Monthly Archives: April 2019
Recently the Delaware Chancery Court rejected an interested executive’s defense of a breach of fiduciary duty claim, reminding us of the importance of making full and accurate disclosures when seeking shareholder approval for a merger or acquisition transaction. In particular, in the case of In re Xura, Inc. Stockholder Litigation the Delaware Chancery Court denied a motion to dismiss brought against a merger target company’s CEO, alleging that he had orchestrated the company’s sale to a particular bidder based on his self-interest in the outcome of the transaction.
The CEO argued that his actions should have been judged by the deferential business judgement rule and not a higher entire fairness standard because the transaction was approved by a majority of the disinterested shareholders. The CEO relied on the 2015 Delaware Supreme Court case of Corwin v. KKR Financing Holdings which held that a transaction that would be subject to enhanced scrutiny would instead be reviewed under the deferential business judgment rule after it was approved by a majority of fully informed stockholders. However, the Court found that the stockholder’s vote was not fully informed as the proxy statement failed to make numerous material disclosures and, as such, could not be used as the usual defense for officers and directors with a stake in the outcome of a transaction.
Board of Directors’ and Key Officers Fiduciary Duties in the Merger Process
State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors. Members of the board of directors have a fiduciary relationship to the corporation, which requires that they act in the best interest of the corporation, as opposed to their own. Key executive officers have a similar duty. Generally a court will not second-guess directors’ decisions as long as the executives have conducted an appropriate process in reaching its decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).
However, in certain instances, such as in a merger and acquisition transaction, where a board or top executives may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash or job security), the board of directors’ and executives actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule” and stems from the Unocal and Revlon cases discussed below, both of which involved hostile takeovers.
A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving officers, directors and/or shareholders such as where directors are on both sides of the transaction. Under the entire fairness standard, the executives must establish that the entire transaction is fair to the shareholders, including both the process and dealings and price and terms. The entire fairness standard is a difficult bar to reach and generally results in in a finding in favor of complaining shareholders.
In all matters, directors’ and executive officers’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure. In short, the duty of care requires the director/officer to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances of that particular corporation. The duty of loyalty requires that there be no conflict between duty and self-interest. The duty of disclosure requires the director/officer to provide complete and materially accurate information to a corporation. Where a director’s duty is to the shareholders, an executive officer can have duties to both the board of directors and the shareholders.
As with many aspects of securities law, and the law in general, a director’s or officer’s responsibilities and obligations in the face of a merger or acquisition transaction depend on the facts and circumstances. From a high level, if a transaction is not material or only marginally material to the company, the level of involvement and scrutiny facing the board of directors or key executives is reduced and only the basic business judgment rule will apply. For instance, in instances where a company’s growth strategy is acquisition-based, the board of directors may set out the strategy and parameters for potential target acquisitions but leave the completion of the acquisitions largely with the C-suite executives and officers who, in turn, will be able to exercise their business judgment in implementing the transactions.
Moreover, the director’s responsibilities must take into account whether they are on the buy or sell side of a transaction. When on the buy side, the considerations include getting the best price deal for the company and integration of products, services, staff, and processes. On the other hand, when on the sell side, the primary objective is maximizing the return to shareholders, though social interests and considerations (such as the loss of jobs) may also be considered in the process.
The law focuses on the process, steps and considerations made by the board of directors and executive officers, as opposed to the actual final decision. The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors and officers in the face of scrutiny. Courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; requests for information from management; and requests for and review of documents and contracts.
In the performance of their obligations and fiduciary responsibilities, a board of directors and executive officers may, and should, seek the advice and counsel of third parties, such as attorneys, investment bankers, and valuation experts. Moreover, it is generally good practice to obtain a third-party fairness opinion on a transaction. Most investment banking houses that do M&A work also provide fairness opinions on transactions. Furthermore, most firms will prepare a fairness opinion even if they are not otherwise engaged or involved in the transaction. In addition to adding a layer of protection to the board of directors and executives, the fairness opinion is utilized by the accountant and auditor in determining or supporting valuations in a transaction, especially where a related party is involved. This firm has relationships with many firms that provide such opinions and encourage our clients to utilize these services.
Delaware Case Law
As with all standards of corporate law, practitioners and state courts look to both Delaware statutes and court rulings to lead the way.
Stemming from Revlon, Inc. vs. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), once a board of directors has made the decision to sell or merge the company, it triggers additional duties and responsibilities, commonly referred to as the “Revlon Duties.” The Revlon Duties provide that once a board has made a decision to sell, it must consider all available alternatives and focus on obtaining the highest value and return for the shareholders. The Revlon case focuses on duties in a sale or breakup of a company rather than a forward growth acquisition. A board of directors in a Revlon situation is, in essence, acting as an auctioneer seeking the best return. However, although the premise of Revlon remains, later decisions take into account the reality that the highest return for shareholders is not strictly limited to dollars received.
Company executives do not have to decide to sell just because an offer has been made. Prior to Revlon, in the case of Unocal vs. Mesa Petroleum, 493 A.2d 946 (Del. 1985), the court found that a board of directors may take defensive measures in the face of a hostile takeover attempt and may consider the preservation of corporate policy and effectiveness of business operations in defending against a takeover. However, once the board has made the decision that a sale or breakup is imminent, the Revlon Duties are invoked and preservation of corporate policy and operations is no longer a deciding factor.
In the case of Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985), the Court found that the board was grossly negligent where it approved the sale of the company after only a few hours of deliberation, failed to inform itself of the chairman’s role and benefits in the sale, and did not seek the advice of outside counsel. Similarly in Cede & Co. vs. Technicolor, Inc., 634 A.2d 345 (Del. 1993), the court found that the board was negligent in approving the sale of a company where it did not search for real alternatives, did not attempt to find a better offer, and had insufficient knowledge of the terms of the proposed merger agreement.
