SEC Proposes Amendments to Accelerated and Large Accelerated Filer Definitions
As promised by SEC Chair Jay Clayton almost a year ago when the SEC amended the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K (see HERE ), on May 9, 2019, the SEC proposed amendments to the definitions of an “accelerated filer” and “large accelerated filer.”
In June 2018, the SEC amended the definition of a smaller reporting company (SRC) to include companies with less than a $250 million public float or if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC is one with less than $100 million in annual revenues during its most recently completed fiscal year. At that time the SEC did not amend the definitions an accelerated filer or large accelerated filer. As a result, companies with $75 million or more of public float that qualify as SRCs remained subject to the requirements that apply to accelerated filers or large accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that these accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act (SOX).
Under the proposed amendments, smaller reporting companies with less than $100 million in revenues would not be required to obtain an attestation of their internal control over financial reporting (ICFR) from an independent outside auditor under Section 404 of SOX. In particular, the proposed amendments would exclude from the accelerated and large accelerated filer definitions a company that is eligible to be an SRC and had no revenues or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available.
The proposed amendments also would increase the transition thresholds for accelerated and large accelerated filers becoming a non-accelerated filer from $50 million to $60 million and for exiting large accelerated filer status from $500 million to $560 million and add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status.
Like the change to the definition of an SRC, it is thought the new proposed amendments will assist with capital formation for smaller companies. The SEC also notes that the proposed amendments are targeted at companies that have delayed going public in recent years and as such, may help stimulate entry into the U.S. capital markets. Making a reference to a statement by SEC Commissioner Hester Peirce at the time of the amendment to the definition of an SRC expressing her disappointment that the definition of accelerated filer and large accelerated filer were not concurrently changed, in the press release announcing the new proposed rule changes Chair Clayton points out, “[I]nvestors in these lower-revenue companies will benefit from more tailored control requirements. Many of these smaller companies – including biotech and health care companies – will be able to redirect the savings into growing their companies by investing in research and human capital.”
Background
The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has been fairly constant over the past few years with a slew of rule changes and proposed rule changes. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.
A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner.
The SEC disclosure requirements are scaled based on company size. The SEC categorized companies as non-accelerated, accelerated and large accelerated in 2002 and the introduced the smaller reporting company category in 2007 to provide general regulatory relief to these entities. The only difference between the requirements for accelerated and large accelerated filers is that large accelerated filers are subject to a filing deadline for their annual reports on Form 10-K that is 15 days shorter than the deadline for accelerated filers.
The filing deadlines for each category of filer are:
| Filer Category | Form 10-K | Form 10-Q |
| Large Accelerated Filer | 60 days after fiscal year-end | 40 days after quarter-end |
| Accelerated Filer | 75 days after fiscal year-end | 40 days after quarter-end |
| Non-Accelerated Filer | 90 days after fiscal year-end | 45 days after quarter-end |
| Smaller Reporting Company | 90 days after fiscal year-end | 45 days after quarter-end |
Significantly, both accelerated filers and large accelerated filers are required to have an independent auditor attest to and report on management’s assessment of internal control over financial reporting in compliance with Section 404(b) of SOX. Non-accelerated filers are not subject to Section 404(b) requirements. Under Section 404(a) of SOX, all companies subject to SEC Reporting Requirements, regardless of size or classification, must establish and maintain internal controls over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment (see HERE).
An ICFR system must be sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS) and to maintain accountability for assets. Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. These requirements apply to any and all companies subject to the SEC Reporting Requirements.
Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR.
Furthermore, auditors review ICFR even where companies are not subject to 404(b). Audit risk assessment standards allow an auditor to rely on internal controls to reduce substantive testing in the financial statement audit. A necessary precondition is testing such controls. Also, an auditor must test the controls related to each relevant financial statement assertion for which substantive procedures alone cannot provide sufficient appropriate audit evidence. Naturally, a lower revenue company has less risk of improper revenue recognition and likely less complex financial systems and controls. In any event, in my experience auditors not only test ICFR but make substantive comments and recommendations to management in the process.
The Section 404(b) independent auditor attestation requirements are considerably more cumbersome and expensive for a company to comply with. In addition to the company requirement, Section 404(b) requires the company’s independent auditor to effectively audit the ICFR and management’s assessment. The auditor’s report must contain specific information about this assessment (see HERE). As all reporting companies are aware, audit costs are significant and that is no less true for this additional audit layer. In fact, companies generally find Section 404(b) the most costly aspect of the SEC Reporting Requirements. Where a company has low revenues, the requirement can essentially be prohibitive to successful implementation of a business plan, especially for emerging and growing biotechnology companies that are almost always pre-revenue but have significant capital needs.
The SEC has come to the conclusion that the added benefits from 404(b) are outweighed by the additional costs and burdens for SRC’s and now lower revenue companies. I am a strong proponent of supporting capital markets for smaller companies, such as those with less than a $700 million market cap and less than $100 million in revenues. I hope the proposed rule changes move quickly through the system.
Detail on Proposed Amendments to Accelerated Filer and Large Accelerated Filer Definitions
Prior to the June 2018 SRC amendments, the SRC category of filers generally did not overlap with either the accelerated or large accelerated filer categories. However, following the amendment, a company with a public float of $75 million or more but less than $250 million regardless of revenue, or one with less than $100 million in annual revenues and a public float of $250 million or more but less than $700 million would be both an SRC and an accelerated filer.
The SEC is proposing to amend the accelerated and large accelerated filer definitions in Exchange Act Rule 12b-2 to exclude any company that is eligible to be an SRC under the SRC revenue test – i.e., one with less than $100 million in annual revenues during its most recently completed fiscal year. The effect of this proposal would be that such a company would not be subject to accelerated or large accelerated filing deadlines for its annual and quarterly reports or to the ICFR auditor attestation requirement.
The proposed rule change would not exclude all SRC’s from the definition of accelerated or large accelerated filers and as such, some companies that qualify as an SRC would still be subject to the shorter filing deadlines and Section 404(b) compliance. In particular, an SRC with a float of greater than $75 million but less than $700 million and less than $100 million in revenue would no longer qualify as either an accelerated or large accelerated filer. On the contrary, an SRC with greater than $75 million in public float and greater than $100 million in revenue will still be categorized as an accelerated filer.
The chart below illustrates the effect of the proposed amendments:
| Proposed Relationships between SRCs and Non-Accelerated and Accelerated Filers | ||
| Status | Public Float | Annual Revenue |
| SRC and Non-Accelerated Filer | Less than $75 million | N/A |
| $75 million to less than $700 million | Less than $100 million | |
| SRC and Accelerated Filer | $75 million to less than $250 million | $100 million or more |
| Accelerated Filer (not SRC) | $250 million to less than $700 million | $100 million or more |
The proposed amendments would revise the public float transition threshold for accelerated and large accelerated filers to become a non-accelerated filer from $50 million to $60 million. Also, the proposed amendments would increase the exit threshold in the large accelerated filer transition provision from $500 million to $560 million in public float to align the SRC and large accelerated filer transition thresholds. Finally, the proposed amendments would allow an accelerated or a large accelerated filer to become a non-accelerated filer if it becomes eligible to be an SRC under the SRC revenue test.
The chart below illustrates the effect of the proposed amendments on transition provisions:
| Proposed Amendments to the Public Float Thresholds | |||
| Initial Public Float Determination | Resulting Filer Status | Subsequent Public Float Determination | Resulting Filer Status |
| $700 million or more | Large Accelerated Filer | $560 million or more | Large Accelerated Filer |
| Less than $560 million but
$60 million or more |
Accelerated Filer | ||
| Less than $60 million | Non-Accelerated Filer | ||
| Less than $700 million but $75 million or more | Accelerated Filer | Less than $700 million but
$60 million or more |
Accelerated Filer |
| Less than $60 million | Non-Accelerated Filer | ||
Statements of Commissioners on Rule Amendment
SEC Chairman Jay Clayton and Commissioners Jackson, Peirce and Roisman all made statements on the proposed rule changes at an open meeting related to the amendment. Chair Clayton’s speech focuses on the fact that most aspects of ICFR remain unchanged as do the heightened requirements that SOX imposed generally. However, the proposed rules “are aimed at the subset of issuers where the added step of an ICFR auditor attestation is likely to add significant costs and is unlikely to enhance financial reporting or investor protection.” Of course, he is hopeful the change will encourage more companies to access public markets.
Commissioner Hester Peirce (may favorite Commissioner) is true to form, supporting the proposed amendments but wishing they had gone further. As she did when the SEC amended the definition of an SRC, Commissioner Peirce criticizes the fact that there now can be overlap between an SRC and accelerated or large accelerated filer, which can cause confusion. As Commissioner Peirce notes, “[T]he process of determining whether a company is an SRC and a non-accelerated filer, or an SRC and an accelerated filer, or outside of both categories is so complicated that even we at the SEC need diagrams to figure it out. The fact that we ourselves struggling to understand our own regime does not bode well for smaller companies trying to follow our rules without the benefit of a staff of seasoned securities attorneys.” The quote hit home; in writing my blog on the SRC rule change and now this rule change, I started creating a diagram for myself until I found that the SEC had published one as well – it was the only way to follow and understand the interactions. Commissioner Peirce would advocate for a fine line whereby all SRC’s would be non-accelerated filers and exempt from Section 404(b). I agree.
Commissioner Roisman supported the proposed rule changes and, like Commissioner Peirce, wondered whether it went far enough.
Commissioner Jackson, also true to form, does not support the proposed amendment at all as he believes that the risk of corporate management fraud is too high to allow the change. Commissioner Jackson uses WorldCom and Enron as his primary example of management without auditor oversight; however, I note that these companies were behemoths compared to the sector of business affected by the current proposal. Commissioner Jackson also questions the data and analysis used by the SEC to support the proposed amendments and instead gathered his own data. Unfortunately, there is often a disconnect between statistical data and real-world applications and as such, my views remain aligned with Commissioner Peirce.
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The 20% Rule – Private Placements
Nasdaq and the NYSE American both have rules requiring listed companies to receive shareholder approval prior to issuing twenty percent (20%) or more of the outstanding securities in a transaction other than a public offering at a price less than the Minimum Price, as defined in the rule. Nasdaq Rule 5635 sets forth the circumstances under which shareholder approval is required prior to an issuance of securities in connection with: (i) the acquisition of the stock or assets of another company (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants (see HERE); (iii) a change of control (see HERE); and (iv) transactions other than public offerings. NYSE American Company Guide Sections 711, 712 a 713 have substantially similar provisions.
Nasdaq and the NYSE recently amended their rules related to issuances in a private placement to provide greater flexibility and certainty for companies to determine when a shareholder vote is necessary to approve a transaction that would result in the issuance of 20% or more of the outstanding common stock or 20% or more of outstanding voting power in a PIPE or similar private placement financing transaction. The amendments simplified the prior multi-part language and changed the pricing test trigger to create a new “Minimum Price.” For my blog on the Nasdaq amendment, see HERE. Although the NYSE American has not yet amended its rule to conform with the changes, I expect it will be forthcoming. In this blog, I will drill down further on the rule and its interpretive guidance.
As I’ve mentioned in each of the blogs in this series, many other Exchange Rules interplay with the 20% Rules; for example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to the issuance of securities in the same transactions that require shareholder approval. Companies need to carefully comply with each of the rules that may interplay with a transaction or proposed transaction.
Nasdaq Rule 5635(d)
Nasdaq Rule 5635(d) requires shareholder approval prior to a 20% issuance of securities at a price that is less than the Minimum Price in a transaction other than a public offering. A 20% issuance is a transaction, other than a public offering, involving the sale, issuance or potential issuance by the company of common stock (or securities convertible into or exercisable for common stock), which alone or together with sales by officers, directors or substantial shareholders of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance. “Minimum Price” means a price that is the lower of: (i) the closing price (as reflected on Nasdaq.com) immediately preceding the signing of the binding agreement; or (ii) the average closing price of the common stock (as reflected on Nasdaq.com) for the five trading days immediately preceding the signing of the binding agreement.
