of the so-called offering “integration doctrine” to securities offerings that occur within 90 days of each other; and
  • Approved the issuance of rule proposals that would reduce or eliminate various restrictions on the resale of securities under Securities Act Rules 144 and 145, including proposals to shorten the holding period requirements of the rules and raise the thresholds for the filing of Form 144. At the date of this SEC Update, the SEC had not issued any releases containing more detailed descriptions of the changes. Accordingly, the following description is based on statements made at the SEC’s open meeting and in SEC documents summarizing the actions. We will issue additional SEC Updates on the actions when the releases become available.

Internal Control Evaluations SEC Interpretive Guidance and Final Rules

The centerpiece of the SEC’s actions was its adoption of interpretive guidance and final rule amendments on management’s assessment of internal control over financial reporting required by Section 404 of the Sarbanes-Oxley Act.

The SEC adopted the interpretive guidance in substantially the form it had proposed in December 2006, which we described in our SEC Update of January 3, 2007. The guidance is centered around two broad principles. First, management should evaluate whether it has implemented controls that adequately address the risk that a material misstatement in the financial statements would not be prevented or deterred in a timely manner. Second, management’s evaluation of evidence about the operation of its controls should be based on its assessment of risk. In response to comments, the SEC adopted modifications to the interpretive guidance designed to (1) align the guidance more closely with Auditing Standard No. 5 of the Public Company Accounting Oversight Board (described below), (2) clarify the role of entity-level controls and the nature of ongoing monitoring activities in relation to management’s evaluation, and (3) enhance the guidance on fraud risk considerations.

The rule amendments provide that a company performing an evaluation of internal control in accordance with the interpretive guidance will satisfy the annual evaluation required by Exchange Act Rules 13a-15 and 15d-15. Any company that already has established a compliant evaluation process which differs from the approach outlined in the interpretive guidance will not be required to alter its process. The new rules will require only one opinion by a company’s independent auditor regarding the effectiveness of the company’s internal control over financial reporting. Thus, there will be no need for a second opinion on management’s assessment of internal controls, as currently required. The SEC also has amended its rules to define the term “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.” The rule amendments will become effective 30 days after publication in the Federal Register.

The SEC decided not to extend the deadlines for implementing Section 404 for non-accelerated filers, which were described in our earlier SEC Update. As a result, non-accelerated filers must provide management’s report on internal control over financial reporting in the annual report for the filer’s first fiscal year ending on or after December 15, 2007. The independent auditor’s opinion on internal control over financial reporting will not be required for these filers until the annual report due date for their first fiscal year ending on or after December 15, 2008. PCAOB Auditing Standard No. 5

On May 24, the PCAOB adopted new Auditing Standard No. 5 relating to audits of a reporting company’s internal control over financing reporting. According to the PCAOB’s press release, the new standard has four principal objectives:

  • To focus the internal control audit on those areas that present the greatest risk that a company’s internal controls will fail to prevent or detect a material misstatement in its financial statements; 
  • To eliminate unnecessary procedures, such as those used to opine on management’s own internal control evaluation process; 
  • To tailor the audit to fit the size and complexity of the company; and
  • To conform the audit requirements to the SEC’s interpretive guidance regarding internal control over financial reporting.

The new audit standard is subject to SEC approval and is expected to be effective for calendar year 2007 audits, with voluntary early adoption by affected parties encouraged.

Modernization of Capital Formation Requirements Disclosure and Reporting Requirements for Smaller Public Companies

The SEC will propose rule amendments to increase the number of companies eligible for the Commission’s revised disclosure and reporting requirements for smaller companies. The Commission is proposing to combine its current categories of “small business issuer” and “nonaccelerated filer” into a new category entitled “smaller reporting companies.” A “smaller reporting company” would be a company with a common equity public float of less than $75 million, up from the current $25 million ceiling for small business issuers. The new category would be the smaller company counterpart of the SEC’s current reporting company categories of “accelerated filer” and “large accelerated filer” under Exchange Act Rule 12b-2. The smaller reporting companies would be eligible to take advantage of the reduced disclosure requirements under the current Regulation S-B, which would be integrated into Regulation S-K. All “S-B” registration forms would be rescinded. Instead, smaller reporting companies would file registration statements and reports on the Commission’s regular forms and would be able to choose on an item-by-item basis whether to take advantage of the reduced disclosure requirements or provide the same disclosure as larger companies.

Form S-3 Eligibility for Primary Shelf Offerings by Smaller Reporting Companies

The SEC is proposing to broaden the eligibility requirements for short-form registration of public offerings on Form S-3 and (for foreign private issuers) Form F-3 to allow “smaller reporting companies” to take advantage of the benefits of abbreviated shelf registration statements for primary offerings if they meet certain conditions. A smaller reporting company would be eligible to use Forms S-3 and F-3 for primary shelf offerings if it: 

  • Has been timely in its Exchange Act filings for one year, in addition to the other eligibility conditions for the use of the forms;
  •  Is not a shell company and has not been a shell company for the prior 12 months; and
  • Will not sell more than the equivalent of 20% of its public float in primary offerings registered on Form S-3 or F-3 during any one-year period.

