Originally published in the January 2011 edition of the M&A Lawyer
As the global private equity industry rebounds from the 2008-2009 recession, private investors have been increasingly receptive to making significant minority investments in public companies. The growth of these types of deals has been driven by, among other things, continued unfavorable financing terms for typical leveraged buyout transactions that marked the pre-financial crisis deal-making era — as well as acute memories of significant leverage buyout failures during the recession. At the same time, while many public companies continue to hold out for higher valuations for change of control transactions, they have found that minority investments can be an efficient and useful technique for raising capital.
In structuring and negotiating the terms of a significant minority investment (generally between 10 percent to 40 percent of the outstanding stock) in a public company, investors must unravel a number of interlocking issues that may not emerge in the typical change of control buyout transaction. Such issues may depend upon, among other things, the long-term investment strategy of the investor, the size of the investment as a percentage of the company's outstanding capital stock, the legal and regulatory regimes applicable to the company and the investment, and the amount of control and influence the investor seeks over the company.
This article highlights some of the issues that private investors should consider in planning for and negotiating such minority investments in public companies.
* * * * * * * * * *
Securities Exchange Restrictions on Private Placements. In a negotiated transaction between an investor and a public company listed on either NASDAQ or the NYSE, the parties will need to consider the applicable rules requiring shareholder approval prior to, among other things, issuing 20 percent or more of the issuer's outstanding common stock (or of securities convertible into or exercisable for common stock) or voting power. For commercial and other reasons, it would be impractical to delay many financing transactions until shareholder approval is obtained.
Many traditional private investments in public company transactions have addressed this limitation by permitting the initial issuance of 19.9 percent of the issuer's common stock, with additional shares being issuable only upon the receipt of shareholder approval. This traditional structure may not be attractive to an investor seeking a significant minority investment if an equity ownership cap of 19.9 percent following the failure to obtain shareholder is not an acceptable outcome.
One alternative transaction structure that may be more attractive to an investor contemplating a significant minority equity investment would be to initially acquire debt that, per its terms, would only become convertible into equity (or a security that could be convertible into equity) upon the receipt of shareholder approval. Under such a transaction structure, the minority investor could protect itself by negotiating an immediate "exit" right by providing for an event of default/acceleration trigger under the initial debt instrument if shareholder approval is not obtained within a certain period.1 Furthermore, the investor should consider whether automatic conversion to equity immediately following the receipt of shareholder approval is preferred, rather than negotiating for the option to remain in the debt instrument following shareholder approval, with subsequent conversion rights at the investor's option. The latter structure would be advantageous from the investor's perspective to, among other things, remain senior to the underlying equity in the capital structure, exercise significant rights through debt covenant protection and increase the option value of the convertible security.
Exit Provisions/Registration Rights. Unlike in a typical control acquisition, a minority investor may not have as much flexibility with respect to the timing of the exit of all or part of the investment. Most companies would be hesitant to allow a "put" right on an equity instrument (requiring the company to repurchase the equity instrument upon demand). Consequently, minority investors in public companies should negotiate for robust registration rights to provide for flexibility of a complete or partial exit through open market dispositions. Subject to certain limited exceptions, if a person or group is deemed to be an "affiliate" of an issuer under the US securities laws, such person or group will only be permitted to sell its securities in such company on an exchange pursuant to an effective registration statement.2 According to guidance provided by the Securities and Exchange Commission (the "SEC"), beneficial ownership of more than 10 percent of an issuer's outstanding equity securities generally gives rise to presumptive affiliate status.3 In addition, affiliate status could be attributed through other indicia of control, such as board representation and negative control rights. Registration rights in such circumstances should be clear to provide that they apply at any time when the holder could be deemed to be an affiliate under the US securities laws, and therefore potentially restricted from selling without the benefit of an effective registration statement.