On the other hand, the court in In re CompuCom Sys., Inc. Shareholders Litigation, 2005 Del. Ch. LEXIS 145 (Del. Ch. Sept. 29, 2005), upheld the board of directors’ business judgment even though the transaction price per share was less than market value, as the board showed it was adequately informed, acted rationally and sought better deals.
In Family Dollar Stores, Inc. Stockholder Litigation, C.A. No. 9985-CB (Del. Ch. Dec. 19, 2014), the court continued to apply the Revlon Duties but supported Family Dollar Stores’ decision to reject Dollar General Corp.’s higher dollar offer in favor of seeking a shareholder vote on Dollar Tree, Inc.’s offer. The court found that the board properly considered all factors, including an evaluation of the relative antitrust risks of selling to either suitor. The court upheld the board’s process in determining maximum value for shareholders, and that such determination is not solely based on a price per share value.
Cleansing Through Shareholder Approval
In 2015 the Delaware Supreme Court case of Corwin v. KKR Financing Holdings held that a transaction that would be subject to enhanced scrutiny under Revlon would instead be reviewed under the deferential business judgment rule after it was approved by a majority of disinterested, fully informed and uncoerced stockholders. In addition to federal securities law requirements imposed on public companies, Delaware law requires disclosure of all material facts when stockholders are requested to vote on a merger. (For more on materiality and the duty to disclose, see HERE and HERE . Corwin provides a strong incentive for companies to ensure full disclosure and as discussed below, based on the new case of In re Xura, Inc. Stockholder Litigation the failure to provide such disclosure may nullify the otherwise strong Corwin defense.
Following the Corwin decision, several Delaware courts enhanced the ruling, finding that the business judgment rule becomes irrebuttable if invoked as a result of a stockholder vote; Corwin is not limited to one-step mergers and thus also applies where a majority of shares tender into a two-step transaction; the ability of plaintiffs to pursue a “waste” claim is exceedingly difficult; even interested officers and directors can rely on the business judgement rule following Corwin doctrine stockholder approval; and if directors are protected under Corwin, aiding and abetting claims against their advisors will also be dismissed.
Once the business judgment rule is invoked, a shareholder generally only has a claim for waste, which is a difficult claim to prove. Corwin makes it difficult for plaintiffs to pursue post-closing claims (including those that would have nuisance value) because defendants will frequently be able to dismiss the complaint at the pleading stage based on the stockholder vote. It is thought that Corwin will help reduce M&A-based litigation which has become increasingly abusive over the years and imposes costs on companies, its stockholders and the marketplace.
Corwin should also be considered in conjunction with the Delaware Supreme Court’s 2014 decision in Cornerstone Therapeutics Inc. Shareholder Litigation in which the Supreme Court held that directors can seek dismissal even in an entire fairness case unless the plaintiff sufficiently alleges that those directors engaged in non-exculpated conduct (i.e., disloyal conduct or bad faith). Cornerstone generally allows an outside, independent director to be dismissed from litigation challenging an interested transaction unless the plaintiff alleges a breach of the duty of loyalty against that director individually. The Corwin case goes further by providing that if there is an informed stockholder vote, then directors who are interested or lack independence can obtain dismissal without having to defend the fairness of the transaction.
Although following Corwin a string of cases strengthened and expanded its doctrine, the recent (December 2018) case of In re Xura, Inc. Stockholder Litigation reminded the marketplace that in order for Corwin to provide its protections, the stockholder approval must be fully informed. In Xura the court found that the disclosures made by the CEO to the board of directors and shareholders and that ultimately were included in the company’s proxy statement were so deficient as to preclude a fully informed, uncoerced decision. The takeaway from Xura is that despite growing officer/director protections in an M&A transaction, process and disclosure remain the bedrock of any defense.
Conflicts of Interest – the Entire Fairness Standard
The duty of loyalty requires that there be no conflict between duty and self-interest. Basically, an officer or director may not act for a personal or non-corporate purpose, including to preserve their job or position. Where a transaction is not cleansed using the Corwin doctrine, where an officer or director is interested in a transaction, the entire fairness standard of review will apply. It is very difficult for an officer or director to defeat a claim where a transaction is being reviewed under the entire fairness standard.
Some states, including Delaware, statutorily codify the duty of loyalty, or at least the impact on certain transactions. Delaware’s General Corporations Law Section 144 provides that a contract or transaction in which a director has interest is not void or voidable if: (i) a director discloses any personal interest in a timely matter; (ii) a majority of the shareholders approve the transaction after being aware of the director’s involvement; or (iii) the transaction is entirely fair to the corporation and was approved by the disinterested board members.
The third element listed by the Delaware statute has become the crux of review by courts. That is, where an executive is interested, the transaction must be entirely fair to the corporation (not just the part dealing with the director). In determining whether a transaction is fair, courts consider both the process (i.e., fair dealing) and the price of the transaction. Moreover, courts look at all aspects of the transaction and the transaction as a whole in determining fairness, not just the portion or portions of the transaction involving a conflict with the executive. The entire fairness standard can be a difficult hurdle and is often used by minority shareholders to challenge a transaction where there is a potential breach of loyalty and where such minority shareholders do not think the transaction is fair to them or where controlling shareholders have received a premium.
To protect a transaction involving an interested executive, it is vital that all officers and directors take a very active role in the merger or acquisition transaction; that the interested executive inform both the directors or other directors, and ultimately the shareholders, of the conflict; that the transaction resemble an arm’s-length transaction; that it be entirely fair; and that negotiations be diligent and active and that the advice and counsel of independent third parties, including attorneys and accountants, be actively sought.
Delaware courts have emphasized that involvement by disinterested, independent directors increases the probability that a board’s decisions will receive the benefits of the business judgment rule and helps a board justify its action under the more stringent standards of review such as the entire fairness standard. Independence is determined by all the facts and circumstances; however, a director is definitely not independent where they have a personal financial interest in the decision or if they have domination or motive other than the merits of the transaction. The greater the degree of independence, the greater the protection. As mentioned, many companies obtain third-party fairness opinions as to the transaction.
