"Going Dark" the Hard Way: Section 12(j) Enforcement Proceedings

Most investors are familiar with the arduous registration process that companies must endure to “go public.”  Some may also know that, due to increasing regulatory compliance costs, many SEC reporting companies have voluntarily gone private or "dark," or are considering doing so. 

This is accomplished by filing a Form 15 terminating the registration of their stock.  Increasingly, however, many delinquent filing companies are learning the hard way that the SEC wants to force them to “go dark” by filing an enforcement action under Section 12(j) of the Exchange Act. [1]  Through such a proceeding, the SEC alleges that the companies are in violation of the reporting provisions requiring them to file current annual and quarterly reports, and seeks a judicial order revoking registration of the delinquent company’s stock – a step that effectively ends public trading.   The number of Section 12(j) proceedings has grown dramatically in recent years.  In 2005, the SEC filed 55 such proceedings against a total of 125 delinquent filing companies. 

Most companies sued in a Section 12(j) proceedings lack the resources or desire to fight.  Indeed, in nearly all instances, their poor financial condition prevented them from being able to file the obligatory reports in the first place.  However, a handful of companies have chosen to litigate against the SEC.  I selected a random group of five recent initial decisions in litigated 12(j) proceedings, In re Gateway Int’l Holdings, Inc., File No. 3-11894 (Aug. 18, 2005), In re CMKM Diamonds, Inc., File No. 3-11858 (July 12, 2005), In re E-Smart Technologies, Inc., File No. 3-10977 (Feb. 3, 2005), In re Agra-Tech, Inc., No. 3-11690 (Dec. 17, 2004) and In re Cybergate, Inc., File No. 3-11512 (Oct. 12, 2004),[2] to determine what lessons could be learned.  Through my review, I identified “aggravating” factors that the Division of Enforcement cited in attempting to persuade the ALJ’s to revoke registration of the companies’ stock.  Further, the outcome of these cases suggests that companies trying to avoid revocation should consider mitigating their violations by belatedly filing their delinquent reports.   

In the five cases, the Division of Enforcement introduced evidence of   illegitimacy and outright fraud.  As an extreme example of such evidence, in CMKM Diamonds, the company had filed a false Form 15, issued false press releases, and was using a fake address. [3] Similarly, in Cybergate, the company failed to disclose that its president was a previously disbarred attorney,[4] and in E-Smart, the president of the company had been charged with undisclosed criminal violations. [5] Interestingly, the SEC had not charged the companies with fraud on the basis of these disclosure issues, and the cases do not indicate whether the companies sought to bar such evidence on relevancy grounds. 

In contrast, in two cases, Gateway and E-Smart, the delinquent companies presented evidence of their belatedly compliance with their reporting obligations.  Their efforts met with mixed success.  In E-Smart, the ALJ initially revoked the registration of the issuer’s common stock.  After the hearing, the company became current in its filings, although it accomplished this in part by filing a “consolidated” annual report containing reported results for two fiscal years, in violation of the Commission’s rules. On remand, the judge declined to impose any sanctions, notwithstanding the issuer’s previous “recurrent and egregious” filing delinquencies. She reasoned that, under the public interest factors set forth in Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff’d on other grounds, 450 U.S. 91 (1981), there was no likelihood of future violations and E-Smart’s management had recognized the wrongfulness of the company’s past violations.  In so doing, the judge cited to a prominent legal commentator who views revocation proceedings as draconian in nature. [6]

The Gateway case involved facts similar to those in E-Smart.   In Gateway, the company filed a “consolidated” annual report prior to the hearing, and filed five quarterly reports after the hearing, thereby becoming current in its filings.  Nonetheless, the ALJ concluded that the public interest factors were satisfied, and revoked registration of Gateway’s stock.  In attempting to distinguish the case from the E-Smart decision, she relied primarily on the fact that Gateway’s annual report contained three “critical deficiencies” that prevented the Division of Corporation Finance from reviewing the filing, while noting that Gateway had previously corrected five additional such deficiencies. Arguably, this was too fine a point to justify reaching a different result than the one in E-Smart.   The Commission will get to decide, since the case is now on appeal.

