Investment Management Update

SEC REDUCES FILING BURDENS ON INVESTMENT AND OPERATING COMPANIES FOR CONFIDENTIAL BUT NOT MATERIAL INFORMATION

As part of its continuing effort to increase efficiency and reduce burdens on publicly traded companies, including registered investment companies, the U.S. Securities Exchange Commission (SEC) recently adopted amendments to Item 601¹ of Regulation S-K to allow issuers to omit certain confidential information from contracts and omit certain schedules from material agreements without requiring a confidential treatment request.² The SEC also adopted a rule requiring investment companies to hyperlink exhibits that are incorporated by reference.³ The SEC’s rule changes are mandated by the Fixing America’s Surface Transportation (FAST) Act of 2015 (the FAST Act), which directed the SEC to modernize and simplify Regulation S-K. The SEC adopted parallel rules and reforms for investment companies. These rule changes are described below.

Omitting Certain Confidential Information From Material Contracts Under Item 601

In its rulemaking for operating companies, the SEC amended Regulation S-K to permit operating registrants to omit confidential information from material contracts without requiring the issuer to file a confidential treatment request and receive approval to omit the confidential information. The SEC imposed two conditions that issuers must determine before they can omit information: (1) the omitted confidential information cannot be material to an investor, and (2) the omitted information would be competitively harmful if disclosed.⁴ This information typically includes pricing schedules, financial account records, and similar information. The SEC routinely granted confidential treatment upon request for this data. Now, issuers do not have to file confidential treatment requests if issuers determine the conditions are satisfied.

Corresponding Revisions to Investment Company Act Forms and Schedules to Allow Omission of Certain Confidential Information

The SEC approved parallel amendments for investment companies that file “other material contracts,” saving filers time. Confidential information that is not material and would be competitively harmful to investment companies can be omitted without the investment company having to file a confidential treatment request. The changes to investment company forms and instructions are set forth in the following table.

Omitting Schedules and Attachments From Exhibits

The SEC also adopted rule changes to Item 601 of Regulation S-K to allow operating companies to omit schedules and attachments to exhibit filings under the Securities Exchange Act of 1934 and Securities Act of 1933 registration statement filings so long as the schedules omitted do not contain material information, the information is not otherwise disclosed in an exhibit or in the body of the disclosure document, and the issuer includes a list identifying the contents of each omitted schedule.⁵ Prior to this amendment, only schedules to merger and acquisition agreements could be omitted from filings.⁶

Applicable Form Changes for Investment Companies

SEC Codifies That Personally Identifiable Information May Be Omitted From Required Exhibit Filings

Historically, the SEC staff has not objected to operating companies omitting sensitive, personally identifiable information such as bank account numbers, Social Security numbers, home addresses, and the like without requiring the filing of a confidential treatment request. The SEC amended Item 601 of Regulation S-K for operating companies to codify this practice.⁷

The SEC also adopted parallel provisions to applicable filing rules for investment company filers to omit personally identifiable information from Investment Company Act filing. The table below lists the changes to investment company forms and instructions codifying these rules.⁸

Investment Companies Must Include Hyperlinks for Exhibits Incorporated by Reference to EDGAR Filings

Since 2017, the SEC has required that operating companies tag exhibits that are incorporated by reference to other EDGAR filings using hyperlinks, allowing readers to click and read the exhibit on EDGAR using Hypertext Markup Language (HTML). The SEC adopted amendments requiring investment companies to also include hyperlinks to filed EDGAR documents if incorporated by reference. Because this process will require work, the SEC has adopted a transition period to allow investment companies to prepare for their filings to switch to the HTML format. The deadline for compliance is April 1, 2020. After that date, all registration statements on Forms N1A, N-2, N-3, N-4, N-5, N-6, N-14, and S-6 and reports on Form N-CSR filings made on or after April 1, 2020 will have to comply.

Taken together, these adopted rules continue the SEC’s efforts to reduce compliance burdens. Although requiring investment companies to make exhibits incorporated by reference to EDGAR filings hyperlinked using HTML will impose some increased burdens on investment companies, in the long-run this is a user-friendly reform for investors.

by Jonathan B. Levy

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SEC CLARIFIES POSITION ON INITIAL COIN OFFERINGS

Recent guidance from the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) and Division of Corporate Finance have shed light on the SEC’s view toward initial coin offerings (ICOs) by applying a classic framework to a new-age issue.

