NYSE Annual Compliance Guidance Memo And Amended Rules
In January, NYSE Regulation sent out its yearly Compliance Guidance Memo to NYSE American listed companies. Although we are already halfway through the year, the annual letter has useful information that remains timely. As discussed in the Compliance Memo, the NYSE sought SEC approval to permanently change its shareholder approval rules in accordance with the temporary rules enacting to provide relief to listed companies during Covid. The SEC approved the amended rules on April 2, 2021.
Amendment to Shareholder Approval Rules
The SEC has approved NYSE rule changes to the shareholder approval requirements in Sections 312.03 and 312.04 of the NYSE Listed Company Manual (“Manual”) and the Section 314 related party transaction requirements. The rule changes permanently align the rules with the temporary relief provided to listed companies during Covid (for more on the temporary relief, see HERE
Prior to the amendment, Section 312.03 of the Manual prohibited certain issuances to (i) directors, officers or substantial shareholders (related parties), (ii) a subsidiary, affiliate, or other closely related person of a related party; or (iii) any company or entity in which a related party has a substantial direct or indirect interest. In particular, related party issuances were prohibited if the number of shares of common stock to be issued, or if the number of shares of common stock into which the securities may be convertible or exercisable, exceeds either 1% of the number of shares of common stock or 1% of the voting power outstanding before the issuance. The rule had limited exception if the issuances were for cash, above a minimum price, no more than 5% of the outstanding common stock and the related party was a related party solely because it is a substantial shareholder of the company.
The amended rules modify the class of persons for which shareholder approval would be required prior to an issuance. The amended rules only require shareholder approval prior to issuances to directors, officers and substantial shareholders. The restriction on a subsidiary, affiliate, or other closely related person of a related party or any company or entity in which a related party has a substantial direct or indirect interest has been removed. In addition, the amended rule broadens the exception such that all cash sales at or above the minimum price would be exempted. Other provisions of the NYSE rules may still require shareholder approval prior to issuances to officers and directors, such as the equity compensation rules that require shareholder approval for issuances to employees, officers, directors and service providers.
The amendment also adds a provision whereby shareholder approval is required prior to any acquisition transaction or series of related transactions in which any related party 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 either the number of shares of common stock or voting power outstanding of 5% or more before the issuance.
The amendments more closely align the NYSE rules with those of the NYSE American and Nasdaq. For a review of the NYSE American and Nasdaq rules for affiliate issuances associated with acquisitions, see HERE. For a review of the NYSE American and Nasdaq rules governing equity compensation shareholder approval requirements, see HERE.
The NYSE has also amended its 20% Rule. In particular, NYSE Section 312.03(c) requires shareholder approval of any transaction relating to 20% or more of the company’s outstanding common stock or voting power outstanding before such issuance but provides the following exceptions: (i) any public offering for cash; and (ii) any bona fide private financing involving a cash sale of the company’s securities that comply with the minimum price requirement. A “bona fide private financing” referred to a sale in which either: (i) a registered broker-dealer purchases the securities from the issuer with a view to the private sale of such securities to one or more purchasers; or (ii) the issuer sells the securities to multiple purchasers, and no one such purchaser, or group of related purchasers, acquires, or has the right to acquire upon exercise or conversion of the securities, more than 5% of the shares of the issuer’s common stock or voting power before the sale.
Under the amended rules, the NYSE has replaced the term “bona fide financing” with “other financing (that is not a public offering for cash) in which the company is selling securities for cash.” This change eliminated the requirement that the issuer sell the securities to multiple purchasers, and that no one such purchaser, or group of related purchasers, acquires more than 5% of the issuer’s common stock or voting power. Also, under the rule change, the provision related to broker-dealer purchases becomes moot.
Of course, the new rules would not eliminate shareholder voting requirements under other NYSE rules such as the acquisition rules where the issuance equals or exceeds 20% of the common stock or voting power. Like the affiliate rule change, the amendment is meant to further align NYSE rules with those of the NYSE American and Nasdaq. For a review of the NYSE American and Nasdaq 20% rules, see HERE.
