Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

IPO

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SPACs and the JOBS Act

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Usha Rodrigues †

Public Inroads in Private Equity

The law has long confined the average investor to trading in public securities[1] while allowing wealthy—or “accredited”[2]—individual investors access to a panoply of private securities, including investment vehicles such as hedge funds and private equity funds. Nevertheless, pressure to let the general public into private equity has been growing. Two forces have contributed to this mounting pressure. First, public investors are eager to try their hand at investing in private enterprise. Second, private firms need capital. In the face of these forces, the sharp line that has long separated public and private firms has become increasingly blurred.[3]

Consider the story of the emerging growth company (EGC), or “Initial Public Offering (IPO) on-ramp,” provision of the Jumpstart Our Business Startups Act (JOBS Act). In its first few months on the books, this provision had effects far different from what its drafters envisioned. The JOBS Act’s IPO on-ramp was intended to ease regular companies’ path to going public; instead, it has inadvertently made it easier for the average investor to get a taste of private equity via special purpose acquisition corporations (SPACs). This piece will briefly describe SPACs, the IPO on-ramp, and how shell companies have taken advantage of a legislative provision intended to bring cash-hungry young companies directly to market. This piece will close with a few thoughts on lessons the story of SPACs’ interaction with the JOBS Act may offer regarding the increasingly indistinct line that divides public and private investment.

 Introducing SPACs

A SPAC is a type of “blank-check” company that goes public to raise a pool of cash and then begins a hunt for a target.[4] The bulk of the IPO proceeds are locked up in a trust account, invested in government-backed securities, and kept safe from the interference of the managers.[5] Once a target is identified, the SPAC managers disclose material financial information about it to shareholders, who then have a say on whether the acquisition occurs by way of voting or opt-out rights.[6] If no suitable target is found, or if a shareholder is unhappy with the deal, she can receive most of her money back—an average of ninety-eight cents on the dollar—from the trust account.[7] But if a SPAC shareholder does like the deal, then she will end up having owned a piece of an acquisition vehicle—in essence, a one-off private equity fund.[8]

The beauty of the SPAC model is that it bifurcates the process of going public, making it faster and cheaper. When the SPAC itself goes public, it is basically an empty shell, so any disclosures required under the Securities Act of 1933 (1933 Act) are minimal and cheap.[9] The SPAC’s Securities Exchange Act of 1934 (Exchange Act) filings are likewise minimal; in essence, they involve nothing more than reporting the rate of return generated in the trust account.[10] If and when the SPAC acquires a target—usually a private company—that target immediately becomes public without the hassle, disclosures, and delay that accompany a typical IPO.[11]

JOBS Act and SPACs

SPACs offered a rare chance for the average investor to participate in the rarified world of investing in private targets, while simultaneously offering those targets an easy route to an IPO. The JOBS Act took a decidedly different approach to blurring the line between public and private investment. Rather than letting the general public into private equity investments, the drafters tried the converse: encouraging more private firms to go public. Yet despite the JOBS Act’s focus on making it easier to bring traditional operating companies to the public market, its provisions have proven unexpectedly appealing for SPACs. Thus, legislation intended to help conventional companies go public is also facilitating a form of private equity investment.

SPACs’ business structure was in place long before the passage of the JOBS Act; indeed, they predated the Act by more than a decade.[12] The whole point of the JOBS Act’s EGC provision was to coax small-cap companies into going public by reducing the burdens of public disclosure and ongoing federal regulation, thereby providing the benefit of access to the public capital markets previously unavailable to them. I thought surely the passage of the JOBS Act was bad news for SPACs. Why agree to be acquired by a SPAC when you can easily go public on your own? The JOBS Act, however, had an unanticipated effect on the SPAC market because the JOBS Act’s IPO on-ramp provision makes it easier and cheaper for any small corporation to go public.[13]

As it turned out, the JOBS Act was not all bad news for SPACs because many SPACs themselves decided to go public using the IPO on-ramp. Indeed, in the eight weeks after the JOBS Act’s passage, over a dozen of the companies taking advantage of the new on-ramp option were SPACs.[14] Four months after the JOBS Act’s passage, one out of every nine EGCs was a SPAC.[15] The trend has not abated; in the first half of August 2012, one out of five firms that made use of the IPO on-ramp provision were SPACs.[16] To say the least, SPACs are making good use of the EGC option.

At first blush, SPACs’ use of the JOBS Act’s on-ramp seems counter-intuitive. It already was, and still is, easy for SPACs to go public under the conventional 1933 Act registration process. After all, SPACs’ disclosures at the start-up phase are largely boilerplate, along the lines of “this is who we are, this is how much money we plan to raise, this is how much we are setting aside in trust.”[17] If it is so easy for SPACs to register under the 1933 Act, why should they bother with the on-ramp provision offered by the JOBS Act?

The answer to this question stems from economic realities. As it turns out, successful SPACs—that is, SPACs that complete acquisitions—can save a lot of money in securities regulation compliance costs by making use of the IPO on-ramp. The payoff comes from greatly reduced ongoing reporting requirements imposed by the Exchange Act.In particular, EGC status under the JOBS Act lasts up to five years, as long as revenues, market capitalization, and debt issuances stay low,[18] and with that status come “scaled-back disclosures, certain exemptions to executive-compensation disclosures and attestation requirements for the auditors.”[19] These features make EGC SPACs comparatively more attractive to potential targets. A private company looking to go public on the cheap (i.e., at even less expense than the JOBS Act’s on-ramp promises) might well favor an EGC SPAC acquirer that promises lower disclosure burdens over a traditional public company acquirer—or, for that matter, a non-EGC SPAC—both of which would require the Exchange Act’s more in-depth disclosure. Time will tell whether EGC SPACs prove to be more successful acquirers than traditional acquirers and non-EGC SPACs.

In sum, despite reformers’ best intentions, many of the first companies to file as EGCs were not small operating companies rushing to access the capital markets as soon as regulatory barriers fell away. Instead, they were firms looking to acquire private firms down the road and take them public. Even so, the net effect may be what the JOBS Act’s drafters intended: if these new EGC SPACs have their way, they will acquire private firms, and thus bring more small firms to the public markets. Yet the SPAC EGCs will accomplish this goal in a roundabout way. More small firms will go public, as the JOBS Act envisioned, but by way of shell companies that allow the general public to participate in the uniquely public form of private equity that SPACs offer. While successful EGC SPACs will thus bring more firms public, they will at the same time allow their own investors to participate in a species of private equity investment, a kind of investment traditionally reserved for accredited investors. All of this supports a telling conclusion: both regulators and the market itself are exerting pressure on the line separating public and private investment, and these two separate forces can combine to produce unanticipated results.

Blurring the Line Between Public and Private

In conclusion, SPACs and the JOBS Act, both considered singly and taken together, signal the mounting pressure building over the divide between public and private investment. SPACs are mechanisms that let the public make private equity-like investments. The IPO on-ramp is an attempt to entice private companies to the public markets. Yet even more tellingly, these separate phenomena have recently interacted in an unexpected way, revealing how difficult it can be for reformers to revise the public-private boundary with any degree of certainty.

