SEC’s Investor Advisory Committee takes on Nasdaq

by Cydney Posner

At the January meeting of the SEC’s Investor Advisory Committee, two Nasdaq representatives made a presentation regarding the recent Solicitation of Comments by the Nasdaq Listing and Hearing Review Council, a standing independent advisory committee, regarding some of the Nasdaq shareholder approval rules.  The reaction of the Committee was, shall we say, largely skeptical, if not downright cynical.

The Solicitation of Comments relates to the Nasdaq rules that generally require companies to obtain shareholder approval before issuing securities in connection with an acquisition of the stock or assets of another company, a change of control or certain private placements at a price less than the greater of book or market value.  The Solicitation  was developed after conversations with the Listing Council and outreach to various constituencies, including companies and investors.  It does not offer specific proposals, but rather is intended to foster a dialogue with the public regarding whether these rules – which were adopted in 1990 – should be updated, without sacrificing crucial investor protections.  Nasdaq suggests that, over the past 25 years, there have been significant changes in the capital markets and securities laws, including development of various corporate governance mechanisms designed for investor protection, such as requirements for majority independent boards. In addition, the increased threat of shareholder litigation may have a salutary effect. “As a result,” Nasdaq suggests, “certain provisions of the rules may no longer serve their original shareholder protection purpose and others may no longer make sense. In addition, companies may face higher costs of capital by structuring transactions in sub-optimal ways in order to satisfy Nasdaq’s shareholder approval rules.”

Acquisitions. Rule 5635(a) requires listed companies to obtain shareholder approval in connection with an acquisition if the potential issuance is equal to 20% of the number of shares of common stock or voting power outstanding, or, if insiders have an interest in the target entity, the threshold is just 5%.  The Solicitation asks

  • whether the 20% threshold is too restrictive and
  • whether, in light of “enhanced investor protection mechanisms and disclosure requirements surrounding related party transactions, the heightened shareholder approval rules governing insider interest in an acquisition are no longer necessary.”

Change of control. Rule 5635(b) requires shareholder approval when an issuance of securities will result in a change of control. However, there is no bright-line test or safe harbor as to what constitutes a change of control.  Nasdaq takes all the facts and circumstances into account, focusing particularly on the voting power, ownership and board representation of investors receiving securities, whether there are any relationships or agreements between the company and the investors, and among the investors. Generally, Nasdaq views a change of control to occur when the investor group would own, or have the right to acquire, 20% or more of the outstanding shares or voting power and those levels of ownership or voting power represent the largest position.  The questions raised here are

  • whether “change of control” should be defined,
  • whether 20% is an appropriate threshold even if the investor group discloses an intent to remain passive, and
  • whether Nasdaq should consider other factors in determining whether a change of control has occurred.

Private placements.  Rule 5635(d) requires shareholder approval prior to an issuance equal to 20% or more of the common stock or voting power outstanding at a price less than the greater of book or market value (with market value measured by reference to the company’s closing bid price). Shareholder approval is also required if any shares are issued to an officer or director in a private placement at a discount to market value.  In determining whether a transaction is a private, not a public, offering, IM-5635-3 outlines the factors considered by Nasdaq. With regard to warrants issued along with common stock or other convertible securities, Nasdaq assigns a value of $0.125 to each warrant in determining whether a transaction is at market price. Nasdaq will analyze the following factors to decide whether two or more transactions should be aggregated: timing of the issuances (generally, whether the transactions are less than six months apart); facts surrounding the initiation of the subsequent transaction(s); commonality of investors; existence of any contingencies between the transactions; specified use of proceeds for each of the transactions; and the timing of the board of directors’ approvals. There are a number of questions raised here, including

  • whether Nasdaq should continue to use closing bid price to measure market value,
  • whether the book value measurement should be eliminated,
  • whether the 20% threshold should be raised for smaller companies, which may be disproportionately affected by the 20% rule, and how smaller company should be defined,
  • whether Nasdaq should permit companies to obtain periodic pre-approvals of these issuances,
  • whether the requirement for shareholder approval where insiders participate should be eliminated, or eliminated when they participate on the same terms as negotiated by the other investors,
  • whether shareholder approval should be required based on a sliding scale, where the number of shares that could be issued without shareholder approval is based on the size of the discount to market price,
  • whether Nasdaq should exclude the value of warrants when determining if a transaction is at a discount if the warrant cannot be exercised for six months and the exercise price of the warrant is equal to or greater than market value,
  • whether the factors for determining public offerings are appropriate,
  • whether Nasdaq should establish a specific time period after which two or more transactions would not be aggregated, and
  • whether companies with a stable shareholder base of long-term holders should be allowed greater latitude to issue shares before shareholder approval is required, the concept being that the stable base “is an indication of implied approval.”

For the most part, the Committee members were about as thrilled with the possible changes implicit in the Solicitation as they were with the FASB materiality proposal (see this PubCo post); even the relatively anodyne notion of eliminating book value as a measurement met with some, albeit limited, pushback.  Underlying this resistance appeared to be the concern that Nasdaq was predisposed to ease the rules, not stiffen them, with the result that the rights of investors would be diminished.  As such, one member submitted, the Solicitation represented part of a “race to the bottom” among the exchanges, a race that has accelerated since these entities dropped their status as non-profit organizations, making the competition among them for listings even more fierce.  One member also questioned the theoretical underpinnings of the Solicitation, as he saw them: that disclosure suffices to cure issues such as insiders’ conflicts of interest and that changes in technology, markets or corporate governance have created sufficient reasons to raise the issuance voting thresholds or otherwise reduce these shareholder protections.  In his view, there was no reason to think that either was true.  For example, dilution was still an issue that they believed required a say by shareholders, and they could not identify market or governance changes that would support raising the threshold for a shareholder vote.  What’s more, the members questioned whether approval by independent directors would really be effective to address problems the rules were intended to address, such as cleansing the taint of insider transactions, nor did the prevalence of shareholder litigation provide the protections that would justify these types of changes. There was also a sidebar as to whether Nasdaq’s definition of “independence,” notwithstanding the subjective or qualitative component of the test, was really adequate to the task: at least one of the committee members questioned whether boards were actually screening for personal relationships that could interfere with the exercise of independent judgment and wondered whether a more explicit requirement might be more effective.  While one member considered it valuable to ask how the rules might be improved, overall, the tenor of the discussion was that “it ain’t broke –don’t fix it.”

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