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Practice Pointer for OTC Quoted Companies: The SEC Wants to Know Why You Don’t Meet NYSE/Nasdaq Corporate Governance Standards

The SEC staff frequently comments during its review process about the lack of an established corporate governance structure, such as board member independence and board committee composition, by OTC quoted issuers, even if not required by SEC and national securities exchange rules.

The SEC staff has regularly prioritized its review of corporate governance disclosure in registration statements, proxy statements and periodic reports. Much of this required disclosure, especially with regard to board member independence and board committee composition, is effectuated through the rules of national securities exchanges, namely the NYSE and Nasdaq, as a result of the Sarbanes-Oxley Act of 2002. Companies whose shares are quoted in the over-the-counter market, however, are not required to comply with the same national securities exchange rules as are NYSE and Nasdaq traded companies. Regardless, OTC quoted companies (e.g., companies whose shares are listed on the OTC Market Group's OTCQB or Pink marketplace) should be aware that the SEC wants to know how and why they do or don’t meet NYSE/Nasdaq-level corporate governance standards.

Aside from Item 407(a) of Regulation S-K, which requires issuers to explain how they define “independence” and to identify directors who are independent, SEC rules do not require OTC quoted companies to have independent members on their board of directors or have standing audit, compensation or nominating committees of their board (or if they have any of such board committees, with independent members). Even if not required by SEC and national securities exchange rules, the SEC staff frequently comments during its review process about a lack of an established corporate governance structure.

For example, a recent SEC comment issued to an OTC quoted issuer reads: “We note your disclosure that your board does not have a separately designated audit committee or other committee that performs similar functions. Please revise your disclosure to describe who will be responsible for performing the duties that would otherwise be performed by an audit committee, to clarify whether the persons performing such duties will be independent, and to describe such duties.”

In the absence of an audit committee, an issuer would need to disclose that either (i) the entire board of directors or (ii) an authorized officer or officers perform the functions of an audit committee, especially in the case of discussions with the issuer’s independent accountant regarding an SEC filing. Further, the issuer would need to identify whether any of the directors or authorized officers are independent (and disclose the definition of independence the issuer is applying to determine who is independent), and describe the duties they would perform among those ordinarily delineated for audit committees by NYSE/Nasdaq companies.

From this more general SEC comment, a waterfall of other comments are customarily issued to OTC issuers. For instance, if the issuer does not have an audit committee, and the entire board performs that function, the SEC would likely ask for a description of the extent of the board’s knowledge of U.S. GAAP to see if there may be an equivalent audit committee financial expert serving on the board. 

If the issuer does not have any independent directors or fewer than a majority of independent directors on its board, the SEC would likely advise the issuer to add disclosure in the “Risk Factors” section of the document regarding this lack of independent directors and its effect on the company. If all of the directors are also executive officers of the company, the SEC may even recommend addressing this risk with language to the effect that such directors will be able to determine their own salaries and perquisites, and there may not be funds available for net income. Other risks to shareholders from the absence of such standards of corporate governance might include the possibility of related party transactions and conflicts of interest, as well as reluctance by investors to provide capital to the company in the future. 

Similarly, if the issuer does not have any board committees, including an audit committee, the SEC would likely request the issuer to revise the Risk Factors section in the document to disclose this fact in a separate risk factor.

In issuing these comments, the SEC is flexing its investor protection muscle by effectively supplementing corporate governance disclosure requirements for OTC quoted companies so that they need to disclose how their corporate governance differs from the corporate governance requirements for NYSE and Nasdaq traded companies.