Controlling stockholders sometimes seek to limit the ability of new investors in their company to interfere with future exit transactions.  They may do this by requiring the new investors to agree to vote in favor of a transaction proposed by the controlling stockholder (a “drag-along agreement”) or to expressly waive any appraisal rights because those rights can create uncertainty for an exit transaction. These arrangements are frequently found in private equity-sponsored companies when there are new equity investments, but until recently there has been uncertainty as to whether they are effective.

In Manti Holdings, LLC v. Authentix Acquisition Company, Inc.,^[1] the Delaware Supreme Court, in a 4 to 1 decision, held that an express agreement in advance by a sophisticated and informed stockholder for consideration to refrain from asserting appraisal rights under section 262 of the Delaware General Corporation Law (the “DGCL”) in connection with a merger of the corporation was valid notwithstanding the statutory grant of appraisal rights. In Manti, the Court was faced with investors who sold their company to a private equity firm and, in connection with rolling over merger consideration into a minority common stock interest in the acquiring company, agreed to refrain from asserting appraisal rights in a subsequent sale of that company. Those investors now sought to disclaim their agreement as invalid so that their exercise of statutory appraisal right would be recognized. The Court would have none of it, and held the “sophisticated and informed” investors to their contractual commitment. In doing so, the Court found that appraisal rights are not so fundamental a feature of the DGCL that they cannot be waived in advance, at least in the circumstances of this case.

In a bench ruling in another case addressing waiver of appraisal rights, In re Altor Bioscience Corp.,^[2] the Court of Chancery, in upholding a covenant not to sue in an agreement that bound only some of the stockholders, ruled that the covenant was not a waiver of appraisal rights because a waiver of a statutory right must be express. In doing so, the court implied that an express waiver could have been valid. Although not addressed by the court, the implication of the court’s ruling is that a drag-along provision also could be valid notwithstanding that voting the shares in favor of the transaction creating appraisal rights would prevent the exercise of those rights. Presumably, in those situations the analysis in Manti regarding the nature of the affected stockholders would be applicable in determining whether the agreement to vote in favor and forgo appraisal rights would be given effect.

Key Lessons

The Manti decision now clarifies that in the right circumstances a drag-along agreement and an express waiver of appraisal rights will be given effect, notwithstanding the statutory grant of appraisal rights.  While Manti provides some insight as to what those circumstances might be and when appraisal rights cannot be denied, the parameters of when a waiver of appraisal rights will be effective remains to be further defined.

---

[1] ‎2021 WL 4165159 (Del. Sept. 13, 2021), reargument denied on Oct. 1, 2021. The Delaware Supreme Court affirmed the decision of the Delaware Court of Chancery in ‎2019 WL 3814453 (Del. Ch. Aug. 14, 2019), which denied reargument of 2018 WL 4698255 (Del. Ch. ‎Oct. 1, ‎‎2018).‎‎

[2] Tr. of Record, C.A. No. 0466-JRS (Del. Ch. May 15, 2019). ‎

In an important decision, the Delaware Court of Chancery, in In re Multiplan Corp. Stockholders Litigation, 2022 WL 24060 (Del. Ch. Jan. 3, 2022), in denying the defendants’ motion to dismiss, addressed claims against the sponsor and other insiders of a special purpose acquisition company or “SPAC” for breach of fiduciary duties in connection with a de-SPAC merger. As we mentioned in our QuickStudy, “SPACs and the Implications for D&O Insurance,” the Multiplan decision was highly anticipated and is significant because it was the first time the Delaware courts had to grapple with the unique structure of SPACs and determine how to apply fundamental principles of Delaware fiduciary duty law to them. In this case, while acknowledging that when they invest stockholders of SPACs are well aware of the inherent conflicts of the SPAC’s sponsor, the Court still applied the entire fairness review standard and decided that the plaintiffs adequately pled an intentional failure of disclosure that was material to the plaintiffs’ decision as stockholders of the SPAC whether to accept the shares in the merger or exercise their redemption rights to receive back their investment.

Factual Background

Churchill Capital Corp. III, a Delaware corporation, was formed as a SPAC in October 2019 during the SPAC boom and completed its $1.1 billion initial public offering in February 2020. As is typical for SPACs, (i) the sponsor received founder’s shares representing 20% of the SPAC’s equity and warrants for nominal consideration, and (ii) the public stockholders purchased units consisting of common stock and warrants for $10 per unit, with the proceeds placed in trust. The SPAC sponsor chose the SPAC’s outside directors, each of whom served as directors in other SPACs formed by the sponsor and had other relationships with the sponsor. As compensation, the directors received interests in the sponsor, which represented indirect interests in the SPAC.

