Section 1 - Practising Law Institute
From PLI’s Course Handbook
Understanding the Securities Laws 2008
#14665
10
alternatives to traditional
public offerings
Michael Kaplan
Davis Polk & Wardwell
Alternatives to Traditional Public Offerings
Michael Kaplan
Davis Polk & Wardwell
Introduction
SPACs / Reverse Mergers
Rule 144A IPOs
144A Trading Platforms
AIM Listings
PIPEs / Registered Directs
Rights Offerings
Spin-Offs
SPACS/Reverse Mergers
What is a SPAC?
• Also known as a “blank check company”
• A public shell organized to acquire one or more businesses or assets
• May limit target business to an industry or region, focus on an industry or region, or have no limit or focus for acquisition
• The SPAC raises money in its IPO which it places in trust until it completes its first acquisition (usually within 24 months)
• If it cannot find one within 24 months (or its shareholders vote “no”), it unwinds
• A “public” private equity fund set up by a management team.
Why Do I Care?
• Since 2005, 144 SPACs have raised $21 billion and an additional 72 SPAC IPOs are pending
• Completed IPOs with proceeds over $100 million: 2004 (1), 2005 (9), 2006 (11), 2007 (37)
• In 2008, to date there have been 7 completed SPAC IPOs with proceeds over $100 million
Why a SPAC?
• A SPAC offers advantages to both management and investors:
Management:
• Management team can form SPAC with very limited capital and without need for sponsor.
• SPACs are sold based on management experience in the industry rather than LBO experience although we are increasingly seeing private equity sponsors.
• Time to market is shorter than for a first-time private equity fund and with perceived higher certainty of execution.
• Instead of answering to sponsor, management answers to a majority independent board of directors and multiple public stockholders, none of which are in a controlling position.
• Management holds liquid equity and options in a public company with visible stock pricing rather than illiquid carried interest paid over time.
• On the other hand, management gets no compensation until acquisition is completed (no “management fee”).
Investors:
• Investors benefit from a less expensive investment with a fair amount of liquidity.
• On the other hand, much of the capital call is moved up-front.
• Because shareholders must vote to approve any transaction, a SPAC cannot offer the same certainty of closing to targets, making it a less competitive bidder in a competitive situation.
How do SPACs Work?
• The management group will invest $25,000 in a SPAC in exchange for 20% of the equity post-IPO; management is restricted from monetizing their equity until after the acquisition is consummated.
• The public purchases units (one share of common stock and one, or sometimes two, warrants).
• Most of the proceeds placed in trust pending acquisition.
• Remaining proceeds fund expenses during the pre-acquisition period, including SEC reporting costs, acquisition due diligence and other expenses.
• Management does not get paid a management fee or other salary until the acquisition closes (although a management company often gets a small administrative fee for office space and administrative services and management does get reimbursement of out-of-pocket expenses).
• In most transactions, management is allowed to pursue other activities without regard to normal business opportunity rules.
• Following an acquisition, the company becomes a normal public company.
• Rule 419 governs any “blank check company” which is defined as:
• A developmental stage company with no specific business plan or purpose, other than to engage in a merger or acquisition with an unidentified company, that is issuing “penny stock” as defined under the Exchange Act.
• A company with $5 million or more of net tangible assets is not a “penny stock.”
• Rule 419 imposes various onerous requirements on blank check companies, including prohibition on trading of its common equity until an acquisition occurs.
• A SPAC is exempt from Rule 419 on the basis that its net tangible assets exceed $5 million; SEC requires filing of 8-K with audited financial statements immediately after IPO to establish exemption.
• While not required, SPAC offerings generally follow the spirit of Rule 419 offerings with a few significant differences.
• 95+% of net proceeds deposited in escrow
• Fair value of first targeted business to represent at least 80% of the amount held in trust
• Units issued in SPAC offerings begin trading on date of IPO
Legal Issues
• Disclosure
• S-1 principally describes structure, investment strategy and industry overview
• No real MD&A or financial statements because no operations.
