ABA Section of Business Law

Trimming the reporting when bad times hit

An SEC staffer tells how to do it

By DAVID C. LEE

T he company is going down. It still needs to follow the SEC’s reporting requirements. But there’s a little bit of slack; read on.

Because of recent difficulties in accessing the capital markets, a number of public companies, particularly those in the technology area, have found it necessary to file voluntary petitions with the U.S. Bankruptcy Court under Chapters 7 or 11 of the U.S. Bankruptcy Code.

Contrary to what some may think, the fact that a public company has begun bankruptcy proceedings or has ceased operations does not mean that it is relieved of its public reporting obligations under the Securities Exchange Act of 1934 (Exchange Act). Federal law, including the Bankruptcy Code and the federal securities laws, does not exempt companies in bankruptcy proceedings from the public reporting requirements.

A public company entering bankruptcy proceedings may, however, be able to modify its reporting scheme by either relying on general guidance provided by the Securities and Exchange Commission or requesting no-action relief from the Division of Corporation Finance (division). Modified reporting allows a public company in reorganization proceedings to replace the filing of its Exchange Act periodic reports with the monthly reports filed according to the Bankruptcy Code.

Through the issuance of Release No. 34-9660 (June 30, 1972), the commission has indicated that it may accept modified periodic reporting from companies in financial difficulty "which have ceased or severely curtailed their operations" when other sufficient means of disclosure exist, so long as the modified public reporting scheme is not inconsistent with investor protection. In outlining the considerations appropriate for modified reporting, the release indicates that the issuer should consider the nature and extent of trading in its securities, the reasons for inability to comply with the reporting requirements and whether modified reporting is consistent with the protection of investors.

In addition, an issuer that wishes to rely on this general guidance should be careful to inform its security holders of its financial condition and material developments relating to the bankruptcy proceeding. An issuer may consider requesting a legal opinion from its counsel as to whether Release No. 34-9660 allows for modified reporting in its particular factual circumstances.

If an issuer wishes to obtain an additional level of comfort that modified public reporting is appropriate or otherwise feels that relying on the general guidance provided by the commission is not sufficient, it has the option of submitting a no-action letter request to the Division of Corporation Finance. A no-action request typically sets forth a set of facts and legal analysis, citing, if applicable, prior no-action letters, commission releases, case law, staff legal bulletins and the like.

A favorable no-action response typically indicates that the division will not take any action (hence the term "no-action letter") in recommending that the commission take enforcement action. The division’s response, however, is not binding on the commission and is generally only a position on enforcement action and not a legal conclusion.

In order to provide specific guidance on the submission of no-action requests regarding modified reporting, the division issued Staff Legal Bulletin No. 2 (April 15, 1997) (SLB No.2) (available at www.sec.gov). In addition, the division’s responses to prior no-action requests provide further insight into its views on modified reporting. SLB No. 2 and prior no-action letters may also be useful in considering whether an issuer is in compliance with Release No. 34-9660, absent a no-action letter. It should be noted that, even if no-action relief is granted modifying an issuer’s obligation to file Forms 10-K and 10-Q, issuers that have a class of equity securities registered according to Section 12(g) are still subject to the requirements of Sections 13, 14 and 16.

Issuers requesting no-action relief should be concerned with the timely submission of the no-action request to the division. The request for no-action relief should be filed before the due date of the issuer’s first periodic report following the filing of the bankruptcy petition. A no-action request will also be considered timely if it is submitted during the bankruptcy proceedings and the issuer is current in its reporting obligations through the date of the no-action request. An issuer that files its no-action request after its emergence from bankruptcy will not receive a favorable response from the division, even if it otherwise satisfies the requirements of SLB No. 2.

Among the most important criteria, SLB No. 2 indicates that the division will consider the efforts the issuer has made "to inform its security holders and the market of its financial condition." The no-action request should include a discussion of the disclosure relating to financial condition made in the issuer’s prior periodic and current reports. Issuers should realize that the narrative disclosure contained in Management’s Discussion & Analysis (MD&A) is of crucial importance, especially in the case of a financially distressed company. Issuers that are experiencing financial difficulty should disclose any material problems, such as noncompliance with covenants in material loan agreements or deficiencies in liquidity. Moreover, the possibility of seeking bankruptcy protection should be disclosed.

"Informing the market," mentioned above, could also include press releases as well as information on the company’s Web site. It should be noted that the issuance of press releases cannot, of course, replace the filing of periodic reports since they do not contain all of the information required by the Exchange Act. Moreover, press releases are not subject to the liability provisions contained in Section 18 of the Exchange Act unless they are filed with the commission.

In addition to the quality of the disclosure in its periodic reports, the division will take into account the issuer’s reporting history. Issuers must be "current" in their Exchange Act reports for the 12-month period prior to the filing of the bankruptcy petition. Failure to file a Form 10-K or 10-Q within the last 12 months prior to the filing with the Bankruptcy Court may be deemed to not adequately inform the market of the issuer’s financial condition, leading to denial of the no-action request.

