Monthly Archives: May 2019
As promised by SEC Chair Jay Clayton almost a year ago when the SEC amended 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 ), on May 9, 2019, the SEC proposed amendments to the definitions of an “accelerated filer” and “large accelerated filer.”
In June 2018, the SEC amended the definition of a smaller reporting company (SRC) to include companies with less than a $250 million public float or if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC is one with less than $100 million in annual revenues during its most recently completed fiscal year. At that time the SEC did not amend the definitions an accelerated filer or large accelerated filer. As a result, companies with $75 million or more of public float that qualify as SRCs remained subject to the requirements that apply to accelerated filers or large accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that these accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act (SOX).
Under the proposed amendments, smaller reporting companies with less than $100 million in revenues would not be required to obtain an attestation of their internal control over financial reporting (ICFR) from an independent outside auditor under Section 404 of SOX. In particular, the proposed amendments would exclude from the accelerated and large accelerated filer definitions a company that is eligible to be an SRC and had no revenues or annual revenues of less than $100 million in the most recent fiscal year for which audited financial statements are available.
The proposed amendments also would increase the transition thresholds for accelerated and large accelerated filers becoming a non-accelerated filer from $50 million to $60 million and for exiting large accelerated filer status from $500 million to $560 million and add a revenue test to the transition thresholds for exiting both accelerated and large accelerated filer status.
Like the change to the definition of an SRC, it is thought the new proposed amendments will assist with capital formation for smaller companies. The SEC also notes that the proposed amendments are targeted at companies that have delayed going public in recent years and as such, may help stimulate entry into the U.S. capital markets. Making a reference to a statement by SEC Commissioner Hester Peirce at the time of the amendment to the definition of an SRC expressing her disappointment that the definition of accelerated filer and large accelerated filer were not concurrently changed, in the press release announcing the new proposed rule changes Chair Clayton points out, “[I]nvestors in these lower-revenue companies will benefit from more tailored control requirements. Many of these smaller companies – including biotech and health care companies – will be able to redirect the savings into growing their companies by investing in research and human capital.”
The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) has been fairly constant over the past few years with a slew of rule changes and proposed rule changes. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.
A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner.
The SEC disclosure requirements are scaled based on company size. The SEC categorized companies as non-accelerated, accelerated and large accelerated in 2002 and the introduced the smaller reporting company category in 2007 to provide general regulatory relief to these entities. The only difference between the requirements for accelerated and large accelerated filers is that large accelerated filers are subject to a filing deadline for their annual reports on Form 10-K that is 15 days shorter than the deadline for accelerated filers.
The filing deadlines for each category of filer are:
|Filer Category||Form 10-K||Form 10-Q|
|Large Accelerated Filer||60 days after fiscal year-end||40 days after quarter-end|
|Accelerated Filer||75 days after fiscal year-end||40 days after quarter-end|
|Non-Accelerated Filer||90 days after fiscal year-end||45 days after quarter-end|
|Smaller Reporting Company||90 days after fiscal year-end||45 days after quarter-end|
Significantly, both accelerated filers and large accelerated filers are required to have an independent auditor attest to and report on management’s assessment of internal control over financial reporting in compliance with Section 404(b) of SOX. Non-accelerated filers are not subject to Section 404(b) requirements. Under Section 404(a) of SOX, all companies subject to SEC Reporting Requirements, regardless of size or classification, must establish and maintain internal controls over financial reporting (ICFR), have management assess such ICFR, and file CEO and CFO certifications regarding such assessment (see HERE).
An ICFR system must be sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS) and to maintain accountability for assets. Access to assets must only be had in accordance with management’s instructions or authorization and recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. These requirements apply to any and all companies subject to the SEC Reporting Requirements.
Likewise, all companies subject to the SEC Reporting Requirements are required to provide CEO and CFO certifications with all forms 10-Q and 10-K certifying that such person is responsible for establishing and maintaining ICFR, have designed ICFR to ensure material information relating to the company and its subsidiaries is made known to such officers by others within those entities, and evaluated and reported on the effectiveness of the company’s ICFR.
Furthermore, auditors review ICFR even where companies are not subject to 404(b). Audit risk assessment standards allow an auditor to rely on internal controls to reduce substantive testing in the financial statement audit. A necessary precondition is testing such controls. Also, an auditor must test the controls related to each relevant financial statement assertion for which substantive procedures alone cannot provide sufficient appropriate audit evidence. Naturally, a lower revenue company has less risk of improper revenue recognition and likely less complex financial systems and controls. In any event, in my experience auditors not only test ICFR but make substantive comments and recommendations to management in the process.
