Monthly Archives: June 2021
On April 12, 2021, the SEC effectively chilled SPAC activity by announcing that it had examined warrant accounting in several SPACs and found that the warrants were being erroneously classified as an asset. The SEC identified two accounting issues, one related to the private placement warrants and the other related to both the private placement and public warrants. These companies were required to restate previously issued financial statements to reclassify warrants as liabilities, and the ripple effect began. Overnight SPAC management teams, accountants and auditors were scrambling to determine if a restatement was required (in most cases it was) and in-process SPACs were put on hold or at least delayed while market participants tried to figure out the meaning of the SEC guidance and how to address it.
The timing of the statement was interesting as well; most calendar year end SPACs had just filed their Form 10-K for FYE 2020 requiring a slew of 8-Ks to disclose non-reliance on previously issued financial statements. Those that had filed a Form 12b-25 to obtain a 15-day extension scrambled to re-do the financial statements before filing and as such most were late in filing. Likewise, many companies that had recently completed business combinations with SPACs had to restate previously issued financial statements and/or delay reports.
The SEC statement specifically indicated that where warrants had been improperly characterized as assets instead of liabilities, a company should consider its obligation to maintain internal controls over financial reporting and disclosure controls and procedures to determine whether those controls are adequate. Further, a company needed to assess whether prior disclosure on the evaluation of internal controls over financial reporting and disclosure controls and procedures needs to be revised in the amended filings. As a result, most restated Exchange Act reports contained a disclosure that previously disclosed internal controls were not, in fact, effective due to a material weakness and added risk factors related to inadequate internal controls including litigation risks.
However, the industry was extremely motivated (with just under $90 billion raised in 2021 so far alone) and it appears that accounting firms and the SEC have agreed on a form of warrant that can classified as equity and not as a liability for financial reporting purposes. Despite the resolutions discussed below, the SEC has not issued any formal guidance or statements updating the April 12, 2021 statement. Many market participants do not feel they can confidently rely on these changes to be sure that the SEC will not find further issues and have called for lawmakers to add clarity.
The Accounting Standards Codification (“ASC”) provides rules and guidelines for when warrants can be classified as equity (and thus an asset) or treated as a liability. Under the rules, a warrant can only be classified as equity if the warrant is indexed to the company’s common stock. One of the features of indexing is that a warrant has a fixed strike price. In its review of SPAC warrants, the SEC found that some warrants included variables that would impact the exercise price and in particular, a variable exercise price depending on whether the warrant was held by the sponsor or a non-permitted transferee.
In a typical SPAC structure (see HERE) the private placement (sponsor) warrants have different features than the public warrants. For example, the private placement warrants are generally not redeemable and always have cashless exercise provisions. The public warrants, on the other hand, are almost always redeemable by the company if the stock trades at $18.00 or higher for 20 out of 30 trading days and only have a cashless exercise feature if there is no effective registration statement as to the underlying shares. Furthermore, both the private warrants and public warrants usually have provisions adjusting the exercise price in certain circumstances associated with the business combination transaction, with the private warrants being entitled to a greater adjustment than the public. The warrant agreement provides that once the private placement warrants are transferred to persons other than certain permitted transferees, they become public warrants and thus are treated differently depending on the holder of the warrant. The SEC took issue with potential variations in exercise price depending on holder of the warrant as not being consistent with the rules allowing indexing, and thus treatment as equity and not a liability.
The SEC staff and market participants have come up with two alternatives to address this issue. The first is to keep private placement warrants separate and distinct from public warrants with no possibility of changes to their terms regardless of transfer. That is, the concept of “permitted transferee” could be removed and all transfers would then be permitted. The issue is that the public warrants generally trade on a national exchange (or OTC Markets) and since the features of the private warrant are different, there would be no opportunity to sell such private warrants on the open market. Liquidity would only be had in a private transaction or upon exercise (which may or may not be in-the-money).
The second alternative is to remove the distinctions between the private and public warrants. Of course, this would change the economics significantly for the sponsor.
Another alternative, which is not a fix to the warrants but a different structure altogether, is to utilize rights instead of warrants. Many SPACs include rights as part of their offering structure, though generally in addition to, and not instead of, a warrant. A right entitles the holder to purchase a share of common stock for xx number of rights (such as one share of common stock for 10 rights). A right generally has a fixed exercise price and is a short-term instrument. Care would have to be given such that a Rights Agreement did not contain the same provisions that the SEC found problematic in the Warrant Agreement.
Forced Cashless Exercise
Some SPAC warrant agreements contain a provision that allows the company to force a cashless conversion (i.e., payment in net shares) if the stock price of the company equals or exceeds $10.00 for a period of time. The exercise price for these warrants is based on a warrant table that varies based on the current stock price and period of time remaining prior to expiration of the warrants. The formula is based on Black-Scholes and is meant to compensation warrant holders for lost value based on the forced exercise. As this provision causes the warrant exercise price to be variable, the SEC found that it precluded the warrants from being treated as equity and instead had to be treated as a liability.
SEC staff, together with accounting professionals, have reached the conclusion that if the warrant table is removed or modified, the warrants could be treated as equity. Removal of the table is straightforward. Modification would need to be in such a manner that the SEC no longer views the exercise price as variable.
I note that if the table is removed, a post business combination company could still proceed with a tender or exchange offer to entice warrant holders to exchange their warrants for cash and/or stock, but the company would no longer have an absolute right to force conversion.
Tender Offer Provisions
In addition to being properly indexed to common stock, in order to qualify for equity treatment, the warrant must allow the company to settle the warrant with shares. That is, GAAP accounting includes a general principle that if an event that is not within the entity’s control could require net cash settlement, then the contract should be classified as an asset or a liability rather than as equity. There is an exception to this rule if net cash settlement can only be triggered in circumstances in which the holders of the shares underlying the contract also would receive cash, such as in a complete change of control.
In its statement the SEC pointed out a fact pattern in which, if a company made a tender or exchange offer that was accepted by the holders of more than 50% of the Class A common stock, all holders of the warrants would be entitled to receive cash for their warrants. Since in the typical SPAC structure the sponsor’s Class B common stock represents 20% of the total issued and outstanding equity, there would not necessarily be a change of control of the company as a result of the tender offer, and thus the exception would not apply. In other words, in the event of a qualifying cash tender offer (which could be outside the control of the entity), all warrant holders would be entitled to cash, while only certain of the holders of the underlying shares of common stock would be entitled to cash. The SEC staff concluded that, in this fact pattern, the tender offer provision would require the warrants to be classified as a liability measured at fair value, with changes in fair value reported each period in earnings.
SEC Staff, together with accounting professionals, have reached the conclusion that if the language in the tender offer provisions is modified such that the tender offer triggering cash settlement of the SPAC warrants results in the maker of the tender offer holding more than 50% of the voting power of the company’s securities, the company would not be precluded from classifying the warrants as equity.
