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
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.
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.
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.
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.
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.