The Section 404(b) independent auditor attestation requirements are considerably more cumbersome and expensive for a company to comply with. In addition to the company requirement, Section 404(b) requires the company’s independent auditor to effectively audit the ICFR and management’s assessment. The auditor’s report must contain specific information about this assessment (see HERE). As all reporting companies are aware, audit costs are significant and that is no less true for this additional audit layer. In fact, companies generally find Section 404(b) the most costly aspect of the SEC Reporting Requirements. Where a company has low revenues, the requirement can essentially be prohibitive to successful implementation of a business plan, especially for emerging and growing biotechnology companies that are almost always pre-revenue but have significant capital needs.
The SEC has come to the conclusion that the added benefits from 404(b) are outweighed by the additional costs and burdens for SRC’s and now lower revenue companies. I am a strong proponent of supporting capital markets for smaller companies, such as those with less than a $700 million market cap and less than $100 million in revenues. I hope the proposed rule changes move quickly through the system.
Detail on Proposed Amendments to Accelerated Filer and Large Accelerated Filer Definitions
Prior to the June 2018 SRC amendments, the SRC category of filers generally did not overlap with either the accelerated or large accelerated filer categories. However, following the amendment, a company with a public float of $75 million or more but less than $250 million regardless of revenue, or one with less than $100 million in annual revenues and a public float of $250 million or more but less than $700 million would be both an SRC and an accelerated filer.
The SEC is proposing to amend the accelerated and large accelerated filer definitions in Exchange Act Rule 12b-2 to exclude any company that is eligible to be an SRC under the SRC revenue test – i.e., one with less than $100 million in annual revenues during its most recently completed fiscal year. The effect of this proposal would be that such a company would not be subject to accelerated or large accelerated filing deadlines for its annual and quarterly reports or to the ICFR auditor attestation requirement.
The proposed rule change would not exclude all SRC’s from the definition of accelerated or large accelerated filers and as such, some companies that qualify as an SRC would still be subject to the shorter filing deadlines and Section 404(b) compliance. In particular, an SRC with a float of greater than $75 million but less than $700 million and less than $100 million in revenue would no longer qualify as either an accelerated or large accelerated filer. On the contrary, an SRC with greater than $75 million in public float and greater than $100 million in revenue will still be categorized as an accelerated filer.
The chart below illustrates the effect of the proposed amendments:
|Proposed Relationships between SRCs and Non-Accelerated and Accelerated Filers|
|Status||Public Float||Annual Revenue|
|SRC and Non-Accelerated Filer||Less than $75 million||N/A|
|$75 million to less than $700 million||Less than $100 million|
|SRC and Accelerated Filer||$75 million to less than $250 million||$100 million or more|
|Accelerated Filer (not SRC)||$250 million to less than $700 million||$100 million or more|
The proposed amendments would revise the public float transition threshold for accelerated and large accelerated filers to become a non-accelerated filer from $50 million to $60 million. Also, the proposed amendments would increase the exit threshold in the large accelerated filer transition provision from $500 million to $560 million in public float to align the SRC and large accelerated filer transition thresholds. Finally, the proposed amendments would allow an accelerated or a large accelerated filer to become a non-accelerated filer if it becomes eligible to be an SRC under the SRC revenue test.
The chart below illustrates the effect of the proposed amendments on transition provisions:
|Proposed Amendments to the Public Float Thresholds|
|Initial Public Float Determination||Resulting Filer Status||Subsequent Public Float Determination||Resulting Filer Status|
|$700 million or more||Large Accelerated Filer||$560 million or more||Large Accelerated Filer|
|Less than $560 million but$60 million or more||Accelerated Filer|
|Less than $60 million||Non-Accelerated Filer|
|Less than $700 million but $75 million or more||Accelerated Filer||Less than $700 million but$60 million or more||Accelerated Filer|
|Less than $60 million||Non-Accelerated Filer|
Statements of Commissioners on Rule Amendment
SEC Chairman Jay Clayton and Commissioners Jackson, Peirce and Roisman all made statements on the proposed rule changes at an open meeting related to the amendment. Chair Clayton’s speech focuses on the fact that most aspects of ICFR remain unchanged as do the heightened requirements that SOX imposed generally. However, the proposed rules “are aimed at the subset of issuers where the added step of an ICFR auditor attestation is likely to add significant costs and is unlikely to enhance financial reporting or investor protection.” Of course, he is hopeful the change will encourage more companies to access public markets.