Exculpation and Indemnification
Many states’ corporate laws allow entities to include provisions in their corporate charters allowing for the exculpation and/or indemnification of directors. Exculpation refers to a complete elimination of liability, whereas indemnification allows for the reimbursement of expenses incurred by an officer or director. Delaware, for example, allows for the inclusion of a provision in the certificate of incorporation eliminating personal liability for directors in stockholder actions for breaches of fiduciary duty, except for breaches of the duty of loyalty that result in personal benefit for the director to the detriment of the shareholders. Indemnification generally is only available where the director has acted in good faith. Exculpation is generally only available to directors, whereas indemnification is available to both officers and directors.
To show that a director acted in good faith, the director must meet the same general test of showing that they met their duties of care, loyalty and disclosure. The best way to do this is to be fully informed and to participate in the process, whether that process involves a merger or acquisition or some other business transaction. As mentioned above, courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; requests for information from management; and requests for, and review of, documents and contracts.
In advising the board of directors and executive officers, counsel should stress that the executive be actively involved in the business decision-making process, review the documents and files, ask questions and become fully informed. The higher the level of diligence, the greater the protection. Furthermore, an executive must fully and completely inform its fellow executives, board members and shareholders of all facts and circumstances and any potential self-interest.
Significantly, it is not important whether the decision ultimately turns out to be good or bad. Hindsight is 20/20. The important factor in seeking protection (via the business judgment rule, and through exculpation and indemnification) is that best efforts are made.
In March, SEC Chairman Jay Clayton and Brett Redfearn, Director of the Division of Trading and Markets, gave a speech to the Gabelli School of Business at Fordham University regarding the U.S. equity market structure, including plans for future reform. Chair Clayton begins his remarks by praising the Treasury Department’s four core principles reports. In particular, the Treasury Department has issued four reports in response to an executive order dated February 3, 2017 requiring it to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system.
The four reports include thorough discussions and frame the issues on: (i) Banks and Credit Unions; (ii) Capital Markets (see my blog HERE); (iii) Asset Management and Insurance; and (iv) Nonbank Financials, Fintech and Innovation (see my blog HERE).
The executive order dated February 3, 2017 directed the Treasury Department to issue reports with the following objectives:
- Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
- Prevent taxpayer-funded bailouts;
- Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
- Enable American companies to be competitive with foreign firms in domestic and foreign markets;
- Advance American interests in international financial regulatory negotiations and meetings;
- Make regulation efficient, effective, and appropriately tailored; and
- Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.
Chair Clayton and Director Redfearn began with a review of the recently adopted SEC’s initiatives related to market structure. In particular, In 2018, the SEC: (i) adopted the transaction fee pilot; (ii) adopted rules to provide for greater transparency of broker order routing practices; and (iii) adopted rules related to the operational transparency of alternative trading systems (“ATSs”) that trade national market system (“NMS”) stocks. The new rules were designed to increase efficiency in markets and importantly provide more transparency and disclosure to investors.
Clayton and Redfearn then turned to the equity market structure agenda for 2019, which is focused on a review and possible overhaul to Regulation NMS. Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.
In recent roundtables on the topics of the market structure for thinly traded securities, regulatory approaches to combating retail fraud, and market data and market access, Chair Clayton and Director Redfearn realized the impact of Regulation NMS on these matters. Each of these topics were then addressed.
Thinly Traded Securities
Regulation NMS mandates a single market structure for all exchange-listed stocks, regardless of whether they trade 10,000 times per day or 10 times per day. The relative lack of liquidity in the stocks of smaller companies not only affects investors when they trade, but also detracts from the companies’ prospects of success. Illiquidity hampers the ability to raise additional capital, obtain research coverage, engage in mergers and acquisitions, and hire and retain personnel. Furthermore, securities with lower volumes have wider spreads, less displayed size, and higher transaction costs for investors.
One idea to improve liquidity is to restrict unlisted trading privileges while continuing to allow off-exchange trading for certain thinly traded securities. Similar to market maker piggyback rights for OTC traded securities, when a company goes public on an exchange, other exchanges can also trade the same security after the first trade on the primary exchange. This is referred to as unlisted trading privileges or UTP. Where a security is thinly traded, allowing trading on multiple platforms can exacerbate the issue. If all trading is executed on a single exchange, theoretically, the volume of trading will increase.
Moreover, institutions are particularly hampered from trading in thinly traded securities as a result of Regulation NMS. That is, the Regulation requires that an indication of interest (a bid) be made public in quotation mediums which indication could itself drive prices up. The risk of information leakage and price impact has been quoted as a reason why a buy-side trader would avoid displaying trading interest on an exchange in the current market structure.
Combating Retail Fraud (Rule 15c2-11; Penny Stocks and Transfer Agents)
The SEC has clearly been focused on retail fraud, and in particular with respect to micro-cap and digital asset securities, under the current regime. The SEC has actively pursued suspected retail fraud and scams in the last few years with the bringing of multiple enforcement actions and imposition of trading suspensions.
In that regard, I was pleased to learn from the speech that the SEC intends to review Rule 15c-211. I’ve written about 15c2-11 many times, including HERE. In that blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11. FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA.
The specific information required to be maintained by the broker-dealer is delineated in Securities Act Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace. The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or under Regulation A and quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv).
The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted on at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed and approved by FINRA by a market maker and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.
Rule 15c2-11 was enacted in 1970 to ensure that proper information was available prior to quoting a security in an effort to prevent micro-cap fraud. At the time of enactment of the rule, the Internet was not available for access to information. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Moreover, since enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures. The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through.
