Nasdaq Board Diversity Proposal
Nasdaq has long been a proponent of environmental, social and governance (ESG) disclosures and initiatives, having published a guide for listed companies on the subject over six years ago (see HERE). In December 2020, Nasdaq took it a step further and proposed a rule which would require listed companies to have at least one woman on their boards, in addition to a director who is a racial minority or one who self-identifies as lesbian, gay, bisexual, transgender or queer. Companies that don’t meet the standard would be required to justify their decision to remain listed on Nasdaq. To help facilitate the proposed rule, Nasdaq has also proposed to offer a complimentary board recruiting solution. A final decision on the proposals is expected this summer.
The SEC recently extended the consideration period and will either approve or disapprove the proposal by August 8, 2021. The newest Regulatory Flex Agenda which was published last week and will be a topic of a future blog, included the subject in proposed rule making stage with action slated by October 2021. Its anyone’s call where this will land. The current SEC regime is more likely to pass a rule than previous administrations but there is still significant pushback. The SEC could also kick the can down the road and ask Nasdaq to strengthen the data backing its proposal.
Nasdaq Proposed Board Diversity Rule
Nasdaq proposes to adopt Rule 5605(f) to the corporate governance requirements for listing and continued listing which would require Nasdaq listed companies, subject to certain exceptions, to: (i) to have at least one director who self identifies as a female, and (ii) have at least one director who self-identifies as Black or African American, Hispanic or Latinx, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, two or more races or ethnicities, or as LGBTQ+, or (iii) explain why the company does not have at least two directors on its board who self-identify in the categories listed above.
Nasdaq also proposed to add to its list of services for listed companies to provide a complimentary board recruiting solution to help advance diversity on company boards. The service would provide companies that have not yet achieved a certain level of diversity with one-year complimentary access for two users to a board recruiting solution, which will provide access to a network of board-ready diverse candidates, allowing companies to identify and evaluate diverse board candidates, and a tool to support board benchmarking. To access the service a listed company must make a request on or before December 1, 2022.
The rule would also require Nasdaq listed companies to disclose statistical information regarding its board’s diversity. Statistical information will be required in an annual report or proxy statement, or on the company’s website. Although not required, the proposed rule encourages disclosure of other diverse attributes such as nationality, disability or veteran status. It could be that a company’s reasoning for not having board members that specifically fit the diverse attributes in the rule, is that it has otherwise a diverse board composition based on other considerations. Under the proposed rule Nasdaq will not assess the substance of an explanation but would just verify that the company has provided one.
Foreign issuers will be required to disclose the gender of board members; voluntary disclosure of LGBTQ+ status; and information regarding underrepresented groups in their home jurisdiction. Also, foreign issuers will be required to have at least two diverse directors including at least one female. Both foreign issuers and smaller reporting companies may satisfy the two diverse director requirements by having two female directors.
The following types of companies would be exempt from the requirements: (i) SPACs; (ii) asset backed issuers; (iii) cooperatives; (iv) limited partnerships; (v) management investment companies; (vi) issuers of non-voting preferred securities, debt securities or derivative securities; and (vii) ETFs and similar funds.
If adopted, the Rule would provide each company with one calendar year from adoption to comply with the Rule’s requirement to provide statistical information disclosures. A company that goes public via a business combination with a SPAC, an IPO, a direct listing, a transfer from another exchange or an uplisting from the OTC Markets would have one year to comply with the disclosure requirements. Failure to provide the disclosure would result in a listing deficiency with the ability to submit a plan for cure and to cure within 180 days. Ultimate non-compliance could result in delisting.
A company would have two calendar years to have, or explain why it does not have, at least one diverse director. A Nasdaq Global Select or Global Market listed company would then have four calendar years to either have, or explain why it does not have, at least two diverse directors and a Nasdaq Capital Markets listed company would have five calendar years.
Purpose of the Proposed Rule
Simply put, Nasdaq is of the view that diversity in the board room equates to good corporate governance. They believe that increased diversity brings fresh perspectives, improved decision making and oversight and strengthened internal controls. Further, Nasdaq asserts that the increased focus on diversity by companies, investors, legislators and corporate governance organizations provides evidence that investor confidence is enhanced by greater board diversity. In conducting an internal study on diversity amongst listed companies, Nasdaq found they fell short and that a regulatory impetus would help.
Nasdaq’s rule proposal indicates it conducted extensive research including reviewing a substantial body of third-party research and conducting interviews. Among the questions it sought to answer were (i) whether there is empirical evidence to support the proposition that board diversity increases shareholder value, investor protections and board decision-making; (ii) investors interest in board diversity information; (iii) the current state of board diversity and disclosure; (iv) causes of underrepresentation; (v) various approaches to encourage board diversity; and (vi) the success of approaches taken by other groups, both domestic and foreign.
Clearly Nasdaq is confident that the answers to these questions support not only the value of board diversity and related disclosure, but the value of regulations requiring same. In addition to the results of its studies, Nasdaq cites the increasing call for diversity by large institutional investors such as Vanguard and BlackRock in their corporate engagement and proxy guidelines. Nasdaq also believes that the SEC disclosure regime supports disclosure requirements in this context.
The 127-page Nasdaq proposed rule release contains an in-depth discussion of Nasdaq’s research, findings, and conclusions. Nasdaq also presents counter-information. There is a lack of studies or information of the association between LGBTQ+ diversity and board representation, stock or other financial performance. Many studies support a correlation between women on the board and increased earnings and other financial metric performance, but some also show a lack of correlation between the two. Studies which include other factors, such as strong shareholder rights, show a decreasing impact of diversity to performance.
Interestingly, I believe it is the non-financial aspects, including investor protections (through increased internal controls, public disclosure and management oversight) and confidence, that are compelling Nasdaq to put forth the proposed rule. As it states in its release “[A]t a minimum, Nasdaq believes that the academic studies support the conclusion that board diversity does not have adverse effects on company financial performance.” Moreover, as most directors are chosen from the current directors and C-Suite executive’s social and business network, without a compelling reason to search elsewhere, such as regulatory compliance, a natural impediment to increased diversity will remain.
Although Nasdaq’s finding and arguments are compelling, I remain on the fence as to whether regulatory action setting quotas is appropriate. Certainly, in today’s environment, there is a strong faction of support for the rule and for improvement in diversity in business as a whole. As a woman, I of course support diversity in business and the boardroom. Where I am on the fence regarding the quota issue, I support the disclosure aspects of the proposed rule. Transparency and disclosure on the topic will only provide better information to make sound decisions moving forward.
Board Diversity – Beyond Nasdaq
Putting aside Nasdaq’s rule publication, a lot of groups and thought leaders have been tackling the question of whether board diversity is a benefit or detriment to corporations with thorough arguments to support both sides of the fence. Board composition is consistently one of the most important topics on the agenda for shareholder engagement, and voting.
Harvard Law Professor Jesse Fried has publicly questioned the empirical value of Nasdaq’s board diversity proposal. Also, University of MN Law Professor and former chief White House ethics lawyer Richard Painter wrote a thorough rebuttal to Nasdaq’s findings. That rebuttal was met with its own rebuttal’s pointing out the lack of, and age, of the data presented. It seems one of the best sources of information is California which imposed a board diversity obligation on corporations domiciled in the state two years ago. Since enactment of the statute there has been a significant increase of women on the boards of California entities, though other minorities, including women of color, continue to lag.
Getting ahead of this year’s proxy season, Glass Lewis published an in-depth report on Board Gender Diversity with an overview of where things stand in the U.S. and internationally, investor and state efforts to promote balance in the boardroom, and academic research on the benefits of diversity. Glass Lewis recognizes the complexity of the issue and the recruiting involved to find uniquely qualified directors who bring a breadth of experience and insight to the board table. Simply adding women to the board for diversity’s sake and without careful consideration of qualifications and experience is unlikely to automatically effect any positive corporate change. With that said, the report also concludes that bringing women and diverse board members will add to the overall viewpoints and knowledge base of a board thereby improving corporate performance.
Many companies are not waiting for a rule to increase diversity disclosure. To help stakeholders compare disclosure practices, KPMG recently launched a free new web-based tool that tracks disclosure about board diversity. The software compares disclosure practices by sector, index (Russell 3000 and S&P 500) and company size. There are several comparative publications as well with one by Deloitte and the Alliance for Board Diversity including information through 2020.
The voluntary increase in disclosure comes, at least partially, from pressure by institutional investors which have been vocal on the subject. In 2020 many of those entities promised to put their views to action by increasing diversity in their own house. The data is not in yet as to whether specific vocal proponents of diversity have made significant internal changes, but some are putting on a better show than others. The Carlyle Group announced a new policy calling for at least one candidate who is Black, Latino, Pacific Islander or Native American to be interviewed for every new position and that at least 30% of its portfolio companies will have ethnic diversity on the board of directors.
Besides investor financial incentives, D&O insurers have started to include diversity practices among the many considerations in granting and pricing liability policies.
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Nasdaq Rule Amendments 2020
In addition to the temporary rule changes and relief that Nasdaq has provided this year for companies affected by Covid-19 (see HERE and HERE), the exchange has enacted various rule amendments with varying degrees of impact and materiality.
In particular, over the last year Nasdaq has amended its delisting process for low-priced securities, updated its definition of a family member for the purpose of determining director independence and has clarified the term “closing price” for purposes of the 20% rule. This blog discusses each of these amendments.
Delisting Process
In April 2020, the SEC approved Nasdaq rule changes to the delisting process for certain securities that fall below the minimum price for continued listing. The rule change modifies the delisting process for securities with a bid price at or below $0.10 for ten consecutive trading days during any bid-price compliance period and for securities that have had one or more reverse stock splits with a cumulative ratio of 250 shares or more to one over the prior two-year period.
Nasdaq’s rules require that primary equity securities, preferred stocks, and secondary classes of common stock maintain a minimum bid price of at least $1.00 per share for continued listing. Under Rule 5810(c)(3)(A), a security is considered deficient with this bid price requirement if its bid price closes below $1.00 for a period of 30 consecutive business days. Under Nasdaq Rule 5810(c)(3)(A), a company with a bid price deficiency has 180 calendar days from notification of the deficiency to regain compliance. A company generally can regain compliance with the bid-price requirement by maintaining a $1.00 closing bid price for a minimum of ten consecutive business days during the 180-day compliance period.
Also under the current rules, if a company is listed on or moves to the Nasdaq Capital Market, the lowest tier of Nasdaq, it may be eligible for a second 180-day period to regain compliance, provided that in the last half of the first compliance period, the company met the market value of publicly held shares requirement, as well as compliance with other Nasdaq rules. Accordingly, a company trading on the Nasdaq Capital Market could have up to 360 days to regain compliance with a deficient bid price.
However, where a company has a bid price below $.10 or has completed several reverse splits, it likely has more severe issues that will not be able to be corrected regardless of the allowable period to regain compliance.