In addition, the minority investor should negotiate registration rights not only for securities acquired in the initial negotiated transaction, but also with respect to any later-acquired securities, so that any registration statement filed with respect to such securityholder's securities would permit a full exit. Furthermore, the minority investor will need to give consideration to the relative priorities of piggy-back registration rights and underwriter cutbacks, particularly if the company has granted registration rights to other significant shareholders or to the group of investors joining the same investment.
Board Independence Requirements. It would be typical in a significant minority investment to require board representation (preferably commensurate with the level of ownership by the minority investor or group of minority investors), but the parties will need to be mindful of the board independence requirements imposed by the SEC and stock exchange listing rules. "Independence" in this context is generally determined by the board, which will need to broadly consider all relevant facts and circumstances with respect to each proposed director, including considering potential conflicts of interest or other circumstances that might bear on the materiality of the appointed director's relationship to the company. Generally, ownership of a significant amount of the equity of an issuer should not, by itself, bar a finding of independence (as these rules generally concern themselves with independence from management).4
Schedule 13D or 13G Disclosure. The Securities and Exchange Act of 1934, as amended (the "Exchange Act") requires disclosure when any person or group acquires beneficial ownership of more than 5 percent of a class of equity securities of a US public company, including through a negotiated acquisition.5
One important consideration for an investor acquiring a minority stake in a public company through a negotiated transaction will be whether to disclose ownership on Schedule 13D (which requires a description of, among other things, certain plans or proposals of the reporting person that relate to or would affect control of the issuer) or in certain circumstances (i.e., if holdings remain below 20 percent of the outstanding class of equity securities and the securities are held without the purpose of changing or influencing control of the issuer), disclose their positions on a less detailed short-form Schedule 13G.6 If the minority investor seeks board representation, recent SEC interpretive guidance has clarified that when an investor subject to the reporting requirements under Section 13 of the Exchange Act has appointed, or is otherwise affiliated with, one or more members of the issuer's board of directors or officers, then, notwithstanding the lack of any specific control intent by such investor, the existence of a board appointee or affiliation with such person will most likely render such person ineligible to file the short-form Schedule 13G in lieu of the more detailed Schedule 13D.7
Another important consideration will be the timing of the disclosure. If an investment is structured initially as a debt investment (with convertibility features only applying following receipt of shareholder approval as may be required by applicable stock exchange regulations), then disclosure could possibly be deferred until the company's shareholders have approved the convertibility feature. If the transaction structure contains convertibility caps as discussed above, the SEC recently noted in interpretive guidance that, depending on the conversion terms, it is possible that the holder would not be deemed to have acquired beneficial ownership of the underlying securities above the conversion cap, and that the analysis would turn on whether the conversion provision that limits ownership is "binding and valid" to effectively eliminate the right of the holder of the convertible security to acquire the underlying shares.8
Section 16 Implications. A beneficial owner of more than 10 percent of any class of equity securities registered under Section 12 of the Exchange Act is an "insider" subject to the rules and regulations under Section 16 of the Exchange Act. These rules require, among other things, public disclosure of all purchases and sales of such securities in prompt filings (i.e., within two business days) with the SEC. In addition, a Section 16 insider is required to disgorge to the company any profits obtained from "short-swing" transactions (i.e., generally described as any purchase and sale, or sale and purchase, of securities of the company within any six-month period).9 Disgorgement claims are generally not waivable by the issuer. In structuring a minority investment transaction, these rules may impose significant restrictions, which can sometimes be unexpected, such as in connection with transferring shares within affiliated funds. Moreover, when structuring transactions involving different classes of securities and convertibility triggers (to, among other things, comply with stock exchange requirements as described above), careful analysis will be required in order to avoid running offside of the short-swing liability rules.
