NASDAQ And NYSE American Shareholder Approval Requirements– Change Of Control

by Laura Anthony, Esq. on April 09, 2019 in NASDAQ, NASDAQ Listing Requirements, NYSE

Nasdaq and the NYSE American both have rules requiring listed companies to receive shareholder approval prior to issuing securities in an amount of 20% or more of their outstanding common stock or voting power or prior to completing transactions which will result in a change of control of the company.  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.  In the first blog in this series I detailed the 20% Rule related to acquisitions, and its cohort, the Acquisition Rule.  In this blog I am detailing the shareholder approval requirements related to transactions resulting in a change of control of the company.  Other Exchange Rules interplay with the rules requiring shareholder approval for equity issuances that affect control of the company.  For example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to issuing securities that may potentially result in a change of control of the company.   

Nasdaq Rule 5635(b)

Nasdaq Rule 5635(b) requires shareholder approval prior to the issuance of securities when the issuance or potential issuance will result in a change of control of the company.  The change of control rule only applies where the change is as a result of the issuance of securities and accordingly, where a change of control occurs without the issuance of securities (such as through the appointment of new board members or the private sale of a control block), no shareholder approval is required. 

NYSE American Company Guide Sections 713

Substantially similar to Nasdaq, the NYSE American Company Guide Section 713(b) requires shareholder approval prior to the listing of additional shares when the issuance or potential issuance will result in a change of control of the company, including, but not limited to, in reverse merger transactions.

Interpretation and Guidance

                Defining Change of Control

In determining whether a change of control has occurred, the Exchange will consider all relevant factors including, but not limited to, post-transaction stock ownership, changes in the management, board of directors, voting power, nature of the business, relative size of the entities, and financial structure of the company.  Generally, if a transaction results in an investor or group of investors obtaining a 20% interest or a right to acquire that interest in a company on a post-transaction basis, and that ownership position would be the largest, the transaction may be presumed to be a change of control and should be carefully reviewed.

Moreover, a change of control can occur when a current control shareholder obtains a higher percentage of the company and thus a new control position.  Nasdaq guidance indicates that if a company’s largest shareholder moves from holding below 20% of the outstanding securities to holding in excess of 20% as a result of a new share issuance, a change of control transaction will have occurred requiring shareholder approval.   

The change of control test is subjective and the Exchanges should be consulted before entering into a transaction which could invoke 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 change of control Rule.  Where a company has multiple classes of common stock, all classes are counted in the amount outstanding, even if one or more class does not trade on the Exchange. 

Although the change of control rules do not specifically refer to voting power, guidance related to the rules clearly indicate that a change in voting power can constitute a change in control (see “Defining Change of Control” above).  Voting power outstanding prior to a transaction 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 change of control 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.”

A company that enters into a transaction with variable priced securities must consider whether the conversion could result in a change of control requiring shareholder approval (in addition to the 20% Rule).  The Exchanges 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 a change of control is possible, and that shareholder approval will be required.  Furthermore, even if variable priced securities contain a share cap, a change of control could still result, requiring shareholder approval (see definition of change of control above).

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; (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 share issuance transactions that occur within close proximity of a transaction in determining whether a change of control has occurred.  Factors that the Exchanges will consider include: (i) the proximity of the financing or transactions involving share issuances; (ii) timing of board approvals; (iii) and stated contingencies in the documents (such as voting rights and board seats). 

                Public Offering

Although the change of control rule does not have an explicit public offering exemption, generally the Exchanges will not require a bona fide public offering to first obtain shareholder approval, even if it would result in a change of control.  As a reminder, 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.  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.  Although the change of control rule does not specifically state an amount of shares that would trigger the rule, companies generally feel comfortable setting share caps at 19.99% (or 4.9% for a reverse acquisition/reverse merger with an interested party that would trigger the Acquisition Rule) when structuring a transaction that could result in a change of control.  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.   

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 obtain control over the company – including, e.g., control over the board of directors.  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.  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 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. 

                Consequences for Violation

Consequences for the violation of the shareholder voting requirements related to a change of control 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 Author

Laura Anthony, Esq.

Founding Partner

Anthony L.G., PLLC

A Corporate Law Firm

LAnthony@AnthonyPLLC.com

Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC 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, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with 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; 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 American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA 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 small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

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