As part of the SPAC structure, the SPAC had two years to effect a merger with an operating company or liquidate by returning the trust proceeds to the public stockholders. If a merger was effected, public stockholders had the right to have their stock redeemed at the $10 IPO price, while they kept their warrants.

Shortly after its IPO, the SPAC identified Multiplan, Inc. as a merger target and successfully executed an agreement for the de-SPAC merger in July 2020. The proxy statement for seeking the necessary stockholder approval was distributed in September and the merger was approved at a stockholders meeting in October 2020, following which the merger was promptly completed. The proxy statement informed the SPAC stockholders of their redemption right if the merger was completed. If the stockholders voted, either for or against the merger, they could chose to have their shares redeemed at the $10 IPO price plus interest rather than accepting shares in the merger. Fewer than 10% of the public stockholders exercised the redemption right. The proxy statement disclosed that Multiplan was dependent on its largest customer for 35% of its revenues but, according to plaintiffs’ allegations, did not disclose that the customer intended to create its own in-house capability that would enable it to move its business from Multiplan and compete with it. When a research firm published a report on Multiplan in November 2020 that discussed the largest customer’s plans, the Multiplan stock price fell almost 40% to several dollars below the $10 redemption price. This lawsuit then followed as a class action on behalf of the SPAC’s stockholders who retained their shares in the de-SPAC merger rather than exercising the redemption right.

The Court’s Analysis

The Court first ruled that the action was properly brought as a direct claim rather than a derivative action because the redemption right, which was the basis of the claim, was an individual right of the stockholders. The Court also ruled that, although the redemption right in the certificate of incorporation was contractual, the claim was not for a breach of contract but rather a breach of the fiduciary duty of disclosure in allegedly denying the stockholders information material to their decision whether to exercise the redemption right.

The Court then ruled that the entire fairness review standard, the most onerous standard, rather than business judgment, applied to determining whether the defendants breached their fiduciary duty for two reasons: (1) the sponsor, as a controlling person, had an interest in the de-SPAC merger different from the public stockholders because (i) it could only realize value if a de-SPAC merger was completed, (ii) it could realize value even if the SPAC overpaid for the target company, and (iii) more funds would be available for use in connection with the merger if there were fewer redemptions; and (2) the SPAC’s directors, who also were defendants, were self- interested because they had conflicts similar to those of the sponsor due to their also having an interest in the founder shares and warrants, as well as not being independent of the sponsor, and they were exposed to material liability if the plaintiffs’ breach of fiduciary duty claims against them prevailed.

Applying the entire fairness standard, based on the facts as pled by the plaintiffs, the Court held that the plaintiffs’ claims were viable, principally because they allege that the sponsor and director defendants disloyally failed to disclose information necessary for the stockholders to exercise their redemption rights triggered by the de-SPAC merger on an informed basis.

Takeaways

Although a significant decision, the holding in Multiplan is in fact limited. The decision focuses on the adequacy of the disclosure made to stockholders in the proxy statement for the de-SPAC merger and their decision whether or not to exercise the redemption right. The Court characterized the redemption right as a fundamental protection for the public stockholders, a key feature of the SPAC structure to ameliorate the sponsor’s inherent conflicts that made the disclosure given to the stockholders all that more important, analogizing it to disclosure in connection with voting to approve a transaction with a controlling stockholder. The Court carefully avoided deciding whether entire fairness would have been the standard of review and whether there could be viable claims based solely upon the conflicting interests of the sponsor and other insiders, and in fact signaled that it might have dismissed the claims if the disclosure in connection with the de-SPAC merger had been adequate.

There are a number of lessons that can be drawn from the MultiPlan decision, including the following:

• Claims based on breach of fiduciary duties in connection with the redemption rights included in the SPAC structure are direct rather than derivative claims because the rights are those of the stockholders individually.
• The inherent conflicts of the sponsor might not alone result in entire fairness review or as the basis for viable claims. This assumes, however, that those conflicts are adequately disclosed and that an effective redemption right exists that gives stockholders a second opportunity to exercise an investment decision.
• Because of the importance of the redemption right to mitigate the inherent sponsor conflicts with respect to the de-SPAC transaction, the quality of the disclosure regarding the de-SPAC merger and the acquisition target takes on increased importance.
• While federal securities law applies to the adequacy of disclosure, the quality of the disclosure is also relevant under Delaware law to determine whether the fiduciary duty of disclosure has been met. Therefore, the Delaware courts also have a role in assessing the adequacy of disclosure as a matter of Delaware law.
• Directors who have equity interests similar to those held by a SPAC’s sponsor are likely to be considered as having a similar self-interest and therefore as not being independent directors. It is possible to consider a different form of compensation for directors that is more aligned with the interests of the public stockholders in order to avoid this conflict. Also, selecting directors that do not have longstanding relationships with the sponsor can help ensure independence. With sufficient independent directors, it would be possible to use a special committee structure like the one often used for conflicted transactions with a controlling stockholder, but use of such a structure likely would be inconsistent with the desire of the sponsor to control the de-SPAC merger process and the expectations of investors regarding the lead role of the sponsor.
• A proliferation of state law corporate breach of fiduciary duty claims, alongside securities class action lawsuits for violation of the securities law antifraud rules, in connection with de-SPAC mergers has been a concern. It remains to be seen what impact the Multiplan decision will have on that. It is possible that the narrow holding in Multiplan focused on the adequacy of disclosure with respect to the redemption right, while recognizing the inherent sponsor conflicts typical in a SPAC structure as well-known to SPAC investors, could serve to mitigate that proliferation. In any event, as noted in our prior QuickStudy, having adequate D&O insurance should be an important part of the protective arrangements in SPAC transactions.