On April 3, 2019, FinHub issued guidance⁹ titled “Framework for ‘Investment Contract’ Analysis of Digital Assets.” Though it does not constitute a rule, regulation, or statement of the SEC, the Framework provides a step-by-step method for analyzing whether a digital asset is a security falling under the Commission’s regulatory reach.

FinHub’s guidance discusses the foundational decision of SEC v. W.J. Howey Co. in the context of offerings of digital assets, such as crypto-coins or tokens. The Howey test and its progeny have found that securities exist when there is (1) the investment of money (2) in a common enterprise with (3) a reasonable expectation of profits to be derived from the efforts of others. FinHub’s stance is that cryptocurrency and ICOs that meet the Howey test are securities.

In FinHub’s view, the analysis often hinges on the third prong, and the purchase and sale typically involve an investment of money in a common venture. Therefore, the question is whether purchasers of a digital asset rely on the efforts of others, such as promoters, sponsors, or other third parties (or affiliated groups of third parties), with the expectation of realizing profits on their investments. In deciding this issue, the Framework asks whether purchasers “reasonably expect” to rely on the efforts of others and whether these efforts are essential to the success of the enterprise, rather than “ministerial.” In addition, FinHub states that when a digital asset is marketed as an investment or transferable on secondary platforms, among other characteristics, it is more likely to create an expectation of profits for purchasers.

Also on April 3, 2019, the SEC’s Division of Corporate Finance issued a no-action letter response¹⁰ stating that it would not recommend an enforcement action against start-up charter air travel company Turnkey Jet, Inc. (TJK) in connection with its ICO.

In its no-action letter request¹¹ to the Commission, TJK applied the Howey test to its proposed ICO. The company conceded that although the sale of its coins arguably constitutes an investment of money in a common venture, there is no expectation of profits to be derived from the efforts of others because “[c]onsumers will have no right to share in any income generated by the operation of [TJK] (or any other affiliated entity).” Purchasers of the company’s digital token are not entitled to “dividends, rebates, rewards, interest or other distributions.” Rather, the tokens are exchangeable for the company’s air charter services.

The Division of Corporate Finance highlighted several factors impacting its decision that the TJK’s tokens are not securities. It noted that:

• The funds from token sales will not be used to build the company’s platform and infrastructure, which will be complete at the time of the ICO;
• The tokens are functional and exchangeable for services at the time of the ICO;
• Tokens are exchangeable only with other users on the company’s platform;
• Tokens will sell at a price of $1 throughout the life of the program and can only be used for flight services;
• Any repurchases of tokens by the company will be at a discount; and
• The token is not marketed as having profit potential.

Though each transaction of digital assets must be analyzed on its own facts, FinHub’s guidance and the Division of Corporate Finance’s no-action letter response provide clarity on certain issues that influence whether digital assets are securities. Importantly, issuers and brokers of crypto coins should be on alert for ICOs where purchasers have a reasonable expectation of profits to be derived from the efforts of others.

by Paul D. Hallgren

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SEC GRANTS NO-ACTION RELIEF RELAXING CAPTAIN IN-PERSON BOARD VOTING REQUIREMENTS

On February 28, 2019, the Division of Investment Management of the Securities and Exchange Commission issued a no-action letter to the Independent Directors Council (IDC) granting no-action relief to certain situations where in-person voting requirements, as set forth in Sections 12(b), 15(c), and 32(a) of the Investment Company Act of 1940, as amended (1940 Act), or Rules 12b-1 or 15a-4(b)(2) under the 1940 Act, may create a significant or unnecessary burden for funds and their boards that outweighs any benefits to fund shareholders.¹²