On June 1, 2021, SEC Chair Gary Gensler and the SEC Division of Corporation Finance issued statements making it clear that the SEC would not be enforcing the 2020 amendments to certain rules governing proxy advisory firms or the SEC guidance on the new rules.
In particular, in July 2020 the SEC adopted amendments to change the definition of “solicitation” in Exchange Act Rule 14a-1(l) to specifically include proxy advice subject to certain exceptions, provide additional examples for compliance with the anti-fraud provisions in Rule 14a-9 and amended Rule 14a-2(b) to specifically exempt proxy voting advice businesses from the filing and information requirements of the federal proxy rules. On the same day, the SEC issued updated guidance on the new rules. See HERE for a discussion on the new rules and related guidance.
Like all rules and guidance related to the proxy process, the amendments were controversial with views generally falling along partisan lines. On June 1, 2021, Chair Gary Gensler issued an extremely brief public statement, as follows:
I am now directing the staff to consider whether to recommend further regulatory action regarding proxy voting advice. In particular, the staff should consider whether to recommend that the Commission revisit its 2020 codification of the definition of solicitation as encompassing proxy voting advice, the 2019 Interpretation and Guidance regarding that definition, and the conditions on exemptions from the information and filing requirements in the 2020 Rule Amendments, among other matters.
On the same day, the SEC Division of Corporation Finance issued a public statement that CorpFin is following Chair Gensler’s direction and revisiting the rules and guidance. CorpFin stated that, in light of the new direction, it will not recommend enforcement action based on the 2019 Interpretation and Guidance or the 2020 Rule Amendments during the period in which the SEC is considering further regulatory action in this area. Moreover, even if the new rules are left in place, CorpFin will not recommend enforcement for a reasonable period of time thereafter, including until current litigation related to the rule changes have been addressed.
Refresher on Amended Rules and Guidance
Rule 14a-1(l) – Definition of “Solicit” and “Solicitation”
The federal proxy rules can be found in Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder. The rules apply to any company which has securities registered under Section 12 of the Act. Exchange Act Rule 14(a) makes it unlawful for any person to “solicit” a proxy unless they follow the specific rules and procedures. Prior to the amendment, Rule 14a-1(l), defined a solicitation to include, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person himself/herself is seeking authorization to act as a proxy. The SEC’s August 2019 guidance confirmed that proxy voting advice by a proxy advisory firm would fit within this definition of a solicitation and the new amendment codified such view.
The amendments change Rule 14a-1(l) to specify the circumstances when a person who furnishes proxy voting advice will be deemed to be engaged in a solicitation subject to the proxy rules. In particular, the definition of “solicit” or “solicitation” now includes “any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee.”
The SEC provides for certain exemptions to the definition of a “solicitation” including: (i) the furnishing of a form of proxy to a security holder upon the unsolicited request of such security holder as long as such request is not to a proxy advisory firm; (ii) the mailing out of proxies for shareholder proposals, providing shareholder lists or other company requirements under Rule 14a-7 related to shareholder proposals; (iii) the performance by any person of ministerial acts on behalf of a person soliciting a proxy; or (iv) a communication by a security holder, who does not otherwise engage in a proxy solicitation, stating how the security holder intends to vote and the reasons therefor. This last exemption is only available, however, if the communication: (A) is made by means of speeches in public forums, press releases, published or broadcast opinions, statements, or advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis, (B) is directed to persons to whom the security holder owes a fiduciary duty in connection with the voting of securities of a registrant held by the security holder (such as financial advisor), or (C) is made in response to unsolicited requests for additional information with respect to a prior communication under this section.
By maintaining a broad definition of a solicitation, the SEC can exempt certain communications, as it has in the definition, in Rule 14a-2(b) discussed below, and through no-action relief, while preserving the application of the anti-fraud provisions. In that regard, the amended SEC rules specifically state that a proxy advisory firm does not fall within the carve-out in Rule 14a1(I) for “unsolicited” voting advice where the proxy advisory firm is hired by an investment advisor to provide advice. Proxy advisory firms do much more than just answer client inquiries, but rather market themselves as having an expertise in researching and analyzing proxies for the purpose of making a voting determination.
On the other hand, in response to commenters, the new rule adds a paragraph to specifically state that the terms “solicit” and “solicitation” do not include any proxy voting advice provided by a person who furnishes such advice only in response to an unprompted request. For example, when a shareholder reaches out to their financial advisor or broker with questions related to proxies, the financial advisor or broker would be covered by the carve-out for unsolicited inquiries.
In response to commenters from the proposing release, the SEC also clarified that a voting agent, that does not provide voting advice, but rather exercises delegated voting authority to vote shares on behalf of its clients, would not be providing “voting advice” and therefore would not be encompassed within the new definition of “solicitation.”
Rule 14a-2(b) – Exemptions from the Filing and Information Requirements
Subject to certain exemptions, a solicitation of a proxy generally requires the filing of a proxy statement with the SEC and the mailing of that statement to all shareholders. Proxy advisory firms can rely on the filing and mailing exemption found in Rule 14a-2(b) if they comply with all aspects of that rule. Rule 14a-2(b)(1) provides an exemption from the information and filing requirements for “[A]ny solicitation by or on behalf of any person who does not, at any time during such solicitation, seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a security holder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization.” The exemption in Rule 14a-2(b)(1) does not apply to affiliates, 5% or greater shareholders, officers or directors, or director nominees, nor does it apply where a person is soliciting in opposition to a merger, recapitalization, reorganization, asset sale or other extraordinary transaction or is an interested party to the transaction.
Rule 14a-2(b)(3) generally exempts voting advice furnished by an advisor to any other person the advisor has a business relationship with, such as broker-dealers, investment advisors and financial analysts. The amendment adds conditions for a proxy advisory firm to rely on the exemptions in Rules 14a-2(b)(1) or (b)(3).
The amendments add new Rule 14a-2(b)(9) providing that in order to rely on an exemption, a proxy voting advice business would need to: (i) include disclosure of material conflicts of interest in their proxy voting advice; and (ii) have adopted and publicly disclosed written policies and procedures design to (a) provide companies and certain other soliciting persons with the opportunity to review and provide feedback on the proxy voting advice before it is issued, with the length of the review period depending on the number of days between the filing of the definitive proxy statement and the shareholder meeting; and (b) provide proxy advice business clients with a mechanism to become aware of a company’s written response to the proxy voting advice provided by the proxy firm, in a timely manner.
The new rules contain exclusions from the requirements to comply with new Rule 14a-2(b)(9). A proxy advisory business would not have to comply with new Rule 14a-2(b)(9) for proxy voting advice to the extent such advice is based on an investor’s custom policies – that is, where a proxy advisor provides voting advice based on that investor’s customized policies and instructions. In addition, a proxy advisory business would not need to comply with the rule if they provide proxy voting advice as to non-exempt solicitations regarding (i) mergers and acquisition transactions specified in Rule 145(a) of the Securities Act; or (ii) by any person or group of persons for the purpose of opposing a solicitation subject to Regulation 14A by any other person or group of persons (contested matters). The SEC recognizes that contested matters or some M&A transactions involve frequent changes and short time windows. This exception from the requirements of Rule 14a-2(b)(9) applies only to the portions of the proxy voting advice relating to the applicable M&A transaction or contested matters and not to proxy voting advice regarding other matters presented at the meeting.
