S ince its adoption in 1967, rule Company). Instead, compliance - - PDF document

42 IFLR/October 2012 www.iflr.com

S

ince its adoption in 1967, rule 12g3-2(b) (Rule) of the Securities Exchange Act 1934 has been the principal home-country disclosure exemption for non-US companies under US securities laws. It allows certain activities that otherwise would result in broader US regulatory implications. In 2008, after 40 years, the Securities and Exchange Commission (SEC) substantially revised the rule, easing compliance by foreign private issuers (FPIs) and facilitating US investment in non-US equities. The most significant revision was to make the rule automatic or, put differently, self-

• executing. This meant that many FPIs

around the world, without any affirmative action on their part, became exempt under the US rules. This effect was amplified by the introduction in recent years of enhanced disclosure obligations in many non-US jurisdictions – one example being the Transparency Directive in Europe. Consequently, the universe of foreign issuers exempt under the rule dramatically

• expanded. Given neither FPIs nor the SEC

are required to notify or announce compliance, the changes also have challenged purchasers and sellers of securities, and their intermediaries, in determining whether or not the exemption is available. On the fourth anniversary of the implementation of the amended rule (Amended Rule), and a year after the transition arrangements ended, it’s timely to look at how it has affected practices in the international securities markets including, most importantly, its impact on market participants. An important pass Historically, the SEC turned to home country disclosure under the Rule as a condition of taking advantage of concessions it granted regarding other rules. Therefore, the Rule has not just functioned as a regulatory junction box for whether an FPI became subject to SEC registration and reporting, and the requirements of the Sarbanes Oxley Act (SEC Reporting Company). Instead, compliance with the Rule also has been a so-called pass for foreign companies, and perhaps more importantly, for other market participants. Below are five common examples. Level one ADR programmes Compliance with the Rule is a condition for an FPI or depositary bank to establish an American Depositary Receipt (ADR) programme for secondary trading in the US

• ver-the-counter (OTC) markets. Because

the Amended Rule is self-executing, depositary banks have set up unsponsored level one ADR programs for nearly 1,300 FPIs, without the consent of the FPIs, affording a much broader range of foreign equities for US investors to trade in the US OTC market. It has also forced some FPIs to consider the implications

• f

those unsponsored programmes. Rule 144A A condition for relying on rule 144A is certain basic information about the issuer being publicly available. Compliance with the Rule remains one of two alternatives for non-SEC Reporting Companies to satisfy the ‘information supplying requirement’ contained in rule 144A(d)(4). In addition to facilitating offerings by issuers, the Amended Rule makes it easier for significant shareholders to sell shares using rule 144A instead of other exemptions, without the involvement of the issuer, if the seller is able to determine that the issuer complies with the Rule. Rule 135c (notice of certain proposed unregistered

• fferings)

This allows limited information to be communicated about an offering, without triggering registration, and is available to SEC Reporting Companies or FPIs that comply with the Rule. In recent years, European rights offerings have relied on rule 135c for limited communications with non- institutional US shareholders. The elimination of the need to apply to the SEC for the exemption, which used to require several weeks, means FPIs have been able to use rule 135c more easily in the middle of a transaction. Rule 15c2-11 (initiation or resumption of quotations without specific information) Broker-dealers in the US are required to have, have reviewed, and provide upon client request certain basic information about companies that they trade on OTC markets in the US. Those obligations can be met with information made available through compliance with the Rule. Spinoffs Compliance with the Rule is a key consideration of the SEC when looking at the adequacy of information in the market to determine whether a company can spin

• ff a foreign subsidiary without SEC

registration. Limitations Home-country disclosure under US securities laws, however, has always had a limited role in creating a pass for other rules. This is partly because the Rule has not distinguished among foreign regulatory

• regimes. Under US home-country disclosure

rules, the FPI was (and still is) required to make available only information that the FPI makes public and provides to shareholders under its home country

