November 2015 - Reverse-Merger.com

SEC Advisory Committee Recommendations Related To Finders

Posted by Securities Attorney Laura Anthony | November 24, 2015 Tags: LawCast Network

On September 23, 2015, the SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) met and finalized its recommendation to the SEC regarding the regulation of finders and other intermediaries in small business capital formation transactions. This is a topic I have written about often, including a recent comprehensive blog which can be read HERE.

By way of reminder, the Committee was organized by the SEC to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”

The Advisory Committee discussed the topic at its meetings on June 3, 2015 and again on July 15, 2015 before finalizing its recommendations, which were published on September 23, 2015. In formulating its recommendations, the Advisory Committee gave specific consideration to the following facts:

The Advisory Committee made four recommendations related to the regulation of finders and other intermediaries in small business capital formation transactions, which I support but have doubts as to the realistic implementation. In particular:

The SEC take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Exchange Act.

The SEC exempt intermediaries on a federal level that are actively involved in the discussions, negotiations and structuring, and solicitation of prospective investors for private financings as long as such intermediaries are registered on the state level.

The SEC spearhead a joint effort with the North American Securities Administrators Association (NASAA) and FINRA to ensure coordinated state regulation and adoption of measured regulation that is transparent, responsive to the needs of small businesses for capital, proportional to the risks to which investors in such offerings are exposed, and capable of early implementation and ongoing enforcement; and

The SEC should take immediate steps to begin to address this set of issues incrementally instead of waiting for the development of a comprehensive solution.

Advisory Committee Considerations in Support of Its Recommendations

The Advisory Committee Letter lists practical facts and realities related to small business and emerging company capital formation in support of its recommendations. In particular:

Small businesses account for the creation of two-thirds of all new jobs, and are the incubators of innovation, generating the majority of net new jobs in the last five years and continuing to add more jobs;

Early-stage capital for these small businesses is raised principally through private offerings that are exempt from registration under the Securities Act of 1933 and state blue sky laws;

More than 95% of private offerings rely on Rule 506 of Regulation D; however, less than 15% of those use a financial intermediary such as a broker-dealer. This is due in part to a lack of interest from registered broker-dealers given the legal costs and risk involved in undertaking a small transaction, ambiguities in the definition of “broker” and the danger of using unregistered finders. (For more on the topic of incentives for broker-dealers to work with smaller offerings, see my blog HERE.

As documented in the findings of an American Bar Association Business Law Section Task Force in 2005 and endorsed by the SEC Government Business Forum on Small Business Capital Formation: (i) failure to address the regulatory issues surrounding finders and other private placement intermediaries impedes capital formation for smaller companies; (ii) the current broker-dealer registration system and FINRA membership process is a deterrent to meaningful oversight; (iii) appropriate regulation would enhance economic growth and job creation; and (iv) solutions are achievable through SEC leadership and coordination with FINRA and the states. For more on the ABA Task Force study, see my blog HERE.

The Advisory Committee is of the view that imposing only limited regulatory requirements, including appropriate investor protections and safeguards on private placement intermediaries with limited activities that do not hold customer funds or securities and deal only with accredited investors, would enhance capital formation and promote job creation.

My Thoughts

I’m practically jumping up and down with excitement that the Advisory Committee gets the issues and is discussing the matter from an overarching theoretical top-down standpoint. To create a workable system, there first has to be a general mapping and understanding of the directional goals. However, my excitement turns realistic, and unfortunately pessimistic, at the thought of the states, FINRA and the NASAA working together to find and actually implement a comprehensive regulatory solution.

Despite the SEC support for the NASAA coordinated review program to simplify the state blue sky process for securities offerings, such as under Tier 1 of Regulation A+, only 43 states participate. I say “only” in this context because the holdouts – including, for example, Florida, New York, Arizona and Georgia – are extremely active states for small business development and private capital formation. Moreover, even using the coordinated review program, the states have vastly different rules and interpretations of the same rules. See my blog HERE for further discussion.

I simply am an advocate for federal over state regulation on securities law matters. Rather than requiring state registration, I would simply create a federal exemption to the broker-dealer registration requirements for finders provided that:

The offering was being made in reliance on an exemption from the Securities Act registration requirements which exemption also exempts state law under the NSMIA (such as Rule 506 of Regulation D or Tier 2 of Regulation A+);

All offers and sales are limited to accredited investors;

The finders do not hold customer funds or securities;

The issuers and finders have disclosure requirements related to the role of the finder and compensation being paid (similar to Section 17(b) disclosure requirements under the Securities Act); and

The finders have liability for violations of the anti-fraud provisions by the issuers to the same extent as underwriter liability.

Of course, issuers would remain subject to all of the current anti-fraud provisions of the private offering exemption laws and thus would be responsible for the representations and actions of their finders, as they are now. Allowing an “above the line” profession of finders to develop will naturally create an environment where those finders that engage in unscrupulous methods will be easily identified and avoided.

For a review of the NSMIA and state blue sky laws, see my two-part blog HERE and HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. The firm’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the producer and host of LawCast, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington D.C., Denver, Tampa, Detroit and Dallas.

