Confidentially Marketed Public Offerings (CMPO)
Not surprisingly, I read the trades including all the basics, the Wall Street Journal, Bloomberg, The Street,The PIPEs Report, etc. A few years ago I started seeing the term “confidentially marketed public offerings” or “CMPO” on a regular basis. The weekly PIPEs Report breaks down offerings using a variety of metrics and in the past few years, the weekly number of completed CMPOs has grown in significance. CMPOs count for billions of dollars in capital raised each year.
CMPO Defined
A CMPO is a type of shelf offering registered on a Form S-3 that involves speedy takedowns when market opportunities present themselves (for example, on heavy volume). A CMPO is very flexible as each takedown is on negotiated terms with the particular investor or investor group. In particular, an effective S-3 shelf registration statement allows for takedowns at a discount to market price and other flexibility in the parameters of the offering such as the inclusion of warrants and terms of such warrants. A CMPO is sometimes referred to as “wall-crossed,” “pre-marketed” or “overnight” offerings.
In a typical CMPO, an underwriter confidentially markets takedowns of an effective S-3 shelf registration statement to a small number of institutional investors. The underwriter will not disclose the name of the issuing company until the institutional investor agrees that they have a firm interest in receiving confidential information and agrees not to trade in such company’s securities until the offering is either completed or abandoned.
When an investor confirms their interest, the company and its banker will negotiate the terms of the offering with the investor(s), including amount, price (generally a discount to market price), warrant coverage and terms of such warrant coverage. The disclosure of the name of the issuer and confidential information related to the offering is referred to as bringing the investor “over the wall.” Once brought over the wall, the potential investor(s) will complete due diligence. This process is completed on a confidential basis.
Once the terms have been agreed upon, the offering is “flipped” from confidential to public and a prospectus supplement, free writing prospectus, if any, a Rule 134 press release and a Form 8-K are prepared and filed informing the market of the offering. These public documents are almost always filed after the market closes and the offering itself generally closes that night as well, though sometimes the closing occurs the next trading day. The closing is the same as a firm commitment underwritten offering, such that there is a single closing of the entire takedown. The closing process and documents are also the same as a firm commitment underwritten offering including an underwriting agreement, opinion of counsel and a comfort letter. As the public disclosure and closing of the offering generally occurs overnight, a CMPO earned the name an “overnight” offering.
Generally the necessary closing documents and public filings have been prepared and are on standby ready to be utilized when a deal is agreed upon. Both the company and investors will wait for a favorable market window, such as an increase in the price and volume of the company’s stock, to close the offering.
S-3 Eligibility; NASDAQ Considerations; FINRA
A CMPO requires an effective S-3 shelf registration statement and accordingly is only available to companies that qualify to use an S-3. Among other requirements, to qualify to use an S-3 registration statement a company must have timely filed all Exchange Act reports, including Form 8-K, within the prior 12 months. An S-3 also contains certain limitations on the value of securities that can be offered. Companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of $75 million or more, may offer the full amount of securities under an S-3 registration. For companies that have an aggregate market value of voting and non-voting common stock held by non-affiliates of less than $75 million, the company can offer up to one-third of that market value in any trailing 12-month period. This one-third limitation is referred to as the “baby shelf rule.”
To calculate the non-affiliate float for purposes of S-3 eligibility, a company may look back 60 days and select the highest of the last sales prices or the average of the bid and ask prices on the principal exchange. The registration capacity for a baby shelf is measured immediately prior to the offering and re-measured on a rolling basis in connection with subsequent takedowns. The availability for a particular takedown is measured as the current allowable offering amount less any amounts actually sold under the same S-3 in prior takedowns. Accordingly, the available offering amount will increase as a company’s stock price increases, and decrease as a stock price decreases.
A company should be careful that a CMPO is structured to comply with the NASDAQ definition of “public offering,” thereby avoiding NASDAQ’s rules requiring shareholder approval for private placements where the issuance will or could equal 20% or more of the pre-transaction outstanding shares. In particular, NASDAQ requires advance shareholder approval when a company sells 20% or more of its outstanding common stock (or securities convertible into common stock) in a private offering, at a discount to the greater of the market price or book value per share of the common stock. A separate NASDAQ rule also requires shareholder approval where officers, directors, employees, consultants or affiliates are issued common stock in a private placement at a discount to market price. CMPO’s have been stopped in their tracks by NASDAQ requiring pre-closing shareholder approval.
A CMPO differs from a standard public offering as it is confidentially marketed and is completed with little or no advance market notice. Accordingly, in determining whether a CMPO qualifies as a public offering, NASDAQ will consider: (i) the type of offering including whether it is being completed by an underwriter on a firm commitment or best-efforts basis (firm commitment being favorable); (ii) the manner of offering and marketing, including number of investors marketed to and how such investors were chosen (the more broad the marketing, the better); (iii) the prior relationship between the investors and the company or underwriter (again, the more broadly marketed, the better, as public offerings are generally widely marketed); (iv) offering terms including price (a deeper discount is unfavorable); and (v) the extent to which the company controls the offering and its distribution (insider participation is unfavorable).