If you have any questions about these or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.

This outline reviews the SEC’s interpretations that relate to the integration of private and public offerings and the challenges they present for the capital formation process. The outline also describes current policies of the SEC staff that affect so-called “PIPE” offerings and “private equity lines.” It has been updated to reflect the impact of the JOBS Act and the SEC’s adoption of implementing rules and interpretations under that Act.

Click here for the complete PDF

On May 14, 2020, the NYSE adopted temporary rules that will permit its listed companies to issue more than 20% of their presently outstanding common stock in a private placement at a discount without the shareholder approval that such a transaction would normally require. Designed to address liquidity needs of COVID-19-affected companies, the new rules are nearly identical to those adopted by Nasdaq on May 4, 2020, which we described here. Unlike Nasdaq, however, the NYSE has not adopted a “safe harbor” that relieves offerings within defined size and pricing ranges from the need to receive further written approval from the exchange.

Specifically, the temporary rule under new Section 312.03T of the Listed Company Manual will be limited to circumstances where:

• the need for the transaction is due to circumstances related to COVID-19 and the proceeds will not be used to fund any acquisition transaction;
• the delay in securing shareholder approval would either (a) have a material adverse effect on the company’s ability to maintain operations under its pre-COVID-19 business plan, (b) result in workforce reductions, (c) adversely impact the company’s ability to undertake new initiatives in response to COVID-19, or (d) seriously jeopardize the financial viability of the enterprise.
• the company undertakes a process designed to ensure that the proposed transaction represents the best terms available for the company; and
• the company’s audit committee or a comparable independent board committee expressly approves reliance on the new exemption and determines that the transaction is in the best interest of the shareholders.

The temporary rule represents a more streamlined approach compared to the NYSE’s existing exception for companies whose financial viability would be jeopardized by any delay to seek shareholder approval, in part because it does not require a mailing to shareholders 10 days in advance of the issuance. But like the Nasdaq rule, it also may be helpful to companies in less dire circumstances who nevertheless need immediate capital to address liquidity and operational challenges associated with the COVID-19 pandemic, to minimize workforce reductions, or to undertake new initiatives such as those for the treatment or prevention of the virus.

A company using this temporary relief will need to submit a supplemental listing application along with a certification describing with specificity how it meets these requirements. The NYSE will review each application to confirm whether the company has established compliance. The NYSE’s written approval must be obtained before the company signs a binding agreement, all of which must occur by June 30, 2020. The issuance of securities may occur after that date, so long as it is within 30 days of the signed agreement.

Notably, the NYSE did not follow Nasdaq’s lead in exempting transactions from its review and approval requirements where the maximum number of shares to be issued is less than 25% of the shares outstanding and where the discount to current market prices is not more than 15%. The NYSE will instead require written approval for all transactions falling within the scope of the rule.

Similar to the Nasdaq rules, the temporary NYSE rules will let related parties participate in such an equity offering in de minimis amounts, if their participation is specifically required by unaffiliated purchasers.  The participation of related parties in such a transaction might otherwise be considered a form of “equity compensation” subject to shareholder approval.

Finally, like the Nasdaq rules, the temporary NYSE rules outline (a) public disclosure requirements applicable to companies availing themselves of the relief, and (b) aggregation rules for private placements within 90 days after a transaction using the temporary rule.

The NYSE has previously provided relief from certain other limited aspects of its shareholder approval rules relating to private placements, which we described here.  The other shareholder approval requirements of the exchange, including those relating to change of control transactions, continue to apply.

Visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19.

On May 4, 2020, the Nasdaq Stock Exchange adopted a new temporary rule that permits listed companies to issue more than 20% of their presently outstanding common stock at a discount from current market prices without the shareholder approval that such a transaction would normally require.