The NYSE has also made a change to Section 314 of the Manual requiring related party transactions to be reviewed by the audit committee. The Exchange has updated the definition of “related party” from officers, directors and principal shareholders to align with the definition provided in Item 404 of Regulation S-K of the Exchange Act.
Annual Compliance Guidance Memo
The NYSE Memo provides a list of important reminders to all exchange listed companies, starting with the requirement to provide a timely alert of all material news. Listed companies may comply with the NYSE’s Timely Alert/Material News policy by disseminating material news via a press release or any other Regulation FD compliant method. For news being released between 7:00 a.m. and 4:00 p.m. EST, a company must call the NYSE’s Market Watch Group (i) ten minutes before the dissemination of news that is deemed to be of a material nature or that may have an impact on trading in the company’s securities; or (ii) at the time the company becomes aware of a material event having occurred and take steps to promptly release the news to the public and provide a copy of any written form of that announcement at the same time via email.
For news releases outside the hours of 7:00 a.m. and 4:00 p.m. EST companies are generally not required to call the Exchange in advance of issuing news, although companies should still provide a copy of material news once it is disclosed, by submitting it electronically through Listing Manager or via e-mail to nysealert@nyse.com. Where the news is related to a dividend or stock distribution, advance notice must be provided regardless of the time of the announcement either by a call within operating hours or in writing after hours.
The requirement to provide the exchange with advance notice of the public release of information also applies to verbal information such as part of a management presentation, investor call or investor conference. In practice, companies usually file their scripts and any presentation materials via a Form 8-K immediately prior to the verbal release of information.
Between the hours of 9:25 a.m. and 4:00 p.m. EST, NYSE will determine if a temporary trading halt should be implemented to allow the market time to fully absorb the news. Between the hours of 7:00 a.m. and 9:25 a.m. EST, NYSE will implement news pending trading halts only at the request of the company.
Companies are prohibited from publishing material news after the official closing time for the NYSE’s trading session until the earlier of 4:05 p.m. EST or the publication of the official closing price of the listed company’s security. This requirement is designed to alleviate confusion caused by price discrepancies between trading prices on other markets after the NYSE official closing time, which is generally 4:00 p.m. EST, and the NYSE closing price upon completion of the auction, which can be after 4:00 p.m. EST.
NYSE notes that a change in the earnings announcement date can sometimes affect the trading price of a company’s stock and/or related securities and those market participants who are in possession of this information before it is broadly disseminated may have an advantage over other market participants. Consequently, listed companies are required to promptly and broadly disseminate to the market, news of the scheduling of their earnings announcements or any change in that schedule and to avoid selective disclosure of that information prior to its broad dissemination. The purpose of these rules is to prevent insider trading or even a jump-start advantage to trading on material information.
The compliance letter also addresses the following matters:
Annual Meeting Requirements – If an annual meeting is postponed or adjourned, such as if quorum is not reached, the company will not be in compliance with Section 302 of the Manual, which requires that a company hold an annual meeting during each fiscal year.
Record Date Notification – To participate in shareholder meetings as well as receive company distributions and other important communications, investors must hold their securities on the relevant record date established by the listed company. For this reason, the NYSE disseminates record date information to the marketplace so that investors can plan their holdings accordingly. Listed companies are required to notify the NYSE at least ten calendar days in advance of all record dates set for any purpose or changes to a set date. Record dates should be set for business days. A press release or filing with the SEC cannot satisfy the notice requirements. The NYSE has no power to waive these requirements and so, if notice is not provided to NYSE as required, a record date may have to be reset.
Redemption and Conversion of Listed Securities – Advance notice must be provided to the NYSE of any call redemptions or conversions of a listed security. The NYSE tracks redemptions and conversions to ensure that any reduction in securities outstanding does not result in noncompliance with the Exchange’s distribution and market capitalization continued listing standards. Also, the NYSE relies on a listed company’s transfer agent or depositary bank to report share information. Transfer agents are required to report shares no later than the 10th day following the end of each calendar quarter.