Commissioner Hester Peirce (may favorite Commissioner) is true to form, supporting the proposed amendments but wishing they had gone further. As she did when the SEC amended the definition of an SRC, Commissioner Peirce criticizes the fact that there now can be overlap between an SRC and accelerated or large accelerated filer, which can cause confusion. As Commissioner Peirce notes, “[T]he process of determining whether a company is an SRC and a non-accelerated filer, or an SRC and an accelerated filer, or outside of both categories is so complicated that even we at the SEC need diagrams to figure it out. The fact that we ourselves struggling to understand our own regime does not bode well for smaller companies trying to follow our rules without the benefit of a staff of seasoned securities attorneys.” The quote hit home; in writing my blog on the SRC rule change and now this rule change, I started creating a diagram for myself until I found that the SEC had published one as well – it was the only way to follow and understand the interactions. Commissioner Peirce would advocate for a fine line whereby all SRC’s would be non-accelerated filers and exempt from Section 404(b). I agree.
Commissioner Roisman supported the proposed rule changes and, like Commissioner Peirce, wondered whether it went far enough.
Commissioner Jackson, also true to form, does not support the proposed amendment at all as he believes that the risk of corporate management fraud is too high to allow the change. Commissioner Jackson uses WorldCom and Enron as his primary example of management without auditor oversight; however, I note that these companies were behemoths compared to the sector of business affected by the current proposal. Commissioner Jackson also questions the data and analysis used by the SEC to support the proposed amendments and instead gathered his own data. Unfortunately, there is often a disconnect between statistical data and real-world applications and as such, my views remain aligned with Commissioner Peirce.
Nasdaq and the NYSE American both have rules requiring listed companies to receive shareholder approval prior to issuing twenty percent (20%) or more of the outstanding securities in a transaction other than a public offering at a price less than the Minimum Price, as defined in the rule. 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 (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants (see HERE); (iii) a change of control (see HERE); and (iv) transactions other than public offerings. NYSE American Company Guide Sections 711, 712 a 713 have substantially similar provisions.
Nasdaq and the NYSE recently amended their rules related to issuances in a private placement to provide greater flexibility and certainty for companies to determine when a shareholder vote is necessary to approve a transaction that would result in the issuance of 20% or more of the outstanding common stock or 20% or more of outstanding voting power in a PIPE or similar private placement financing transaction. The amendments simplified the prior multi-part language and changed the pricing test trigger to create a new “Minimum Price.” For my blog on the Nasdaq amendment, see HERE. Although the NYSE American has not yet amended its rule to conform with the changes, I expect it will be forthcoming. In this blog, I will drill down further on the rule and its interpretive guidance.
As I’ve mentioned in each of the blogs in this series, many other Exchange Rules interplay with the 20% Rules; for example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to the issuance of securities in the same transactions that require shareholder approval. Companies need to carefully comply with each of the rules that may interplay with a transaction or proposed transaction.
Nasdaq Rule 5635(d)
Nasdaq Rule 5635(d) requires shareholder approval prior to a 20% issuance of securities at a price that is less than the Minimum Price in a transaction other than a public offering. A 20% issuance is a transaction, other than a public offering, involving the sale, issuance or potential issuance by the company of common stock (or securities convertible into or exercisable for common stock), which alone or together with sales by officers, directors or substantial shareholders of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance. “Minimum Price” means a price that is the lower of: (i) the closing price (as reflected on Nasdaq.com) immediately preceding the signing of the binding agreement; or (ii) the average closing price of the common stock (as reflected on Nasdaq.com) for the five trading days immediately preceding the signing of the binding agreement.
The September 2018 rule amendment creating a new “Minimum Price” standard provides more flexibility by adding the option of choosing between the closing bid price and the five-day average closing price. For example, in a declining market, the five-day average closing price will be above the current market price, which could make it difficult for companies to close transactions because investors could buy shares at a lower price in the market. Likewise, in a rising market, the five-day average could result in a below-market transaction triggering shareholder approval requirements.