New Rule 14a-2(b)(9) is not required to be complied with until December 1, 2021. Solicitations that are exempt from the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.
Conflicts of Interest
The rule release provides some good examples of conflicts of interest that would require disclosure, including: (i) providing proxy advice to voters while collecting fees from the company for advice on governance or compensation policies; (ii) providing advice on a matter in which one of its affiliates or other clients has a material interest, such as a transaction; (iii) providing voting advice on corporate governance standards while, at the same time, working with the company on matters related to those same standards; (iv) providing voting advice related to a company where affiliates of the proxy advisory business hold major shareholder, board or officer positions; and (v) providing voting advice to shareholders on a matter in which the proxy advisory firm or its affiliates had provided advice to the company regarding how to structure or present the matter or the business terms to be offered.
The prior rules did generally require disclosure of material interests, but the amended rules require a more specific and robust disclosure. The amended rules require detailed disclosure of: (i) any information regarding an interest, transaction or relationship of the proxy voting advice business or its affiliates that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction or relationship; and (ii) any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction or relationship. The final rule as written reflects a principles-based approach and adds more flexibility to the proxy advisory business than the more prescriptive-based rule proposal.
Although the rule requires prominent disclosure of material conflicts of interest to ensure the information is readily available, it provides flexibility in other respects. The rule does not dictate the particular location or presentation of the disclosure in the advice or the manner of its conveyance as some commenters recommended. Accordingly, the rule would give a proxy voting advice business the option to include the required disclosure either in its proxy voting advice or in an electronic medium used to deliver the proxy voting advice, such as a client voting platform, which allows the business to segregate the information, as necessary, to limit access exclusively to the parties for which it is intended. Likewise, the disclosure of policies and procedures related to conflicts of interest is flexible. This may include, for example, a proxy voting advice business providing an active hyperlink or “click-through” feature on its platform allowing clients to quickly refer from the voting advice to a more comprehensive description of the business’s general policies and procedures governing conflicts of interest.
Review and Feedback on Proxy Advisory Materials
Although some of the largest proxy advisory firms, such as ISS and Glass Lewis, voluntarily provide S&P 500 companies with an opportunity to review and provide some feedback on advice, there is still a great deal of concern as to the accuracy and integrity of advice, and the need to formally allow all companies and soliciting parties an opportunity to review and provide input on such advice prior to it being provided to solicitation clients. Likewise, it is equally important that clients learn of written feedback and responses to a proxy advisor’s advice. The amended rules are designed to address the concerns but as adopted are more principles-based and less prescriptive than the proposal.
The proposed amendments would have required a standardized opportunity for timely review and feedback by companies and third parties and require specific disclosure to clients of written responses. The time for review was set as a number of days based on the date of filing of the definitive proxy statement. However, commenters pushed back and the SEC listened.
The final rules allow proxy advisory businesses to take matters into their own hands. In particular, a proxy voting advice business must adopt and publicly disclose written policies and procedures reasonably designed to ensure that (i) companies that are the subject of proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the proxy voting advice business’s clients; and (ii) the proxy voting advice business provides its clients with a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice by companies that are the subject of such advice, in a timely manner before the shareholder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action).
As adopted, the new rule does not dictate the manner or specific timing in which proxy voting advice businesses interact with companies, and instead leaves it within the discretion of the proxy voting advice business to choose how best to implement the principles embodied in the rule and incorporate them into the business’s policies and procedures. Although advice does not need to be provided to companies prior to be disseminated to proxy voting business’s clients, it is encouraged where feasible. Under the final rules, companies are not entitled to be provided copies of advice that is later revised or updated in light of subsequent events.
New Rule 14a-2(b)(9) provides a non-exclusive safe harbor in which a proxy advisory firm could rely upon to ensure that its written policies and procedures satisfy the rule. In particular:
(i) If its written policies and procedures are reasonably designed to provide companies with a copy of its proxy voting advice, at no charge, no later than the time it is disseminated to the business’s clients. The safe harbor also specifies that such policies and procedures may include conditions requiring companies to (a) file their definitive proxy statement at least 40 calendar days before the security holder meeting and (b) expressly acknowledge that they will only use the proxy voting advice for their internal purposes and/or in connection with the solicitation and will not publish or otherwise share the proxy voting advice except with the companies’ employees or advisers.
(ii) If its written policies and procedures are reasonably designed to provide notice on its electronic client platform or through email or other electronic means that the company has filed, or has informed the proxy voting advice business that it intends to file, additional soliciting materials setting forth the companies’ statement regarding the advice (and include an active hyperlink to those materials on EDGAR when available).
The safe harbor allows a proxy advisory firm to obtain some assurances as to the confidentiality of information provided to a company. Policies and procedures can require that a company limit use of the advice in order to receive a copy of the proxy voting advice. Written policies and procedures may, but are not required to, specify that companies must first acknowledge that their use of the proxy voting advice is restricted to their own internal purposes and/or in connection with the solicitation and will not be published or otherwise shared except with the companies’ employees or advisers.
It is not a condition of this safe harbor, nor the principles-based requirement, that the proxy voting advice business negotiate or otherwise engage in a dialogue with the company, or revise its voting advice in response to any feedback. The proxy voting advice business is free to interact with the company to whatever extent and in whatever manner it deems appropriate, provided it has a written policy that satisfies its obligations.
Rule 14a-9 – the Anti-Fraud Provisions
All solicitations, whether or not they are exempt from the federal proxy rules’ filing requirements, remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact. The amendments modify Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending upon the particular facts and circumstances, be considered misleading within the meaning of the rule.
The types of information a proxy voting advice business may need to disclose include the methodology used to formulate the proxy voting advice, sources of information on which the advice is based, or material conflicts of interest that arise in connection with providing the advice, without which the proxy voting advice may be misleading. Currently the Rule contains four examples of information that may be misleading, including: (i) predictions as to specific future market values; (ii) information that impugns character, integrity or personal reputation or makes charges concerning improper, illegal or immoral conduct; (iii) failure to be clear as to who proxy materials are being solicited by; and (iv) claims made prior to a meeting as to the results of a solicitation.
The new rule adds to these examples the information required to be disclosed under 14a2-(b), including the failure to disclose the proxy voting advice business’s methodology, sources of information and conflicts of interest. The proxy advisor must provide an explanation of the methodology used to formulate its voting advice on a particular matter, although the requirement to include any material deviations from the provider’s publicly announced guidelines, policies, or standard methodologies for analyzing such matters, was dropped from the proposed rule. The SEC uses as an example a case where a proxy advisor recommends a vote against a director for the audit committee based on its finding that the director is not independent while failing to disclose that the proxy advisor’s independence standards differ from SEC and/or national exchange requirements and that the nominee does, in fact, meet those legal requirements.