• regulation. This is irrespective of whether

those home country disclosure requirements are extensive or negligible. The Amended Rule substantially expanded the universe of FPIs that qualify for the exemption, but as a self-executing exemption, market participants are now often left to decide whether or not the FPI complies. As described below, market participants have adapted to the change. Evolution of the exemptive scheme A third class of companies required to be regulated as SEC Reporting Companies was added in 1964. In addition to those companies that had publicly offered securities or had listed their securities on a US stock exchange, any company that had 500 shareholders (recently changed under the JOBS Act to 2000, or 500 non- accredited investors) and at least $10 million (originally $1 million) in assets. The

• bjective was to regulate companies with

significant public share ownership. Since neither the asset nor shareholder thresholds were limited to the US, the legislation potentially would have dragged all foreign public companies into the SEC reporting

HOME-COUNTRY DISCLOSURE

US style: home country rules

The financial crisis had started when the revamp of rule 12g3-2(b) was finalised. How has the market responded?

www.iflr.com IFLR/October 2012 43

net, even if they had little to do with the US. To address this issue, the legislation granted the SEC power to exempt FPIs. After a transitional exemption for all FPIs, the SEC adopted two explicit exemptions in the Rule in 1967. One was (and still is) a blanket, self-executing exemption for FPIs with fewer than 300 shareholders resident in the United States. If an FPI had 300 or more US resident shareholders, the Rule allowed an FPI also to claim an exemption. To do this, however, the FPI had to make a formal written application to the SEC, which included: a description of the home- country disclosure regime; the number of US shareholders; the percentage of

• utstanding securities held by the US

shareholders; an explanation of how the US holders acquired the securities; and, the date and circumstances of the most recent public distribution of securities. Failure to claim the exemption when an FPI had 300 or more US holders meant that the FPI was in violation of its obligations to be registered under section 12(g), although there seems little evidence that the SEC ever actively sought to enforce such violations. Technically the exemption was effective as soon as the application was made to the

• SEC. The regulator reviewed the application

and several weeks later sent a form card back to the issuer stating only that the SEC acknowledged that the issuer was claiming the exemption. Level one sponsored programmes usually were only established

• nce the issuer received the card, since
• ccasionally the SEC staff did have

comments on the application. The SEC then placed the FPI on its list, which it published from time-to-time, of FPIs claiming the exemption. Thereafter, for continuing compliance, the FPI had to send to the SEC’s Public Reference Room in Washington DC hard copies of documents that it published in its home market or distributed to its shareholders. This exemptive scheme worked well for

• years. Many companies did not know (or

care) that they were exempt under the Rule because they had fewer than 300 US resident shareholders. Those FPIs interested in facilitating a modest US investor appetite for their shares, but which did not wish to be subject to full SEC reporting requirements, established a claim for the exemption under the Rule, usually in connection with a sponsored ADR programme or rule 144A

• ffering. They did not mind the burden of

submitting an application to claim the exemption to the SEC, or the modest burden of sending their home-country disclosure in the mail to the SEC Public Reference Room in DC. The globalisation

• f equity trading, however, led investors to

increasingly seek information through the internet for investment opportunities, rather than be passive recipients, and increased regulation of securities markets abroad. The Rule needed to be revamped. No doubt fewer FPIs qualified for automatic exemption under the Rule because they had more than 300 US resident shareholders, and many US investors – through the internet and otherwise – simply invested directly in the shares of FPIs irrespective of whether they had claimed exemption under the Rule. The amendments came at a time when the SEC was particularly active in its rulemaking to modernise rules for FPIs. In March 2007, the SEC promulgated rules

• n

deregistration, adopting a trading volume test for an FPI wishing to end its SEC Reporting Company status. This ended a long-running controversy over FPIs finding it difficult to leave the SEC registration regime when they wished to. In December 2007, the SEC allowed FPI SEC Reporting Companies to use International Financial Reporting Standards (IFRS) instead of reconciling to US GAAP . In September 2008, the SEC updated is Cross-Border M&A Rules, and also updated its reporting requirements for SEC Reporting Company