SPACs and the JOBS Act’s IPO on-ramp are but two examples of recent trends that suggest that the line separating the public and private investment spheres may be blurring. Another example, the CROWDFUND Act, applies pressure on the other side of the public-private line: rather than making it easier for more private companies to access the public markets, it allows unaccredited investors a chance to invest limited sums in private companies for the first time.[20]

Securities regulation ultimately involves a delicate balancing act, with investors’ need for protection and firms’ thirst for capital pulling in opposite directions. The traditional balance reserved robust investor protection for the public markets, and allowed wealthy investors exclusive access to more risky, and potentially more profitable, private firm investment.[21] But SPACs are a sign that the general public also desires to furnish capital to private firms in exchange for the chance to earn a higher rate of return.  At the same time, the JOBS Act signals a desire on the part of regulators and firms alike to allow companies to enjoy the benefits of being public while reducing some of the burdens that have traditionally accompanied public status.  Such examples thus, in different ways, indicate that the public-private boundary may be shifting dramatically.

 

Preferred citation: Usha Rodrigues, SPACs and the JOBS Act, 3 Harv. Bus. L. Rev. Online 17 (2012), https://www.hblr.org//?p=2488.

† Associate Professor of Law, University of Georgia School of Law.  I thank Mike Stegemoller and the staff of the Harvard Business Law Review.  Any errors are my own.

[1] See, 15 U.S.C.A. § 77d (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[2] Rule 501 of Regulation D describes several categories of accredited investors, including certain banks, charitable organizations, and certain high net worth individuals, who may invest in securities that are not registered. 17 C.F.R.  § 230.501(a) (2012). Most notably, individuals with a net annual income of over $200,000 or a total net worth of over one million dollars may invest in securities that are not registered provided that those securities meet the general disclosure requirements of Rule 502. 17 C.F.R. § 230.502 (2012).

[3] For a few recent scholarly discussions of the public-private divide, see Donald C. Langevoort & Robert B. Thompson, “Publicness” in Contemporary Securities Regulation After the JOBS Act (Georgetown Law and Econ. Research Paper, No. 12-002, 2012) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1984686; Adam C. Pritchard, Revisiting “Truth in Securities” Revisited: Abolishing IPOs and Harnessing Private Markets in the Public Good (Univ. of Mich. Law & Econ. Research Paper No. 12-010, 2012) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2103246; Usha Rodrigues, Securities Law’s Dirty Little Secret, 81 Fordham L. Rev. (forthcoming 2013) (on file with the author).

[4] Usha Rodrigues & Mike Stegemoller, Exit, Voice, and Reputation: The Evolution of SPACs, 37 Del. J. Corp. L. (forthcoming 2012).

[5] Id.

[6] Id.

[7] Id.

[8] See Steven M. Davidoff, Black Market Capital, 2008 Colum. Bus. L. Rev. 172, 225 (2008) (“SPACs are a species of private equity: these are capital pools organized to acquire individual businesses. But because of the general requirement that the initial acquisition comprise eighty percent of its assets, SPACs typically only acquire a single privately-held business. Despite these important distinctions, SPACs otherwise attempt to mimic private equity returns by employing comparable structures and practices. For example, SPACs utilize similar leverage to increase the size and potential returns of their acquisitions. The managers of SPACs are also typically provided twenty percent of the initial share offering at nominal amounts; ownership they are required to maintain until and after consummation of an acquisition.”).

[9] Daniel S. Riemer, Special Purpose Acquisition Companies: Spac and Span, or Blank Check Redux?, 85 Wash. U.L. Rev. 931, 950–51 (2007) (describing typical SPAC registration disclosure).

[10] Rodrigues & Stegemoller, supra note 4.

[11] Some call SPACs back-door IPOs, but SPACs differ from the seedier reverse mergers that led to so many Chinese companies with questionable accounting practices going public. Id.

[12] Riemer, supra note 9, at 944–45.

[13] For example, emerging growth companies need to disclose only two years of audited financial information prior to going public. 15 U.S.C.A. 77g(a)(2)(A) (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012). They are not subject to Sarbanes-Oxley’s dreaded internal controls provision. 15 U.S.C.A. § 7262(b) (West 2009& Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[14] Emily Chasan, Meet the JOBS Act’s Jobs-Free Companies, Wall St. J., June 4, 2012, at B1.

[15] Chris Hitt, “I Am Shocked, Shocked”: Blank Check Companies and the “Scandal” of the JOBS Act, Blogmosaic (Aug. 16, 2012), http://blogmosaic.knowledgemosaic.com/2012/08/16/spacs-as-egcs/.

[16] Id.

[17] See, e.g., Acquicor Tech. Inc., Registration Statement (Form S-1) (Sept. 2, 2005).

[18] 15 U.S.C.A. 77b(a) (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[19] Chasan, supra note 14.

[20] Title III of the JOBS Act, the CROWDFUND Act, allows issuers to sell up to one million dollars of securities in a twelve-month period without Securities Act of 1933 registration. Any investor can invest in these companies—they are not reserved for accredited investors only. If an investor’s annual net worth or income is less than $100,000, she can invest no more than 5% of her net worth or annual income or $2,000, whichever is greater. Jumpstart Our Business Startups Act, Pub. L No. 112-106, sec. 302, § 4(a)(6)(B)(i), 126 Stat. 306, 315 (2012). If an investor’s annual net worth or annual income is equal to or more than $100,000, then she can invest no more than the greater of 10% of her net worth or annual income and $100,000. Id.

[21] Individuals qualify as accredited investors by having a net annual income of over $200,000 or a total net worth of over one million dollars. 17 C.F.R. § 230.215 (2012).  SEC regulations and industry practice dictates that only this special class of individual investors can invest in hedge funds, private equity funds, and venture capital funds. Thus, historically at least, ordinary investors have been shut out of the private market, except via pension funds that in effect pool the resources of many investors into an accredited-investor fund. No private market mutual funds currently exist.

By

Comments on Seasoning of Reverse Merger Companies Before Uplisting to National Securities Exchanges

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David N. Feldman*

Introduction

Blockbuster Entertainment, Occidental Petroleum, Turner Broadcasting, Tandy Corp. (Radio Shack), Texas Instruments, Jamba Juice, and Berkshire Hathaway are just a few well-known companies that went public through a “reverse merger.” To the uninitiated, a reverse merger is a deceptively simple concept. Instead of pursuing a traditional initial public offering (IPO) utilizing an investment bank as an underwriter, a company arranges for its stock to be publicly traded following a merger or similar transaction with a publicly held “shell” company. The public shell has no other business but to look for a private company to merge with. Upon completion of the merger, the private company instantly becomes public. The shareholders of the private company typically take over the majority of the stock of the former shell, enabling them to still operate the business of the formerly private company.

As laid out below, the process is generally quicker, cheaper, simpler, less dilutive, and less risky than an IPO, but it has its own unique risks and challenges.  Reverse mergers are typically complex transactions with hidden traps that even practitioners experienced in this technique easily fall into.  When done right, however, these hidden dangers can be avoided and the transaction can move forward quickly and smoothly.