To qualify, a listed company will need to submit the normal Listing of Additional Shares (LAS) notification along with a supplement in which it certifies that:

• the need for the transaction is due to circumstances related to COVID-19;
• delaying the transaction to obtain shareholder approval would either (a) have a material adverse impact on the company’s ability to maintain operations under its pre-COVID-19 business plan; (b) result in workforce reductions; (c) adversely impact the company’s ability to undertake new initiatives in response to COVID-19; or (d) seriously jeopardize the financial viability of the enterprise;
• the company undertook a process designed to ensure that the proposed transaction represents the best terms available to the company; and
• the company’s audit committee or a comparable independent board committee has expressly approved reliance on the new exemption and determined that the transaction is in the best interest of the shareholders.

If the maximum number of shares that can be issued is less than 25% of the outstanding shares or voting power prior to the transaction, and if the purchase price per share is not below a 15% discount from the Minimum Price as defined in the Nasdaq rules (generally, the market price at the time the purchase agreement is signed), then the transaction will not require further approval by Nasdaq after the company submits its LAS notification and supplemental certification. Transactions outside of this “safe harbor” will need the written approval of the Nasdaq Listing Qualifications Department before any securities can be issued. Transactions involving warrants will not be eligible for the safe harbor.

For companies whose eligibility is subject to Nasdaq review, neither the adopting release nor the temporary rule gives much indication how Nasdaq will evaluate whether a company qualifies under the standards above. For example, it is unclear what sort of process the company will need to undertake in order to ensure that the proposed transaction represents the best terms available. The required company certification addresses the process and not the outcome – i.e., the company does not certify that the terms are in fact the best available, only that its process was designed to achieve that result. Although companies meeting the safe harbor conditions will not undergo Nasdaq review, they should still carefully consider their certification and be prepared to defend it.

The temporary rule was accompanied by a narrow exception to the listing rule that requires shareholder approval of equity compensation arrangements in which directors, officers and employees participate. Nasdaq interprets sales of stock to such persons in capital-raising transactions to require shareholder approval where they may be considered a form of equity compensation. In an offering under the temporary rule, if unaffiliated purchasers require affiliates to put their personal capital at risk, those affiliates’ participation will not require shareholder approval so long as they are not involved in negotiations and they are limited to a de minimis amount.

To use the temporary rule, a company would need to execute a binding agreement, submit the LAS notification and supplemental certification to Nasdaq and obtain any required approvals of the Listing Qualifications Department by June 30, 2020. Companies should give Nasdaq enough time to review their submission. The issuance of securities under the binding agreement may occur after June 30, 2020 so long as it is within 30 days after the date of the agreement.

A company using this exception will need to file a Form 8-K or press release at least two days before the issuance of the shares noting, among other things, that shareholder approval would have been required but for the company’s reliance on the temporary rule. Companies will not need to give the 15 days’ advance notice normally required for a Listing of Additional Shares notification.

Nasdaq has recognized that its existing “financial viability” exception to its shareholder approval requirements may not adequately address the needs of listed companies impacted by COVID-19.  Some companies will not qualify for that exception despite being dramatically affected by the pandemic, while others will be unable to mail notice to all shareholders ten days prior to issuing securities. As an alternative, the temporary rule represents a streamlined approach. Beyond companies whose financial viability is jeopardized, the temporary rule may be useful for other companies in need of immediate capital to address liquidity and operational challenges arising from the COVID-19 pandemic or to minimize workforce reductions.  The adopting release makes clear that the temporary rule also could be used to fund new initiatives relating to COVID-19, giving as examples a company raising funds to develop a test for the virus or a vaccine.

The temporary rule has no effect on the Nasdaq rules requiring shareholder approval of transactions resulting in a change of control or, other than in the narrow circumstance described above, transactions involving equity compensation arrangements for officers, directors and employees.

Visit our COVID-19 Resource Center often for up-to-date information to help you stay informed of the legal issues related to COVID-19.

In a settled enforcement action,[1] the Securities and Exchange Commission reminded private equity firms and registered investment advisors of their obligation to implement and enforce compliance procedures, in particular procedures to prevent the misuse of material non-public information.  In this action, Ares Management LLC agreed to a $1 million payment to settle charges that its compliance procedure failed to prevent trading of shares of a public portfolio company on whose board a representative of the private equity firm served as a director while it had material non-public information.

It is not unusual for private equity firms to have representatives serve on boards of public companies in which they invest.  This service often puts these firms in the position of having access to material non-public information which is shared within the firm.  The SEC emphasized that these special circumstances create particular risks for these firms and it is therefore critical that they have proper policies and procedures in place to address these risks.  Although Ares had policies and procedures which placed the portfolio company’s shares on its restricted list and its compliance staff checked with the company to make sure the company’s trading window was open, according to the SEC the compliance staff failed, before approving the trading, to inquire whether the board representative and others in the firm were in possession of material non-public information. The SEC order also notes that the compliance staff failed to adequately document its inquiries.

