By Robert C. Hackney
In this blog post we are going to discuss how the federal and state securities laws apply to acquisitions including a discussion of when the securities issued in connection with an acquisition must be registered under the Securities Act of 1933 as well as a discussion of the tender offer rules and the rules governing proxy contests, all of which can play into a merger or acquisition transaction.
The sale of securities is regulated on two levels. The first being the federal level and the second being the state level. When you are involved in any transaction where securities are being sold or exchanged, you have to be careful to comply with both federal and the applicable state laws because there exists what is known as concurrent jurisdiction, which simply means that they both have the right to regulate these transactions. Certain portions of state law have been preempted by federal law, so it can be a complex maze to navigate.
The specifics of registering securities, particularly with regard to initial public offerings, is beyond the scope of this blog post, so we won’t go into the details at this point, but you must be aware of the most important aspects of the application of the securities laws to acquisition transactions. When you have any kind of a corporate combination which involves exchanges of securities such as stock for stock transactions, your deal then involves the “sale” of securities because an exchange is defined as a sale under the securities laws. Consequently, your deal is subject to the registration requirements of the Securities Act of 1933 and any of the applicable state blue sky laws, unless there is an exemption from registration with which you can comply.
Federal Law
The way the Securities Act of 1933 is organized, all securities must be registered unless the securities, or the transaction to which they relate, is specifically exempted from the registration requirements. I like to tell my clients that this is one of the inverted laws in the American legal system because as an issuer, you are basically guilty until proven innocent, and what that means is that the way the federal and state securities laws are drafted, the person who claims an exemption from registration has the burden of proving that the exemption applies to those particular securities or transactions.
Consequently, if you as an issuer are ever challenged (by that I mean, if a regulator or someone who got your securities files a lawsuit against you), all they really have to do is allege that you sold them a security and it wasn’t registered and that is all that they have to prove, (if they are alleging the sale of unregistered securities against you). You must then pick up the ball and carry it and must be able to prove to the court that the exemption or exemptions that you are relying upon apply specifically to your deal. That is why there is almost as much paperwork involved in a private placement of securities as there is in a public offering so that the issuer, if ever challenged, can prove that it complied with all of the laws.
Exemptions Generally
When you talk about the federal laws and the federal exemptions under the securities laws, there are some exemptions that are provided for specifically in the 1933 Act, and then there have been a series of rules that have been passed under the authority of the Act, which set forth some other exemptions. Specifically, under the ’33 Act, the main rules I am referring to are contained in what is called Regulation D.
The most commonly seen exempt transactions are those that are done under Regulation D and also those that rely on Section 4(2) of the ’33 Act. Section 4(2) of the ’33 Act simply says that securities are exempt from regulation that are issued in transactions by an issuer “not involving any public offering.”
The idea behind both Sections 4(2) and Regulation D is that the burdensome registration process can be avoided in small business transactions under certain conditions. Very generally, the factors that indicate the availability of the Section 4(2) exemption are:
1) the number of offerees,
2) the size and the manner of the offering,
3) the sophistication from a financial standpoint of the investors,
4) the relationship of the investors to the issuing entity,
5) the material information that has been disclosed to the investors, and
6) restrictions on the transferability or the resale of the securities that have been sold.
• the number of offerees
Early judicial decisions in this area focused to a great deal on the number of offerees involved in a transaction and you will frequently hear people who aren’t very familiar with the process say things or ask questions like “as long as I keep it under 35 investors, I’m ok, right?” The important thing to remember is that the answer to that question is “No, you’re not all right, that there is a lot more to it than just a number’s game,” but again, very generally speaking, the smaller the number, the better the chance that a Section 4(2) exemption will be available to you. Again, that is just one factor, and it’s not the deciding or determining factor.
• the size and the manner of the offering
The factors of size and manner of offering relate to what kind of a process is involved in raising the funding, for example, is there an investment banker involved? Or is there an underwriter or some other professional money raiser who takes part in the transaction?