• Management
• Integrity and experience of management team is key since SPAC is essentially a shell company with few other assets.
• Background report by independent third party an important part of due diligence.
• Acquisitions in contemplation
• As a result of one deal announced soon after pricing of the IPO, the SEC routinely requests all SPACs to affirm that they have done nothing to identify a potential target business.
• As a result, a SPAC generally states in its IPO prospectus that it: (1) has no specific acquisition under consideration; and (2) has not been in contact with any prospective acquisition partner.
• If management or sponsor have other business activities that involve evaluating investment opportunities, the SEC may be particularly focused on this point.
• As a result, it is critical that no research is conducted, or external discussions occur, prior to consumption of the IPO.
• Blue Sky laws
• If securities are listed on the AMEX, NYSE or NASDAQ, then the blue sky securities registration requirements are preempted under the Securities Act.
• If no listing, then Blue Sky laws apply.
• Generally, no retail distribution for SPAC securities traded on the OTC Bulletin Board is permitted as very few states will register a “blank check” offering.
• Unlimited sales may be made to institutional purchasers, defined under the Blue Sky laws to include financial institutions, insurance companies, registered investment companies, pension funds, etc.
• Resales in the secondary market are not restricted.
• Investment Company Act
• Funds held in the trust account are invested in money market funds and/or U.S. government securities so that a SPAC is not deemed to be an investment company under the Investment Company Act.
• A SPAC may not purchase any investment securities, other than money market funds and/or U.S. government securities, in order to rely on Rule 3a-1 under the Investment Company Act.
• All assets outside the trust account should be “good assets” for purposes of the Investment Company Act analysis.
• Shell Company rules
• Although a SPAC is not governed by Rule 419, it does constitute a “shell company” under the new SEC rules effective in August 2005.
• A shell company is an “ineligible issuer” and, as a result, cannot use free writing prospectuses to convey “time of sale” information.
• A shell company is required to indicate its status as a shell company on the cover page of its Form 10-K, 10-Q or 20-F filings.
• As a shell company, a SPAC that is reporting its initial acquisition of a target business must furnish information comparable to that required in an IPO prospectus within four business days. It can no longer simply file a Form 8-K containing a brief description of such acquisition.
• The SEC eliminated the use of Form S-8 for shell companies.
• Makes management equity plans more cumbersome, but not impossible.
• Shell companies are excluded from the safe harbor of Rule 139, which could affect the ability of the underwriter to participate in future offerings to the extent it issues research on the SPAC post acquisition.
SPAC – Reverse Merger
• A “Reverse Merger” is where a company seeking to go public opts, instead of an IPO, to merger with a blank check company, such as a SPAC, and thereby ends up as a public company
• Perceived advantage is that the process avoids market risks endemic to IPO issuers
• On the other hand, there is a risk that the SPAC shareholders, who are entitled to a vote, can vote no
• This happened to a significant number of SPACs in the last year
• While process is different than an IPO, SEC rules require that the SPAC prepare a proxy for the shareholder approval process which includes S-1 level disclosure about the target, and is subject to SEC review; process is effectively the same from an SEC perspective
• Negotiating with potential targets
• SPACs often enter into confidentiality/no-trading agreements with major investors prior to announcement of an acquisition in an attempt to gauge interest.
• SPACs will want to get potential targets to waive claims against the trust. In addition, breakup fees present issues for SPACs.
• Conflict concerns
• The sponsor is incentivized to find a deal to avoid losing its investment.
• The underwriter is incentivized to find a deal to avoid losing its deferred underwriting spread.
• Because of resistance from hedge funds threatening to vote “no” in prior deals, pressure to have investment banks help in soliciting “yes” votes or helping find investors to buy the stock that would vote “yes”.
• Legal constraints / SEC concerns
• Purchase of stock from investors by founders also raises potential issues in certain circumstances. SEC enforcement is currently focused on potential violations of Regulation M, Rule 13e-4, Regulation 14D and Regulation 14E as a result of such purchases.
• Use of projections in roadshow.
Rule 144A IPOs
What is a 144A IPO?
