From the Sox Up - Gardere Securities Law Blog - Law. Trends. Cases of Interest.

Within the last two weeks, there have been two new calls for the Securities and Exchange Commission to amend its Rule 502(c) of Regulation D to eliminate the prohibition of “general solicitation or general advertising” (the “Prohibition”) with respect to certain exempt, private securities offerings. 

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In August 2011, we commented on proposals by the major national securities exchanges to impose additional listing requirements on companies completing a reverse merger with a shell company.  The SEC announced earlier this month that it approved each of the rule changes, as amended, on an accelerated basis.  It just became significantly harder for the shares of a reverse-merger shell company to become listed.

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We reported in May 2011 about the future of capital formation—through testimony by the SEC Chairman before a Congressional committee and the Committee Chairman’s comments.  At the time Chairman Schapiro had asked the SEC staff to take a “fresh look” at the offering rules.  The next chapter appears to have now begun with the Chairman’s formation of an Advisory Committee on Small and Emerging Companies on Sept. 13, 2011.

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The SEC recently (Aug. 8, 2011) proposed (PDF) an amendment to Rule 146 under Section 18 of the Securities Act of 1933 to designate certain securities on BATS Exchange, Inc. as “covered securities” for purposes of Section 18.  As a general matter, “covered securities” are exempt from state law registration or qualification requirements pursuant to the National Securities Markets Improvement Act of 1996 (“NSMIA”).  The proposed amendment raises the question:  what securities are “covered securities” today?

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Groupon announced on Jun. 2, 2011 that it would be going public.  It is rumored that the long-awaited IPO could possibly raise around $3 billion.  That size of IPO would give the social buying site a valuation estimated at $30 billion, a stark difference from the $5 billion that Google offered to purchase it for just months ago. 

And that’s not the only interesting aspect of the IPO.  Following the likes of LinkedIn, Renren and Google, Groupon also announced that it will use a dual-class share structure. In its SEC filing, Groupon disclosed that while co-founder and chief executive officer Andrew Mason only owns 7.7% of the company’s Class A stock, he additionally owns 41.7% of Groupon’s Class B stock.  Eric Lefkovsky, another co-founder, owns another 41.7% of the Class B Stock.  While the rights of the Class B shares were not disclosed in the filing, they typically allow founders to retain control, through greater voting power, of the company while still having shares traded in the public market.

With the recent announcements of both LinkedIn (see our earlier post) and Groupon using the dual-class share structure, we can see that investors and owners have strong opinions, both positive and negative, about this corporate governance structure. 

To most investors, two classes of shares are simply seen as unfair.  By creating a class of shareholders with super-voting rights, power is given to a select group of shareholders.  Typically, senior management is part of the higher voting power class, so there may be less accountability to the publicly traded class, and certainly the publicly traded class has less of a voice.  Dual-class IPOs also tend to be priced at lower price-per-earnings and price-per-sales ratios than comparable single-class IPOs. In addition, research shows that shareholders with super-voting rights dislike raising cash through the sale of additional shares or using shares as currency for acquisitions because this might dilute their voting power influence. Thus, these companies may tend to have more debt than companies with single-class structures.  Consequently, this research also shows that shares of companies with dual-class structures underperform the stock market.

Nevertheless, the dual-class share structure does have its benefits, at least from a management and founder perspective.  Many praise it because it allows management to ignore all kinds of short and medium-term noise in the market to which most public companies fall prey.  Thus,  the dual-class structure allows managers to create and follow long-term goals that can in turn create long-term value.  Additionally, this structure can prevent hostile takeovers that may bring an end to any opportunity of a long-term franchise.  All in all, if both classes of shareholders’ goals are aligned, long-term success might be more likely than with a single-class structure.

OUR TAKE: An IPO with dual-class share structures presents a host of benefits and challenges for investors and founders/owners alike.  When considering an IPO, companies should know their options and weigh the good and bad to determine which structure will best set their company on a positive trajectory.  This decision will not only make a long-term impact in how the company operates, but likely also its success.  Investors must weigh the impact of a super-class of stock, and the resulting lack of control, against potential long-term benefits.

*Many thanks to Lamar Dowling, a Gardere summer associate and JD/MBA student at Southern Methodist University, for his contributions to this post.

Nasdaq recently announced SEC approval of its BX Venture Market.  According to Nasdaq, this new exchange will provide smaller issuers, including over-the-counter traded issuers and issuers failing to meet the listing standards of other national exchanges, with a transparent and well-regulated listing alternative. 

To qualify for listing on the BX Venture Market, issuers must meet numerous listing standards, which are set forth in the SEC’s release (PDF).  These standards will be lower than that of Nasdaq, the NYSE and other national exchanges, attracting smaller, less liquid companies.  Among other requirements, including quantitative listing requirements, these listing standards will require:

• three independent directors;
• an independent audit committee;
• independent director oversight of executive compensation;
• review of related party transactions by independent directors;
• shareholder approval of equity compensation;
• annual shareholder meetings; and
• a code of conduct for all directors, officers and employees.

The BX Venture Market anticipates receiving listing applications in the third quarter of 2011, and currently plans to launch in the fourth quarter of 2011. 

