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learning center: publication detail
Dates to Remember:

August 9, 2011
Deadline for Large Accelerated Filers and Accelerated Filers to file Form 10-Q for quarter ended June 30, 2011.

August 15, 2011
Deadline for Non-Accelerated Filers and Smaller Reporting Companies to file Form 10-Q for quarter ended June 30, 2011; Deadline to file Form 13-F for quarter ended June 30, 2011.

September 5, 2011
Labor Day - SEC and U.S. markets closed.

Quote of the Day I:

"Equity capital is crucial for young, innovative companies that are rich with ideas but short on cash…It is particularly troubling that the SEC continually fails to open the market for equity private placements to accredited investors, or at least [Qualified Institutional Buyers], which could spur innovation without compromising the safety of unaccredited investors."

– The Honorable Darrell E. Issa, Chairman of the Committee on Oversight and Government Reform, U.S. House of Representatives, in a letter dated March 22, 2011 to the Honorable Mary L. Schapiro, Chairman of the SEC.

Quote of the Day II:

"…companies seeking access to capital in the U.S. markets should not be overburdened by unnecessary or superfluous regulations...Striking the right balance between facilitating access to capital by companies and protecting investors in our rules and orders is a critical goal of the SEC."

– The Honorable Mary L. Schapiro, Chairman of the SEC in a letter dated April 6, 2011 to the Honorable Darrell E. Issa responding to his letter dated March 22, 2011.

Public Company Perspectives
August 2011
Authors: Stephen E. Fox, Irwin A. Kishner

The SEC has continued its recent pace in bringing enforcement proceedings and looking into allegations of fraud. Perhaps most significantly, the SEC has publicly commented on the allegations of fraud relating to public companies that become public as a result of reverse mergers. Our featured article, found below the  new "Of Note" section summarizing events of the past quarter, discusses the SEC's comments.

The SEC has also adopted the highly controversial final rules relating to the Dodd-Frank Act's whistleblower program. As discussed below, companies will need to re-evaluate their existing compliance and reporting policies to reduce the risks of wrongdoing, as well as reinforce a culture that prevents employees from bypassing the companies' policies and going straight to the SEC after discovering potentially damaging information.

Of Note:

  • The SEC announced in its timetable for implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act that it will adopt final rules on the disclosure relating to conflict minerals, disclosure by resource extraction issuers and disclosure of mine safety information. The deadline for adopting these rules was in April 2011.  Members of Congress have asked the SEC to explain the delay. Look for a future issue of Public Company Perspectives for a discussion of the rules, once adopted.
  • The SEC acknowledged that since it has not specified a taxonomy for use by foreign private issuers that prepare their financial statements in accordance with international financial reporting standards (IFRS), those foreign private issuers cannot comply with the interactive data reporting requirements for fiscal periods ending on or after June 15, 2011, which they otherwise are required to do. Until the SEC specifies a taxonomy, such foreign private issuers need not submit interactive data files or post such files on their website.
  • SEC Chairman Mary L. Schapiro outlined the steps that the SEC has taken and intends to take to reduce regulatory burdens on raising capital, including the formation of a new Advisory Committee on Small and Emerging Companies and an evaluation of triggers for public reporting.
  • Meredith Cross, the director of the SEC's Division of Corporation Finance, expressed concern as to whether the SEC can deliver a workable rule under Section 953(b) of the Dodd-Frank Act, which directs the SEC to require companies to publicly disclose the median annual total income for all employees (other than the CEO) and to calculate the ratio of that median income to the annual total income of the company's CEO.
  • The Dodd-Frank Act directed the SEC to conduct a study to determine how to reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act (auditor attestation requirement) for issuers whose market capitalization is between $75 million and $250 million. The SEC's Office of the Chief Accountant performed such a study and recommended that such issuers remain subject to Section 404(b). Accordingly, only issuers with a market capitalization of less than $75 million will be exempt from Sarbanes-Oxley's auditor attestation requirements.
  • The SEC has been reviewing whether current disclosure requirements relating to exposure to cybersecurity risks are adequate. Currently, such risks must be disclosed only if material to a public company.
  • The Public Company Accounting Oversight Board, or PCAOB, agreed to issue for public comment a concept release to enhance the quality and utility of auditors' reports, instead of the boilerplate language currently used.