Annual Report Website Posting Requirement – Section 203.01 of the Manual requires that a company post its annual report on its website simultaneously with the filing of the report with the SEC. A listed company that is not required to comply with the SEC proxy rules (such as foreign issuers) must also post a prominent undertaking on its website to provide all holders the ability, upon request, to receive a hard copy of the complete audited financial statements free of charge; and issue a press release that discloses that the Form 10-K, 20-F, 40-F or N-CSR has been filed with the SEC, includes the company’s website, and indicates that shareholders have the ability to receive hard copy of the complete audited financial statements free of charge upon request.
Corporate Governance Requirements – All listed companies must file an annual affirmation that it is in compliance with the corporate governance requirements. The affirmation must be filed no later than 30 days after the company’s annual meeting and if no meeting is held, 30 days after the filing of its annual report (10-K, 20-F, 40-F or N-CSR) with the SEC. In addition, a listed company must file an Interim Written Affirmation promptly (within 5 business days) after any triggering event specified on that form. Domestic companies are not required to submit an Interim Written Affirmation for changes that occur within 30 days after the annual meeting, as these can be included in the Annual Written Affirmation.
Transactions Requiring Supplemental Listing Applications – A company is required to file a Listing of Additional Securities (“LAS”) application to obtain authorization from the NYSE for a variety of corporate events, including (i) the issuance or reserve for issuance of additional shares of a listed security; (ii) the issuance or reserve for issuance of additional shares of a listed security that are issuable upon conversion of another security; (iii) change in corporate name, state of incorporation or par value; and/or (iv) the listing of a new security (such as preferred stock or warrants). No additional securities can be issued until the NYSE authorizes the LAS. Moreover, authorization is required whether the securities will be issued privately or through a registration and even if conversion is not possible until some future date. Authorization takes approximately 2 weeks.
Broker Search Cards – SEC Rule 14a-13 requires any company soliciting proxies in connection with a shareholder meeting to send a search card to any entity that the company knows is holding shares for beneficial owners. The search card must be sent: (i) at least 20 business days before the record date for the annual meeting; or (ii) such later time as permitted by the rules of the national exchange on which the securities are listed. The NYSE American does not have any rules allowing for a later search card and accordingly, all listed companies must comply with the Rule 14a-13 20-day requirement.
NYSE Rule 452, Voting by Member Organizations – The Exchange reviews all listed company proxy materials to determine whether NYSE American member organizations that hold customer securities in “street name” accounts as brokers are allowed to vote on proxy matters without having received specific client instructions. The Exchange recommends that listed companies submit their preliminary proxies for preliminary, confidential review.
Shareholder Approval and Voting Rights Requirements – Sections 303A.08 and 312.03 of the Manual outline the Exchange’s shareholder approval requirements including the 20% rules. Listed companies are strongly encouraged to consult the Exchange prior to entering into a transaction that may require shareholder approval including, but not limited to, the issuance of securities: (i) with anti-dilution price protection features; (ii) that may result in a change of control; (iii) to a related party; (iv) in excess of 19.9% of the pre-transaction shares outstanding; and (v) in an underwritten public offering in which a significant percentage of the shares sold may be to a single investor or to a small number of investors (as this may be deemed a private offering requiring approval).
Listed companies are also encouraged to consult the Exchange prior to entering into a transaction that may adversely impact the voting rights of existing shareholders of the listed class of common stock, as such transactions may violate the Exchange’s voting rights. Examples of transactions which adversely affect the voting rights of shareholders of the listed common stock include transactions which result in a particular shareholder having: (i) board representation that is out of proportion to that shareholder’s investment in the company; or (ii) special rights pertaining to items that normally are subject to shareholder approval under either state or federal securities laws, such as the right to block mergers, acquisitions, disposition of assets, voluntary liquidation, or certain amendments to the company’s organizational/governing documents.
Voting Requirements for Proposals at Shareholder Meetings – Section 312.07 of the Manual provides that, where shareholder approval is required under NYSE rules, the minimum vote that constitutes approval for such purposes is approval by a majority of votes cast (i.e., the number of votes cast in favor of the proposal exceeds the aggregate of votes cast against the proposal plus abstentions).