• Process substantially similar to an IPO
• Shares are sold in a broadly distributed offering to institutional investors on a private placement basis
• Roadshow similar to a typical IPO roadshow and includes typical IPO buyers (principal difference is no retail since it is a private placement)
• Shares are traded among institutional investors through DTC after the offering
• Principal difference from an IPO is no SEC review until after the offering
• Accessing the market prior to SEC review can save 8-12 weeks
• Issuer agrees to file a resale registration statement and apply for listing on an exchange after the offering so that shares can eventually be publicly traded
• Documentation is substantially the same as the documentation for a traditional IPO
• Content of offering memorandum substantially the same as a traditional IPO prospectus
• Comfort letters, opinions and other documentation is substantially the same as in a traditional IPO
Why Do I Care?
• Approximately 100 144A IPOs have been completed
• Size and volume of transactions and number of market participants has increased significantly in last few years
How Do 144A IPOs Work?
• Resale Shelf and Piggyback Rights
• Resale shelf
• Issuer covenants to file a resale shelf within 90 days and cause it to be effective within 180 days
• Penalty for failure is typically loss of special bonus to management or, less frequently, liquidated damages
• Piggyback rights
• 144A buyers have the right to sell in the IPO subject to customary underwriters’ cutback
• Piggyback rights apply only to the IPO and not subsequent offerings
• Lock-ups
• Issuer agrees to a typical traditional IPO 180-day lockup
• 144A buyers agree to a 60-day lockup that commences at the time of the traditional IPO
• Designed to protect the eventual traditional IPO
• Issuer is permitted to suspend the resale shelf registration statement during this period to enforce lock-up
• Listing
• Issuer covenants to apply for listing on NASDAQ or the NYSE in connection with the resale shelf
• Difficulty in meeting the listing requirements if 144A IPO is not followed by a traditional IPO
• NYSE requires 2,000 holders of round lots
• NASDAQ NMS requires 400 holders of round lots
• NASDAQ Small Cap requires 300 holders of round lots
• Sarbanes-Oxley
• Sarbanes-Oxley requirements do not begin to apply until the resale shelf registration statement is filed
• Nonetheless, for marketing reasons many issuers voluntarily comply with certain items such as:
• Securing at least one independent board member and undertaking to have 2 more within 90 days and a majority within 180 days (i.e., the requirements applicable if it had been a traditional IPO)
• Creation of an audit committee and compensation committee
• Creation of internal audit function
• Compliance with Section 404 (management assessment of internal controls) is not required for a new registrant until its second annual report on Form 10-K
• Implication of SEC position on PIPEs (see later)
• Presumption that resale registration statements covering 30% or more of the outstanding shares are primary offerings
• Position aimed at “toxic” convertible securities
• Large number of selling securityholders is a helpful fact
• If the offering is deemed to be a primary
• Sellers need to be listed as “underwriters”
• Shelf registration statement not available for S-1 issuers
144A Trading Platforms
• Major banks are in the process of developing private electronic trading platforms.
• For example, Goldman has developed GSTrUE, a private 144A trading system; other banks formed OPUS system.
• Hedge funds and private equity groups are beginning to explore alternative ways to raise permanent capital without submitting to the public disclosure required following an IPO.
• Shares are sold pursuant to Rule 144A but no commitment to register like a traditional 144A IPO.
• Improve reporting and governance requirements to replicate certain SEC rules
• Note: Section 12(g) of 34 Act can require registration if >500 holders; platforms generally police this
AIM Listings
• AIM is the alternative market of the London Stock Exchange, which was launched in 1995.
• Unlike most other markets, AIM does not stipulate minimum listing criteria.
• To gain admission
• requires an admission document that include information about the company’s directors, their promoters, business activities and financial position.
• document is not pre-vetted by the exchange or regulatory authorities but by a nominated advisor
• the offering is done as an institutional placement to avoid the need to prepare a public offering document that would require approval by the U.K. regulatory authorities
• Was popular, but many now view as sub-optimal due to minimal liquidity and trading
• Ongoing Obligations
• interim and full-year financial performance announcements
• developments that might impact future performance and/or share price
• generally no requirement for documentation or shareholder approval for acquisitions or dispositions
Legal Issues
• For U.S. companies, securities must currently be in certificated form to comply with the category 3 restrictions under Regulation S.