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« SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part 1 SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part II- Rules 504 And 505 »

SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part 1

Posted by Securities Attorney Laura Anthony | November 17, 2015 Tags: LawCast Network

On October 30, 2015, the SEC published proposed rule amendments to facilitate intrastate and regional securities offerings. This rule proposal comes following the September 23, 2015, Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) recommendation to the SEC regarding the modernization of the Rule 147 Intrastate offering exemption. The SEC has proposed amendments to Rule 147 to modernize the rule and accommodate adopted state intrastate crowdfunding provisions. The proposed amendment eliminates the restriction on offers and eases the issuer eligibility requirements, provided however the issuer must comply with the specific state securities laws. In addition, the SEC has proposed amendments to Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad actor disqualifications from reliance on the rule. Finally, the SEC has made technical amendments to Rule 505 of Regulation D.

In this Part I of the blog, I will discuss the Rule 147 amendment and in Part II, I will discuss the changes to Rules 504 and 505.

Background on Rule 147 and Rationale for Amendments

Both the federal government and individual states regulate securities, with the federal provisions often preempting state law. When federal provisions do not preempt state law, both federal and state law must be complied with. On the federal level, every issuance of a security must either be registered under Section 5 of the Securities Act, or exempt from registration. Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Section 3(a)(11) is often referred to as the Intrastate Exemption.

Rule 147 as it exists is a safe harbor promulgated under Section 3(a)(11) and provides further details on the application of the Intrastate Exemption. Neither Section 3(a)(11) nor Rule 147 preempt state law. That is, an issuer relying on Section 3(a)(11) and Rule 147 would still need to comply with all state laws related to the offer and sale of securities.

Rule 147 was adopted in 1974 and has not been updated since that time. Rule 147 has limitations that simply do not comport with today’s world. For example, the rule does not allow offers to out-of-state residents at all. Most website advertisements related to an offering are considered offers and if same are viewable by out-of-state residents, as they naturally would be, they would violate the rule.

Also, the current Rule 147 requires that an issuer be incorporated in the state in which the offering occurs. In today’s world, many companies incorporate in Nevada or Delaware (or other states) for valid business reasons even though all of their operations, income and revenue may be located in a different state. Moreover, the current Rule 147 requires that at least 80% of a company’s revenues, assets and use of proceeds be within the state in which the offering is conducted. Many issuers find meeting all three thresholds to be unduly burdensome.

The topic of intrastate offerings has gained interest in the marketplace since the passage of the JOBS Act in 2012 and the passage of numerous state-specific crowdfunding provisions. It is believed that in the near future a majority of states will have passed state-specific crowdfunding statutes. However, the current statutory requirements in Section 3(a)(11) and regulatory requirements in Rule 147 make it difficult for issuers to take advantage of these new state crowdfunding provisions.

Recently the SEC Advisory Committee on Small and Emerging Companies made recommendations to the SEC related to amendments to the Rule 147 Intrastate offering exemption. The Advisory Committee made the following specific recommendations to modernize Rule 147:

Allow for offers made in reliance on Rule 147 to be viewed by out-of-state residents but require that all sales be made only to residents of the state in which the issuer has its main offices;

Remove the need to use percentage thresholds for any type of issue eligibility requirements and evaluate whether alternative criteria should be used for determining the necessary nexus between the issuer and the state where all sales occur; and

Eliminate the requirement that the issuer be incorporated or organized in the same state where all sales occur.

Considering the Advisory Committee’s recommendations, as well as those of other market participants, the SEC has published proposed Rule 147 amendments related to intrastate offerings, and Rule 504 related to intrastate and regional offerings.

The proposed rule changes generally: (i) eliminate the offer restrictions while continuing to require that sales be made only to residents of the issuer’s state; (ii) redefine “intrastate offering” to ease some issuer eligibility requirements; (iii) limit the availability of the Rule 147 exemption to offerings that are either registered or exempt at the state level and which offerings are limited to no more than $5 million; (iv) amend Rule 504 to increase the aggregate offering amount from $1 million to $5 million and to add bad actor disqualifications from reliance on the rule; and (v) make technical conforming amendments to Rule 505.

Proposed Rule Amendments

The proposed amendments to Rule 147 will allow an issuer to engage in any form of general solicitation or general advertising, including the use of publicly accessible websites, to offer and sell its securities, so long as all sales occur within the same state or territory in which the issuer’s principal place of business is located. Moreover, the offering must be either registered or exempt in the state in which all of the purchasers are resident, and the state registration or exemption provision must limit the amount of securities an issuer may sell to no more than $5 million in a twelve-month period. Furthermore, the state statue must impose an investment limitation on investors. The proposed amendments define an issuer’s principal place of business as the location in which the officers, partners, or managers of the issuer primarily direct, control and coordinate the activities of the issuer and further require the issuer to satisfy at least one of four threshold requirements that would help ensure the in-state nature of the issuer’s business.

Interestingly, by amending Rule 147 to allow issuers that are not incorporated in a particular state to participate in intrastate offerings, the rule will no longer comply with the statutory provisions of Section 3(a)(11). Rather than amend Section 3(a)(11), the SEC is relying on its general authority under Section 28 of the Securities Act and making Rule 147 a stand-alone intrastate offering exemption that would no longer be a safe harbor or promulgated under Section 3(a)(11).