NASDAQ also has rules requiring an advance application for the listing of additional shares resulting from follow-on offerings. Generally NASDAQ requires 15 days advance notice, but will often waive this advance notice upon request.
A CMPO will need to comply with FINRA rule 5110, the corporate finance rule. Generally FINRA will process a 5110 clearance on the same day. Moreover, there are several exemptions to issuer 5110 compliance, including based on the size of the company’s public float. For a brief overview of Rule 5110, see my blogHERE.
Confidentiality; Regulation FD; Insider Trading
By nature a CMPO involves the disclosure of confidential information to potential investors, including, but not limited to, that the company is considering a public offering takedown, the pricing terms of the offering, warrant coverage, and the disclosure of potentially confidential information during the due diligence phase. To ensure compliance with Regulation FD and avoid insider trading, the company and its underwriters will obtain a confidentiality agreement from the potential investors. The agreement will include a trading blackout for a specific period of time, generally until the offering either closes or is abandoned.
Although the confidential portion of the CMPO usually occurs very quickly (a week or two), many institutional investors require that the company issue a public “cleansing” statement if the offering does not proceed within a specified period of time. The cleansing statement would need to disclose any material non-public information disclosed to the potential investor as part of the negotiation and due diligence related to the offering. In the event the offering proceeds to a close, the offering documents (including potential free writing prospectus or prospectus supplement, Rule 134 press release and 8-K) will include all material non-public information previously disclosed to potential investors during the confidential phase. Both the company and the investor need to be careful that the filed offering materials and/or cleansing statement contain all necessary information to avoid potential insider trading issues.
The company must be sure to also file with the SEC all written marketing offering materials associated with a registered offering either as part of the prospectus or as a free writing prospectus. Generally with a CMPO, the written materials provided to investors are limited to public filings and investor presentation materials such as a PowerPoint already in the public domain that do not, in and of themselves, contain any material non-public information and therefore do not need to be filed with the SEC as offering materials.
As a reminder, Regulation FD excludes communications (i) to a person who owes the issuer a duty of trust or confidence such as legal counsel and financial advisors; (ii) communications to any person who expressly agrees to maintain the information in confidence (such as potential investors in a CMPO); and (iii) communications in connection with certain offerings of securities registered under the Securities Act of 1933 (this exemption does not include registered shelf offerings and, accordingly, generally does not include a CMPO).
Benefits of a CMPO
A CMPO offers a great deal of flexibility to a company and its bankers. Utilized correctly, a CMPO can have minimal market impact. It is widely believed that announcements of public offerings, and impending dilution and selling pressure, invite short selling and speculative short-term market activity. Since a CMPO is confidential by nature and the time between the public awareness and completion of a particular takedown is very short (oftentimes the same day), the opportunity for speculating and short sellers is minimized. Moreover, as a result of the confidential nature of a CMPO, if a particular offering or takedown is abandoned, the market is unaware, relieving the company of the typical downward pricing pressure associated with an abandoned offering. Likewise, this confidential process allows the company to test the waters and only proceed when investor appetite is confirmed.
As a registered offering, CMPO securities are freely tradable and immediately transferable, incentivizing investment activity and reducing the negotiated discount to market associated with restricted securities. Offering expenses for a CMPO are also less than a fully marketed follow-on public offering. The CMPO is based on an existing S-3 shelf registration, thus reducing drafting costs. Also, the expense of marketing an offering itself, including a road show, is reduced or eliminated altogether.
Although the structure of a CMPO requires that the issuing company be S-3 shelf registration eligible, CMPOs are often used by small and development-stage companies (such as technology and biotech companies) that have smaller market capitalizations and need to tap into the capital of the public markets on a more frequent basis to fund ongoing research and development of products.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC 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 as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of 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; Regulation A/A+ offerings; 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 MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2016
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SEC Has Approved A Two-Year Tick Size Pilot Program For Smaller Public Companies
On May 6, 2015 the SEC approved a two-year pilot program with FINRA and the national securities exchanges that will widen the minimum quoting and trading increments, commonly referred to as tick sizes, for the stocks of smaller public companies. The goal of the program is to study whether wider tick sizes improve the market quality and trading of these stocks.
The basic premise is that if a tick size is wider, the spread will be bigger, and thus market makers and underwriters will have the ability to earn a larger profit on trading. If market makers and underwriters can earn larger profits on trading, they will have incentive to make markets, support liquidity and issue research on smaller public companies. The other side of the coin is that larger spreads and more profit for the traders equates to increased costs to the investors whose accounts are being traded.
The tick size program includes companies that meet the following $3 billion or less in market capitalization, an average trading volume of one million shares or less, and a volume weighted average price of at least $2.00 for every trading day. The pilot study group includes a control group of 1400 securities and three test groups with 400 securities in each. Notably, the tick size program will not include micro-cap securities with a weighted average price of less than $2.00 per day.