Exemption for Non-Reporting Companies From Exchange Act Registration of Stock Options

The SEC is proposing a new exemption from the registration provisions of Section 12(g) of the Exchange Act for non-reporting (privately-held) companies with 500 or more record holders of compensatory employee stock options. Companies with at least 500 holders of record of a class of equity security and assets in excess of $10 million at the end of their fiscal year must register the class pursuant to Section 12(g). Unless non-reporting companies have qualified for an exemption from Section 12(g) registration based on the terms and administration of their stock option plans, this requirement subjects such companies with 500 or more option holders and more than $10 million in assets to registration of the class of options under Section 12(g).

The new exemption from Section 12(g) registration would apply to compensatory stock options granted by non-reporting companies pursuant to a written compensatory stock option plan where:

  • The option holders are limited to employees, consultants, directors, and advisors; 
  • Limitations on transferability are imposed; and 
  • Risk factor disclosure and financial information of the type currently required by Rule 701 under the Securities Act is provided, in situations where the $5 million limit of Rule 701 is exceeded, to the option holders and holders of shares received upon exercise of the options.

The proposed exemption would extend only to the class of options and not to the common stock underlying the options. Accordingly, Section 12(g) registration still would be triggered for companies with more than $10 million in assets once they have 500 or more holders of their common stock.

The SEC will propose a second Section 12(g) registration exemption that would apply to compensatory employee stock options of reporting companies that have registered the common stock underlying the options under Section 12. Notwithstanding the technical applicability to them of Section 12(g) registration for a class of stock options, public companies generally have not filed to register this second class of equity securities under Section 12. The registration by public companies of the underlying common stock under Section 12 has afforded their option plan participants access to all reports and other information required of SEC filers.

Regulation D Under the Securities Act

Consistent with previous initiatives to modernize the requirements for the registration of public offerings, the SEC is proposing amendments primarily designed to have a similar effect with respect to offerings that are not registered. Many smaller public companies currently rely extensively on the exemptions from Securities Act registration provided by Regulation D for private offerings and other capital-raising activities. The SEC is proposing amendments to Regulation D that would reduce or eliminate various regulatory burdens on companies relying on the Regulation. The SEC proposes to amend Regulation D to add a new Rule 507 containing a registration exemption for offerings made to persons who meet prescribed financial qualification requirements or who are insiders of the issuer. An individual would be a “Rule 507 qualified purchaser” if the person owns at least $2.5 million in investments or has a personal annual income of $400,000 or an aggregate annual income with spouse of $600,000. An institutional investor generally would be a “Rule 507 qualified purchaser” if it owns $10 million in investments. Directors, executive officers, and general partners of the issuer would qualify as “Rule 507 qualified purchasers” without regard to any monetary threshold. Revised Regulation D would permit publication of “tombstone”-type advertising of these offerings.

The proposals also would provide additional ways for a person to qualify as an “accredited investor” under Regulation D. The current standards relating to total assets, net worth, and income would be augmented by a new “investments-owned” standard of $750,000 for individuals and $5 million for institutions. In addition, several new categories of entities would be added to the existing list of approved “accredited investors.” The monetary thresholds for “accredited investors” and “Rule 507 qualified purchasers” would automatically be adjusted for inflation beginning September 1, 2012. Further help to companies making offerings under Regulation D would be provided by the SEC’s proposal to require only a 90-day separation between unregistered offerings (rather than the current six months) to qualify for the safe harbor from integration of offerings provided by Rule 502 of Regulation D. In addition, the SEC is proposing to require electronic filing by issuers relying on Regulation D of Form D, which is the notice of sales made under the Regulation and which the SEC says it will revise and update. Finally, the SEC is proposing to update the “bad actor” disqualification provisions that currently apply only to offerings under Rule 505 and to extend the revised provisions to all offerings under Regulation D. Resales of Securities Under Rules 144 and 145

In a highly significant change, the SEC is proposing to reduce to six months the current one-year holding period required for restricted securities of reporting companies sold under Rule 144. (Restricted securities are securities acquired from the issuer or an affiliate in a nonpublic offering or in certain other types of exempt offerings.) The one-year requirement, however, would continue to apply to restricted securities of non-reporting companies.

The SEC’s proposal to adopt a six-month holding period for restricted securities of reporting companies would have a string attached in the form of a provision that would toll (or freeze) the holding period during any period in which the holder had a short position, or had entered into a put equivalent position, with respect to the securities. In 1990, the SEC had eliminated a similar tolling period provision for short positions that had been in the rule since its adoption in 1972.

The proposals also would reduce from two years to one year the holding period for restricted securities required under Rule 144(k) for non-affiliates who have not been affiliates during the immediately preceding three months. This change would enable these persons to be free of all Rule 144 resale limitations if the one-year and non-affiliation requirements are met. With respect to resales of restricted securities by affiliates, the SEC is proposing to eliminate the manner of sale requirements of Rule 144(f) for debt securities, to raise the thresholds for filing the Form 144 notice of sale, and to codify certain staff interpretations of Rule 144. The SEC also is soliciting comment on whether filings on Form 4 and Form 144 should be coordinated to reduce duplicative paperwork requirements for insiders required to file both forms. Under this approach, affiliates who are subject to Section 16 under the Exchange Act could, at their option, satisfy their Form 144 filing requirement by timely filing a Form 4 reporting the sale of the securities. Finally, the SEC is proposing to limit to registered business combination transactions involving blank check or shell companies the application of the “presumptive underwriter” provision in current Rule 145(c) that restricts resales of merger securities by directors, officers, and other affiliates of the combining companies. The SEC also proposes to revise the related resale restrictions in Rule 145(d) applicable to such insiders to conform to the modified restrictions proposed for Rule 144.