The rule amendment allows Nasdaq to provide a notice of Staff Delisting Determination to a company that has traded below $1.00 for thirty consecutive business days (the time it would normally receive its deficiency notice) if the security has a closing bid price of $0.10 or less for a period of ten consecutive trading days. Likewise, instead of receiving a notice of deficiency, a company will receive a Staff Delisting Determination if it falls out of compliance with the $1.00 minimum bid price after completing one or more reverse stock splits resulting in a cumulative ratio of 250 shares or more to one over the two-year period immediately prior to such non-compliance.
A company could appeal the Staff Delisting Determination to a Nasdaq hearing panel which could grant a 180-day compliance period if it believes the company will be able to achieve and maintain compliance with the bid-price requirement.
The rule amendment was effective immediately and applied to all companies that received notice of noncompliance with the bid-price requirement after the date of its effectiveness. However, on May 14, 2020, Nasdaq extended the new rule such that it will be effective for companies that first receive notification of non-compliance on or after September 1, 2020. Nasdaq extended the rule effective date to provide relief for companies experiencing wide trading fluctuations as a result of Covid-19. The effective date extension is in addition to Nasdaq’s prior announcement that it would toll the 180-day period for companies that had already received a non-compliance notice, through June 30, 2020 (see HERE).
Although the new rule was extended, Nasdaq notes that it still may rely on its discretion to deny a second 180-day period to regain compliance for a company with a very low stock or that has completed multiple prior reverse splits. For a review of Nasdaq’s current initial listing standards, see HERE.
Definition of Family Member for Purposes of Determining Director Independence
Back in December, I wrote a blog drilling down on the Nasdaq board independence requirements (see HERE) and noted that a few months earlier, the SEC had declined to approve a Nasdaq rule change to the definition of “family member.”
Nasdaq Rule 5605 delineates the listing qualifications and requirements for a board of directors and committees, including the independence standards for board members. Nasdaq requires that a majority of the board of directors of a listed company be “independent” and further that all members of the audit, nominating and compensation committees be independent.
For purposes of Rule 5605, “family member” was defined as a person’s spouse, parents, children and siblings, whether by blood, marriage or adoption, or anyone residing in such person’s home. This definition technically encompasses stepchildren as they are children “by marriage.” However, when applying the three-year look-back provisions, a company does not have to consider a person who is no longer a family member as a result of legal separation, divorce, death or incapacitation.
In June 2019, Nasdaq proposed to amend the definition of “family member” to narrow who can be included and add a level of certainty. In particular, Nasdaq proposed to change the definition to “a person’s spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home.” In the proposed rule-change release, Nasdaq admitted that it did not intend to include stepchildren and that the change would correct this mistake. The proposed language matched the NYSE definition. However, in September 2019, the SEC instituted proceedings to determine whether to disapprove the proposed rule change believing that the rule release made an over-correction.
In February, Nasdaq submitted its third amendment to the proposed rule change, which was approved by the SEC. Although the definition of “family member” as approved by the SEC, is the same as proposed in June 2019, the rule release now states that Nasdaq intends to exclude domestic employees who share the director’s home, and stepchildren who do not share the director’s home, from the types of relationships that always preclude a finding that a director is independent. Rather, a company’s board of directors will need to examine all facts and circumstances to determine if a particular step-child relationship would be likely to interfere with the director’s exercise of independent judgment in carrying out his or her responsibilities
Clarification of “Closing Price” in 20% Rule
In January 2020, Nasdaq filed a rule change to clarify the meaning of the term “Closing Price” as used in Rule 5635(d), known as the 20% Rule. For more information on Rule 5635(d), see HERE. The rule change does not make any substantive changes but rather is meant to clarify the language to avoid any potential confusion.
Nasdaq Rule 5635(d) requires shareholder approval prior to a 20% issuance of securities at a price that is less than the Minimum Price in a transaction other than a public offering. A 20% issuance is a transaction, other than a public offering, involving the sale, issuance or potential issuance by the company of common stock (or securities convertible into or exercisable for common stock), which alone or together with sales by officers, directors or substantial shareholders of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance. “Minimum Price” means a price that is the lower of: (i) the closing price (as reflected on Nasdaq.com) immediately preceding the signing of the binding agreement; or (ii) the average closing price of the common stock (as reflected on Nasdaq.com) for the five trading days immediately preceding the signing of the binding agreement.
The rule amendment changes the term “closing price” to “Nasdaq Official Closing Price” in the definition of Minimum Price. The term Nasdaq Official Closing Price had been used in the September 2018 rule release when Nasdaq adopted the definition of Minimum Price. Aligning the language will add a layer of consistency and avoid any confusion for listed companies.
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Nasdaq Proposed Rule Changes To Its Discretionary Listing And Continued Listing Standards
On April 21, 2020, the SEC Chairman Jay Clayton and a group of senior SEC and PCAOB officials issued a joint statement warning about the risks of investing in emerging markets, especially China, including companies from those markets that are accessing the U.S. capital markets (see HERE). Previously, in December 2018, Chair Clayton, SEC Chief Accountant Wes Bricker and PCAOB Chairman William D. Duhnke III issued a similar cautionary statement, also focusing on China (see HERE).
Following the public statements, in June 2020, Nasdaq issued new proposed rules which would make it more difficult for a company to list or continue to list based on the quality of its audit, which could have a direct effect on companies based in China.
Nasdaq Proposed Rule Changes
On June 2, 2020, the Nasdaq Stock Market filed a proposed rule change to amend IM-5101-1, the rule which allows Nasdaq to use its discretionary authority to deny listing or continued listing to a company. The rule currently provides that Nasdaq may use its authority to deny listing or continued listing to a company when an individual with a history of regulatory misconduct is associated with that company. The rule sets out a variety of factors that may be considered by the exchange in making a determination. I’ve detailed the current rule below.
The proposed rule change will add discretionary authority to deny listing or continued listing or to apply additional or more stringent criteria to an applicant based on considerations surrounding a company’s auditor or when a company’s business is principally administered in a jurisdiction that is a “restrictive market.” The proposed rule change is meant to codify Nasdaq’s current interpretation of its discretionary authority to provide clarity to the marketplace on its position related to the importance of quality audits.
Nasdaq’s listing requirements are designed to ensure that a company is prepared for the reporting and administrative requirements of being a public company, to provide for transparency and the protection of investors, and to ensure sufficient investor interest to support a liquid market. Rule 5101 describes Nasdaq’s broad discretionary authority over the initial and continued listing of securities on Nasdaq in order to maintain the quality of and public confidence in the market, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to protect investors and the public interest.
Part of both the general federal securities laws and Nasdaq requirements relate to properly completed audits by an independent auditor. Investors need to be able to rely on the audit report to gain confidence that the financial statements are properly completed and free of material misstatements due to mistakes or fraud. For more on the requirements for an audit report, see HERE.
Auditors are subject to oversight by both the SEC and PCAOB. PCAOB inspections are designed to, among other things, identify deficiencies in audits and/or quality control procedures. Investigations can lead to the audited public company having to revise and refile its financial statements or its assessment of the effectiveness of its internal control over financial reporting. In addition, through the quality control remediation portion of the inspection process, inspected firms identify and implement practices and procedures to improve future audit quality. Accordingly, Nasdaq relies on auditors and the PCAOB oversight to maintain audit integrity.
Citing the recent joint public statement by SEC Chair Clayton, SEC Chief Accountant Sagar Teotia, SEC Division of Corporation Finance Director William Hinman, SEC Division of Investment Management Director Dalia Blass, and PCAOB Chairman William D. Duhnke III (see HERE), Nasdaq notes that audit work and the practices of auditors in certain countries, cannot be effectively reviewed or subject to the usual oversight. Those countries currently include Belgium, France, China and Hong Kong.
Currently, Nasdaq may rely upon its broad authority provided under Rule 5101 to deny initial or continued listing or to apply additional and more stringent criteria when the auditor of an applicant or a Nasdaq-listed company: (i) has not been subject to an inspection by the PCAOB, (ii) is an auditor that the PCAOB cannot inspect, or (iii) otherwise does not demonstrate sufficient resources, geographic reach or experience as it relates to the company’s audit, including in circumstances where a PCAOB inspection has uncovered significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls. The proposed rule change is meant to codify the existing rights of Nasdaq in that regard.
The proposed rule change would add a new paragraph (b) to IM-5101-1 detailing factors that Nasdaq will consider including:
(i) whether the auditor has been subject to PCAOB inspection including due to the audit firm being located in a jurisdiction that limits the PCAOB’s inspection ability;
(ii) if the auditor has been inspected, whether the results of the inspection indicate the auditor has failed to respond to inquiries or requests by the PCAOB or that the inspection revealed significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls;
(iii) whether the auditor can demonstrate that it has adequate personnel in offices participating in the audit with expertise in applying U.S. GAAP, GAAS or IFRS, in the company’s industry;
(iv) whether the auditor’s training program for personnel participating in the company’s audit is adequate;
(v) for non-U.S. auditors, whether the auditor is part of a global network or other affiliation of auditors where the auditors draw on globally common technologies, tools, methodologies, training and quality assurance monitoring; and
(vi) whether the auditor can demonstrate to Nasdaq sufficient resources, geographic reach or experience as it relates to the company’s audit.
An auditor would not necessarily have to satisfy each of the factors but rather Nasdaq will consider all facts and circumstances, and may impose additional or more stringent criteria to mitigate concerns. Additional criteria could include: (i) higher equity, assets, earnings or liquidity measures; (ii) that an offering be completed on a firm commitment basis (as opposed to best efforts); (iii) lock-ups for officers, directors or other insiders; (iv) higher float percentage or market value of unrestricted publicly held shares; or (v) higher average OTC trading volume before an uplisting.
The proposed rule change would also add a new subparagraph (c) to IM-5101-1 to confirm Nasdaq’s ability to impose additional or more stringent criteria in other circumstances, including when a company’s business is principally administered in a jurisdiction that Nasdaq determines to have secrecy laws, blocking statutes, national security laws or other laws or regulations restricting access to information by regulators of U.S.-listed companies in such jurisdiction (a “Restrictive Market”). In determining whether a company’s business is principally administered in a Restrictive Market, Nasdaq may consider the geographic locations of the company’s: (i) principal business segments, operations or assets; (ii) board and shareholders’ meetings; (iii) headquarters or principal executive offices; (iv) senior management and employees; and (v) books and records.
In the event that Nasdaq relies on its discretionary authority and determines to deny the initial or continued listing of a company, it would issue a denial or delisting letter to the company that will inform the company of the factual basis for the Nasdaq’s determination and its right for review of the decision.
Current Rule IM-5101-1
Nasdaq may use its authority under Rule 5101 to deny initial or continued listing to a company when an individual with a history of regulatory misconduct is associated with the company. Such individuals are typically an officer, director, substantial shareholder, or consultant to the company. In making this determination, Nasdaq will consider a variety of factors, including:
(i) the nature and severity of the conduct, taking into consideration the length of time since the conduct occurred;
(ii) whether the conduct involved fraud or dishonesty;
(iii) whether the conduct was securities-related;
(iv) whether the investing public was involved;
(v) how the individual has been employed since the violative conduct;
(vi) whether there are continuing sanctions (either criminal or civil) against the individual;
(vii) whether the individual made restitution;
(viii) whether the company has taken effective remedial action; and
(ix) the totality of the individual’s relationship with the company including their current or proposed position, current or proposed scope of authority, responsibility for financial accounting or reporting and equity interest.