Section 3(a)(11) will remain a separate exemption for companies that wish to rely on its provisions, though practically speaking, I believe it will likely be rarely used, if ever.

In its rule release, the SEC points out that if the new rule is adopted in its proposed form, most states will need to amend their current intrastate offering exemptions to fully avail themselves of the new rule. In doing so, the states would be free to impose additional requirements or restrictions as deemed necessary or appropriate to facilitate local capital formation and investor protection.

Amendment to “Offer” Restrictions

Currently Rule 147 does not allow offers to out-of-state residents at all. Most website advertisements related to an offering are considered offers and if same are viewable by out-of-state residents, as they naturally would be, they would violate the rule. One of the main concepts behind crowdfunding is the ability to use the internet and social media to solicit the crowd for an investment. Accordingly, state regulators and practitioners were concerned that internet advertisements made in accordance with state crowdfunding provisions would violate Rule 147.

To help alleviate the problem, the SEC issued guidance in its Compliance and Disclosure Interpretations (C&DI’s) addressing the ability to advertise using the internet or social media in a state crowdfunding offering; however, the “offer” restriction remained.

Rule 147 as amended requires issuers to limit sales to in-state residents but no longer limits offers to in-state residents. Amended Rule 147 will permit issuers to engage in general solicitation and advertising without restriction, including offers to sell securities using any form of mass media and publicly available websites, so long as all sales of securities are limited to residents of the state in which the issuer has its principal place of business and which state’s intrastate registration or exemption provisions the issuer is relying upon. As offers are not limited but sales are, all solicitation and offer materials will need to include prominent disclosures stating that sales may only be made to residents of a particular state.

Determining Whether an Issuer is a “Resident” of, and Doing Business in, a Particular State

Rule 147 currently provides that an issuer shall be deemed to be a resident of the state in which: (i) it is incorporated or organized, if it is an entity requiring incorporation or organization; (ii) its principal office is located, if it is an entity not requiring incorporation or organization; or (iii) his or her principal residence is located, if an individual.

This provision is problematic in today’s corporate world, where many entities decide to incorporate in a particular state, such as Nevada or Delaware, for valid business purposes, even though all of their operations and offices may be located in a different state. The SEC agrees that the state of entity formation should not affect the ability of an issuer to be considered a “resident” for purposes of an intrastate offering exemption at the federal level.

Accordingly, the proposed rule amendment eliminates the requirement related to state of incorporation while continuing to require that an issuer have its principal place of business in the offering state. In addition, the issuer must satisfy at least one of a list of four other requirements meant to satisfy the residence requirement. In particular, the issuer will need to meet one of the three 80% thresholds or the new majority-of-employees threshold test.

Under the current Rule 147, an issuer shall be deemed to be doing business within a state if the issuer meets ALL of the following requirements: (i) the issuer, together with its subsidiaries, derived at least 80% of its gross revenues in the most recent fiscal year or most recent six-month period from that state, whichever is closer in time to the offering; (ii) the issuer had 80% of its assets located in that state in the most recent semiannual fiscal year; and (iii) the issuer intends to use and uses at least 80% of the net proceeds from the intrastate offering in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services in that state. In addition, under the current rule, the principal office of the issuer must be located within that state.

The new rule retains the three 80% threshold tests and even adds a fourth threshold based on the location of a majority of the issuer’s employees. Presumably a majority is satisfied by a greater than 50% determination. However, instead of having to comply with all of the threshold tests, the issuer need only comply with one of the four tests, in addition to maintaining its principal place of business in the state.

The amended Rule 147 further simplifies the “doing business in” standard by only requiring that the issuer’s principal place of business be in the subject state regardless of where its principal office is located. An issuer’s “principal place of business” will be defined as the “location from which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.” Issuers will be required to either register the offering in the state where all the purchasers are located or rely on a state registration exemption that limits the amount of the offering to no more than $5 million in any 12-month period and imposes investment limitations on investors. I note that concurrent with the proposed Rule 147 rule release, the SEC has proposed to increase the offering limit under Rule 504 to $5 million, allowing Rule 147 and Rule 504 to work together as an Intrastate Offering Exemption.

As discussed below, securities will need to “come to rest” in the hands of purchasers before resales will be allowed. Similarly, if an issuer changes its principal place of business to a new state, it would not be able to conduct an intrastate offering in reliance on Rule 147 in the new state until the securities sold in the prior state had “come to rest” in the hands of the purchasers. The “come to rest” period, both for resales and for second intrastate offerings, shall be a period of 9 months.

As with all provisions of the new Rule 147, in passing their own intrastate offering exemption, a state could impose additional requirements for use in their particular state.

Determining Whether the Investors and Potential Investors are Residents of a Particular State

Currently under Rule 147, all offers, offers to sell, offers for sale and sales of securities in an intrastate-exempted offering must be made to residents of the state in which the offering is conducted. For the purpose of determining the residence of an offeree or purchaser: (i) a corporation, partnership, trust or other form of business organization shall be deemed to be a resident of a state if, at the time of the offer and sale, it has its principal office within such state; (ii) an individual shall be deemed to be a resident of a state if, at the time of the offer and sale, his or her principal residence is within that state; and (iii) a corporation partnership, trust or other form of business organization formed specifically to take part in an intrastate offering will not be resident of the state unless all of its beneficial owners are residents of that state.

