On September 26, 2018, the Securities and Exchange Commission (the "SEC") approved amendments to Nasdaq Rule 5635(d) (the "20% Rule") to (i) change the definition of "market value" for purposes of the 20% Rule, (ii) eliminate the requirement for shareholder approval of certain private issuances at a price less than book value but greater than market value and (iii) make certain conforming changes. The SEC's order granting accelerated approval of the amendments notes that the changes to the definition of "market value" for purposes of the 20% Rule, which instead look to a "Market Price" measurement that is further discussed below, may provide a better indication of actual market value, make this measurement less prone to manipulation and help ensure transparency to investors in calculating this metric.
Importantly, the amended 20% Rule only applies to issuers listed on Nasdaq. Issuers listed on the New York Stock Exchange ("NYSE") are instead governed by NYSE Rule 312.03(c)1 (the "NYSE Rule"), which is similar to the amended 20% Rule, but contains some important differences in determining which offerings are exempt from shareholder approval. The nuances of the NYSE Rule are beyond the scope of this discussion, which is limited to Nasdaq's 20% Rule. Additionally, limited partnerships listed on Nasdaq should be aware that they are not subject to the 20% Rule2, so this discussion will not be of particular importance to them.
Background of Nasdaq Rule
When a company offers 20% or more of its equity in an offering that is priced below the market value of the security, existing public shareholders can be significantly diluted and the company's smaller shareholders may be prohibited from participating in the offer if it is private. The 20% Rule, and the NYSE Rule, are designed to prevent this dilution by giving shareholders an opportunity to vote on such offerings and prior notice thereof sufficient to allow the shareholders to sell their stock before the consummation of the offering.
Prior Nasdaq Rule
Prior to the amendments, Nasdaq Rule 5635(d) required shareholder approval of a private placement transaction involving: (1) the sale, issuance, or potential issuance by a company of common stock (or securities convertible into or exercisable for common stock) at a price less than the greater of book or market value which, together with sales by officers, directors, or substantial shareholders (defined as holders of at least 5% of the company's common stock) of the company, equals 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance or (2) the sale, issuance, or potential issuance by a company of common stock (or securities convertible into or exercisable for common stock) equal to 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance for less than the greater of the book or market value of the stock.
Amended Nasdaq Rule
Under the amendments, the two tests will be combined into a requirement that shareholder approval be obtained prior to a "20% Issuance" at a price that is less than the "Minimum Price." For purposes of amended Rule 5635(d), "20% Issuance" means a transaction, other than a public offering, involving the sale, issuance, or potential issuance of common stock (or securities convertible into or exercisable for common stock), which, alone or together with sales by officers, directors, or substantial shareholders (defined as holders of at least 5% of the company's common stock), equals 20% or more of the common stock or voting power outstanding before the issuance. "Minimum Price" means a price that is the lower of: (i) the closing price (as reflected on Nasdaq.com) immediately preceding the signing of the binding agreement or (ii) the average closing price of the common stock (as reflected on Nasdaq.com) for the five trading days immediately preceding the signing of the binding agreement.
Highlight of Changes to Nasdaq Rule
The highlights to the changes effected by the amended 20% Rule include:
- Closing Price on Nasdaq.com vs. Closing Bid Price. The amended 20% Rule looks to the closing price reflected on Nasdaq.com rather than the prior metric of the closing Nasdaq bid price, which change is consistent with the approach of other exchanges.
- Addition of Five Trading-Day Average Closing Price Metric. The amended 20% Rule adds a new metric in determining whether a shareholder vote is necessary that looks to the five-day average closing price. Nasdaq stated that this metric is useful because assessing the market value of a security as of a specific time can be impractical in a volatile market.
- Elimination of Book Value Measure. A security's book value will no longer be used to determine whether shareholder approval is needed under the amended 20% Rule. Nasdaq noted that book value was an inappropriate measure of whether a transaction is dilutive because book value is an accounting measure that employs the historical costs of assets rather than their current value, and, along with other data, is already incorporated into the market value of the security.
- Lower of the Two Measures. The amended 20% Rule requires a shareholder vote if the offering price is less than the lower of the closing price on Nasdaq.com and the five-day average closing price, whereas the old rule required a shareholder vote if the offering price was less than the greater of the "market value" and book value.
- References to Private Placements. The amended 20% Rule revises the title of Rule 5635(d) and the preamble of Rule 5635 to replace references to "private placements" with "transactions other than public offerings" in order to conform to the language used in Nasdaq Rule IM-5635-3, which defines "public offering."
The amended 20% Rule provides issuers greater flexibility in structuring their transactions by allowing them to account for market volatility and one-off events that can create an artificially high or low price. Additionally, the replacement of the book value measure with a five-day price average and use of the lower of the closing price and five-day average will likely reduce the number of transactions requiring a shareholder vote because (i) a security's book value is rarely greater than its market value and (ii) the five-day average closing price will likely be below the final day's closing price if the offering occurs in a rising price environment.
Issuers should be aware that their ability to issue equity in private offerings without shareholder approval is still limited by important Nasdaq rules which require a shareholder vote for (i) certain discounted issuances to a company's officers, directors, employees and consultants3, (ii) issuances that result in a change of control of the issuer4 and (iii) certain issuances in connection with the acquisition of the stock or assets of another company5.
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