Nasdaq may also exercise its discretionary authority with a company filed for bankruptcy, when its auditor issues a disclaimer opinion or when financial statements do not contain a required certification.
Where concerns are raised, Nasdaq will consider remedial measures by the company including the individual’s resignation, divestiture of stock holdings, termination of contractual arrangements or the creation of a voting trust to vote their shares. Nasdaq will also consider past corporate governance.
Nasdaq may impose restrictions or heightened listing requirements where concerns are raised, but may not allow for exceptions or lower standards to the listing rules. In the event that Nasdaq staff denies initial or continued listing based on such public interest considerations, the company may seek review of that determination through the procedures set forth in the Rule 5800 Series. On consideration of such appeal, a listing qualifications panel comprised of persons independent of Nasdaq may accept, reject or modify the staff’s recommendations by imposing conditions.
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NASDAQ Provides Additional Relief To Shareholder Approval Requirements For Companies Affected By Covid-19
Nasdaq has provided additional relief to listed companies through temporary rule 5636T easing shareholder approval requirements for the issuance of shares in a capital raise. The rule was effective May 4, 2020 and will continue through and including June 30, 2020. The purpose of the rule change is to give listed companies affected by Covid-19 quicker access to much-needed capital.
Temporary Rule 5636T is limited to the transactions and shareholder approval requirements specifically stated in the rule. If shareholder approval is required based on another rule, such as a change of control, or another Nasdaq rule is implicated, those other rules will need to be complied with prior to an issuance of securities.
The Nasdaq shareholder approval rules generally require companies to obtain approval from shareholders prior to issuing securities in connection with: (i) certain acquisitions of the stock or assets of another company (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants (see HERE); (iii) a change of control (see HERE); and (iv) certain private placements at a price less than the minimum price as defined in Listing Rule 5635(d) (see HERE.)
An exception is available for companies in financial distress where the delay in securing stockholder approval would seriously jeopardize the financial viability of the company. To request a financial viability exception, the company must complete a written request including a letter addressing how a delay resulting from seeking shareholder approval would seriously jeopardize its financial viability and how the proposed transaction would benefit the company. The standard is usually difficult to meet.
Earlier in the Covid-19 crisis, Nasdaq indicated that it will consider the impact of disruptions caused by the pandemic in its review of any pending or new requests for a financial viability exception. Nasdaq required that reliance by the company on a financial viability exception be expressly approved by the company’s audit committee and that the company obtain Nasdaq’s approval prior to proceeding with the transaction. Under the rule, companies also have to provide notice to shareholders at least ten days prior to issuing securities in the exempted transaction.
Exception to Private Placement 20% Rule
Nasdaq now has enacted temporary rule 5636T formalizing an exception to the shareholder approval requirement in Rule 5635(d) (the private placement 20% Rule) through June 30, 2020. Nasdaq Rule 5635(d) requires shareholder approval prior to a 20% issuance of securities at a price that is less than the Minimum Price in a transaction other than a public offering. A 20% issuance is a transaction, other than a public offering, involving the sale, issuance or potential issuance by the company of common stock (or securities convertible into or exercisable for common stock), which alone or together with sales by officers, directors or substantial shareholders of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance. “Minimum Price” means a price that is the lower of: (i) the closing price (as reflected on Nasdaq.com) immediately preceding the signing of the binding agreement; or (ii) the average closing price of the common stock (as reflected on Nasdaq.com) for the five trading days immediately preceding the signing of the binding agreement.
The exception is limited to circumstances where the delay in obtaining shareholder approval would: (i) have a material adverse impact on the company’s ability to maintain operations under its pre-Covid-19 business plan; (ii) result in workforce reductions; (iii) adversely impact the company’s ability to undertake new initiatives in response to Covid-19; and (iv) seriously jeopardize the financial viability of the company. In addition, in order to rely on the exception, the company has to demonstrate to Nasdaq that the need for the transaction is due to circumstances related to COVID-19 and that the company undertook a process designed to ensure that the proposed transaction represents the best terms available to the company.
No prior approval of the exception by Nasdaq is required if the maximum amount of common stock (or securities convertible into common stock) issuable in the transaction is less than 25% of the total shares outstanding and less than 25% of the voting power outstanding before the transaction and the maximum discount to the Minimum Price at which shares could be issued is 15%. Although prior approval is not necessary, companies must notify Nasdaq about such transactions as promptly as possible, and file a listing of additional shares (LAS) notification at least two days before issuing shares. An LAS notification is required where a transaction may result in the potential issuance of common stock, or securities convertible into common stock, of greater than 10% of either the total shares outstanding or the voting power outstanding on a pre-transaction basis and therefore would always be required where the shareholder approval requirements under Rule 5635(d) are invoked. The LAS must normally be filed 15 calendar days prior to issuing the additional shares.
For transactions where greater than 25% of the shares or voting power will be issued or where the discount is in excess of 15% of the Minimum Price, a company must get Nasdaq’s approval prior to the share issuance. Companies can seek approval by filing the LAS notification and the required supplement. Once approval is received, the company can proceed with the transaction (i.e., it does not have to wait 15 days).
The LAS Supplement must include a cover letter addressing the following factors:
(i) The need for the transaction is due to Covid-19 circumstances. This section should provide specific details of the facts and circumstances including the impact of Covid-19 on the company’s operations, workforce, new initiatives and financial viability.
(ii) The delay in securing shareholder approval would have a material impact on the company’s ability to maintain operations under its Covid-19 business plan; would result in workforce reductions; would adversely impact the company ability to undertake new initiatives in response to Covid-19; or would seriously jeopardize the company financial viability. This section should provide specific details and address at least one of the following: (i) how long the company will be able to meet its current obligations such as payroll, lease payments and debt servicing if it does not complete the proposed transaction; (ii) what is the current and projected cash position and burn rate; (iii) would the company be required to file for bankruptcy if it had to wait for shareholder approval; and (iv) what would be the impact to the company’s operations if it had to wait for shareholder approval.
(iii) The company undertook a process designed to ensure that the proposed transaction represents the best terms available to the company. This section should include an overview of all meetings, inquiries and communications conducted by the company and its outside advisors when structuring the transaction and any other factors considered in reaching the decision to proceed.
(iv) The audit committee or comparable body of the board of directors, comprised solely of independent, disinterested directors, expressly approved reliance on the temporary rule and the transaction itself and that it is in the best interest of shareholders. This section should include a copy of the operable executed resolution or minutes of the board committee approving the transaction and setting forth the required criteria.
Furthermore, in order to rely on the Rule the company must execute a binding agreement, receive Nasdaq approval, if necessary, and have filed its LAS notification if required, prior to the close of business on June 30, 2020. However, the shares can be issued after June 30, 2020 as long as the issuance is no more than 30 calendar days following the date of the binding agreement.
Nasdaq also requires that the company notify the public about the transaction and reliance on the temporary rule by filing a Form 8-K if required by SEC rules or by issuing a press release no later than two business days before issuing the securities. The 8-K or press release must disclose: (i) the terms of the transaction, including the number of shares of common stock that could be issued; (ii) that shareholder approval would ordinarily be required under Nasdaq rules; (iii) that the company is relying on the temporary rule excepting shareholder approval; and (iv) that the audit committee or comparable body of the board of directors, comprised solely of independent, disinterested directors, expressly approved reliance on the temporary rule and the transaction itself and that it is in the best interest of shareholders.
Nasdaq will aggregate issuances of securities in reliance on the exception in Rule 5636T with any subsequent issuance by the company, other than a public offering, at a discount to the Minimum Price if the binding agreement governing the subsequent issuance is executed within 90 days of the prior issuance.
Exception to Equity Compensation Rule
Temporary Rule 5636T can also be relied upon where Rule 5635(c) would trigger a shareholder approval requirement as part of the transaction. Nasdaq Rule 5635(c) requires shareholder approval prior to the issuance of securities when a stock option or purchase plan is to be established or materially amended or other equity compensation arrangement made or materially amended, pursuant to which stock may be acquired by officers, directors, employees, or consultants, except for: (1) warrants or rights issued generally to all security holders of the company or stock purchase plans available on equal terms to all security holders of the company (such as a typical dividend reinvestment plan); (2) tax qualified, non-discriminatory employee benefit plans (e.g., plans that meet the requirements of Section 401(a) or 423 of the Internal Revenue Code) or parallel nonqualified plans (including foreign plans complying with applicable foreign tax law), provided such plans are approved by the company’s independent compensation committee or a majority of the company’s Independent Directors; or plans that merely provide a convenient way to purchase shares on the open market or from the company at market value; (3) plans or arrangements relating to an acquisition or merger as permitted under IM-5635-1; or (4) issuances to a person not previously an employee or director of the company, or following a bona fide period of non-employment, as an inducement material to the individual’s entering into employment with the company, provided such issuances are approved by either the company’s independent compensation committee or a majority of the company’s Independent Directors.
Unaffiliated investors often require a company’s senior management to put their personal capital at risk and participate in a capital raising transaction alongside the unaffiliated investors. This request is likely to increase where a company affected by Covid-19 seeks to raise capital. Temporary Rule 5636T provides for an exception from shareholder approval under Rule 5635(c) for an affiliate’s participation in the transaction provided the affiliate’s participation in the transaction was specifically required by unaffiliated investors. The temporary rule limits each affiliate’s participation to no more than 5% of the transaction and all affiliates’ participation collectively must be less than 10% of the transaction total. Any affiliate investing in the transaction must not have participated in negotiating the economic terms of the transaction.
« SEC Publishes FAQ On COVID-19 Effect On S-3 Registration Statements SEC Proposed Rule Changes for Exempt Offerings – Part 3 »
NYSE, Nasdaq And OTC Markets Offer Relief For Listed Companies Due To COVID-19
In addition to the SEC, the various trading markets, including the Nasdaq, NYSE and OTC Markets are providing relief to trading companies that are facing unprecedented challenges as a result of the worldwide COVID-19 crisis.
NYSE
The NYSE has taken a more formal approach to relief for listed companies. On March 20, 2020 and again on April 6, 2020 the NYSE filed a notice and immediate effectiveness of proposed rule changes to provide relief from the continued listing market cap requirements and certain shareholder approval requirements.
Recognizing the extremely high level of market volatility as a result of the COVID-19 crisis, the NYSE has temporarily suspended until June 30, 2020 its continued listing requirement that companies must maintain an average global market capitalization over a consecutive 30-trading-day period of at least $15 million. Likewise, the NYSE is suspending the requirement that a listed company maintain a minimum trading price of $1.00 or more over a consecutive 30-trading-day period, through June 30, 2020.
The NYSE intends to waive certain shareholder approval requirements for continued listing on the NYSE through June 30, 2020. In particular, in light of the fact that many listed companies will have urgent liquidity needs in the coming months due to lost revenues and maturing debt obligations, the NYSE is proposing to ease shareholder approval requirements to allow capital raises. The big board amendments align the requirements more closely with the NYSE American requirements.
