Monthly Archives: March 2019
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.
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.
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.”
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.
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.