The September 2018 rule amendment creating a new “Minimum Price” standard provides more flexibility by adding the option of choosing between the closing bid price and the five-day average closing price. For example, in a declining market, the five-day average closing price will be above the current market price, which could make it difficult for companies to close transactions because investors could buy shares at a lower price in the market. Likewise, in a rising market, the five-day average could result in a below-market transaction triggering shareholder approval requirements.
NYSE American Company Guide Section 713
The NYSE American Company Guide Section 732 requires shareholder approval prior to the listing of additional shares in connection with a transaction, other than a public offering, involving: (i) the sale, issuance, or potential issuance by the company of common stock (or securities convertible into common stock) at a price less than the greater of book or market value which together with sales by officers, directors or principal shareholders of the company equals 20% or more of presently outstanding common stock; or (ii) the sale, issuance, or potential issuance by the issuer of common stock (or securities convertible into common stock) equal to 20% or more of presently outstanding stock for less than the greater of book or market value of the stock.
Interpretation and Guidance
Public Offering
Although the rules do not require shareholder approval for a transaction involving “a public offering,” the Exchanges do not automatically consider all registered offerings as public offerings.
Generally, all firm commitment underwritten securities offerings registered with the SEC will be considered public offerings. Likewise, any other securities offering which is registered with the SEC and which is publicly disclosed and distributed in the same general manner and extent as a firm commitment underwritten securities offering will be considered a public offering for purposes of the 20% Rule. In other instances, when analyzing whether a registered offering is a “public offering,” the Exchanges will consider: (a) the type of offering (including whether underwritten, on a best efforts basis with a placement agent, or self-directed by the company); (b) the manner in which the offering is marketed (including the number of investors and breadth of marketing effort); (c) the extent of distribution of the offering (including the number of investors and prior relationship with the company); (d) the offering price (at market or a discount); and (e) the extent to which the company controls the offering and its distribution.
A registered direct offering will not be assumed to be public and will be reviewed using the same factors listed above. Likewise, a Rule 144A offering will be considered on its facts and circumstances, though generally share caps are used in these transactions to avoid an issue. On the other hand, a confidentially marketed public offering (CMPO) is a firm commitment underwritten offering and, as such, will be considered a public offering.
Substantial Shareholder
A substantial shareholder is defined in the negative and requires the company to consider the power that a particular shareholder asserts over the company. Nasdaq specifically provides that someone that owns less than 5% of the shares of the outstanding common stock or voting power would not be considered a substantial shareholder for purposes of the Rules.
Shares to be Issued in a Transaction; Shares Outstanding; Votes to Approve
In determining the number of shares to be issued in a transaction, the maximum potential shares that could be issued, regardless of contingencies, should be included. The maximum potential issuance includes all securities initially issued or potentially issuable or potentially exercisable or convertible into shares of common stock as a result of the transaction. The percentage to be issued is calculated by dividing the maximum potential issuance by the number of shares of common stock issued and outstanding prior to the transaction.
In determining the number of shares outstanding immediately prior to a transaction, only shares that are actually outstanding should be counted. Shares reserved for issuance upon conversion of securities or exercise of options or warrants are not considered outstanding for the purpose of the 20% Rule. Where a company has multiple classes of common stock, all classes are counted in the amount outstanding, even if one or more classes do not trade on the Exchange.
Voting power outstanding as used in the Rule refers to the aggregate number of votes which may be cast by holders of those securities outstanding which entitle the holders to vote generally on all matters submitted to the company’s security holders for a vote.
Where shareholder approval is required under the 20% Rule, approval can be had by a majority of the votes cast on the proposal. The proxy for approval of a transaction under the 20% Rule should provide specific details on the proposed financing transaction.
Convertible Securities; Warrants; Anti-Dilution Provisions
Convertible securities and warrants can either convert at a fixed or variable rate. If the securities are convertible at a fixed price, Nasdaq will determine whether the issuance is below the Minimum Price, and for the NYSE American at a price less than the greater of book or market value, if the conversion or exercise price is less than the applicable threshold price at the time the parties enter into a binding agreement with respect to the issuance.
Variable rate conversions are generally tied to the market price of the underlying common stock and accordingly, the number of securities that could be issued upon conversion will float with the price of the common stock. That is, the lower the price of a company’s common stock, the more shares that could be issued and conversely, the higher the price, the fewer shares that could be issued. Variable priced convertible securities tend to cause a downward pressure on the price of common stock, resulting in additional dilution and even more common stock issued in each subsequent conversion round. This chain of convert, sell, price reduction, and convert into more securities, sell, further price reduction and resulting dilution is sometimes referred to as a “death spiral.”
The 20% Rule requires that the company consider the largest number of shares that could be issued in a transaction when determining whether shareholder approval is required. Where a transaction involves variable priced convertible securities, and no floor on such conversion price is included or cap on the total number of shares that could be issued, the Exchanges will presume that the potential issuance will exceed 20% and that shareholder approval will be required.
The calculation of whether an issuance is above 20% and below the threshold Minimum Price where warrants are involved can be complicated. Where warrants are involved, Nasdaq will require shareholder approval if the issuance of common stock is less than the 20% threshold and such stock is issued below the Minimum Price if the exercise of the warrants would result in greater than a 20% issuance. However, the warrants do not need to be included in the calculation if the exercise price is above the Minimum Price and the warrants are not exercisable for at least six months. If the common stock portion of an offering that includes warrants exceeds the 20% threshold, Nasdaq will value the warrants at $0.125, regardless of whether the exercise price exceeds the market value. This is referred to as the “1/8th Test.” In this case, shareholder approval will be required even if the warrants are not exercisable for six months.
However, Nasdaq has indicated that convertible bonds with flexible settlement provisions (i.e., cash or stock at the company’s option) will be treated the same way as physically settled bonds under the rule. If the conversion price of the bonds equals or exceeds the Minimum Price, shareholder approval will not be required. Contrarily, Nasdaq will treat a convertible security with a flexible settlement provision as if it will be settled in securities for purposes of the 20% Rule.
Moreover, the Exchanges generally view variable priced transactions without floors or share caps as disreputable and potentially raising public interest concerns. Nasdaq specifically addresses these transactions, and the potential public interest concern, in its rules. In addition to the demonstrable business purpose of the transaction, other factors that Nasdaq staff will consider in determining whether a transaction raises public interest concerns include: (1) the amount raised in the transaction relative to the company’s existing capital structure; (2) the dilutive effect of the transaction on the existing holders of common stock; (3) the risk undertaken by the variable priced security investor; (4) the relationship between the variable priced security investor and the company; (5) whether the transaction was preceded by other similar transactions; and (6) whether the transaction is consistent with the just and equitable principles of trade.
Nasdaq will closely examine any transaction that includes warrants that are exercisable for little or no consideration (i.e., “penny warrants”) and may object to a transaction involving penny warrants even if shareholder approval would not otherwise be required. Warrants with a cashless exercise feature are also not favored by the Exchanges and will be closely reviewed. Nasdaq guidance indicates it will review the following factors related to warrants with cashless exercise features: (i) the business purpose of the transaction; (ii) the amount to be raised (if the acquisition includes a capital raise); (iii) the existing capital structure; (iv) the potential dilutive effect on existing shareholders; (v) the risk undertaken by the new investors; (vi) the relationship between the company and the investors; (vii) whether the transaction was preceded by similar transactions; (viii) whether the transaction is “just and equitable”; and (ix) whether the warrant has provisions limiting potential dilution. In practice, many warrants include dilutive share caps and have cashless features that only kick in if there is no effective registration statement in place for the underlying common stock.
Any contractual provisions that could result in lowering the transaction price to below the Minimum Price, including anti-dilution provisions, most favored nations, true-up and similar provisions will be viewed as a discounted issuance. Likewise, a provision that allows a company to voluntarily reduce the conversion or exercise price to a price that could be below the Minimum Price, will be treated as a discounted issuance.
Aggregation
Both Nasdaq and the NYSE American may aggregate financing transactions that occur within close proximity of each other in determining whether the 20% Rule applies. Nasdaq considers the following factors when considering aggregation: (i) timing of the issuances; (ii) facts surrounding the subsequent transactions (e.g., planned at time of first transaction); (iii) commonality of investors; (iv) existence of contingencies between the transactions; (v) commonalities as to use of proceeds; and (vi) timing of board approvals. Moreover, transactions that are more than six months apart are generally not aggregated. Although the NYSE American does not provide such specific guidance, in practice, their analysis is substantially similar.
Two-Step Transactions and Share Caps
As obtaining shareholder approval can be a lengthy process, companies sometimes bifurcate transactions into two steps and use share caps as part of a transaction structure. A company may limit the first part of a transaction to 19.9% of the outstanding securities and then, if and when shareholder approval is obtained, issue additional securities. Companies may also structure transactions such that issuances related to a private offering, including through convertible securities, are capped at no more than 19.9% of total outstanding.
In order for a cap to satisfy the rules, it must be clear that no more than the threshold amount (19.9%) of securities outstanding immediately prior to the transaction, can be issued in relation to that transaction, under any circumstances, without shareholder approval. In a two-step transaction where shareholder approval is deferred, shares that are issued or issuable under the cap must not be entitled to vote to approve the remainder of the transaction. In addition, a cap must apply for the life of the transaction, unless shareholder approval is obtained. For example, caps that no longer apply if a company is not listed on Nasdaq are not permissible under the Rule. If shareholder approval is not obtained, then the investor will not be able to acquire 20% or more of the common stock or voting power outstanding before the transaction. Where convertible securities were issued, the shareholder would continue to hold the balance of the original security in its unconverted form.
Moreover, where a two-step transaction is utilized, the transaction terms cannot change as a result of obtaining, or not obtaining, shareholder approval. For example, a transaction may not provide for a sweetener or penalty. The Exchanges believe that the presence of alternative outcomes have a coercive effect on the shareholder vote and thus deprive the shareholders of their ability to freely determine whether the transaction should be approved. Nasdaq provides specific examples of a defective share cap, such as where a company issues a convertible preferred stock or debt instrument that provides for conversions of up to 20% of the total shares outstanding with any further conversions subject to shareholder approval. However, the terms of the instrument provide that if shareholders reject the transaction, the coupon or conversion ratio will increase or the company will be penalized by a specified monetary payment, including a rescission of the transaction. Likewise, a transaction may provide for improved terms if shareholder approval is obtained. The NYSE American similarly provides that share caps cannot be used in a way that could be coercive in a shareholder vote.
Reverse Acquisitions
A reverse acquisition or reverse merger is one in which the acquisition results in a change of control of the public company such that the target company shareholders control the public company following the closing of the transaction. In addition to the 20% Rule, a change of control would require shareholder approval under the Change of Control Rule and the Acquisition Rule will likely apply as well. A company must re-submit an initial listing application in connection with a transaction where the target and new control entity was a non-Exchange listed entity prior to the transaction.
In determining whether a change of control has occurred, the Exchange will consider all relevant factors including, but not limited to, changes in the management, board of directors, voting power, ownership, nature of the business, relative size of the entities, and financial structure of the company.
Exceptions
The Exchanges have a “financial viability” exception to the 20% Rule. Although rarely granted, to qualify for the financial viability exception, a listed company must apply in writing and demonstrate that: (i) the delay in securing stockholder approval would seriously jeopardize the financial viability of the company; and (ii) reliance on the exception has been expressly approved by the company’s audit committee or comparable board committee comprised of all independent, disinterested directors. A determination will be rendered by the Exchange very quickly, such as in a matter of days.