• the relationship of the investors to the issuing entity
Although there have been recent changes to the “general solicitation’ rules in recent years, generally a Section 4(2) exemption does not permit any general solicitation, which has frequently been interpreted to mean that there can be no advertising or other marketing designed to reach huge numbers of people through mass media. The financial sophistication aspect speaks for itself, because the law generally views the experienced investor as being able to take care of himself or herself and might not generally need the protection afforded by the disclosure requirements of registration. The relationship between the investors and the issuer is important because long time friends and business associates are typically assumed to have greater ability to obtain material information from an issuer.
• the sophistication from a financial standpoint of the investors
The law takes into account the background and experience of the investors. There is a presumption that a sophisticated business person who has made many investments is in a better position to judge the situation than the proverbial retired little old lady in tennis shoes (although this is not always the case).
• the material information that has been disclosed to the investors
Information actually provided to the investors is important because it also may show if the investors have been treated fairly in what they have been told and last of all restrictions on transferability or resale, which affect the liquidity of a security, indicate that generally for the longer period of time that an investor is tied to the investment, the greater the chances that this is purely a private offering and not a public one. For these reasons you will see some of the investment representations made in private placement subscription agreements that indicate that the investor knows that the investment is illiquid and will have to be held for a substantial period of time.
The Advent of Regulation D
Because Section 4(2) is so broad in its statutory form, it is subject to change based upon the judicial decisions that have come out which interpret the section. Many issuers don’t want to take the risk that the exemption won’t apply to them because the area is fairly murky when it comes down to specifics. The reality is that courts in one part of the country could interpret the section differently than courts in another area. As a result of that situation, the SEC passed Regulation D which sets forth a much clearer standard that can be followed and relied upon by an issuer, which is commonly referred to as a “safe harbor.” You have undoubtedly heard the term “accredited investor” and the concept of an accredited investor is something that comes directly from Regulation D.
Specifics of Regulation D
Regulation D is a series of rules, the three substantive ones originally being Rule 504, Rule 505 and Rule 506 (although Rule 505 has now been repealed). Along with the repeal of Rule 505, the SEC amended Rule 504, and split Rule 506 into two parts, 506(b) and 506(c). Traditionally, since Regulation D was adopted in the 1990s, the vast majority of private securities transactions have relied upon Rule 506 (now 506b). Generally Rule 506b exempts the deal from registration when sales are made to no more than thirty five non-accredited investors. There is no general solicitation or advertising and all investors receive disclosure of the same kind of information that would be included in a registration statement. Where this fits in an acquisition transaction is that an acquiror can issue stock and/or debt instruments under a Regulation D offering to a target’s shareholders if there are a small enough number of shareholders of the target, and the other requirements of Regulation D can be met, the most stringent of which involves the giving of various audited financial information (if non-accredited investors are involved). Rule 506c, created pursuant to the JOBS Act, permits general solicitation under very specific standards.
By using the Regulation D exemption, an acquiror can avoid substantial expense and delay in connection with an acquisition, because if you can’t fit within one of the exemptions, the acquiror will have to file a registration statement on Form S-4 and register the securities that it intended to exchange with the target’s stockholders.
There are some other exemptions from registration under the federal law that I want to just mention in passing so that you are aware of them. One is the Section 1145 exemption under the U.S. Bankruptcy Code, which exempts securities that are involved in an exchange that has been judicially or administratively approved. This is most frequently seen when a company is coming out of bankruptcy pursuant to a plan that is approved by the bankruptcy court.
Another exemption that is used is contained in Section 3(a)(11) of the ’33 Act and is known as the intrastate offering exemption, which provides that securities are exempt from registration if they are part of a issue that is offered and sold only to persons who reside in a single state where the issuer is a corporation, incorporated in that state. This is a very difficult exemption to take advantage of because if even one of the offerees is a non-resident, then the exemption is not available. There is also the problem of what the SEC calls the offering coming to rest, and what that means is that if a resident of a single state resells the security to a non-resident within a short period of time, the SEC could argue that the offering had not been completed and the securities had not come to rest until such time as they were in the hands of the non-residents, and consequently the intrastate offering exemption would not be available. Again, this is a very tough exemption to use although in some specific particular circumstances it might be one that could be advantageous.