The new proposed rule adds a qualifier such that if the issuer reasonably believes that the investor is a resident of the applicable state, the standard will be satisfied. The reasonable belief standard is consistent with other provisions in Regulation D including Rule 506(c) as the accreditation of an investor. In shifting the responsibility to require a reasonable belief as to residency, the SEC is eliminating the current requirement that the investor provide a written representation as to residency. The view is that a self-attestation from an investor, without more, is not enough to create a reasonable belief and so that technical requirement would not add to the rule, and in fact could deter as it would allow issuers to believe that they could rely on such written statement.

The SEC provides examples of proof of residency. For individuals, proof may be an established relationship with the issuer, documentation as to home address and utility or related bills, tax returns, driver’s license and identification cards. The residency of an entity purchaser would be the location where, at the time of the sale, the entity has its principal place of business, which, like the issuer, is where “the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the [investor].”

Resale Restrictions

Even though securities issued relying on the Intrastate Exemption are not restricted securities for purposes of Rule 144, current Rule 147(e) prohibits the resale of any such securities for a period of nine months except for resales made in the same state as the Intrastate Offering. Market makers or dealers desiring to quote such securities after the nine-month period must comply with all of the requirements of Rule 15c2-11 regarding current public information. Moreover, Rule 147 specifically requires the placing of a legend on any securities issued in an intrastate offering setting forth the resale restrictions. Currently, in the case of an allowable in-state resale, the purchaser must provide written representations supporting their state of residence.

The proposed new Rule 147 provides that for a period of nine months from the date of sale to a particular purchaser, any resale by that purchaser may be made only to persons resident with the state of the offering. Accordingly resales out of state may only be made after the nine-month holding period. To ensure enforcement, an issuer must place a legend on the securities and stop transfer instructions to the transfer agent.

Avoiding Integration While Using the Intrastate Exemption

The determination of whether two or more offerings could be integrated is a question of fact depending on the particular circumstances at hand. Rule 502(a) and SEC Release 33-4434 set forth the factors to be considered in determining whether two or more offerings may be integrated. In particular, the following factors need to be considered in determining whether multiple offerings are integrated: (i) are the offerings part of a single plan of financing; (ii) do the offerings involve issuance of the same class of securities; (iii) are the offerings made at or about the same time; (iv) is the same type of consideration to be received; and (v) are the offerings made for the same general purpose.

Current Rule 147(b)(2) provides an integration safe harbor. That is, offerings made under Section 3 or Section 4(a)(2) of the Securities Act or pursuant to a registration statement will not be integrated with an Intrastate Exemption offering if such offerings take place six months prior to the beginning or six months following the end of the Intrastate Exemption offering. To rely on this safe harbor, during the six-month periods, an issuer may not make any offers or sales of securities of the same class as those offering in the intrastate offering. Rule 147(b)(2) is merely a safe harbor. Issuers and practitioners may still conduct their own analysis in accordance with the five-factor test enumerated above.

The proposed new Rule 147 amends the current integration safe harbor to be consistent with the new Regulation A/A+ safe harbor. In particular, under the proposed rule, offers and sales under Rule 147 would not be integrated with: (i) prior offers or sales of securities; or (ii) subsequent offers or sales of securities that are (a) registered under the Securities Act; (b) conducted under Regulation A; (c) exempt under Rule 701 or made pursuant to an employee benefit plan; (d) exempt under Regulation S; (e) exempt under Section 4(a)(6) – i.e., Title III Crowdfunding; or (f) made more than six months after the completion of the offering. The rule maintains that it is just a safe harbor and that issuers may still conduct their own analysis in accordance with the five-factor test.

Disclosure/Legend Requirements

Current Rule 147 requires written disclosure on resale limitations and requires that stop transfer instructions be given to the issuer’s transfer agent. The new rule retains the requirement but provides more definitive instruction. In particular, a written disclosure would need to be given to each offeree and purchaser at the time of any offer or sale. However, the disclosure can be given in the same manner as the offer for an offeree (i.e., could be verbal) but must be in writing as to a purchaser.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« Mergers And Acquisitions; Appraisal Rights SEC Advisory Committee Recommendations Related To Finders »

Mergers And Acquisitions; Appraisal Rights

Posted by Securities Attorney Laura Anthony | November 10, 2015 Tags: LawCast, LawCast Network, LawCast-2, lawcast-3, Merger Agreement, mergers & Acquisitions

Unless they are a party to the transaction itself, such as in the case of a share-for-share exchange agreement, shareholders of a company in a merger transaction generally have what is referred to as “dissenters” or “appraisal rights.” An appraisal right is the statutory right by shareholders that dissent to a particular transaction, to receive the fair value of their stock ownership. Generally such fair value may be determined in a judicial or court proceeding or by an independent valuation. Appraisal rights and valuations are the subject of extensive litigation in merger and acquisition transactions. As with all corporate law matters, the Delaware legislature and courts lead the way in setting standards and precedence.