The dramatic increase in popularity of reverse mergers in the last decade resulted from a confluence of factors. These include the fickleness of the IPO market and its near universal unavailability for companies with less than $150 million in market value, more willingness in certain hedge fund investors to seek greater potential upside in exchange for more patience with respect to liquidity, and SEC regulatory action in the area bringing greater transparency and legitimacy to the technique. In addition, a type of shell company known as a “special purpose acquisition company,” or SPAC, became tremendously popular in the mid-2000s, attracting such luminaries as Goldman Sachs, Apple founder Steve Wozniak, and many more to the world of shells. Finally, as will be discussed below, there was until recently, a large number of companies from China seeking a US public listing through a reverse merger.  On average, about 200 reverse mergers are completed each year.[1]

 

Comparing Reverse Mergers and IPOs

The process of a reverse merger is much speedier than an IPO, allowing needed capital to be raised more quickly and more easily. Typically, reverse mergers can be completed in three to four months, whereas IPOs can take nine to twelve months or more.[2]  Reverse mergers also are much less expensive.  Depending on the cost of a shell, a reverse merger can be completed for less than $1 million and sometimes even less than $200,000.  IPOs, on the other hand, cost millions.[3]

IPOs also are more dependent on market conditions than reverse mergers. In the end, an IPO comes down to how the market is behaving during the week that the IPO is slated to be carried out.  If the market is down, the deal may be delayed, the offering price may be reduced, and some deals simply get shelved at the last minute.  Because there is generally not much trading immediately following a reverse merger, current market conditions are simply less important.

IPOs also typically involve the sale of a fairly large percentage of a company’s stock. In general, reverse mergers tend to raise less money initially, allowing a company’s founder to retain a greater percentage of his company’s equity. Additional funds are raised later, hopefully at a time when the stock price has risen and the offering would thereby be less dilutive.

It is often said that one advantage of an IPO is the robust trading that takes place after the offering. The primary goal of the syndicate of underwriters is to get initial investors in, and then out, of the stock relatively quickly, within hours or a few days. They support the stock during this time. Whether they support it after that initial burst of activity depends on many factors and cannot be assured.

It is true that initial trading after a reverse merger is often thin. Companies are trained to think differently with a reverse merger and work on building market support over a reasonable period of time, rather than expecting a “pop” in the stock as with an IPO. Many reverse merger companies pursue larger public offerings after they go public to gain some of the trading benefit that attaches to an IPO.


Basics of Reverse Mergers

In a 2005 rulemaking, the SEC defined a shell company as a registrant that has (1) no or nominal operations and (2) either: (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.[4]  In a 2007 rulemaking, amending Securities Act’s Rule 144,[5] the SEC further indicated that a start-up company with limited operations could be considered as having more than mere nominal operations, in other words as not a shell,[6] and in the aforementioned 2005 rulemaking, the SEC generally declared “that companies and their professional advisors often use shell companies for many legitimate corporate structuring purposes.”[7]

Shells are valued in the marketplace based on how many shareholders they have, whether the stock is trading, whether the company is required to file periodic reports with the SEC, and how “clean” the shell is. Shells come about in one of two ways. In one type, a public operating business is sold or goes out of business; while the company remains public, its operations have ceased. This leaves behind a public shell whose shares typically can continue to trade. Shells can also be created from scratch, utilizing SEC Form 10 to register a shell’s common stock so that the company becomes fully SEC reporting but has no shares to be traded until a business combination is completed and a full SEC registration process is undertaken. These “Form 10 shells” had become very popular in the last six years as they are completely clean, with no past operations to scrub for liability exposure.

If one is completing a reverse merger with an SEC reporting shell company, a variety of special rules apply. For example, SEC Form 8-K requires, within four business days after the completion of the transaction, a filing on that form of all information that would be in an SEC Form 10 for the combined company.[8] This is effectively the equivalent of an IPO prospectus, with fully-audited financial statements, detailed company description, executive compensation, ownership chart and the like.  The industry refers to it as the “super” Form 8-K.  In addition, certain rules allowing the public resale of shares that have not been registered with the SEC require a delay following the completion of a reverse merger before these shares can begin to be sold.[9]

In the 2007 rulemaking on Rule 144, mentioned above, the SEC imposed an additional requirement on public companies that were at one point shell companies, mandating that such companies complete all of their regular filings with the SEC for the last 12 months if a shareholder wants to publicly sell shares that have not been registered.[10] This rule applies forever and the industry has dubbed it the “evergreen” requirement. In October 2008, this author, along with nine law firms, submitted a petition for rulemaking requesting that this limitation be reversed and that former shells be treated like any other public company.[11] To date, the Commission has not taken any action on the petition.

In addition, as will be discussed in greater depth below, the New York Stock Exchange, NYSE Amex, and Nasdaq have all imposed special limitations on when a company completing a reverse merger can be permitted to apply to “uplist” to their exchange.


Brief History and Rule 419

In the 1970s and 1980s, a number of unsavory players entered the reverse merger space, forming new shell companies, raising money through IPOs of these shells, and simply taking the money as fees for themselves.  Other abuses, some relating to trading of the stock of the shells, were also rather rampant.  However, a number of legitimate players also emerged.  Other fraudulent “boiler room” abuses also were common in lower priced stocks.  This resulted in the passage of the Penny Stock Reform Act of 1990.[12]  Among other things, it directed the SEC to segregate registration statements (including IPOs) that relate to offerings by shell companies.  In response, in 1992 the SEC passed Rule 419 under the Securities Act of 1933.[13]

Rule 419 placed significant restrictions on any attempt to complete a traditional IPO for a shell company (they then called them blank check companies with a little bit different definition). The rule requires virtually all cash raised in the shell IPO to be placed in escrow, no trading in the shell’s stock prior to a reverse merger, a time limit of 18 months to complete a transaction or return all invested cash, and shareholder approval of the merger transaction. Shareholders also have an “opt out” to receive their money back if they vote against the transaction. The restrictions do not apply to a public offering by a shell of at least $5 million- this exception ultimately spawned the SPAC movement described above.

Passing this rule eliminated most of the abusers from the market. But the rule also hurt many quality players. Most discovered quickly that, as a practical matter, it was going to be nearly impossible to take shells public under Rule 419, much less have an easy time getting the SEC to approve the proxy disclosure required to obtain shareholder approval for a transaction. As indicated above, this ultimately led many to acquire shells from the carcasses of former public operating companies or set up new shells using Form 10, which is not subject to the Rule 419 restrictions.[14]


Recent Developments

As mentioned above, in the last decade hundreds of companies located in China became US public companies through reverse mergers. A number of other Chinese companies completed traditional IPOs during this time. But in the late 2000s, before the market meltdown, Chinese companies represented about one-quarter of all reverse mergers. The Public Company Accounting Oversight Board (PCAOB), which oversees auditing firms of public companies, discerned that of the 603 reverse mergers between January 2007 and March 2010, 159 were Chinese companies, about 26%.[15] However, starting in early 2010, the financial press and short sellers began reporting allegations of primarily accounting fraud in a number of these companies.[16] A number of class action lawsuits are now pending against Chinese companies, although some have been dismissed.[17]

These developments also led the SEC to begin actively investigating not only these companies but microcap fraud in general. This review also encompassed the reverse merger industry, including attorneys, accountants and investment banks. It also led the SEC to issue a recent “investor bulletin” on the risks of reverse mergers, which mostly described the risks inherent in investing in any small or microcap stock.[18] In addition, the PCAOB has issued warnings to accountants about reverse mergers.[19] The US Justice Department also is now involved in the investigation of alleged accounting fraud in reverse mergers.[20]


“Seasoning” Requirements

In recent months, in large part as a result of the actions of the SEC, PCAOB, and others, the SEC approved rules permitting the three largest US stock exchanges to build a speed bump to exchange listing for companies completing reverse mergers.