The entire industry agrees that 15c2-11 needs an overhaul and so again, I was very pleased that Chair Clayton and Director Redfearn acknowledge the issue. Chair Clayton has directed the Division of Trading and Markets staff to promptly prepare a recommendation to the SEC to update the rules. I hope that the SEC will review and consider the OTC Markets’ suggestions for modification of the rules, including (i) make the Form 211 process more objective and efficient (currently FINRA conducts a merit review as opposed to a disclosure review); (ii) Form 211 materials should be made public and issuers should be liable for any misrepresentations; (iii) Interdealer Quotation Systems should be able to review 211 applications from broker-dealers; and (iv) allow broker-dealers to receive expense reimbursement for the 211 due diligence process.
Chair Clayton and Director Redfearn also hit on penny stocks. Penny stocks are generally defined by Exchange Act Rule 3a51-1 as securities priced below $5.00. The world of penny stocks has taken a hit lately, with Bank of America and its brokerage Merrill Lynch exiting the space altogether (see HERE) and with a slew of enforcement proceedings against clearing firms that accept customer deposits of low-priced securities. Chair Clayton indicates that he has asked the SEC staff to review the sales practice requirements relating to penny stocks. Director Redfearn adds that the staff plans to re-examine the current exceptions from the definition of “penny stock” with a view of providing heightened protections for retail customers.
Unfortunately I think that the SEC groups a stock trading at $.01 with no current information as the same as an OTCQX or Nasdaq Capital Markets security trading at $1.50 that is current in all its SEC Reporting Obligations. Likewise, the SEC groups a zero-revenue OTC Pink no-information company with one with $10 million in annual revenues and consistent yearly growth. I agree 100% that there are companies in the micro-cap space that should not be there and are ripe for scammers and fraudulent activity, but there are also great companies that are supplying the lifeline of American jobs and economic growth. I am concerned about the current regulatory discrimination against all low-priced securities and hope that in its reviews and studies, the SEC staff recognizes the distinctions.
Director Redfearn also has his sights set on transfer agents, mentioning the 2015 Advance Notice of Proposed Rulemaking and Concept Release on Transfer Agents – see HERE. The goal is to move forward transfer agent rule making and to propose a specific rule related to the transfer agents’ obligations related to the tracking and removal of restrictive legends.
Market Data and Market Access
There are currently two main sources of market data and market access in the U.S. equity markets. The first is the consolidated public data feeds distributed pursuant to national market system plans jointly operated by the exchanges and FINRA. The second is an array of proprietary data products and access services that the exchanges and other providers sell to the marketplace. The second set generally are faster, more content-rich, and more costly than the consolidated data feeds.
The SEC is exploring improving the free data feeds issued by the exchanges and FINRA, including to improve speed, content, order protection and best execution, depth of information, governance, transparency and fair and efficient access to the information.
On April 3, 2019, the SEC’s Division of Corporation Finance published a “Framework for Investment Contract Analysis of Digital Assets,” issued a No-Action Letter to Turnkey Jet, Inc. and made a statement on both. Although all guidance is appreciated, there is really nothing new or different about the analysis, which is firmly based on SEC v. W.J. Howey Co. (the “Howey Test”). Moreover, as discussed below, even though the SEC found that Turnkey Jet did not need to comply with the federal securities laws in the issuance and sales of its tokens, the opinion and issued guidelines do not go far enough and still leave a great deal of uncertainty.
Framework for Investment Contract Analysis of Digital Assets
The SEC’s framework sets forth facts and circumstances to be considered in applying the Howey Test to determine if a digital asset is an investment contract and thus a security subject to state and federal securities laws in its issuance and subsequent re-sales. The U.S. Supreme Court’s Howey case and subsequent case law have found that an “investment contract” exists when there is (i) the investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits (iv) to be derived from the efforts of others. See by blog HERE for a general discussion of Howey HERE and HERE being applied to analyze a hypothetical token.
Howey doesn’t just examine the form of the asset or instrument itself (which, in the case of a digital asset, is computer code) but also the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold. The first prong of Howey, an investment of money, is usually easily satisfied as digital assets (or any investments) usually involve the exchange of money or other form of consideration. Case law progeny of Howey has long clarified that the “money” referred to in Howey can be any valid form of consideration or exchange of value.
In its framework analysis, the SEC points out that “bounty programs” also involve the exchange of value. As I discussed in this blog HERE, bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Bounty programs are a means of advertising and have gained in popularity in ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as registering at a website, reading and sharing materials, or marketing and making improvements to aspects of the cryptocurrency framework.
The second prong of Howey, a common enterprise, also typically exists where there is an issuance or sale of a digital asset. That is, investments in digital assets usually involve a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.
The third element of Howey, a reasonable expectation of profits, involves a more in-depth analysis. Profits can include capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings. Price appreciation resulting solely from external market forces impacting the supply and demand for an underlying asset generally is not considered “profit” under the Howey test. In analyzing whether there is a reasonable expectation of profits from an investment in a digital asset, the SEC considers:
- Whether the digital asset gives the holder rights to share in the enterprise’s income or profits or to realize gain from capital appreciation. This could be from dividends or distributions or capital appreciation from secondary trading markets;
- The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future (the SEC gives quite a bit of weight to this factor);
- Purchasers expect the efforts of others to result in capital appreciation;
- There is little apparent correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset;
- There is little apparent correlation between quantities the digital asset typically trades in (or the amounts that purchasers typically purchase) and the amount of the underlying goods or services a typical consumer would purchase for use or consumption;
- More money is raised than is needed to establish a functional network or digital asset;
- Money continues to be expended to increase and improve the value of the network or digital asset;
- The digital asset is marketed, directly or indirectly, using any of the following: (i) the expertise of an Active Participant or its ability to build and grow the network or digital asset value; (ii) that the digital asset is an investment; (iii) intended use of proceeds is to develop the network or the digital asset; (iv) touting the future functionality of the network or asset; (v) the promise to build a future business or operations; (vi) secondary market or transferability; (vii) potential profitability of the network; or (viii) capital appreciation of the digital asset.