• FPIs. The Rule changes were proposed in

February 2008, and adopted, with modifications, the following September. Beyond these measures, as the financial crisis was unfolding, the SEC also advanced innovative suggestions about how global markets might reach for expanded mutual recognition across borders. In the winter of 2007-2008, senior SEC staff published an article (in their personal capacity) about how such an approach might work. In 2008, the SEC entered a mutual recognition agreement with the Australian authorities for so-called substituted compliance for trading by brokers and regulation of stock

• exchanges. These initiatives evaporated as

the financial crisis began to boil. However, the approach revealed a focus on secondary markets as the first step in mutual recognition – precisely the principal territory of the Rule – on how a more global regulatory system might work. Such thinking no doubt informed the approach for the proposed rule and ultimately the Amended Rule. Revision to the Rule was long overdue. One reason for the delay might have been the magnitude of the challenge. The Rule requires consideration of where to draw the line for forcing foreign companies into full SEC reporting. Because compliance with the Rule has also operated as a pass to facilitate

• ther transactions, as outlined above, there

was also the question of what is necessary to protect US investors investing in shares of companies complying with the Rule (but not subject to SEC reporting). The SEC did not go down the route urged by some, that the Rule be available only to FPIs subject to more extensive home-country reporting regimes, such as in Europe. Presumably, that approach might permit the SEC to expand the use of the Rule as a pass in other rulemaking, opening greater potential for mutual recognition. The SEC, however, has seemed reluctant to go into the business of evaluating regulatory regimes in other

• countries. In proposing and adopting the

Amended Rule, the regulator did, however, borrow heavily from regulation S. It used trading volume (instead of the number of US shareholders, for example) as a metric to determine when the SEC thought it had a legitimate regulatory interest. The Amended Rule requires an FPI to be listed on one or more overseas exchanges and have at least 55% of its trading volume conducted on no more than two of those

• exchanges. The overseas listing requirement is

meant to ensure the FPI is subject to some kind of disclosure regime – a way to protect US investors. Under the old rule, a foreign listing was not actually a requirement, although in its administration of the rule the SEC staff usually made it one. The trading volume requirement was borrowed from the regulation S concept of Substantial US Market Interest. The original proposal even

HOME-COUNTRY DISCLOSURE

“As a self-executing

exemption, market participants are now

• ften left to decide

whether or not the FPI complies”

“The approach

revealed a focus on secondary markets as the first step in mutual recognition”

44 IFLR/October 2012 www.iflr.com

HOME-COUNTRY DISCLOSURE

required no more than 20% of the trading volume be in the US (the same as regulation S). The 20% threshold encountered stiff resistance and was dropped in the Amended

• Rule. Using a trading threshold as a condition,

however, is also the approach as the then new de-registration rules (with 5% or less of the trading volume in the US required for deregistration) for drawing the line for when US regulators determine that, on balance, US regulation should, or should not apply. Practical implications The nature of the non-US disclosure required under the Amended Rule basically did not change. The SEC did expand the English translation obligation, eliminating ‘English summaries or versions’ for press releases and proxy materials. The staff has made clear that ‘generally available’ means information must be free, and nominal charges for documents, such as through Companies House in the UK, means those documents do not qualify as ‘generally available’. But for both translations and availability, compliance often is still found because only information material to an investment decision (as under the old rule) is

• required. Also, because in developed

disclosure regimes such as in Europe, material information is usually, in the

• rdinary course and for compliance with

home-country rules, posted on the FPI’s website and/or an alternative electronic information delivery system, and frequently in English. The method of disclosure, however, dramatically changed. No more SEC application to claim the exemption. No need to send hard copies of home-country disclosure to the SEC. FPIs could find themselves in compliance with the Rule without ever knowing. Many urged the SEC to modify its proposals, to require FPIs to publicly to announce their compliance, or to notify the SEC of their compliance. The SEC did not adopt that approach. Because the Amended Rule is self- executing, lawyers frequently need to determine whether or not an FPI is

