23 April, 2019
LIQUIDITY TO CONTINUE DESPITE US GOVERNMENT SHUTDOWN
The US capital markets continue to provide a valuable source of funding for Australian companies. Larger Australian IPOs and capital raisings continue to be structured to access US investors and our securities practice has enabled us to act for issuer and underwriter on both the Australian and US law aspects of equity and debt offerings in 2018.
Developments in US federal securities law and regulation and, more generally, the policy direction of US lawmakers and the US Securities and Exchange Commission (the SEC) have significant implications for securities offering execution practices around the world, both in the context of IPOs and other offerings registered with the SEC, as well as offerings exempt from SEC registration undertaken pursuant to Rule 144A and as traditional private placements. All of these offering structures are used by Australian issuers.
The past year has seen the SEC continue its efforts to strike a balance between encouraging capital formation and protecting investors:
- the SEC sustained its razor sharp focus on initial coin offerings (ICOs) and offerings involving other digital assets in 2018, intensifying its enforcement activity against issuers and other market participants;
- the SEC released interpretive guidance and undertook cybersecurity-related enforcement actions, highlighting its expectation that companies implement appropriate internal accounting controls to mitigate cyber-related risks and protect company assets in compliance with US federal securities laws; and
- as part of its ongoing disclosure effectiveness initiative, the SEC finalised a series of amendments to disclosure standards that had become redundant, duplicative, overlapping or outdated, and addressed several specific topics where, in its view, disclosure to investors should be improved. Both staff guidance and SEC enforcement activity highlight the SEC’s focus on enhancing the utility of corporate disclosures for the investing public – and willingness to take action where company disclosures fail to comply with SEC standards and related staff guidance.
While the SEC has maintained its focus on regulatory compliance and enhancing investor protection, the launch of the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) has underscored the SEC’s additional commitment to working with fintech developers, entrepreneurs, investors and other market participants on new approaches to capital formation, market structure and financial services. Recognition by SEC staff that digital assets functioning on “sufficiently decentralised” networks may no longer constitute securities for purposes of the US federal securities laws has been welcomed by fintech developers. The roadmap for compliance by unregistered ICOs identified through recent settlement orders is also anticipated to assist entrepreneurs and developers in navigating the regulatory landscape. Further, potential expansion of the “testing the waters” relief (currently available only to emerging growth companies) may also incentivise corporates with significant revenues to undertake SEC registered IPOs and list their equity securities on a US exchange.
INITIAL COIN OFFERINGS REMAIN IN SHARP FOCUS
The SEC continued its razor sharp focus on ICOs and offerings involving cryptocurrencies in 2018, undertaking enforcement action against issuers and various other market participants, both in respect of fraudulent transactions and violations of the registration requirements under the US federal securities laws. In a major speech in June 2018, the Director of the SEC Division of Corporation Finance, William Hinman, articulated the SEC staff’s approach to evaluating whether a digital asset constitutes a security.
The SEC has re-emphasised the applicability of the US federal securities laws to virtual organisations and entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment, and related offers and sales of securities. Amplifying prior guidance – that “by and large” ICOs involve the offer and sale of securities and directly implicate the registration requirement under the US Securities Act (the Securities Act) and the anti-fraud provisions of the US federal securities laws – SEC Chairman Jay Clayton confirmed in testimony before the United States Senate in February 2018, “I believe every ICO I’ve seen is a security”.
In particular, the SEC has broadly condemned structuring approaches under which tokens are asserted to provide investors with certain “utility” characteristics as elevating “form over substance”. The SEC has explicitly warned that it has not endorsed the approach under the Simple Agreement for Future Tokens (SAFT) framework, which seeks to distinguish (i) the initial stage private funding by accredited investors pursuant to the SAFT investment contract (which is acknowledged to be a security), from (ii) the tokens offered to investors once the network is functional (which are asserted under the SAFT framework to not constitute securities).
Director Hinman’s June 2018 speech – since endorsed by Chairman Clayton as reflecting the approach taken by the SEC staff in evaluating whether a digital asset is a security – identifies two non-exhaustive sets of factors to be considered in assessing whether a particular digital asset transaction will be subject to the US federal securities laws, each focusing on whether the value received for the digital asset is invested in a common enterprise with a reasonable expectation of profit derived from the efforts of others. Expressly acknowledging that the digital asset itself may not be a security (as is the case for Bitcoin and Ether), Director Hinman highlighted that the primary issue in determining whether a digital asset is offered as an investment contract (and thus constitutes a security) is “whether a third party . . . drives the expectation of a return”. When the network on which a digital asset functions becomes sufficiently decentralised that investors do not have an expectation of profits based on the efforts of others (and are purchasing the digital asset for consumption, as compared to investment), the digital asset may no longer constitute a security.
At the time of finalisation of this article, the “plain English” guidance that will assist developers in determining whether their cryptocurrency and token offerings constitute the offer and sale of securities under US federal securities laws (as promised by Director Hinman in November 2018) had not yet been released.
During 2018 the SEC undertook enforcement action against issuers engaged in unregistered ICOs, celebrity promoters of ICOs, an unregistered cryptocurrency exchange, unregistered crypto investment funds and hedge funds and unregistered investment advisers. A November 2018 joint statement by the SEC Division of Corporation Finance, the SEC Division of Investment Management and the SEC Division of Trading and Markets also highlighted the applicability of the US Investment Company Act and the US Investment Advisers Act to investment vehicles engaged in investing in digital assets and their service providers.