- Related to a re-sale of a digital asset, further consideration should be given to (i) digital assets’ value separate from the continued development of a network; (ii) value of digital assets correlation to the good or service for which it can be exchanged; (iii) trading volume corresponds with level of demand for good or service for which it can be exchanged; (iv) whether network is built out and functionality of the digital asset; (v) whether economic benefit from appreciation is incidental to functionality; (vi) insiders’ access to material non-public information.
The fourth element of Howey, “derived from the efforts of others,” also involves a more in-depth analysis. When a promoter, sponsor, or other third party (i.e., “Active Participant”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met. A relevant portion of this inquiry is a review of the economic realities of the transaction, including the manner in which the digital asset is offered and sold.
The SEC focuses on two key issues:
- Does the purchaser reasonably expect to rely on the efforts of an Active Participant?
- Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature?
In answering these two fundamental questions, the SEC guidance lists the following characteristics that support a finding that the purchaser is relying on the efforts of others:
- An Active Participant is responsible for the development, improvement (or enhancement), operation, or promotion of the network;
- An Active Participant will perform tasks and responsibilities rather than decentralizing performance to the community. This factor is not eliminated just because some tasks are decentralized, but rather an analysis is made as to the significance of the tasks;
- An Active Participant creates or supports a market for, or the price of, the digital asset. This can include (i) controlling the creation and issuance of the digital asset; or (ii) taking other actions to support a market price of the digital asset, such as by limiting supply or ensuring scarcity, through, for example, buybacks, “burning,” or other activities.
- An Active Participant has a lead or central role in the direction of the ongoing development of the network or the digital asset – for example, deciding governance issues, code updates, or how third parties participate in the validation of transactions;
- An Active Participant has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including, for example: (i) determining the compensation for service providers; (ii) determining whether or where the digital asset will trade; (iii) determining the issuance of additional digital assets; (iv) making or contributing to managerial level business decisions; or (v) responsibility for security of the network.
- Purchasers would reasonably expect the Active Participant to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such (i) the Active Participant retains ownership and has the ability to realize capital appreciation from the digital asset; (ii) the Active Participant distributes the digital asset as compensation or their compensation is tied to the value of the digital asset; (iii) the Active Participant owns or controls intellectual property rights related to the digital asset or network; or (iv) the Active Participant monetizes the value of the digital asset.
- Related to a re-sale of a digital asset, further consideration should be given to (i) whether or not the efforts of the Active Participant continue to be important to the value of the digital asset; (ii) whether the network is fully functional such that the managerial efforts of an Active Participant are no longer essential; and (iii) whether the efforts of an Active Participant are no longer affecting the enterprise’s success.
In addition to the Howey factors, the SEC provides a list of other relevant considerations, including:
- Whether the digital asset is offered and sold for use or consumption by its purchasers;
- Whether the network is fully developed and operational;
- Whether holders of the digital asset can immediately use its functionality;
- The digital assets’ creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network (for example, limiting use within the network);
- Prospects for appreciation in the value of the digital asset are limited;
- With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency;
- With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services;
- There is a correlation between the purchase price of the digital asset and a market price of the particular good or service for which it may be redeemed or exchanged;
- The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose; and
- Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market.
Turnkey Jet No-Action Letter
In the first SEC No-Action letter on the question as to whether a particular token distribution would be required to register as a security, the SEC opined that TurnKey Jet, Inc. could offer and sell its token without the need to register under the federal securities laws. The SEC’s conclusion was supported by the facts that (i) no funds from the sales would be used to develop the network which would be fully operational at the time of any sales; (ii) the tokens would be immediately usable for their intended functionality; (iii) the tokens could not be transferred outside the Turnkey system and thus no secondary market can develop; (iv) the tokens will have a fixed price; (v) if Turnkey repurchases the tokens, it will only do so at a discount to their face value; and (vi) the tokens are marketed for functionality and not investment.
Turnkey’s No-Action Letter is not surprising in its result – it seems from a reading of the company’s letter to the SEC that it checked every box to avoid a finding that it could be considered to be engaged in a securities offering. The issue is that the letter, together with the SEC guidance, continue to leave questions for those operating tokens that do not “check all the boxes.”
Turnkey’s letter to the SEC made several representations regarding the token including that “[A]t no time will Token sales include a rebate program, rewards program, or similar or otherwise allow for the monetization of an economic benefit or bonus for buying Tokens.” My question is, what if it did include a reward program? In the SEC guidance it lays out an example of a retail point system, concluding that such a system would weigh in favor of not requiring compliance with the federal securities laws. In particular, the SEC example is as follows:
For example, take the case of an online retailer with a fully-developed operating business. The retailer creates a digital asset to be used by consumers to purchase products only on the retailer’s network, offers the digital asset for sale in exchange for real currency, and the digital asset is redeemable for products commensurately priced in that real currency. The retailer continues to market its products to its existing customer base, advertises its digital asset payment method as part of those efforts, and may “reward” customers with digital assets based on product purchases. Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. The digital assets are not transferable; rather, consumers can only use them to purchase products from the retailer or sell them back to the retailer at a discount to the original purchase price. Under these facts, the digital asset would not be an investment contract.
The SEC’s example of a point system and the basis for its opinion in Turnkey does not match with the reality of loyalty or reward points in the consumer world. The fact is that there is a large secondary market for airline and other loyalty points, as I discussed back in June 2018 (see my blog HERE). Anyone with an American Express card knows they can trade and transfer points among many different award systems and even use the points for cash on Amazon.com, Walmart, Saks Fifth Avenue and a list of other partner providers. Although a particular point provider may fix the value for issuance of the point, the value that same point gets when traded for other points in other systems fluctuates. Points are generally marketed and sold or distributed for consumer consumption and not for their value appreciation, but not completely.
The SEC also puts weight on the fact that Turnkey is not using the tokens to raise working capital, but rather as a form of selling their product (purchasing air charter services); however, the entire loyalty point industry uses the proceeds from the sale of their points for working capital. According to its Form 10-K for the FYE December 31, 2018, Delta Airlines generated $2.651 billion from the sale of loyalty travel awards in 2018, representing approximately 15% of its total passenger revenue.