The NYSE big board rules prohibit issuances to related parties if the number of shares of common stock to be issued, or if the number of shares of common stock into which the securities may be convertible or exercisable, exceeds either 1% of the number of shares of common stock or 1% of the voting power outstanding before the issuance subject to a limited exception if the issuances are above a minimum price and no more than 5% of the outstanding common stock. For a review of the NYSE American rule for affiliate issuances, see HERE. The NYSE also requires shareholder approval for private issuances below the minimum price for any transactions relating to 20% or more the outstanding common stock or voting power. For a review of the 20% rule for the NYSE American, see HERE.
Realizing that existing large shareholders and affiliates are often the only willing providers of capital when a company is undergoing difficult times, the rule change allows for the issuance of securities to affiliates that exceed the 1% or 5% limits if completed prior to June 30, 3030 where the securities are sold for cash that meets the minimum price and if the transaction is reviewed and approved by the company’s audit committee or a comparable committee comprised solely of independent directors. The waiver cannot be relied upon if the proceeds would be used for an acquisition of stock or assets of another company in which the affiliate has a direct or indirect interest. Furthermore, the waiver does not extend to shareholder approval requirements triggered by the transaction under other rules such as the equity compensation rule or change of control rule. The substantially similar NYSE American rules can be reviewed HERE – equity compensation, and HERE – change of control.
The NYSE has also waived the 20% rule for private placements completed through and including June 30, 2020 where a bona fide financing is made to a single purchaser for cash meeting the minimum price requirement. Again, the waiver does not extend to shareholder approval requirements triggered by the transaction under other rules such as the equity compensation rule or change of control rule.
Nasdaq
The Nasdaq has taken a less formal approach on some of its requirements and a formal rule amendment on others. Although Nasdaq has not suspended its listing requirements, it will give due weight to the realities surrounding the worldwide crisis in both considering listing standards compliance and requests for financial viability waivers, such as under Rule 5635.
Generally, companies newly deficient with the bid price, market value of listed securities, or market value of public float requirements have at least 180 days to regain compliance and may be eligible for additional time. Nasdaq has enacted a temporary rule change such that companies that fall out of compliance with these listing standards related to price through and including June 30, 2020 will have additional time to regain compliance. That is, the non-compliance period will be tolled through June 30, 2020 and not counted in the 180 day period. Companies will still receive notification of non-compliance and will still need to file the appropriate Form 8-K. Companies that no longer satisfy the applicable equity requirement can submit a plan to Nasdaq Listing Qualifications describing how they intend to regain compliance and, under the Listing Rules, Listing Qualifications’ staff can allow them up to six months plus the tolling period, to come back into compliance with the requirement.
The information memorandum confirms that listed companies that avail themselves of the 45-day extension for Exchange Act filings (see HERE) will not be considered deficient under Nasdaq Rule 5250(c) which requires all listed companies to timely file all required SEC periodic financial reports. Companies that are unable to file a periodic report by the relevant due date, but that are not eligible for the relief granted by the SEC, can submit a plan to Nasdaq Listing Qualifications describing how they intend to regain compliance and, under the Listing Rules, Listing Qualifications’ staff can allow them up to six months to file.
As discussed in my blog related to SEC COVID-19 relief (see HERE), the SEC has granted relief where a company is required to comply with Exchange Act Sections 14(a) or 14(c) requiring the furnishing of proxy or information statements to shareholders, and mail delivery is not possible due to the coronavirus and the company has made a good-faith effort to deliver such materials. Nasdaq likewise will not consider a company in non-compliance with Rule 5250(d) requiring companies to make available their annual, quarterly and interim reports to shareholders or Rule 5620(b) requiring companies to solicit proxies and provide proxy statements for all meetings of shareholders when relying on the SEC relief. Nasdaq confirms that it permits virtual shareholder meetings as long as it is permissible under the relevant state law and shareholders have the opportunity to ask questions of management.
The Nasdaq shareholder approval rules generally require companies to obtain approval from shareholders prior to issuing securities in connection with: (i) certain acquisitions of the stock or assets of another company (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants (see HERE); (iii) a change of control (see HERE); and (iv) certain private placements at a price less than the minimum price as defined in Listing Rule 5635(d) (see HERE.
An exception is available for companies in financial distress where the delay in securing stockholder approval would seriously jeopardize the financial viability of the company. To request a financial viability exception, the company must complete a written request including a letter addressing how a delay resulting from seeking shareholder approval would seriously jeopardize its financial viability and how the proposed transaction would benefit the company. The standard is usually difficult to meet; however, Nasdaq has indicated that it will consider the consider the impact of disruptions caused by COVID-19 in its review of any pending or new requests for a financial viability exception. In addition, reliance by the company on a financial viability exception must expressly be approved by the company’s audit committee and the company must obtain Nasdaq’s approval to rely upon the financial viability exception prior to proceeding with the transaction. Under the rule, companies must also provide notice to shareholders at least ten days prior to issuing securities in the exempted transaction.
OTC Markets
OTC Markets Group has provided blanket relief for OTCQB and OTCQX companies with certain deficiencies until June 30, 2020. Until that date, no new compliance deficiency notices will be sent related to bid price, market cap, or market value of public float. Also, any OTCQX or OTCQB company that has already received a compliance notice related to bid price, market cap, or market value of public float with a cure period expiring between March and June will automatically receive an extension until June 30, 2020 to cure their deficiency.
OTC Markets has also extended the implementation date for compliance with the OTCQB rules requiring at least 50 beneficial shareholders and minimum float of 10% or $2 million in market value of public float, respectively, until June 30, 2020. The extension applies only to companies already traded on OTCQB as of May 20, 2018. All other companies were subject to these requirements effective May 20, 2018.
« Disclosures Related To COVID-19 SEC Proposed Rule Changes for Exempt Offerings – Part 2 »
Nasdaq Extends Direct Listings
The Nasdaq Stock Market currently has three tiers of listed companies: (1) The Nasdaq Global Select Market, (2) The Nasdaq Global Market, and (3) The Nasdaq Capital Market. Each tier has increasingly higher listing standards, with the Nasdaq Global Select Market having the highest initial listing standards and the Nasdaq Capital Markets being the entry-level tier for most micro- and small-cap issuers. For a review of the Nasdaq Capital Market listing requirements, see HERE as supplemented and amended HERE.
On December 3, 2019, the SEC approved amendments to the Nasdaq rules related to direct listings on the Nasdaq Global Market and Nasdaq Capital Market. As previously reported, on February 15, 2019, Nasdaq amended its direct listing process rules for listing on the Market Global Select Market (see HERE).
Interestingly, around the same time as the approval of the Nasdaq rule changes, the SEC rejected amendments proposed by the NYSE big board which would have allowed a company to issue new shares and directly raise capital in conjunction with a direct listing process. In other words, the NYSE proposed an IPO without an underwriter. Although it was not clear as to all of the aspects of the proposal that prompted the rejection, in late December the NYSE made some adjustments to the proposed rule change and resubmitted it to the SEC. The most significant adjustment would be to allow listings with a capital raise of $100 million, down from $250 million in the first proposal. To qualify for the direct listing, the total value of shares, including those previously outstanding and those sold in the direct listing process, would need to be $250 million or higher. As of the date of this blog, no SEC action has been taken on the latest proposal.
Direct Listings in General
In a direct listing process, a company completes one or more private offerings of its securities, thus raising money up front, and then files a registration statement with the SEC to register the shares purchased by the private investors. Although a company can use a placement agent/broker-dealer to assist in the private offering, it is not necessary. A company would also not necessarily need a banker in the resale direct listing process. A benefit to the company is that it has received funds much earlier, rather than after a registration statement has cleared the SEC. For more on direct listings, including a summary of the easier process on OTC Markets, see HERE.
Where a broker-dealer assists in the private placement, the commission for the private offering may be slightly higher than the commissions in a public offering. One of the reasons is that FINRA regulates and must approve all public offering compensation, but does not limit or approve private offering placement agent fees. For more on FINRA Rule 5110, which regulates underwriting compensation, see HERE. A second reason a broker-dealer may charge a higher commission is that there is higher risk to investors in a private offering that does not have an immediately available public exit.
The investors take a greater risk because the shares they have purchased are restricted and may only be resold if registered with the SEC or in accordance with an exemption from registration such as Rule 144. Oftentimes a company offers a registration rights agreement when conducting the private offering, contractually agreeing to register the shares for resale within a certain period of time. Due to the higher risk, private offering investors generally are able to buy shares at a lower valuation than the intended IPO price. The pre-IPO discount varies but can be as much as 20% to 30%.
Furthermore, most private offerings are conducted under Rule 506 of Regulation D and are limited to accredited investors only or very few unaccredited investors. As a reminder, Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors—provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company. Rule 506(c) allows for general solicitation and advertising of the offering. For more on Rule 506, see HERE.
Accordingly, in a direct listing process, accredited investors are generally the only investors that can participate in the pre-IPO discounted offering round. Main Street investors will not be able to participate until the company is public and trading. Although this raises debate in the marketplace – a debate which has resulted in increased offering options for non-accredited investors such as Regulation A – the fact remains that the early investors take on greater risk and, as such, need to be able to financially withstand that risk. For more on the accredited investor definition including the SEC’s recent proposed amendments, see HERE.
The private offering, or private offerings, can occur over time. Prior to a public offering, most companies have completed multiple rounds of private offerings, starting with seed investors and usually through at least a series A and B round. Furthermore, most companies have offered options or direct equity participation to its officers, directors and employees in its early stages. In a direct listing, a company can register all these shareholdings for resale in the initial public market.
Like many tech companies, Spotify’s share price has been erratic, but as of the date of this blog is slightly higher than its initial listing price on the NYSE. However, in a direct listing there is a chance for an initial dip, as without an IPO and accompanying underwriters, there will be no price stabilization agreements. Usually price stabilization and after-market support is achieved by using an overallotment or greenshoe option. An overallotment option – often referred to as a greenshoe option because of the first company that used it, Green Shoe Manufacturing – is where an underwriter is able to sell additional securities if demand warrants same, thus having a covered short position. A covered short position is one in which a seller sells securities it does not yet own, but does have access to.
A typical overallotment option is 15% of the offering. In essence, the underwriter can sell additional securities into the market and then buy them from the company at the registered price, exercising its overallotment option. This helps stabilize an offering price in two ways. First, if the offering is a big success, more orders can be filled. Second, if the offering price drops and the underwriter has oversold the offering, it can cover its short position by buying directly into the market, which buying helps stabilize the price (buying pressure tends to increase and stabilize a price, whereas selling pressure tends to decrease a price).
Direct Listing on NASDAQ
A company seeking to list securities on Nasdaq must meet minimum listing requirements, including specified financial, liquidity and corporate governance criteria. Nasdaq listing Rules IM-5405-1 and IM-5505-1 set forth the direct listing requirements for the Nasdaq’s Global Market and Capital Market respectively. The Rules describe how the Exchange will calculate compliance with the initial listing standards related to the price of a security, including the bid price, market capitalization, the market value of listed securities and the market value of publicly held shares.