Featured Articles:

SEC Warns Investors About Investing in Reverse Merger Companies

On June 9, 2011, the SEC issued an Investor Bulletin about investing in companies that enter the U.S. capital markets through reverse mergers. A reverse merger in this context refers to a situation in which a private operating company accesses the U.S. capital markets by merging with an existing public company, typically a "shell company" with no operations or assets of any kind. Pursuant to a reverse merger transaction, shareholders of the private operating company exchange their shares for shares of the public company so that they own a controlling interest of the shell company post-transaction. In addition, the management of the private operating company also becomes the management of the combined company. As a result, post-closing, the combined company looks very similar to the private operating company but with a public float.

After a short discussion of why a company would pursue a reverse merger -- to facilitate its access to the capital markets in a manner that is perceived as quicker and less costly than a traditional initial public offering -- and where reverse merger company securities are listed or traded, the SEC discusses some of the risks associated with investing in reverse merger companies and warns investors to proceed with caution when considering whether to invest in reverse merger companies. These risks, according to the SEC, include:

  • Many companies either fail or struggle to remain viable following a reverse merger.
  • As with other kinds of investments, there have been instances of fraud and other abuses involving reverse merger companies.
  • Some foreign companies use small U.S. auditing firms, some of which may not have the resources to meet their auditing obligations when all or substantially all of the private operating company's operations are in another country.  The lack of resources may lead to a failure to identify circumstances where these companies may not be complying with the relevant accounting standards.

The Bulletin continues by listing some of the more common risk factor disclosures that are used by reverse merger companies in their public filings. It also discusses six reverse merger companies that had their stock suspended from trading by the SEC in recent months, and states that the SEC has recently revoked the securities registration of "several" reverse merger companies.

The Bulletin concludes with a reminder that investors should be careful when considering investing in the stocks of reverse merger companies and provides the following tips:

  • Research the company in question.
  • Review the company's SEC filings.
  • Be aware of the risks of companies that do not file reports with the SEC.
  • Be skeptical of information received.

In addition to the Bulletin, SEC Chairman Mary L. Schapiro stated in a letter to Rep. Patrick McHenry (R-N.C.),that the SEC is working with the PCAOB and other regulators to identify problematic audit practices and auditor conduct with respect to reverse merger companies registered with the SEC. The SEC and the PCAOB, for instance, have expressed concern that U.S. auditors may be issuing opinions on financial statements based almost entirely on work performed by a non-U.S. firm that is not registered with the PCAOB. Additionally, SEC Commissioner Luis Aguilar recently called attention to a rise in accounting issues from Chinese reverse merger companies, and staff members of the SEC have publicly stated that they have seen an increase in auditor resignations from non-U.S. reverse merger companies, which raises concerns of fraud in those companies.

This Bulletin comes at a time when there is substantial press about Chinese public companies that are the subject of class action lawsuits alleging, among other things, accounting and reporting misrepresentations, some of which were cited in the Bulletin. Many of these Chinese public companies -- approximately 150 since 2007 -- became public through a reverse merger. By some counts, almost 25% of all securities lawsuits filed in 2011 were against Chinese companies. In addition, Nasdaq has jumped on the bandwagon by proposing additional listing requirements for reverse merger companies, including allowing the listing of a reverse merger company's stock only after a six month trading period as a reporting company and maintaining a bid price of $4 per share or higher during at least thirty of the sixty trading days immediately preceding the filing of the listing application with Nasdaq.

While there have always been and there always will be bad actors in the reverse merger space, as the recent press clearly demonstrates, not all reverse merger companies are engaging in fraud. However, the Bulletin specifically singles out reverse merger companies – while alluding to foreign operating companies – as entities to be concerned about from an investor protection viewpoint. It is interesting to note, however, that the suggestions made by the SEC in the Bulletin would apply to any company, whether U.S. or foreign, whether small or large and whether public through a traditional IPO or by way of a reverse merger. Furthermore, many of the risk factors cited by the SEC in the Bulletin are not specific to reverse merger companies. Accordingly, while we applaud the SEC for raising investor awareness of potential bad actors and seeking to teach investors what they need to know to protect themselves, we feel the SEC has unfairly targeted a legitimate way for companies to go public in the U.S.

SEC Adopts Final Rules to Implement the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934

The SEC adopted new rules, effective August 12, 2011, to implement Section 21F of the Securities Exchange Act of 1934, which was added by the Dodd-Frank Act. Section 21F directs the SEC to pay awards to whistleblowers who voluntarily provide the SEC with original information about a violation of the securities laws that leads to a successful enforcement action that results in monetary sanctions exceeding $1 million. The rules define certain terms and outline the procedures for making a claim for a whistleblower award and the SEC's procedures for making a decision on such claims. Since the rules have been proposed, they have been controversial because of concerns that the whistleblower program, as adopted, would impact a company's internal compliance processes, as discussed further below.