NYSE American Company Guide Section 713
The NYSE American Company Guide Section 732 requires shareholder approval prior to the listing of additional shares in connection with a transaction, other than a public offering, involving: (i) the sale, issuance, or potential issuance by the company of common stock (or securities convertible into common stock) at a price less than the greater of book or market value which together with sales by officers, directors or principal shareholders of the company equals 20% or more of presently outstanding common stock; or (ii) the sale, issuance, or potential issuance by the issuer of common stock (or securities convertible into common stock) equal to 20% or more of presently outstanding stock for less than the greater of book or market value of the stock.
Interpretation and Guidance
Although the rules do not require shareholder approval for a transaction involving “a public offering,” the Exchanges do not automatically consider all registered offerings as public offerings.
Generally, all firm commitment underwritten securities offerings registered with the SEC will be considered public offerings. Likewise, any other securities offering which is registered with the SEC and which is publicly disclosed and distributed in the same general manner and extent as a firm commitment underwritten securities offering will be considered a public offering for purposes of the 20% Rule. In other instances, when analyzing whether a registered offering is a “public offering,” the Exchanges 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.
A registered direct offering will not be assumed to be public and will be reviewed using the same factors listed above. Likewise, a Rule 144A offering will be considered on its facts and circumstances, though generally share caps are used in these transactions to avoid an issue. 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.
A substantial shareholder is defined in the negative and requires the company to consider the power that a particular shareholder asserts over the company. Nasdaq specifically provides that someone that owns less than 5% of the shares of the outstanding common stock or voting power would not be considered a substantial shareholder for purposes of the Rules.
Shares to be Issued in a Transaction; Shares Outstanding; Votes to Approve
In determining the number of shares to be issued in a transaction, the maximum potential shares that could be issued, regardless of contingencies, should be included. The maximum potential issuance includes all securities initially issued or potentially issuable or potentially exercisable or convertible into shares of common stock as a result of the transaction. The percentage to be issued is calculated by dividing the maximum potential issuance by the number of shares of common stock issued and outstanding prior to the transaction.
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 the purpose of the 20% Rule. Where a company has multiple classes of common stock, all classes are counted in the amount outstanding, even if one or more classes do not trade on the Exchange.
Voting power outstanding as used in the Rule refers to the aggregate number of votes which may be cast by holders of those securities outstanding which entitle the holders to vote generally on all matters submitted to the company’s security holders for a vote.
Where shareholder approval is required under the 20% Rule, approval can be had by a majority of the votes cast on the proposal. The proxy for approval of a transaction under the 20% Rule should provide specific details on the proposed financing transaction.
Convertible Securities; Warrants; Anti-Dilution Provisions
Convertible securities and warrants can either convert at a fixed or variable rate. If the securities are convertible at a fixed price, Nasdaq will determine whether the issuance is below the Minimum Price, and for the NYSE American at a price less than the greater of book or market value, if the conversion or exercise price is less than the applicable threshold price at the time the parties enter into a binding agreement with respect to the issuance.
Variable rate conversions are generally tied to the market price of the underlying common stock and accordingly, the number of securities that could be issued upon conversion will float with the price of the common stock. That is, the lower the price of a company’s common stock, the more shares that could be issued and conversely, the higher the price, the fewer shares that could be issued. Variable priced convertible securities tend to cause a downward pressure on the price of common stock, resulting in additional dilution and even more common stock issued in each subsequent conversion round. This chain of convert, sell, price reduction, and convert into more securities, sell, further price reduction and resulting dilution is sometimes referred to as a “death spiral.”
The 20% Rule requires that the company consider the largest number of shares that could be issued in a transaction when determining whether shareholder approval is required. Where a transaction involves variable priced convertible securities, and no floor on such conversion price is included or cap on the total number of shares that could be issued, the Exchanges will presume that the potential issuance will exceed 20% and that shareholder approval will be required.
The calculation of whether an issuance is above 20% and below the threshold Minimum Price where warrants are involved can be complicated. Where warrants are involved, Nasdaq will require shareholder approval if the issuance of common stock is less than the 20% threshold and such stock is issued below the Minimum Price if the exercise of the warrants would result in greater than a 20% issuance. However, the warrants do not need to be included in the calculation if the exercise price is above the Minimum Price and the warrants are not exercisable for at least six months. If the common stock portion of an offering that includes warrants exceeds the 20% threshold, Nasdaq will value the warrants at $0.125, regardless of whether the exercise price exceeds the market value. This is referred to as the “1/8th Test.” In this case, shareholder approval will be required even if the warrants are not exercisable for six months.