Delaware Statutory Appraisal Rights

Although the details and appraisal rights process vary from state to state (often meaningfully), as with other state corporate law matters, Delaware is the leading statutory example and the Delaware Chancery Court is the leader in judicial precedence in this area of law. More than half of U.S. public companies and more than two-thirds of Fortune 500 companies are domiciled in Delaware.

Moreover, as is consistent with all states, the Delaware General Corporation Law (“DGCL”) Section 262 providing for appraisal rights requires both petitioning stockholders and the company to comply with strict procedural requirements. The following is a high-level summary of the detailed procedures and process required by the company and stockholders where appraisal rights are available and where the stockholder desires to avail itself of such rights.

Except in share exchange transactions where all shareholders are a direct party to the transaction and transaction documents, stockholders of a corporation that is being acquired in a merger transaction have a statutory right to a court appraisal of the fair value of their shares. Dissenting stockholders may seek this judicial determination as an alternative to accepting the merger consideration being offered in the transaction negotiated by the company’s board of directors.

Section 262 of the DGCL gives any stockholder of a Delaware corporation who (i) is the record holder of shares of stock on the date of making an appraisal rights demand, (ii) continuously holds such shares through the effective date of the merger, (iii) complies with the procedures set forth in Section 262, and (iv) has neither voted in favor of nor consented in writing to the merger, to seek an appraisal by the Court of Chancery of the fair value of their shares of stock.

Where an action allowing for appraisal rights is to be voted on by stockholders, the corporation must give written notice to its stockholders as of the meeting notice record date, not less than 20 days prior to the meeting. The written notice must include a copy of Section 262 of the DGCL. Each stockholder electing to demand appraisal rights for their shares must (i) deliver a written demand to the company for appraisal prior to the taking of the stockholder vote on the merger (or, in the case of a short-form merger or a merger approved by a written consent of stockholders, within 20 days of the mailing of a notice to stockholders informing them of the approval of the merger), (ii) file a petition with the Delaware Court of Chancery within 120 days after the effective date of the merger, and (iii) serve a copy of such petition on the corporation surviving the merger. Within 10 days of the effective date of the merger, the surviving corporation must give each stockholder that has elected appraisal rights, and not thereafter voted for or consented to the merger, notice of such merger effective date.

Where an action allowing for appraisal rights is approved without a vote by stockholders, within 10 days of the approval the corporation shall notify each of the stockholders who are entitled to appraisal rights of the approval of the merger and that appraisal rights are available. If already completed, the notice shall include the effective date of the merger. The written notice must include a copy of Section 262 of the DGCL. Each stockholder electing to demand appraisal rights for their shares must deliver a written demand to the company for appraisal within 20 days of the mailing of a notice to stockholders informing them of the approval of the merger. Thereafter the same procedures will apply as when approval was by a vote of stockholders.

At the hearing the court will determine the stockholders that have properly complied with the statute and are entitled to appraisal rights. Once it is determined which stockholders are entitled to an appraisal, the court will proceed with the substantive process of determining fair value. The statute requires that in determining such fair value, the court shall take into account all relevant factors (see the discussion below regarding the substantive fair value determinations).

Unless the court has good cause and determines otherwise, interest of 5% above the Federal Reserve discount rate shall accrue on the fair value of the shares from the date of the merger until the date paid. The court also has the statutory right to grant or deny the recovery of attorney’s fees and costs to a petitioning shareholder. From and after the effective date of the merger, stockholders who have demanded appraisal rights are not entitled to vote their shares or to receive any dividends or other distributions (including the merger consideration) on account of these shares unless they properly withdraw their demand for appraisal.

Dependent on the consideration to be received, appraisal rights are not available for (i) shares of the corporation surviving the merger if the merger does not require the approval of the stockholders of such corporation and (ii) shares of any class or series that is listed on any national security exchange or held of record by more than 2,000 holders. In particular, these exceptions do not apply if the holders of such shares are required to accept in the merger any consideration other than (i) shares of stock of the corporation surviving or resulting from the merger or consolidation, (ii) shares of stock of any other corporation that will be listed on a national securities exchange or held of record by more than 2,000 holders, (iii) cash in lieu of fractional shares, or (iv) any combination of the foregoing. In addition, these exceptions do not apply in respect of shares held by minority stockholders that are converted in a short-form parent subsidiary merger.

Section 262 of the DGCL also allows for a corporation to include in its certificate of incorporation the same merger appraisal rights for (i) amendments to the certificate of incorporation and (ii) the sale of all or substantially all of the assets of the corporation.

Determining Fair Value; The Longpath and Merion Capital Cases

On October 21, 2015, in Merion Capital LP v. BMC Software, Inc., the Delaware Court of Chancery rejected a dissenting shareholders effort to receive greater than the set merger price through the appraisal rights process. The Merion opinion is consistent with the June 30, 2015, Delaware Court of Chancery opinion which also rejected a dissenting shareholders effort to receive greater than the set merger price through the appraisal rights process. In Merion Capital and Longpath Capital, LLC v. Ramtron Int’l Corp., the Delaware court continued its recent consistent record of upholding the merger price as the most reliable indicator of fair value where the merger price was reached after a fair and adequate process in an arm’s length transaction. In this case, the merger price followed several rejected bids, an active solicitation of other potential buyers, and a three-month hard bargaining process.

