In December, 2006, members of our Firm’s Specialty Finance Group met with David Lynn, Chief Counsel of the Securities and Exchange Commission’s Division of Corporation Finance, and Carol McGee, Deputy Chief Counsel, in an attempt to clarify the Staff’s recent application of Rule 415 under the Securities Act of 1933.

Although the Staff contends that its position on Rule 415 has not changed, it is incontrovertible that the Staff is using this Rule to disallow many types of deals that were previously permitted.

In its continued scrutiny of the PIPEs marketplace and its efforts to curb market abuses, the Staff has focused its regulatory energy on Rule 415, which is the rule issuers rely upon to subsequently register for resale the shares issued in a PIPE transaction. Under existing Staff interpretation and practice, issuers have been able to register as a valid secondary offering under Rule 415 shares they sold in a PIPE representing well upwards of 50% of their outstanding public float (i.e., the number of outstanding shares held by non-affiliates). Beginning last Spring, the Staff began tightening the availability of Rule 415 for secondary offerings, particularly where the number of shares being registered exceeded 30% of the issuer's public float. If the Staff does not allow an offering to be considered as a secondary offering, then the offering is a deemed primary offering. The consequences of being a deemed primary offering are twofold: (1) the issuer must meet the higher, primary offering eligibility criteria for using a Form S-3 Registration Statement, meaning that it must have a public float in excess of $75 million; and (2) each of the investors named as a selling shareholder in the registration statement must be identified as an underwriter. If the issuer fails to meet the eligibility criteria for using a Form S-3, the Staff requires the issuer to withdraw the registration statement and re-file it on either a Form S-1 or SB-2. This can be time consuming and costly, since the Staff only comments after the issuer has already filed its registration statement, and the other forms of registration statement require additional detailed financial and narrative disclosures. Underwriter status, however, is the real "showstopper" in the sense that it immediately exposes the selling shareholder to full liability for any misstatements or omissions in that registration statement (subject to a due diligence defense). The practical impact of this new Staff focus is that issuers can no longer sell and register as many securities as in the past, thereby making many future PIPE deals smaller than past deals.

The Staff does not have any definitive guidance on this 415 Issue, so navigating through it has proven quite difficult. To their credit, however, the members of the Staff are concerned about the impact these perceived changes have had, particularly on the ability of smaller public companies to raise money. The Staff also have been quite willing to speak directly with market participants about their concerns. Given the complexity of this issue and the absence of any written guidance from the Staff, the information in the marketplace is fragmented, frequently inconsistent and, indeed, sometimes wrong. Further, people who already have met with the Staff on the 415 Issue have apparently taken away from those meetings what they wanted to hear or thought they heard. As a result, information is out in the marketplace that is not consistent with the SEC’s position. At the risk of further muddying the waters, we summarize below our “takeaways” from our meeting with the Staff.

Focus of SEC Concern

The Staff remains concerned about abusive transaction structures, and market participants who are more likely to engage in illegal trading activities in and around PIPE transactions. We discussed with the Staff a number of different scenarios under which the Rule 415 Issue might arise. Of most interest to PIPE investors, we asked the Staff about a “classic” PIPE transaction in which an issuer sells shares of common stock at a discount to market with warrants that are exercisable at a premium to market and contain customary price-related antidilution adjustments. The Staff reassured us that this “classic” structure was not particularly concerning to them and was not the focus of its scrutiny. Instead, the Staff referred us to transactions such as “toxic convertibles” where convertible notes are issued with floating conversion prices, resulting in a conversion into a multiple (e.g., 2x, 3x, 4x or higher) of the total number of outstanding shares. The Staff noted that in many of these transactions, the issuer’s stock price trades down over time and that public investors are often unaware of the risk these transactions create. The Staff also pointed to transactions with excessive up-front financing fees or hidden transaction fees as additional areas of concern. In particular, the Staff expressed a strong desire for issuers to include adequate disclosure about the fees paid in these transactions. The Staff’s new use of Rule 415 is designed to curtail these “toxic convertible” transactions, and not impair the more traditional or “classic” type of PIPE transactions. However, as the Staff acknowledged rather colorfully, “When you cast out a net, you catch some dolphins with the tuna.”