• May be of limited use to U.S. companies to avoid registering with the Securities and Exchange Commission.
• If the number of record holders exceeds 500 at the end of a company’s fiscal year, the company must register under Section 12(g) of the Securities Exchange Act of 1934.
PIPEs
• A Private Investment in Public Equity
• Involves a private placement under Section 4(2) of either common stock or convertible securities
• Typically done at a discount to market price
• Investment bank acts as placement agent, but investors buy directly from the issuer and are responsible for their own due diligence
• Purchasers pay issuer directly; with proceeds deposited in advance and held in escrow until closing when all fund together
• Historically, purchasers committed to buy prior to filing a registration statement, but closing was conditioned upon effectiveness to allow immediate resale
• Today, PIPEs investors buy privately, with an obligation to file a resale registration statement after closing
Registered Directs
• Effectively a registered PIPE
• Investment bank acts as agent as opposed to principal
• Placement fee typically comparable to applicable underwriting spread
• Transactions are typically $5 to $50 million, principally in the biotech and health care space
• Typically involves pre-marketing
• Presents same issues as PIPEs
• Because of potential statutory underwriter liability if the bank is named in the prospectus or participates in marketing the diligence procedures are comparable to an underwritten transaction
• Disclosure opinions, comfort letters, etc.
• Logistical issues with closing similar to a PIPE
• Accounts need to deposit money in advance
• Cash needs to be held in escrow until all accounts have funded
Registered Directs / PIPEs
• Legal issues
• Regulation FD / selective disclosure
• Gun jumping
Regulation FD / Selective Disclosure
• Information provided under NDAs to avoid Regulation FD
• Content of material non-public information
• Existence of transaction
• Transaction terms
• Other information such as earnings
• Timing issues
• Account will be restricted from trading once brought over the wall
• NDAs
• Format
• Oral with email confirmation versus written
• Negotiation of written NDAs can be time consuming
• Release from NDA
• If deal happens
• Upon announcement?
• Time for market to absorb the confidential information?
• Potential disclosure issue if deal aborted
• Registered Direct
• Does issuer have a shelf or other suitable registration statement?
• Ability of WKSIs to make pre-filing offers pursuant to Rule 163
• Only available for the issuer
• Facilitation of meetings by bankers raises issues
• Safe harbor for communications 30 days before filing pursuant to Rule 163A
• Not available for references to the offering
• Filing obligation for FWPs
• PIPEs
• No gun-jumping issues
• NYSE and NASDAQ shareholder approval requirements
• Exception for “bona fide” private financings at the greater of book or market
• If not through a broker-dealer then no single purchaser can acquire over 5%
• If through a broker-dealer can be to a single purchaser
• Change of control is a separate issue
• Resale Registration Statements for PIPEs
• For small companies that are not eligible for shelf primary offerings, SEC has taken view that PIPES resale is effectively a primary offering and thus cannot be done on a shelf basis. General guideline is that sale of more than 30% of outstanding float is a primary offering
• Hedging Issues for PIPEs
• Many PIPES investors have sold shares into the public market (these shares are borrowed from others) right after purchasing the restricted shares in the PIPES offering
• SEC has taken the view that if the borrow is covered by shares from the PIPES offering (once registered for resale), then the initial sale was an illegal public distribution of the shares bought in the PIPES offering
• Three courts have rejected this view but SEC has not abandoned the position
Rights Offerings
• Rights are distributed to shareholders entitling them to subscribe for common stock
• Purchase price is at a discount to the market price
• Typically registered (required in the case of a U.S. public company)
Who Does Rights Offerings?