Generally there are four recurring valuation techniques used in an appraisal rights proceeding: (i) the discounted cash flow (DCF) analysis; (ii) a comparable company’s analysis and review; (iii) a comparable transactions analysis and review and (iv) the merger price itself. Merger price is usually reached through the reality of a transaction process, as opposed to the academic and subjective valuation processes used in litigation challenging such price. Courts unanimously give greater, and usually 100%, weight to the merger price where the merger negotiation process was adequate.

Where there is a question as to the process resulting in the final merger price, Delaware courts generally look to the DCF analysis as the next best indicator of fair value. In this case, the court rejected the DCF analysis presented by the parties’ experts in the litigation as based on unreliable management projections. Although a DCF analysis is often used in litigation to challenge the merger price, as with the Longpath case, the Delaware courts will not give much weight to a DCF model based on management-prepared projections where such projections are prepared outside the ordinary course of business such as in response to a hostile takeover bid, other potential transaction or for use in litigation. Moreover, even where management projections are prepared in the ordinary course, the courts will consider the process used, assumptions made and the experience of management in preparing such projections as well as other qualitative and quantitative standards as to their reliability.

In addition to being skeptical regarding the weight to be given a DCF analysis, courts will likewise be skeptical regarding comparable transactions. In reviewing comparable transactions, courts will consider the types of companies involved, multiples used in each industry, and basic business realities.

Prior to the recent slew of cases upholding merger price as the best indication of value, the seminal case on appraisal rights was Weinberger v. UOP, 457 A.2d 701 (Del. 1983), which held that a proper valuation approach “must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.” The Weinberger court also held that the valuation should include elements of future value that are known or susceptible to proof, excluding only speculative elements. Following Weinberger the DCF model gained in popularity with the Delaware courts. As discussed above, recently the DCF model has been losing ground in favor of the merger price itself where the price is achieved following a fair and adequate process in an arm’s length transaction.

Managing Risks Associated with Appraisal Rights

The best way to manage risks associated with the appraisal process, and all aspects of the merger itself, is to pay meticulous attention to the process. The board of directors should utilize legal and financial advisors and delve into information gathering, analytical and deliberative processes and the manner in which they are documented in order to ensure that a defensible record is produced. See also my blog related to directors’ responsibilities in the merger process and the importance of the process itself, HERE.

Careful attention must be paid to the disclosure documents provided to stockholders related to the transaction. The document should include a thorough description of all relevant facts that support the fairness of the merger consideration. Relevant facts include, among other matters, historical operating results and future prospects, competitive and other risks, levels of liquidity and capital resources, internal and external indicia of value, efforts to explore strategic alternatives and the results thereof, opportunities for interested parties to submit competing acquisition proposals, and fairness opinions obtained from financial advisors and supporting analyses. Of course, as with all anti-fraud considerations, the document cannot misstate or omit material facts and information.

Hedging in Merger Transactions

There has been a recent dramatic increase in appraisal rights actions filed by shareholders that purchase shares after the record date of the relevant transaction. That is, it appears that a group of investors are hedging on merger transactions and utilizing the appraisal process as part of their hedging strategy. An interesting paper and analysis by the The Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Appraisal Arbitrage – Is There a Delaware Advantage” sets forth a well thought out theory as to why this investment strategy may be profitable to arbitrageurs. Here is a brief summary of the theory and for those interested in learning more about this theory, I encourage reading the entire paper.

First, Delaware allows shareholders to pursue appraisal rights even if they purchase shares after the record date for voting on the transaction. Investors can delay their investment decision until they have a better idea of valuation of the target. Moreover, by delaying the investment decision to as close as possible to the closing date, investors can minimize or even eliminate the risk that the deal will not close.

Second, many courts give preference to the DCF analysis valuation method. However, investment bankers advising on M&A deals tend to be more conservative. The paper points out that in a review of sample deals, nearly two-thirds of the time there was a differential between valuation used by investment bankers in providing fairness opinions to parties in an M&A transaction and fair values determined by the Delaware Courts. Investors have an opportunity to take advantage of this spread.

Third, the Delaware statute requires the court to determine a point estimate rather than a range of fair value. Accordingly, transactions completed at the low end of the DCF value range have a greater chance of a court determining that the fair value is higher, even if only by a few points.

Finally, the Delaware statutory rate for successful petitioner in an appraisal rights action is higher than the current yield on U.S. Treasury Bonds, thus creating a potential economic incentive for arbitrageurs.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« The Materiality Standard; NYSE Amends Rules; FASB Proposed Guidance SEC Proposes Amendments Related To Intrastate And Regional Securities Offerings- Part 1 »

The Materiality Standard; NYSE Amends Rules; FASB Proposed Guidance

Posted by Securities Attorney Laura Anthony | November 3, 2015 Tags: fasb proposed guidance, materiality standard, nyse amends rules

The recent increase in regulatory activity and marketplace discussion on the topic of disclosure has not been limited to the small business arena or small cap marketplace. Effective September 28, 2015, the New York Stock Exchange (“NYSE”) amended its Rule 202.06 of the NYSE Listed Company Manual, which governs the procedures that listed companies must follow for the release of material information. Also, the Financial Accounting Standards Board (FASB) has issued two exposure drafts providing guidance and seeking comments on the use of materiality to help companies eliminate unnecessary disclosures in their financial statements and to determine what is “material” for inclusion in notes to the financial statements. Both exposure drafts solicit public comment on proposed amendments to the Statement of Financial Accounting Concepts published by FASB.