However, Nasdaq has indicated that convertible bonds with flexible settlement provisions (i.e., cash or stock at the company’s option) will be treated the same way as physically settled bonds under the rule. If the conversion price of the bonds equals or exceeds the Minimum Price, shareholder approval will not be required. Contrarily, Nasdaq will treat a convertible security with a flexible settlement provision as if it will be settled in securities for purposes of the 20% Rule.
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.
Nasdaq will closely examine any transaction that includes warrants that are exercisable for little or no consideration (i.e., “penny warrants”) and may object to a transaction involving penny warrants even if shareholder approval would not otherwise be required. Warrants with a cashless exercise feature are also not favored by the Exchanges and will be closely reviewed. Nasdaq guidance indicates it will review the following factors related to warrants with cashless exercise features: (i) the business purpose of the transaction; (ii) the amount to be raised (if the acquisition includes a capital raise); (iii) the existing capital structure; (iv) the potential dilutive effect on existing shareholders; (v) the risk undertaken by the new investors; (vi) the relationship between the company and the investors; (vii) whether the transaction was preceded by similar transactions; (viii) whether the transaction is “just and equitable”; and (ix) whether the warrant has provisions limiting potential dilution. In practice, many warrants include dilutive share caps and have cashless features that only kick in if there is no effective registration statement in place for the underlying common stock.
Any contractual provisions that could result in lowering the transaction price to below the Minimum Price, including anti-dilution provisions, most favored nations, true-up and similar provisions will be viewed as a discounted issuance. Likewise, a provision that allows a company to voluntarily reduce the conversion or exercise price to a price that could be below the Minimum Price, will be treated as a discounted issuance.
Both Nasdaq and the NYSE American may aggregate financing transactions that occur within close proximity of each other in determining whether the 20% Rule applies. Nasdaq considers the following factors when considering aggregation: (i) timing of the issuances; (ii) facts surrounding the subsequent transactions (e.g., planned at time of first transaction); (iii) commonality of investors; (iv) existence of contingencies between the transactions; (v) commonalities as to use of proceeds; and (vi) timing of board approvals. Moreover, transactions that are more than six months apart are generally not aggregated. Although the NYSE American does not provide such specific guidance, in practice, their analysis is substantially similar.
Two-Step Transactions and Share Caps
As obtaining shareholder approval can be a lengthy process, companies sometimes bifurcate transactions into two steps and use share caps as part of a transaction structure. A company may limit the first part of a transaction to 19.9% of the outstanding securities and then, if and when shareholder approval is obtained, issue additional securities. Companies may also structure transactions such that issuances related to a private offering, including through convertible securities, are capped at no more than 19.9% of total outstanding.
In order for a cap to satisfy the rules, it must be clear that no more than the threshold amount (19.9%) of securities outstanding immediately prior to the transaction, can be issued in relation to that transaction, under any circumstances, without shareholder approval. In a two-step transaction where shareholder approval is deferred, shares that are issued or issuable under the cap must not be entitled to vote to approve the remainder of the transaction. In addition, a cap must apply for the life of the transaction, unless shareholder approval is obtained. For example, caps that no longer apply if a company is not listed on Nasdaq are not permissible under the Rule. If shareholder approval is not obtained, then the investor will not be able to acquire 20% or more of the common stock or voting power outstanding before the transaction. Where convertible securities were issued, the shareholder would continue to hold the balance of the original security in its unconverted form.
Moreover, where a two-step transaction is utilized, the transaction terms cannot change as a result of obtaining, or not obtaining, shareholder approval. For example, a transaction may not provide for a sweetener or penalty. The Exchanges believe that the presence of alternative outcomes have a coercive effect on the shareholder vote and thus deprive the shareholders of their ability to freely determine whether the transaction should be approved. Nasdaq provides specific examples of a defective share cap, such as where a company issues a convertible preferred stock or debt instrument that provides for conversions of up to 20% of the total shares outstanding with any further conversions subject to shareholder approval. However, the terms of the instrument provide that if shareholders reject the transaction, the coupon or conversion ratio will increase or the company will be penalized by a specified monetary payment, including a rescission of the transaction. Likewise, a transaction may provide for improved terms if shareholder approval is obtained. The NYSE American similarly provides that share caps cannot be used in a way that could be coercive in a shareholder vote.
A reverse acquisition or reverse merger is one in which the acquisition results in a change of control of the public company such that the target company shareholders control the public company following the closing of the transaction. In addition to the 20% Rule, a change of control would require shareholder approval under the Change of Control Rule and the Acquisition Rule will likely apply as well. 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.