• Foreign issuers
• Not unusual method for raising capital outside the U.S. due to statutory preemptive rights in many jurisdictions
• Micro cap issuers
• OTC and other micro cap issuers use it as a method to raise capital without the need of an underwriter
• Deals typically less than $25 million
• Controlled companies
• To avoid allegations from the public that the terms of the investment were not fair, financial sponsors and other controlling shareholders seeking to invest equity sometimes structure the investment as a rights offering
• Companies emerging from bankruptcy
• Many of the largest rights offerings have been done by companies concurrent with their emergence from bankruptcy
• Of the 25 rights offerings filed in 2007
• 8 were foreign issuers
• 8 were micro/small cap issuers
• 7 were controlled companies
• 2 were emerging from bankruptcy
How do you do a Rights Offering?
• Offer needs to be registered with the SEC on the appropriate form
• S-1 or S-3 for US issuer and F-1 or F-3 for a foreign issuer
• Registration statement is subject to potential review like any other registration statement
• Note WKSIs can use an automatically effective registration statement and avoid review risk
• NYSE requirements – Rule 703
• file a listing application, if possible, at least two weeks before effectiveness
• notice to holders at least 10 days before the record date for the distribution of rights
• if at all practicable, have the registration statement become effective six business days before the record date
• subscription period must be at least 16 days after mailing
• Blue sky rules
• The pre-emption of Blue Sky laws does not apply to warrants or rights, so the offering will need to comply with Blue Sky laws
Standby Commitments
• Backstop or “standby” underwriting commitment
• In the context of foreign issuers and issuers emerging from bankruptcy there is generally a desire for certainty that the rights will be exercised. Accordingly, there is typically a “standby” underwriting commitment from an investment bank.
• Prior to the adoption of Regulation M in 1997, there were very specific rules that limited purchase and sale activities of a standby underwriter in a rights offering. Regulation M effectively deregulated rights offerings and eliminated these requirements.
• Investor commitment
• In the context of a controlled company, the controlling shareholder typically agrees to purchase any shares not purchased by the public.
• Even in the context of a controlled company, there is a role for an investment bank as “dealer manager” for the rights offering.
Business Considerations in Structuring Rights Offerings
• Price
• The larger the discount to the current market price, the more aggrieved shareholders are likely to be – which can lead to litigation
• Transferability of rights
• If rights are transferable, then shareholders uninterested in subscribing could sell the rights, leading to a market in the rights and increasing the likelihood of full subscription
• Controlling shareholder would generally prefer to make rights non-transferable to maximize its ability to purchase in the offering
• Standby underwriter would prefer transferability
• Under-subscription allocation
• Unexercised rights are generally allocated to subscribing holders pro rata based upon
• The number of rights requested or
• The number of rights allocated
• Allocating unexercised rights based on the number of rights allocated will increase the allocation to large shareholders and is therefore generally preferred by controlling shareholders
Spin-Offs
• What is a spin-off?
• Dividend of the stock of a subsidiary to the parent’s shareholders, resulting in a separation of the subsidiary from the parent and creation of a new public company
• What is the motivation for a spin-off?
• Corporate “clarity” and focus
• Market effects
• Overview of areas of law and practice involved
• Spin-off entails a dividend of the stock of the subsidiary under state dividend law
• Shareholder approval issues
• Usually not required; if >50% of parent assets, may be disposition of “substantially all” assets needing vote
• Many spin-offs are intended to be achieved on a tax-free basis
• The spin-off will need to be analyzed under applicable fraudulent conveyance criteria
• The distribution of the stock to public shareholders needs to comply with applicable securities laws
• It is the SEC's view (in Staff Legal Bulletin No. 4) that the subsidiary does not have to register a spin-off under the Securities Act when:
• the parent shareholders do not provide consideration for the spun-off shares;
• the spin-off is pro-rata to the parent shareholders;
• the parent provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets;
• the parent has a valid business purpose for the spin-off; and
• if the parent spins-off "restricted securities,“ it has held those securities for at least one year
• A split-off (where parent stock is exchanged for subsidiary stock) must be registered on
Form S-4
• Structuring considerations in separating parent and distributed equity
• Allocation of: assets, liabilities, management
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