• compliant. Sometimes the outcome of the

analysis is the key to structuring a transaction (for example, a block trade by a shareholder using rule 144A) and determining whether a no-registration

• pinion

is appropriate. Typically, consideration

• f

the home-country regulatory regime (more or less extensive), is combined with a review of the issuer’s actual disclosure, which is then measured against the requirements of the Amended Rule. This means there needs to be an understanding of the home-country regulatory regime as well as applying the results of due diligence to the Amended Rule. The first development under the Amended Rule was the dramatic increase in unsponsored level one ADR programmes. The longstanding position of the SEC is that unsponsored programmes and a sponsored level one programme cannot coexist. Before the Amended Rule, depositaries generally needed the cooperation of an FPI to apply for, and to maintain, the Rule exemption. This meant most programmes were

• sponsored. Post Amended Rule, the

depositaries could do their own diligence on companies without a sponsored programme to determine compliance independently, allowing a depositary to file a form F-6 with the SEC to create an unsponsored

• programme. Because there is no prohibition
• n multiple unsponsored programmes for

any issuer (as long as there is no sponsored programme), many FPIs now find up to four unsponsored programmes in their shares,

• ver which they have no control. Today,

there appear to be about 1,300 FPIs with

• ne or more unsponsored programmes,

mostly set up since 2008. This compares to 675 companies that claimed the exemption in 2005 under the old rule, the last time the SEC published its list of 12g3-2(b) companies. The solution for FPIs that do not like unsponsored programmes in their shares is to convert to a sponsored programme. The process of conversion may have been slowed because of concerns about enhancing the FPI’s jurisdictional nexus with the US, and arguably increasing exposure to US securities litigation. An odd combination of earlier cases like Pinker v Roche Holdings, and the holding in Morrison v National Australia Bank has probably discouraged some FPIs from converting to sponsored programmes. The concerns are no doubt over-hyped for many FPIs but US litigation concerns will continue to lurk in any US efforts to open inbound foreign investment opportunities. Form F-6 requires a representation that the FPI is in compliance with the Rule. During the rulemaking process the depositaries successfully lobbied for that representation to be qualified by their ‘reasonable, good faith belief after exercising reasonable diligence’. The fact that an unsponsored programme has been created by one or more depositaries may suggest to others that a company is in fact

• compliant. That does not replace the need to

conduct independent diligence for a particular unrelated transaction, especially when a no-registration opinion is requested. The qualification does, however, seem consistent with the SEC’s objectives in making the Rule automatic, and provides guidance to others in considering their due diligence in other circumstances. The standard for due diligence to establish the exemption should not be higher in a private placement than a SEC filing. The Amended Rule has proved useful for unregistered block trades where the seller does not wish to involve the issuer of the subject shares. These sales can be achieved using other private placement exemptions but underwriters frequently require two-way investment letters in those circumstances, which can be clumsy in a fast-moving block

• trade. Before the Amended Rule, lawyers

devised a so-called work-around to use rule

• 144A. Instead of using the Rule to satisfy

rule 144A’s information supplying requirement, the more general information- supplying alternative in 144A(d)(4) was

• used. This analysis has relied on language in

rule 144A’s adopting release in 1990. The argument has been that most listed issuers in Europe would meet that alternative. A few have even argued that the information available did not need to be in English. With the Amended Rule, it is now easier to rely on the more objective standard of the Rule, to ease opinions and concerns of going a step too far in reliance on the information- supplying alternative. The future With the financial crisis, it’s understandable that regulators in many jurisdictions have retreated from considering how global markets might function across borders through mutual recognition or substituted compliance, through the acceptance of home-country requirements. This might change in the future, to meet the demands

• f global investors. The US approach seems

to have been first to focus on the secondary rather than the primary markets, and the Amended Rule will feature prominently in those developments, if and when they come. By Jones Day partner Daniel Bushner in London

“The SEC has

seemed reluctant to go into the business

• f evaluating

regulatory regimes in other countries”