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NYSE American Compliance Guidance MEMO
In January, NYSE Regulation sent out its yearly Compliance Guidance Memo to NYSE American listed companies. The annual letter updates companies on any rule changes from the year and reminds companies of items the NYSE deems important enough to warrant such a reminder.
The only new item in this year’s letter relates to advance notice of stock dividends and distributions. Effective February 1, 2018, the NYSE requires listed companies to provide ten minutes’ advance notice to the exchange of any announcement with respect to a dividend or stock distribution, whether the announcement is during or outside exchange traded hours. This change is consistent with other NYSE and Nasdaq rules which generally require notifications of announcements, including press releases, that could impact trading, at least 10 minutes prior to such notification.
The NYSE letter also provides a list of important reminders to all exchange listed companies, starting with the requirement to provide a timely alert of all material news. Part 4 of the Company Guide requires listed companies to promptly release to the public any news or information which might reasonably be expected to materially affect the market for its securities. Listed companies may comply with the NYSE’s Timely Alert/Material News policy by disseminating material news via a press release or any other Regulation FDcompliant method. Furthermore, for news being released between 7:00 a.m. and 4:00 p.m. Eastern time, a company must call the NYSE’s Market Watch Group (i) ten minutes before the dissemination of news that is deemed to be of a material nature or that may have an impact on trading in the company’s securities; or (ii) at the time the company becomes aware of a material event having occurred and take steps to promptly release the news to the public and provide a copy of any written form of that announcement at the same time via email. As noted above, where the news is related to a dividend or stock distribution, advance notice must be provided regardless of the time of the announcement.
The NYSE includes examples of material news such as earnings, mergers/acquisitions, executive changes, redemptions/conversions, securities offerings and pricings related to these offerings, major product launches, regulatory rulings, new patent approvals and dividend or major repurchase announcements. Once notified, NYSE Marketwatch will determine if a temporary trading halt should be effected to allow the market time to fully absorb the news. Also, if the news is being released between 7:00 a.m. and 9:25 a.m., the company can request a temporary trading halt.
Furthermore, the requirement to provide the exchange with advance notice of the public release of information also applies to verbal information such as part of a management presentation, investor call or investor conference. In practice, companies usually file their scripts and any presentation materials via a Form 8-K immediately prior to the verbal release of information.
Similarly, NYSE believes that a change in the earnings announcement date can sometimes affect the trading price of a company’s stock and/or related securities and those market participants who are in possession of this information before it is broadly disseminated may have an advantage over other market participants. Consequently, listed companies are required to promptly and broadly disseminate to the market, news of the scheduling of their earnings announcements or any change in that schedule and to avoid selective disclosure of that information prior to its broad dissemination.
The purpose of these rules is to prevent insider trading or even a jump-start advantage to trading on material information. It is widely believed that insider trading rules are in need of an overhaul. Generally, insider trading refers to buying or selling a security in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. For more information, see HERE.
The compliance letter also addresses the following matters:
Annual Meeting Requirements – If an annual meeting is postponed or adjourned, such as if quorum is not reached, the company will not be in compliance with Section 704 of the Company Guide, which requires that a company hold an annual meeting during each fiscal year.
Record Date Notification – Listed companies are required to notify the NYSE at least ten calendar days in advance of all record dates set for any purpose or changes to a set date. Record dates should be set for business days.
Redemption and Conversion of Listed Securities – Advance notice must be provided to the NYSE of any call redemptions or conversions of a listed security. The NYSE tracks redemptions and conversions to ensure that any reduction in securities outstanding does not result in noncompliance with the Exchange’s distribution and market capitalization continued listing standards.
Annual Report Website Posting Requirement – Section 610(a) of the Company Guide requires that a company post its annual report on its website simultaneously with the filing of the report with the SEC.
Corporate Governance Requirements – All listed companies must file an annual affirmation that it is in compliance with the corporate governance requirements. The affirmation must be filed no later than 30 days after the company’s annual meeting and if no meeting is held, 30 days after the filing of its annual report (10-K, 20-F, 40-F or N-CSR) with the SEC.