The original proposals for a so-called “seasoning” period for post-reverse merged companies were first published in the middle of 2011. The Nasdaq proposal[21] (as amended) was filed on June 8, 2011. The New York Stock Exchange (NYSE)[22] and its affiliate’s, NYSE Amex (Amex),[23] proposals were filed on August 4, 2011. The author submitted a comment letter[24] to the NYSE Amex proposal on August 29, 2011, and a comment letter[25] to the Nasdaq proposal on August 30, 2011. The NYSE and Amex proposals were virtually identical in both their justifications for the proposed action and the structure of the new limitations. Nasdaq’s justifications were slightly different, as was their proposed solution.

NYSE and Amex Proposals

The NYSE and Amex proposals would have required that a company completing a reverse merger with a shell company “season” its trading on an over-the-counter market or another national securities exchange for 12 months before an “uplisting” would be permitted to either of these exchanges. The only exception would be if the company were conducting a large public offering to raise net proceeds of at least $40 million in a so-called “firm commitment” transaction.  A broker-dealer acting as underwriter in raising this money must have substantial capital in order to be permitted to conduct a firm commitment offering. Strangely, while every other listing standard for NYSE is higher than those for Amex, the $40 million minimum offering to avoid seasoning was the same in both the NYSE and Amex proposals.

The proposals also required that before uplisting after a year of trading over-the-counter, the company’s stock must have been trading for a “sustained period” at the minimum price required to be listed. Finally, the company must have completed one full year of regular SEC filings. Interestingly, the proposal suggests that it will treat as reverse mergers combinations with certain public companies that would not technically qualify as shells under the SEC definition. If a company is not particularly active, they might consider it as a shell for purposes of seasoning.

The justifications offered as to why these actions are necessary: (1) allegations of accounting fraud, (2) suspension of trading or registration of some reverse merger companies, (3) an SEC enforcement action against an auditing firm involved with reverse mergers, and (4) the issuance of an SEC bulletin on reverse mergers.

Why is seasoning the best response to this? The proposals suggest greater assurance of reliable reporting, time for auditors to detect fraud, ability to address internal control weaknesses, and time for market and regulatory scrutiny of the company.

Nasdaq Proposal

The Nasdaq proposal required only six months of seasoning, but it did not provide an exception for any public offering, even if firm commitment. Nasdaq originally proposed avoiding seasoning with a firm commitment offering, but the June 2011 amendment to its proposal eliminated that exception. It required maintenance of the price you would need to initially list for at least 30 of the 60 trading days before applying. It further required filing at least six months of activity on SEC reports, and similarly expanded the definition of shell company much as in the NYSE and Amex proposals.

Nasdaq used most of the same bases for the proposal as NYSE and Amex but added a few more: (1) concerns raised that certain promoters have regulatory histories or are involved in transactions that are “disproportionately beneficial” to them, (2) the PCAOB has cautioned accounting firms having “identified issues” with audits of these companies, and (3) Nasdaq’s being aware of situations where it appeared that efforts to manipulate prices took place to meet Nasdaq’s minimum price.

An additional reason they believed seasoning would be helpful was that the Financial Industry Regulatory Authority (FINRA), which regulates broker-dealers, can monitor trading patterns and “uncover potentially manipulative trading.” 

Final Rules

Ultimately the final rules on the seasoning requirements passed[26] in November 2011, and each rule essentially harmonized all of the proposals into one so that all three exchanges are applying essentially the same seasoning requirement. In all three final rules, seasoning is required (trading on a market other than the larger exchange) for at least one full fiscal year of the company, the stock must trade for a sustained period at the minimum level required to list before uplisting, and a “firm commitment” underwriting with gross proceeds of at least $40 million allows a company to bypass seasoning on any of the three exchanges. In addition, SPACs that trade over-the-counter would also be subject to seasoning after they complete reverse mergers.


Comment

Unfortunately, the rush to attack reverse mergers because of the issues with Chinese companies fails to acknowledge a number of things. First, a number of Chinese companies facing allegations of fraud completed IPOs rather than reverse mergers.[27] This includes Longtop Financial, whose IPO underwriter was Goldman Sachs and auditor was Deliotte.[28] Second, a good number of the Chinese companies accused of fraud did complete reverse mergers.  However, these mergers combined with Form 10 shells that had no trading in the stock until they completed a full public offering, with all the same investor protections as an IPO.[29] Thus, the problem is not with the method by which these companies went public, it is about the companies themselves. It is disappointing that the regulators chose a broad brush, overly expansive approach in their offensive against reverse mergers.

Not long ago, regulators levied hundreds of millions of dollars in fines against major underwriting firms following illegal activities in the IPO market of the late 1990s.[30] One could therefore ask which approach is the most legitimate way to take a company public.

More specifically, the seasoning rules represent the wrong reaction to a very limited problem. This draconian idea is responding to what to this day remain essentially mere allegations of fraud. Currently the SEC and Department of Justice are investigating whether fraud took place and discovery is beginning in class action lawsuits.[31] There have been no new allegations of fraud in a number of months, leading one to assume that even if fraud is found, the issue is now essentially contained to the several dozen Chinese companies being accused. Also, a number of the cases have been thrown out of court for failure to provide specific evidence of fraud other than the allegations of short sellers.

The exchanges also suggest that seasoning is necessary because some reverse merger companies’ trading was suspended. This has mostly occurred when companies fail and then cease their public reporting, or issue questionable press releases. Since companies completing reverse mergers are generally less mature than companies conducting traditional IPOs, a larger percentage is inherently likely to fail. It is unclear how seasoning will address this problem. In fact, it is likely to make failure more likely since it is more difficult for a company to raise capital when trading over-the-counter.

Regarding the backgrounds of promoters, mentioned by Nasdaq, the exchanges have broad discretionary authority to examine the regulatory histories of and financial arrangements made with these individuals. The exchange can simply refuse to list a company which includes questionable characters or compensation they deem unreasonable. And again, it is not clear how seasoning the company addresses this issue at all.[32]

Nasdaq also suggests that it wants to impose seasoning because some companies uplisting from the over-the-counter markets may have artificially inflated their trading prices to meet the minimum initial listing price. But many reverse mergers are completed with Form 10 shells, after which a public offering is undertaken. In this case there is no trading at all until the company is listed on the national exchange, so the trading price inflation issue disappears completely. Indeed, seasoning might lead to the perverse result of incentivizing artificial price inflation to complete the uplisting after mandatory trading over-the-counter, whereas permitting the continuation of Form 10 shell mergers and public offering uplists would have clearly eliminated the concern.

To suggest that the issuance of an SEC bulletin warning of the risks of reverse mergers or the PCAOB’s having “identified issues” with reverse merger audits is a reason for tightening exchange regulation, respectfully, does not in and of itself provide substantive support for this extreme reaction. And the fact that there has been only one SEC enforcement action against one accounting firm does nothing to suggest there is a systemic problem requiring such a dramatic response.

