A 20% Solution?
February 8, 2010
Most people refer to it simply as the “20% rule” and many who appreciate its importance are unfamiliar with the rule’s specifics. The language of the Nasdaq and NYSE rules is substantially similar and the rules tend to be interpreted in substantially the same way.
In substance, the 20% rule provides that a listed company is required to obtain shareholder approval if a private-placement transaction could result in an issuance of 20% or more of the company’s pre-transaction total shares outstanding at a price less than the greater of the book value or market price per share. The application of the 20% rule, while seemingly straightforward, is actually complex in practice. And it is fair to say that the 20% rule tends to drive structuring decisions made in connection with private placements, PIPE transactions and registered direct financings.
For the securities exchanges, an SEC-registered offering is not necessarily a “public offering,” so a number of registered securities offerings that are marketed in a targeted manner are subject to the application of this regulation.
The 20% rule is designed to provide shareholders with a meaningful voice in significant capital-raising transactions where they will face dilution. It is also intended to provide shareholders with adequate notice prior to the consummation of a transaction, and adequate disclosure relating to the transaction. The thought is that this will serve to provide shareholders with the opportunity to either sell their shares or to vote on the transaction.
As with apple pie and motherhood, it is difficult to take issue with a rule that is intended to foster the timely flow of information to shareholders and to support a principle of corporate democracy.
Nevertheless, we think it is time to reconsider the need for, and application of, the 20% rule. To begin with, both exchanges already have in place a rule that requires prior shareholder approval of any transaction that will result in a change in control. As neither exchange has adopted a precise definition of “change in control,” and each transaction is evaluated based on the relevant facts and circumstances, the operative effect of the change-of-control rule is to require shareholder approval of most transactions that convey 35% or more of the voting stock to a proposed purchaser and any affiliate. In any situation, the percentage may be determined to be lower or higher, given the particular facts and circumstances, but there is always a threshold above which a shareholder vote will be required. Given this change-in-control voting requirement, does the 20% rule actually provide any meaningful additional protection to existing shareholders?
And, does the additional protection, if any, outweigh the need to facilitate capital raising?
It may be particularly timely to reconsider the rule in light of current market dynamics. We continue to see a melding of securities-offering methodologies.
It was once easy to distinguish a “private” offering from a “public” offering; however, hybrid-financing methodologies, like PIPE transactions, registered direct transactions and, most recently, premarketed or “wall-crossed” public offerings, blur the traditional lines.
However, all of these financing approaches are increasingly popular and increasingly important funding tools for issuers. In connection with its amendments relaxing the eligibility requirements for use of a short-form-registration statement on Form S-3 for primary offerings, the SEC said that smaller public companies need access to public financing alternatives and commented on the increase use of many hybrid-financing formats.
The availability of a short-form-registration statement for smaller companies has been an important development. Having an effective shelf-registration statement provides an issuer with flexibility in accessing the market. The ability to be nimble in choosing among financing methodologies remains critical even as we see the return to greater stability in the capital markets. In adopting the eligibility changes, the SEC did impose a limit on the amount of securities that could be issued by smaller companies pursuant to a smaller-company shelf-registration statement. After initially considering a cap of 20% of the issuer’s public float, the SEC rules incorporated a 30% limit. Without commenting on the utility of this cap (or any cap), perhaps the market would benefit from reconciling the issuance caps.
As always, issuers tend to find approaches to financing.
Since private placements and PIPE transactions are invariably priced at a discount to market in order to compensate investors for purchasing illiquid securities, few such transactions can involve an amount of stock that would be greater than 19.9% of a company’s outstanding shares. Right? Well, not exactly. Many such offerings are structured as “at market” deals, wherein the issuer offers common stock and warrants.
The warrants are intended to provide an “equity kicker” for investors. The current warrant exemption for transactions involving the issuance of less than 20% of the pre-transaction total common shares outstanding effectively allows for the issuance of a limitless number of warrants, provided that they are priced at the greater of book or market value and are not exercisable for at least six months.
So, if one determines that warrants provide a generally reliable work-around, the change-in-control rule, requiring a shareholder vote, furnishes ample protection for shareholders, and the 20% rule continues to make it more complicated for smaller companies to raise the capital that they actually require.
Anna T. Pinedo and James R. Tanenbaum are partners at Morrison & Foerster.
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