Nasdaq guidance suggests an in-depth letter focusing on how a delay resulting from seeking shareholder approval would seriously jeopardize its financial viability and how the transaction would benefit the company. The letter should also describe the proposed transaction in detail and should include the identity of the investors. Nasdaq provides a list of examples of information that should be discussed in the letter, including: (i) the facts and circumstances that led to the company’s predicament; (ii) how long the company will be able to meet its current obligations, such as payroll, lease payments, and debt service, if it does not complete the proposed transaction; (iii) the company’s current and projected cash position and burn rate; (iv) other alternatives; (v) why a step transaction will not work; (vi) would the company file for bankruptcy without the transaction; (vii) the impact to operations while waiting for shareholder approval; (viii) why the company didn’t enter into a transaction sooner; (ix) demonstrate that the transaction will rescue the company; (x) demonstrate that the company will continue to meet Nasdaq’s listing requirements; and (xi) explain changes in voting power.
A company that gets approval for this exception must send a mailing to all shareholders at least 10 days prior to the issuance of securities under the exception. The letter must disclose the terms of the transaction, including number of shares to be issued and consideration received, that the company is relying on the financial viability exception and that the audit committee (or other committee) has approved the reliance on the exception. The company must also file an 8-K and issue a press release with the same information also no later than 10 days before the issuance.
Furthermore, shareholder approval is not required if the issuance is part of a court-approved reorganization under the federal bankruptcy laws or comparable foreign laws.
Also, a foreign private issuer that has elected to follow its home country rules will be exempt from the 20% Rule if it notifies Nasdaq, provides an opinion from local counsel that shareholder approval would not be required, and discloses its practices in its annual report on Form 20-F.
Consequences for Violation
Consequences for the violation of the 20% Rule or Acquisition Rule can be severe, including delisting from the Exchange. Companies that are delisted from an Exchange as a result of a violation of these rules are rarely ever re-listed.
« NASDAQ And NYSE American Shareholder Approval Requirement – Equity Based Compensation SEC Proposes Amendments to Accelerated and Large Accelerated Filer Definitions »
NASDAQ And NYSE American Shareholder Approval Requirement – Equity Based Compensation
Nasdaq and the NYSE American both have rules requiring listed companies to receive shareholder approval prior to issuing securities when a stock option or purchase plan is to be established or materially amended or other equity compensation arrangement made or materially amended, pursuant to which stock may be acquired by officers, directors, employees, or consultants. Nasdaq Rule 5635 sets forth the circumstances under which shareholder approval is required prior to an issuance of securities in connection with: (i) the acquisition of the stock or assets of another company (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants; (iii) a change of control (see HERE); and (iv) transactions other than public offerings (see HERE). NYSE American Company Guide Sections 711, 712 and 713 have substantially similar provisions.
In this blog I am detailing the shareholder approval requirements related to equity-based compensation of officers, directors, employees or consultants. Other Exchange Rules interplay with the rules requiring shareholder approval for equity issuances and for equity compensation issuances in general. For example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to establishing or materially amending a stock option plan, purchase plan or other equity compensation arrangement pursuant to which stock may be acquired by officers, directors, employees, or consultants without shareholder approval.
Nasdaq Rule 5635(c)
Nasdaq Rule 5635(c) requires shareholder approval prior to the issuance of securities when a stock option or purchase plan is to be established or materially amended or other equity compensation arrangement made or materially amended, pursuant to which stock may be acquired by officers, directors, employees, or consultants, except for: (1) warrants or rights issued generally to all security holders of the company or stock purchase plans available on equal terms to all security holders of the company (such as a typical dividend reinvestment plan); (2) tax qualified, non-discriminatory employee benefit plans (e.g., plans that meet the requirements of Section 401(a) or 423 of the Internal Revenue Code) or parallel nonqualified plans (including foreign plans complying with applicable foreign tax law), provided such plans are approved by the company’s independent compensation committee or a majority of the company’s Independent Directors; or plans that merely provide a convenient way to purchase shares on the open market or from the company at market value; (3) plans or arrangements relating to an acquisition or merger as permitted under IM-5635-1; or (4) issuances to a person not previously an employee or director of the company, or following a bona fide period of non-employment, as an inducement material to the individual’s entering into employment with the company, provided such issuances are approved by either the company’s independent compensation committee or a majority of the company’s Independent Directors. Promptly following an issuance of any employment inducement grant in reliance on this exception, a company must disclose in a press release the material terms of the grant, including the recipient(s) of the grant and the number of shares involved.
NYSE American Company Guide Section 711
Substantially similar to Nasdaq, the NYSE American Company Guide Section 711 requires shareholder approval with respect to the establishment or material amendments to a stock option or purchase plan or other equity compensation arrangement pursuant to which options or stock may be acquired by officers, directors, employees, or consultants, except for: (1) issuances to an individual, not previously an employee or director of the company, or following a bona fide period of non-employment, as an inducement material to entering into employment with the company provided that such issuances are approved by the company’s independent compensation committee or a majority of the company’s independent directors, and, promptly following an issuance of any employment inducement grant in reliance on this exception, the company discloses in a press release the material terms of the grant, including the recipient(s) of the grant and the number of shares involved; or (2) tax-qualified, non-discriminatory employee benefit plans (e.g., plans that meet the requirements of Section 401(a) or 423 of the Internal Revenue Code) or parallel nonqualified plans, provided such plans are approved by the company’s independent compensation committee or a majority of the company’s independent directors; or plans that merely provide a convenient way to purchase shares in the open market or from the issuer at fair market value; or (3) a plan or arrangement relating to an acquisition or merger; or (4) warrants or rights issued generally to all security holders of the company or stock purchase plans available on equal terms to all security holders of the company (such as a typical dividend reinvestment plan).
The NYSE American requires a listed company to notify the exchange in writing if it intends to rely on any of the exemptions.
Interpretation and Guidance
Definition of Consultant
For purposes of this rule, a “consultant” is anyone for whom the company is eligible to use a Form S-8. Accordingly, shareholder approval would be required for stock awards, plans or arrangements for the issuance of equity to: (i) natural persons; (ii) that provide bona fide services to the company; and (iii) whose services are not in connection with the offer or sale of securities in a capital-raising transaction, and who does not directly or indirectly promote or maintain a market for the company’s securities.
Adoption of Plans
A company may adopt an equity plan or arrangement, and grant options (but not shares of stock) thereunder, prior to obtaining shareholder approval provided that: (i) no options can be exercised prior to obtaining shareholder approval, and (ii) the plan can be unwound, and the outstanding options cancelled, if shareholder approval is not obtained. Companies should be aware of any accounting issues that may arise under these circumstances.
A company that has a plan in place at the time of listing on an Exchange would not be required to obtain shareholder approval for that plan, but would be required to obtain approval for future amendments.
Material Amendments
For purposes of the rule, both Exchanges specifically indicate that a material amendment would include, but not be limited to: (i) any material increase in the number of shares to be issued under the plan, including sublimits (other than as a result of a reorganization, stock split, merger or spin-off); (ii) a material increase in benefits including repricing (such as lowering the strike price of an option) or extensions of duration (though a change in a vesting schedule without more is not material); (iii) a material expansion of the class of participants eligible for the plan; or (iv) an expansion of the types of options or awards under the plan, including value for value exchanges.
If a plan allows for the issuance of stock options, adding stock appreciation rights (SARs) to a plan would not be material as SARs are substantially similar to options. Similarly, if a plan allows for the issuance of restricted stock, adding restricted stock units (RSUs) would not be material.
An amendment to increase tax withholding associated with awards to satisfy tax obligations is not considered a material amendment. Likewise, allowing a recipient to surrender unissued shares to satisfy a tax obligation would not be considered a material amendment. Adding a cashless exercise feature is also not a material amendment.
Neither Exchange will require shareholder approval if the plan, by its own terms, allows for specific actions without further approval, including, for example, the re-pricing of options. In order to rely on the ability to amend, the plan must be specific in the terms and actions that are allowed. A general authority to amend will not obviate the need for shareholder approval for what would otherwise be considered a material amendment. Moreover, some pricing changes, such as changing the exercise price from the closing bid price on the day of grant to the average of the high and low market price on the same day, would not require a new approval.
However, if a plan has a formula that allows for automatic increases of the shares available under the plan (“evergreen plan”) or a formula for automatic grants, the plan cannot have a term in excess of ten years unless shareholder approval is obtained every ten years. Plans that do not contain a formula and do not impose a limit on the number of shares available for grant would require shareholder approval of each grant under the plan.
As the rule specifically only applies to equity grants, awards or compensation and not cash, a company could buy back outstanding awards for cash without first seeking shareholder approval.
Mergers
Plans or arrangements involving a merger or acquisition do not require shareholder approval in two situations. First, shareholder approval will not be required to convert, replace or adjust outstanding options or other equity compensation awards to reflect the merger transaction. Second, shares available under certain plans acquired in acquisitions and mergers may be used for certain post-transaction grants without further shareholder approval provided the plan had originally been approved by shareholders.
In particular, where a non-listed company is acquired by or merged with a listed company, the listed company may use shares for post-transaction grants of options and other equity awards without further shareholder approval, provided: (i) the time during which those shares are available for grants is not extended beyond the period when they would have been available under the pre-existing plan, absent the transaction, and (ii) such options and other awards are not granted to individuals who were employed by the granting company or its subsidiaries at the time the merger or acquisition was consummated.
Plans adopted in contemplation of a merger or acquisition will not be considered pre-existing for purposes of this exception. Where an evergreen plan is assumed in a merger, the ten-year period for shareholder approval is measured from the date the target company established the plan.
Any additional shares available for issuance under a plan or arrangement acquired in connection with a merger or acquisition would be counted in determining whether the transaction involved the issuance of 20% or more of the company’s outstanding common stock, thus triggering the shareholder approval requirements under Rule 5635(a) related to mergers and acquisitions.
Source of Shares
A requirement that grants be made out of treasury shares or repurchased shares will not alleviate shareholder approval requirements.
Inducement Exemption
The inducement exemption can only be used for employment, and not consulting, arrangements. However, in some circumstances the exemption may be relied upon to induce a consultant to enter into an employment arrangement. An exchange would consider all facts and circumstances related to the relationship. This exemption can only relied upon in connection with the initial inducement for employment. Accordingly, if an inducement award is materially amended, the amendment would require shareholder approval notwithstanding that the initial award did not.
Likewise, the determination of a “bona fide period of non-employment” requires a facts and circumstances analysis. Generally an exchange will consider: (i) whether there was a relationship between the company and former employee during the time of non-employment; (ii) whether the former employee received payments from the company during the period of non-employment; (iii) the reasons for ending the employment relationship; (iv) whether the former employee was employed elsewhere after leaving the company; and (v) whether there was an agreement or understanding that the employee would return to the company.
For purposes of the required press release disclosure, four days will generally satisfy the “promptly” requirement. A company can aggregate the disclosure of inducements where the inducements were made in connection with a merger or acquisition, or a company regularly offers such awards. In that regard, a company can adopt a plan that will be used solely for inducements, without the necessity of shareholder approval. However, inducement grants made to executive officers must always be individually disclosed.
Parallel Nonqualified Plan
A parallel nonqualified plan means a plan that is a “pension plan” within the meaning of the ERISA Act that is designed to work in parallel with a qualified tax plan to provide benefits that exceed IRS compensation limitations. A plan will not be considered a parallel nonqualified plan unless: (i) it covers all or substantially all employees of an employer who are participants in the related qualified plan whose annual compensation is in excess the compensation limits; (ii) its terms are substantially the same as the qualified plan that it parallels except for the elimination of the limitations; and, (iii) no participant receives employer equity contributions under the plan in excess of 25% of the participant’s cash compensation.
Below Market Sales
The private sale of securities to officers, directors, employees or consultants at a price less than market value is considered a form of “equity compensation” and, as such, requires shareholder approval. For purposes of this rule, market value is the consolidated closing bid price immediately preceding the time the company enters into a binding agreement to issue the securities. Shareholder approval would not be required if the officer, director, employee or consultant was purchasing securities from the company in a public offering.