As I talked about back in 2018, online platforms such as www.points.com and www.webflyer.com operate using contractual partnerships with entities that issue loyalty points. In fact, points.com is owned by Points International Ltd., which trades on the TSX and Nasdaq and refers to itself as “the global leader in loyalty currency management.” In a 6-K, Points has this to say about the loyalty industry:
Year-over-year, loyalty programs continue to generate a significant source of ancillary revenue and cash flows for companies that have developed and maintain these loyalty programs. According to the Colloquy group, a leading consulting and research firm focused on the loyalty industry, the number of loyalty program memberships in the US increased from 3.3 billion in 2014 to 3.8 billion in 2016, representing an increase of 15% (source: 2017 Colloquy Loyalty Census Report, June 2017). As the number of loyalty memberships continues to increase, the level of diversification in the loyalty landscape is evolving. While the airline, hotel, specialty retail, and financial services industries continue to be dominant in loyalty programs in the US, smaller verticals, including the restaurant and drug store industries are beginning to see larger growth in their membership base. Further, newer loyalty concepts, such as large e-commerce programs, daily deals, and online travel agencies, are becoming more prevalent. As a result of this changing landscape, loyalty programs must continue to provide innovative value propositions in order to drive activity in their programs.
Points’ recent annual report provides that “[T]he Loyalty Currency Retailing segment provides products and services designed to help loyalty program members unlock the value of their loyalty currency and accelerate the time to a reward. Included in this segment are the Corporation’s buy, gift, transfer, reinstate, accelerator and status miles services. These services provide loyalty program members the ability to buy loyalty program currency (such as frequent flyer miles or hotel points) for themselves, as gifts for others, or perform a transfer of loyalty currency to another member within the same loyalty program.”
I also have trouble differentiating loyalty reward programs with bounty programs. Like in a bounty program, a loyalty reward is issued as compensation for an action such as shopping at a retail outlet, using a credit card, or staying at a hotel.
In Vanderkam & Sanders (January 27, 1999), an unnamed operator of an Internet-based auto referral service proposed to issue free stock to anyone who registered at the company’s website or who referred others to it. Visitors would complete a simple registration form and would not be required to provide cash, property or services for their shares. The SEC ruled that “the issuance of securities in consideration of a person’s registration on or visit to an issuer’s Internet site would be an event of sale” and would be unlawful unless “the subject of a registration statement or a valid exemption from registration.”
In Simplystocks.com (February 4, 1999), a web-based provider of financial information proposed to distribute free stock from a pool of entrants who logged in to the company’s website and provided their name, address, Social Security number, phone number and email address and then chose a log-in name and password. Visitors would receive one entry in the stock pool for each day they logged in to the website. After 180 days, the stock would be randomly allocated among the entrants in the stock pool. The SEC stated that the Simplystocks.com stock giveaway would be unlawful unless registered or exempt from registration.
In Andrew Jones (June 8, 1999), the promoter proposed to issue free stock to the first one million people who signed up or referred others to sign up. Shares would be claimed either by sending a self-addressed stamped envelope to the company along with the person’s name, address and email address, or by visiting the company’s website and providing the same information. The company said the information provided by shareholders would be used solely for corporate purposes and would not be sold or given to others or used for advertising purposes. The SEC ruled that “the issuance of securities in consideration of a person’s registration with the issuer, whether or not through the issuer’s Internet site, would be an event of sale” and would be unlawful unless registered or exempt from registration.
Certainly in those cases the companies were issuing common stock which is defined as a security without needing to reference the Howey Test; however, more recently, in the Matter of Tomahawk Exploration LLC, the SEC found that Tomahawk’s issuance of tokens under the Bounty Program constituted an offer and sale of securities because the company provided tokens to investors in exchange for services designed to advance Tomahawk’s economic interests and foster a trading market for its securities. In other words, the services required in the bounty program were a valid consideration. It has long been established that value for securities can be in the form of services, cash, property, or anything that a board of directors reasonably determines as valuable. Tomahawk received value in the form of online marketing and promotion, and by the creation of a secondary public trading market for its token.
I see the need for further guidance from the SEC on tokens vs. rewards as the “token economy” continues to flourish and develop.
Further Reading on DLT/Blockchain and ICOs
For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.
For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.
For an update on state-distributed ledger technology and blockchain regulations, see HERE.
For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.
For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.
For a review of the CFTC’s role and position on cryptocurrencies, see HERE.
For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.
To learn about SAFTs and the issues with the SAFT investment structure, see HERE.
To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.
For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.
For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.
For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.
For a review of Wyoming’s blockchain legislation, see HERE.
For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.
For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.
For a review of SEC enforcement driven guidance on digital asset issuances and trading, see HERE.
For information on the SEC’s FinTech hub, see HERE.
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.
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).
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.
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.
Laura Anthony, Esq.
Anthony L.G., PLLC
A Corporate Law Firm
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.
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Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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On March 20, 2019 the SEC adopted amendments to Regulation S-K as required by the Fixing America’s Surface Transportation Act (“FAST Act”). The proposed amendments were first published on October 11, 2017 (see HERE). A majority of the amendments were adopted as proposed. As part of the SEC’s ongoing Disclosure Effectiveness Initiative, the amendments are designed to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. For a detailed list of actions that have been taken by the SEC as part of its Disclosure Effectiveness Initiative, see my summary at the end of this blog.
The FAST Act, passed in December 2015, contained two sections requiring the SEC to modernize and simplify the requirements in Regulation S-K. Section 72002 required the SEC to amend Regulation S-K to “further scale or eliminate requirements… to reduce the burden on emerging growth companies, accelerated filers, smaller reporting companies, and other smaller issuers, while still providing all material information to investors.” In addition, the SEC was directed to “eliminate provisions… that are duplicative, overlapping, outdated or unnecessary.”
