November 23, 2014

Advertisement

November 21, 2014

November 20, 2014

Benefits of Quotation on the Over-The-Counter (OTC) Markets in lieu of Exchange Act Registration

The public securities markets are a useful source of capital and liquidity for issuers and their security holders.  Many issuers access the public securities markets by registering a class of securities under the Securities Exchange Act of 1934 (the “Exchange Act”) and listing their securities on a national securities exchange such as the NASDAQ Stock Markets.  However, the Exchange Act imposes several obligations upon issuers that can result in significant costs being incurred, both in terms of financial expense and the need to invest management time and attention in regulatory compliance.

An issuer is generally required to register a class of its securities under the Exchange Act if the issuer has more than $10 million in total assets as of the last day of its most recently completed fiscal year and the class of security is held of record by either 2,000 persons or 500 persons who are not accredited investors.  Issuers with a class of securities registered under the Exchange Act are subject to the Sarbanes-Oxley Act of 2002, which imposes obligations relating to the composition, authority and activities of the audit committee of the board of directors and an issuer’s relationship with its auditors, among other things.  National securities exchanges impose corporate governance requirements, such as requirements that an issuer have separate compensation and audit committees and that committee members satisfy independence requirements established by the exchange.  Further, the Exchange Act requires an issuer to conduct annual evaluations of its internal control over financial reporting, and to disclose material weaknesses in its internal control.  Material weaknesses may include failure to have a separate audit committee comprised of independent directors or failure to employ a sufficiently qualified chief financial officer.  The Exchange Act also requires an issuer to file audited year-end financial statements with the Securities and Exchange Commission, and an issuer that has a class of securities registered under the Exchange Act is subject to the Securities and Exchange Commission’s proxy solicitation rules, which now include requirements to hold non-binding shareholder votes to approve executive compensation.  These are some, but not all, of the matters that a ’34 Act reporting company must address.

The costs of compliance with the Exchange Act regulatory scheme can be prohibitively expensive for issuers with smaller capitalizations and start-ups that have limited financial resources.  The OTC Pink Market (also known as the Pink Sheets) offers another option for public trading for issuers that are not required to have a class of securities registered under the Exchange Act, as securities can be quoted on the Pink Sheets without being registered under the Exchange Act.  The Pink Sheets can offer access to the public securities markets without subjecting the issuer to compliance with the disclosure and reporting obligations and corporate governance requirements under the Exchange Act and the Sarbanes-Oxley Act.

An issuer that currently has a class of securities registered under Section 12(g) of the Exchange Act is generally permitted to deregister if there are fewer than 300 holders of record of the class of securities, or if there are fewer than 500 holders of such securities and the issuer’s total assets have not exceeded $10 million on the last day of its last three fiscal years.  After an issuer deregisters under the Exchange Act and delists its securities from any national securities exchange on which they were listed, the issuer can apply for quotation on the Pink Sheets.

An issuer is not required to disclose any information as a condition to having its securities quoted on the Pink Sheets.  However, the federal securities laws require issuers to provide adequate current public information in certain circumstances (for example, for the safe harbor provided by Rule 144 of the Securities Act of 1933 for resales of securities in the public markets[1], which applies regardless of whether the issuer’s securities are registered under the Exchange Act).  In addition, regular disclosure of financial and operating results and other material events is important for transparency and maintaining the trust and confidence of security holders, regardless of whether such disclosure is required by law (the OTC warns investors that publicly traded companies that do not provide adequate current public information are highly risky and should be treated with suspicion).  Furthermore, an issuer that deregisters under the Exchange Act in order to be quoted on the OTC Markets is likely to experience a decline in the trading price of its securities because the issuer is no longer subject to the Exchange Act’s rigorous disclosure requirements.  The issuer can mitigate the decline by continuing to make adequate current public information available.

Issuers can provide adequate current public information by making filings with the OTC pursuant to the OTC Alternative Reporting Standard, which requires issuers to file an initial disclosure statement (which must be updated to disclose any changes to the information on annual basis), quarterly and annual financial reports, and current reports to disclose material events as and when such events occur.  As described below, there are several important differences between reporting under the OTC Alternative Reporting Standard and the Exchange Act that represent the potential for significant savings for issuers, in terms of both financial expense and labor, while at the same time allowing the issuer complying with the OTC Alternative Reporting Standard to have its securities traded in the public securities markets.

Edgar conversion not required.  Documents filed with the OTC are uploaded directly to the OTC Disclosure and News Service[2] in PDF format.  Issuers do not need to engage a third party financial printer to convert filings into “Edgar format,” which is required to file documents on the Securities and Exchange Commission’s Edgar system, or expend labor hours reviewing proofs of converted documents for conversion errors.

XBRL financial statements not required.  The OTC does not require issuers to file their financial statements in XBRL format, as required by the SEC.

Audited financial statements not required.  The OTC does not require issuers to file audited year-end financial statements.

Reduced disclosure obligations.  Several items that are required to be disclosed in reports filed under the Exchange Act are not required in reports filed under the OTC Alternative Reporting Standard, which include the following:

  • Controls and procedures and internal control over financial reporting;
  • Risk factors;
  • Market for registrant’s common equity and related stockholder matters (i.e. historical stock price table and related disclosures);
  • Results of votes of security holders;
  • Changes in and disagreements with accountants on accounting and financial disclosure; and
  • Quantitative and qualitative disclosures about market risk.

In addition, the executive compensation disclosure under the OTC Alternative Reporting Standard is not as extensive as it is under the Exchange Act, as the Summary Compensation Table under Item 402 of Regulation S-K and other tables setting forth information about the compensation of executive officers and directors are not required.

Section 16 reports and Schedule 13G/D not required.  Section 16(a) of the Exchange Act requires officers, directors and 10% beneficial owners to file reports with the SEC that disclose their beneficial ownership of an issuer’s securities and changes in their beneficial ownership.  Rules 13d-1 and 13d-2 under the Exchange Act require any 5% beneficial owner to file a calendar year-end report disclosing the beneficial owner’s interest and changes in such interest.  The OTC Alternative Reporting Standard does not require insiders to file separate reports with the OTC disclosing their beneficial ownership, although beneficial ownership of officers, directors and control persons is disclosed in the initial report that is filed with the OTC, which must be updated to disclose any changes on an annual basis.



[1] Rule 144 provides that if an issuer is not subject to the reporting requirements of the Exchange Act, then there must be publicly available information about the issuer, which is specified in Rule 15c2-11 under the Exchange Act.

[2] The subscription fee for the Disclosure and News Service is $4,200 per year, plus a $500 application fee to subscribe; there is no per-report fee.

© 2014 Giordano, Halleran & Ciesla, P.C. All Rights Reserved

TRENDING LEGAL ANALYSIS


About this Author

John L. Sikora, Giordano Law Firm, Business Attorney
Associate

Mr. Sikora assists clients with the planning and organization of businesses, with corporate governance matters, and with various business transactions, including sales and purchases of businesses. He also assists with the preparation of reports and other documents required to be filed with the Securities and Exchange Commission.

732-741-3900