Like it previously did for the Global Select Market, Nasdaq is now providing a methodology for companies which have not been listed on a national securities exchange or traded in the over-the-counter market pursuant to FINRA Form 211 immediately prior to the initial pricing and which wish to list their securities to allow existing shareholders to sell their shares.
Direct Listings are subject to all initial listing requirements applicable to equity securities and, subject to applicable exemptions, the corporate governance requirements set forth in the Rule 5600 Series. In addition to setting forth the method for determining initial listing requirements based on the price of a security, including the bid price, market capitalization and market value of publicly held shares, the new rules require that a listing can only be completed upon effectiveness of a registration statement that solely registers securities for resale by existing shareholders (i.e., no new shares may be registered).
The rule changes will also clarify that an IPO Cross can be used for the initial pricing of such securities. An IPO Cross is a methodology for the initiation of trading of a security where there has been no underlying IPO. To allow for the IPO cross initial trading, a broker-dealer must serve in the role of financial advisor to perform the functions that an underwriter would perform in an IPO to initiate trading.
Under the amended rules, Nasdaq will determine a security’s price based on (i) a third party tender offer for cash; (ii) a sale between unaffiliated third parties; (iii) equity sales by the company; (iv) an independent valuation meeting specific standards; or (v) a valuation as determined by a private placement market. Both IM 54-5-1 and IM-5505-1 are identical on their substantive provisions for direct listing valuations. In order to be considered evidence of valuation under (i) – (iii), the transactions must be completed within the prior six months and be substantial in size representing sales of at least 20% of the market value of unrestricted publicly held shares requirement.
In addition, any affiliate involvement in the transactions must be less than 5% per affiliate or 10% total, must have been suggested or required by a non-affiliate, and the affiliate must not have participated in negotiations.
Any valuation used for this purpose must be provided by an entity that has significant experience and demonstrable competence in the provision of such valuations. The valuation must be of a recent date as of the time of the approval of the company for listing and the evaluator must have considered, among other factors, the annual financial statements required to be included in the registration statement, along with financial statements for any completed fiscal quarters subsequent to the end of the last year of audited financials included in the registration statement. Nasdaq will consider any market factors or factors particular to the listing applicant that would cause concern that the value of the company had diminished since the date of the valuation and will continue to monitor the company and the appropriateness of relying on the valuation up to the time of listing. Nasdaq may withdraw its approval of the listing at any time prior to the listing date if it believes that the valuation no longer accurately reflects the company’s likely market value.
(f) A valuation agent shall not be considered independent if:
(1) At the time it provides such valuation, the valuation agent or any affiliated person or persons beneficially own in the aggregate as of the date of the valuation, more than 5% of the class of securities to be listed, including any right to receive any such securities exercisable within 60 days.
(2) The valuation agent or any affiliated entity has provided any investment banking services to the listing applicant within the 12 months preceding the date of the valuation. For purposes of this provision, “investment banking services” includes, without limitation, acting as an underwriter in an offering for the issuer; acting as a financial adviser in a merger or acquisition; providing venture capital, equity lines of credit, Popes (private investment, public equity transactions), or similar investments; serving as placement agent for the issuer; or acting as a member of a selling group in a securities underwriting.
(3) The valuation agent or any affiliated entity has been engaged to provide investment banking services to the listing applicant in connection with the proposed listing or any related financings or other related transactions.
For a security that has had sustained recent trading in a private placement market prior to listing, Nasdaq will determine a company’s price, market value of listed securities and market value of unrestricted publicly held shares based on the lesser of: (i) the value calculable based on the valuation calculated in accordance with the standards listed above and (ii) the value calculable based on the most recent trading price in a private placement market.
For purposes of the rule, a private placement market is one that is operated by a national securities exchange or a registered broker-dealer. Nasdaq will examine the trading price trends for the stock in the private placement market over a period of several months prior to listing and will only rely on a private placement market price if it is consistent with a sustained history over that several-month period evidencing a market value in excess of Nasdaq’s market value requirement.
For a security that has not had sustained recent trading in a private placement market for a period of several months prior to listing, Nasdaq will determine that such company has met the market value of publicly held shares requirement if the company has a valuation, as calculated via the above methods, in excess of 200% of the otherwise applicable requirement. For example, to list on the Nasdaq Global Market the valuation (if not gleaned from a private placement market) will need to be at least $8 per share. Likewise, each of the liquidity calculations will need to exceed 200% of the regular listing requirement.
Furthermore, if Nasdaq determines that the valuation evidence required by IM 5405-1 and IM-5505-1 is not reliable, Nasdaq will require evidence, including a review of all facts and circumstances, that the various valuation and pricing requirements exceed 250% of the listing standards. The rule release reminds companies that Nasdaq has broad discretion over the listing process and may deny an application, even if the technical requirements are met, if it believes such denial is necessary to protect investors and the public interest. I suspect that Nasdaq will carefully review any applications for a direct listing.
Foreign Exchange Listings
Where a company is transferring from, or seeking to dual list on, Nasdaq from a foreign exchange where there is a broad, liquid market in the securities, Nasdaq will consider the value based on the recent trading price in the foreign market.
« SEC Fall 2019 Regulatory Agenda SEC Proposes Amendments To MD&A Disclosures »
Drill Down On NASDAQ Audit Committee Requirements
I’ve written several times about Nasdaq listing requirements including the general listing requirements (see HERE) and the significant listing standards changes enacted in August of this year (see HERE). This blog will drill down on audit committees which are part of the corporate governance requirements for listed companies. Nasdaq Rule 5605 delineates the requirements for a Board of Directors and committees. The Nasdaq rule complies with SEC Rule 10A-3 related to audit committees for companies listed on a national securities exchange.
SEC Rule 10A-3
SEC Rule 10A-3 requires that each national securities exchange have initial listing and ongoing qualification rules requiring each listed company to have an audit committee comprised of independent directors. Although the Nasdaq rules detail its independence requirements, the SEC rule requires that at a minimum an independent director cannot directly or indirectly accept any consulting, advisory or other compensation or be affiliated with the company or any of its subsidiaries. The prohibition against compensation does not include a reasonable compensation for serving as a director.
Like the Nasdaq rules, the SEC allows for different independence standards for foreign private issuers (FPI) following their home country rules and even allows for affiliation as long as the person is not an executive officer of the FPI.
The audit committee of each listed company, in its capacity as a committee of the board of directors, must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for auditing and audit-related services. Furthermore, the SEC requires that an executive officer of a listed company promptly notify the national exchange if he or she becomes aware of any material non-compliance with the audit committee requirements by that listed company.
Although charter requirements are detailed in the Nasdaq rule, the SEC rule requires that the audit committee establish certaDrill Down On NASDAQ Audit Comin processes and procedures for handling complaints regarding accounting, internal financial controls and auditing matters, including for the confidential submission by employees. The SEC rule also requires that an audit committee be given the power, authority and funding to engage independent counsel and other advisors to carry out its tasks. Funding must also be provided to hire audit firms and pay administrative expenses.
The SEC allows for a phase-in for compliance when a company is completing an initial public offering. In particular, all but one director may be dependent for 90 days following the IPO and a minority of the audit committee may be dependent for one year from effectiveness of the registration statement. The SEC rule also contains general exemptions from the audit committee requirements including: (i) for consolidated subsidiaries that are listed on another exchange with similar audit committee requirements; (ii) FPI’s that follow home country rules and have a similar committee to an audit committee and satisfy certain additional conditions; and (iii) related to the listing of certain options, futures, asset-backed issuers, investment trusts, a passive trust or foreign governments. Specific disclosure is required when an exemption is being relied upon including an assessment of whether, and if so, how, such reliance would materially adversely affect the ability of the audit committee to act independently and to satisfy the other requirements of Rule 10A-3.
The SEC rule specifically requires that an exchange must give a listed company the opportunity to cure a defect in the audit committee requirements prior to delisting. Moreover, the SEC rule provides that if an independent director on the audit committee loses independence as a result of factors outside of their control, that person may remain on the audit committee until the next annual shareholders meeting or one year from the date of the occurrence that caused the board member to no longer be independent.
Nasdaq Rule 5605
Audit Committee Composition
One of the corporate governance related listing requirements is that a company have an audit committee consisting solely of independent directors (for more information on independence qualifications see HERE) who also satisfy the requirements of SEC Rule 10A-3 and who can read and understand fundamental financial statements including a balance sheet, income statement and cash flow statement. The audit committee must have at least three members. One member of the audit committee must have employment experience in finance or accounting, an accounting certification or other experience that results in the individual’s financial sophistication.
None of the committee members can have participated in the preparation of the financial statements of the company or any of its current subsidiaries for the prior three years. An individual will be considered to have participated in the preparation of the company’s financial statements if the individual has played any role in compiling or reviewing those financial statements, including a supervisory role. An interim officer who signed or certified the company’s financial statements will be deemed to have participated in the preparation of the company’s financial statements and, therefore, could not serve on the audit committee for three years.
The eligibility requirements to serve on the audit committee apply to all committee members whether or not such member is afforded non-voting status or other limitations on their participation with the committee.
Nasdaq has a limited exception to the independence requirements where a director meets the independence standards in SEC Rule 10A-3 but not the more detailed requirements of Nasdaq rules, is not currently an executive officer, employee or family member of an executive officer and exceptional circumstances makes the appointment of the person in the best interests of the company and its shareholders. Specific disclosures are required when relying on this exception including the nature of the relationship that makes the person non-independent and the reasons for the board’s determination. A committee member appointed under this exception may not serve for more than two years and cannot be chair of the audit committee. Unlike the implementation of many exceptions to Nasdaq rules (such as for example the 20% rule), the limited exception for audit committee compliance for exceptional circumstances does not require Nasdaq approval.
Audit Committee Charter
Rule 5605(c) requires that each company must certify that it has adopted a formal written committee charter and that the audit committee will review and reassess the charter on an annual basis. The certification is submitted one time and a copy of the actual charter does not need to be provided to Nasdaq. However, Item 407(d)(1) of Regulation S-K requires that companies report whether a current copy of its audit committee charter is available on its website and provide the website address. If the charter is not on the website, companies should include the charter as an appendix to its proxy statement at least once every three years or in any year in which the charter has been materially amended.
The charter must specify: (i) the scope of the audit committee’s responsibilities and how it carries out those responsibilities including structure, processes and membership requirements; (ii) the audit committee’s responsibility to ensure they receive written statements from the outside auditor regarding relationships between the auditor and the company and actively taking steps for ensuring the independence of the auditor; (iii) the committee’s purpose of overseeing the accounting and financial reporting processes of the company and the audits of the financial statements of the company; and (iv) the specific audit committee responsibilities and authority.
Furthermore, the charter must establish procedures for the confidential, anonymous submission by employees of the listed company of concerns regarding questionable accounting or auditing matters.