This action should send a strong message to private equity firms that when they have representatives on the board of public portfolio companies they need to have appropriate compliance procedures in place to prevent improper trading when they have material non-public information and they need to make sure those procedures are followed.  A failure to do so can result in not only antifraud liability for improper insider trading but also failure to comply with the Investment Advisers Act requirements that investment advisers have reasonable compliance policies and procedures.

[1] In the Matter of Ares Management LLC, IA-5511 (May 26, 2020), available here.

On July 22, 2020, the SEC adopted final rules on the application of its proxy solicitation rules to proxy voting advisors. (See our November 2019 blog post on the proposed rules here.) Among other things, the new rules will, for practical purposes, require these proxy advisory firms – most notably Institutional Shareholder Services (ISS) and Glass Lewis – to make their voting recommendations for any public company’s annual meeting of shareholders available to that company at or before the time the recommendations become available to the proxy advisory firm’s institutional investor clients, so long as the public company files its proxy statement at least 40 days before the meeting. Proxy advisory firms will also need to give their clients a means to become aware of any written statements made by the public company about their voting advice prior to the shareholder meeting. The new rules also address concerns over proxy advisory firms’ conflicts of interest.

At the same time, the SEC also issued supplementary guidance to registered investment advisors regarding their proxy voting responsibilities in view of the new rules, building upon guidance released in August 2019. (See our blog post and our FUNDamentals QuickStudy discussing the earlier guidance here and here.)

Proxy rules applied to proxy voting advisory firms

Institutional investors hold the vast majority of shares in the public equity markets today. Since 2003, proxy advisory firms have come to play a critical role by providing voting recommendations for use in shareholder meetings for the thousands of public companies within the portfolios of their investment adviser and institutional investor clients. Because many investment advisers and institutional investors have essentially outsourced their voting decisions to these proxy advisory firms, the voting guidelines adopted by these firms have become an important standard – some would say de facto regulations – in executive compensation decisions and the design of equity compensation plans, the adoption of anti-takeover measures, and other governance matters. Because these firms will often recommend that investors vote against, or withhold a vote from, a company’s director nominees where the company’s governance policies, anti-takeover protections, board independence, compensation policies or other practices fall outside of the advisory firm’s guidelines, the influence of these voting guidelines extends well beyond matters put directly to a shareholder vote.

These voting guidelines are often stricter than SEC, NYSE or Nasdaq requirements and are adopted and revised without formal public input and with varying degrees of transparency. Public companies have minimal opportunity to review and respond to these recommendations before they are published: ISS permits only S&P 500 companies to review reports 24-48 hours before publication, but only for factual inaccuracies and not for comment on the recommendations themselves, while Glass Lewis permits companies to review only certain underlying data points 24-48 hours in advance for factual inaccuracies, but not the report itself.  The result is often a voting recommendation that, from the proxy advisor’s perspective, distills the general voting preferences of an institutional shareholder base and applies it to thousands of public company shareholder proposals on a compressed timeframe during the annual proxy season, but from a public company’s perspective, often applies a one-size-fits-all approach to a company’s individual circumstance, without an effective means for the company to tell its story in a way that may influence the recommendation or outcome.

Against this backdrop, the new SEC rules will codify the staff’s prior position that proxy advisors’ voting advice constitutes a “solicitation” subject to the SEC’s proxy rules, including the anti-fraud provisions of Rule 14a-9 that prohibit materially false or misleading statements.  Importantly, the existing exemptions from the information and filing requirements under Rule 14a-2(b)(1) and (3), upon which proxy advisors currently rely, will no longer be available unless:

• The proxy advisor includes in its advice or on its electronic platform prominent disclosure of certain conflicts of interests, transactions or relationships that may bear on its objectivity, and its policies used to identity and address such conflicts; and
• The proxy advisor has adopted and publicly disclosed written policies reasonably designed to ensure that (a) registrants that are the subject of proxy voting advice have that advice made available to them at or prior to the time the advice is disseminated to the proxy advisor’s clients, and (b) the proxy advisor’s clients have a mechanism by which they can reasonably be expected to become aware of any written statements regarding the voting advice made by a public company who is the subject of that advice.

The policies adopted by the proxy advisor may include conditions requiring that, to receive the proxy voting advice, a public company must file its definitive proxy statement at least 40 days prior to the shareholder meeting, and also may require the public company to acknowledge that it will use its copy of the voting advice only for limited purposes in connection with the solicitation, and will not otherwise publish or share it.  The policies may also require that, in order for the proxy advisory firm to make its clients aware of a public company’s written statements in response, the company must notify the proxy advisory firm that it intends to file or has filed additional soliciting materials with the SEC.

The requirement that a proxy advisor ensure registrant access to recommendations will not apply to advice based on customized voting policies that are proprietary to a proxy voting advisor’s client, nor to recommendations relating to merger transactions or contested matters.