Again, generally speaking you should be aware of the fact that Rule 145 exists. Rule 145 extends all of the disclosure requirements that are involved in the original issue of securities to merger and acquisition transactions as well as various asset transfers and reclassifications. The law before 1973 was that a merger or other business combination did not involve a sale of securities and consequently the registration provisions would not apply to such a transaction. When the SEC passed Rule 145, it was doing nothing more than verifying that if an exemption from registration were not available, then a merger or consolidation or even certain asset transfers would need to involve the filing of a registration statement which today is done under a form that is known as Form S-4.
Tender Offers and Proxy Contests
The other two areas that involve SEC matters are the areas of tender offers and of proxy contests. Very basically, a tender offer is nothing more than an offer being made by a person or an entity that is known as a bidder, to purchase stock of a target corporation from its shareholders. Tender offers are made for cash or securities such as stock, warrants, debentures, or bonds or they can be some combination of these. If the bidder is offering any type of securities to the shareholders of the target, then the registration provisions of the securities laws that we have just talked about come into play and the bidder will be required to not only comply with all of the tender offer rules but also the registration provisions of the federal and state securities laws.
In a cash tender offer, the bidder must comply with the tender offer rules only and since he is offering cash, he will not have the restraint placed upon him that is inherent in registering securities. Of course, it is possible in a situation involving less than thirty five non-accredited investors to issue either stock or some form of a debt instrument from the bidder and I have been involved in those situations so I know that it is possible even in a substantially sized company.
Tender Offer defined
But let’s go back again briefly to the definition of a tender offer, because I want to mention the fact that the SEC proposed a definition of a tender offer, which was neither adopted nor withdrawn which defined a tender offer as including both:
1) one or more offers to purchase or solicitations of offers to sell securities of a single class made during a 45 day period to more than 10 persons and seeking the acquisition of more than 5 percent of the class of securities of the target and
2) an offer to purchase disseminated in a wide spread manner providing for a premium over the market price in excess of 5 percent or two dollars, whichever was greater, and made without providing a meaningful opportunity to negotiate price and other terms.
Again, this is what the SEC at one point and time said they thought was a tender offer, and again, the proposal was not adopted, but it was also not withdrawn.
There is a fair amount of case law on this point and the cases seem to say that there are approximately eight situations that indicate that a stock purchase program is a tender offer and they are as follows:
1. Active and widespread solicitation of public shareholders for the shares of an issuer.
2. Solicitation made for a substantial percentage of the issuer’s stock.
3. An offer to purchase made at a premium over the prevailing market price.
4. The terms of the offer are firm rather than negotiable.
5. The offer is contingent on the tender of a fixed number of shares, often subject to a fixed maximum number to be purchased.
6. The offer is open only for a limited period of time.
7. Offerees are subject to pressure to sell their stock.
8. Public announcement of a purchasing program concerning the target company precedes or accompanies the rapid accumulation of a large amount of the target company’s securities.
The reason I outlined this for you is because you are going to want to know when your active securities purchase in the marketplace becomes viewed as a tender offer, and not just open market purchases. Let me make some very general suggestions that will not apply to every case. The first is that you are going to pay a premium over the market price, don’t make it a substantial premium and make it in terms of a negotiable offer, not a firm price. Second, don’t actively solicit a large group of shareholders. Keep your solicitations to a minimum and make sure that the people that you are contacting are sophisticated investors. Third, don’t set a specific time limit and fourth, be careful that you are not violating Rule 10(b)(13), which prohibits a person who is making a tender offer from making any formal or informal arrangements to purchase any stock after the termination of a formal tender offer. The effect of such an agreement could be to treat differently or unequally holders of securities of the same class which is not permitted. This doesn’t mean, however, that you can’t make arrangements prior to a tender offer, and those arrangements are disclosed in the tender offer. What it means is that you can’t make any arrangement once the tender offer has begun until such times as it has been concluded.