Poison Pills. The so-called "poison pill" is a common and potent tactic public companies use to thwart hostile takeovers. The effect of this feature, which can generally be adopted by a US company's board of directors, is to make the issuer's stock prohibitively expensive or otherwise unattractive to an unwanted acquirer by issuing "rights" to its existing shareholders (other than the unwanted hostile acquirer) to purchase equity securities of the company at a steep discount. These rights are typically only exercisable following the occurrence of a triggering event, such as when a person or group acquires more than a specified percentage of a company's outstanding securities. The trigger percentage is often set around 15 percent to 20 percent, although that may vary depending on, among other things, whether existing significant stockholders may have been "grandfathered" in at a higher percentage ownership threshold.10
As such, when an investor structures a negotiated minority investment transaction with a public company, it should understand whether the company has a poison pill, and if so, the contours of such pill, including understanding the relevant triggers for the issuance of rights thereunder. In most cases, the board of directors has the power under its shareholder rights plan to waive its application with respect to a particular transaction or investor. Such waiver will often be a condition to the investor's investment in the company if done through a negotiated transaction. In addition, the minority investor should consider whether continued application of the poison pill would act as an effective block on acquiring additional securities of the company, whether through a negotiated transaction with the company, third party purchases or otherwise and, consequently, whether provisions should be made upon the initial investment to provide for adequate flexibility in making such add-on investments and prospective waivers. Failure to do so could act as an effective "standstill" that would preclude the investor from increasing its stake in the company.
Business Combination Statutes. Many US public companies are incorporated in states whose legislation contains business combination statutes, such as Section 203 of the Delaware General Corporation Law. Such statutes generally prohibit these companies from engaging in any business combinations with an "interested stockholder" – generally defined to include any person that owns over a specified percentage of the company's voting stock (usually in excess of 10 percent to 20 percent) – unless the board has approved the business combination before the person became an interested stockholder. In the case of a negotiated minority investment, the parties will often seek to preserve the flexibility to do additional transactions (including add-on equity or debt investments) in the future - in such cases, these business combination statutes are broadly drafted and could preclude most conceivable future transactions. Consequently, in such cases, the parties will need to take the necessary actions (primarily through appropriate board resolutions and issuer representations) so that such statutory provisions are inapplicable prior to making the initial investment if it (or future transactions) would cause the minority investor to exceed the applicable ownership threshold. Moreover, if state law provides for an "opt-out" mechanism rather than an "opt-in" mechanism for application of the statute, the absence of a specific provision in the company's constituent documents (i.e., charter or bylaws) may not preclude the possibility that the company is subject to such a statute.
Control Share Acquisition Statutes. Similar to business combination statutes, many US public companies are incorporated in states whose legislation contains control share acquisition statutes. Such statutes generally provide that an "acquiring person" (i.e., a person or group that owns or proposes to acquire more than a specified percentage of a company's stock - often as low as 10 percent) – is able to vote above such specified percentage only with the affirmative approval (through a vote) of a specified percentage of holders of the outstanding shares (excluding shares held by the acquiring person). The investor making the minority investment will need to confirm that such statutes do not apply so that its voting rights are not unduly restricted. As with the business combination statutes, diligence on the company's constituent documents may not be sufficient to conclude whether such statutes are inapplicable if the law of the state of the company's incorporation provides for "opt-out" mechanisms rather than "opt-in" mechanisms.
Non-US Regulatory Issues. Many companies that are subject to US securities law and/or US stock exchange listing rules are incorporated outside of the US or have securities listed on non-US securities exchanges. In such cases, investors will need to analyze additional issues in making a potential minority investment, including understanding how the combination of various regulatory regimes to which the company is subject may affect not only the initial investment, but the ability of the investor to subsequently acquire or dispose of securities of the issuer.
For example, many non-US jurisdictions (including several countries in Asia and Europe, and in Canada) require a stockholder to make a mandatory tender offer to all of a company's stockholders if such stockholder acquires securities from third parties in excess of a specified ownership threshold. In addition, particular consideration should be given to the interplay and potential conflicts between foreign and US legislations and stock exchange rules. The combination of these regulatory regimes can create significant obstacles in the event that the minority investor desires to increase or exit its position in the company following the initial investment.