We also discussed with the Staff the “Alternative Public Offering” (APOs) (i.e., transactions in which a PIPE occurs simultaneously with or shortly after the reverse merger), as an example of transactions that receive Rule 415 scrutiny. Many commentators have indicated that the Staff seems to have a different set of criteria in mind when reviewing reverse mergers, and that APOs can register many more shares than customary PIPEs. We explored some examples of these transactions with the Staff during our meeting. The Staff recognized that the typical reverse merger transaction, where there is an exceedingly small public float and a relatively high multiple of that float sold in a concurrent financing transaction, does not present the same abusive concerns as, say, the toxic transactions. Consistent with some of the commentators’ views, the Staff indicated a willingness to view these transactions differently than other PIPE financing transactions, and allow greater flexibility in registering the shares in an APO.

Staff Will Rely on Comment Process

Because the Staff continues to apply a facts and circumstances test to Rule 415, the Staff does not believe it is possible or appropriate to provide general interpretive guidance on Rule 415. As a result, the Staff expects to resolve Rule 415 issues on a case-by-case basis through the registration statement comment process. The Staff does, however, expect to standardize the comments it issues with respect to the Rule 415 Issue, so issuers can better gage how to respond to and resolve the Staff’s concerns. Consistent with its concerns about the ultimate purchasers of these securities (i.e., the investing public), the Staff has indicated that its comments will not only focus on the Rule 415 Issue, but also ask for additional disclosure relating to the costs and risks of these private offerings.

The additional disclosure will relate to:

  • The dilutive impact of this offering and similar past transactions
  •  The amount actually received by the issuer from the transaction
  • The costs of the transaction, including all fees paid or payable
  • Increased risk disclosure

In our view, these enhanced disclosures should be included now in all resale registration statements, regardless of whether the issuer believes that Rule 415 may be an issue, rather than waiting for a Staff comment. While not conclusive about it, the Staff seemed to indicate that providing this type of disclosure may actually obviate the need for the issuance of a Rule 415 comment, even where the offering size exceeds 30% of the public float.

The 30% Test is Only a Screening Device

The Staff advised us that there is an established percentage test (which we believe is 30%, although the Staff would not confirm the number) that will be used as a screening device, and not as a “hard-and-fast rule” as to what will constitute a deemed primary offering by an issuer. As described to us, for administrative purposes, the Staff needed to implement a simple test for its reviewers to determine whether to issue a Rule 415 comment on a particular registration statement. As the Staff reviewer examines a registration statement, one of the items on its “checklist” is to determine whether the number of shares being registered exceeds 30% of the public float, and if it does, then, under the current Staff policy, the reviewer will automatically add comments asking why the issuer believes the offering constitutes a valid secondary offering under Rule 415. While a fully diluted calculation may be more appropriate in a given situation, the necessary information is not readily available to the reviewers and the Staff cannot justify the time a reviewer would have to spend acquiring the necessary information. Consequently, this is the reason for an overly simplified test, and why, in our view, the added disclosure discussed above is important to include at the outset.

Facts and Circumstances Test Still Applies

The Staff maintained that the facts and circumstances test set out in the Staff’s Manual of Publicly Available Telephone Interpretations still applies and that, in the Staff’s view, its interpretation of Rule 415 has not changed. Section D, Question 29 of that Manual sets out the factors that the Staff believes are relevant to determining whether a purported secondary offering is really a primary offering:

  • How long have the selling stockholders have held their shares 
  •  How the selling stockholders received their shares 
  •  The relationship between the selling stockholders and the issuer 
  •  The amount of shares involved 
  •  Whether the sellers are in the business of underwriting securities 
  •  Whether under all the circumstances it appears that the seller is acting as a conduit for the issuer

The Staff emphasized the importance of the nature of the selling shareholders in its analysis. The longer the selling shareholders’ expected holding period, the less likely the offering will appear to be a primary offering.

The Staff’s View on Related Matters Number of Shares Registered is Only One Factor

In our conversation, the Staff indicated that the number of shares being registered is the primary factor to trigger a comment related to Rule 415, but that the number of shares being registered is only one factor in the analysis of whether or not the offering actually constitutes a primary or secondary. As a result, if other factors are favorable, an issuer in a particular transaction may be able to register more shares than another issuer in a different situation.