The whistleblower program provides a bounty to any individual or individuals who provide original information to the SEC that relates to a possible violation of the securities laws that has occurred, is ongoing, or is about to occur, in an amount of 10% to 30% of the monetary penalty when over $1 million, in the discretion of the SEC as described further below. The SEC will also pay awards based on amounts collected in certain related judicial or administrative actions brought by the U.S. Attorney General, an appropriate regulatory authority, a self-regulatory organization or a state attorney general in a criminal case as long as the related case is based on the same original information that the whistleblower provided to the SEC.

In order for the whistleblower to avail himself or herself of the program, the whistleblower must provide the information to the SEC before a request, inquiry or demand that relates to the same subject matter is directed to the whistleblower or his or her representative, by the SEC, the PCAOB, any self-regulatory organization or any other authority of the federal government, state attorney general or securities regulatory authority. Further, the whistleblower cannot have been required to report the information pursuant to a pre-existing legal duty, a contractual duty that is owed to the SEC or other organization referred to above, or a duty that arises out of a judicial or administrative order.

The information provided by the whistleblower must be original information, meaning it must be:

  • derived from the whistleblower's independent knowledge (factual information in the whistleblower's possession that is not derived from publicly available sources) or independent analysis (the whistleblower's own analysis whether done alone or in combination with others);
  • not already known to the SEC;
  • not exclusively derived from an allegation made in a judicial or administrative hearing, in a governmental report, hearing, audit, or investigation, or from the news media; and
  • provided to the SEC for the first time after July 21, 2010, which is the date of enactment of the Dodd-Frank Act.

The SEC would not consider information to be derived from a whistleblower's independent knowledge or independent analysis in any of the following circumstances:

  • If the whistleblower obtained the information through a communication that was subject to the attorney-client privilege, except in limited circumstances;
  • If the whistleblower obtained the information in connection with the legal representation of a client on whose behalf the whistleblower or the whistleblower's employer is providing services and the whistleblower seeks to use the information to make a whistleblower submission, except in certain limited circumstances;
  • If the whistleblower obtained the information because he or she was (a) an officer, director, trustee or partner of an entity and another person informed the whistleblower of allegations of misconduct, or he or she learned the information in connection with the entity's processes for identifying, reporting and addressing possible violations of law, (b) an employee whose principal duties involve compliance or internal audit responsibilities or is employed by a firm retained to perform such functions, (c) employed by or otherwise associated with a firm retained to conduct an inquiry or investigation into possible violations of law or (d) an employee of, or other person associated with, a public accounting firm if the whistleblower obtained the information through the performance of an engagement required of an independent public accountant under the federal securities laws;
  • If the whistleblower obtained the information in a manner determined by a U.S. court to violate applicable federal or state criminal law.

However, the SEC will consider information from those referred to in the third bullet above, if (a) the whistleblower has a reasonable basis to believe that disclosure of the information to the SEC is necessary to prevent the relevant entity from engaging in conduct that is likely to cause substantial injury to the financial interest or property of the entity or investors, (b) the whistleblower has a reasonable basis to believe that the relevant entity is engaging in conduct that will impede an investigation of the misconduct or (c) at least 120 days has elapsed since the whistleblower provided the information to the relevant entity's audit committee, chief legal officer, chief compliance officer or their equivalent, or the whistleblower's supervisor, or if the whistleblower received the information under circumstances indicating that any such party was already aware of the information.

In exercising the SEC's discretion in determining the appropriate award percentage, the SEC may consider the factors set forth in the rules and may increase or decrease the award percentage based upon its analysis of these factors. Factors that may increase the amount of a whistleblower's award include the significance of the information provided by the whistleblower, the assistance provided by the whistleblower, the interest in the information provided by the whistleblower to law enforcement and whether the whistleblower participated in the entity's existing internal compliance and reporting systems. Factors that may decrease the amount of a whistleblower's award include the culpability or involvement of the whistleblower in matters associated with the action, whether there was any unreasonable reporting delay and whether the whistleblower interfered with the internal compliance and reporting systems of the entity. 

The rules also provide for procedures for submitting the information, confidentiality of the submissions and procedures for determining awards based upon a related action, among other things.