During the pilot the control group will be quoted at the current tick size increment of $.01 per share and will trade at the currently permitted increments. The first test group will be quoted in increments of $.05 but will continue to trade at any price increment that is currently permitted. The second test group will be quoted in increments of $.05 and will also trade at $.05 minimum increments subject to certain exceptions. The third test group will be quoted in increments of $.05 and will be subject to an additional “trade at” requirement to prevent price matching. The third test group will have the same exceptions as the second and an additional block size exception.
Background and Reasoning for the Program
Since the inception of decimalization in 2001 and minimum price variation of one penny for exchange-traded companies, there has been a significant change in the nature of trading and role of market participants. Many market participants believe that underwriters and market makers have lost their incentive to make markets and produce research for micro-, small- and mid-capitalization companies.
The JOBS Act directed the SEC to conduct a study and report to Congress on how decimalization affected the number of IPO’s and the liquidity and trading of stock in smaller public companies. The JOBS Act also gives the SEC the authority to designate a minimum increment for the trading of emerging growth companies that is more than $.01 but less than $.10. In July 2012 the SEC submitted the “Decimalization Report” to Congress, failing to reach a firm conclusion and instead realizing further research was needed, including by pursuing a pilot program to study the impact of wider tick sizes. The SEC believes that the current approved tick size pilot program will provide the necessary information to determine whether to permanently change tick sizes for these smaller companies.
As mentioned, the goal of the program is to study whether wider tick sizes improve the market quality and trading of these stocks. The basic premise is that if a tick size is wider, the spread will be bigger, and thus market makers and underwriters will have the ability to earn a larger profit on trading. If market makers and underwriters can earn larger profits on trading, they will have incentive to make markets, support liquidity and issue research on smaller public companies. Moreover, additional market makers may enter the market as they see an opportunity to earn value. Additional market makers will equate to additional liquidity, which in turn attract more investors.
Issuers benefit from increased liquidity and market activity and quality in several ways. More trading activity and increased investor awareness could reduce the company’s cost of capital and improve opportunities to attract capital. That is, more investors will be willing to invest directly into the company, through PIPE transactions, registered secondary offerings, equity lines and the like as they will see a strong exit strategy. Moreover, with higher liquidity and market value, the ultimate exit by these investors will have less of a downward impact on trading price. Where the investment instrument was convertible (such as convertible debt, warrants and options) using a market price formula, less downward pressure on trading price will mean fewer shares will need to be issued in the conversion and the existing shareholders will suffer less dilution.
In addition, one of the main purposes of going public is to use capital stock as currency in making acquisitions and attracting key executives. Where the company has an active trading market, market maker support and strong liquidity, the value of the capital stock is likewise higher. Not only will the capital cost of making stock-based acquisitions and attracting and retaining high-quality key executives be reduced but for some issuers, it will make the difference of being able to utilize this benefit of being public at all.
Although there is no doubt that improved liquidity, market activity and market maker and underwriter support is extremely beneficial to all public companies, and in serious need for improvement for smaller public companies, it is not known whether the increased tick size will have the desired outcome.
The other side of the coin is that larger spreads and more profit for the traders with the increased tick size equates to increased costs to the investors whose accounts are being traded. Moreover, the program itself will be complex and costly to implement for market participants. Market participants have stringent rules to follow for each test group to ensure a valid test result. Each participant must adopt written policies and procedures and monitor and report results.
Conclusion
It is important that the SEC and market participants actively seek to improve the market quality for smaller public companies, and this is just one measure in that wheelhouse. However, it is a two-year program. I’m anxious to see more timely efforts in this arena, such as through the launch of venture exchanges.
The Author
Attorney Laura Anthony
LAnthony@LegalAndCompliance.com
Founding Partner, Legal & Compliance, LLC
Corporate, Securities and Business Transaction Attorneys
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Ms. Anthony has structured her securities law practice as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the host of LawCast.com, the securities law network.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Download our mobile app at iTunes and Google Play.
Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.
This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.
© Legal & Compliance, LLC 2015
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The ECOS Matter; When Is A Reverse Split Effective?
In what was presumably an unintended consequence, the application of an SEC- approved FINRA regulation has resulted in a conflict between state and federal corporate law for a small publicly traded company.
On September 16, 2014, Ecolocap Solutions, Inc. (“ECOS”) filed a Form 8-K in which it disclosed that FINRA had refused to process its 1-for-2,000 reverse split. At the time of the FINRA refusal, ECOS had already received board and shareholder approval and had filed the necessary amended articles with the State of Nevada, legally effectuating the reverse split in accordance with state law. Moreover, ECOS is subject to the reporting requirements under the Securities Exchange Act of 1934, as amended (“Exchange Act”), and had filed a preliminary and then definitive 14C information statement with the SEC, reporting the shareholder approval of the split.
The ECOS 8-K attached a copy of the FINRA denial letter, which can be viewed HERE. In support of its denial of the reverse split, FINRA relied upon its discretion under FINRA Rule 6490 and the existence of a previous SEC action against an individual who is the principal of an entity that is a convertible note holder of ECOS. In particular, FINRA cited an SEC order issued on November 25, 2013 against Curt Kramer, Mazuma Corporation, Mazuma Funding Corporation and Mazuma Holding Corporation involving violations of Section 5 of the Securities Act of 1933 and Rule 504. FINRA cited that Curt Kramer is a principal of Asher Enterprises and that Asher Enterprises, in turn, is a convertible note holder in ECOS and therefore FINRA was refusing to process the reverse split.