Section 72003 required the SEC to conduct a study on Regulation S-K and, in that process, to consult with the SEC’s Investor Advisory Committee (the “IAC”) and the Advisory Committee on Small and Emerging Companies (the “ACSEC”) and then to issue a report on the study findings, resulting in a report that was issued on November 23, 2016. Section 72003 specifically required that the report include: (i) the finding made in the required study; (ii) specific and detailed recommendations on modernizing and simplifying the requirements in Regulation S-K in a manner that reduces the costs and burdens on companies while still providing all material information; and (iii) specific and detailed recommendations on ways to improve the readability and navigability of disclosure documents and to reduce repetition and immaterial information. The current amendments seek to implement the various findings and recommendations in the November report.
The new amendments are specifically intended to improve the readability and navigability of company disclosures, and to discourage repetition and disclosure of immaterial information. In particular, the amendments will: (i) increase flexibility in the discussion of historical periods in Management’s Discussion and Analysis; (ii) revise forms to update, streamline and improve disclosures including eliminating risk factor examples in form instructions and revising the description of property requirement to emphasize a materialitythreshold; (iii) eliminate certain requirements for undertakings in registration statements; (iv) allow companies to redact confidential information from most exhibits without filing a confidential treatment request; and (v) incorporate technology to improve access to information on the cover page of certain filings by requiring data tagging and hyperlinks.
The amendments relating to the redaction of confidential information in certain exhibits will become effective immediately. The rest of the amendments will be effective 30 days after they are published in the Federal Register, except that the requirements to tag data on the cover pages of certain filings are subject to a three-year phase-in, and the requirement that certain investment company filings be made in HTML format and use hyperlinks will be effective for filings on or after April 1, 2020.
- Description of Property (Item 102)
Item 102 requires disclosure of the location and general character of the principal plants, mines, and other materially important physical properties of the company and its subsidiaries. The instructions to Item 102 require the company to disclose information reasonable to inform investors as to the suitability, adequacy, productive capacity and utilization of facilities. The amendment emphasizes materiality and requires a company to disclose physical properties only to the extent that such properties are material to the company.
- Management’s Discussion and Analysis (MD&A) (Item 303)
Item 303(a) requires a company to discuss their financial condition, changes in financial condition, and results of operations using year-to-year comparisons. The discussion is required to cover the period of the financial statements in the report (i.e., 2 years for smaller reporting companies and emerging growth companies and 3 years for others). Where trend information is relevant, the discussion may include 5 years with a disclosure of selected financial data.
The amendments remove the reference to a “year to year comparison” and instead allow a company to present the disclosure in whatever format it believes will enhance the reader’s understanding of the information. The amendment will also eliminate the reference to a five-year look-back in the instructions, but rather a company will be able to use any presentation or information that it believes will enhance a reader’s understanding.
Where three years of financial statements are included, the amendments will allow the company to eliminate the earliest year in its discussion as long as the information has been included in a prior filing on EDGAR and the company identifies the location of the prior filing. This differs from the proposed amendment, which would have required the disclosure to have been included in a Form 10-K in order to be omitted and would have contained a specific reference to the materiality of the information. In the final adopting release, the SEC notes that materiality is always the standard and that adding a materiality qualifier to the rule itself was superfluous language that might cause confusion or a belief that some different standard of materiality was being adopted.
The amendments will flow through to foreign private issuers as well with conforming changes to the instructions for Item 5 of Form 20-F.
- Directors, Executive Officers, Promoters and Control Persons (Item 401)
Item 401 requires disclosure of identifying and background information about a company’s directors, executive officers, and significant employees. The amendments clarify the instructions to Item 401 to explain that the information is not required to be duplicated in various parts of a Form 10-K and/or proxy statement, but need only appear once and may be incorporated by reference in other parts of the documents.
- Compliance with Section 16(a) (Item 405)
Section 16(a) of the Exchange Act requires officers, directors, and specified types of security holders to report their beneficial ownership of a company’s equity securities using forms prescribed by the SEC, such as an initial Form 3, amendments on Form 4 and annual Form 5. Item 405 requires the company to disclose each person who failed to timely file a Section 16 report during the most recent fiscal year or prior years. Section 16 reporting persons are required to deliver a copy of their reports to the company, though in practice, this is rarely done. The amendments remove this requirement and allow the company to review EDGAR filings for compliance with Section 16(a).
In addition, the amendment eliminates the need to include the heading at all if there are no delinquencies to report, rather than include the heading with a statement such as “none” and removes the checkbox on the cover page of Form 10-K related to the disclosure. The amendment includes several changes to make the instructions and title of this section conform to the SEC’s “plain English” requirements.
- Corporate Governance (Item 407)
The amendment will update the instructions and information required under Item 407 to remove reference to an obsolete audit standard and rather just refer broadly to applicable PCAOB and SEC requirements. EGC’s and smaller reporting companies are both exempted from the Item 407 requirements, and the amendment clarifies the instruction language accordingly.
- Outside Front Cover Page of the Prospectus (Item 501(b))
The amendments are designed to streamline the front cover page of a prospectus and give a company flexibility in designing the page to tailor to their business and particular offering. The changes include (i) eliminating instructions related to changing or clarifying a name that may be confused with a well-known company; (ii) allowing for a statement that the offering price will be determined by a particular method or formula that is more fully explained in the prospectus with a cross-reference to the page number; (iii) requiring the disclosure of the principal trading market and company symbol, even if such trading market is not a national exchange; and (iv) streamlining the “subject to completion” legend.
- Risk Factors (Item 503(c))
A company is required to disclose the most significant factors that make an offering speculative or risky. Although the disclosure is intended to be principles-based, many examples are included in the instructions. The amendments would move Item 503(c) to Subpart 100 to clarify that risk factors are also required in a Form 10 and Exchange Act periodic reports and not just offering-related disclosures. The amendment also eliminates the risk factor examples from the instructions.