Transactions Requiring Supplemental Listing Applications – A company is required to file a Listing of Additional Securities (“LAS”) application to obtain authorization from the NYSE for a variety of corporate events, including (i) the issuance or reserve for issuance of additional shares of a listed security; (ii) the issuance or reserve for issuance of additional shares of a listed security that are issuable upon conversion of another security; (iii) change in corporate name, state of incorporation or par value; and/or (iv) the listing of a new security (such as preferred stock or warrants). No additional securities can be issued until the NYSE authorizes the LAS. Moreover, authorization is required whether the securities will be issued privately or through a registration and even if conversion is not possible until some future date. Authorization takes approximately 2 weeks.
Broker Search Cards – SEC Rule 14a-13 requires any company soliciting proxies in connection with a shareholder meeting to send a search card to any entity that the company knows is holding shares for beneficial owners. The search card must be sent: (i) at least 20 business days before the record date for the annual meeting; or (ii) such later time as permitted by the rules of the national exchange on which the securities are listed. The NYSE American does not have any rules allowing for a later search card and accordingly, all listed companies must comply with the Rule 14a-13 20-day requirement.
NYSE American Rule 452, Voting by Member Organizations – The Exchange reviews all listed company proxy materials to determine whether NYSE American member organizations that hold customer securities in “street name” accounts as brokers are allowed to vote on proxy matters without having received specific client instructions. The Exchange recommends that listed companies submit their preliminary proxies for preliminary, confidential review.
Shareholder Approval and Voting Rights Requirements – Sections 711 through 713 of the Company Guide outline the Exchange’s shareholder approval requirements including the 20% rules. Listed companies are strongly encouraged to consult the Exchange prior to entering into a transaction that may require shareholder approval including, but not limited to, the issuance of securities: (i) with anti-dilution price protection features; (ii) that may result in a change of control; (iii) to a related party; (iv) in excess of 19.9% of the pre-transaction shares outstanding; and (v) in an underwritten public offering in which a significant percentage of the shares sold may be to a single investor or to a small number of investors (as this may be deemed a private offering requiring approval).
Listed companies are also encouraged to consult the Exchange prior to entering into a transaction that may adversely impact the voting rights of existing shareholders of the listed class of common stock, as such transactions may violate the Exchange’s voting rights. Examples of transactions which adversely affect the voting rights of shareholders of the listed common stock include transactions which result in a particular shareholder having: (i) board representation that is out of proportion to that shareholder’s investment in the company; or (ii) special rights pertaining to items that normally are subject to shareholder approval under either state or federal securities laws, such as the right to block mergers, acquisitions, disposition of assets, voluntary liquidation, or certain amendments to the company’s organizational/governing documents.
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Multiple Classes of Stock and the Public Company
In March 2017, Snap Inc. completed its IPO, selling only non-voting Class A common shares to the investing public and beginning an ongoing discussion of the viability and morality of multiple classes of stock in the public company setting. No other company has gone public with non-voting stock on a U.S. exchange. Although Facebook and Alphabet have dual-class stock structures, shareholders still have voting rights, even though insiders hold substantial control with super-voting preferred stock.
Snap’s stock price was $10.79 on May 7, 2018, well below is IPO opening price of $17.00. Certainly the decline has a lot to do with the company’s floundering app, Snapchat, which famously lost $1.3 billion in value when reality star Kylie Jenner tweeted that she no longer used the app, but the negativity associated with the share structure has made it difficult to attract institutional investors, especially those with a history of activism. Although there was a net increase of $8.8 million in institutional ownership in the company for the quarter ending March 2018, the approximate 20% total institutional ownership is below average for the Internet software/services industry and the increase in the quarter resulted from purchases by 2 institutions where 8 others decreased their holdings.
Moreover, many institutions, including pension funds, have holdings in Snap because they buy index funds, including ETFs, and Snap is in the S&P 500. The Council of Institutional Investors has even sent Snap a letter urging it to reconsider its share structure.