Three of the revocation cases raised the issue of “going dark” voluntarily by filing a Form 15.  Once such a form is filed, termination of the company’s registration takes effect 90 days later, while its duty to file reports is immediately suspended.  However, if the certification on Form 15 is subsequently withdrawn or denied, the company must, within 60 days, file with the Commission all reports which would have been required had the certification on Form 15 not been filed. See Exchange Act Rule 12g-4.

On its face, the filing of a Form 15 would appear to obviate the need to revoke registration of a company’s stock.  But in Agra-Tech, Judge McEwen stated that the filing of Forms 15 by three delinquent filers after the institution of adversarial proceedings did not mitigate the likelihood of further violation.   However, inconsistently, in the Cybergate and E-Smart decisions, McEwen noted, with disapproval, that the companies in these cases could have filed Forms 15, but had declined to do so, thereby suggesting that such filings would have made revocation unnecessary.[7]  This reasoning appears to be consistent with Commission precedent. [8] 

Judge McEwen’s analysis in Agra-Tech is unpersuasive.  The judge downplayed the significance of the forms because the certifications contained therein could be subsequently withdrawn or denied, and the forms evidenced a lack of intent to be subject to the reporting requirements.[9]   However, unlike in other cases, there was no evident basis for withdrawing or denying such certification.  For instance, in CMKM Diamonds, the company was forced to withdraw its previously filed Form 15 because it discovered that it “actually had 698 shareholders of record as of the filing date,” rather than the maximum of 300 shareholders contemplated under Rule 12g-4. [10] Similarly, the Commission has sought to deny a company’s Form 15 certification only where the form itself expresses uncertainty about the number of shareholders.[11]  Accordingly, unless there is reason to doubt a company’s qualification for deregistration under Rule 12g-4, a Form 15 should be regarded as an effective last-ditch defense to a Section 12(j) proceeding.

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[1] Section 12(j) of the Exchange Act authorizes the SEC to suspend or revoke the registration of a security if it finds that the issuer has failed to comply with “any provision of this title or the rules and regulations thereunder.”  In practice, the SEC brings Section 12(j) proceedings against companies that violate the reporting provisions contained in Sections 13(a) and 15(d) of the Exchange Act and rules thereunder (particularly 13a-1 and 13a-13, requiring the filing of annual and quarterly reports).

[2] See http://www.sec.gov/litigation/aljdec/id294bpm.pdf, http://www.sec.gov/litigation/aljdec/id291bpm.pdf, http://www.sec.gov/litigation/aljdec/id272lam.pdf, http://www.sec.gov/litigation/aljdec/id268lam.pdf and http://www.sec.gov/litigation/aljdec/id264lam.pdf.

[3]  See CMKM Diamonds, at pp. 4-5.

[4]  See Cybergate, at p. 3.

[4]  See Cybergate, at p. 3.

[5]  See E-Smart, at p. 5.

[6] See 4 Louis Loss & Joel Seligman, Securities Regulation 1892 (3d ed., rev. vol. 2000)

[7]  See Cybergate, p. 4, E-Smart at p. 8.

[8] For instance, in SEC v. Johnson, No. 04-RB-0626 (D. Colo. Sept. 10, 2004), the Commission accepted a microcap issuer’s offer of settlement to consent to an injunction, without revocation of its common stock, http://www.sec.gov/litigation/litreleases/lr18879.htm.  In its complaint, the SEC alleged that the issuer had previously filed a Form 15 terminating the registration of its common stock.  See http://www.sec.gov/litigation/complaints/comp18652.htm

[9]  See Agra-Tech, p. 5.

[10] See CMKM Diamonds, p. 5.

[11]  See In re Bacardi Corp., File No. 3-7019, 1990 SEC LEXIS 3920 (Feb. 15, 1990).