Issuances to an entity controlled by an officer, director, employee, or consultant of the a company may also be considered equity compensation under certain circumstances, such as where the issuance would be accounted for under GAAP as equity compensation or result in the disclosure of compensation under Regulation S-K.
Broker Votes
Broker-dealers may not vote client proxies on equity compensation plans unless the beneficial owner of the shares has given voting instructions. That is, equity compensation plans are considered “non-routine” items prohibiting broker votes on behalf of their clients.
Foreign Private Issuers
Although the rule applies to foreign private issuers, if such issuer is otherwise following its home country practices in accordance with the Exchange rules, it can do so related to this shareholder approval requirement as well.
Consequences for Violation
This rule is strictly construed and, as such, all plans or material amendments to a plan, regardless of the number of shares under the plan or arrangement, require shareholder approval. Consequences for the violation of any of the Exchange’s rules, including shareholder approval rules, can be severe, including delisting from the Exchange. Companies that are delisted from an Exchange as a result of a violation of these rules are rarely ever re-listed.
« Mergers And Acquisitions; Board Of Directors Responsibilities – Delaware The 20% Rule – Private Placements »
Mergers And Acquisitions; Board Of Directors Responsibilities – Delaware
Recently the Delaware Chancery Court rejected an interested executive’s defense of a breach of fiduciary duty claim, reminding us of the importance of making full and accurate disclosures when seeking shareholder approval for a merger or acquisition transaction. In particular, in the case of In re Xura, Inc. Stockholder Litigation the Delaware Chancery Court denied a motion to dismiss brought against a merger target company’s CEO, alleging that he had orchestrated the company’s sale to a particular bidder based on his self-interest in the outcome of the transaction.
The CEO argued that his actions should have been judged by the deferential business judgement rule and not a higher entire fairness standard because the transaction was approved by a majority of the disinterested shareholders. The CEO relied on the 2015 Delaware Supreme Court case of Corwin v. KKR Financing Holdings which held that a transaction that would be subject to enhanced scrutiny would instead be reviewed under the deferential business judgment rule after it was approved by a majority of fully informed stockholders. However, the Court found that the stockholder’s vote was not fully informed as the proxy statement failed to make numerous material disclosures and, as such, could not be used as the usual defense for officers and directors with a stake in the outcome of a transaction.
Board of Directors’ and Key Officers Fiduciary Duties in the Merger Process
State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship to the corporation, which requires that they act in the best interest of the corporation, as opposed to their own. Key executive officers have a similar duty. Generally a court will not second-guess directors’ decisions as long as the executives have conducted an appropriate process in reaching its decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).
However, in certain instances, such as in a merger and acquisition transaction, where a board or top executives may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash or job security), the board of directors’ and executives actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule” and stems from the Unocal and Revlon cases discussed below, both of which involved hostile takeovers.
A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving officers, directors and/or shareholders such as where directors are on both sides of the transaction. Under the entire fairness standard, the executives must establish that the entire transaction is fair to the shareholders, including both the process and dealings and price and terms. The entire fairness standard is a difficult bar to reach and generally results in in a finding in favor of complaining shareholders.
In all matters, directors’ and executive officers’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure. In short, the duty of care requires the director/officer to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances of that particular corporation. The duty of loyalty requires that there be no conflict between duty and self-interest. The duty of disclosure requires the director/officer to provide complete and materially accurate information to a corporation. Where a director’s duty is to the shareholders, an executive officer can have duties to both the board of directors and the shareholders.
As with many aspects of securities law, and the law in general, a director’s or officer’s responsibilities and obligations in the face of a merger or acquisition transaction depend on the facts and circumstances. From a high level, if a transaction is not material or only marginally material to the company, the level of involvement and scrutiny facing the board of directors or key executives is reduced and only the basic business judgment rule will apply. For instance, in instances where a company’s growth strategy is acquisition-based, the board of directors may set out the strategy and parameters for potential target acquisitions but leave the completion of the acquisitions largely with the C-suite executives and officers who, in turn, will be able to exercise their business judgment in implementing the transactions.
Moreover, the director’s responsibilities must take into account whether they are on the buy or sell side of a transaction. When on the buy side, the considerations include getting the best price deal for the company and integration of products, services, staff, and processes. On the other hand, when on the sell side, the primary objective is maximizing the return to shareholders, though social interests and considerations (such as the loss of jobs) may also be considered in the process.
The law focuses on the process, steps and considerations made by the board of directors and executive officers, as opposed to the actual final decision. The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors and officers in the face of scrutiny. Courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; requests for information from management; and requests for and review of documents and contracts.
In the performance of their obligations and fiduciary responsibilities, a board of directors and executive officers may, and should, seek the advice and counsel of third parties, such as attorneys, investment bankers, and valuation experts. Moreover, it is generally good practice to obtain a third-party fairness opinion on a transaction. Most investment banking houses that do M&A work also provide fairness opinions on transactions. Furthermore, most firms will prepare a fairness opinion even if they are not otherwise engaged or involved in the transaction. In addition to adding a layer of protection to the board of directors and executives, the fairness opinion is utilized by the accountant and auditor in determining or supporting valuations in a transaction, especially where a related party is involved. This firm has relationships with many firms that provide such opinions and encourage our clients to utilize these services.
Delaware Case Law
As with all standards of corporate law, practitioners and state courts look to both Delaware statutes and court rulings to lead the way.
Stemming from Revlon, Inc. vs. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), once a board of directors has made the decision to sell or merge the company, it triggers additional duties and responsibilities, commonly referred to as the “Revlon Duties.” The Revlon Duties provide that once a board has made a decision to sell, it must consider all available alternatives and focus on obtaining the highest value and return for the shareholders. The Revlon case focuses on duties in a sale or breakup of a company rather than a forward growth acquisition. A board of directors in a Revlon situation is, in essence, acting as an auctioneer seeking the best return. However, although the premise of Revlon remains, later decisions take into account the reality that the highest return for shareholders is not strictly limited to dollars received.
Company executives do not have to decide to sell just because an offer has been made. Prior to Revlon, in the case of Unocal vs. Mesa Petroleum, 493 A.2d 946 (Del. 1985), the court found that a board of directors may take defensive measures in the face of a hostile takeover attempt and may consider the preservation of corporate policy and effectiveness of business operations in defending against a takeover. However, once the board has made the decision that a sale or breakup is imminent, the Revlon Duties are invoked and preservation of corporate policy and operations is no longer a deciding factor.
In the case of Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985), the Court found that the board was grossly negligent where it approved the sale of the company after only a few hours of deliberation, failed to inform itself of the chairman’s role and benefits in the sale, and did not seek the advice of outside counsel. Similarly in Cede & Co. vs. Technicolor, Inc., 634 A.2d 345 (Del. 1993), the court found that the board was negligent in approving the sale of a company where it did not search for real alternatives, did not attempt to find a better offer, and had insufficient knowledge of the terms of the proposed merger agreement.
On the other hand, the court in In re CompuCom Sys., Inc. Shareholders Litigation, 2005 Del. Ch. LEXIS 145 (Del. Ch. Sept. 29, 2005), upheld the board of directors’ business judgment even though the transaction price per share was less than market value, as the board showed it was adequately informed, acted rationally and sought better deals.
In Family Dollar Stores, Inc. Stockholder Litigation, C.A. No. 9985-CB (Del. Ch. Dec. 19, 2014), the court continued to apply the Revlon Duties but supported Family Dollar Stores’ decision to reject Dollar General Corp.’s higher dollar offer in favor of seeking a shareholder vote on Dollar Tree, Inc.’s offer. The court found that the board properly considered all factors, including an evaluation of the relative antitrust risks of selling to either suitor. The court upheld the board’s process in determining maximum value for shareholders, and that such determination is not solely based on a price per share value.
Cleansing Through Shareholder Approval
In 2015 the Delaware Supreme Court case of Corwin v. KKR Financing Holdings held that a transaction that would be subject to enhanced scrutiny under Revlon would instead be reviewed under the deferential business judgment rule after it was approved by a majority of disinterested, fully informed and uncoerced stockholders. In addition to federal securities law requirements imposed on public companies, Delaware law requires disclosure of all material facts when stockholders are requested to vote on a merger. (For more on materiality and the duty to disclose, see HERE and HERE . Corwin provides a strong incentive for companies to ensure full disclosure and as discussed below, based on the new case of In re Xura, Inc. Stockholder Litigation the failure to provide such disclosure may nullify the otherwise strong Corwin defense.
Following the Corwin decision, several Delaware courts enhanced the ruling, finding that the business judgment rule becomes irrebuttable if invoked as a result of a stockholder vote; Corwin is not limited to one-step mergers and thus also applies where a majority of shares tender into a two-step transaction; the ability of plaintiffs to pursue a “waste” claim is exceedingly difficult; even interested officers and directors can rely on the business judgement rule following Corwin doctrine stockholder approval; and if directors are protected under Corwin, aiding and abetting claims against their advisors will also be dismissed.
Once the business judgment rule is invoked, a shareholder generally only has a claim for waste, which is a difficult claim to prove. Corwin makes it difficult for plaintiffs to pursue post-closing claims (including those that would have nuisance value) because defendants will frequently be able to dismiss the complaint at the pleading stage based on the stockholder vote. It is thought that Corwin will help reduce M&A-based litigation which has become increasingly abusive over the years and imposes costs on companies, its stockholders and the marketplace.
Corwin should also be considered in conjunction with the Delaware Supreme Court’s 2014 decision in Cornerstone Therapeutics Inc. Shareholder Litigation in which the Supreme Court held that directors can seek dismissal even in an entire fairness case unless the plaintiff sufficiently alleges that those directors engaged in non-exculpated conduct (i.e., disloyal conduct or bad faith). Cornerstone generally allows an outside, independent director to be dismissed from litigation challenging an interested transaction unless the plaintiff alleges a breach of the duty of loyalty against that director individually. The Corwin case goes further by providing that if there is an informed stockholder vote, then directors who are interested or lack independence can obtain dismissal without having to defend the fairness of the transaction.
Although following Corwin a string of cases strengthened and expanded its doctrine, the recent (December 2018) case of In re Xura, Inc. Stockholder Litigation reminded the marketplace that in order for Corwin to provide its protections, the stockholder approval must be fully informed. In Xura the court found that the disclosures made by the CEO to the board of directors and shareholders and that ultimately were included in the company’s proxy statement were so deficient as to preclude a fully informed, uncoerced decision. The takeaway from Xura is that despite growing officer/director protections in an M&A transaction, process and disclosure remain the bedrock of any defense.
Conflicts of Interest – the Entire Fairness Standard
The duty of loyalty requires that there be no conflict between duty and self-interest. Basically, an officer or director may not act for a personal or non-corporate purpose, including to preserve their job or position. Where a transaction is not cleansed using the Corwin doctrine, where an officer or director is interested in a transaction, the entire fairness standard of review will apply. It is very difficult for an officer or director to defeat a claim where a transaction is being reviewed under the entire fairness standard.
Some states, including Delaware, statutorily codify the duty of loyalty, or at least the impact on certain transactions. Delaware’s General Corporations Law Section 144 provides that a contract or transaction in which a director has interest is not void or voidable if: (i) a director discloses any personal interest in a timely matter; (ii) a majority of the shareholders approve the transaction after being aware of the director’s involvement; or (iii) the transaction is entirely fair to the corporation and was approved by the disinterested board members.
The third element listed by the Delaware statute has become the crux of review by courts. That is, where an executive is interested, the transaction must be entirely fair to the corporation (not just the part dealing with the director). In determining whether a transaction is fair, courts consider both the process (i.e., fair dealing) and the price of the transaction. Moreover, courts look at all aspects of the transaction and the transaction as a whole in determining fairness, not just the portion or portions of the transaction involving a conflict with the executive. The entire fairness standard can be a difficult hurdle and is often used by minority shareholders to challenge a transaction where there is a potential breach of loyalty and where such minority shareholders do not think the transaction is fair to them or where controlling shareholders have received a premium.