The discussion has gained regulatory attention as well. On February 15, 2018, SEC Commissioner Robert J. Jackson Jr. gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” in which he talked about the detriments of closely held perpetual control stock in a public company.
Days prior to Commissioner Jackson’s speech, Commissioner Kara Stein gave a speech at Stanford University about the role of corporate shareholders. Commissioner Stein posits that the relationship between a company and its shareholders should be mutual, including in areas involving cyber threats, board composition, shareholder activism and dual-class capital structures. Stein sees dual-class structures as purposefully disenfranchising shareholders and being inherently undemocratic.
Perhaps feeling the pressure, on May 2, 2018, Zynga founder Mark Pincus announced he will convert his super-voting preferred stock into common stock, eliminating the company’s dual-class structure. As a result of the conversion, Pincus’ voting power was reduced from 70% to 10%. His prior 10% economic stake remains unchanged.
SEC Commissioner Robert J. Jackson Jr.’s Speech: Perpetual Dual-Class Stock: The Case Against Corporate Royalty
On February 15, 2018, SEC Commissioner Robert J. Jackson Jr., gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” at the University of California, Berkley campus. Commissioner Jackson began the substantive portion of his speech with a summary background of a dual-class stock structure. I’ve supplemented his explanation with additional information.
Dual-class voting typically involves two more or more classes of stock, with one class having significantly more voting power than the others. The higher voting shares are often called “super-voting.” Typically, in a dual-class structure, the equity issued to the public is common equity with one vote per share and equity issued to insiders would be super-voting preferred stock. A company may also have other classes of preferred stock with various rights issued to different investors. Snap’s issuance of non-voting common stock to the public takes this structure one step further.
Historically, the NYSE did not allow companies to go public with dual-class voting structures. However, the takeover battles in the 1980s resulted in a change in the rules to allow for insider and management anti-takeover voting protection. Today, it is common for companies to go public with dual classes of voting stock. Public companies using dual-class are today worth more than $5 trillion, and more than 14% of the 133 companies that listed on U.S. exchanges in 2015 have dual-class voting. That compares with 12% of firms that listed on U.S. exchanges in 2014, and just 1% in 2005. Nearly half of the companies with dual-class shares give corporate insiders super-voting rights in perpetuity.
Commissioner Jackson acknowledges the reasons for a dual-class structure, and the desire by entrepreneurs and founders to go public while retaining control; however, he also quickly asserts that such a structure undermines accountability. Prior to accessing public markets, management control is beneficial in that it allows visionaries and entrepreneurs to innovate and disrupt industries without the short-term pressure of a loss of control over their efforts. However, perpetual outsized voting rights not only provide ultimate control to founders and entrepreneurs, but to their heirs as well, who may or may not be strong managers, entrepreneurs and visionaries.
Although many market players are recently strongly advocating for a change in rules to prohibit companies from going public with a dual-class structure, Commissioner Jackson advocates a change such that a dual-class structure has a time limit or expiration date. There may be benefits to management control for a period of time, but that benefit ultimately runs out after a company is public and certainly once the founding management retires, leaves, passes away or otherwise ceases their entrepreneurial run. He suggests that the exchanges propose amended rules in this regard.
Commissioner Jackson waxes philosophical pointing out the foundation of the United States origins, the Constitution and government structure, all of which are designed to allow for a change in regime and a vote by the masses. Even in public markets, power is not meant to continue in perpetuity, which is one of the reasons that the U.S. requires public companies to report and provide disclosure to investors and shareholders. Jackson likens perpetual super-voting stock as creating corporate royalty.
However, for the sake of the debate, I note that in the free market system, it is likely that if management that holds super-voting shares does not perform, the underlying business will lose value, consumers will stop buying the product, and institutions will stop owning the stock and investing. The corporate royalty would then be under self-preserving pressure to be acquired by a stronger competitor with a better management team.
In fact, Jackson continues his speech with analytics indicating that companies with super-voting insider control, do not perform as well as their counterparts. A recent study by Martijn Cremers, Beni Lauterbach, and Anete Pajuste entitled The Life-Cycle of Dual-Class Firms (Jan. 1, 2018) shows that the costs and benefits of dual-class structures change over time, with such companies trading at a premium shortly after the IPO, but decreasing over time.