The Exchanges have a “financial viability” exception to the 20% Rule. Although rarely granted, to qualify for the financial viability exception, a listed company must apply in writing and demonstrate that: (i) the delay in securing stockholder approval would seriously jeopardize the financial viability of the company; and (ii) reliance on the exception has been expressly approved by the company’s audit committee or comparable board committee comprised of all independent, disinterested directors. A determination will be rendered by the Exchange very quickly, such as in a matter of days.
Nasdaq guidance suggests an in-depth letter focusing on how a delay resulting from seeking shareholder approval would seriously jeopardize its financial viability and how the transaction would benefit the company. The letter should also describe the proposed transaction in detail and should include the identity of the investors. Nasdaq provides a list of examples of information that should be discussed in the letter, including: (i) the facts and circumstances that led to the company’s predicament; (ii) how long the company will be able to meet its current obligations, such as payroll, lease payments, and debt service, if it does not complete the proposed transaction; (iii) the company’s current and projected cash position and burn rate; (iv) other alternatives; (v) why a step transaction will not work; (vi) would the company file for bankruptcy without the transaction; (vii) the impact to operations while waiting for shareholder approval; (viii) why the company didn’t enter into a transaction sooner; (ix) demonstrate that the transaction will rescue the company; (x) demonstrate that the company will continue to meet Nasdaq’s listing requirements; and (xi) explain changes in voting power.
A company that gets approval for this exception must send a mailing to all shareholders at least 10 days prior to the issuance of securities under the exception. The letter must disclose the terms of the transaction, including number of shares to be issued and consideration received, that the company is relying on the financial viability exception and that the audit committee (or other committee) has approved the reliance on the exception. The company must also file an 8-K and issue a press release with the same information also no later than 10 days before the issuance.
Furthermore, shareholder approval is not required if the issuance is part of a court-approved reorganization under the federal bankruptcy laws or comparable foreign laws.
Also, a foreign private issuer that has elected to follow its home country rules will be exempt from the 20% Rule if it notifies Nasdaq, provides an opinion from local counsel that shareholder approval would not be required, and discloses its practices in its annual report on Form 20-F.
Consequences for Violation
Consequences for the violation of the 20% Rule or Acquisition Rule can be severe, including delisting from the Exchange. Companies that are delisted from an Exchange as a result of a violation of these rules are rarely ever re-listed.
Nasdaq and the NYSE American both have rules requiring listed companies to receive shareholder approval prior to issuing securities when a stock option or purchase plan is to be established or materially amended or other equity compensation arrangement made or materially amended, pursuant to which stock may be acquired by officers, directors, employees, or consultants. 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 (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants; (iii) a change of control (see HERE); and (iv) transactions other than public offerings (see HERE). NYSE American Company Guide Sections 711, 712 and 713 have substantially similar provisions.
In this blog I am detailing the shareholder approval requirements related to equity-based compensation of officers, directors, employees or consultants. Other Exchange Rules interplay with the rules requiring shareholder approval for equity issuances and for equity compensation issuances in general. For example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to establishing or materially amending a stock option plan, purchase plan or other equity compensation arrangement pursuant to which stock may be acquired by officers, directors, employees, or consultants without shareholder approval.
Nasdaq Rule 5635(c)
Nasdaq Rule 5635(c) requires shareholder approval prior to the issuance of securities when a stock option or purchase plan is to be established or materially amended or other equity compensation arrangement made or materially amended, pursuant to which stock may be acquired by officers, directors, employees, or consultants, except for: (1) warrants or rights issued generally to all security holders of the company or stock purchase plans available on equal terms to all security holders of the company (such as a typical dividend reinvestment plan); (2) tax qualified, non-discriminatory employee benefit plans (e.g., plans that meet the requirements of Section 401(a) or 423 of the Internal Revenue Code) or parallel nonqualified plans (including foreign plans complying with applicable foreign tax law), provided such plans are approved by the company’s independent compensation committee or a majority of the company’s Independent Directors; or plans that merely provide a convenient way to purchase shares on the open market or from the company at market value; (3) plans or arrangements relating to an acquisition or merger as permitted under IM-5635-1; or (4) issuances to a person not previously an employee or director of the company, or following a bona fide period of non-employment, as an inducement material to the individual’s entering into employment with the company, provided such issuances are approved by either the company’s independent compensation committee or a majority of the company’s Independent Directors. Promptly following an issuance of any employment inducement grant in reliance on this exception, a company must disclose in a press release the material terms of the grant, including the recipient(s) of the grant and the number of shares involved.