1. In-Person Voting Requirements Under the 1940 Act

   Section 15(c) of the 1940 Act requires that the terms of an investment advisory contract or principal underwriting agreement and any renewal thereof be approved by a vote of a majority of the fund’s directors who are not parties to the contract or agreement or “interested persons” (as defined in Section 2(a)(19) of the 1940 Act) of any such party. Rule 12b-1 under the 1940 Act requires that a plan regarding distribution-related payments pursuant to that Rule (12b-1 Plan) be approved by a vote of the fund’s board of directors and the directors who are not interested persons of the fund (independent directors) and have no direct or indirect financial interest in the operation of the 12b-1 Plan or in any agreements related to the 12b-1 Plan. Rule 15a-4(b)(2) under the 1940 Act requires that certain interim contracts be approved by a vote of the fund’s board of directors, including a majority of independent directors. Section 32(a) requires that independent public accountants be selected by a vote of a majority of the fund’s independent directors. In each case, the required votes must be cast in person.
   
   

2. No-Action Relief
   The no-action letter provides relief from the 1940 Act’s in-person meeting requirements for the following two situations:¹³
• Relief 1: the directors needed for the required approval cannot meet in person due to unforeseen or emergency circumstances, provided that (i) no material changes to the relevant contract, plan, and/or arrangement are proposed to be approved, or approved, at the meeting, and (ii) such directors ratify the applicable approval at the next in-person board meeting. According to the IDC, unforeseen or emergency circumstances include any circumstances that, as determined by the board, could not have been reasonably foreseen or prevented and that make it impossible or impracticable for directors to attend a meeting in-person. Such circumstances would include, but not be limited to, illness or death, including of family members, weather events or natural disasters, acts of terrorism, and disruptions in travel that prevent some or all directors from attending the meeting in person.
• Relief 2: the directors needed for the required approval previously fully discussed and considered all material aspects of the proposed matter at an in-person meeting but did not vote on the matter at that time, provided that no director requests another in-person meeting.
3. Board Actions
   The no-action relief discussed in Section II applies to each of the following board actions as follows:

1. For renewal of an investment advisory contract or principal underwriting contract pursuant to Section 15(c) of the 1940 Act, either Relief 1 or Relief 2 applies.
2. For approval of an investment advisory contract or principal underwriting contract pursuant to Section 15(c) of the 1940 Act, only Relief 2 applies.
3. For approval of an interim advisory contract pursuant to Rule 15a-4(b)(2) under the 1940 Act, only Relief 2 applies.
4. For renewal of the fund’s 12b-1 Plan, either Relief 1 or Relief 2 applies.
5. For approval of the fund’s 12b-1 Plan, only Relief 2 applies.
6. For selection of the fund’s independent public accountant pursuant to Section 32(a) of the 1940 Act, if such accountant is the same accountant as selected in the immediately preceding fiscal year, either Relief 1 or Relief 2 applies.

For selection of the fund’s independent public accountant pursuant to Section 32(a) of the 1940 Act, if such accountant is not the same accountant as selected in the immediately preceding fiscal year, only Relief 2 applies.

by Joanna (Ying) Jiang

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SEC PROPOSES "TEST-THE-WATERS" EXPANSION

On February 19, 2019, the SEC voted to propose Rule 163B under the Securities Act of 1933, as amended (the Securities Act), and amendments to Rule 405 (collectively the Proposed Rule) promulgated under the Securities Act to reform the rules regarding “test-the-waters” communications.¹⁴ The Proposed Rule,¹⁵ if adopted, would expand the test-the-waters accommodation, currently available only to emerging growth companies (EGCs), to all issuers, including investment company issuers.

1. Background

   Section 5(c) of the Securities Act generally prohibits any written or oral offers to sell securities prior to the filing of a registration statement. Once a registration statement has been filed, Section 5(b)(1) generally requires issuers to use a prospectus that complies with Section 10 of the Securities Act for any written offers of securities. Any violation of these restrictions is commonly referred to as “gun-jumping.”

   In 2012, Congress passed the Jumpstart Our Business Startups Act, which created Section 5(d) of the Securities Act. Section 5(d) permits EGCs and any person authorized to act on its behalf to engage in oral or written communications with potential investors that are qualified institutional buyers (QIBs) or institutional accredited investors (IAIs) before or after filing a registration statement to gauge such investors’ interest in a contemplated securities offering. In 2017, the SEC expanded another rule, previously available only to EGCs, to allow issuers to submit confidential filings in connection with an initial public offering. Consistent with that prior expansion, the Proposed Rule would provide increased flexibility to issuers in their communications with certain investors in connection with proposed securities offerings.
   