However, the launch of the FinHub in October 2018 reflects the SEC’s commitment to working with fintech developers, entrepreneurs, investors and other market participants on new approaches to capital formation, market structure and financial services, while maintaining its focus on regulatory compliance and enhancing investor protection. Indeed, November 2018 settlement orders against CarrierEQ Inc. (AirFox) and Paragon Coin Inc. (Paragon) pave a path to compliance for unregistered ICOs. In addition to imposing civil penalties, these orders required Airfox and Paragon to register their tokens as securities under the US Securities Exchange Act, to file periodic reports with the SEC and to compensate token purchasers. Specifically, Airfox and Paragon were required to notify each token purchaser of its rescission rights (ie to be reimbursed for its original purchase or to sue for recovery or damages if such purchaser no longer owned the tokens). We believe that the compensation and registration requirements included in the AirFox and Paragon settlements are likely to be imposed in future settlements in respect of unregistered ICOs that did not qualify for an exemption from registration. The settlement framework is also instructive for issuers of unregistered ICOs seeking to comply with the US federal securities laws.
OUR TAKE
We expect the SEC to continue to vigorously police the cryptocurrency markets in 2019. In view of the roadmap for remediation of non-compliance provided by the AirFox and Paragon actions, we anticipate that enforcement activity against unregistered ICOs will intensify during the coming year, with the SEC likely to be unsympathetic to issuers whose ICOs failed to qualify for an exemption from Securities Act registration, irrespective of whether some attempts to qualify were made. Recent statements by the SEC and the launch of FinHub reflect the SEC’s efforts to encourage technological innovations that benefit investors in the fintech space, while ensuring adherence by all market participants involved in the issuance and trading of digital assets with the requirements of the US federal securities laws.
We envisage that the promised “plain English” guidance will provide market participants with further clarity as to the circumstances under which digital asset transactions constitute an offer and sale of securities under US federal securities laws. We also expect further legislative initiatives in relation to the regulation of digital assets during the coming year. We anticipate that any comprehensive statutory regime will seek to clarify the scope of the regulatory powers of the SEC, the US Commodity Futures Trading Commission, the US Department of the Treasury, the US Federal Reserve and other US federal regulators, and to bridge existing jurisdiction gaps between federal agencies.
CYBERSECURITY CONTINUES TO BE A KEY PRIORITY AREA
OUR TAKE
In view of the Altaba cybersecurity disclosure enforcement action and the warning sounded by the October 2018 SEC report of investigation, we expect the SEC to vigilantly examine companies’ cybersecurity disclosures, whether companies’ internal accounting controls are adequate to mitigate the risk of cyber-incidents and safeguard company assets, and whether companies’ disclosure controls and procedures facilitate timely assessment of appropriate disclosure in relation to cyber breaches and threats. In view of the SEC’s focus on this area, we anticipate an increase in enforcement activity in response to cybersecurity incidents, as well as potentially in private litigation related to cyber breaches. We would advise issuers:
- to ensure that their cybersecurity disclosure is tailored to their specific business and operations, and industry context;
- to consider whether their insider trading policies protect against corporate insiders trading in advance of company disclosures of material cybersecurity incidents;
- to reassess their cybersecurity risk management policies and procedures in light of emerging cyber-related risks and threats, to implement internal controls tailored to address cybersecurity risks relevant to their particular business and operations, and to prioritise the training of employees on those policies and procedures; and
- to involve outside advisors early in the process when analysing and responding to any cybersecurity incident.
CONTINUED FOCUS ON MATERIAL INFORMATION DISCLOSURES
OUR TAKE
Reforms proposed and adopted by the SEC in 2018 continue to modernise the disclosure framework, consistent with the SEC’s disclosure effectiveness initiative – which we have previously described as “evolution, not revolution”. With the SEC focused on enhancing the readability and navigability of disclosure documents, discouraging repetition and the disclosure of immaterial information, and reducing the cost and burden of compliance, we anticipate that a form of the Regulation S-K reforms proposed in October 2017 will be adopted during the course of 2019. Following its adoption of revised disclosure requirements for SEC registrants engaged in mining in October 2018, we also expect the SEC to progress its reform of the industry-specific disclosure requirements applicable to bank holding companies (as currently reflected in SEC Industry Guide 3) during the course of 2019.
The SEC’s willingness to engage in modernisation and enhancement of the disclosure framework while also addressing, through formal and informal guidance, particular disclosure topics that it believes will materially impact investors is a helpful approach for investors and promotes the efficiency of the securities markets and capital formation.
PROPOSED EXTENSION OF “TESTING THE WATERS” PROVISIONS"
OUR TAKE
While the majority of IPOs by Australian issuers that are directed to the US capital markets are structured to be exempt from SEC registration, US listings offer particular attractions for sector-specific and significantly-sized Australian issuers. An extension of the “testing the waters” provision to larger companies would enable more Australian companies to assess investor interest – and potential valuation – prior to undertaking preparations for a US IPO. We believe that the availability of this relief will incentivise more companies with significant revenues to consider SEC registered IPOs and listing of their equity securities on a US exchange.
REVIEW OF THE PRIVATE OFFERING FRAMEWORK
OUR TAKE
Given the frequent use by non-US issuers (including Australian issuers) of the private offering exemptions under Section 4(a)(2) of the Securities Act and pursuant to Rule 144A (when raising capital from large institutional investors in the United States), the concept release is likely to be important reading for Australian issuers and financial intermediaries.
Once the concept release has been issued, Herbert Smith Freehills will circulate a client memorandum on the implications of the review for non-US issuers looking to access the US capital markets. There will also be a public comment period and we expect to submit a comment letter to the SEC. We would welcome your views as part of this process.
For further information, please contact:
Siddhartha Sivaramakrishnan, Partner, Herbert Smith Freehills
siddhartha.sivaramakrishnan@hsf.com