Blockers Ineffective

The Staff acknowledged that it has recognized the efficacy of “blockers” (i.e., contractual limitations that prohibit an investor from acquiring more than a specific percentage of the issuer’s outstanding stock, say 4.99% or 9.99%), but was quick to limit its position to certain situations. Since the Staff’s focus under Rule 415 is on the number of shares that may ultimately be distributed to the public, it will ignore any such blocker provisions in calculating the number of shares being registered.

Lock-ups Do Not Work

The Staff did not believe that including lock-up provisions that prevented a selling stockholder from selling stock for a specific period, such as 90 or 180 days, would be helpful in its analysis. The Staff’s disdain for lock-ups comes from its belief that investors typically do not comply with them or find ways to evade them. The Staff was not persuaded by the fact that lock-ups can be enforced by an issuer giving its transfer agent stop transfer instructions.

Atmospherics Remain Important

The Staff will continue to be interested in the “atmospherics” of a particular transaction. The Staff emphatically pointed out its disdain for toxic converts and other abusive transactions, and will do what it can to curb their use. Similarly, the identity, number and type of investors will remain important. Paradoxically, the Staff would prefer a larger number of small investors as compared to a small number of larger institutions. Apparently, in the Staff’s view, it is less likely that a coordinated distribution of securities will occur with a more diffuse roster of investors. Similarly, the Staff will be more hostile to “traders” than to “buy-and-hold” investors. In the Staff’s opinion, arbitrageurs who do no fundamental due diligence on an issuer and are only interested in the technical aspects of the market for the issuer’s securities are much more likely to flip the securities purchased and thus effect a distribution. Accordingly, in marketing a transaction, placement agents and issuers will now need to be more aware and concerned about the type of investor included in the book. When the investor group is dominated by “buy-and-hold” investors, the Staff will be less likely to conclude a distribution will take place. In anticipation of Staff comments, we are advising our investor clients to begin to pull together information that may be relevant to a Staff inquiry, such as the average period of time a position is held, the due diligence process conducted, any pre-existing long-term holding in the issuer and any other helpful facts. Interestingly, having the right to board representation may either be helpful or hurtful, depending on the circumstances. In some situations, it is evidence that the investor is a long-term holder of the stock. In others, it is an indicia of control that could make a particular transaction look more like a distribution by insiders.

Ability to Register Cut-Back Shares Uncertain

The Staff would not take a position on whether it would allow an issuer to effect a subsequent registration of any shares cut out of a registration statement in order to comply with Rule 415 and avoid treatment as a primary offering. The Staff was clear, however, that it would presume any contractual commitment to register any cut-back shares as evasive, and impose a high hurdle to rebut that presumption. In the absence of a written contractual provision to register cut-back shares, if the Staff finds from the facts and circumstances that any such arrangement existed or that the subsequent registration of cut-back shares was part of a scheme to evade Rule 415, it appears that the Staff will not allow an issuer to file a second registration statement for the cut-back shares. Unfortunately, the Staff did not indicate whether or in what circumstances they would find such an arrangement or view the cut-back provisions as an attempt to evade Rule 415. We sensitized the Staff to the fact that uncertainty in this area would continue to chill investment activity and ultimately raise the cost of funds for issuers, but this was to no avail. We expect this issue to play out in the Staff’s comment letters.

Only Time Will Tell

We told the Staff that its actions in the comment process will either create more confusion or, hopefully, restore some much-needed certainty to the PIPEs market. The Staff indicated that it is dedicated to providing consistent comments to issuers, and recognizes that it is incumbent upon them to do so. Only time will tell whether the Staff’s application of Rule 415 will succeed in ridding the market of the targeted abuses, or whether it will simply shrink the lower end of the market altogether. In the meantime, we believe it is important for market participants to separate fact from fiction and to apply what has been learned to date to current and future transactions. We expect that further information will be forthcoming in the near future as the comment process continues. Until more certainty is available, issuers, investors and agents should tread carefully and consult with their legal advisers about these matters.