More “broken windows” enforcement from the SEC?

by Cydney Posner

Yesterday, the SEC announced that it had sanctioned ten companies (generally, smaller reporting companies traded on OTC Link) for failing to make required Form 8-K disclosures related to financings and unregistered stock sales. Individual penalties were either $25,000 or $50,000, being paid to the SEC in installments.

As noted in this post, SEC Chair Mary Jo White has declared an “enforcement mission” of the SEC to be implementation of the “broken windows” theory of crime deterrence made famous decades ago in NYC: “The [‘broken windows’] theory is that when a window is broken and someone fixes it – it is a sign that disorder will not be tolerated.  But, when a broken window is not fixed, it ‘is a signal that no one cares, and so breaking more windows costs nothing.’”  Likewise with securities law violations, “minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines.  And so, I believe it is important to pursue even the smallest infractions.“ In September, the SEC announced charges against a number of individuals and companies for violations of requirements to make filings under Sections 16 and 13 of the Exchange Act.  Yesterday, with these sanctions for 8-K and 10-Q/10-K violations, the SEC appears, once again, to be applying this theory — or perhaps a corollary of it — taking enforcement action against these small players for reporting violations, instead of just issuing deficiency letters or taking similar action.  Some have argued that the broken windows theory was not actually very effective in practice (see, e.g., this article), and it will be interesting to see what, if any, impact implementation of this enforcement policy will have.

Each of the companies entered into an agreement with a financing company to sell shares, but failed to make the required 8-K disclosure regarding the financing or private stock sale, even though the transactions involved significant dilution.  Companies are required, within four business days, to file Forms 8-K  to report entry into material definitive agreements (under Item 1.01), and  to report  unregistered sales of equity securities (under Item 3.02), unless the sales constitute (in the aggregate since the last report) less than 1% of the shares outstanding (5% for smaller reporting companies). In one case, unreported sales allegedly aggregated over 35,000% of outstanding shares as last reported. (Maybe that’s more like a collapsed roof and busted door than a broken window….)

Three of the companies also “failed to use accurate numbers when later reporting the dilution of their common stock in quarterly or annual reports.”   Forms 10-Q and 10-K require disclosure of the number of outstanding shares of common stock as of the latest practicable date, and the SEC emphasized that the “information must be true, correct, and complete.”  According to the SEC’s Director of Enforcement, “[t]hese enforcement actions reinforce the ongoing need for full disclosure to shareholders concerning an issuer’s entry into highly dilutive financing agreements.”

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