To protect a transaction involving an interested executive, it is vital that all officers and directors take a very active role in the merger or acquisition transaction; that the interested executive inform both the directors or other directors, and ultimately the shareholders, of the conflict; that the transaction resemble an arm’s-length transaction; that it be entirely fair; and that negotiations be diligent and active and that the advice and counsel of independent third parties, including attorneys and accountants, be actively sought.
Delaware courts have emphasized that involvement by disinterested, independent directors increases the probability that a board’s decisions will receive the benefits of the business judgment rule and helps a board justify its action under the more stringent standards of review such as the entire fairness standard. Independence is determined by all the facts and circumstances; however, a director is definitely not independent where they have a personal financial interest in the decision or if they have domination or motive other than the merits of the transaction. The greater the degree of independence, the greater the protection. As mentioned, many companies obtain third-party fairness opinions as to the transaction.
Exculpation and Indemnification
Many states’ corporate laws allow entities to include provisions in their corporate charters allowing for the exculpation and/or indemnification of directors. Exculpation refers to a complete elimination of liability, whereas indemnification allows for the reimbursement of expenses incurred by an officer or director. Delaware, for example, allows for the inclusion of a provision in the certificate of incorporation eliminating personal liability for directors in stockholder actions for breaches of fiduciary duty, except for breaches of the duty of loyalty that result in personal benefit for the director to the detriment of the shareholders. Indemnification generally is only available where the director has acted in good faith. Exculpation is generally only available to directors, whereas indemnification is available to both officers and directors.
To show that a director acted in good faith, the director must meet the same general test of showing that they met their duties of care, loyalty and disclosure. The best way to do this is to be fully informed and to participate in the process, whether that process involves a merger or acquisition or some other business transaction. As mentioned above, courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; requests for information from management; and requests for, and review of, documents and contracts.
Conclusion
In advising the board of directors and executive officers, counsel should stress that the executive be actively involved in the business decision-making process, review the documents and files, ask questions and become fully informed. The higher the level of diligence, the greater the protection. Furthermore, an executive must fully and completely inform its fellow executives, board members and shareholders of all facts and circumstances and any potential self-interest.
Significantly, it is not important whether the decision ultimately turns out to be good or bad. Hindsight is 20/20. The important factor in seeking protection (via the business judgment rule, and through exculpation and indemnification) is that best efforts are made.
« Equity Market Structure – Musings By The SEC; 15c2-11 And Penny Stocks NASDAQ And NYSE American Shareholder Approval Requirement – Equity Based Compensation »
Equity Market Structure – Musings By The SEC; 15c2-11 And Penny Stocks
In March, SEC Chairman Jay Clayton and Brett Redfearn, Director of the Division of Trading and Markets, gave a speech to the Gabelli School of Business at Fordham University regarding the U.S. equity market structure, including plans for future reform. Chair Clayton begins his remarks by praising the Treasury Department’s four core principles reports. In particular, the Treasury Department has issued four reports in response to an executive order dated February 3, 2017 requiring it to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system. The four reports include thorough discussions and frame the issues on: (i) Banks and Credit Unions; (ii) Capital Markets (see my blog HERE); (iii) Asset Management and Insurance; and (iv) Nonbank Financials, Fintech and Innovation (see my blog HERE). The executive order dated February 3, 2017 directed the Treasury Department to issue reports with the following objectives:- Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
- Prevent taxpayer-funded bailouts;
- Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
- Enable American companies to be competitive with foreign firms in domestic and foreign markets;
- Advance American interests in international financial regulatory negotiations and meetings;
- Make regulation efficient, effective, and appropriately tailored; and
- Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.
« SEC Adopts Rules to Amend Regulation S-K Mergers And Acquisitions; Board Of Directors Responsibilities – Delaware »
SEC Adopts Rules to Amend Regulation S-K
On March 20, 2019 the SEC adopted amendments to Regulation S-K as required by the Fixing America’s Surface Transportation Act (“FAST Act”). The proposed amendments were first published on October 11, 2017 (see HERE). A majority of the amendments were adopted as proposed. As part of the SEC’s ongoing Disclosure Effectiveness Initiative, the amendments are designed to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. For a detailed list of actions that have been taken by the SEC as part of its Disclosure Effectiveness Initiative, see my summary at the end of this blog.
The FAST Act, passed in December 2015, contained two sections requiring the SEC to modernize and simplify the requirements in Regulation S-K. Section 72002 required the SEC to amend Regulation S-K to “further scale or eliminate requirements… to reduce the burden on emerging growth companies, accelerated filers, smaller reporting companies, and other smaller issuers, while still providing all material information to investors.” In addition, the SEC was directed to “eliminate provisions… that are duplicative, overlapping, outdated or unnecessary.”
Section 72003 required the SEC to conduct a study on Regulation S-K and, in that process, to consult with the SEC’s Investor Advisory Committee (the “IAC”) and the Advisory Committee on Small and Emerging Companies (the “ACSEC”) and then to issue a report on the study findings, resulting in a report that was issued on November 23, 2016. Section 72003 specifically required that the report include: (i) the finding made in the required study; (ii) specific and detailed recommendations on modernizing and simplifying the requirements in Regulation S-K in a manner that reduces the costs and burdens on companies while still providing all material information; and (iii) specific and detailed recommendations on ways to improve the readability and navigability of disclosure documents and to reduce repetition and immaterial information. The current amendments seek to implement the various findings and recommendations in the November report.
The new amendments are specifically intended to improve the readability and navigability of company disclosures, and to discourage repetition and disclosure of immaterial information. In particular, the amendments will: (i) increase flexibility in the discussion of historical periods in Management’s Discussion and Analysis; (ii) revise forms to update, streamline and improve disclosures including eliminating risk factor examples in form instructions and revising the description of property requirement to emphasize a materialitythreshold; (iii) eliminate certain requirements for undertakings in registration statements; (iv) allow companies to redact confidential information from most exhibits without filing a confidential treatment request; and (v) incorporate technology to improve access to information on the cover page of certain filings by requiring data tagging and hyperlinks.
The amendments relating to the redaction of confidential information in certain exhibits will become effective immediately. The rest of the amendments will be effective 30 days after they are published in the Federal Register, except that the requirements to tag data on the cover pages of certain filings are subject to a three-year phase-in, and the requirement that certain investment company filings be made in HTML format and use hyperlinks will be effective for filings on or after April 1, 2020.
Final Amendments
- Description of Property (Item 102)
Item 102 requires disclosure of the location and general character of the principal plants, mines, and other materially important physical properties of the company and its subsidiaries. The instructions to Item 102 require the company to disclose information reasonable to inform investors as to the suitability, adequacy, productive capacity and utilization of facilities. The amendment emphasizes materiality and requires a company to disclose physical properties only to the extent that such properties are material to the company.
- Management’s Discussion and Analysis (MD&A) (Item 303)
Item 303(a) requires a company to discuss their financial condition, changes in financial condition, and results of operations using year-to-year comparisons. The discussion is required to cover the period of the financial statements in the report (i.e., 2 years for smaller reporting companies and emerging growth companies and 3 years for others). Where trend information is relevant, the discussion may include 5 years with a disclosure of selected financial data.
The amendments remove the reference to a “year to year comparison” and instead allow a company to present the disclosure in whatever format it believes will enhance the reader’s understanding of the information. The amendment will also eliminate the reference to a five-year look-back in the instructions, but rather a company will be able to use any presentation or information that it believes will enhance a reader’s understanding.
Where three years of financial statements are included, the amendments will allow the company to eliminate the earliest year in its discussion as long as the information has been included in a prior filing on EDGAR and the company identifies the location of the prior filing. This differs from the proposed amendment, which would have required the disclosure to have been included in a Form 10-K in order to be omitted and would have contained a specific reference to the materiality of the information. In the final adopting release, the SEC notes that materiality is always the standard and that adding a materiality qualifier to the rule itself was superfluous language that might cause confusion or a belief that some different standard of materiality was being adopted.
The amendments will flow through to foreign private issuers as well with conforming changes to the instructions for Item 5 of Form 20-F.
- Directors, Executive Officers, Promoters and Control Persons (Item 401)
Item 401 requires disclosure of identifying and background information about a company’s directors, executive officers, and significant employees. The amendments clarify the instructions to Item 401 to explain that the information is not required to be duplicated in various parts of a Form 10-K and/or proxy statement, but need only appear once and may be incorporated by reference in other parts of the documents.
- Compliance with Section 16(a) (Item 405)
Section 16(a) of the Exchange Act requires officers, directors, and specified types of security holders to report their beneficial ownership of a company’s equity securities using forms prescribed by the SEC, such as an initial Form 3, amendments on Form 4 and annual Form 5. Item 405 requires the company to disclose each person who failed to timely file a Section 16 report during the most recent fiscal year or prior years. Section 16 reporting persons are required to deliver a copy of their reports to the company, though in practice, this is rarely done. The amendments remove this requirement and allow the company to review EDGAR filings for compliance with Section 16(a).
In addition, the amendment eliminates the need to include the heading at all if there are no delinquencies to report, rather than include the heading with a statement such as “none” and removes the checkbox on the cover page of Form 10-K related to the disclosure. The amendment includes several changes to make the instructions and title of this section conform to the SEC’s “plain English” requirements.
- Corporate Governance (Item 407)
The amendment will update the instructions and information required under Item 407 to remove reference to an obsolete audit standard and rather just refer broadly to applicable PCAOB and SEC requirements. EGC’s and smaller reporting companies are both exempted from the Item 407 requirements, and the amendment clarifies the instruction language accordingly.
- Outside Front Cover Page of the Prospectus (Item 501(b))
The amendments are designed to streamline the front cover page of a prospectus and give a company flexibility in designing the page to tailor to their business and particular offering. The changes include (i) eliminating instructions related to changing or clarifying a name that may be confused with a well-known company; (ii) allowing for a statement that the offering price will be determined by a particular method or formula that is more fully explained in the prospectus with a cross-reference to the page number; (iii) requiring the disclosure of the principal trading market and company symbol, even if such trading market is not a national exchange; and (iv) streamlining the “subject to completion” legend.
- Risk Factors (Item 503(c))
A company is required to disclose the most significant factors that make an offering speculative or risky. Although the disclosure is intended to be principles-based, many examples are included in the instructions. The amendments would move Item 503(c) to Subpart 100 to clarify that risk factors are also required in a Form 10 and Exchange Act periodic reports and not just offering-related disclosures. The amendment also eliminates the risk factor examples from the instructions.
- Plan of Distribution (Item 508)
Item 508 requires disclosure about the plan of distribution for securities in an offering, including information about underwriters. The term “sub-underwriter” is referred to in the rule; however, it is not defined. The rules define a “sub-underwriter” as “a dealer that is participating as an underwriter in an offering by committing to purchase securities from a principal underwriter for the securities but is not itself in privity of contract with the issuer of the securities.”
- Undertakings (Item 512)
Item 512 provides undertakings that a company must include in Part II of its registration statement, depending on the type of offering. The amendments simplify the undertakings requirements and eliminate provisions that are duplicative because the requirement already exists, or that are obsolete due to changes in the law. For example, Items 512(d), 512(e) and 512(f) are all obsolete and should be eliminated. Item 512(c) related to unsold rights offerings that are then offered to the public, can be eliminated as other provisions of the law would require the company to update the (or complete a new) registration statement regardless.
- Exhibits (Item 601)
The amendment makes several changes to the exhibit filing requirements to streamline and reduce the volume of documents which are required to be filed, many of which may not be material. Only newly reporting companies will be required to file material contracts that were entered into within two years of the applicable registration statement or report, thus reducing duplicative, voluminous disclosures.
The amendment adds exhibits related to Item 202 disclosures (registered capital stock, debt securities, warrants, rights, American Depository Receipts, and other securities) to Exchange Act periodic reports on Form 10-K and 10-Q. Such exhibits are currently only required in registration statements, Form 8-K and Schedule 14A.