Jackson’s staff studied 157 dual-class IPOs that occurred within the past 15 years. Of the 157 companies, 71 had sunset provisions or provisions that terminated the dual-class structure over time, and 86 gave insiders control forever. Whereas the companies traded relatively equally for the first few years, after seven years, those with a perpetual dual-class structure traded at a substantial discount to the others. Furthermore, when a company with a perpetual dual-class structure voluntarily eliminated the second control class, there was a significant increase in valuation.
As mentioned, institutional investors and market participants have vocally opposed dual-class structures for public companies. In December 2017, the Investor as Owner Subcommittee of the SEC’s Investor Advisory Committee published a report entitled Discussion Draft: Dual Class and Other Entrenching Governance Structures in Public Companies strongly opposing the structure. In addition to its letter to Snap, the Council of Institutional Investors has published a page on its website discussing and advocating for one-share equal voting rights for public companies.
Furthermore, the FTSE Russell index will now exclude all companies whose float is less than 5% of total voting power, the S&P Dow will now exclude all dual-class companies and the MSCI will reduce dual-class companies from its indexes. Commissioner Jackson is concerned that excluding dual-class stock companies from indexes does more harm than good. Many Main Street investors own public equities through funds or ETFs that in turn either own or mirror indexes. By removing dual-class companies from index funds, Main Street investors lose the opportunity to invest in these companies, some of which are the most innovative in the country today.
Commissioner Jackson’s suggestion of finding a middle ground whereby a company could complete an IPO with a dual-class structure and allow its visionaries to build without short-term shareholder pressure, but then limiting that sole control to a defined period, was met with praise and approval. Several market participants, including the SEC’s Investor Advisory Committee and the Council of Institutional Investors, made comments supporting the suggestion.
More on Preferred Equity
Although the topic of super-voting features in dual-class stock structures has been hotly debated recently, it is not the only feature that may be in preferred stock. Preferred stock is the most commonly used investment instrument due to its flexibility. Preferred stock can be structured to offer all the characteristics of equity as well as of debt, both in financial and non-financial terms. It can be structured in any way that suits a particular deal. The following is an outline of some of the many features that can be included in a preferred stock designation:
- Dividends – a dividend is a fixed amount agreed to be paid per share based on either the face value of the preferred stock or the price paid for the preferred stock (which is often the same); a dividend can be in the form of a return on investment (such as 8% per annum), the return of investment (25% of all net profits until the principal investment is repaid) or a combination of both. Although a dividend can be structured substantially similar to a debt instrument, there can be legal impediments to a dividend payment and a creditor generally takes priority over an equity holder. The ability of an issuer to pay a dividend is based on state corporate law, the majority of which require that the issuer be solvent (have the ability to pay creditors when due) prior to paying a dividend. Accordingly, even though the issuer may have the contractual obligation to pay a dividend, it might not have the ability (either legally or monetarily) to make such payments;
– As a dividend may or may not be paid when promised, a dividend either accrues and cumulates (each missed dividend is owed to the preferred shareholder) or not (we didn’t get the dividend this quarter, but hopefully next);
– Although a dividend payment can be structured to be paid at any interval, payments are commonly structured to be paid no more frequently than quarterly, and often annually;
– Dividends on preferred stock are generally preferential, meaning that any accrued dividends on preferred stock must be fully paid before any dividends can be paid on common stock or other junior securities;
- Voting Rights – as discussed, preferred stock can be set up to establish any level of voting rights from no voting rights at all, voting rights on certain matters (sole vote on at least one board seat; voting rights as to the disposition of a certain asset but otherwise none), or super-voting rights (such as 10,000 to 1 or 51% of all votes);
- Liquidation Preferences – a liquidation preference is a right to receive a distribution of funds or assets in the event of a liquidation or sale of the company issuer. Generally creditors take precedence over equity holders; however, preferred stock can be set up substantially similar to a debt instrument whereby a liquidation preference is secured by certain assets, giving the preferred stockholder priority over general unsecured creditors vis-à-vis that asset. In addition, a liquidation preference gives the preferred stockholder a priority over common stockholders and holders of other junior equities. The liquidation preference is usually set as an amount per share and is tied into the investment amount plus accrued and unpaid dividends;