Even if one assumes the justifications for action are legitimate, requiring trading over-the-counter results in a number of unintended consequences without adequately addressing the alleged reasons for the proposals.

The exchanges all now require prices in over-the-counter trading during seasoning to be at the same level as they expect for an initial listing on the exchange. But as we know, governance and other obligations on the over-the-counter markets (such as the OTC Bulletin Board and the platforms of OTC Markets Group) are substantially less stringent than on exchanges. Therefore, it is a much greater challenge to develop volume in stock trading because analysts do not generally follow these stocks and certain funds and brokerages are prohibited from purchasing their stock.

As a result, the requirement to maintain a particular stock price as high as one expects on the exchange is simply unfair and unrealistic to achieve on the OTC markets. Trading in the stock should not be a requirement of seasoning.  A period where all SEC filings are made in a timely and complete fashion and can be examined by exchange officials would have seemed sufficient enough. This could well result in the next great software or defense company being denied the opportunity for an uplisting because of the very challenges of the trading platform that the new rules relegate them to.  Indeed, a primary reason that Form 10 shells became so popular was the opportunity to complete a reverse merger and private financing, followed by a public offering directly onto a national exchange, all while completely bypassing the over-the-counter markets and their unique challenges. Seasoning may well skewer this efficient and investor-protective method of financing and listing a company.

It also makes no sense that both the NYSE and the Amex have imposed the same minimum offering amount to bypass seasoning when all other listing criteria are lower on Amex than on NYSE. It would have been preferable, as pointed out in this author’s comment letters, that there be no minimum to a public offering, or if a minimum is required, offer a lower one for Amex, perhaps $15 million. This might also have worked for Nasdaq. The same investor protections apply in a small firm commitment public offering as a larger one.

Historically, regulators targeted reverse mergers because there was a period during which fraud was a serious problem.  It was unfortunate that there is now another attempt to dismantle a technique which the SEC itself had declared to be legitimate, and where the alleged fraud took place, if at all,  in a narrow and potentially severable corner of the space, and where the same alleged fraud may have occurred in IPOs and transactions where full public offerings took place.

In 2010, at the SEC’s Government-Business Forum on Small Business Capital Formation, SEC Chairman  Mary L. Schapiro said “reliable data suggests that small businesses have created 60-to-80 percent of net new American jobs over the last ten years. Making sure small businesses can attract the investments they need to grow and thrive is vital to America’s economic recovery.”[33] One can only hope that Chairman Schapiro and her fellow commissioners reconsider their position on this ill-advised set of new rules and instead do all they can to reduce impediments to capital formation for these key engines of the American economy, with an appropriate balance to ensure that small company investors are well protected.

 

Preferred citation: David N. Feldman, Comments on Seasoning of Reverse Merger Companies Before Uplisting to National Securities Exchanges, 2 Harv. Bus. L. Rev. Online 140 (2012), https://www.hblr.org//?p=2133.

* David N. Feldman is a partner at Richardson & Patel and is considered one of the country’s leading experts on alternatives to traditional initial public offerings, including reverse mergers.  He is the author of Reverse Mergers and Other Alternatives to a Traditional IPO (Bloomberg Press, 2d ed. 2009), which has been translated into Chinese and is regarded as the “seminal text” on reverse mergers.  Mr. Feldman also maintains and contributes to www.reversemergerblog.com, a blog discussing the latest issues in reverse mergers and visited by thousands of professionals each month.

[1] See, e.g., Bill Meagher, Year in Review: Deal Flow, APOs Grow Significantly, 7 The Reverse Merger Report, No. 1, Jan. 13, 2011 (reporting 246 completed reverse mergers in 2010, a 25% increase from the prior year).

[2] David N. Feldman & Steven Dresner, Reverse Mergers: Taking a Company Public Without an IPO 23 (Bloomberg Press, 2d ed. 2009) (noting that most reverse merger “transactions involving legitimate players completing proper due diligence and negotiation of documents” can be completed within a “three- to four-month process if there is a contemporaneous financing,” but that a typical IPO “usually takes nine to twelve months from start to finish and can easily take longer”).

[3] Id. at 22 (noting that “[m]ost reverse mergers can be completed for under $1 million” including “the cost of acquiring the public shell” and “transactions costing less than $200,000 [are] not unusual;” however, an IPOs are “much more expensive, costing at least several million dollars”).

[4] Use of Form S-8, Form 8-K, and Form 20-F by Shell Companies, Securities Act and Exchange Act Release No. 8587, 85 SEC Docket 2825 (July 15, 2005).

[5] General Rules and Regulations, Securities Act of 1933, Persons Deemed Not to Be Engaged in a Distribution and Therefore Not Underwriters, 17 C.F.R. § 230.144 (2012).

[6] Revisions to Rules 144 and 145, Securities Act Release No. 8869, 92 SEC Docket 110, at n.172 (Dec. 6, 2007) (noting that “Rule 144(i)(1)(i) is not intended to capture a ‘startup company’ … in the definition of a reporting or non-reporting shell company, as [the staff] believe[s] that such a company does not meet the condition of having ‘no or nominal operations’”).

[7] Securities Act and Exchange Act Release No. 8587, supra note 4, at 2.

[8] Id. at 10.

[9] See Rule 144(d), supra note 5 (“Holding period for restricted securities”).

[10] Securities Act Release No. 8869, supra note 6, at 21 (revising paragraph (i) of Rule 144).

[11] Letter from David Feldman, Esq., et al. to SEC (Oct. 1, 2008), available at http://www.sec.gov/rules/petitions/2008/petn4-572.pdf.

[12] Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Pub. L. No. 101-429, 104 Stat. 931 (1990).

[13] Regulation C-Registration, Securities Act of 1933, Offerings by Blank Check Companies, 17 C.F.R. § 230.419 (2012).

[14] Form 10 is a registration under the Securities Exchange Act of 1934 while Rule 419 was promulgated under the Securities Act of 1933.

[15] Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010, Public Company Accounting Oversight Board, Mar. 14, 2011, available at http://pcaobus.org/Research/Documents/Chinese_Reverse_Merger_Research_Note.pdf.

[16] See, e.g., Bill Alpert & Leslie P. Norton, Beware this Chinese Export, Barron’s, Aug. 28, 2010, available at http://online.barrons.com/article/SB50001424052970204304404575449812943183940.html.

[17] See Timothy P. Harkness, Chinese Companies Under Fire: The Recent Boom in U.S. Securities Cases Against Chinese Public Companies, Thomson Reuters Business Law Currents, Feb. 24, 2012, available at http://currents.westlawbusiness.com/Article.aspx?id=eff19be9-2bfc-4568-95b3-f0a263919b8e (noting the increasing pace of securities class action filings against Chinese companies during 2011, especially against companies employing reverse merger techniques to raise money).

[18] Investor Bulletin: Reverse Mergers, Office of Investor Education and Advocacy at the SEC (Jun. 2011), available at http://www.sec.gov/investor/alerts/reversemergers.pdf

[19] Activity Summary and Audit Implications, supra note 15.

[20] See, e.g., Harkness, supra note 17 (noting an FBI raid on New York Global Group, a company known for helping arrange so-called “reverse mergers” for Chinese companies).