- Plan of Distribution (Item 508)
Item 508 requires disclosure about the plan of distribution for securities in an offering, including information about underwriters. The term “sub-underwriter” is referred to in the rule; however, it is not defined. The rules define a “sub-underwriter” as “a dealer that is participating as an underwriter in an offering by committing to purchase securities from a principal underwriter for the securities but is not itself in privity of contract with the issuer of the securities.”
- Undertakings (Item 512)
Item 512 provides undertakings that a company must include in Part II of its registration statement, depending on the type of offering. The amendments simplify the undertakings requirements and eliminate provisions that are duplicative because the requirement already exists, or that are obsolete due to changes in the law. For example, Items 512(d), 512(e) and 512(f) are all obsolete and should be eliminated. Item 512(c) related to unsold rights offerings that are then offered to the public, can be eliminated as other provisions of the law would require the company to update the (or complete a new) registration statement regardless.
- Exhibits (Item 601)
The amendment makes several changes to the exhibit filing requirements to streamline and reduce the volume of documents which are required to be filed, many of which may not be material. Only newly reporting companies will be required to file material contracts that were entered into within two years of the applicable registration statement or report, thus reducing duplicative, voluminous disclosures.
The amendment adds exhibits related to Item 202 disclosures (registered capital stock, debt securities, warrants, rights, American Depository Receipts, and other securities) to Exchange Act periodic reports on Form 10-K and 10-Q. Such exhibits are currently only required in registration statements, Form 8-K and Schedule 14A.
Related to material agreement exhibits, the amendment also clarifies that schedules and exhibits to exhibits need not be filed unless they are, in and of themselves, material to an investment decision. Although historically the SEC did not object to the omission of schedules and exhibits to exhibits with personally identifiable information, the rules generally required the filing of a confidential treatment request for most omissions. The amendments allow a company to omit schedules and exhibits to exhibits as long as a description of the omitted documents is included. Likewise, the amendments will allow a company to redact information that is both (i) not material, and (ii) competitively harmful if disclosed without the need for a confidential treatment request. Exhibits with redacted information must be clearly labeled accordingly.
The amendments are not meant to alter what information is deemed confidential or can be omitted, but rather to streamline the process by allowing a company to redact without the confidentiality treatment process. The amendments related to redaction and confidential information only apply to material agreement exhibits under Item 601(b)(10) and not to other categories of exhibits, which would rarely contain competitively harmful information. The SEC may still randomly review company filings and “scrutinize the appropriateness of a registrant’s omissions of information from its exhibits.” I expect that for the first year or so following the implementation of these amendments, the SEC will review redactions on a regular basis, providing guidance via comment letters assisting practitioners in advising their clients.
- Incorporation by Reference
Currently rules related to incorporation by reference are spread among a variety of regulations, including Regulation S-K, Regulation C, Regulation 12B and numerous forms. The amendments will revise Item 10(d), Rule 411, Rule 12b-23 and a number of SEC forms to simplify and modernize these rules while still providing all material information. The amendments streamline the rules and further allow for incorporation by reference to eliminate duplicative disclosure.
The rules will require a hyperlink to information that is incorporated by reference if the information is available on EDGAR rather than having to file the document as an exhibit to the registration statement or report.
The rules specifically do not add or change the rules related to cross-references or other incorporation within the financial statements to other disclosure items. There is a concern as to the impact on auditor review requirements if such links or changes are added. In particular, items that are included within financial statements are subject to audit and internal review, internal controls over financial reporting and XBRL tagging. Furthermore, forward-looking statement safe-harbor protection is not available for information inside the financial statements.
The amendments include several amendments to forms to conform with and implement all the changes in the rules. Moreover, companies will now have to include the national exchange or principal U.S. trading market, the trading symbol and title of each class of securities on the cover page of Forms 8-K, 10-Q, 10-K, 20-F and 40-F.
The amendments will require all of the information on the cover pages of Form 10-K, Form 10-Q, Form 8-K, Form 20-F, and Form 40-F to be tagged in Inline XBRL in accordance with the EDGAR Filer Manual.
Further Background on SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes.
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. To review my blog on the final rules, see HERE and on the proposed rules, see HERE.
In November, 2018, I published a blog on how to seek relief from the financial statement disclosure requirements pursuant to Rule 3-13 of Regulation S-X. See HERE.
In the fourth quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act and the Securities Exchange. The proposed rule amendments were originally published in June 2016. In addition to providing better information to investors about a company’s mining properties, the amendments are intended to more closely align the SEC rules with current industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). In addition, the amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K. See HERE.
On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE and later issued updated C&DI on the new rules – see HERE. The initial proposed amendments were published on June 27, 2016 (see HERE).
In December 2017, the American Bar Association (“ABA”) submitted its fourth comment letter to the SEC related to the financial and business disclosure requirements in Regulation S-K. For a review of that letter and recommendations, see HERE.
In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report made specific recommendations for change to the disclosure rules and regulations, including those related to special-interest and social issues and duplicative disclosures. See more on the Treasury Report HERE.
On October 11, 2017, the SEC published proposed rule amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The proposed rule amendments implement a mandate under the Fixing America’s Surface Transportation Act (“FAST Act”). The proposed amendments would: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See my blog HERE. On March 20, 2019, the SEC adopted final rules on this proposal, which is the subject of this blog.
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. The new Rule went into effect on September 1, 2017 for most companies and on September 1, 2018 for smaller reporting companies and non-accelerated filers. See my blog HERE on the Item 601 rule changes and HERErelated to SEC guidance on same.
On November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K as required by Section 72003 of the FAST Act. A summary of the report can be read HERE.
On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.
On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. Final amendments were approved on August 17, 2018 – see HERE.
The July 2016 proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
In September 2015, the SEC also issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Taking into account responses to portions of that request for comment, in the summer of 2018, the SEC adopted final rules to simplify the disclosure requirements applicable to registered debt offerings for guarantors and issuers of guaranteed securities, and for affiliates whose securities collateralize a company’s securities. See my blog HERE.
As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE.
In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.
In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. See my blog HERE.