Related to material agreement exhibits, the amendment also clarifies that schedules and exhibits to exhibits need not be filed unless they are, in and of themselves, material to an investment decision. Although historically the SEC did not object to the omission of schedules and exhibits to exhibits with personally identifiable information, the rules generally required the filing of a confidential treatment request for most omissions. The amendments allow a company to omit schedules and exhibits to exhibits as long as a description of the omitted documents is included. Likewise, the amendments will allow a company to redact information that is both (i) not material, and (ii) competitively harmful if disclosed without the need for a confidential treatment request. Exhibits with redacted information must be clearly labeled accordingly.
The amendments are not meant to alter what information is deemed confidential or can be omitted, but rather to streamline the process by allowing a company to redact without the confidentiality treatment process. The amendments related to redaction and confidential information only apply to material agreement exhibits under Item 601(b)(10) and not to other categories of exhibits, which would rarely contain competitively harmful information. The SEC may still randomly review company filings and “scrutinize the appropriateness of a registrant’s omissions of information from its exhibits.” I expect that for the first year or so following the implementation of these amendments, the SEC will review redactions on a regular basis, providing guidance via comment letters assisting practitioners in advising their clients.
- Incorporation by Reference
Currently rules related to incorporation by reference are spread among a variety of regulations, including Regulation S-K, Regulation C, Regulation 12B and numerous forms. The amendments will revise Item 10(d), Rule 411, Rule 12b-23 and a number of SEC forms to simplify and modernize these rules while still providing all material information. The amendments streamline the rules and further allow for incorporation by reference to eliminate duplicative disclosure.
The rules will require a hyperlink to information that is incorporated by reference if the information is available on EDGAR rather than having to file the document as an exhibit to the registration statement or report.
The rules specifically do not add or change the rules related to cross-references or other incorporation within the financial statements to other disclosure items. There is a concern as to the impact on auditor review requirements if such links or changes are added. In particular, items that are included within financial statements are subject to audit and internal review, internal controls over financial reporting and XBRL tagging. Furthermore, forward-looking statement safe-harbor protection is not available for information inside the financial statements.
- Forms
The amendments include several amendments to forms to conform with and implement all the changes in the rules. Moreover, companies will now have to include the national exchange or principal U.S. trading market, the trading symbol and title of each class of securities on the cover page of Forms 8-K, 10-Q, 10-K, 20-F and 40-F.
- XBRL
The amendments will require all of the information on the cover pages of Form 10-K, Form 10-Q, Form 8-K, Form 20-F, and Form 40-F to be tagged in Inline XBRL in accordance with the EDGAR Filer Manual.
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes.
In December 2018 the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.
In November, 2018, I published a blog on how to seek relief from the financial statement disclosure requirements pursuant to Rule 3-13 of Regulation S-X. See HERE.
In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE.
On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).
In December 2017, the American Bar Association (“ABA”) submitted its fourth comment letter to the SEC related to the financial and business disclosure requirements in Regulation S-K. For a review of that letter and recommendations, see HERE.
In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report made specific recommendations for change to the disclosure rules and regulations, including those related to special-interest and social issues and duplicative disclosures. See more on the Treasury Report HERE.
On October 11, 2017, the SEC published proposed rule amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The proposed rule amendments implement a mandate under the Fixing America’s Surface Transportation Act (“FAST Act”). The proposed amendments would: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See my blog HERE. On March 20, 2019, the SEC adopted final rules on this proposal, which is the subject of this blog.
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers. See my blog HERE on the Item 601 rule changes and HERErelated to SEC guidance on same.
On November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K as required by Section 72003 of the FAST Act. A summary of the report can be read HERE.
On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.
On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. Final amendments were approved on August 17, 2018 – see HERE.
The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
In September 2015, the SEC also issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Taking into account responses to portions of that request for comment, in the summer of 2018, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities. See my blog HERE.
As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE.
In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.
In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. See my blog HERE.
« The 20% Rule- Acquisitions Equity Market Structure – Musings By The SEC; 15c2-11 And Penny Stocks »
The 20% Rule- Acquisitions
Nasdaq and the NYSE American both have “20% Rules” requiring listed companies to receive shareholder approval prior to issuing unregistered securities in an amount of 20% or more of their outstanding common stock or voting power. Nasdaq Rule 5635 sets forth the circumstances under which shareholder approval is required prior to an issuance of securities in connection with: (i) the acquisition of the stock or assets of another company; (ii) equity-based compensation of officers, directors, employees or consultants; (iii) a change of control; and (iv) transactions other than public offerings (see HERE related to Rule 5635(d)). NYSE American Company Guide Sections 711, 712 and 713 have substantially similar provisions.
In a series of blogs I will detail these rules and related interpretative guidance. Many other Exchange Rules interplay with the 20% Rules; for example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to the issuance of securities in the same transactions that require shareholder approval, among others, and for an acquisition transaction at a lower 10% threshold. However, this blog is limited to the circumstances under which shareholder approval is required in conjunction with acquisitions under the 20% Rule and Acquisition Rule.
Nasdaq Rule 5635(a)
Nasdaq Rule 5635(a) requires shareholder approval prior to the issuance of securities in connection with the acquisition of the stock or assets of another company: (1) where, due to the present or potential issuance of common stock, including shares issued pursuant to an earn-out provision or similar type of provision, or securities convertible into or exercisable for common stock, other than a public offering for cash: (a) the common stock has or will have upon issuance voting power equal to or in excess of 20% of the voting power outstanding before the issuance of stock or securities convertible into or exercisable for common stock; or (b) the number of shares of common stock to be issued is or will be equal to or in excess of 20% of the number of shares of common stock outstanding before the issuance of the stock or securities; or (2) any director, officer or substantial shareholder of the company has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction or series of related transactions and the present or potential issuance of common stock, or securities convertible into or exercisable for common stock, could result in an increase in outstanding common shares or voting power of 5% or more. Part (2) of the provision is known as the “acquisition rule.”
Nasdaq Rule 5635(a) applies to strategic partnerships, joint ventures and similar transactions between companies as well.
NYSE American Company Guide Sections 712
Substantially similar to Nasdaq, the NYSE American Company Guide Section 712 requires shareholder approval prior to the listing of additional shares to be issued as sole or partial consideration for an acquisition of the stock or assets of another company in the following circumstances: (a) if any individual director, officer or substantial shareholder of the listed company has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction and the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in outstanding common shares of 5% or more; or (b) where the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in outstanding common shares of 20% or more.
Interpretation and Guidance
Substantial Shareholder
A substantial shareholder is defined in the negative and requires the company to consider the power that a particular shareholder asserts over the company. Nasdaq specifically provides that someone that owns less than 5% of the shares of the outstanding common stock or voting power would not be considered a substantial shareholder for purposes of the Rules.
Shares to be Issued in a Transaction; Shares Outstanding; Votes to Approve
In determining the number of shares to be issued in a transaction, the maximum potential shares that could be issued, regardless of contingencies, should be included. The maximum potential issuance includes all securities initially issued or potentially issuable or potentially exercisable or convertible into shares of common stock as a result of the transaction, including from earn-out clauses, penalty provisions and equity compensation awards.
In determining the number of shares outstanding immediately prior to a transaction, only shares that are actually outstanding should be counted. Shares reserved for issuance upon conversion of securities or exercise of options or warrants are not considered outstanding for purpose of the 20% Rule or Acquisition Rule. Where a company has multiple classes of common stock, all classes are counted in the amount outstanding, even if one or more classes do not trade on the Exchange.
Voting power outstanding as used in the Rule refers to the aggregate number of votes which may be cast by holders of those securities outstanding which entitle the holders to vote generally on all matters submitted to the company’s security holders for a vote.
Where shareholder approval is required under the 20% Rule or Acquisition Rule, approval can be had by a majority of the votes cast on the proposal.
Convertible Securities; Warrants
Convertible securities and warrants can either convert at a fixed or variable rate. Variable rate conversions are generally tied to the market price of the underlying common stock and accordingly, the number of securities that could be issued upon conversion will float with the price of the common stock. That is, the lower the price of a company’s common stock, the more shares that could be issued and conversely, the higher the price, the fewer shares that could be issued. Variable priced convertible securities tend to cause a downward pressure on the price of common stock, resulting in additional dilution and even more common stock issued in each subsequent conversion round. This chain of convert, sell, price reduction, and convert into more securities, sell, further price reduction and resulting dilution is sometimes referred to as a “death spiral.”
The 20% Rule and Acquisition Rule require that the company consider the largest number of shares that could be issued in a transaction when determining whether shareholder approval is required. Where a transaction involves variable priced convertible securities, and no floor on such conversion price is included or cap on the total number of shares that could be issued, the Exchanges will presume that the potential issuance will exceed 20% and that shareholder approval will be required.
Moreover, the Exchanges generally view variable priced transactions without floors or share caps as disreputable and potentially raising public interest concerns. Nasdaq specifically addresses these transactions, and the potential public interest concern, in its rules. In addition to the demonstrable business purpose of the transaction, other factors that Nasdaq staff will consider in determining whether a transaction raises public interest concerns include: (1) the amount raised in the transaction relative to the company’s existing capital structure; (2) the dilutive effect of the transaction on the existing holders of common stock; (3) the risk undertaken by the variable priced security investor; (4) the relationship between the variable priced security investor and the company; (5) whether the transaction was preceded by other similar transactions; and (6) whether the transaction is consistent with the just and equitable principles of trade.
Likewise, Nasdaq will closely examine any transaction that includes warrants that are exercisable for little or no consideration (i.e., “penny warrants”) and may object to a transaction involving penny warrants even if shareholder approval would not otherwise be required. Warrants with a cashless exercise feature are also not favored by the Exchanges and will be closely reviewed. Nasdaq guidance indicates it will review the following factors related to warrants with cashless exercise features: (i) the business purpose of the transaction; (ii) the amount to be raised (if the acquisition includes a capital raise); (iii) the existing capital structure; (iv) the potential dilutive effect on existing shareholders; (v) the risk undertaken by the new investors; (vi) the relationship between the company and the investors; (vii) whether the transaction was preceded by similar transactions; (viii) whether the transaction is “just and equitable”; and (ix) whether the warrant has provisions limiting potential dilution. In practice, many warrants include dilutive share caps and have cashless features that only kick in if there is no effective registration statement in place for the underlying common stock.
Aggregation
Both Nasdaq and the NYSE American may aggregate financing transactions that occur within close proximity of an acquisition in determining whether the 20% Rule or Acquisition Rule apply. Factors that the Exchange’s will consider include: (i) the proximity of the financing to the acquisition; (ii) timing of board approvals; (iii) stated contingencies in the acquisition documents; and (iv) stated or actual use of proceeds. Multiple acquisitions may also be aggregated. Factors that will be considered in aggregating multiple acquisitions include: (i) timing of the acquisitions; (ii) commonality of ownership of the target companies; (iii) commonality of officers and directors in the target companies; and (iv) the existence of any contingencies between or among the transactions.
Furthermore, there is no pricing test when determining if shareholder approval is required for securities issues in connection with an acquisition and as such, shares issued in a private offering that is part of the acquisition transaction will be aggregated for the 20% Rule even if the offering is above the Minimum Price (for more on Minimum Price, see HERE). In determining whether the financing is in connection with the acquisition, the Exchange will review the factors listed above. If the financing is not in connection with the acquisition such as where the proceeds are specifically designated for other purposes, the pricing test related to the private offering 20% rule (Rule 5635(d)) would apply.
Public Offering
An acquisition may be completed in coordination with a public offering of securities such as to raise funds for the operations of the acquired company or to pay for the acquisition itself in a cash transaction. The Exchanges will consider the stock issued in the offering when determining whether shareholder approval is required (see Aggregation discussion above). Although the rules do not require shareholder approval for a transaction involving “a public offering for cash,” the Exchanges do not automatically consider all registered offerings as public offerings.