   

2. The Proposed Rule

   Below are some important takeaways from the Proposed Rule.

• Eligibility: All issuers, including non-reporting issuers, EGCs, non-EGCs, well-known seasoned issuers, and investment companies (including registered investment companies and business development companies [BDCs]), would be eligible to rely on the Proposed Rule.
  
  
• Intended Recipients of Test-the-Waters Communications: Under the Proposed Rule, issuers are allowed to engage in test-the-waters communications with QIBs or IAIs either prior to or following the date of filing of a registration statement related to such offering.
  
  
• Reasonable Belief Requirement: The Proposed Rule would require the issuer to have a reasonable belief that a potential investor is a QIB or IAI. Unlike Rule 506(c) of Regulation D, which imposes a burden on issuers to verify investor status, the Proposed Rule only requires the issuer to establish a reasonable belief with respect to the potential investor’s status based on the particular facts and circumstances. The SEC is not proposing to specify the steps that an issuer could or must take to establish a reasonable belief that the intended recipients of test-the-waters communications are QIBs or IAIs. Instead, issuers should continue to rely on the methods they currently use to establish a reasonable belief regarding an investor’s status as a QIB or accredited investor pursuant to Rule 144A and Rule 501(a) of Regulation D, respectively. For example, Rule 144A(d)(1) sets forth non-exclusive means to determine whether a prospective purchaser is a QIB, including allowing issuers to rely on the prospective purchaser’s most recent publicly available financial statements, the most recent publicly available information appearing in documents filed by the prospective purchaser with the SEC or another U.S. federal, state, or local government agency or self-regulatory organization, or with a foreign governmental agency or self-regulatory organization, etc.
  
  
• Test-the-Waters Communications Are “Offers”: According to the SEC, test-the-waters communications, while exempt from the gun-jumping provisions of Section 5, would nonetheless still be considered “offers” as defined in Section 2(a)(3) of the Securities Act and would therefore be subject to Section 12(a)(2) liability, in addition to the anti-fraud provisions of the federal securities laws. Additionally, information provided in a test-the-waters communication under the Proposed Rule must not conflict with material information in the related registration statement. Further, issuers subject to Regulation FD would need to consider whether any information in the test-the-waters communication would trigger any obligations under Regulation FD, or whether an exception to Regulation FD would apply.
  
  
• Legend or Filing Requirement: An issuer contemplating a registered securities offering may solicit interest from QIBs and IAIs without legending or filing test-the-water communications that comply with the Proposed Rule. Although an issuer is not required to file the test-the-waters communications with the SEC, as is currently the practice of the SEC when reviewing offerings conducted by EGCs, the SEC or its staff could request that an issuer furnish the staff any test-the-waters communications used in connection with an offering.

   

• Exclusivity: The Proposed Rule would not act as an exclusive election, and an issuer could rely on other Securities Act communication rules or exemptions when determining how, when, and what to communicate with respect to a contemplated securities offering. If the same issuer decides to claim the availability of another exemption or communication rule with respect to those communications, the conditions of the other exemption or rule relied upon must be satisfied.
3. Implications for Investment Companies

The Proposed Rule would similarly apply to investment company issuers. Test-the-waters communications may help investment companies better assess market demand for a particular investment strategy, as well as appropriate fee structures, prior to incurring the full costs of a registered offering. However, as recognized by the SEC, certain features of investment companies may make their use of the Proposed Rule more limited than other issuers because it is common practice to simultaneously file a registration statement under both the Investment Company Act of 1940, as amended (the 1940 Act), and the Securities Act to take advantage of certain efficiencies. If funds collectively continue to prefer to file a single registration statement under both the 1940 Act and the Securities Act, funds may be less likely to use the Proposed Rule for pre-filing communications than other issuers. However, funds that preliminarily engage in exempt offerings, including certain registered closed-end funds and BDCs, could rely on the Proposed Rule to engage in pre-filing communications if they are considering a subsequent registered offering.

by Joanna (Ying) Jiang

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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.