[21] Proposed Rule Change to Adopt Additional Listing Requirements for Reverse Mergers, Exchange Act Release No. 64633, File No. SR-NASDAQ-2011-073, 2011 WL 2292155 (June 8, 2011)..

[22] Proposed Rule Change Amending Sections 102.01 and 103.03 of the Exchange’s Listed Company Manual to Adopt Additional Listing Requirements for Reverse Mergers, Exchange Act Release No. 65034, File No. SR-NYSE-2011-38, 2011 WL 3407846 (Aug. 4, 2011).

[23] Proposed Rule Change Amending Section 101 of the NYSE Amex Company Guide to Adopt Additional Listing Requirements for Companies Applying to List After a Reverse Merger, Exchange Act Release No. 65033, File No. SR-NYSEAmex-2011-55, 2011 WL 3407845 (Aug. 4, 2011).

[24] Letter from David Feldman, Esq. to SEC (Aug. 29, 2011), available at http://www.sec.gov/comments/sr-nyseamex-2011-55/nyseamex201155-1.htm.

[25] Letter from David Feldman, Esq. to SEC (Aug. 30, 2011), available at http://www.sec.gov/comments/sr-nasdaq-2011-073/nasdaq2011073-1.htm.

[26] Approval to Rule Change, Release No. 65708, File No. SR-NASDAQ-2011-073, 2011 WL 5434020 (Nov. 8, 2011); Granting Approval to Rule Change, Release No. 65709, File No. SR-NYSE-2011-38, 2011 WL 5434021 (Nov. 8, 2011); Filing of Rule Change, Release No. 65033, File No. SR-NYSEAmex-2011-55, 2011 WL 3407845 (Aug. 4, 2011).

[27] Floyd Norris, The Audacity of Chinese Frauds, N.Y. Times, May 26, 2011, at B1.

[28] Id.

[29] David Feldman, Reverse Merger Report Touts Form 10 Shells, Reverse Merger Blog, Feb. 21, 2011, available at http://www.reversemergerblog.com/2010/02/21/reverse-merger-report-touts-form-10-shells.

[30] See, e.g., Andrew Countryman, Regulators Join Forces in Effort to Curb Conflicts, IPO Excesses, Chicago Tribune, Oct. 4, 2002, available at http://articles.chicagotribune.com/2002-10-04/business/0210040097_1_ipo-process-analyst-conflicts-gen-eliot-spitzer.

[31] See Azam Ahmed, Chinese Reverse-Merger Companies Draw Lawsuits, N.Y. Times DealBook, July 26, 2011, available at http://dealbook.nytimes.com/2011/07/26/chinese-reverse-merger-companies-draw-lawsuits.

[32] NYSE Listed Company Manual §703.08, available at http://nysemanual.nyse.com.

[33] Mary L. Schapiro, Remarks to the SEC Government-Business Forum on Small Business Capital Formation (Nov. 18, 2010), available at http://www.sec.gov/news/speech/2010/spch111810mls.htm.

By

In Dodd-Frank’s Shadow: The Declining Competitiveness of U.S. Public Equity Markets

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David Daniels*

As we enter into 2011, things are looking up. The Dow Jones has recently broken through 12,000 and is climbing to pre-recession heights. The economy has emerged from the greatest downturn since the Great Depression and continues to show modest growth.[1] Unemployment is slowly decreasing.[2] But all is not well. A potentially worrying trend that gained traction at the beginning of the millennia continues to unfold: the decline of the competitiveness of U.S. public equity markets.

For example, consider the U.S. primary equity markets. In 2000, these markets attracted 54% of all global initial public offerings (IPOs)—IPOs by foreign companies issued on at least one public exchange outside the company’s domestic market.[3] Similarly, foreign companies raised about 82% of the dollar value of all global IPOs on U.S. public exchanges.[4] The numbers were 26% and 10%, respectively, in 2010.[5] Foreign companies, it seems, have been increasingly likely to forego our public equity markets and list elsewhere. These figures, however, do not tell the whole story. So-called Rule 144A IPOs—issuances done on U.S. private equity markets—by foreign companies have risen markedly in proportion. Over the past ten years, the number of these issuances as a percentage of total global IPOs in the U.S. has increased from 62% to 81%.[6] The percentage value of these IPOs has grown even faster—from 60% to 95%.[7]

The proportionate rise in private equity issuances is especially important. Although technology has improved access to foreign markets for retail investors, the private equity market continues to be accessible only to institutional entities and the very wealthy.[8] More tellingly, foreign companies cross-listed on U.S. exchanges incur, on average, a 2.47% lower cost of capital than in Rule 144A markets (11.54% vs. 14.01%, respectively).[9] Since companies accessing these private equity markets are free from most U.S. securities regulation, including registration and liability under the Securities Act of 1933 and the Sarbanes-Oxley Act,[10] the rising regulatory and litigation burden imposed by such legislation may be an important factor in accounting for the proportionate increase in Rule 144A market issues and foreign companies’ shift to overseas exchanges.

Indeed, global financial services executives have confirmed that the litigious nature of U.S. capital markets is a central factor in undermining the competitiveness of those markets.[11] The perceived unfairness and unpredictability of the U.S. legal system have driven companies away from our public exchanges; 46% of executives surveyed believed the U.K. had more predictable legal outcomes compared with 16% for the U.S.[12] Likewise, 43% of executives thought the U.K. had a fairer legal process versus 14% for the U.S.[13] Furthermore, a majority of executives felt companies listed in the U.K. were less likely to be sued than those listed on our public exchanges.[14] However, while there are benefits of a stricter legal system, they may not outweigh the liability costs imposed on companies trading publicly in U.S. equity markets.

There is no doubt that tough enforcement mechanisms serve key deterrence and compensatory goals. Wronged shareholders should be compensated for their losses and corporate wrongdoers must be deterred from managerial shirking and self-dealing. Yet the U.S. legal system may not be accomplishing either of these goals in the securities litigation context. Deterrence of wrongdoing is undermined by corporations and their insurers typically bearing the full cost of any settlement against individual defendants.[15] Federal securities class actions, a feature unique to the American legal system,[16] fail to adequately compensate victims for their losses. Because the vast majority of federal security class actions are either settled or dismissed,[17] shareholder compensation often falls short. The median ratio of class action settlement to investor losses, which has steadily declined over the past fifteen years, is now at only 2.4%.[18] While average settlements, adjusting for outliers, are at an all-time high,[19] so are plaintiff’s attorney fees that further reduce the value of what injured shareholders ultimately receive.[20] Section 308 of the Sarbanes-Oxley Act was intended to streamline the regulatory process by adding civil penalties obtained from defendants to a fund used to compensate plaintiffs,[21] but the number of federal securities class action filings has not significantly declined over the last decade.[22]

Several other factors have led to the decline in the competitiveness of U.S. public equity markets. Increasing liquidity in foreign and private markets and better regulation of foreign public markets have each eroded the competitive advantage that our public exchanges once had.[23] Improvements in technology have made it easier for U.S. investors to invest in foreign markets.[24] Not only is there little that can be done to reverse the impact of these factors; such advancements are actually beneficial for us. U.S. companies can safely tap into a wider range of markets for funding, and U.S. investors can better diversify their holdings by investing overseas with a smaller increase in risk or inconvenience. Instead, policy makers should focus on a fourth factor: the regulatory costs imposed on companies choosing to list on our public equity markets versus the foreign and private alternatives. Such costs have been cited by financial services CEOs as the most important issue in determining the international competitiveness of our public equity markets.[25]

Policy makers should be mindful, however, of reducing regulatory costs too much. A “race to the bottom” would not improve our markets’ competitive position and would only harm their integrity. Instead, regulatory costs should be balanced against increasing transparency and accountability so that risk and agency costs are reduced. In turn, corporate borrowing costs would decrease and share prices should increase.