The technical mechanics of a tender offer are sufficiently complicated to take up a number of hours just in just their basic explanation, but let’s try to hit the highlights here and talk about some of the advantages and disadvantages of tender offers as part of your merger and acquisition strategy.
The Advantages of tender offers
The first advantage is that this is an offer to a target’s stockholders and the target company’s management and board of directors is not required to vote on or approve the bidder’s offer. If the shareholder’s tender their stock they are entering into a contract with the bidder directly and the target company itself is not a party itself to that contract. This is probably to your biggest advantage if this tender offer will be deemed to be a hostile tender offer because it permits a method by which you can acquire the target company against the wishes and desires of the target company’s management.
Tender offers are regulated by what is known as the Williams Act. The Williams Act does require that a target’s board of directors must meet and take a position on the tender offer and disclose that position to its shareholders. The target’s shareholders then have the right to make up their own mind after taking into consideration the arguments that have been made by both the target’s management and by the bidder.
Secondly, some boards, while they would not negotiate a merger with an acquiring company, may not openly oppose a tender offer and thus without either the active support of the target’s management or a hostile reaction to the tender offer, an acquisition may be made when it could not be made through negotiation with the company’s management.
Third, depending upon the situation, it may be cheaper for an acquiror to buy most of the stock of the target than to purchase that corporation’s assets in a negotiated transaction with its management.
Fourth, if management negotiates with an acquiror, it runs the risk that a court sometime in the future will determine that the price that management accepted was not adequate or not fair for the shareholders. In a tender offer where there is no competing bid, that situation is less likely to occur. In a merger transaction, a shareholder after the fact may decide that the exchange ratio really was not good enough and may bring an action against the board, but if the shareholder has accepted the tender himself, without there having been any board approval, it obviously becomes more difficult for a shareholder to blame that situation on the target’s management.
And fifth, the great advantage of the relatively short period of time that it takes to consummate a tender offer makes the process very popular. This is particularly true in a cash tender offer because there is no SEC pre-clearance of the documents. By that I mean that as soon as the bidder is ready to commence its tender offer, it does so under its own timetable and doesn’t need to file any documents with the SEC until the offer is commenced. That is not the case where you have a proxy solicitation and it is also not the case where you have to file a registration statement in connection with issuing securities pursuant to either a tender offer or a merger. You must keep in mind that the SEC requires a minimum twenty business day offering period for a tender offer so conceivably, for a cash tender offer, the acquisition can be completed within twenty days. Because of the things the usually occur during the pendency of a tender offer, however, it is somewhat unusual to see one conclude that quickly.
Disadvantages of tender offers
The first is that the bidder must offer a premium over the market price of the securities to attract the target’s shareholders, and that is only the beginning. In addition, there are investment banking fees, attorney’s fees, accountant’s fees, costs of publicity, fees connected with printing, and dissemination of all the information to the target’s shareholders. On top of that there is the risk of litigation that is involved in a tender offer. Management may decide to fight the bidder and drag the bidder into costly litigation which adds to the bottom line cost of the shares if the tender is successful.
The second problem is one of due diligence, or I should say lack of due diligence. In many tender offer situations, the bidder must rely upon public filings to get the background information that it needs on the target and no matter what they say about the full disclosure requirements of the securities laws, you just can’t get all the detailed information that you really should have to do a good due diligence background investigation of the target without the cooperation of the target.
Third, in a more traditional merger or acquisition that is negotiated, an acquiror will have the benefit of representations and warranties that are contained in the acquisition agreement and can have the right to go after the selling stockholders if certain things are not as represented. In a tender offer there is no such benefit. It is usually an “as is” purchase and what you see or really what you don’t see, is what you get.
Fourth, if you don’t buy all of the stock of the target, you may end up with minority stockholders and the bidder will have to deal with those minority stockholder and their interests which is frequently problematic.
And fifth, there are state anti-takeover statutes which provide another layer of regulation in addition to the federal layer of regulation under the Williams Act.