– In addition to a liquidation preference, preferred stockholders can partake in liquidation profits (for example, preferred stockholder gets entire investment back plus all accrued and unpaid dividends, plus 30% of all profits from the sale of the company issuer; or preferred stockholder gets entire investment back plus all accrued and unpaid dividends and then participates pro rata with common stockholders on any remaining proceeds (known as a participating liquidation preference);
- Conversion or exchange rights – a conversion or exchange right is the right to convert or exchange into a different security, usually common stock;
– Conversion rights include a conversion price which can be set as any mathematical formula, such as a discount to market (75% of the average 7-day trading price immediately prior to conversion); a set price per share (preferred stock with a face value of $5.00 converts into 5 shares of common stock thus $1.00 per share of common stock); or a valuation (converts at a company valuation of $30,000,000);
– Conversion rights are generally at the option of the stockholder, but the issuer can have such rights as well, generally based on the happening of an event such as a firm commitment underwriting (the issuer has the right to convert all preferred stock at a conversion price of $10.00 per share upon receipt of a firm commitment for the underwriting of a $50,000,000 IPO);
– The timing of conversion rights must be established (at any time after issuance; only between months 12 and 24; within 90 days of receipt of a firm commitment for a financing in excess of $10,000,000);
– conversion rights usually specify whether they are in whole or in part and, for public companies, limits are often set (conversion limited such that cannot own more than 4.99% of outstanding common stock at time of conversion);
- Redemption/put rights – a redemption right in the form of a put right is the right of the holder to require the issuer to redeem the preferred stock investment (to “put” the preferred stock back to the issuer); the redemption price is generally the face value of the preferred stock or investment plus any accrued and unpaid dividends; redemption rights generally kick in after a certain period of time (5 years) and provide an exit strategy for a preferred stock investor;
- Redemption/call rights – a redemption right in favor of the issuer is a call option (the issuer can “call” back the preferred stock); generally when the redemption right is in the form of a call a premium is placed on the redemption price (for example, 125% of face value plus any accrued and unpaid dividends or a pro rata share of 2.5 times EBITDA);
- Anti-dilution protection – anti-dilution protection protects the investor from a decline in the value of their investment as a result of future issuances at a lower valuation. Generally the issuer agrees to issue additional securities to the holder, without additional consideration, in the event that a future issuance is made at a lower valuation such as to maintain the investors overall value of investment; an anti-dilution provision can also be as to a specific percent ownership (the holder will never own below 10% of the total issued capital of the issuer);
- Registration rights – registration rights refer to SEC registration rights and can include demand registration rights (the holder can demand that the issuer register their equity securities) or piggyback registration rights (if the issuer is registering other securities, it will include the holder’s securities as well);
- Transfer restrictions – preferred stock can be subject to transfer restrictions, either in the preferred stock instrument itself or separately in a shareholder’s or other contractual agreement; transfer restrictions usually take the form of a right of first refusal in favor of either the issuer or other security holders, or both;
- Co-sale or tag along rights – co-sale or tag-along rights are rights of holders to participate in certain sales of stock by management or other key stockholders;
- Drag-along rights – drag-along rights are the rights of the holder to require certain management or other key stockholders to participate in a sale of stock by the holder;
- Other non-financial covenants – preferred stock, either through the instrument itself or a separate shareholder or other contractual agreement, can contain a myriad of non-financial covenants, the most common being the right to appoint one or more persons to the board of directors and to otherwise assert control over management and operations; other such rights include prohibitions against related party transactions; information delivery requirements; non-compete agreements; confidentiality agreements; limitations on management compensation; limitations on future capital transactions such as reverse or forward splits; prohibitions against the sale of certain key assets or intellectual property rights; in essence non-financial covenants can be any rights that the preferred stockholder investor negotiates for.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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