A commonly cited provision that goes too far in increasing costs without a commensurate increase in benefits is Section 404 of the Sarbanes-Oxley Act.[26] Envisioned as a way of bolstering the credibility of public companies’ internal control systems, Section 404’s costs of verification and disclosure have ended up being many times greater than expected.[27] First-year implementation costs of internal control systems for large companies were eighty times greater than originally planned and recurring costs vastly exceed initial estimates.[28] Worse yet, smaller companies were disproportionately burdened.[29] Although Section 404 addressed serious internal control issues that led to the corporate scandals of the dot-com era and likely increased intra-firm transparency, critics argue its benefits are difficult to measure, thus making its costs all the harder to justify. [30]

In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) was signed into law. One of the things it did was to ease the burden Section 404 had on small companies and introduce several corporate governance mandates that aim to increase transparency and accountability of companies listed on U.S. public equity markets.[31] Unfortunately, neither of these goals is likely to be met in the short term.

One of Dodd-Frank’s most ambitious corporate governance provisions, Section 971, aimed to open up the director nomination process to shareholders via proxy and instill more accountability upon corporate directors.[32] Critics, however, argue that improved shareholder proxy access would lead to harmful investor activism[33] and an unnecessary focus on political issues diverting attention away from creating shareholder wealth.[34] Due to a legal challenge by the U.S. Chamber of Commerce, the SEC has stayed implementation of the provision until the 2012 proxy season.[35]

Another promising provision, Section 951, was designed to give shareholders a non-binding advisory vote on executive and director compensation,[36] but its efficacy in improving managerial accountability has also been called into question. Specifically, opponents contend it will shift power to proxy advisory firms and not to individual shareholders who are seldom involved in the voting process.[37]

Ultimately, the Dodd-Frank Act does not go far enough toward improving the competitiveness of our public equity markets. Much more needs to be done. Securities litigation reform is one possibility, but such change is unlikely. Instead, policy makers should focus on better balancing the costs of regulation against increased corporate transparency and accountability. If nothing is done, our leadership in providing the best public equity markets will continue to erode.

* J.D. Candidate, 2013, Harvard Law School.

[1] National Income and Product Accounts Gross Domestic Product, 4th Quarter and Annual 2010 (Second Estimate), Bureau of Economic Analysis (March 21, 2011), http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm.

[2] Unemployment Rate – Updated Monthly, http://employeeissues.com/blog/unemployment-rate/ (Mar. 21, 2011).

[3] Committee on Capital Markets Regulation, Share of Global IPOs (Narrowly Defined) Captured by U.S. Exchanges (December, 2010), http://www.capmktsreg.org/competitiveness/2010Q3update/(2A)Share_of_Global_IPOs_Captured_by_US_Exchanges(narrow).pdf .

[4] Id.

[5] Id.

[6] Committee on Capital Markets Regulation, Rule 144A IPOs by Foreign Companies as a Percentage of Total Global IPOs in the U.S. (December, 2010), http://www.capmktsreg.org/competitiveness/2010Q3update/(4)Rule_144A_IPOs_by_Foreign_Companies_as_a_Percentage_of_Total_Global_IPOs_in_the_US.pdf.

[7] Id.

[8] Committee on Capital Markets Regulation, Committee Interim Report, 34 (November 30, 2006), http://www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf.

[9] Luzi,Hail & Christian Leuz, Cost of Capital Effects and Changes in Growth Expectations around U.S. Cross-Listings, 52 (European Corp. Goverance Inst., Paper No. 46, 2006), http://www.law.yale.edu/documents/pdf/cbl/HL_ECGI_Fin461.pdf .

[10] Committee on Capital Markets Regulation, supra note 6, at 45.

[11] See Michael R. Bloomberg & Charles E. Schumer, Sustaining New York’s and the U.S.’ Global Financial Services Leadership, 73 (2007).

[12] Id. at 76.

[13] Id. at 76.

[14] See id. at 76.

[15] Committee on Capital Markets Regulation, supra note 6, at 78.

[16] Id. at 71.

[17] National Economic Research Associates, Trends 2010 Year-End Update, 13 (December 2010).

[18] Id. at 25.

[19] Id. at 18.

[20] Id. at 23.

[21] Committee on Capital Markets Regulation, supra note 6, at 82.

[22] See National Economic Research Associates, supra note 14, at 2.

[23] Committee on Capital Markets Regulation, supra note 6, at 4.

[24] Id. at 4.

[25] Bloomberg, supra note 9, at 79.

[26] Stephen M. Bainbridge, Corporate Governance and U.S. Capital Market Competitiveness, 16 (UCLA School of Law, Paper No. 10-13, 2010), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1696303.

[27] Id. at 23.

[28] Id. at 23–24.

[29] Id. at 24.

[30] Id. at 29.

[31] Stephen M. Bainbridge, The Corporate Governance Provisions of Dodd-Frank, 2 (UCLA School of Law, Paper No. 10-14, 2010), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1698898##.

[32] Id. at 2.

[33] Id. at 11.

[34] Paul Atkins, The SEC’s Sop to Unions, Wall St. J., Aug. 27, 2010, at A15.

[35] Bainbridge, supra note 29, at 11.

[36] Id. at 2.

[37] See Stephen M. Bainbridge, Will the Unaccountable Power of RiskMetrics Put Teeth in the Dodd Bill’s Say on Pay Provision?, ProfessorBainbridge.com (Apr. 22, 2010), http://www.professorbainbridge.com/professorbainbridgecom/2010/04/will-the-unaccountable-power-of-risk-metrics-put-teeth-in-the-dodd-bills-say-on-pay-provision.html.

Preferred citation: David Daniels, In Dodd-Frank’s Shadow: The Declining Competitiveness of U.S. Public Equity Markets, 1 Harv. Bus. L. Rev. Online 56 (2011), https://www.hblr.org//?p=1072.

By

Questioning the 500 Equity Holders Trigger

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William K. Sjostrom, Jr.

An obscure provision of the Securities Exchange Act of 1934 (Exchange Act)[1] has received unprecedented attention in recent months because of the prominent role it appears to be playing in Facebook’s decision on going public. Specifically, Exchange Act Section 12(g)(1) requires any company with  “total assets exceeding [$10,000,000] and a class of equity security . . . held of record by five hundred or more . . . persons” to register such security under the Exchange Act.[2] The measurement date for these thresholds is the last day of a company’s fiscal year. It then has 120 days from that date to register. Today, the practical effect of this rule is to force certain types of firms into the public markets earlier than is desirable. A shift from a shareholder-based trigger to one based on trading volume would preserve the Rule’s underlying policy concerns while mitigating this unintended effect.