Generally, all firm commitment underwritten securities offerings registered with the SEC will be considered public offerings. Likewise, any other securities offering which is registered with the SEC and which is publicly disclosed and distributed in the same general manner and extent as a firm commitment underwritten securities offering will be considered a public offering for purposes of the 20% and Acquisition Rules. In other instances, when analyzing whether a registered offering is a “public offering,” Nasdaq will consider: (a) the type of offering (including whether underwritten, on a best efforts basis with a placement agent, or self-directed by the company); (b) the manner in which the offering is marketed (including the number of investors and breadth of marketing effort); (c) the extent of distribution of the offering (including the number of investors and prior relationship with the company); (d) the offering price (at market or a discount); and (e) the extent to which the company controls the offering and its distribution. Although the NYSE American does not issue formal guidance on factors it will consider, in practice it is substantially the same as Nasdaq.
A registered direct offering will not be assumed to be public and will be reviewed using the same factors listed above. On the other hand, a confidentially marketed public offering (CMPO) is a firm commitment underwritten offering and, as such, will be considered a public offering.
Two-Step Transactions and Share Caps
As obtaining shareholder approval can be a lengthy process, companies sometimes bifurcate transactions into two steps and use share caps as part of a transaction structure. A company may limit the first part of a transaction to 19.9% of the outstanding securities and then, if and when shareholder approval is obtained, issue additional securities. Companies may also structure transactions such that issuances related to an acquisition, including earn-out provisions or convertible securities, are capped at no more than 19.9% of total outstanding. Likewise, the limitations would be set at 4.9% where there is an interested officer, director or substantial shareholder.
In order for a cap to satisfy the rules, it must be clear that no more than the threshold amount (19.9% or 4.9%) of securities outstanding immediately prior to the transaction, can be issued in relation to that transaction, under any circumstances, without shareholder approval. In a two-step transaction where shareholder approval is deferred, shares that are issued or issuable under the cap must not be entitled to vote to approve the remainder of the transaction. In addition, a cap must apply for the life of the transaction, unless shareholder approval is obtained. For example, caps that no longer apply if a company is not listed on Nasdaq are not permissible under the Rule. If shareholder approval is not obtained, then the investor will not be able to acquire 20% or more of the common stock or voting power outstanding before the transaction. Where convertible securities were issued, the shareholder would continue to hold the balance of the original security in its unconverted form.
Moreover, where a two-step transaction is utilized, the transaction terms cannot change as a result of obtaining, or not obtaining, shareholder approval. For example, a transaction may not provide for a sweetener or penalty. The Exchanges believe that the presence of alternative outcomes have a coercive effect on the shareholder vote and thus deprive the shareholders of their ability to freely determine whether the transaction should be approved. Nasdaq provides specific examples of a defective share cap, such as where a company issues a convertible preferred stock or debt instrument that provides for conversions of up to 20% of the total shares outstanding with any further conversions subject to shareholder approval. However, the terms of the instrument provide that if shareholders reject the transaction, the coupon or conversion ratio will increase or the company will be penalized by a specified monetary payment, including a rescission of the transaction. Likewise, a transaction may provide for improved terms if shareholder approval is obtained. The NYSE American similarly provides that share caps cannot be used in a way that could be coercive in a shareholder vote.
Reverse Acquisitions
A reverse acquisition or reverse merger is one in which the acquisition results in a change of control of the public company such that the target company shareholders control the public company following the closing of the transaction. In addition to the 20% and Acquisition Rules, a change of control would require shareholder approval under the Change of Control Rule. A company must re-submit an initial listing application in connection with a transaction where the target and new control entity was a non-Exchange listed entity prior to the transaction.
In determining whether a change of control has occurred, the relevant Exchange will consider all relevant factors including, but not limited to, changes in the management, board of directors, voting power, ownership, nature of the business, relative size of the entities, and financial structure of the company.
Exceptions
The Exchanges have a “financial viability” exception to the 20% Rule, which I will detail in a future blog in this series as the exception is not relevant (or would rarely be relevant) to an acquisition transaction. Furthermore, shareholder approval is not required if the issuance is part of a court-approved reorganization under the federal bankruptcy laws or comparable foreign laws.
Consequences for Violation
Consequences for the violation of the 20% Rule or Acquisition Rule can be severe, including delisting from the Exchange. Companies that are delisted from an Exchange as a result of a violation of these rules are rarely ever re-listed.
« The Under $300 Million Market Cap Class SEC Adopts Rules to Amend Regulation S-K »
The Under $300 Million Market Cap Class
Depending on whom you ask, a public company with less than $300 million market cap could be considered a micro-cap company, a penny stock (unless their share price is over $5.00), a lower middle market company or even middle market. Divestopedia defines “lower middle market” as “the lower end of the middle market segment of the economy, as measured in terms of annual revenue of the firms. Firms with an annual revenue in the range of $5 million to $50 million are grouped under the lower middle market category.” Wikipedia defines “middle market” as “companies larger than small businesses but smaller than big businesses that account for the middle third of the U.S. economy’s revenue. Each of these companies earns an annual revenue of between $100 million and $3 billion.” In a speech to the Greater Cleveland Middle Market Forum, SEC Commissioner Robert J. Jackson, Jr. defined a middle market company as those with trailing twelve-month sales of $50 million to $1 billion.
As I’ve written about previously, Bank of America, and their brokerage, Merrill Lynch, will not transact business in the securities of companies with less than a $300 million market cap and less than a $5.00-per-share stock price. Moreover, even if the stock price is over $5.00, such transactions or requested trades will face increased scrutiny and may not be processed right away. See HERE .Bank of America clearly thinks that under $300 million is a micro-cap company.
I realize that I am interchanging between market cap and revenue, but that is also common. For example, SEC rules define a smaller reporting company (SRC) as those with less than a $250 million public float or if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. A Google search for definitions of micro-cap, small-cap, lower middle market and middle market resulted in as many variations to the definition, based on both revenues and market cap, as Google pages I took the time to peruse.
Last summer the Investor Responsibility Research Center (IRRC) Institute published a report titled “Microcap Board Governance” providing some interesting information on public companies with less than $300 million in market capitalization. Leaving aside the semantics of the class size of these companies, this blog will summarize some of the information in the IRRC Report and add my usual commentary.
The IRRC Report
Since most companies with less than a $300 million market cap are not included in any major indices nor receive widespread analyst coverage, there is less aggregated information on their board composition and governance practices. The IRRC Report examined 160 companies representing approximately 10% of this company class which are traded on U.S. stock exchanges. Seventy-three percent (73%) trade on the Nasdaq, and the balance are on the NYSE or NYSE American.
Of the 160 companies, three-quarters have been public for more than 5 years, illustrating that not all small public companies are early-stage growth companies. Only 14% of the companies were still led by their founder. Although the IRRC report didn’t address the reasons or meaning behind these numbers, I think it makes sense in the overall corporate ecosystem. Very few companies will successfully grow to large-cap entities, nor should they. High-growth models come with great risk and can often lead to a total business failure. For instance, a company that goes public with a $50 million market cap and then grows 10%-20% year over year would still be in the under $300 million market cap class after 5 years, but also will likely have strong infrastructure and internal controls and provide steady growth to its investors.
Furthermore, the majority of the companies are in industry sectors that lend themselves to either slow growth or have seen dramatic industry change over the last decade. Thirty percent (30%) of the companies were in the healthcare sector, which notoriously has a very long research and development, pre-revenue lifecycle. Finance companies comprised another 18%, which sector has transformed post-Dodd-Frank, which was enacted in 2010 (see HERE). Rounding out the industries were consumer goods and services (15%), energy and utilities (11%), basic industries and transportation (10%), capital goods (9%) and technology (7%).
More than half the companies went public in the first 10 years of their founding. Although private equity has become more readily available for some companies (technology companies in particular), postponing a public offering, in my experience smaller companies have more opportunity to access capital through public markets then private sources. In fact, I believe the benefits of public capital markets are even more pronounced for small companies because they tend to be more innovative than large companies and they account for a substantial percentage of the jobs created every year. Public markets give an opportunity for some recouping of early-stage investments, incentivize employees through stock options and grants, add economic exposure and, of course, enhance access to capital for continued growth.
The under $300 million class tends to have smaller boards (five or less) than larger companies (nine or more). Men dominate the boards in this class even more so than in larger companies. The majority (61%) of the under $300 million market cap companies studied have no female directors serving on their boards, compared to less than one-quarter (21%) of the Russell 3000 boards. Furthermore, only 12% of these companies have more than one female director, while nearly half (45%) of the Russell 3000 companies have more than one female director. Not surprisingly, the under $300 million class pays their CEO’s less than larger companies (with as much shareholder scrutiny), though the average CEO age (in their 50’s) is the same for other classes of public companies. Directors are also paid much less than their larger cap counterparties, with the average being $90,000 for the under $300 million class and $180,000 for serving on a Russell 3000 company.
With smaller boards come fewer independent directors, more variability in the number and timing of meetings, and a less complex committee structure with many electing not to appoint a chairman of the board. In a period of shareholder activism and socially motivated investing, the board composition of the under $300 million class could be a hindrance to some institutional investments. In reading this study, I see an opportunity for these companies to stand out from the average by putting more attention into their board composition as well as governance and process.
To further illustrate the importance of these factors, on February 6, 2019, the SEC issued two new identical C&DI related to disclosure of board diversity, and in particular:
Question: In connection with preparing Item 401 disclosure relating to director qualifications, certain board members or nominees have provided for inclusion in the company’s disclosure certain self-identified specific diversity characteristics, such as their race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background. What disclosure of self-identified diversity characteristics is required under Item 401 or, with respect to nominees, under Item 407?
Answer: Item 401(e) requires a brief discussion of the specific experience, qualifications, attributes, or skills that led to the conclusion that a person should serve as a director. Item 407(c)(2)(vi) requires a description of how a board implements any policies it follows with regard to the consideration of diversity in identifying director nominees. To the extent a board or nominating committee in determining the specific experience, qualifications, attributes, or skills of an individual for board membership has considered the self-identified diversity characteristics referred to above (e.g., race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background) of an individual who has consented to the company’s disclosure of those characteristics, we would expect that the company’s discussion required by Item 401 would include, but not necessarily be limited to, identifying those characteristics and how they were considered. Similarly, in these circumstances, we would expect any description of diversity policies followed by the company under Item 407 would include a discussion of how the company considers the self-identified diversity attributes of nominees as well as any other qualifications its diversity policy takes into account, such as diverse work experiences, military service, or socio-economic or demographic characteristics.
As with all public companies, the majority of the under $300 million class is incorporated in Delaware (59%) followed by Nevada (16%) and Maryland (7%). I note that as you move up the chain, Delaware comprises a larger and larger percentage of all public companies.
Not surprisingly, a greater majority of these companies tend to be owned by management and insiders than the larger companies. Management tends to face greater and greater dilution as a company grows and continues to access capital markets for financing or issues equity for mergers and acquisitions and employee stock grants. Also, the control ownership of this group tends to be in straight common stock, with only 7% of the companies examined having a dual stock class structure.
« SEC Rules For Disclosure Of Hedging Policies The 20% Rule- Acquisitions »
SEC Rules For Disclosure Of Hedging Policies
In December 2018, the SEC approved final rules to require companies to disclose practices or policies regarding the ability of employees or directors to engage in certain hedging transactions, in proxy and information statements for the election of directors. The new rules implement Section 14(j) of the Securities Exchange Act of 1934 (“Exchange Act”) as mandated by the Dodd-Frank Act and will require the robust disclosure on hedging policies and practices including a description of any hedging transactions that are specifically permitted or disallowed. The proposed rules had initially been published on February 9, 2015 – see HERE.
Smaller reporting companies and emerging growth companies must comply with the new disclosure requirements in their proxy and information statements during fiscal years beginning on or after July 1, 2020. All other companies must comply in fiscal years beginning July 1, 2019. As foreign private issuers (FPI) are not subject to the proxy statement requirements under Section 14 of the Exchange Act, FPIs are not required to make the new disclosures.