NYSE American Company Guide Section 711
Substantially similar to Nasdaq, the NYSE American Company Guide Section 711 requires shareholder approval with respect to the establishment or material amendments to a stock option or purchase plan or other equity compensation arrangement pursuant to which options or stock may be acquired by officers, directors, employees, or consultants, except for: (1) issuances to an individual, not previously an employee or director of the company, or following a bona fide period of non-employment, as an inducement material to entering into employment with the company provided that such issuances are approved by the company’s independent compensation committee or a majority of the company’s independent directors, and, promptly following an issuance of any employment inducement grant in reliance on this exception, the company discloses in a press release the material terms of the grant, including the recipient(s) of the grant and the number of shares involved; or (2) tax-qualified, non-discriminatory employee benefit plans (e.g., plans that meet the requirements of Section 401(a) or 423 of the Internal Revenue Code) or parallel nonqualified plans, provided such plans are approved by the company’s independent compensation committee or a majority of the company’s independent directors; or plans that merely provide a convenient way to purchase shares in the open market or from the issuer at fair market value; or (3) a plan or arrangement relating to an acquisition or merger; or (4) warrants or rights issued generally to all security holders of the company or stock purchase plans available on equal terms to all security holders of the company (such as a typical dividend reinvestment plan).
The NYSE American requires a listed company to notify the exchange in writing if it intends to rely on any of the exemptions.
Interpretation and Guidance
Definition of Consultant
For purposes of this rule, a “consultant” is anyone for whom the company is eligible to use a Form S-8. Accordingly, shareholder approval would be required for stock awards, plans or arrangements for the issuance of equity to: (i) natural persons; (ii) that provide bona fide services to the company; and (iii) whose services are not in connection with the offer or sale of securities in a capital-raising transaction, and who does not directly or indirectly promote or maintain a market for the company’s securities.
Adoption of Plans
A company may adopt an equity plan or arrangement, and grant options (but not shares of stock) thereunder, prior to obtaining shareholder approval provided that: (i) no options can be exercised prior to obtaining shareholder approval, and (ii) the plan can be unwound, and the outstanding options cancelled, if shareholder approval is not obtained. Companies should be aware of any accounting issues that may arise under these circumstances.
A company that has a plan in place at the time of listing on an Exchange would not be required to obtain shareholder approval for that plan, but would be required to obtain approval for future amendments.
For purposes of the rule, both Exchanges specifically indicate that a material amendment would include, but not be limited to: (i) any material increase in the number of shares to be issued under the plan, including sublimits (other than as a result of a reorganization, stock split, merger or spin-off); (ii) a material increase in benefits including repricing (such as lowering the strike price of an option) or extensions of duration (though a change in a vesting schedule without more is not material); (iii) a material expansion of the class of participants eligible for the plan; or (iv) an expansion of the types of options or awards under the plan, including value for value exchanges.
If a plan allows for the issuance of stock options, adding stock appreciation rights (SARs) to a plan would not be material as SARs are substantially similar to options. Similarly, if a plan allows for the issuance of restricted stock, adding restricted stock units (RSUs) would not be material.
An amendment to increase tax withholding associated with awards to satisfy tax obligations is not considered a material amendment. Likewise, allowing a recipient to surrender unissued shares to satisfy a tax obligation would not be considered a material amendment. Adding a cashless exercise feature is also not a material amendment.
Neither Exchange will require shareholder approval if the plan, by its own terms, allows for specific actions without further approval, including, for example, the re-pricing of options. In order to rely on the ability to amend, the plan must be specific in the terms and actions that are allowed. A general authority to amend will not obviate the need for shareholder approval for what would otherwise be considered a material amendment. Moreover, some pricing changes, such as changing the exercise price from the closing bid price on the day of grant to the average of the high and low market price on the same day, would not require a new approval.
However, if a plan has a formula that allows for automatic increases of the shares available under the plan (“evergreen plan”) or a formula for automatic grants, the plan cannot have a term in excess of ten years unless shareholder approval is obtained every ten years. Plans that do not contain a formula and do not impose a limit on the number of shares available for grant would require shareholder approval of each grant under the plan.
As the rule specifically only applies to equity grants, awards or compensation and not cash, a company could buy back outstanding awards for cash without first seeking shareholder approval.