A company registers by filing a Form 10 with the Securities and Exchange Commission (SEC).[3] Form 10 requires the company to disclose, among other things, a detailed description of its business, properties, transactions with management, legal proceedings, and executive compensation as well as its audited financial statements.[4] Once a company has a security registered under the Exchange Act, it is required to file with the SEC annual, quarterly, and current reports and must comply with SEC proxy regulations.[5] Additionally, its directors, officers, and holders of ten percent or more of the total shares outstanding become subject to the short-swing profit rules under Exchange Act Section 16.[6] Basically, the company has the same SEC obligations as a public company but does not receive the benefits of going public, principally a large infusion of equity capital and liquidity for its stock.

Facebook has never been in a hurry to go public, especially because it has been able to privately raise plenty of capital. Widespread speculation, however, has the company filing to go public in April 2012. This is because Facebook has well over $10 million in total assets and recently disclosed that it plans to surpass 499 shareholders this year.[7] December 31 is the last day of Facebook’s fiscal year, so assuming it has 500 or more shareholders on that date, it will be required to file a Form 10 by April 29, 2012. People figure that Facebook will conclude that it might as well go public if it has to file public company reports regardless.

Google faced a similar situation in 2003. It had total assets of well over $10,000,000 and more than 500 shareholders on December 31, 2003, the close of its fiscal year.[8] Thus, it ended up filing a Form 10 on April 29, 2004, the same day it filed its IPO registration statement. As Google noted in its registration statement: “By law, certain private companies must report as if they were public companies. The deadline imposed by this requirement accelerated our decision [to go public].”[9]

Section 12(g)(1) is not actually designed to pressure private companies to go public sooner than they otherwise would, although it had that effect on Google and appears that it will have the same effect on Facebook. Congress added it to the Exchange Act in 1964 “[t]o extend to investors in certain over-the-counter securities the same protection now afforded to those in listed securities by providing that the issuers of certain securities now traded over the counter shall be subject to the same requirements that now apply to issuers of securities listed on an exchange.”[10] Up until that time, many public companies whose shares were actively traded, but not on an exchange, were not subject to Exchange Act reporting requirements, proxy regulations, or short-swing profit rules. As the SEC recently noted, “the registration requirement of Section 12(g) was aimed at issuers that had ‘sufficiently active trading markets and public interest and consequently were in need of mandatory disclosure to ensure the protection of investors.’”[11]

Number of record holders may have been a sensible proxy in 1964 for whether there was an active trading market in a company’s securities, but I do not think it is a sensible proxy today. There was no trading market in Google’s stock before it went public. One has developed recently for Facebook shares, but this has little to do with the number of Facebook shareholders. Rather, it is likely attributable to Facebook’s having over 500 million active users, making it perhaps the most well-known private company in the world.

More importantly, with the disappearance of the small IPO market over the last decade and a half, many companies are forced to remain private for much longer than similar companies had to in the past.[12] As a result, these companies have to do more rounds of private equity financing with each round adding more shareholders and getting the company closer to the 500-shareholder trigger. Unlike Google and Facebook, however, these companies do not have underwriters waiting in the wings to take them public when they do cross the 499 shareholder threshold. Thus, they may have to curtail their financing activities to ensure that they do not cross the threshold.

The bottom line is that Section 12(g) causes some companies to go public sooner than they otherwise would and constrains other companies’ ability to raise equity financing. Neither of these outcomes is desirable. Hence, the SEC should adopt a new rule exempting from Section 12(g) private companies with no active secondary trading in their securities.[13]

In that regard, the new rule could define “active secondary trading” as a volume greater than an average of ten trades per month during a company’s fiscal year.[14] A company could control the number of trades in its stock by imposing a restriction on its shares requiring company approval in advance of any transfer, with the restriction automatically expiring if and when the company goes public.[15]

The benefit of this approach is that Section 12(g) will then generally only capture companies with securities that are actively traded and will therefore much more closely align with the purpose behind its enactment. As a result, companies such as Google and Facebook will be able to control the timing of becoming subject to Exchange Act registration and therefore will not be forced to go public earlier than they want. Additionally, private companies with no active secondary trading in their securities will be able to seek private equity capital without concern for ending up with more than 499 shareholders.

[1] Securities Exchange Act of 1934, 15 U.S.C. § 78 (2006).

[2] 15 U.S.C. § 78(g)(1)(B). Note that Section 12(g)(1) actually specifies a “total assets” cutoff of $1 million, but Rule 12g-1 under the Exchange Act exempts issuers with $10 million or less in total assets from the application of Section 12(g)(1), essentially setting the cutoff at $10 million. See 17 C.F.R. § 240.12g-1.

[3] 15 U.S.C. § 78(12)(b).

[4] See U.S. Sec. & Exch. Comm’n, Form 10, pt. I, at 2–3, available at http://www.sec.gov/about/forms/form10.pdf.

[5] 15 U.S.C. § 78(13).

[6] 15 U.S.C. § 78(16).

[7] See Anupreeta Das et. al, Facebook Sets Stage for IPO Next Year, Wall St. J., Jan. 6, 2011, at A1.

[8] Google Inc., Registration Statement (Form S-1), at 36 (Apr. 29, 2004), available at http://www.sec.gov/Archives/edgar/data/1288776/000119312504073639/ds1.htm.

[9] Google Inc., Registration Statement (Form S-1), at iv (Apr. 29, 2004), available at http://www.sec.gov/Archives/edgar/data/1288776/000119312504073639/ds1.htm.

[10] H.R. Rep. No. 88-1418, at 1 (1964), reprinted in 1964 U.S.C.C.A.N. 3013, 3027.

[11] Exemption of Compensatory Employee Stock Options from Registration Under Section 12(g) of the Securities Exchange Act of 1934, Exchange Act Release No. 34-56010, 2007 WL 1953119 at *2 (July 5, 2007) (emphasis added) (quoting Reporting by Small Issuers, Exchange Act Release No. 23,407, 1986 WL 703825 at *2 (July 8, 1986)).

[12] See David Weild & Edward Kim, Grant Thornton LLP, Market Structure is Causing the IPO Crisis 7 (2009), available at http://www.grantthornton.com/staticfiles/GTCom/Public%20companies%20and%20capital%20markets/Files/IPO%20crisis%20-%20Sep%202009%20-%20FINAL.pdf.

[13] Although I do not raise it here, elsewhere I have argued that the SEC should adopt a new rule exempting private companies with 100 or fewer non-accredited investors from Section 12(g). See William K. Sjostrom, Jr., Carving a New Path to Equity Capital and Share Liquidity, 50 BC L. Rev. 639, 665–68 (2009). As I explain in that article, the SEC has ample authority under the Exchange Act to adopt Section 12(g) exemptions. See id. at 670–72.

[14] The rule could exclude from the count transfers made by gift, to family members, to trusts for estate planning purposes, and the like.

[15] The company would likely need to put the restriction in place prior to selling its shares to investors.

Preferred citation: William K. Sjostrom, Jr., Questioning the 500 Equity Holders Trigger, 1 Harv. Bus. L. Rev. Online 43 (2011), https://www.hblr.org//?p=1028.