Likewise, a proxy advisor must make disclosure to the extent that the proxy voting advice is based on information other than the company’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the company.
Supplemental Guidance for Investment Advisors
On the same day as enacting the amended rules, the SEC Commissioners, also in a 3-1 divided vote, endorsed supplemental guidance for investment advisors in light of the new rules. The guidance updates the prior guidance issued in August 2019 – see HERE. The supplemental guidance assists investment advisers in assessing how to consider company responses to recommendations by proxy advisory firms that may become more readily available to investment advisers as a result of the amendments to the solicitation rules under the Exchange Act.
The supplemental guidance states that an investment adviser should have policies and procedures to address circumstances where the investment adviser becomes aware that a company intends to file or has filed additional soliciting materials with the SEC, after the investment adviser has received the proxy advisory firm’s voting recommendation but before the submission deadline. The supplemental guidance also addresses disclosure obligations and client consent when investment advisers use automated services for voting such as when they receive pre-populated ballots from a proxy advisory services firm.
Small public companies are in trouble and they need help now! Once in a while there is a perfect storm forming that can only result in widespread damage and that time is now for small public companies, especially those that trade on the OTC Markets. The trains on track to collide include a combination of (i) the impending amended Rule 15c2-11 compliance deadline (which alone would be and is a clear positive); (ii) the proposed Rule 144 rule changes to eliminate tacking upon the conversion of market adjustable securities; (iii) the SEC onslaught of litigation against micro-cap convertible note investors claiming unlicensed dealer activity; (iv) the OTC Markets new across the board unwillingness to allow companies to move from the Pink to the QB if they have outstanding convertible debt; and (v) the SEC’s unwillingness to recognize the OTC Pink as a trading market and its implications on re-sale registration statements.
Any one of these factors alone would not be catastrophic, and in the case of the 211 overhaul, is extremely beneficial. However, putting together all of these elements will inevitably result in the complete failure of many small public companies and unfortunately, a disproportionate number of those companies will be operated by woman and minorities.
Of course, I am not the only one that realizes this. In late 2020 a group of market participants including small public companies, investors, law firms, and advocates formed the Small Public Company Coalition (SPCC) as a first-in-kind, high-level properly organized advocate and lobbying group to bring the issues in front of those that can make a difference including the SEC and Congress.
The SPCC is a member-driven, federal advocacy coalition consisting of participants in the micro-cap space. The SPCC is the real deal with active involvement from the brightest at Gibson Dunn & Crutcher, an international law firm with over 1,400 lawyers, and organized lobbying efforts led by Polaris Consulting, a top 10 lobbying firm in D.C. The team at Gibson, Dunn wrote an excellent comment letter response to the SEC proposed changes to Rule 144 that was signed by over 60 market participants and includes a complete economic impact analysis prepared by James Overdahl, Ph.D, who is the former Chief Economist for both the SEC and the CFTC. The SPCC has also been actively meeting with groups at the SEC and in Congress in support of the cause. For more information on the SPCC see www.thespcc.com or reach out to email@example.com.
On September 26, 2020, the SEC adopted final rules amending Securities Exchange Act (“Exchange Act”) Rule 15c2-11. From a high level, the amended rule will require that a company have current and publicly available information as a precondition for a broker-dealer to either initiate or continue to quote its securities; will narrow reliance on certain of the rules exceptions, including the piggyback exception; will add new exceptions for lower risk securities; and add the ability of OTC Markets itself to confirm that the requirements of Rule 15c2-11 or an exception have been met, and allow for broker-dealers to rely on that confirmation. The new rule will not require OTC Markets to submit a Form 211 application or otherwise have FINRA review its determination that a broker-dealer can quote a security, prior to the quotation by a broker-dealer. For a detailed summary of the new rules, see HERE.
Compliance with the majority of the rule’s requirements, including that all quoted companies have current information in order to remain 211 eligible, is slated for September 28, 2021. For companies that are Alternatively Reporting or intend to be Alternatively Reporting to OTC Markets, the ability to upload information requires access to the OTC Markets OTCIQ system. A company must apply to OTC Markets in order to gain access to the OTCIQ system (and thus publish current information on OTC Markets). If a company has been inactive for a period of time, or if a company goes through a change of control, a new OTCIQ application must be submitted.
Access to the OTCIQ system is the first barrier to entry for companies that wish to publish current information in compliance with the 211 rules, using the Alternative Reporting Standard. OTC Markets is inundated with such applications and has publicly announced that if an application is not submitted before June 30, 2021, it will not be processed in time to allow a company to access the system to upload current information prior to the September 28th deadline. Upon submitting an application, the current processing time is approximately 12 weeks.
Unlike obtaining EDGAR filing codes from the SEC, access to the OTCIQ system involves a merit review. The application itself requires the disclosure of all officers, directors and 5% or greater shareholders and the submittal of a background check authorization form for each. If there is negative history, either actual or reputational, related to any of the people listed on the form, OTC Markets has the authority to, and will likely, deny the application. In addition, if a company’s stock has been the subject of volatility in recent months (as so many have – see my blog on Gary Gensler’s recent speech on the subject including social media influencing stock prices – HERE), OTC Markets can, and has routinely been, denying the OTCIQ application.
I applaud the efforts to clean up the micro-cap markets but have issue with the discretionary and arbitrary nature of the review and decision-making process. The SEC has clearly defined bad actor rules, which include a shareholder ownership threshold of 20% and does not include a person’s “reputation.” For a detail of the bad actor rules, see HERE. Small and micro-cap companies often go through changes of control including both organic changes and reverse acquisitions. In fact, the new 211 rules give shell companies an 18-month runway to complete an acquisition. As I discuss below, I understand that OTC Markets is in a unique position to witness micro-cap fraud and the dealings of those that give penny stocks a bad name. I also understand that they are trying to find a balance between allowing access and protection of investors and the reputation of the marketplace itself. However, I would advocate for a more prescriptive test that mirrors the SEC bad actor rules with discretionary power only in extreme circumstances.
I am reminded of FINRA’s similar arbitrary use of Rule 6490 back in 2013-2015. Rule 6490 allows FINRA to deny a corporate action (such as name change, reverse split, etc.) if, among other reasons, “FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors.”
For a period of time, FINRA was relying on “may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors” to deny corporate actions to companies that had any relationship, no matter how far removed, with a person that FINRA deemed a threat, regardless of any actual legal proceedings. See HERE for more information. Several issuers litigated FINRA’s seemingly expansive and arbitrary use of the rule to deny corporate actions. Although the SEC sided with FINRA and upheld their authority, FINRA adjusted their policy moving forward.