Plans or arrangements involving a merger or acquisition do not require shareholder approval in two situations. First, shareholder approval will not be required to convert, replace or adjust outstanding options or other equity compensation awards to reflect the merger transaction. Second, shares available under certain plans acquired in acquisitions and mergers may be used for certain post-transaction grants without further shareholder approval provided the plan had originally been approved by shareholders.
In particular, where a non-listed company is acquired by or merged with a listed company, the listed company may use shares for post-transaction grants of options and other equity awards without further shareholder approval, provided: (i) the time during which those shares are available for grants is not extended beyond the period when they would have been available under the pre-existing plan, absent the transaction, and (ii) such options and other awards are not granted to individuals who were employed by the granting company or its subsidiaries at the time the merger or acquisition was consummated.
Plans adopted in contemplation of a merger or acquisition will not be considered pre-existing for purposes of this exception. Where an evergreen plan is assumed in a merger, the ten-year period for shareholder approval is measured from the date the target company established the plan.
Any additional shares available for issuance under a plan or arrangement acquired in connection with a merger or acquisition would be counted in determining whether the transaction involved the issuance of 20% or more of the company’s outstanding common stock, thus triggering the shareholder approval requirements under Rule 5635(a) related to mergers and acquisitions.
Source of Shares
A requirement that grants be made out of treasury shares or repurchased shares will not alleviate shareholder approval requirements.
The inducement exemption can only be used for employment, and not consulting, arrangements. However, in some circumstances the exemption may be relied upon to induce a consultant to enter into an employment arrangement. An exchange would consider all facts and circumstances related to the relationship. This exemption can only relied upon in connection with the initial inducement for employment. Accordingly, if an inducement award is materially amended, the amendment would require shareholder approval notwithstanding that the initial award did not.
Likewise, the determination of a “bona fide period of non-employment” requires a facts and circumstances analysis. Generally an exchange will consider: (i) whether there was a relationship between the company and former employee during the time of non-employment; (ii) whether the former employee received payments from the company during the period of non-employment; (iii) the reasons for ending the employment relationship; (iv) whether the former employee was employed elsewhere after leaving the company; and (v) whether there was an agreement or understanding that the employee would return to the company.
For purposes of the required press release disclosure, four days will generally satisfy the “promptly” requirement. A company can aggregate the disclosure of inducements where the inducements were made in connection with a merger or acquisition, or a company regularly offers such awards. In that regard, a company can adopt a plan that will be used solely for inducements, without the necessity of shareholder approval. However, inducement grants made to executive officers must always be individually disclosed.
Parallel Nonqualified Plan
A parallel nonqualified plan means a plan that is a “pension plan” within the meaning of the ERISA Act that is designed to work in parallel with a qualified tax plan to provide benefits that exceed IRS compensation limitations. A plan will not be considered a parallel nonqualified plan unless: (i) it covers all or substantially all employees of an employer who are participants in the related qualified plan whose annual compensation is in excess the compensation limits; (ii) its terms are substantially the same as the qualified plan that it parallels except for the elimination of the limitations; and, (iii) no participant receives employer equity contributions under the plan in excess of 25% of the participant’s cash compensation.
Below Market Sales
The private sale of securities to officers, directors, employees or consultants at a price less than market value is considered a form of “equity compensation” and, as such, requires shareholder approval. For purposes of this rule, market value is the consolidated closing bid price immediately preceding the time the company enters into a binding agreement to issue the securities. Shareholder approval would not be required if the officer, director, employee or consultant was purchasing securities from the company in a public offering.
Issuances to an entity controlled by an officer, director, employee, or consultant of the a company may also be considered equity compensation under certain circumstances, such as where the issuance would be accounted for under GAAP as equity compensation or result in the disclosure of compensation under Regulation S-K.
Broker-dealers may not vote client proxies on equity compensation plans unless the beneficial owner of the shares has given voting instructions. That is, equity compensation plans are considered “non-routine” items prohibiting broker votes on behalf of their clients.
Foreign Private Issuers
Although the rule applies to foreign private issuers, if such issuer is otherwise following its home country practices in accordance with the Exchange rules, it can do so related to this shareholder approval requirement as well.
Consequences for Violation
This rule is strictly construed and, as such, all plans or material amendments to a plan, regardless of the number of shares under the plan or arrangement, require shareholder approval. Consequences for the violation of any of the Exchange’s rules, including shareholder approval rules, 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.