It should be noted that in some no-action letters prior to October 1996, issuers who were not current in their periodic reports — such as, failed to file a Form 10-K or 10-Q — were granted no-action for future periodic reports, but not for the report that resulted in the issuer being noncurrent. The division subsequently changed its position in the no-action letter Focus Surgery (Oct. 3, 1996) and now declines no-action relief if an issuer has failed to file any periodic reports for the last 12 months.

Adequate disclosure is not helpful if it is not timely. As a result, untimely reporting of periodic reports could weigh against the granting of no-action relief. An issuer that has untimely filed one or two periodic reports is not, however, necessarily precluded from receiving no-action relief. SLB No. 2 indicates that "an issuer submitting a request should have been current in its Exchange Act reports for the 12 months before its Bankruptcy Code filing." (emphasis added). Thus, presumably, an issuer that has untimely filed one periodic report may not be precluded from no-action relief, on the basis that, while it was untimely, it had filed all required reports and is thus "current" with respect to its reporting. The issuer, however, should explain why its periodic reports were untimely.

Contrast this situation with an issuer that has failed to file a periodic report. In this instance, the issuer is not current in its reporting, as a direct result of its failure to file the required report and will not receive no-action relief.

In addition, the issuer is required under the Exchange Act to file a Form 8-K informing security holders of its filing for bankruptcy within 15 calendar days of the bankruptcy petition. If the Form 8-K is filed more than 15 days after the filing of the bankruptcy petition, the issuer should include an explanation as to why the Form 8-K was not timely filed.

While SLB No. 2 indicates that there is no "specific, objective test concerning the timing of the Form 8-K filing," a substantial period of time between the bankruptcy filing and the filing of the Form 8-K could preclude the granting of no-action relief, even if a press release relating to the filing of the bankruptcy petition is issued. Failure to file a Form 8-K informing security holders of the bankruptcy filing at all , however, will result in the denial of no-action relief.

Another factor that should be considered is whether the issuer is able to continue reporting under the Exchange Act after the filing of its bankruptcy petition. SLB No. 2 indicates that the no-action request should discuss:

• whether operations have ceased or the extent they have been curtailed,

• why periodic reporting would present undue hardship to the issuer,

• why the issuer cannot comply with the disclosure requirements, and

• why the issuer believes granting the no-action request is consistent with investor protection.

An issuer that has ceased operations altogether obviously does not generate income from operations, and, assuming that it has no other productive assets, does not generate cash flow. Sales of substantial portions of an issuer’s operating assets also presents evidence that an issuer may not have the capability to generate future income. When addressing why filing periodic reports presents undue hardship, issuers often point to practical problems, such as lack of accounting personnel to handle financial statements, lack of cash to pay reporting expenses and the like.

Quantification of the expected costs of an audit, legal fees and other expenses associated with compiling Exchange Act reports should be provided in the no-action request since it allows for comparison of the expected costs with the "cash and cash equivalents" line item as disclosed in the latest balance sheet. In some instances, the Bankruptcy Court may decline to approve the disbursement of funds for the preparation of periodic reports, a factor the division may take into account.

In addition, express representations from management that (1) filing of the Exchange Act reports would be an undue hardship and (2) that the reports to be filed with the bankruptcy court are sufficient for investor protection should be included in the no-action request letter. With respect to the second representation, issuers typically indicate that the reports submitted by the issuer to the Bankruptcy Court and the U.S. trustee under Rule 2015 are sufficient for the protection of investors since financial statements contained in the monthly operating reports are provided on a more frequent basis relative to financial statements contained in Form 10-K and Forms 10-Q. Moreover, the purpose of the monthly disclosure statements is to provide creditors with enough information to allow for evaluation of the plan of reorganization.

Perhaps the most important factor is the "nature and extent of trading in the issuer’s securities." In particular, the issuer should indicate:

• whether the securities are listed on an exchange or Nasdaq,

• the volume of securities traded for the three months prior to the bankruptcy filing and each month thereafter and

• the current number of market makers in the securities.

If the securities are still listed and traded on an exchange or the Nasdaq National or SmallCap stock markets, it is "sufficient evidence that there is an active market for those securities," and SLB No. 2 indicates that the division will not grant no-action relief in these instances. SLB No. 2 indicates that securities are not considered to be "traded" if "(1) those securities have been delisted; or (2) trading in those securities on those markets has been formally suspended."

Even if a company has been delisted, the existence of an active over-the-counter market for the issuer’s securities could weigh heavily against the granting of no-action relief because investors are trading without access to current publicly filed information relating to the company.

An issuer should provide the number of shares traded, as well as the number of trades, per month for the three months prior to the bankruptcy filing and each month thereafter. Providing a graph or tabular presentation that shows decreased volume in trading of securities favors modified reporting; however, a mere decrease in volume would not appear to be sufficient if substantial trading still exists.