In its 8-K filing, ECOS took a strong stance against FINRA, stating that pricing information published by FINRA is inaccurate. In support of their position, ECOS sets forth that the subject reverse split was already legally effective in accordance with state law and therefore FINRA’s refusal to reflect such capital change in ECOS trading quotation results in public misinformation regarding the company’s capitalization. ECOS also objected to FINRA’s application of Rule 6490 in this case by denying that either Mr. Kramer or Asher Enterprises is “connected” with the company as contemplated by the Rule. Furthermore, they stated that the subject SEC action was completely unrelated to ECOS or the reverse split.
Although FINRA has not issued a responsive statement, one of its mandates is to protect investors and maintain fair and orderly markets. In this instance, the Company’s stock is actively trading at $.0001 per share. The Company’s total outstanding shares increased from 893,615,983 one year ago to 6,865,010,372 as of April 2014. ECOS has been in the development stage since January 1, 2007 and has not reported any revenues since September, 2010. The overwhelming majority of the increase in outstanding stock is the result of the conversion of convertible debt, and most of funds received by the company from the note holders was used for salaries, as well as interest on the convertible debt and fees for staying a publicly-traded company (such as satisfying reporting obligations). Although the information in the Company’s filings as to its business operations is sparse, it has been in the same business with the same management since 2007, without any financial success. As of June 30, 2014, the Company had approximately $664,000 in convertible outstanding notes payable. The Company intends to complete a 1:2000 reverse split, which will reduce the total outstanding shares to 3.9 million and presumably increase the share price to $.20.
However, the Company’s new, higher share price will likely be temporary due to the lack of any underlying business success to create support for a higher market valuation. In addition, FINRA realizes that in all probability, upon enactment of the inflated share price, existing note holders have an increased incentive to convert their debt into freely tradable shares and may begin selling these shares in the market. Should such selling pressure occur, and the new share price decrease, any shareholder that purchased at $.20 will most likely suffer a loss. Should the cycle of selling continue, the outstanding shares will increase, potentially into the billions, until the share price is once again $.0001. Taking this into account, FINRA’s concerns are self-evident.
There clearly exists a fundamental conflict between federal and state law and the ability to regulate corporate actions. It raises the basic question of “When is a reverse split effective?” If pursued, this action opens the door for court interpretation of FINRA’s authority under Rule 6490 in general.
Rule 6490
Effective September 27, 2010, the SEC approved FINRA Rule 6490 (Processing of Company Related Actions). Rule 6490 requires that corporations whose securities are trading on the over-the-counter market (OTCQX, OTCQB, OTCBB or pinksheets) timely notify FINRA of certain corporate actions, such as dividends, forward or reverse splits, rights or subscription offerings, and name changes. The Rule grants FINRA discretionary power when processing documents related to the announcements.
Rule 6490 works in conjunction with Exchange Act Rule 10b-17. Rule 10b-17 provides that “it shall constitute a manipulative or deceptive device or contrivance as used in section 10(b) of the Act for any issuer of a class of securities publicly traded… to fail to give notice in accordance with paragraph (b) of this section of the following actions relating to such class of securities: (1) a dividend or other distribution in cash or in kind… (2) a stock split or reverse split; or (3) a rights or other subscription offering.” Section (b) requires that notice be given to FINRA “no later than 10 days prior to the record date involved.”
FINRA also issues trading symbols to over-the-counter traded issuers and maintains a database of trading symbols for issuers. When FINRA completes the processing of a corporate action, OTC marketplace is notified of such changes and actions. Most commonly, changes and actions include the re-pricing of securities after a forward or reverse split and the issuance of a new trading symbol following a name change or merger.
Prior to 2010, FINRA’s role has been predominantly ministerial due to their limited jurisdictional ability to impose informational or other regulatory requirements, and fundamental lack of power to reject requested changes. However, since the SEC began expressing concern that entities were using FINRA to assist in fraudulent activities, Rule 6490 was created.
The Rule codifies FINRA’s authority to conduct in-depth reviews of company-related actions and equips the staff with discretion to refuse the processing of such actions in situations when the information or requisite forms are incomplete or when certain indicators of potential fraud exist. FINRA staff now possesses broad discretion to request additional documents and supporting evidence to verify the accuracy of submitted information.
