On September 24, 2010, the Canadian Securities Administrators (CSAs) published staff notice 41-305 Share Structure Issues - Initial Public Offerings, which discusses factors considered by regulators when assessing a proposed share structure in an initial public offering (IPO) of securities and, specifically, whether a proposed structure is contrary to the public interest. According to the notice, the CSAs have encountered a number of IPOs where questions with respect to proposed share structures raised public interest concerns and led to a recommendation against the issuance of a prospectus receipt.
The staff notice highlights that the CSAs are particularly concerned with companies that have already issued an “unusually large” number of shares for nominal cash consideration (or for assets or business development where the value is not readily supportable), especially where the company has a limited history of operations and the IPO financing is relatively small. The CSAs' concerns stem from the fact the large number of nominally priced shares can create a platform for future market manipulation and the dilution of invested capital caused by existing shares issued for nominal amounts means that IPO investors receive an “unconscionably” low percentage of ownership compared to the amount of capital they are investing.
When the CSAs adopted National Policy 46-201 - Escrow for Initial Public Offerings (NP 46-201) in 2002, they indicated that issues associated with nominally-priced stock were better addressed by underwriters appropriately exercising their responsibilities related to IPO pricing and timing, and that securities regulators would rely on management of the issuer, underwriters and stock exchanges to assess the appropriateness of share capital structures. In the notice, staff acknowledges that this is still the case with the majority of issuers, but cautions that the CSAs' recent experience is that issuers still file prospectuses with capital structures that raise public interest concerns.
The CSAs recognize that structuring issues are complex and, accordingly, the notice is not meant to provide certainty for every possible scenario but, rather is intended to provide insight into the factors considered when staff evaluates proposed structures. The CSAs provided a list of qualitative and quantitative factors they consider when evaluating the acceptability of proposed IPO share structures.
The factors considered include:
- Comparing the IPO price with the average price paid by the founders (generally, the term “founders” means anyone who is a director, officer, promoter or insider of the issuer). The CSAs are particularly concerned with share capital structures where the IPO price “significantly exceeds” the average price paid by the founders.
- Assessing the proportion of capital to be contributed by the IPO purchasers in comparison to the percentage of ownership they will receive. The CSAs are concerned where the amount of capital to be contributed by IPO purchasers will be “significantly disproportionate” to their equity interest on completion of the offering.
- Comparing the average capital contributed per share for all issued and outstanding shares on completion of the offering and the purchase price per IPO share. The CSAs are concerned with situations where that average is "significantly reduced" due to a large block of founders' shares issued for nominal amounts.
- Whether founders have spent time, effort or resources developing a business, which may justify a structure containing significant founders' shares. While indicating that they would not normally object to share capital structures that reflect a realisation of business developments efforts or demonstrate value, the CSAs indicated in the notice that they may request an explanation of the size of a founders' position and the discount relative to the IPO price.
- The CSAs may only have concern with some (and not all) of the founders' shares, due to the fact that some founders may have received shares at a significantly lower average price than other founders.
- The more cash a founder has invested and the longer it has been invested, the more likely the share structure at issue will be acceptable.
- The presence of convertible securities at exercise prices lower than the IPO price may lead to the rejection of a share structure “[i]f the number [of convertible securities] is large enough or the exercise price is low enough.”
As indicated earlier, the notice is not meant to provide certainty for every scenario, but is intended to provide insight into factors considered in evaluating proposed share capital structures. So, perhaps, purposefully, the notice does not establish bright-line tests to assess what thresholds would lead a regulator to reject a particular share structure.
With concepts such as “significantly exceeds,” “significantly disproportionate” and “significantly reduced,“ one can conclude that the regulators would prefer that, as indicated in connection with the adoption of NP 46-201, management of the issuers, underwriters and stock exchanges police themselves and assess the appropriateness of proposed share capital structures and that the regulators need only to intervene in those cases that raise public interest concerns.
The CSAs stated that they will continue to monitor the issue and consider what further guidance or policy changes may be appropriate.r