Finally, the new rules amend the anti-fraud provisions of Rule 14a-9 to add examples of how proxy voting advice may be misleading within the meaning of that rule. A proxy advisory firm may run afoul of the anti-fraud rules if it fails to disclose material information about such items as the advisory firm’s methodology, sources of information or conflicts of interest.

Guidance for investment advisers

In August 2019, the SEC provided guidance to investment advisers, such as fund managers, regarding their proxy voting responsibilities and related fiduciary duties, particularly where an investment adviser is relying on a proxy advisory firm for voting decisions. The SEC has supplemented that guidance to reflect the new rules.

The supplemental guidance addresses the use of services provided by proxy advisory firms that will either populate each client’s votes shown on the proxy advisory firm’s electronic voting platform with the proxy advisory firm’s own recommendations, or automatically submit the client’s votes based on those recommendations (sometimes called robo-voting).  The guidance suggests that in order to demonstrate that it is making voting determinations in its clients’ best interests, an investment advisor should consider whether its own policies and procedures address circumstances where it becomes aware that a public company intends to file or has filed additional soliciting material relevant to the vote before the submission deadline. Where it becomes aware of such additional material with sufficient advance notice, the investment adviser would likely need to consider the additional information prior to exercising voting authority.

The guidance also suggests that an investment adviser who uses automated voting services should consider disclosing to its own clients the extent to which it uses those services, and how its policies and procedures address circumstances when it becomes aware that an issuer has filed additional information relating to a matter to be voted upon. This disclosure could be made on the adviser’s Form ADV under Rule 206(4)-6 of the Investment Advisers Act. Without this information, the SEC suggests that clients might not have enough information to provide informed consent for purposes of agreeing to the scope of its relationship with the investment adviser, or for purposes of the investment adviser’s obligation under its duty of loyalty to provide full and fair disclosure relating to the advisory relationship. In order to be “full and fair,” the SEC reiterated that the disclosure should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision on whether to provide its consent.

Key takeaways

It remains unclear what effect these new rules will have over time on the broad powers wielded by proxy advisory firms over corporate policies and shareholder voting results. However, they will no doubt offer some relief to public companies who have struggled to reconcile their board’s views on how to act in the best interests of shareholders under their individual circumstances with the sometimes monolithic prescriptions in the proxy advisory firms’ voting guidelines. Taken together with the guidance for investment advisers, the new rules should provide public companies of all sizes reliable access to the voting recommendations, facilitate communication of a company’s position to the recipients of those recommendations, encourage institutional investors to take company responses into account when exercising their voting discretion, and give investment advisers second thoughts about using proxy advisory firms’ services to fulfill their proxy voting responsibilities to their clients.

Proxy advisory firms will not be required to comply with the new rules until December 1, 2021, so that the 2022 proxy season will be the first experience for most companies with the new rules. This timing is also subject to actions in the pending lawsuit brought by ISS challenging the SEC’s authority to regulate it, which was stayed until the SEC adopted final rules. The changes to the definition of “solicitation” and to the anti-fraud provisions of Rule 14a-9 will be effective 60 days after publication in the Federal Register, since they represent codification of existing staff provisions.

Finally, we note that this is one step in a larger effort by the SEC to revisit the complex system through which proxy statements are distributed by public companies and shares are voted. In Chairman Clayton’s public statement accompanying the adoption of the new rules and guidance, he noted that efforts to address “proxy plumbing” and “universal proxy” are on the Commission’s short-term agenda.

If you have questions about the new rules or guidance, your regular Locke Lord contact and any of the authors can discuss these matters with you.

The Securities and Exchange Commission on August 26, 2020 adopted changes to the definition of accredited investor intended to modernize the exempt offering process. It also made related changes to the definition of qualified institutional buyer. This was one of two actions taken by the SEC on that date; see our blog post relating to changes to certain public company disclosure requirements at this link.

The concept of “accredited investor” is important in identifying investors able to readily participate in private offerings exempt from registration. For example, an issuer can sell to an unlimited number of accredited investors in a Rule 506(b) offering, and can do so without meeting any express information requirements. In addition, an issuer can sell only to accredited investors that it has verified as such in a Rule 506(c) offering using general solicitation. In the past, accredited investors were determined by quantitative measures, income or net worth tests for individual investors and total assets for institutional investors. These objective measures were used as a surrogate for financial sophistication, either directly or through the ability to obtain advice. In its recent action, the SEC adopted amendments to the definition of accredited investor to add qualitative measures for individuals based on professional certifications, designations or credentials and to expand the institutional investors that qualify, both by identifying more types of institutions and adding an additional test based on amount of investments. Notably, the SEC did not change any of the existing quantitative tests, which have been in place unchanged for many years.