Audit Committee Responsibilities and Authority
The audit committee is responsible for items delineated in SEC Rule 10A-3 and in particular related to: (i) registered public accounting firms, (ii) complaints relating to accounting, internal accounting controls or auditing matters, (iii) authority to engage advisers, and (iv) funding as determined by the audit committee.
Cure Periods
All non-compliance with audit committee requirements requires prompt notification to Nasdaq.
Consistent with SEC Rule 10A-3, if a member of the audit committee loses independent status for reasons outside the member’s reasonable control, the audit committee member may remain on the audit committee until the earlier of its next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement. A company relying on this provision must provide notice to Nasdaq immediately upon learning of the event or circumstance that caused the noncompliance.
If noncompliance is a result of dropping below the minimum member requirements (three members), the company will have until the earlier of the next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement – provided, however, that if the annual shareholders meeting occurs no later than 180 days following the event that caused the vacancy, the company shall instead have 180 days from such event to regain compliance. A company relying on this provision must provide notice to Nasdaq immediately upon learning of the event or circumstance that caused the noncompliance.
Exception
If a company has a class of equity securities listed on another exchange with SEC Rule 10A-3 audit committee requirements, they may list securities of a consolidated subsidiary on Nasdaq without having a separate audit committee for that subsidiary.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including sitting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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law·cast
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Nasdaq Board Independence Standards
Nasdaq Rule 5605 delineates the listing qualifications and requirements for a board of directors and committees, including the independence standards for board members. Nasdaq requires that a majority of the board of directors of a listed company be “independent” and further that all members of the audit, nominating and compensation committees be independent.
Under Rule 5605, an “independent director” means a person other than an executive officer or employee of a company or any individual having a relationship which, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. In other words, the question of independence must ultimately be determined by the board of directors who must make an affirmative finding that a director is independent. However, the Nasdaq rules specify certain relationships that would disqualify a person from being considered independent. Stock ownership is not on the list and is not enough, without more, to preclude independence.
Rule 5605 specifies that the following people cannot be considered independent:
(i) a director who is, or at any time during the past three years was, employed by the company, provided however, interim employment of less than one year would not be a disqualifier as long as such employment had since terminated. In addition, employment by an entity that was later acquired by the company would not disqualify a director from being independent provided the former officer was not employed by the company after the acquisition;
(ii) a director who accepted or who has a family member who accepted any compensation from the company in excess of $120,000 during any period of twelve consecutive months within the three years preceding the determination of independence, other than: (a) compensation for board or board committee service; (b) compensation paid to a family member who is an employee but not an executive of the company; (c) benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (d) compensation received while acting as an interim officer as long as such employment lasted for less than a year and has since terminated. Options received for services should be valued using a commonly accepted option pricing formula, such as the Black-Scholes or binomial model at the time of grant. The option value is considered a payment upon grant even if the option does not immediately vest or if there are conditions to vesting or exercise. This prohibition is meant to capture any compensation that directly benefits the director or family member and as such would include political contributions to a campaign by either. However, it is not meant to capture ordinary course business transactions such as interest on an arm’s-length loan;
(iii) a director who is a family member of an individual who is, or at any time during the past three years was, employed by the company as an executive officer;
(iv) a director who is, or has a family member who is, a partner in (other than limited partner), or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is more, other than the following: (a) payments arising solely from investments in the company’s securities; or (b) payments under non-discretionary charitable contribution matching programs;
(v) a director of the company who is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the company serve on the compensation committee of such other entity; or
(vi) a director who is, or has a family member who is, a current partner of the company’s outside auditor, or was a partner or employee of the company’s outside auditor who worked on the company’s audit at any time during any of the past three years.
Reference to the “company” includes parents and subsidiaries or any other entities that the company consolidates financial statements with, including variable interest entities. Executive officer refers to any person covered by SEC Rule 16a-1(f) and in particular the company’s president, principal financial officer, principal accounting officer, any vice-present in charge of a principal business unit, division or function or any officer or person who performs a policymaking function, which can include officers of a parent or subsidiary.
For purposes of Rule 5605, “family member” means a person’s spouse, parents, children and siblings, whether by blood, marriage or adoption, or anyone residing in such person’s home. This definition technically encompasses stepchildren as they are children “by marriage.” However, when applying the three-year look-back provisions, a company does not have to consider a person who is no longer a family member as a result of legal separation, divorce, death or incapacitation.
In June 2019, Nasdaq proposed to amend the definition of “family member” to narrow who can be included and add a level of certainty. In particular, Nasdaq proposed to change the definition to “a person’s spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person’s home.” In the proposed rule change release, Nasdaq admitted that it did not intend to include stepchildren and that the change would correct this mistake. The new proposed language matches the NYSE definition.
However, in September 2019, the SEC instituted proceedings to determine whether to disapprove the proposed rule change. The SEC basically thinks Nasdaq is over-correcting in its new proposed rule. Certainly it would make sense to exclude a stepchild where the parents marry after the child is an adult and no parental relationship exists, but not where the step-parent raises or is otherwise close to the stepchild. The SEC also does not necessarily believe that the term “children” excludes stepchildren, nor as noted, should it. As of publication of this blog, no further action has been taken.
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The 20% Rule – Private Placements
Nasdaq and the NYSE American both have rules requiring listed companies to receive shareholder approval prior to issuing twenty percent (20%) or more of the outstanding securities in a transaction other than a public offering at a price less than the Minimum Price, as defined in the rule. Nasdaq Rule 5635 sets forth the circumstances under which shareholder approval is required prior to an issuance of securities in connection with: (i) the acquisition of the stock or assets of another company (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants (see HERE); (iii) a change of control (see HERE); and (iv) transactions other than public offerings. NYSE American Company Guide Sections 711, 712 a 713 have substantially similar provisions.
Nasdaq and the NYSE recently amended their rules related to issuances in a private placement to provide greater flexibility and certainty for companies to determine when a shareholder vote is necessary to approve a transaction that would result in the issuance of 20% or more of the outstanding common stock or 20% or more of outstanding voting power in a PIPE or similar private placement financing transaction. The amendments simplified the prior multi-part language and changed the pricing test trigger to create a new “Minimum Price.” For my blog on the Nasdaq amendment, see HERE. Although the NYSE American has not yet amended its rule to conform with the changes, I expect it will be forthcoming. In this blog, I will drill down further on the rule and its interpretive guidance.
As I’ve mentioned in each of the blogs in this series, many other Exchange Rules interplay with the 20% Rules; for example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to the issuance of securities in the same transactions that require shareholder approval. Companies need to carefully comply with each of the rules that may interplay with a transaction or proposed transaction.
Nasdaq Rule 5635(d)
Nasdaq Rule 5635(d) requires shareholder approval prior to a 20% issuance of securities at a price that is less than the Minimum Price in a transaction other than a public offering. A 20% issuance is a transaction, other than a public offering, involving the sale, issuance or potential issuance by the company of common stock (or securities convertible into or exercisable for common stock), which alone or together with sales by officers, directors or substantial shareholders of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance. “Minimum Price” means a price that is the lower of: (i) the closing price (as reflected on Nasdaq.com) immediately preceding the signing of the binding agreement; or (ii) the average closing price of the common stock (as reflected on Nasdaq.com) for the five trading days immediately preceding the signing of the binding agreement.
The September 2018 rule amendment creating a new “Minimum Price” standard provides more flexibility by adding the option of choosing between the closing bid price and the five-day average closing price. For example, in a declining market, the five-day average closing price will be above the current market price, which could make it difficult for companies to close transactions because investors could buy shares at a lower price in the market. Likewise, in a rising market, the five-day average could result in a below-market transaction triggering shareholder approval requirements.
NYSE American Company Guide Section 713
The NYSE American Company Guide Section 732 requires shareholder approval prior to the listing of additional shares in connection with a transaction, other than a public offering, involving: (i) the sale, issuance, or potential issuance by the company of common stock (or securities convertible into common stock) at a price less than the greater of book or market value which together with sales by officers, directors or principal shareholders of the company equals 20% or more of presently outstanding common stock; or (ii) the sale, issuance, or potential issuance by the issuer of common stock (or securities convertible into common stock) equal to 20% or more of presently outstanding stock for less than the greater of book or market value of the stock.
Interpretation and Guidance
Public Offering
Although the rules do not require shareholder approval for a transaction involving “a public offering,” the Exchanges do not automatically consider all registered offerings as public offerings.
Generally, all firm commitment underwritten securities offerings registered with the SEC will be considered public offerings. Likewise, any other securities offering which is registered with the SEC and which is publicly disclosed and distributed in the same general manner and extent as a firm commitment underwritten securities offering will be considered a public offering for purposes of the 20% Rule. In other instances, when analyzing whether a registered offering is a “public offering,” the Exchanges will consider: (a) the type of offering (including whether underwritten, on a best efforts basis with a placement agent, or self-directed by the company); (b) the manner in which the offering is marketed (including the number of investors and breadth of marketing effort); (c) the extent of distribution of the offering (including the number of investors and prior relationship with the company); (d) the offering price (at market or a discount); and (e) the extent to which the company controls the offering and its distribution.
A registered direct offering will not be assumed to be public and will be reviewed using the same factors listed above. Likewise, a Rule 144A offering will be considered on its facts and circumstances, though generally share caps are used in these transactions to avoid an issue. On the other hand, a confidentially marketed public offering (CMPO) is a firm commitment underwritten offering and, as such, will be considered a public offering.
Substantial Shareholder
A substantial shareholder is defined in the negative and requires the company to consider the power that a particular shareholder asserts over the company. Nasdaq specifically provides that someone that owns less than 5% of the shares of the outstanding common stock or voting power would not be considered a substantial shareholder for purposes of the Rules.
Shares to be Issued in a Transaction; Shares Outstanding; Votes to Approve
In determining the number of shares to be issued in a transaction, the maximum potential shares that could be issued, regardless of contingencies, should be included. The maximum potential issuance includes all securities initially issued or potentially issuable or potentially exercisable or convertible into shares of common stock as a result of the transaction. The percentage to be issued is calculated by dividing the maximum potential issuance by the number of shares of common stock issued and outstanding prior to the transaction.
In determining the number of shares outstanding immediately prior to a transaction, only shares that are actually outstanding should be counted. Shares reserved for issuance upon conversion of securities or exercise of options or warrants are not considered outstanding for the purpose of the 20% Rule. Where a company has multiple classes of common stock, all classes are counted in the amount outstanding, even if one or more classes do not trade on the Exchange.
Voting power outstanding as used in the Rule refers to the aggregate number of votes which may be cast by holders of those securities outstanding which entitle the holders to vote generally on all matters submitted to the company’s security holders for a vote.
Where shareholder approval is required under the 20% Rule, approval can be had by a majority of the votes cast on the proposal. The proxy for approval of a transaction under the 20% Rule should provide specific details on the proposed financing transaction.
Convertible Securities; Warrants; Anti-Dilution Provisions
Convertible securities and warrants can either convert at a fixed or variable rate. If the securities are convertible at a fixed price, Nasdaq will determine whether the issuance is below the Minimum Price, and for the NYSE American at a price less than the greater of book or market value, if the conversion or exercise price is less than the applicable threshold price at the time the parties enter into a binding agreement with respect to the issuance.