FINRA will still deny a corporate action if there is an actual bad actor involved in the company, and even if there is a significant shareholder or investor, whether debt or equity, that is the subject of a pending SEC or other regulatory proceeding but now the results of a review can be anticipated. FINRA considers actual filed legal proceedings and will even provide a company with an opportunity to explain the circumstances and provide exculpatory information. FINRA no longer considers unsubstantiated anonymous internet trolls in its review process. I hope OTC Markets goes the same route.
I also hope that OTC Markets changes its policy of penalizing a company’s ability to provide current public information, because of recent stock volatility and/or internet chat activity. In January 2021 the equity markets saw unprecedented volatility fueled in part by the use of trading apps such as Robinhood and TD Ameritrade and chat rooms such as on Reddit. Many exchange traded middle market companies, such as GameStop and AMC Theaters, were affected as were multiple OTC Markets entities, many of which lacked current public information. In February 2021 the SEC suspended the trading of several OTC Markets companies as result of social media triggered trading volatility without corresponding public information. Of course, this was a valid response.
However, I do not understand OTC Markets denying the ability to provide current information as a result of third-party social media activity or trading volatility (especially when the whole market was experiencing trading volatility). As OTC Markets pointed out in its comment letter response to the proposed 15c2-11 rules and in its application to the SEC for the formation of an expert market, there are companies that trade without current public information that are legitimate businesses. There are also many companies that are now motivated to provide current information as a result of the impending 211 compliance date. They should be allowed to do so, regardless of trading activity.
I note that if any of these companies have engaged in improper stock promotion, pump and dump activity, providing fraudulent or inaccurate public information or misinformation, there are numerous remedies available. The OTC Markets can tag the company with a caveat emptor designation and the SEC can initiate a trading suspension and subsequent enforcement action.
Even once an application for filing code access is granted, all information must be reviewed by OTC Markets prior to receiving current information status or confirmation of 15c2-11 eligibility. Absent actual identifiable bad actors, this seems the best gateway for OTC Markets to exercise its gatekeeper role. Also, in that gatekeeper role, OTC Markets should follow its stated position in its comment letter to the SEC in response to the 211 rule changes and make the review process more objective and efficient. OTC Markets should not review the merits of the information itself. The goal should be to ensure the markets have the information mandated by Rule 15c2-11, that such information is publicly available for the investing community, and that an issuer has the responsibility for the accuracy of the information.
Proposed Rule 144 Rule Changes
On December 22, 2020, the SEC proposed amendments to Rule 144 which would eliminate tacking of a holding period upon the conversion or exchange of a market adjustable security that is not traded on a national securities exchange. Market adjustable securities usually take the form of convertible notes which have become a very popular and common form of financing for micro- and small-cap public companies over the past decade or so but have been under attack in recent years. The reasoning for the attacks range from the dilutive effect of the financing (yes, it’s dilutive); to labeling all market adjustable security investors and lenders as predatory sharks swimming in a sea of innocent guppies; to the SEC’s claim that serial lenders are acting as unlicensed dealers; to no articulated reason at all.
When the rule was first proposed and I blogged about it (see HERE), I saw the rule as adding some clarity to an opaque attack by market participants against a category of investors. In other words, I saw it as adding boundaries to what was otherwise just discrimination. Now I think it is a reactive, under-educated, excessive regulatory response to a perceived issue, fraught with unintended consequences. The hardest hit group from the fallout of this rule will be woman- and minority-majority-owned businesses.
In a standard convertible note structure, an investor lends money in the form of a convertible promissory note. Generally, the note can either be repaid in cash, or if not repaid, can be converted into securities of the issuer. Since Rule 144 allows for tacking of the holding period as long as the convertible note is outstanding for the requisite holding period, the investor would be able to sell the underlying securities into the public market immediately upon conversion. The notes generally convert at a discount to market price so if the converted securities are sold quickly, it appears that a profit is built in. The selling pressure from the converted shares has a tendency to push down the stock price of the issuer. On the flip side, because of the market adjustable feature, the lender can usually offer a lower interest rate and better terms.
The notes also generally have an equity blocker (usually 4.99%) such that the holder is prohibited from owning more than a certain percentage of the company at any given time to ensure they will never be deemed an affiliate and will not have to file ownership reports under either Sections 13 or 16 of the Exchange Act (for more on Sections 13 and 16, see HERE). As a result, there is the potential for a note holder to require multiple conversions each at 4.99% of the outstanding company stock in order to satisfy the debt. Each conversion would be at a discount to the market price with the market price being lower each time as a result of the selling pressure. This can result in a large increase in the number of outstanding shares and a decrease in the share price. Over the years, this type of financing has often been referred to as “toxic.”
Extreme dilution is only possible in companies that do not trade on a national securities exchange. Both the NYSE and Nasdaq have provisions that prohibit the issuance of more than 20% of total outstanding shares, at a discount to a minimum price, without prior shareholder approval. For more on the 20% Rule, see HERE. In addition to protecting the shareholders from dilution, the 20% Rule is a built-in blocker against distributions and as such, the SEC proposed Ruel 144 change only includes securities of an issuer that does not have a class of securities listed, or approved to be listed, on a national securities exchange.
Although on first look it sounds like these transactions are risk-free for the investor and that the proposed legislation makes perfect sense – they are not and it does not. Putting aside the fact that not even the SEC could enunciate the problem they are trying to fix (the SEC does not even mention extreme dilution), and only provided a few sentences on the economic impact of the rule (i.e., the impact is “unclear”), a further review makes it obvious the rule doesn’t make sense.
It isn’t all profits and using dollars to light cigars for adjustable security investors. First, Rule 144 itself creates some hurdles. In particular, in order to rely on the shorter six-month holding period for reporting companies, the company must be current in its reporting obligations. Also, if the company was formerly a shell company, it must always remain current in its reporting obligations to rely on Rule 144. If a company becomes delinquent, the investor can no longer convert its debt and oftentimes the company does not have the cash to pay back the obligation. Further, over the years it has become increasingly difficult to deposit the securities of penny stock issuers. Regardless of whether Rule 144 requires current information, most brokerage firms will not accept the deposit of securities of a company without current information, and many law firms, including mine, will not render an opinion for the securities of those dark companies.
There are market risks as well. If a company has very low volume and/or an extremely low price, market adjustment will not save the day for the investor. Also, conversion is generally based on a formula over the days prior to the conversion. There is no guarantee that the price will not drop in the time it takes to convert and deposit securities. Of course, there is the time value of money. No matter what, an investor is in for 6 months and would have foregone options on how to put the money to better use.
The problems with the proposed rule go deeper. I urge everyone to read the Comments of the SPCC in response to the rule, the response letter by Michael A. Adelstein, Partner at Kelley, Drye & Warren, LLP and the numerous, almost across the board, comments in opposition to the proposed rule. Whereas the SEC proposed rule contains almost no economic analysis whatsoever, the SPCC’s 187-page response contains an in-depth economic analysis by James Overdahl, Ph.D, who is the former Chief Economist for both the SEC and the . The results are grim, especially for development stage companies with limited capital and revenue.