Specifically, the amendments:

• Add a new category for individuals based on credentials designated by the SEC from time to time, which initially include holders in good standing of Series 7, Series 65 and Series 82 licenses (generally securities professionals). The SEC invites suggestions for other designations.
• Add “knowledgeable employees” of private funds for investments in that fund.
• Add certain institutions to the list of those that can qualify based on having $5 million in total assets, including codifying the SEC’s prior interpretation that limited liability companies can qualify.
• Permit any entity to qualify if it has investments in excess of $5 million and was not formed for purposes of the investment.
• Add family offices with at least $5 million in assets under management and their family clients.
• Replace “spouse” for the joint annual net income test with “spousal equivalent.”

The amendments also expand the definition of “qualified institutional buyer” for purposes of Rule 144A to include any institutional investors included in the accredited investor definition so long as they meet the $100 million in securities owned and invested requirement.

The amendments are welcome changes to modernize the rules even though they are unlikely to expand significantly the ability of companies to access capital. The SEC’s adopting release with the full text of the changes is available at this link, with the initial order designating credentialed securities professionals as accredited investors available at this link. The amendments take effect 60 days after publication in the Federal Register.

*          *          *

If you have any questions about these changes or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.

The Securities and Exchange Commission on November 2, 2020, by a 3 to 2 vote, adopted significant changes to the rules governing capital raising through private offerings and other offerings exempt from registration under the Securities Act of 1933. The adopting release (available here) indicates that these changes are designed “to harmonize, simplify, and improve … the exempt offering framework” and “to promote capital formation and expand investment opportunities while preserving and improving important investor protections.” The changes also are designed to reduce the friction between different offerings under integration principles. The new rules are effective 60 days after publication in the Federal Register.

The changes made by the new rules, along with the recently expanded definition of “accredited investor” (see our description here), will significantly enhance the ability of companies to use exempt offerings to raise capital as an alternative to registered offerings.  The Commission also has recently proposed to adopt a conditional exemption from broker-dealer regulation for individuals serving as “finders” for companies seeking to raise funds.

Changes to Offering Exemptions

The SEC has made changes to broaden certain of the existing exemptions in a number of ways:

• Offering limits. The amount that may be offered under the three exemptions that currently are capped are increased as follows: (i) the Regulation A Tier 2 primary offerings limit is increased from $50 million to $75 million and the secondary sales limit is increased from $15 million to $22.5 million; (ii) the Regulation Crowdfunding limit is increased from $1.07 million to $5 million; and (iii) the Regulation D Rule 504 limit is increased from $5 million to $10 million.
• Investor limits. The investment limits for investors in Regulation Crowdfunding offerings are loosened by eliminating those limits for accredited investors and by allowing non-accredited investors to rely on the greater of their annual income or net worth in calculating the limit.
• Offering communications. The restrictions on offering communications resulting from the ban on “general solicitation” are eased by permitting use of limited materials to “test-the-waters” before deciding which exemption to use for sales.  The changes also exempt “demo day” communications from being a general solicitation.
• Other specific changes. The eligibility of issuers to use Regulation A and Regulation Crowdfunding is expanded.  The information requirements for non-accredited investors permitted in Rule 506(b) private offerings are reduced by aligning them with those for Regulation A offerings, which most notably will permit many issuers to use unaudited financial statements in offerings up to $20 million.  The Rule 506(c) accredited investor verification safe harbor is expanded by allowing an issuer to rely on a written representation by an investor whose status as an accredited investor was verified within the prior five years.  Some common provisions, including bad actor disqualification, has been made more consistent across exemptions.
• Regulation S directed selling efforts. Instead of adopting amendments to Regulation S as proposed, the SEC reaffirmed its position that general solicitation permitted in a domestic offering will not be considered to be “directed selling efforts” in connection with a Regulation S offering if the general solicitation was not undertaken for the purpose of conditioning the market in the United States for the securities offered in the Regulation S offering.

Integration of offerings

The new rules go a long way toward reducing the uncertainty and legal risk associated with the integration of otherwise separate offerings by establishing a general principle that no integration is required if each offering, based on its particular facts and circumstances, meets the requirements for an exemption or complies with the registration requirements.  They also provide several safe harbors as follows:

• Offerings separated by 30 days (a reduction from the existing six-month separation period) would not be integrated, provided in the case of an exempt offering that does not permit general solicitation that follows an offering that permits general solicitation the issuer has a reasonable belief that each purchaser was not solicited through general solicitation or had a preexisting substantive relationship with the purchaser. However, there may not be more than 35 non-accredited investors in offerings under Rule 506(b) during a 90-day period.
• As now in effect, a firewall would exist for Rule 701 and Regulation S offerings so that neither would be integrated with other offerings.
• Offerings for which a registration statement has been filed would not be integrated if made after termination or completion of an offering for which general solicitation is not permitted or, if the terminated or completed offering permitted general solicitation, if it was made only to qualified institutional buyers or institutional accredited investors or was terminated or completed more than 30 days before commencement of the registered offering.
• Exempt offerings using permitted general solicitation made after other terminated or completed offerings for which general solicitation is not permitted will not be integrated to defeat those other offerings.