NYSE Rule 202.06 Amendment

As published in the federal register, the NYSE proposes to amend Section 202.06 of the Manual to “(i) expand the premarket hours during which listed companies are required to notify the Exchange prior to disseminating material news, and (ii) provide the Exchange with authority to halt trading (a) during pre-market hours at the request of a listed company, (b) when the Exchange believes it is necessary to request certain information from listed companies, and (c) when an Exchange-listed security is also listed on another national or foreign securities exchange and such other exchange halts trading in such security for regulatory reasons. The Exchange also proposes to amend Section 202.06 of the Manual to provide guidance related to the release of material news after the close of trading on the Exchange.”

In particular, the amendment extends pre-market notification hour requirements to 7:00 a.m. Eastern Time prior to disseminating material news. Currently listed companies are only required to notify the NYSE a minimum of 10 minutes before they release material news “shortly before the opening or during market hours.” Market hours begin at 9:30 a.m. Eastern Time. With the amendment, a listed company will be required to comply with the “Material News Policy” and notify the NYSE at least 10 minutes before disseminating material news between 7:00 a.m. and 4:00 p.m. Eastern Time. The NYSE notes that most companies release news related to corporate actions and other material events between 7:00 a.m. and 9:30 a.m. Material news has the potential to cause volatility in both price and volume and accordingly, the purpose of the rule is to allow the NYSE the opportunity to halt trading in certain circumstances, including where it needs to obtain more information about the news release.

The amendment includes an advisory from the NYSE requesting that listed companies delay the release of material news after the close of trading until the earlier of (i) publication of the company’s official closing price on the NYSE or (ii) 15 minutes after the close of trading on the NYSE. This request is intended to facilitate an orderly closing process to trading on the NYSE. The advisory does not require that listed companies delay the release of material news but does make the advisory suggestion. Companies are still technically allowed to release news promptly at 4:00 p.m. upon market close when they deem appropriate.

Rule 202.06, as amended, will continue to require that listed companies release material news to the public by the “fastest available means.” The amendment contains a statement that listed companies generally will be required to either (i) include the news in a Form 8-K or other SEC filing or (ii) issue the news in a press release to major news wire services, including, at a minimum, Dow Jones & Company, Inc., Reuters Economic Services, and Bloomberg Business News. Listed companies that comply with current NYSE requirements should not need to change their practices for publicly releasing material information as a result of this clarification. The amendment also removes a variety of outdated references, such as references suggesting that telephone, fax, and hand delivery are acceptable means of releasing material news under NYSE rules.

The amendment also includes clarification as to the imposition of NYSE trading halts both during pre-market and regular market hours. The amendment will allow the NYSE to institute a trading halt before the opening of trading for the release of material news at the request of the listed company. It is believed that the company itself has the greatest insight as to whether a trading halt would be appropriate in light of the news it intends to release.

Although a pre-market trading halt may only be imposed at the request of the company, the amendment will also allow the NYSE to temporarily halt trading to facilitate an orderly opening process, if it appears that the dissemination of material news will not be complete prior to the opening of trading on the NYSE. Upon the NYSE’s implementation of a trading halt, other national securities exchanges, some of which maintain trading hours starting as early as 4 a.m., will also halt trading in the listed company’s security. Nasdaq Stock Market Rule 4120(a)(1) includes similar provisions with respect to trading halts between the hours of 4 a.m. and 9:30 a.m.

Moreover, the amendment will provide that if a listed company releases material information during NYSE trading hours, the NYSE may halt trading and may request additional information from the company relating to (i) the material news, (ii) the listed company’s compliance with NYSE continued listing requirements or (iii) any other information necessary to protect investors and the public interest. If the NYSE halts trading under these circumstances, it may continue the trading halt until it has received and evaluated the additional information provided by the company. Prior to the amendment, Rule 202.06 limited the NYSE’s authority to halt trading to situations in which a listed company intended to release material news during market hours. Nasdaq Stock Market Rule 4120(a)(5) is similar to this portion of Rule 202.06, as amended.

FASB GUIDANCE

FASB has issued two exposure drafts seeking comment and providing guidance on the use of materiality to help companies eliminate unnecessary disclosures in their financial statements and to determine what is “material” for inclusion in notes to the financial statements. Both exposure drafts solicit public comment on proposed amendments to the Statement of Financial Accounting Concepts published by FASB. Both exposure drafts solicit public comment on proposed amendments to the Statement of Financial Accounting Concepts published by FASB.

Financial reporting concepts are complex and generally are determined with the guidance of the company’s Chief Financial Officer, outside accountant and ultimately with comment and input from the independent accountant/auditor. However, legal counsel often does and should advise on concepts and facts which underlie the disclosure decisions and help guide management in making appropriate determinations. Accordingly, it is important that public company legal counsel have an understanding of the basics of financial disclosure and underlying principles and concepts, including the basics of GAAP accounting. In fact, the exposure draft for Qualitative Characteristics of Useful Financial Information completely defers to legal concepts in determining materiality. This firm’s team is strong in that regard.