It is quite possible that the rule’s implementation will bankrupt hundreds of small public companies. As the SEC notes, unlisted small public companies often have one source, and only one source, of quick affordable capital and that is market adjustable convertible securities. Eliminating this source of financing will likely drive these companies out of business (eliminating jobs and investment funds at the same time). As it is undeniably harder for woman and minorities to raise money, especially from traditional sources, they will be the hardest hit. (See my summary of the Annual Report of Office of Advocate for Small Business Capital Formation – HERE.)
The SEC comment letter focuses on the grievous consequences to small businesses as well as the legal legislative issues with the proposed rule (arbitrary and capricious, etc.). The letter also contains an excellent history of Rule 144 including citing the numerous reasons the SEC amended the rule in 1997 to codify the long-standing practice of allowing tacking to the original issue date of a convertible note upon conversion to securities. Likewise, the comment letter contains a thoughtful dissertation that convertible notes are not overly dilutive but rather provide an affordable valuable form of financing and support the SEC’s mission of promoting access to capital for small companies.
Michael A. Adelstein’s comment response letter takes a more analytic approach with a broader market view discussing the different types of issues and investors and even propounding alternative language to the proposed rule. The fact is that the issuers targeted by the proposed rule change are generally not S-3 eligible, cannot rely on the National Securities Market Improvements Act for registrations (i.e., they must comply with state blue sky laws which are arduous) and generally have smaller floats limiting the amount that could be sold in a re-sale registration statement (because it would be considered an indirect primary offering). For these companies’ private placements of public equity or debt (i.e., a PIPE) is the only potential source of meaningful capital. If the company properly uses the capital obtained in PIPE transactions, they will grow out of the need for market-adjustable securities and will move on to registered and underwritten offerings.
Moreover, the SEC does not even consider the impact on small exchange traded companies. If an exchange traded company is struggling financially, under the new rules, it is unlikely that an investor will provide market adjustable convertible sources of capital for fear the company will be delisted and they will lose the ability to tack onto the holding period. As Mr. Adelstein notes, “[A] market-adjustable security can save entire businesses and thousands of jobs, as well as some or all of the value of investments already made into such businesses.”
Likewise, the SEC focuses only on convertible notes, disregarding the multiple types of market adjustable convertible securities which will also be impacted such as floaters, amorts, resets, forced convertibles and default convertibles. Mr. Adelstein’s comment letter contains an excellent discussion of these different types of instruments and provisions, but the most important point is it is not a one-size-fits-all investment. The SEC must at least consider the use of these different instruments and what impact a broad swipe of the pen can have.
Similarly, not all investors are the same. The SEC lumps together all market-adjustable security investors as pump-and-dump offenders out to take advantage of the marketplace. This simply isn’t true. There are some bad actors, but in my experience the majority are sophisticated investors looking to establish a long-term funding relationship with a client. The dumpers earn a reputation as such very quickly and are not sought after for further investments. I don’t mean to say the good ones are purely altruistic, but it just makes good business sense to establish long-term relationships and trade wisely to support growth. Fundamentals count. It is costly from an administrative perspective (accounting, deposit fees, opinion letters, brokerage fees, etc.) to manage multiple small investments. Also, the profit ratio for small investments is significantly lower than for larger ones. A company that utilizes capital properly and continues to grow will have a higher sustained stock price, more volume and more access to a diverse portfolio of capital only rounding out with market adjustable securities. A sophisticated investor will not just dump but will wait for good news and market changes, trading strategically. In this case, all investors make a larger return on investment dollars and are invited back to participate in future opportunities with even higher potential ROI’s and growth opportunities (every company is a small company in the beginning).
Considering the dramatic negative impact, the proposed rule will have on small and micro-cap companies, it seems obvious that there are many, less intrusive ways in which to approach the perceived problem. The SEC could require shareholder approval for any market adjustable convertible security issuance that could result in 20% or greater dilution, mirroring the current Exchange rules for all public companies. The SEC could also allow for tacking where, in fact, the securities were not issued at a discount to market regardless of market adjustable provisions in the security.
SEC Unlicensed Dealer Litigation
Prior to proposing the amendment to Rule 144, the SEC launched a different attack on investors/lenders of market adjustable securities. In November 2017 the SEC shocked the industry when it filed an action against Microcap Equity Group, LLC and its principal alleging that its investing activity required licensing as a dealer under Section 15(a) of the Exchange Act. Since that time, the SEC has filed approximately four more cases with the sole allegation being that the investor acted as an unregistered dealer. I am aware of several other entities that are under investigation for the same activity, which will likely result in enforcement actions.
The SEC certainly knew of the proliferation of convertible note and other market adjustable securities financings over the years. Rule 415 governs the registration requirements for the sale of securities to be offered on a delayed or continuous basis, such as in the case of the take down or conversion of convertible debt and warrants. In 2006 the SEC issued guidance on Rule 415 that the rule would not be available for re-sale registration statements where in excess of 30% of the company’s float was being registered for re-sale. The SEC indicated it would view such registrations as indirect primary offerings, that could not be priced at the market. The SEC action was in direct response to the proliferation of market adjustable equity line of credit financings during that time. Although there were a few large investors that did the majority of the financings, the SEC did not raise the dealer issue.
As mentioned before the Rule 144, 1997 amendment which specifically allowed tacking of the conversion holding period, spoke in depth as to this kind of financing. Likewise, the 2008 amendments that reduced the holding periods to six months and one year also addressed convertible financing and added a provision to clarify that tacking is also allowed upon the exercise of options and warrants where there is a cashless exercise feature. Again, the SEC did not raise an issue that the most prolific investors could be acting as an unlicensed dealer. To the contrary, the SEC recognized the importance of this type of financing.
On September 26, 2016, and again on the 27th, the SEC brought enforcement actions against issuers for the failure to file 8-K’s associated with corporate finance transactions and in particular PIPE transactions involving the issuance of convertible debt, preferred equity, warrants and similar instruments. Prior to the announcement of these actions, I had been hearing rumors in the industry that the SEC has issued “hundreds” of subpoenas (likely an exaggeration) to issuers related to PIPE transactions and to determine 8-K filing deficiencies. See HERE for my blog at the time. The SEC did not mention any potential violations by the investors themselves.
Nothing in the prior SEC rule making, interpretive guidance, or enforcement actions foresaw the current dealer litigation issue. The SEC litigation put a chill on convertible note investing and has left the entire world of hedge funds, family offices, day traders, and serial PIPE investors wondering if they can rely on previously issued SEC guidance and practice on the dealer question. So far, the SEC has only filed actions for unlicensed dealer activity against investors that invest specifically using convertible notes in penny stock issuers. Although there is a long-standing legal premise that a dealer in a thing must buy and sell the same thing (a car parts dealer is not an auto dealer, an icemaker is not a water dealer, etc.), there is nothing in the broker-dealer regulatory regime or guidance that limits broker-dealer registration requirements based on the form of the security being bought, sold or traded or the size of the issuer.