New Item 407(i) of Regulation S-K will require a company to describe any practices or policies it has adopted regarding the ability of its employees, officers or directors to purchase securities or other financial instruments, or otherwise engage in transactions that hedge or offset, or are designed to hedge or offset, any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director. The disclosure requirement may be satisfied by providing a full summary of the practices or policies or by including the full policy itself in the disclosure.
The disclosure requirement extends to equity securities of parent and subsidiaries of the reporting company. The rules regulate disclosure of company policy as opposed to directing the substance of that policy or the underlying hedging activities. The rule specifically does not require a company to prohibit a hedging transaction or otherwise adopt specific policies; however, if a company does not have a policy regarding hedging, it must state that fact and the conclusion that hedging is therefore permitted.
The Senate Committee on Banking, Housing, and Urban Affairs stated in its report that Section 14(j) is intended to “allow shareholders to know if executives are allowed to purchase financial instruments to effectively avoid compensation restrictions that they hold stock long-term, so that they will receive their compensation even in the case that their firm does not perform.”
Background
Currently disclosure requirements related to hedging policies are set forth in Item 402(b) of Regulation S-K and are included as part of a company’s Compensation Discussion and Analysis (“CD&A”). CD&A requires material disclosure of a company’s compensation policies and decisions related to named executive officers. Item 402(b) only requires disclosure of hedging policies “if material” and only for named executive officers. Moreover, CD&A is not required at all for smaller reporting companies, emerging growth companies, closed-end investment companies or foreign private issuers.
Hedging transactions themselves may be disclosed in other SEC reports. For example, Form 4 filings by officers, directors and greater than 10% shareholders would include disclosures of hedging transactions involving derivative securities. Hedging transactions involving pledged securities would be included in disclosures related to the beneficial ownership of officers, directors and greater than 5% shareholders in SEC reports such as a company’s annual report, registration statements or proxy materials. However, there is currently no rule that specifically requires the disclosure of hedging policies and that encompasses all reporting issuers.
New Item 407(i) of Regulation S-K
The SEC determined that disclosure of hedging policies constitutes a corporate governance disclosure and, as such, should be contained in Item 407, keeping all corporate governance disclosure requirements in one rule. As indicated above, the final new Item 407(i) of Regulation S-K will:
• require the company to describe any practices or policies it has adopted, whether written or not, regarding the ability of employees, officers, directors or their designees to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds), or otherwise engage in transactions that hedge or offset, or are designed to hedge or offset, any decrease in the market value of company equity securities granted to the employee, officer, director or designee or held directly or indirectly by the employee, officer, director or designee;
• a company will be required either to provide a fair and accurate summary of any practices or policies that apply, including the categories of persons covered and any categories of hedging transactions that are specifically permitted and any categories that are specifically disallowed, or to disclose the practices or policies in full;
• if the company does not have any such practices or policies, require the company to disclose that fact or state that hedging transactions are generally permitted. Likewise, if a company only has a practice or policy that covers a subset of employees, officers or directors, they would need to affirmatively disclose that uncovered persons are permitted to engage in hedging transactions;
• specify that the equity securities for which disclosure is required include equity securities of the company or any parent, subsidiary, or subsidiaries of the company’s parent. Moreover, the disclosure is not limited to registered equity securities, but rather any class of securities;
• require the disclosure in any proxy statement on Schedule 14A or information statement on Schedule 14C with respect to the election of directors. Disclosure is not required in a Form 10-K even if incorporated by reference from the proxy or information statement; and
• clarify that the term “employee” includes officers of the company.
The essence of Item 407(i) is to disclose any allowable transactions that could result in downside price protection, regardless of how that hedging is achieved (for example, purchasing or selling a security, derivative security or otherwise). Accordingly, the rule specifically does not define the term “hedge” but rather is meant to cover any transaction with the economic effect of offsetting any decrease in market value.
Similarly, the Rule does not define the term “held directly or indirectly” but rather will leave it to a company to describe the scope of their hedging practices or policies, which may include whether and how they apply to securities that are “indirectly” held. To the extent that it is undefined or a person may not be covered based on the definition, again, a company would disclose that hedging is permitted as to those that are not covered.
The new Rule only requires disclosure of policies and practices and not hedging transactions themselves. CD&A requires material disclosure of a company’s compensation policies and decisions related to named executive officers. The new Rule adds an instruction to Item 402(b) related to CD&A such that the required disclosure can be satisfied by the new disclosure required by Item 407(i).
Section 14(j) specifically referred to any employee or member of the board of directors. The final rule clarified that officers are also covered in the disclosure. The Rule covers all employees, regardless of the materiality of their position. As the disclosure is about policies and practices, and does not mandate required policy or practice, the SEC saw no benefit in limiting the disclosure requirement to only certain covered persons. Consistently with the concept of allowing a company to define terms and scope in their adopted policies and practices, the definition and scope of “held directly or indirectly” will be left to a company to describe in its policy, if any, and associated disclosure.
« SEC Proposes Expanding Testing The Waters For All Companies The Under $300 Million Market Cap Class »
SEC Proposes Expanding Testing The Waters For All Companies
As anticipated, on February 19, 2019 the SEC voted to propose an expansion of the ability to “test the waters” prior to the effectiveness of a registration statement in a public offering, to all companies. Currently only emerging growth companies (“EGCs”) (or companies engaging in a Regulation A offering) can test the waters in advance of a public offering of securities. The proposal would implement a new Securities Act Rule 163B. For an in-depth analysis of testing the waters and communications during an offering process, see my two-part blog HERE and HERE. The SEC proposal is open for public comment for a sixty (60)-day period.
Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. The public offering process is divided into three periods: (1) the pre-filing period, (2) the waiting or pre-effective period, and (3) the post-effective period. Communications made by the company during any of these three periods may, depending on the mode and content, result in violations of Section 5 of the Securities Act of 1933 (the “Securities Act”). Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.”
All forms of communication could create “gun-jumping” issues (e.g., press releases, interviews, and use of social media). “Gun jumping” refers to written or oral offers of securities made before the filing of the registration statement and written offers made after the filing of the registration statement other than by means of a prospectus that meet the requirements of Section 10 of the Securities Act, a free writing prospectus or a communication falling within one of the several safe harbors from the gun-jumping provisions.
In April 2012, the JOBS Act established a new process and disclosures for public offerings by a new class of companies – i.e., emerging growth companies (“EGCs.”) An EGC is defined as a company with total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. In particular, Section 5(d) of the Securities Act of 1933 (“Securities Act”) allows EGCs to test the waters by engaging in communications with certain qualified investors. The SEC proposal would create a new Securities Act Rule 163B allowing all companies intending to file, or who have filed, a registration statement.
Permitting companies to test the waters is intended to provide increased flexibility to such issuers with respect to their communications about contemplated registered securities offerings, as well as a cost-effective means for evaluating market interest before incurring the costs associated with such an offering. Since the enactment of the JOBS Act, 87% of all IPOs have been by EGCs, leaving non-EGC companies at a disadvantage where specific rules favor EGC status.
The current proposal is consistent with other SEC actions to extend benefits afforded to EGCs to other issuers. That is, in June, 2017, the SEC expanded the ability to file confidential registration statements, previously only available to EGCs, to all companies – see HERE.
Section 5(d) of the Securities Act – Testing the Waters; Proposed New Rule 163B
Section 5(d) of the Securities Act provides an EGC with the flexibility to “test the waters” by engaging in oral or written communications with qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”) in order to gauge their interest in a proposed offering, whether prior to or following the first filing of any registration statement, subject to the requirement that no security may be sold unless accompanied or preceded by a Section 10(a) prospectus. Generally, in order to be considered a QIB, you must own and invest $100 million of securities, and in order to be considered an IAI, you must have a minimum of $5 million in assets.
Under the current rules, “well-known seasoned issuers,” or WKSIs, can engage in similar test-the-waters communications, but smaller reporting companies that do not otherwise qualify as an EGC cannot.
An EGC may utilize the test-the-waters provision with respect to any registered offerings that it conducts while qualifying for EGC status. Test-the-waters communications can be oral or written. An EGC may also engage in test-the-waters communications with QIBs and institutional accredited investors in connection with exchange offers and mergers. When doing so, an EGC would still be required to make filings under Sections 13 and 14 of the Exchange Act for pre-commencement tender offer communications and proxy soliciting materials in connection with a business combination transaction.
There are no form or content restrictions on these communications, and there is no requirement to file written communications with the SEC. During the first year or two following enactment of the JOBS Act, the SEC staff regularly asked to see any written test-the-waters materials during the course of the registration statement review process, but eventually these requests ceased. The SEC staff maintains the right to ask to review test-the-waters, or any, communications made by a company during the S-1 review process.
The new SEC proposal would expand the test-the-waters provisions currently available to EGCs, to all companies. In particular, proposed Securities Act Rule 163B would permit any issuer, including investment companies, or any person authorized to act on its behalf, to engage in oral or written communications with potential investors that are, or are reasonably believed to be, QIBs or IAIs, either prior to or following the filing of a registration statement, to determine whether such investors might have an interest in a contemplated registered securities offering. The proposed rule would be non-exclusive, and an issuer could rely on other Securities Act communications rules or exemptions when determining how, when, and what to communicate related to a contemplated securities offering.
The proposed rule would not require a filing with the SEC or any particular legend on the communications. Like other communications during a registration process, the test-the-waters communications must be consistent with and cannot conflict with the information in a related registration statement.
Companies that are subject to Regulation FD will need to be cognizant of whether any information in a test-the-waters communication would trigger a disclosure obligation under Regulation FD and make the required disclosure accordingly. As a reminder, Regulation FD requires that companies take steps to ensure that material information is disclosed to the general public in a fair and fully accessible manner such that the public as a whole has simultaneous access to the information. Regulation FD requires the filing of a Form 8-K immediately prior to or simultaneously with the issuance of the information. Where information is accidentally released, the filing must be made immediately after the release and on the same calendar day.
It is important to note that anti-fraud provisions, such as Section 12(a)(2) and 10(b), still apply to such communications.
Thoughts on the Proposal
The SEC believes that by allowing more test-the-waters communications, companies will be encouraged to participate in public markets which, in turn, promotes more investment opportunities for more investors and improves transparency and resiliency in the marketplace. Furthermore, added communication can enhance the ability of issuers to conduct successful offerings and lower the cost of capital. I agree, but it is not enough. Although the proposal is certainly welcome, and I’m sure will pass through the comment process and be enacted by the SEC, I would advocate for a rule amendment that not only expands test-the-waters communications for all issuers but that broadens the category of potential investor that could be the subject of such communications, to include all accredited investors.
In its proposal release, the SEC notes that the 2015 modernization of Regulation A, which allows companies to test the waters with all potential investors, without restriction as to the type of investors, has helped modernize the Securities Act communication rules. I have trouble understanding why the SEC is comfortable with the unfettered Regulation A test-the-waters communications, but is limiting offerings registered under the Securities Act to qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”). Certainly the potential total investor loss is limited in a Regulation A offering (with the high end maxing out at $50 million for a Tier 2 offering) and Regulation A communications require specified disclaimers and filing with the SEC, but I still find it to be a disconnect.
In the proposal, on several occasions, the SEC points out that QIBs and IAIs are sophisticated and do not need the protections of the Securities Act. I believe that the current change is in line with a conservative “incremental change” approach. A next-step middle ground could be to require any test-the-waters communications that are made available to potential investors that are not QIBs or IAIs to contain a specified legend and be filed with the SEC. That way, a company embarking on an offering could decide if it wants to take on the filing liability under Section 11 of the Securities Act or limit its test-the-waters communications to QIBs and IAIs.
« NYSE American Compliance Guidance MEMO SEC Rules For Disclosure Of Hedging Policies »