Variable rate conversions are generally tied to the market price of the underlying common stock and accordingly, the number of securities that could be issued upon conversion will float with the price of the common stock. That is, the lower the price of a company’s common stock, the more shares that could be issued and conversely, the higher the price, the fewer shares that could be issued. Variable priced convertible securities tend to cause a downward pressure on the price of common stock, resulting in additional dilution and even more common stock issued in each subsequent conversion round. This chain of convert, sell, price reduction, and convert into more securities, sell, further price reduction and resulting dilution is sometimes referred to as a “death spiral.”
The 20% Rule requires that the company consider the largest number of shares that could be issued in a transaction when determining whether shareholder approval is required. Where a transaction involves variable priced convertible securities, and no floor on such conversion price is included or cap on the total number of shares that could be issued, the Exchanges will presume that the potential issuance will exceed 20% and that shareholder approval will be required.
The calculation of whether an issuance is above 20% and below the threshold Minimum Price where warrants are involved can be complicated. Where warrants are involved, Nasdaq will require shareholder approval if the issuance of common stock is less than the 20% threshold and such stock is issued below the Minimum Price if the exercise of the warrants would result in greater than a 20% issuance. However, the warrants do not need to be included in the calculation if the exercise price is above the Minimum Price and the warrants are not exercisable for at least six months. If the common stock portion of an offering that includes warrants exceeds the 20% threshold, Nasdaq will value the warrants at $0.125, regardless of whether the exercise price exceeds the market value. This is referred to as the “1/8th Test.” In this case, shareholder approval will be required even if the warrants are not exercisable for six months.
However, Nasdaq has indicated that convertible bonds with flexible settlement provisions (i.e., cash or stock at the company’s option) will be treated the same way as physically settled bonds under the rule. If the conversion price of the bonds equals or exceeds the Minimum Price, shareholder approval will not be required. Contrarily, Nasdaq will treat a convertible security with a flexible settlement provision as if it will be settled in securities for purposes of the 20% Rule.
Moreover, the Exchanges generally view variable priced transactions without floors or share caps as disreputable and potentially raising public interest concerns. Nasdaq specifically addresses these transactions, and the potential public interest concern, in its rules. In addition to the demonstrable business purpose of the transaction, other factors that Nasdaq staff will consider in determining whether a transaction raises public interest concerns include: (1) the amount raised in the transaction relative to the company’s existing capital structure; (2) the dilutive effect of the transaction on the existing holders of common stock; (3) the risk undertaken by the variable priced security investor; (4) the relationship between the variable priced security investor and the company; (5) whether the transaction was preceded by other similar transactions; and (6) whether the transaction is consistent with the just and equitable principles of trade.
Nasdaq will closely examine any transaction that includes warrants that are exercisable for little or no consideration (i.e., “penny warrants”) and may object to a transaction involving penny warrants even if shareholder approval would not otherwise be required. Warrants with a cashless exercise feature are also not favored by the Exchanges and will be closely reviewed. Nasdaq guidance indicates it will review the following factors related to warrants with cashless exercise features: (i) the business purpose of the transaction; (ii) the amount to be raised (if the acquisition includes a capital raise); (iii) the existing capital structure; (iv) the potential dilutive effect on existing shareholders; (v) the risk undertaken by the new investors; (vi) the relationship between the company and the investors; (vii) whether the transaction was preceded by similar transactions; (viii) whether the transaction is “just and equitable”; and (ix) whether the warrant has provisions limiting potential dilution. In practice, many warrants include dilutive share caps and have cashless features that only kick in if there is no effective registration statement in place for the underlying common stock.
Any contractual provisions that could result in lowering the transaction price to below the Minimum Price, including anti-dilution provisions, most favored nations, true-up and similar provisions will be viewed as a discounted issuance. Likewise, a provision that allows a company to voluntarily reduce the conversion or exercise price to a price that could be below the Minimum Price, will be treated as a discounted issuance.
Aggregation
Both Nasdaq and the NYSE American may aggregate financing transactions that occur within close proximity of each other in determining whether the 20% Rule applies. Nasdaq considers the following factors when considering aggregation: (i) timing of the issuances; (ii) facts surrounding the subsequent transactions (e.g., planned at time of first transaction); (iii) commonality of investors; (iv) existence of contingencies between the transactions; (v) commonalities as to use of proceeds; and (vi) timing of board approvals. Moreover, transactions that are more than six months apart are generally not aggregated. Although the NYSE American does not provide such specific guidance, in practice, their analysis is substantially similar.
Two-Step Transactions and Share Caps
As obtaining shareholder approval can be a lengthy process, companies sometimes bifurcate transactions into two steps and use share caps as part of a transaction structure. A company may limit the first part of a transaction to 19.9% of the outstanding securities and then, if and when shareholder approval is obtained, issue additional securities. Companies may also structure transactions such that issuances related to a private offering, including through convertible securities, are capped at no more than 19.9% of total outstanding.
In order for a cap to satisfy the rules, it must be clear that no more than the threshold amount (19.9%) of securities outstanding immediately prior to the transaction, can be issued in relation to that transaction, under any circumstances, without shareholder approval. In a two-step transaction where shareholder approval is deferred, shares that are issued or issuable under the cap must not be entitled to vote to approve the remainder of the transaction. In addition, a cap must apply for the life of the transaction, unless shareholder approval is obtained. For example, caps that no longer apply if a company is not listed on Nasdaq are not permissible under the Rule. If shareholder approval is not obtained, then the investor will not be able to acquire 20% or more of the common stock or voting power outstanding before the transaction. Where convertible securities were issued, the shareholder would continue to hold the balance of the original security in its unconverted form.
Moreover, where a two-step transaction is utilized, the transaction terms cannot change as a result of obtaining, or not obtaining, shareholder approval. For example, a transaction may not provide for a sweetener or penalty. The Exchanges believe that the presence of alternative outcomes have a coercive effect on the shareholder vote and thus deprive the shareholders of their ability to freely determine whether the transaction should be approved. Nasdaq provides specific examples of a defective share cap, such as where a company issues a convertible preferred stock or debt instrument that provides for conversions of up to 20% of the total shares outstanding with any further conversions subject to shareholder approval. However, the terms of the instrument provide that if shareholders reject the transaction, the coupon or conversion ratio will increase or the company will be penalized by a specified monetary payment, including a rescission of the transaction. Likewise, a transaction may provide for improved terms if shareholder approval is obtained. The NYSE American similarly provides that share caps cannot be used in a way that could be coercive in a shareholder vote.
Reverse Acquisitions
A reverse acquisition or reverse merger is one in which the acquisition results in a change of control of the public company such that the target company shareholders control the public company following the closing of the transaction. In addition to the 20% Rule, a change of control would require shareholder approval under the Change of Control Rule and the Acquisition Rule will likely apply as well. A company must re-submit an initial listing application in connection with a transaction where the target and new control entity was a non-Exchange listed entity prior to the transaction.
In determining whether a change of control has occurred, the Exchange will consider all relevant factors including, but not limited to, changes in the management, board of directors, voting power, ownership, nature of the business, relative size of the entities, and financial structure of the company.
Exceptions
The Exchanges have a “financial viability” exception to the 20% Rule. Although rarely granted, to qualify for the financial viability exception, a listed company must apply in writing and demonstrate that: (i) the delay in securing stockholder approval would seriously jeopardize the financial viability of the company; and (ii) reliance on the exception has been expressly approved by the company’s audit committee or comparable board committee comprised of all independent, disinterested directors. A determination will be rendered by the Exchange very quickly, such as in a matter of days.
Nasdaq guidance suggests an in-depth letter focusing on how a delay resulting from seeking shareholder approval would seriously jeopardize its financial viability and how the transaction would benefit the company. The letter should also describe the proposed transaction in detail and should include the identity of the investors. Nasdaq provides a list of examples of information that should be discussed in the letter, including: (i) the facts and circumstances that led to the company’s predicament; (ii) how long the company will be able to meet its current obligations, such as payroll, lease payments, and debt service, if it does not complete the proposed transaction; (iii) the company’s current and projected cash position and burn rate; (iv) other alternatives; (v) why a step transaction will not work; (vi) would the company file for bankruptcy without the transaction; (vii) the impact to operations while waiting for shareholder approval; (viii) why the company didn’t enter into a transaction sooner; (ix) demonstrate that the transaction will rescue the company; (x) demonstrate that the company will continue to meet Nasdaq’s listing requirements; and (xi) explain changes in voting power.
A company that gets approval for this exception must send a mailing to all shareholders at least 10 days prior to the issuance of securities under the exception. The letter must disclose the terms of the transaction, including number of shares to be issued and consideration received, that the company is relying on the financial viability exception and that the audit committee (or other committee) has approved the reliance on the exception. The company must also file an 8-K and issue a press release with the same information also no later than 10 days before the issuance.
Furthermore, shareholder approval is not required if the issuance is part of a court-approved reorganization under the federal bankruptcy laws or comparable foreign laws.
Also, a foreign private issuer that has elected to follow its home country rules will be exempt from the 20% Rule if it notifies Nasdaq, provides an opinion from local counsel that shareholder approval would not be required, and discloses its practices in its annual report on Form 20-F.
Consequences for Violation
Consequences for the violation of the 20% Rule or Acquisition Rule can be severe, including delisting from the Exchange. Companies that are delisted from an Exchange as a result of a violation of these rules are rarely ever re-listed.
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The 20% Rule- Acquisitions
Nasdaq and the NYSE American both have “20% Rules” requiring listed companies to receive shareholder approval prior to issuing unregistered securities in an amount of 20% or more of their outstanding common stock or voting power. Nasdaq Rule 5635 sets forth the circumstances under which shareholder approval is required prior to an issuance of securities in connection with: (i) the acquisition of the stock or assets of another company; (ii) equity-based compensation of officers, directors, employees or consultants; (iii) a change of control; and (iv) transactions other than public offerings (see HERE related to Rule 5635(d)). NYSE American Company Guide Sections 711, 712 and 713 have substantially similar provisions.
In a series of blogs I will detail these rules and related interpretative guidance. Many other Exchange Rules interplay with the 20% Rules; for example, the Exchanges generally require a Listing of Additional Securities (LAS) form submittal at least 15 days prior to the issuance of securities in the same transactions that require shareholder approval, among others, and for an acquisition transaction at a lower 10% threshold. However, this blog is limited to the circumstances under which shareholder approval is required in conjunction with acquisitions under the 20% Rule and Acquisition Rule.