Specifically, there is no precedent for the theory that if you trade in convertible notes instead of open market securities, private placements instead of registered deals, bonds instead of stock, or warrants instead of preferred stock, etc., you either must be licensed as a dealer or are exempt. Likewise, there is nothing in the broker dealer regime that suggests that if you invest in penny stock issuers vs. middle market or exchange traded entities you need to be licensed as a dealer. Again, the entire community that serially invests or trades in public companies is in a state of regulatory uncertainty and the capital flow to small- and micro-cap companies has diminished accordingly. Although the SEC has had some wins in the litigations, the issue is far from settled.
Importantly, the dealer litigation, together with the proposed Rule 144 rule changes, makes it that much harder for small and developing public companies to obtain financing to execute on their business plans, support job growth and support the U.S. economy.
OTC Markets QB Standards
I mentioned above that most of the comment letter responses to the proposed Rule 144 amendments were in opposition to the rule change. One that was not, is OTC Markets itself. In supporting the proposed rule change, OTC Markets merely suggested that it not discriminate against OTC Markets securities, but rather that the new rule should apply across the board to both OTC Markets and Exchange traded issuers.
OTC Markets is in a unique position to witness the red flags of micro-cap fraud and has valiantly been engaged in an uphill battle to combat that fraud, and earn the respect of the SEC, FINRA and other regulators. To its credit, it has done an amazing job. Nothing is more illustrative of that than the complete dichotomy between the December 16, 2016 SEC White Paper on penny stocks which disregarded OTC Markets as a viable marketplace and showed a complete disinterest in it or its efforts to create a venture market (see HERE) and the new 15c2-11 rule release which hands over the power to determine compliance with the rule to OTC Markets itself.
Moreover, in the years prior to the 2016 White Paper and certainly since, the OTC Markets has consistently implemented new rule and policy changes, all in an effort to deter micro-cap fraud and create a respected market. They have and are succeeding.
But I don’t agree with everything. In recent years, OTC Markets has taken a stance against convertible note lenders and the issuers that rely on their financing. Effective October 1, 2020, OTC Markets formally updated its QB rules to add that it may “[R]efuse the application for any reason, including but not limited to stock promotion, dilution risk, and use of ‘toxic’ financiers if it determines, in its sole and absolute discretion, that the admission of the Company’s securities for trading on OTCQB, would be likely to impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.”
This would be fair enough if, like FINRA, it only denied an application if one of the investors or participants was a bad actor under the SEC rules, or had actual proceedings filed against it. Rather, though, OTC Markets has taken it one step further and has been denying the majority of QB applications where the applicant has convertible securities on the books.
In the past few months, this has become a big topic of conversation among market participants. In addition to clients and potential clients, other attorneys, broker-dealers and transfer agents have reached out to me to discuss insight or guidance. Is one convertible instrument enough to deny a QB application? Is three too many? Why are applications being denied even when the convertible instruments are not market adjustable? Will shareholder approval of the financings solve the problem? What if the total amount of potential dilution is less than 20%? 10% or even 5%?
Yesterday, on June 7, 2021, OTC Markets published some guidance on dilution risk associated with an OTCQB or OTCQX application. OTC Markets is focusing on:
- Whether an issuer has recent or currently outstanding convertible notes with conversion features that provide significant discounts to the current market price and whether such notes are held by company officers, directors and control persons;
- Whether an issuer has other classes of outstanding securities that are convertible into common stock at largely discounted rates and are not held by officers or directors;
- A capital table and/or “toxic financing” structure that will substantially reorganize the share ownership of the company;
- Whether an issuer has had a history of substantial increases in the amount of its outstanding shares;
- Whether an issuer has had a history of multiple or large reverse stock splits; and
- Whether an issuer has engaged lenders that have been the subjects of regulatory actions regarding “toxic financing” and related concerns.
The OTC Markets guidance indicates that an application can be renewed if a company takes corrective measures including enhancing corporate governance, providing additional disclosure, changing capital structure or adding protections for minority investors.
Although we appreciate all guidance, it is still opaque. It comes down to effectively identifying and solving a problem. The guidance indicates “substantial discount to market” but in my experience, even convertible notes at a fixed conversion price have been problematic. I know OTC Markets wants to allow listings on the QB and QX and is also trying to be a good steward and fiduciary to the marketplace. It is clear that we are in a period of transition.
In addition to the existence of convertible debt, like the OTCIQ application, OTC Markets has been doing a deep-dive merit review on all companies that apply to the QB and has been quick to deny an application, often without articulating the reasons or in perfunctory emails with a high-level reason that has been the source of some frustration for applicants.
Trading on the QB is not merely for optics. It has a definitive regulatory and capital raising impact.
The OTC Pink is not a Recognized Marketplace
A company that trades on the OTC Pink market may not rely on Rule 415 to file a re-sale registration statement whereby the selling shareholders can sell securities into the market at market price. That is, all registration statements, whether re-sale, primary or indirect primary, must be at a fixed price unless the issuer is trading on the OTCQB or higher.
Rule 415 sets forth the requirements for engaging in a delayed offering or offering on a continuous basis. Under Rule 415 a re-sale offering may be made on a delayed or continuous basis other than at a fixed price (i.e., it may be priced at the market). It is axiomatic that for a security to be sold at market price, there must be a market. There was a time when the SEC refused to recognize any of the tiers of OTC Markets, as a “market” for purposes of at-the-market offerings. On May 16, 2013, the SEC issued a C&DI recognizing the OTCQB and OTCQX as market for purposes of filing and pricing a re-sale registration statement.
However, OTC Pink is still not a recognized market. As there is no actual rule that identifies what is a market for purposes of Rule 415, the SEC has looked to Item 501(b)(3) of Regulation S-K. Item 501 provides the requirements for disclosing the offering price of securities on the forepart of a registration statement and outside front cover page of a prospectus. Item 501 requires that either a fixed price be disclosed or a formula or other method to determine the offering price based on market price. The SEC uses this rule to require a fixed price where a company trades on the OTC Pink since there is no identifiable “market” to tie a price too.
In light of the SEC dealer litigation and proposed Rule 144 amendments, many companies are engaging with investors for registered offerings. Even though the SEC is a proponent of exempt offerings (thus the redo of the entire exempt offering structure in November 2020), it seems that encouraging companies to register offerings will reduce micro-cap fraud and should be supported by OTC Markets. However, in order to properly utilize registration statements for capital market financing transactions, a company must trade on the OTCQB or better. A company’s added difficulty in being accepted to trade on the QB is just another notch on the tightening noose of OTC Markets companies.