In addition, investors will need to analyze any disclosure obligations that may be applicable to investments in the offshore company or offshore listed securities (and how such disclosure obligations interact with the US securities law disclosure obligations, including under Section 13 and 16 of the Exchange Act), as well as potential foreign ownership limitations, which can be particularly acute in highly regulated industries.
Group Status. Many private equity and hedge funds follow a "wolf pack" approach where such funds network extensively and often take positions following other funds' initiatives. In such and other circumstances, including if a negotiated transaction is made with one or more co-investors, consideration will need to be given to whether such co-investors are deemed to have formed a "group" with each other under applicable securities laws. If the parties are deemed to have formed a "group" for such purposes, then one important consequence is that each member of the group may be deemed to have beneficial ownership over all of the other group members' securities, including for purposes of determining the relevant ownership thresholds for, among other things as discussed herein, the company's poison pill, control share and business combination statutes, Schedule 13D and Schedule 13G disclosure, mandatory tender offer rule triggers and the consequences of "affiliate" status, including restrictions on the ability to sell securities of the issuer without an effective registration statement.
Conclusion. As many private investors expand their investment strategies to include making significant minority investments in public companies, such strategies have begun to gain mainstream acceptance as both an investment tool for private investors and a useful capital raising technique for public companies. Such transactions and investment strategies can introduce novel and complex business and legal issues, which require careful dissection as the parties to the transaction navigate through a puzzle of multidisciplinary and often multijurisdictional issues and implications.
Footnotes
1. Under such a possible transaction structure, careful consideration will need to be given to the interpretive guidance regarding the utility of what NASDAQ terms "alternative outcomes" under NASDAQ Listing Rule interpretation IM-5635-2 (Adopted March 12, 2009 (SR-NASDAQ-2009-018)), which generally provides that if the terms of a transaction can change based on the outcome of the shareholder vote, then no shares of common stock may be issued prior to the vote. NASDAQ guidance has indicated that the presence of an alternative outcome may have a coercive effect on the shareholder vote, thus depriving shareholders of their ability to freely exercise their vote.
2. A privately negotiated sale to certain sophisticated third-party purchasers may also be permitted under certain circumstances pursuant to applicable exemptions and interpretations under the Securities Act of 1933, as amended.
3. See American Standard, SEC No-Action Letter, 1972 WL 19628 (Oct. 4, 1972). Although the presumption is rebuttable, a person who claims that he is not an affiliate in order to use the exemption from registration has the burden of proving the availability of the exemption.
4. See, e.g., NASDAQ IM-5605 (Definition of Independence) - Rule 5605(a)(2), adopted March 12, 2009 (SR-NASDAQ-2009-018); amended June 16, 2009 (SR-NASDAQ-2009-052).
5. See Rule 13d-1 under the Exchange Act.
6. See Rule 13d-1(b) and (c).
7. See Question 103.04 of the updated and consolidated compliance and disclosure interpretations under Exchange Act Sections 13(d) and 13(g) and Regulation 13D-G Beneficial Ownership Reporting (Updated November 16, 2009).
8. See Question 103.03 of the updated and consolidated compliance and disclosure interpretations under Exchange Act Sections 13(d) and 13(g) and Regulation 13D-G Beneficial Ownership Reporting (Updated November 16, 2009) and the Brief of the Securities and Exchange Commission, Amicus Curiae in Levy v. Southbrook International Investments, Ltd., September 14, 2009.
9. See Section 16(b) under the Exchange Act.
10. A recent court decision has upheld the right of a board of directors to set a poison pill threshold as low as 4.99 percent. On October 4, 2010, the Delaware Supreme Court affirmed the Delaware Court of Chancery's decision in Selectica, Inc. v. Versata, Inc., C.A. No. 4241-VCN, 2010 WL 703062 (Feb. 26, 2010), which upheld a board's adoption of a poison pill with a 4.99 percent triggering threshold, which poison pill was designed to protect the usability of the corporation's net operating losses.
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.