Rule 6490(d)(3) provides:
(3) Deficiency Determination
In circumstances where an SEA Rule 10b-17 Action or Other Company-Related Action is deemed deficient, the Department may determine that it is necessary for the protection of investors, the public interest and to maintain fair and orderly markets, that documentation related to such SEA Rule 10b-17 Action or Other Company-Related Action will not be processed. In instances where the Department makes such a deficiency determination, the request to process documentation related to the SEA Rule 10b-17 Action or Other Company-Related Action, as applicable, will be closed, subject to paragraphs (d)(4) and (e) of this Rule. The Department shall make such deficiency determinations solely on the basis of one or more of the following factors: (1) FINRA staff reasonably believes the forms and all supporting documentation, in whole or in part, may not be complete, accurate or with proper authority; (2) the issuer is not current in its reporting requirements, if applicable, to the SEC or other regulatory authority; (3) FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors; and/or (5) there is significant uncertainty in the settlement and clearance process for the security. (emphasis added)
Exchange Act Rule 10b-17 appears to be limited to notice and allows the SEC to pursue an enforcement action for the failure to give such notice in a timely manner. Rule 6490 goes further, stating a corporation action “will not be processed” if FINRA makes a “deficiency determination.” Clearly subsections (3) and (4) give broad discretionary authority to FINRA to render such a deficiency determination and refuse to process an action.
Further exacerbating the existing conflict between the application of state and federal law is the fact that FINRA requires that a Company submit the file-stamped amendments to its corporate charter as part of their review process. Simply stated, the FINRA corporate action process requires that a Company legally completes the corporate action (reverse split, name change, etc.) on the state level prior to issuing a determination as to whether it will process the already-completed change with the marketplace.
State vs. Federal Regulation of Corporate Law
Historically the regulation of corporate law has been firmly within the power and authority of the states. However, over the past few decades the federal government has become increasingly active in matters of corporate governance. In waves, typically following a period of scandal in business or financial markets, the federal government has enacted regulation either directly or indirectly imposing upon state corporate regulations. The predominant method of federal regulation of corporate governance is through the enactment of mandatory terms that either reverse or preempt state law rules on the same point.
State corporation law is generally based on the Delaware and Model Act and offers corporations a degree of flexibility from a menu of reasonable alternatives that can be tailored to companies’ business sectors, markets and corporate culture. Moreover, state judiciaries review and rule upon corporate governance matters considering the facts and circumstances of each case and setting factual precedence based on such individual circumstances. The traditional fiduciary duties that govern state corporations laws include the duties of care and loyalty and are tempered by the business judgment rule.
The duty of care requires that directors exercise the same level of care that would be expected from an ordinarily prudent person in the conduct of his or her own affairs. This includes making an informed decision, seeking the advice of experts when necessary, and considering both the positive and negative impacts of a decision. The duty of loyalty is essentially a proscription against conflict of interest and self-dealing. The business judgment rule basically says that if a director follows both his duty of loyalty and duty of care, then the decision should be deferred to.
Director actions that result in a fraud upon shareholders and investors is actionable under federal (and state) securities laws. Both the state and federal securities regulators are charged with preventing fraud on the markets and protecting the integrity of the trading markets in general.
Conclusion
The ECOS matter has raised heated debate on whether FINRA fairly applied its authority in this case and as to the meaning of “connected.” Publicly traded companies, by nature, have ever-evolving shareholders and investors, the identities of which are often not in the power or control of the company itself. Stock is personal property that generally may be freely transferred by its owners (which should not be confused with suggesting that such transferred stock is always freely tradable on a public market). Debt instruments are negotiable instruments and generally transferrable by the debt holder. The sale and transfer of such debt instruments is common. In the small cap world, changes in management and control are fairly commonplace, as is the change in the business direction of a company.
Regulators are tasked with the job of supporting these changes in the small and micro-cap space and giving every entrepreneur a fair shot while preventing abuses in the system and what such as in this case, they ultimately see, as crossing the line.
Clearly it is problematic when state and federal rules and regulations cause a conflicting result, leaving a board of directors, shareholders and the investing public in a state of flux. What is the capitalization of ECOS? In accordance with state law, the company has approximately 3.4 million shares issued and outstanding; however, according to the over-the-counter marketplace, the company has approximately 6.8 billion shares outstanding. Legally it seems that the company has 3.4 million shares of stock outstanding at a trading price of $.0001 and that FINRA’s refusal to process relates solely to a refusal to re-price the stock as a result of the reverse split and not a broader refusal to recognize the validly of the share reduction itself.
However, many people in the industry are debating the impact and meaning of the decision with divergent views and conclusions, including the legal effect of the reverse split.
A discussion of federal law pre-emption is beyond the scope of this blog. However, even if I did include a treatise on the subject, the answer would be difficult. As an attorney I could write a very good argument that state law applies (the states regulate corporations and where the federal law would yield a different result, state law should apply), and I could also write a very good argument that federal law applies (the states regulate corporations and where the federal law would yield a different result, state law should apply except where there is a competing strong federal policy – such as the regulation of public markets). I could argue that the federal government has no right to stop a corporation from effectuating a name change or reverse split but only the power to prosecute the failure to provide adequate notice of same. I could also argue that the federal government has the right to take actions that may prevent fraud being committed on public markets, including by refusing to allow a name change or reverse split.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Securities, Reverse Merger and Corporate Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Ms. Anthony has structured her securities law practice as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile.
Contact Legal & Compliance LLC. Inquiries of a technical nature are always encouraged.
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Reverse Merger Attorney
What is a reverse merger? What is the process?