Nasdaq Rule 5635(a)
Nasdaq Rule 5635(a) requires shareholder approval prior to the issuance of securities in connection with the acquisition of the stock or assets of another company: (1) where, due to the present or potential issuance of common stock, including shares issued pursuant to an earn-out provision or similar type of provision, or securities convertible into or exercisable for common stock, other than a public offering for cash: (a) the common stock has or will have upon issuance voting power equal to or in excess of 20% of the voting power outstanding before the issuance of stock or securities convertible into or exercisable for common stock; or (b) the number of shares of common stock to be issued is or will be equal to or in excess of 20% of the number of shares of common stock outstanding before the issuance of the stock or securities; or (2) any director, officer or substantial shareholder of the company has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction or series of related transactions and the present or potential issuance of common stock, or securities convertible into or exercisable for common stock, could result in an increase in outstanding common shares or voting power of 5% or more. Part (2) of the provision is known as the “acquisition rule.”
Nasdaq Rule 5635(a) applies to strategic partnerships, joint ventures and similar transactions between companies as well.
NYSE American Company Guide Sections 712
Substantially similar to Nasdaq, the NYSE American Company Guide Section 712 requires shareholder approval prior to the listing of additional shares to be issued as sole or partial consideration for an acquisition of the stock or assets of another company in the following circumstances: (a) if any individual director, officer or substantial shareholder of the listed company has a 5% or greater interest (or such persons collectively have a 10% or greater interest), directly or indirectly, in the company or assets to be acquired or in the consideration to be paid in the transaction and the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in outstanding common shares of 5% or more; or (b) where the present or potential issuance of common stock, or securities convertible into common stock, could result in an increase in outstanding common shares of 20% or more.
Interpretation and Guidance
Substantial Shareholder
A substantial shareholder is defined in the negative and requires the company to consider the power that a particular shareholder asserts over the company. Nasdaq specifically provides that someone that owns less than 5% of the shares of the outstanding common stock or voting power would not be considered a substantial shareholder for purposes of the Rules.
Shares to be Issued in a Transaction; Shares Outstanding; Votes to Approve
In determining the number of shares to be issued in a transaction, the maximum potential shares that could be issued, regardless of contingencies, should be included. The maximum potential issuance includes all securities initially issued or potentially issuable or potentially exercisable or convertible into shares of common stock as a result of the transaction, including from earn-out clauses, penalty provisions and equity compensation awards.
In determining the number of shares outstanding immediately prior to a transaction, only shares that are actually outstanding should be counted. Shares reserved for issuance upon conversion of securities or exercise of options or warrants are not considered outstanding for purpose of the 20% Rule or Acquisition Rule. Where a company has multiple classes of common stock, all classes are counted in the amount outstanding, even if one or more classes do not trade on the Exchange.
Voting power outstanding as used in the Rule refers to the aggregate number of votes which may be cast by holders of those securities outstanding which entitle the holders to vote generally on all matters submitted to the company’s security holders for a vote.
Where shareholder approval is required under the 20% Rule or Acquisition Rule, approval can be had by a majority of the votes cast on the proposal.
Convertible Securities; Warrants
Convertible securities and warrants can either convert at a fixed or variable rate. Variable rate conversions are generally tied to the market price of the underlying common stock and accordingly, the number of securities that could be issued upon conversion will float with the price of the common stock. That is, the lower the price of a company’s common stock, the more shares that could be issued and conversely, the higher the price, the fewer shares that could be issued. Variable priced convertible securities tend to cause a downward pressure on the price of common stock, resulting in additional dilution and even more common stock issued in each subsequent conversion round. This chain of convert, sell, price reduction, and convert into more securities, sell, further price reduction and resulting dilution is sometimes referred to as a “death spiral.”
The 20% Rule and Acquisition Rule require that the company consider the largest number of shares that could be issued in a transaction when determining whether shareholder approval is required. Where a transaction involves variable priced convertible securities, and no floor on such conversion price is included or cap on the total number of shares that could be issued, the Exchanges will presume that the potential issuance will exceed 20% and that shareholder approval will be required.
Moreover, the Exchanges generally view variable priced transactions without floors or share caps as disreputable and potentially raising public interest concerns. Nasdaq specifically addresses these transactions, and the potential public interest concern, in its rules. In addition to the demonstrable business purpose of the transaction, other factors that Nasdaq staff will consider in determining whether a transaction raises public interest concerns include: (1) the amount raised in the transaction relative to the company’s existing capital structure; (2) the dilutive effect of the transaction on the existing holders of common stock; (3) the risk undertaken by the variable priced security investor; (4) the relationship between the variable priced security investor and the company; (5) whether the transaction was preceded by other similar transactions; and (6) whether the transaction is consistent with the just and equitable principles of trade.
Likewise, Nasdaq will closely examine any transaction that includes warrants that are exercisable for little or no consideration (i.e., “penny warrants”) and may object to a transaction involving penny warrants even if shareholder approval would not otherwise be required. Warrants with a cashless exercise feature are also not favored by the Exchanges and will be closely reviewed. Nasdaq guidance indicates it will review the following factors related to warrants with cashless exercise features: (i) the business purpose of the transaction; (ii) the amount to be raised (if the acquisition includes a capital raise); (iii) the existing capital structure; (iv) the potential dilutive effect on existing shareholders; (v) the risk undertaken by the new investors; (vi) the relationship between the company and the investors; (vii) whether the transaction was preceded by similar transactions; (viii) whether the transaction is “just and equitable”; and (ix) whether the warrant has provisions limiting potential dilution. In practice, many warrants include dilutive share caps and have cashless features that only kick in if there is no effective registration statement in place for the underlying common stock.
Aggregation
Both Nasdaq and the NYSE American may aggregate financing transactions that occur within close proximity of an acquisition in determining whether the 20% Rule or Acquisition Rule apply. Factors that the Exchange’s will consider include: (i) the proximity of the financing to the acquisition; (ii) timing of board approvals; (iii) stated contingencies in the acquisition documents; and (iv) stated or actual use of proceeds. Multiple acquisitions may also be aggregated. Factors that will be considered in aggregating multiple acquisitions include: (i) timing of the acquisitions; (ii) commonality of ownership of the target companies; (iii) commonality of officers and directors in the target companies; and (iv) the existence of any contingencies between or among the transactions.
Furthermore, there is no pricing test when determining if shareholder approval is required for securities issues in connection with an acquisition and as such, shares issued in a private offering that is part of the acquisition transaction will be aggregated for the 20% Rule even if the offering is above the Minimum Price (for more on Minimum Price, see HERE). In determining whether the financing is in connection with the acquisition, the Exchange will review the factors listed above. If the financing is not in connection with the acquisition such as where the proceeds are specifically designated for other purposes, the pricing test related to the private offering 20% rule (Rule 5635(d)) would apply.
Public Offering
An acquisition may be completed in coordination with a public offering of securities such as to raise funds for the operations of the acquired company or to pay for the acquisition itself in a cash transaction. The Exchanges will consider the stock issued in the offering when determining whether shareholder approval is required (see Aggregation discussion above). Although the rules do not require shareholder approval for a transaction involving “a public offering for cash,” the Exchanges do not automatically consider all registered offerings as public offerings.
Generally, all firm commitment underwritten securities offerings registered with the SEC will be considered public offerings. Likewise, any other securities offering which is registered with the SEC and which is publicly disclosed and distributed in the same general manner and extent as a firm commitment underwritten securities offering will be considered a public offering for purposes of the 20% and Acquisition Rules. In other instances, when analyzing whether a registered offering is a “public offering,” Nasdaq will consider: (a) the type of offering (including whether underwritten, on a best efforts basis with a placement agent, or self-directed by the company); (b) the manner in which the offering is marketed (including the number of investors and breadth of marketing effort); (c) the extent of distribution of the offering (including the number of investors and prior relationship with the company); (d) the offering price (at market or a discount); and (e) the extent to which the company controls the offering and its distribution. Although the NYSE American does not issue formal guidance on factors it will consider, in practice it is substantially the same as Nasdaq.
A registered direct offering will not be assumed to be public and will be reviewed using the same factors listed above. On the other hand, a confidentially marketed public offering (CMPO) is a firm commitment underwritten offering and, as such, will be considered a public offering.
Two-Step Transactions and Share Caps
As obtaining shareholder approval can be a lengthy process, companies sometimes bifurcate transactions into two steps and use share caps as part of a transaction structure. A company may limit the first part of a transaction to 19.9% of the outstanding securities and then, if and when shareholder approval is obtained, issue additional securities. Companies may also structure transactions such that issuances related to an acquisition, including earn-out provisions or convertible securities, are capped at no more than 19.9% of total outstanding. Likewise, the limitations would be set at 4.9% where there is an interested officer, director or substantial shareholder.
In order for a cap to satisfy the rules, it must be clear that no more than the threshold amount (19.9% or 4.9%) of securities outstanding immediately prior to the transaction, can be issued in relation to that transaction, under any circumstances, without shareholder approval. In a two-step transaction where shareholder approval is deferred, shares that are issued or issuable under the cap must not be entitled to vote to approve the remainder of the transaction. In addition, a cap must apply for the life of the transaction, unless shareholder approval is obtained. For example, caps that no longer apply if a company is not listed on Nasdaq are not permissible under the Rule. If shareholder approval is not obtained, then the investor will not be able to acquire 20% or more of the common stock or voting power outstanding before the transaction. Where convertible securities were issued, the shareholder would continue to hold the balance of the original security in its unconverted form.
Moreover, where a two-step transaction is utilized, the transaction terms cannot change as a result of obtaining, or not obtaining, shareholder approval. For example, a transaction may not provide for a sweetener or penalty. The Exchanges believe that the presence of alternative outcomes have a coercive effect on the shareholder vote and thus deprive the shareholders of their ability to freely determine whether the transaction should be approved. Nasdaq provides specific examples of a defective share cap, such as where a company issues a convertible preferred stock or debt instrument that provides for conversions of up to 20% of the total shares outstanding with any further conversions subject to shareholder approval. However, the terms of the instrument provide that if shareholders reject the transaction, the coupon or conversion ratio will increase or the company will be penalized by a specified monetary payment, including a rescission of the transaction. Likewise, a transaction may provide for improved terms if shareholder approval is obtained. The NYSE American similarly provides that share caps cannot be used in a way that could be coercive in a shareholder vote.
Reverse Acquisitions
A reverse acquisition or reverse merger is one in which the acquisition results in a change of control of the public company such that the target company shareholders control the public company following the closing of the transaction. In addition to the 20% and Acquisition Rules, a change of control would require shareholder approval under the Change of Control Rule. A company must re-submit an initial listing application in connection with a transaction where the target and new control entity was a non-Exchange listed entity prior to the transaction.
In determining whether a change of control has occurred, the relevant Exchange will consider all relevant factors including, but not limited to, changes in the management, board of directors, voting power, ownership, nature of the business, relative size of the entities, and financial structure of the company.
Exceptions
The Exchanges have a “financial viability” exception to the 20% Rule, which I will detail in a future blog in this series as the exception is not relevant (or would rarely be relevant) to an acquisition transaction. Furthermore, shareholder approval is not required if the issuance is part of a court-approved reorganization under the federal bankruptcy laws or comparable foreign laws.
Consequences for Violation
Consequences for the violation of the 20% Rule or Acquisition Rule can be severe, including delisting from the Exchange. Companies that are delisted from an Exchange as a result of a violation of these rules are rarely ever re-listed.
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