Basic requirements of a tender offer
There are a number of ways that a bidder can commence a tender offer. The bidder can either publish a long form advertisement in the newspaper, it can publish a summary advertisement in the newspaper, or it can publish or send to shareholders of the target copies of the tender offer materials. There is also something known as the five day business rule. If a bidder makes a public announcement that identifies the bidder and the target as well as the number of shares that the bidder will seeking, and the price or range of prices that will be offered and the SEC says that a tender offer has been commenced and within five days of that announcement the bidder either has to publicly announce its decision not to proceed with the tender offer, or it has got to file and distribute its tender offer documents.
The date of commencement is important because as we mentioned previously there is a minimum twenty business day offering period, so the bidder is usually very careful to go by the book when it comes to commencement of the offerings so that there is no question later as to whether or not the offer had been open for a minimum of twenty days. The most commonly used method of commencing an offering is by summary advertisement and you can frequently open the Wall Street Journal and find a summary advertisement for a tender offer.
On the day that the tender offer commences, or within in five days after under the five day business rule, the bidder has to file what is known as a Schedule 14(d)(1). This is a document that outlines the information about who the bidder is, who the target is, how much is being offered for the securities and in what manner, how long the offer is open for, and other information that is required to be disclosed by the rules. The Schedule 14(d)(1) gets filed with the SEC, copies are sent to the target and any stock exchange on which the company’s securities are traded. If a tender offer is already in progress by another bidder, the new bidder must send a copy of his Schedule 14(d)(1) to the other bidder or bidders that are involved in competing tender offers. If material changes occur, that would change any of the information contained in the Schedule 14(d)(1), the bidder is required to amend his documents. The Schedule 14(d)(1) is a technical document that is usually produced in what is known as a wraparound fashion. By that I mean that most of the information that is required by the rules is really set forth in the exhibits to Schedule 14(d)(1) and it is those exhibits for the most part that are sent to shareholders and they are specifically a document known as an offer to purchase and another document which is known as a letter of transmittal.
The offer to purchase is just that. It tells the target’s shareholders what the deal is and the letter of transmittal is the method by which the target stockholders can tender their shares. Any shares that are tendered can be withdrawn by a stockholder at any time during the pendency of the tender offer. If the tendered shares have not been purchased within sixty days from the date of the original offer, then a stockholder may also withdraw his shares under those circumstances. The tender offer rules require that a bidder must either promptly pay the consideration offered or return the tendered shares. The withdrawal provisions I just talked about would come into play where the tender offer period has ended and the bidder’s depositary and other agents are verifying that they have all the appropriate documentation to transfer the shares to the bidder before actually paying for them and during this period sixty days have run since the beginning of the tender offer, then the tendering shareholders would have the right to withdraw those shares if they had not obviously withdrawn them during the time that the tender offer was open.
As I mentioned before, a bidder cannot directly or indirectly purchase or arrange to purchase any securities of the target during the time that the tender offer is open other than pursuant specifically to the tender offer itself. In other words, the bidder cannot go into the marketplace and buy more stock at the market rate during the time that he has got a tender offer pending and he also can’t privately negotiate any purchases of stock until the tender offer has either been withdrawn or the offering period has expired. SEC rules provide that if a bidder is offering to purchase less than all the outstanding stock of the company and more shares are tendered then the bidder has offered to purchase, then the bidder must buy those shares on a pro rata basis. This situation led to an abuse know as short tendering which means that a stockholder would tender more shares than he actually owned in hopes of increasing the pro rata amount that would be accepted. The law provides that a stockholder cannot tender a security unless that at the time of the tender and at the time of the pro ration period, they own the security that was tendered. It is also improper for a stockholder to engage in hedged tendering which means that he tenders to more than one bidder or he tenders in the tender offer and also sells his securities in the open market.
In Part 2 of this blog post, we will discuss the Proxy Solicitation Rules and other disclosure rules under the federal securities laws that related to mergers and acquisitions.