The first exposure draft is “Qualitative Characteristics of Useful Financial Information” and was issued September 24, 2015 with a comment cutoff date of December 8, 2015. The main purpose of the proposed amendments in this release is to ensure that the materiality concepts discussed by FASB align with the legal concept of materiality. In fact, the release defers the materiality concept to a question of legality rather than accounting.

In particular, the proposed amendment includes the addition of the following language:

“Materiality is a legal concept. In the United States, a legal concept may be established or changed through legislative, executive, or judicial action. The Board observes but does not promulgate definitions of materiality. Currently, the Board observes that the U.S. Supreme Court’s definition of materiality, in the context of the antifraud provisions of the U.S. securities laws, generally states that information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information. [TSC Industries, Inc. v. Northway, Inc.] Consequently, the Board cannot specify or advise specifying a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.”

As can be seen, FASB is taking the approach of a complete deferral to the legal concept of materiality, including the U.S. Supreme Court’s interpretation.

The second exposure draft is “Notes to Financial Statements” and was issued September 24, 2015 with a comment cutoff date of December 8, 2015. The main purpose of the proposed amendments is to promote discretion on behalf of the board of directors of a reporting company in determining what disclosures are material and relevant to their particular company and circumstances. This release, together with the “Qualitative Characteristics of Useful Financial Information” discussed above, both further FASB’s recognition that (1) additional explanation about how to appropriately consider materiality or entity-specific relevance in deciding which information to provide in the notes could be effective in reducing or eliminating irrelevant disclosures; and (ii) a reduction in volume of immaterial information would improve the effectiveness of the notes to financial statements.

FASB is aware of the issues that either prevent or inhibit the reductions in disclosures—in particular: (i) the requirement to communicate omissions of immaterial disclosures as an “error” to the audit committee (and thus making it easier to disclose than defend non-disclosure); (ii) litigation concerns (especially from activist shareholder groups); (iii) possible internal control changes required to support added discretion on disclosure; and (iv) possible SEC comments (again making it easier to disclose than defend non-disclosure).

The proposed amendments in the exposure draft would (i) allow for quantitative and qualitative considerations of materiality in determining disclosures and recognizing that some, all or none of the requirements in a disclosure section may be material (or not) to a particular company; (ii) refer to materiality as a legal concept; and (iii) state specifically that an omission of immaterial information is not an accounting error. The proposed amendment would also make conforming changes to the Accounting Standards Codification, including cross-referencing updates.

General Commentary on Materiality

The disclosure requirements at the heart of the federal securities laws involve a delicate and complex balancing act. Too little information provides an inadequate basis for investment decisions; too much can muddle and diffuse disclosure and thereby lessen its usefulness. The legal concept of materiality provides the dividing line between what information companies must disclose, and must disclose correctly, and everything else. Materiality, however, is a highly subjective standard, often colored by a variety of factual presumptions.

The guiding purpose of the many and complex disclosure provisions of the federal securities laws is to promote “transparency” in the financial markets. However, the task of winnowing out the irrelevant, redundant and trivial from the potentially meaningful material falls on corporate executives and their professional advisors in the creation of corporate disclosure, and on investment advisors, stock analysts and individual investors in its interpretation. The concept of materiality represents the dividing line between information reasonably likely to influence investment decisions and everything else.

Only those misstatements and omissions that are material violate many provisions of the securities laws, including the bedrock provisions requiring accurate financial reporting. In 1976, the U.S. Supreme Court set the standard for a materiality evaluation, which standard remains today. In TSC Industries, Inc. v. Northway, Inc., the Supreme Court held that information should be deemed material if there exists a substantial likelihood that it would have been viewed by the reasonable investor as having significantly altered the total mix of information available to the public.

Despite this standard, the concept remains fact-driven and difficult to apply. There are no numeric thresholds to establish materiality, and market reaction is inconsistent and not always available. Ultimately professionals and company management must consider all facts and circumstances available to them on any given day to determine the materiality of a given disclosure in light of the standard established by the Supreme Court in TSC Industries.

Generally, professionals and company management must look in the first instance at specific disclosure guidelines set out in the federal securities rules and regulations (such as Regulations S-X and S-K and Forms 10-Q, 10-K and 8-K). Second, professionals and company management must consider all facts presently affecting the company. For instance, a specific disclosure may be highly relevant in light of current economic conditions and of little importance in a different economic climate. Ethical issues are generally not considered material, unless specifically required by statute (such as the Foreign Corrupt Practices Act).

The SEC has issued guidance on materiality in Staff Accounting Bulletin No. 99 (SAB 99). Although SAB 99 is meant to clarify some materiality issues, many practitioners find that it confuses rather than clarifies. Really the guidance just reiterates that materiality cannot be defined by law or standards but must be determined anew for each fact and disclosure issue.

In determining materiality, practitioners should keep in mind Regulation FD, which prohibits the selective disclosure of material information. That is, Regulation FD requires that if material information is to be disclosed, it must be disclosed to the entire market, either through a press release or Form 8-K or both, and not selectively, such as to certain analysts or market professionals.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

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