As part of the anti-retaliation provisions of the rules, employers are prohibited from taking an adverse action against the whistleblower for acting as a whistleblower.  The anti-retaliation provisions apply whether or not the whistleblower satisfies the requirements, procedures and conditions to qualify for an award, as long as the whistleblower had a reasonable belief that an actual violation occurred. In light of the new anti-retaliation rules, it is advisable for companies to re-examine their policies and train managers and supervisors to avoid taking actions against employees that could later be deemed retaliatory.

The SEC, in adopting the final rules, declined to make it mandatory for whistleblowers to report wrongdoings through an entity's internal compliance procedures, as many commentators to the proposed release requested. Instead, the SEC refined the proposal so that whistleblowers are not required to go through internal compliance procedures, but tried to balance the competing interests by incentivizing whistleblowers to in fact do so by providing that the whistleblowers who report problems to the company would still be eligible for an award if the company then passes the tip and any other subsequently discovered information to the SEC. Additionally, as stated above, the SEC will take into account whether a whistleblower bypassed the company's internal compliance procedures when determining the appropriate award percentage.

As a result, it is important that companies highlight to their employees the importance of internal compliance and reporting programs to avoid situations where employees bypass such programs in an attempt to collect on the award. Companies should also review their existing internal compliance and reporting programs to reduce opportunities for wrongdoing and to ensure these programs allow them to identify, investigate and handle possible misconduct quickly and effectively.

Proposed Rule:

Disqualification Of Felons And Other Bad Actors From Rule 506 Offerings.

On May 25, 2011, the SEC proposed amendments to its rules to implement Section 926 of the Dodd-Frank Act. Section 926 requires the SEC to adopt rules that disqualify securities offerings involving certain felons and other bad actors from relying on Rule 506 of Regulation D, a safe harbor from SEC registration for private placements.

The proposed amendments to Rule 506 would disqualify an offering that involves "covered persons," which include the issuer and any predecessor of the issuer or affiliated issuer, any director, officer, general partner or managing member of the issuer, any beneficial owner of 10% or more of any class of the issuer's equity securities, any promoter connected with the issuer in any capacity at the time of the sale, any person that has been or will be paid remuneration for solicitation of purchasers in connection with the sale of securities in the offering and any director, officer, general partner or managing member of any such compensated solicitor.

The proposed amendments also include a list of events that would give rise to disqualification, which include:

  • criminal convictions;
  • court injunctions and restraining orders;
  • final orders of certain state and federal regulators;
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons;
  • suspension or exposure from membership in, or suspension or bar from associating with a member of, a security self-regulatory organization;
  • SEC stop orders and orders suspending a Regulation A exemption; and
  • U.S. Postal Service false representation orders.

The proposal provides for a reasonable care exception under which a company can rely on the Rule 506 exemption, despite the existence of a disqualifying event, if it can show that it did not know and could not have known of the disqualification.  The burden would be on the issuer to establish that it exercised reasonable care, which would require an inquiry into the relevant facts, the nature of which would depend on the facts and circumstances. In order to avail itself of the reasonable care exception, an issuer should consider, beyond factual inquiry of the covered person, investigating publicly available databases and even taking further steps depending on the facts and circumstances.  

The proposal also provides that the SEC may grant a waiver if it determines that the issuer has shown good cause that it is not necessary, under the circumstances, that the registration exemption be denied.

Under the proposal, the disqualification provisions would apply to all sales made under Rule 506 after the effective date of the amended provisions.  However, offerings made after the effective date would be subject to disqualification for all disqualifying events that had occurred within the relevant look-back period, regardless of whether the disqualifying event occurred before the enactment of the Dodd Frank Act or effectiveness of the amendments to Rule 506. This will likely be one of the more controversial aspects of this proposal, as individuals may be adversely affected if, for instance, they had negotiated a settlement with the SEC before the Dodd-Frank Act was enacted – had the person known at the time that the settlement would have the effect of losing Rule 506 safe harbor eligibility, the person may have negotiated a different settlement or even chosen to litigate the allegations.

The proposal also discusses other possible amendments, which will go beyond the specific mandate of the Dodd-Frank Act, to various other SEC rules to make bad actor disqualification more uniform across other exemption rules. Some of these additional proposals include applying the proposed bad actor disqualification provisions to other offerings such as Regulation A, Rule 505 of Regulation D and Regulation E.

For more information on these issues, please contact Stephen Fox at 212.592.5924 or or Irwin Kishner at 212.592.1435 or

Copyright © 2011 Herrick, Feinstein LLP. 
Public Company Perspectives is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.