A reverse merger is the most common alternative to an initial public offering (IPO) or direct public offering (DPO) for a company seeking to go public. A “reverse merger” allows a privately held company to go public by acquiring a controlling interest in, and merging with, a public operating or public shell company. The SEC defines a “shell company” as a publically traded company with (1) no or nominal operations and (2) either no or nominal assets or assets consisting solely of any amount of cash and cash equivalents.
In a reverse merger process, the private operating company shareholders exchange their shares of the private company for either new or existing shares of the public company so that at the end of the transaction, the shareholders of the private operating company own a majority of the public company and the private operating company has become a wholly owned subsidiary of the public company. The pre-closing controlling shareholder of the public company either returns their shares to the company for cancellation or transfers them to individuals or entities associated with the private operating business. The public company assumes the operations of the private operating company. At the closing, the private operating company has gone public by acquiring a controlling interest in a public company and having the public company assume operations of the operating entity.
A reverse merger is often structured as a reverse triangular merger. In that case, the public shell forms a new subsidiary which new subsidiary merges with the private operating business. At the closing the private company, shareholders exchange their ownership for shares in the public company and the private operating business becomes a wholly owned subsidiary of the public company. The primary benefit of the reverse triangular merger is the ease of shareholder consent. That is because the sole shareholder of the acquisition subsidiary is the public company; the directors of the public company can approve the transaction on behalf of the acquiring subsidiary, avoiding the necessity of meeting the proxy requirements of the Securities Exchange Act of 1934.
The SEC requires that a public company file Form 10 type information on the private entity within four days of completing the reverse merger transaction (a super 8-K). Upon completion of the reverse merger transaction and filing of the Form 10 information, the once private company is now public. Form 10 information refers to the type of information contained in a Form 10 Registration Statement. Accordingly, a Super 8-K is an 8-K with a Form 10 included therein.
Like any transaction involving the sale of securities, the issuance of securities to the private company shareholders must either be registered under Section 5 of the Securities Act or use an available exemption from registration. Generally, shell companies rely on Section 4(a)(2) or Rule 506 of Regulation D under the Securities Act for such exemption.
The Transaction
A reverse merger is a merger transaction with the difference being that the target ultimately ends up owning a majority of the acquirer. However, the documentation and process to complete the transaction is substantially the same as a forward merger.
Generally the first step in a reverse merger is executing a confidentiality agreement and letter of intent. These documents can be combined or separate. If the parties are exchanging information prior to reaching the letter of intent stage of a potential transaction, a confidentiality agreement should be executed first.
In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information. For instance, a reporting entity may have disclosure obligations in association with the initial negotiations for a transaction, which would need to be exempted from the confidentiality provisions. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality such as a prohibition against solicitation of customers or employees (non-competition) and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.
Next is the letter of intent (“LOI”). An LOI is generally non-binding and spells out the broad parameters of the transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money associated with conducting due diligence and drafting the transaction contracts and supporting documents. Among other key points, the LOI may set the price or price range, the parameters of due diligence, necessary pre-deal recapitalizations, confidentiality, exclusivity, and time frames for completing each step in the process. Along with an LOI, the parties’ attorneys prepare a transaction checklist which includes a “to do” list along with a “who do” identification.
Following the LOI, the parties will prepare a definitive agreement which is generally titled either a “Share Exchange Agreement” or a “Merger Agreement.” In a nutshell, the Merger Agreement sets out the financial terms of the transaction and legal rights and obligations of the parties with respect to the transaction. The Merger Agreement sets forth closing procedures, preconditions to closing and post-closing obligations, and sets out representations and warranties by all parties and the rights and remedies if these representations and warranties are inaccurate.
The main components of the Merger Agreement and a brief description of each are as follows:
1. Representations and Warranties – Representations and warranties generally provide the buyer and seller with a snapshot of facts as of the closing date. From the seller the facts are generally related to the business itself, such as that the seller has title to the assets, there are no undisclosed liabilities, there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the buyer the facts are generally related to legal capacity, authority and ability to enter into a binding contract. The seller also represents and warrants its legal ability to enter into the agreement.
2. Covenants – Covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that the private company must continue to operate the business in the ordinary course and maintain assets pending closing and if there are post-closing payouts that the seller continues likewise. All covenants require good faith in completion.
3. Conditions – Conditions generally refer to pre-closing conditions such as shareholder and board of director approvals, that certain third-party consents are obtained and proper documents are signed. Closing conditions usually include the payment of the compensation by the buyer. Generally, if all conditions precedent are not met, the parties can cancel the transaction.
4. Indemnification/remedies – Indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.
5. Schedules – Schedules generally provide the meat of what the seller is purchasing, such as a complete list of customers and contracts, all equity holders, individual creditors and terms of the obligations. The schedules provide the details.
6.In the event that the parties have not previously entered into a letter of intent or confidentiality agreement providing for due diligence review, the Merger Agreement may contain due diligence provisions. Likewise, the agreement may contain no-shop provisions, breakup fees, and/or non-compete and confidentiality provisions if not previously agreed to separately.
