by Cydney Posner
As you may recall, in April of this year, the NYSE filed with the SEC a proposed rule change that 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 officers, directors or substantial security holders (“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. Under the proposal, the shareholder approval requirements of Sections 312.03(c) (issuance of 20% or more of shares) and 312.03(d) (change in control) would continue to apply. After several almost fruitless comment periods and an order from the SEC instituting proceedings to determine whether to disapprove the proposal, on December 31, the SEC issued an order accelerating approval of the proposed rule change, as amended. Prior to approval of the change, shareholder approval was required before the issuance of shares, when, among other circumstances, the number of shares to be issued to one of the exempted parties identified above exceeded either 1% of the number of shares of common stock or 1% of the voting power outstanding before the issuance. The NYSE argued that the rule change was necessary for competitive purposes, given that neither Nasdaq nor the NYSE Market has a comparable requirement.
After the proposal was first published, the SEC received no comments on the proposal nor did it receive any comments when the comment period was extended. But because of the legal and policy issues involved, in August, 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. (See this PubCo post.)
Nevertheless, very few comments were received. However, the NYSE submitted its own comment letter taking issue with the SEC’s conclusion that the proposal would allow shares to be issued at a discount to related parties without shareholder approval. (See this PubCo post. ) The letter stressed that the NYSE’s “longstanding policy is that any time a listed company sells equity securities to a director, officer or employee for a price that is at a discount to the then-current market price, such securities are deemed to be equity compensation requiring shareholder approval under Section 303A.08. Nothing in the proposed amendment will change the Exchange’s application of this policy going forward….When selling up to 19.9% of its outstanding equity securities to a director, officer or employee, in order to be exempt from shareholder approval (under both Section 303A.08 and the proposed Section 312.03(b)), an Early Stage Company would have to price the transaction at or above then then-current market price. When priced at or above then then-current market price, the shares sold are not equity compensation and there is no economic dilution to the Early Stage Company’s shareholders.”
Then in October, the new Investor Advocate, Rick Fleming, issued a statement regarding his “First Official Recommendation ” to the SEC: that the SEC disapprove the NYSE’s proposed rule change. The proposal, he believed, reflected a “race to the bottom” among the exchanges. 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, he contended, current investors would face potential dilution of their ownership control. He also disagreed with the NYSE that audit committee approval was an adequate substitute for a shareholder vote in this case. (See this PubCo post.)
On December 10, 2015, the NYSE filed Amendment No. 2 to the proposed rule change, modifying the proposed rule language to clarify that:
- the proposed exemption would not be applicable to a sale of securities to any of the categories of exempted persons (identified above) if the proceeds of the transaction would be used to fund an acquisition of stock or assets of another company where the person had a direct or indirect interest in the company or assets to be acquired or in the consideration to be paid for the acquisition;
- any sale of a company’s securities at a below-market price constitutes equity compensation and is therefore subject to the shareholder approval requirements under Section 303A.08; and
- shareholder approval of any issuance is required if any of the subparagraphs of Section 312.03 requires approval, even if the transaction would not require approval under the proposed change to Section 312.03(b), or one or more of the other subparagraphs.
In response to the Investor Advocate’s concern that the potential for a greater percentage of shares to be issued at a discount to substantial security holders, without a shareholder vote, could lead to harmful dilution of the economic value of existing shares, as well as other potentially dilutive effects, the SEC indicated that it believes that the proposed rule change is, on balance, consistent with the Exchange Act. With respect to potential dilution, the SEC believes that the significant proposed limitations (for example, continuing to require shareholder approval of issuances of discounted shares to officers or directors, or to a substantial security holder that is an employee or other service provide or of shares that result in a change in control), “together with the countervailing potential benefits to the ability of small issuers to efficiently raise capital, and to fair competition among the listing exchanges, sufficiently offset those risks. Because the proposal allows early stage companies the flexibility to meet their financing needs while still preserving significant shareholder rights afforded under the other provisions of Section 312.03, the Commission finds that the proposal is consistent with investor protection and the public interest.” The SEC also believes that the approval of the early stage company’s audit committee is an appropriate safeguard to protect shareholder interests. According to the SEC, “facilitating the ability of early stage companies to efficiently raise needed capital under the limited circumstances permitted by the proposed rule change is in the public interest. By definition, early stage companies are those that have not yet generated significant revenue from operations, and may therefore need to raise capital quickly in order to fund their ongoing operations. Allowing early stage companies to flexibly raise capital, subject to audit committee approval and the other limitations described above, but without the delays inherent in a shareholder vote, could improve the business prospects of such companies and ultimately inure to the benefit of shareholders.” While acknowledging the Investor Advocate’s concern regarding a race to the bottom, the SEC was also concerned that disapproval of the proposal would undermine the Exchange Act goal of facilitating fair competition among the exchanges. In effect, the SEC has responded to its own concerns raised earlier in the year when it initiated “disapproval proceedings” regarding the proposal.
Finally, given that the SEC rejected all of the Investor Advocate’s concerns in his first official recommendation, the SEC still gave him an “ataboy,” acknowledging that he made “important contributions” to improving the extent and
quality of information available to the SEC on this issue and encouraging him “to continue bringing important matters to our attention, including identifying circumstances where incremental changes, while consistent with the Act, may be contributing to cumulative impacts that harm investors or impede fair and orderly markets.”