On April 16, 2021, the SEC voted to reopen the comment period on the proposed rules for the use of Universal proxy cards in all non-exempt solicitations for contested director elections. The original rules were proposed on October 16, 2016 (see HERE) with no activity since. However, it is not surprising that the comment period re-opened, and it is not as a result of the new administration. The SEC’s Spring and Fall 2020 semi-annual regulatory agendas and plans for rulemaking both included universal proxies as action items in the final rule stage. Prior to that, the topic had sat in the long-term action category for years.
In light of the several years since the original proposing release, change in corporate governance environment, proliferation of virtual shareholder meetings, and rule amendments related to proxy advisory firms (see HERE) and shareholder proposals in the proxy process (see HERE), the SEC believed it prudent to re-open a public comment period. In addition, the SEC including additional questions for public input in its re-opening release.
Each state’s corporate law provides for the election of directors by shareholders and the holding of an annual meeting for such purpose. Companies subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”), must comply with Section 14 of the Exchange Act, which sets forth the federal proxy rules and regulations. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies.
Currently where there is a contested election of directors, shareholders are likely receive two separate and competing proxy cards from the company and the opposition. Each card generally only contains the directors supported by the sender of the proxy – i.e., all the company’s director picks on one card and all the opposition’s director picks on the other card. A shareholder that wants to vote for some directors on each of the cards, cannot currently do so using a proxy card. The voting process would only allow the shareholder to return one of the cards as valid. If both were returned, the second would cancel out and replace the first under state corporate law.
Although the current proxy rules do allow for all candidates to be listed on a single card, such candidate must agree. Generally, in a contested election the opposing candidates will not agree, presuming it will impede the process for the opposition or have the appearance of an affiliation or support that does not exist. Moreover, neither party is required to include the other’s nominees, and accordingly, even if the director nominees would consent, they are not included for strategic purposes.
Shareholders can always appear in person, or in today’s world – virtually in person, and vote for any directors, whether company or opposition supported, but such appearance is rare and adds an unfair expense to those shareholders. Besides other impediments, where shares are held in a brokerage account in street name, a shareholder desiring to appear in person needs to go through an added process of having a proxy changed from the brokerage firm to their individual name before they will be on the list and allowed to appear and vote in person. Over the years, some large shareholders have taken to sending a representative to meetings so that they could split a vote among directors nominated by a company and those nominated by opposition. To provide the same voting rights to shareholders utilizing a proxy card as they would have in person, the proposed new rule would require the use of a universal proxy card with all nominees listed on a single card.
In 1992 the SEC adopted Rule 14a-4(d)(4), called the “short slate rule,” which allows an opposing group that is only seeking to nominate a minority of the board, to use their returned proxy card, and proxy power, to also vote for the company nominees. The short slate rule has limitations. First, it is granting voting authority to the opposition group who can then use that authority to vote for some or all of company nominees, at their discretion. Second, although a shareholder can give specific instruction on the short slate card as to who of the company nominees they will not vote for, they will still need to review a second set of proxies (i.e., those prepared by the company) to get those names.
In 2013 the SEC Investor Advisory Committee recommended the use of a universal proxy card, and in 2014 the SEC received a rulemaking petition from the Council of Institutional Investors making the same request. As a response, the SEC issued the rule proposal which would require the use of a “universal proxy” card that includes the names of all nominated director candidates.
SEC Proposed Rule
On October 16, 2016, the SEC proposed amendments to the federal proxy rules to require the use of universal proxy cards in connection with contested elections of directors. In particular, the proposed rule would:
- Create new Rule 14a-19 to require the use of universal proxy cards in all non-exempt solicitations in connection with contested director elections. The universal proxy card would not be required where the election of directors is uncontested. There may be cases where shareholder proposals are contested by a company, in which case a shareholder would still receive two proxy cards; however, in such case, all director nominees must be included in each groups proxy cards;
- Revise the consent required of a bona fide director nominee such that a consent for nomination will include the consent to be included in all proxy statements and proxy cards. Clear disclosure distinguishing company and dissident nominees will be required in all proxy statements;
- Eliminate the short slate rule;
- Prescribe certain filing, notice, and solicitation requirements of companies and dissidents when using universal proxy cards;
- Require dissidents to provide companies with notice of intent to solicit proxies in support of nominees other than the company’s nominees, and to provide the names of those nominees. The rule changes specify timing and notice requirements;
- Require dissidents in a contested election subject to new Rule 14a-19 to solicit holders of at least a majority of the voting power of shares entitled to vote on the election of directors;
- Provide for a filing deadline for the dissidents’ definitive proxy statement; and
- Prescribe formatting and other requirements for the universal proxy cards.
The Proposed Rules also include other improvements to the proxy voting process, such as mandating that proxy cards include an “against” voting option when permitted under state laws and requiring disclosure about the effect of a “withhold” vote in an election.
The SEC rule release has a useful chart on the timing of soliciting universal proxy cards:
|Due Date||Action Required|
No later than 60 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, by the later of 60 calendar days prior to the date of the annual meeting or the tenth calendar day following the day on which public announcement of the date of the annual meeting is first made by the registrant. [proposed Rule 14a-19(b)(1)]
Dissident must provide notice to the registrant of its intent to solicit the holders of at least a majority of the voting power of shares entitled to vote on the election of directors in support of director nominees other than the registrant’s nominees and include the names of those nominees.
|No later than 50 calendar days before the anniversary of the previous year’s annual meeting date or, if the registrant did not hold an annual meeting during the previous year, or if the date of the meeting has changed by more than 30 calendar days from the previous year, no later than 50 calendar days prior to the date of the annual meeting. [proposed Rule 14a- 19(d)]||Registrant must notify the dissident of the names of the registrant’s nominees.|
|No later than 20 business days before the record date for the meeting. [current Rule 14a-13]||Registrant must conduct broker searches to determine the number of copies of proxy materials necessary to supply such material to beneficial owners.|
|By the later of 25 calendar days before the meeting date or five calendar days after the registrant files its definitive proxy statement. [proposed Rule 14a-19(a)(2)]||Dissident must file its definitive proxy statement with the Commission.|
The proposed new rules will not apply to companies registered under the Investment Company Act of 1940 or BDC’s but would apply to all other entities subject to the Exchange Act proxy rules, including smaller reporting companies and emerging growth companies.
In its rule release, the SEC discusses the rule oppositions fear that a universal proxy card will give strength to an already bold shareholder activist sector, but notes that “a universal proxy card would better enable shareholders to have their shares voted by proxy for their preferred candidates and eliminate the need for special accommodations to be made for shareholders outside the federal proxy process in order to be able to make such selections.”
Companies have a concern that dissident board representation can be counterproductive and lead to a less effective board of directors due to dissension, loss of collegiality and fewer qualified persons willing to serve. The SEC rule release solicits comments on this point.
Moreover, there is a concern that shareholders could be confused as to which candidates are endorsed by whom, and the effect of the voting process itself. In order to avoid any confusion as to which candidates are endorsed by the company and which by opposition, the SEC is also including amendments that would require a clear distinguishing disclosure on the proxy card. Additional amendments require clear disclosure on the voting options and standards for the election of directors.