The next and final steps are the actual closing in which the shares of stock and reverse merger consideration change hands and a Super 8-K is filed with the SEC.
Reverse Merger Consideration/The Cost of the Shell
In a reverse merger transaction, the private operating business must pay for the public shell company. That payment may be in cash, equity or both. Although the cash price of shell entities can vary and changes over time as does the value of all assets, as of the day of this blog, the average cash value of a fully reporting public entity with no liabilities, no issues (such as a DTC chill) and which is otherwise “clean” is between $280,000 – $400,000. The price variance depends on many factors, such as pre- and post-closing conditions (such as a requirement that the public entity complete a name change and/or stock split prior to closing); the ultimate percent ownership that will be owned by the private operating company shareholders; how quickly the transaction can close; whether the private entity has its “ducks in a row” (see below); whether the entities have complete due diligence packages prepared; and whether any broker-dealers or investment bankers must be paid in association with the transaction.
Where the private operating business is paying for the public shell entity with equity, the current shareholders of the public shell company keep a larger portion of their pre-closing equity and therefore own a greater percent of the new combined companies post-closing. That is, the current public company shareholders have a lower level of dilution in the transaction.
For example, in a cash reverse merger transaction, generally the current control shareholders of the public company cancel or otherwise divest themselves of all of their share ownership and the post-closing share ownership is anywhere from 80%/20% to 99%/1% with the private operating company shareholders owning the majority. In an equity transaction, the current control shareholders keep some or all of their current share ownership. In addition, the final post-closing capitalization will generally be anywhere from 51%/49% to 80%/20% with the private operating company shareholders owning the majority.
The percentage of ownership maintained by the public company shareholders will depend on the perceived value of the private operating company and an expectation of what the value of their share ownership could be in the future. Clearly there is risk involved for the public company shareholders. That is, control shareholders may have to decide whether to accept $300,000 today or maintain a stock ownership level that they hope will be worth much more than that at some time in the future. From the private operating company’s perspective, they are diluting their current ownership and giving up a piece of the pie.
Accordingly, in an equity transaction, the parties to the reverse merger will negotiate the value of the private operating business. For business entities with operating history, revenue, profit margins and the like, valuation is determined by mathematical calculations and established mathematically based matrixes (usually 1x to 8x EBITDA). For a development stage or start-up venture, the necessary elements to complete a mathematical analysis simply do not exist. In this case, valuation is based on negotiation and a best guess.
Establishing valuation for a development stage or start-up entity ultimately comes down to an investor’s (i.e., in a reverse merger, public company shareholders who agree to forgo cash and keep equity instead) perception of risk versus reward. Risk is easy to determine: If I could get $300,000 cash for the public shell today, I may lose that $300,000 by accepting equity instead. Reward, on the other hand, is an elusive prospect based on the potential success of a business.
In determining value, an analysis (due diligence) should be conducted on a minimum of the following: market data; competition; pricing and distribution strategies; assets and liabilities; hidden liabilities; inflated assets; technology risks; product development plans; legal structure; legal documentation; corporate formation documents and records; and management, including backgrounds on paper, and face-to-face assessments.
Areas of Consideration in Determining Valuation
The following areas should be researched and considered in valuation. The below list is in no particular order.
1. Investment comps: Have investors, either private or public, recently funded similar companies, and if so, on what terms and conditions and at what valuation;
2. Market Data: What is the product market; what is the size of the market; how many new players enter the market on a yearly basis and what is their success rate;
3. Competition: Who are the major competitors; what is their valuation; how does this company differ from these competitors;
4. Uniqueness of product or technology: How is the product or technology unique; can it easily be duplicated; patent, trademark and other intellectual property protections;
5. Pricing and Distribution Strategies: What are the major impediments to successful entry into the marketplace; what is the plan for successful entry into the marketplace; has order fulfillment, including transportation costs, been considered; connections to end users for the product or service; what are profit margins and will the margins increase as the business grows and scales;
6. Capital investments to date: What capital investments have been made to the company to date, including both financial and services;
7. Assets and liabilities: What does the balance sheet look like; are there hidden liabilities; any off-balance sheet arrangements; how are assets valued; are any assets either over- or undervalued; is there clear title to all assets;
8. Technology Risks: What technologies are relied upon; what is the state of evolvement of those technologies; can they keep up;
9. Product Development Plans: Are there a model and samples; have they been tested; have manufacturing channels been established; exclusive contracts with manufacturers; what is the overall plan to bring the product to market and subsequently become a competitor in the industry;
10. Legal Structure: Legal structure of current outstanding equity – just common equity or common and preferred, and if preferred, what rights are associated therewith (redemption rights; liquidation preferences; dividends; voting rights);
11. Legal documentation: Not only whether corporate records are in order, but are all contracts and arrangements properly documented;
12. Future financing needs: Will significant future financing be necessary to achieve the business plan; what is the risk of a future down round (note that a down round is a future financing at a lower valuation resulting in dilution to the current investors);
13. Exit strategies: How will the current shareholder be able to sell; will the shares have piggyback or demand registration rights; reliance on Rule 144?; lockup or other additional holding periods?;
14. Management: This is perhaps the most important consideration – Does the management team have a proven history of success; prior business experience in this and other industries; work ethic; general management skills; organization skills; presentation skills; research skills; coachability; ability to attract others with strong credentials who believe in the business and are willing to work to make the business a success; does management present well in meetings and face-to-face discussions;