Alternatives to Registration Chart

We have updated the Alternatives to Registration Chart we have co-authored for many years to reflect the revisions to the exempt offering framework adopted by the SEC. The new Chart can be found at this link, with printing instructions at this link.

Conclusion

The revisions adopted by the SEC will facilitate the ability of companies to raise capital in the private markets. This will be especially significant for smaller and medium-size companies for which the public markets may not be a viable alternative, including those companies for which venture and other institutional private funding may not be available. The revisions also will simplify the ability to do contemporaneous and sequential offerings by eliminating uncertainties in complying with securities law requirements. Taken as a whole, the new rules represent a significant development in the regulation of exempt securities offerings.

*          *          *

If you have any questions about the rule changes or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.

The Securities and Exchange Commission on August 26, 2020 adopted changes to the business, legal proceeding and risk factor disclosures made by public companies and companies going public. This was one of two actions taken by the SEC on that date; see our blog post describing changes to the definition of accredited investor and related changes to the qualified institutional buyer definition at this link.

The changes are meant to improve the usefulness of disclosure by public companies about their business, their material pending legal proceedings, and the factors that make an investment in their securities speculative or risky. Most of these changes represent an extension of principles-based disclosure over specific line-item requirements for the particular company.

Specifically, the amendments to Item 101 (Description of Business) of Regulation S-K:

• Eliminate the existing five-year timeframe and prescriptive disclosure requirements relating to the general development of the business in favor of a principles-based mandate to describe only information material to an understanding of the general development of the business. Information about the year and form of a company’s organization is no longer required.
• Permit a company to forgo a full discussion of the general development of the business in a filing other than an initial registration statement, if it provides an update since the last periodic report or registration statement that contained a full discussion of its development. Companies taking advantage of this option will need to incorporate the full discussion by reference with a hyperlink to the prior report or registration statement.
• Adopt a more principles-based requirement for a narrative discussion of the business done and intended to be done by the company, focusing on its dominant segment or each reportable segment for which financial information is presented. The specific disclosure requirements in the existing rule have been replaced by a similar but non-exhaustive list of topics that may be material.
• Include as a disclosure topic a new category covering human capital resources, to the extent a discussion of such matters would be material to investors. This covers any human capital measures or objectives that the company focuses on in managing the business. The rule lists measures or objectives that address the development, attraction and retention of personnel as a non-exclusive list of potentially relevant subjects that may be addressed, but each company will need to tailor its own disclosure in light of its workforce. Companies may, depending on their circumstance, need to address turnover, use of contractors, full- or part-time status, diversity or other factors its management considered important. The requirement to disclose the number of employees has been retained.
• Replace the disclosure topic relating to environmental enforcement matters with a general topic covering the material effects that compliance with governmental regulations may have on capital expenditures, earnings and the competitive position of the business.

The amendments to Item 103 (Legal Proceedings) of Regulation S-K:

• Expressly permit hyperlinking or cross-referencing to legal proceedings disclosure elsewhere in the document in order to avoid duplicative disclosure. This may include the MD&A, risk factors or financial statement footnotes.
• Raise the threshold for disclosure of environmental proceedings by government agencies to cover matters that the company reasonably believes will result in monetary sanctions over $300,000 (increased from $100,000). A company may also adopt an alternative threshold that is reasonably designed to result in disclosure of material environmental matters, so long as the threshold does not exceed the lower of $1 million or one percent of the company’s consolidated current assets. A company taking advantage of this option will need to disclose its chosen threshold (including any changes) in each annual and quarterly report.

Finally, the amendments to Item 105 (Risk Factors) of Regulation S-K:

• Require a summary of the risk factor disclosures of no more than two pages, if the full risk factor section exceeds 15 pages.
• Require the risk factor section to be organized logically with relevant headings in addition to the sub-captions currently required.
• Emphasize the principles-based approach of Item 105 by requiring disclosure of material risks. Disclosure of risks that generally apply to any company or any offering is specifically discouraged; if such risks are included, they will need to be presented at the end of the risk factor section under the caption “General Risk Factors.”

The amendments represent a modernization of disclosure rules that have rarely been updated in 30 years, and should provide companies with greater flexibility to tailor their disclosure to matters material for them and avoid duplicative disclosure. The SEC’s adopting release with a full text of the changes is at this link. The changes take effect 30 days after publication in the Federal Register.

*          *          *

If you have any questions about the rule changes or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.