OUR TAKE:  The BX Venture Market may provide emerging businesses and other smaller issuers with an attractive alternative to the OTC Bulletin Board and Pink Sheets, or the more stringent standards of other national exchanges.  Whether the BX Venture Market will spawn a new age of IPOs for smaller and venture-backed issuers remains to be seen.  But the emergence of the BX Venture Market, combined with the SEC’s efforts to review impediments to capital formation, is a step forward for smaller issuers.

SEC Chairman Mary L. Schapiro testified on the future of capital formation before the U.S. House of Representatives Committee on Oversight and Government Reform in a visit to Capitol Hill on May 10, 2011.  Committee Chairman Darrell Issa (R-Cal.) had previously raised concerns to Chairman Schapiro about rules that he believes are restricting capital formation in the United States.

In her testimony, Chairman Schapiro recognized the need to facilitate access to investment capital, but at the same time satisfy the SEC’s obligation to protect investors and U.S. public markets.  She has instructed the SEC staff to “take a fresh look at some of our offering rules to develop ideas for the Commission to consider that would reduce the regulatory burdens on small business capital formation in a manner consistent with investor protection.”  Schapiro focused on two of the rules that Representative Issa finds at fault:  the ban on general solicitation in connection with most private offerings; and the 500-shareholder threshold for public reporting requirements.

Under Section 4(2) of the Securities Act of 1933 and Regulation D, general solicitation and advertising is prohibited except in connection with Rule 504 offerings, which are limited in size.  According to a report by The Deal Pipeline on May 11, 2011, the general solicitation ban has been criticized for years.  Some argue that the ban is unnecessary because those who do not purchase a security are not harmed by a general solicitation.  On the other hand, the ban may make it more difficult for “fraudsters to attract investors.”  According to Chairman Schapiro, the SEC has to balance these considerations.  Representative Issa went so far as to raise the question whether the ban violates the First Amendment.  However, there does not appear to be any real support for that position.

Section 12(g) of the Securities Exchange Act of 1934 requires a company to register its securities, and thereby become a public reporting company, if at the end of its fiscal year the securities are “held of record” by 500 or more persons.  Chairman Schapiro believes that both the threshold number and how holders of record are determined needs to be reviewed.  She acknowledged that the securities markets have changed significantly since the threshold was established.  It is not clear that 500 is a relevant number today or whether certain types of shareholders should be excluded.  Also, the way shares are held today may result in inequitable treatment between public and private companies.  Most public shares are held in street name, so a public company may actually have thousands of beneficial shareholders, but only a relatively small number of holders of record.  On the other hand, private company shareholders hold shares directly and are all deemed to be holders of record.  The public company could go “dark” if it has less than 500 holders of record, while the private company that hits the 500 threshold must begin public reporting.

Chairman Schapiro did note that the SEC has addressed the 500-shareholder threshold with regulatory relief in the past, including providing an exemption to the threshold for compensatory stock options in Rule 12h-1(f).  According to an AP report on May 10, 2011, Representative Issa has asked the SEC to consider additionally exempting company employees who own stock from counting toward the threshold.

OUR TAKE:  Capital formation is key to the economy.  It is critical that the SEC and Congress recognize the impact of changing markets and practices in determining what rules and restrictions should reasonably be in place to protect the investing public and the integrity of our public markets.  The reality is that many very large and successful companies are postponing or foregoing IPOs.  The ability to facilitate capital raising by private companies, therefore, takes on even greater importance.  The SEC’s review should result in proposals to modernize the rules while maintaining its investor-protection mission.

The SEC recently (Feb. 9, 2011) proposed rule amendments (PDF) that would eliminate the requirement of credit ratings in determining the eligibility of an issuer to use a short-form registration statement or the expedited shelf registration process.  The SEC announced the rule amendments as the first in a series of proposed rulemaking to remove references to credit ratings as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Issuers that are eligible for short-form registration have more limited disclosure requirements and are also able to register securities “on the shelf.”  Currently, one of the ways to satisfy the transaction requirements for eligibility is to have registered nonconvertible securities that have been rated investment grade by at least one nationally recognized statistical rating organization.

Under the proposed rule changes, the credit rating requirement would be replaced by a test tied to the amount of non-convertible debt and other securities the issuer has sold in the previous three years.  The test would be met if the issuer has issued over $1 billion of non-convertible securities, other than common equity, in the last three years.  The test is modeled after the standard used to determine if an issuer is a WKSI, or well-known seasoned issuer.  The proposed amendments would result in changes to both Form S-3 and Form F-3, as well as other registration statements that refer to Form S-3/F-3 eligibility, such as Form S-4.

Comments to the proposed amendments must be submitted by Mar. 28, 2011.  The SEC is seeking comments that provide alternative approaches to the proposed $1 billion test.

OUR TAKE:  Driven by the Dodd-Frank Act, this is the SEC’s first step to eliminate reliance in its rules on credit ratings.  Substantially similar rules were proposed in 2008, but were met with strong objections.  The Dodd-Frank Act requirements reflect the negative view of credit rating organizations as a contributing factor in the U.S. economic downturn and direct the SEC to substitute creditworthiness standards that the SEC determines are appropriate.