The Demise of the Death Spiral – SEC Interpretation of Rule 415
Without fanfare, publications, or other notice, in mid 2006, PIPE investors and the Issuers that utilized them noticed a big difference in the way that the Securities and Exchange Commission’s (SEC) division of corporate finance reviewed and commented upon, resale registration statements. Although the SEC staff contended that its position on Rule 415 had not changed, there was, incontrovertibly, a dramatic impact felt by Issuers and PIPE investors.
For years, Issuers had relied upon Rule 415 in order to register the resale of shares issued in PIPE transactions (a “secondary offering”). Rule 415 governs the registration requirements for the sale of securities to be offered on a delayed or continuous basis, such as in the case of the take down or conversion of convertible debt and warrants. In the years prior to 2006, Issuers would register shares they sold in a PIPE transaction, which could represent in excess of 50% of their outstanding public float.
Convertible Debt and Subsequent Resale
In a typical convertible debt and/or warrant PIPE transaction, the exercise price to convert the debt or warrant was based on a discount to current market price. Accordingly, the PIPE investor would convert a small percentage of the debt or warrant into common shares and immediately sell those shares on the open market, thus forcing down the price of the stock. The PIPE investor would then convert another small percentage of the debt or warrant at a discount to the new lower market price and again immediately re-sell the shares, further depressing the market price. This process could continue infinitum until all of the debt or warrants had been converted leaving the Company’s stock price considerably lower than where it started. Thus the term “death spiral”.
The SEC recognized this pattern and the negative effect it had on the marketplace. Beginning in mid 2006, the SEC staff began tightening the availability of Rule 415 for secondary offerings, particularly where the number of shares being registered exceeded 30% of the Issuers public float. The SEC was able to do this without rule amendments or such by simply taking the position that the registration of in excess of 30% of the public float should be closely reviewed and possibly considered a primary offering and not a secondary offering at all. A primary offering is one where the securities are being sold by the Issuer (or in this case on behalf of the Issuer) as opposed to a third party, such as a PIPE investor.
Primary versus Secondary Offerings
The consequences of deeming an offering a primary offering as opposed to a secondary offering are two-fold. First, Rule 415, the rule that allows securities to be registered for sale on a delayed or continuous basis, is generally unavailable for primary offerings by small business issuers. Second, a primary offering requires that each of the investors named as a selling security holder be identified as an underwriter. Underwriter status exposes the named underwriter to full liability for any misstatements or omissions in that registration statement (subject to a due diligence defense). Most PIPE investors want to be just that, investors, not guarantors of the statements, or misstatements, of an Issuer.
The SEC staff made it clear that its interpretation of Rule 415 was meant to curtail death spirals and other “toxic offerings” which tended to flood the market with penny stocks whose value continued to decline. The SEC’s efforts worked. Since mid 2006 the number of Rule 415 registered PIPE offerings declined dramatically. Prominent PIPE investors such as Cornell Capital and the Laurus Fund significantly decreased their investments in small business issuers.
Small business issuers found it considerably harder to attract PIPE and other speculative investors. In fact, it is the pressure from these small business issuers that has since prompted other changes in federal securities laws, such as the decreased holding period under Rule 144, and the use of registration exemptions to lure investors, such as Section 3(a)(9) and (10) of the Securities Act.
Reverse Merger Exceptions
It should be noted as well, that in the past year, the SEC staff is again routinely allowing the registration of securities in excess of 30% of the public float in cases where the registrant was a shell company and has just completed a reverse merger or other transaction that causes it to cease being a shell company. Presumably this has been to assist small business issuers attract investors following the depressive effects of the prohibition of the use of Rule 144 for companies that are or become shell companies.
Securities attorney Laura Anthony provides expert legal advice and ongoing corporate counsel to small public Companies as well as private Companies seeking to go public on the Over the Counter Bulletin Board Exchange (OTCBB). Ms. Anthony counsels private and small public Companies nationwide regarding reverse mergers, due diligence on public shells, corporate transactions and all aspects of securities law.
Ms. Anthony is the Founding Partner of Legal & Compliance, LLC, a national corporate, securities and civil litigation law firm based in West Palm Beach, Florida. The firm’s corporate and securities attorneys provide technical legal services to small and mid-size private and public (OTCBB) Companies, entrepreneurs, and business professionals nationwide. Contact us today for a FREE consultation!