16. Developmental milestones: Has the company achieved its developmental milestones to date?
Advantages of a Reverse Merger
The primary advantage of a reverse merger is that it can be completed very quickly. As long as the private entity has its “ducks in a row,” a reverse merger can be completed as quickly as the attorneys can complete the paperwork. Having your “ducks in a row” includes having completed audited financial statements for the prior two fiscal years and quarters up to date (or from inception if the company is less than two years old), and having the information that will be necessary to file with the SEC readily available. The reverse merger transaction itself is not a capital-raising transaction, and accordingly, most private entities complete a capital-raising transaction (such as a PIPE) simultaneously with or immediately following the reverse merger, but it is certainly not required. In addition, many companies engage in capital restructuring (such as a reverse split) and a name change either prior to or immediately following a reverse merger, but again, it is not required.
Raising money is difficult and much more so in the pre-public stages. In a reverse merger, the public company shareholders become shareholders of the operating business and no capital raising transaction needs to be completed to complete the process. Accordingly, companies that may be less mature in their development and unable to attract sophisticated capital financing can use a reverse merger to complete a going public transaction and still benefit from being public while they grow and mature. Such benefits include the ability to use stock and stock option plans to attract and keep higher-level executives and consultants and to make growth acquisitions using stock as currency.
Disadvantages of a Reverse Merger
There are several disadvantages to a reverse merger. The primary disadvantage is the restriction on the use of Rule 144 where the public company is or ever has been a shell company. Rule 144 is unavailable for the use by shareholders of any company that is or was at any time previously a shell company unless certain conditions are met. In order to use Rule 144, a company must have ceased to be a shell company; be subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; filed all reports and other materials required to be filed by section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the issuer was required to file such reports and materials), other than Form 8-K reports; and have filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer a shell company – then those securities may be sold subject to the requirements of Rule 144 after one year has elapsed from the date that the issuer filed “Form 10 information” with the SEC.
Rule 144 now affects any company that was ever in its history a shell company by subjecting them to additional restrictions when investors sell unregistered stock under Rule 144. The new language in Rule 144(i) has been dubbed the “evergreen requirement.” Under the so-called “evergreen requirement,” a company that ever reported as a shell must be current in its filings with the SEC and have been current for the preceding 12 months before investors can sell unregistered shares.
Another disadvantage concerns undisclosed liabilities, lawsuits or other issues with the public shell. Accordingly, due diligence is an important aspect of the reverse merger process, even when dealing with a fully reporting current public shell. The third primary disadvantage is that the reverse merger is not a capital-raising transaction (whereas an IPO or DPO is). An entity in need of capital will still be in need of capital following a reverse merger, although generally, capital-raising transactions are much easier to access once public. The fourth disadvantage is immediate cost. The private entity generally must pay for the public shell with cash, equity or a combination of both. However, it should be noted that an IPO or DPO is also costly.
In addition, the NYSE, NYSE MKT (formerly AMEX) and NASDAQ exchanges have enacted more stringent listing requirements for companies seeking to become listed following a reverse merger with a shell company. The rule change prohibits a reverse merger company from applying to list until the combined entity had traded in the U.S. over-the-counter market, on another national securities exchange, or on a regulated foreign exchange for at least one year following the filing of all required information about the reverse merger transaction, including audited financial statements. In addition, new rules require that the new reverse merger company has filed all of its required reports for the one-year period, including at least one annual report. The new rule requires that the reverse merger company “maintain a closing stock price equal to the stock price requirement applicable to the initial listing standard under which the reverse merger company is qualifying to list for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to the filing of the initial listing application.” The rule includes some exceptions for companies that complete a firm commitment offering resulting in net proceeds of at least $40 million.
Finally, whether an entity seeks to go public through a reverse merger or an IPO, they will be subject to several, and ongoing, time-sensitive filings with the SEC and will thereafter be subject to the disclosure and reporting requirements of the Securities Exchange Act of 1934, as amended.
The Author
Attorney Laura Anthony
LAnthony@LegalAndCompliance.com
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Merger and Corporate Attorneys
Corporate and Securities Attorney Laura Anthony’s legal expertise includes but is not limited to registration statements, including Forms S-1, S-4, S-8 and Form 10, PIPE transactions, debt and equity financing transactions, private placements, reverse mergers, forward mergers, asset acquisitions, joint ventures, crowdfunding, and compliance with the reporting requirements of the Securities Exchange Act of 1934 including Forms 10-Q, 10-K and 8-K, the proxy requirements of Section 14, Section 16 filings and Sarbanes-Oxley mandated policies. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for corporate changes such as name changes, reverse and forward splits and change of domicile.
Contact Legal & Compliance LLC. Technical inquiries are always encouraged.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Download our mobile app at iTunes and Google Play.
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