SLB No. 2 indicates that "[g]eneral statements in the request that trading has been ‘minimal’ or ‘insignificant’ are not sufficient to enable the division to reach a conclusion on the request." However, statements indicating that there is "no trading" in the securities are deemed sufficient with the understanding that "no trading" means that there is zero, or close to zero, volume.

In addition, the number of market makers in the issuer’s securities should be disclosed. Because of the nature of the market maker’s role in the financial markets, that is, the maintaining of bid and ask prices in securities, the existence of market makers could be deemed as evidence of trading. The issuer should indicate, if true, that there are no market makers in its securities. Statements by the issuer that it believes that no market makers exist are generally not sufficient; rather, it should provide confirmation that no market makers exist.

For an issuer whose securities are traded on the Pink Sheets, the issuer should contact the National Quotation Bureau to determine whether any market makers have filed a Form 211, which is required in order for a market maker to initiate market making activities. Information relating to the number of securities outstanding, as well as the number of record holders, should also be provided.

Sometimes, a large portion of the issuer’s securities are held by officers, directors or affiliates. Even if there is a lack of trading in the securities, the issuer should indicate what assurances it has received that significant shareholders will not trade their shares, the concern being that the significant shareholders may dump their shares in the open market. Any agreements or arrangements to this effect between the issuer and significant shareholders should be discussed in the no-action request.

In addition, the issuer should take any reasonable efforts to stop trading in its securities, such as giving stop-transfer instructions to its transfer agent. At a minimum, the issuer should not encourage trading. In this regard, press releases, as well as Web sites, should be careful to omit any information that could be construed as encouraging trading in the issuer’s securities. For example, including information relating to the market in which the issuer’s stock trades and the ticker symbol may raise the concern that the issuer is encouraging trading in its stock.

Whether or not no-action relief is not granted, it is important for the issuer to comply with its obligations under the Exchange Act by notifying security holders, usually through Form 8-K, of any material developments during the bankruptcy proceedings, including the monthly reports, likelihood of liquidation payments to be made to security holders, amounts of expenses and approval of any debtor-in-possession financing arrangements.

If material information is known but not disclosed, and the company has a pending no-action request, then no-action relief may not be available. As such, it is important to notify the market as soon as possible as to how the security holders will be treated in connection with the bankruptcy proceedings, as well as reporting this information on Form 8-K, since this information is material to security holders.

After a reorganization plan is effective according to the Bankruptcy Court’s approval, the company should file a Form 8-K that (1) discloses the approval as well as all other information required by Item 3(b) of Form 8-K and (2) contains an audited balance sheet. Moreover, SLB No. 2 indicates that any filings under the Securities Act or the Exchange Act must include audited GAAP financial statements for all periods for which audited financial statements are required even though the issuer was subject to bankruptcy proceedings during those periods.

An issuer effecting a liquidation should file a final Form 8-K reporting the completion of the liquidation event. Once the reorganization plan is effective, the issuer’s obligation to file Forms 10-K and 10-Q resumes.

As to matters relating to eligibility for Forms S-2 and S-3, the current public information requirement of Rule 144(c)(1) and the definition of a "reporting issuer" as contained in Rule 902(i) of Regulation S, SLB No. 2 indicates that an issuer that modifies its reporting requirements will not be able to claim that it has been "current" as contemplated by these rules or forms. As such, the various time periods applicable to each of these rules or forms restart if an issuer modifies its periodic reports.

An issuer deciding whether or not to modify its periodic reporting should carefully consider whether the benefits of modified reporting outweigh the availability of Rule 144, Regulation S and Forms S-2 and S-3 immediately after completion of the bankruptcy proceedings.

In contrast, with respect to Rule 12h-3, issuers that have modified their reporting obligations as a result of favorable no-action relief will be considered to have filed "all reports required by Section 13(a)" (a condition of Rule 12h-3). Rule 12h-3 generally allows an issuer to suspend its duty to file periodic reports under Section 15(d) if there are fewer than 300 record holders of the particular class, or there are fewer than 500 record holders and assets are $10 million or less at the end of each of the issuer’s last three fiscal years. Assuming that Rule 12h-3’s other requirements and the conditions in a favorable no-action response are met, the issuer will be able to suspend its reporting obligations.

If an issuer wishes to obtain comfort that modifying its public reporting scheme in the context of bankruptcy proceedings is appropriate, it should ensure that it has fully complied with its obligations under the federal securities laws prior to and during its bankruptcy.

Careful consideration of, and compliance with, the requirements of Release No. 34-9660 and SLB No. 2 will ultimately allow an issuer to modify the costs associated with reporting obligations under the Exchange Act, allowing the issuer to concentrate on liquidation or reorganization into a financially stable company.

 Lee is special counsel, Division of Corporation Finance, at the Securities and Exchange Commission in Washington. The author thanks Martin Dunn, associate director, Patricia Miller, special counsel, in the division of Corporation Finance, SEC, and Professor Therese Maynard, Loyola Law School, Los Angeles, for their assistance. The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed are those of the author and do not necessarily reflect the views of the commission or its staff.

Back to Business Law Home Page