by Cydney Posner
Today, the new Investor Advocate, Rick Fleming, issued a statement regarding his “First Official Recommendation” to the SEC. What was that recommendation? He recommended that the SEC disapprove the NYSE’s proposed rule change that would exempt certain early stage companies from having to obtain shareholder approval before selling additional shares to insiders and other related parties.
As discussed in this PubCo post, in early August, the SEC issued an Order instituting proceedings to determine whether to disapprove a proposal from the NYSE to amend Sections 312.03(b) and 312.04 (shareholder approval) of the NYSE Listed Company Manual. The proposal would exempt from the NYSE’s shareholder approval requirements “Early Stage Companies” that seek to issue, subject to audit committee approval, shares, for cash, to related parties, affiliates of related parties or entities in which a related party has a substantial interest. An “Early Stage Company” would be defined as a company that has not reported revenues greater than $20 million in any two consecutive fiscal years since its incorporation. The NYSE had contended that the proposed rule change was necessary to make its rules more comparable to NASDAQ’s and enable it to compete with NASDAQ for listings of early stage companies.
The SEC had received no comments on the proposal either when it was first published or when the comment period was extended. But because of the legal and policy issues involved, the SEC instituted “disapproval proceedings” to encourage comments on whether the proposal was consistent with the Exchange Act requirement that the rules of the securities exchanges be designed to, among other things, prevent fraud and manipulation, promote just and equitable principles of trade and protect investors and the public interest. The two main concerns raised by the SEC were that the proposal would allow shares to be issued at a discount to related parties without shareholder approval and that audit committee approval of these types of potentially dilutive transactions might not suffice. So far, the only taker on the SEC’s invitation to comment has been the NYSE, commenting on its own proposal. In its comments, the NYSE clarified that, under the proposal, any issuance to a director, officer or employee for a price that is at a discount to the market price would be deemed equity compensation requiring shareholder approval. See this PubCo post.
That clarification notwithstanding, Fleming argued that the proposal would “result in at least two significant changes. First, shares could be sold to substantial security holders at a discount, and those sales would no longer require shareholder approval unless they exceeded twenty percent of outstanding shares or resulted in a change of control. Second, all Related Parties, including officers and directors, could obtain a significantly larger share of ownership control by paying the then-current market price for additional shares in a private transaction, without a vote of the existing shareholders.”
In addition, current investors would face potential dilution of their ownership control, which “could ultimately result in decisions that are adverse to the interests of the original shareholders.” Although infusions of capital may be helpful to all investors, “when the recipient of new shares is a Related Party, it creates a risk that the company may be engaging in a ‘sweetheart deal’ that is motivated by a conflict of interest. Under these circumstances, where a transaction with a Related Party creates a heightened risk of significant harm to existing shareholders, those shareholders should be given the opportunity to evaluate the merits of the transaction and to vote on whether to approve it. The NYSE proposal would strip this right from them.” Moreover, Fleming did not agree with the NYSE that audit committee approval was an adequate substitute for a shareholder vote in this case.
Why this particular proposal and not something that has generated more interest or controversy? Precisely because there has been no interest in it. The statement indicates that, “given the general lack of awareness of [Exchange] filings among investors, the exchanges may have come to expect little scrutiny from investors of their routine proposals. Those days are now over. Today I make my first formal recommendation to the Commission, and it marks the beginning of my Office’s efforts to shine a brighter light on rule changes by the exchanges, either to oppose proposals that may be detrimental to investors or, conversely, to support the efforts of exchanges to amend their rules in ways that benefit investors.”
In his recommendation, Fleming expresses concern that the NYSE proposal “reflects something of a ‘race to the bottom’ amongst the exchanges. While it may be true that other exchanges are less strict in their requirements for shareholder approval of related party transactions, we believe the Commission should be encouraging the exchanges to enhance their standards, not devolve to the lowest common denominator because of competitive concerns.”