In a series of blogs, I detailed Nasdaq and NYSE American rules requiring listed companies to receive shareholder approval in particular instances, including prior to the issuance of certain securities. In particular, Nasdaq Rule 5635 sets forth the circumstances under which shareholder approval is required prior to an issuance of securities in connection with: (i) the acquisition of the stock or assets of another company (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants (see HERE); (iii) a change of control (see HERE); and (iv) transactions other than public offerings (see HERE). NYSE American Company Guide Sections 711, 712 and 713 have substantially similar provisions.
Each of these rules necessarily interacts with the Exchanges’ rules and policies related to voting rights.
Nasdaq Rule 5640 provides that “[V]oting rights of existing Shareholders of publicly traded common stock registered under Section 12 of the Act cannot be disparately reduced or restricted through any corporate action or issuance.” Similarly, NYSE American Company Guide Section 122 provides, “[V]oting rights of existing shareholders of publicly traded common stock registered under Section 12 of the Exchange Act cannot be disparately reduced or restricted through any corporate action or issuance. Examples of such corporate action or issuance include, but are not limited to, the adoption of time-phased voting plans, the adoption of capped voting rights plans, the issuance of super voting stock, or the issuance of stock with voting rights less than the per share voting rights of the existing common stock through an exchange offer.” To clarify, the Exchange allows the issuance of a class of lower voting stock but the higher voting class cannot be eligible to convert into the lower voting class.
The rule cannot be circumvented by shareholder approval. That is, shareholders may not vote to disenfranchise themselves or to disparately reduce their voting rights. Thus, shareholder approval for the transaction that led to a violation of the voting rights rule will not remedy the violation.
Both Exchanges’ rule is intended to be flexible under the facts and circumstances of an issuance, giving the Exchange wide latitude to engage in discussions with a company and approve, or disapprove, of an issuance that could violate the voting rights rule. In reviewing an issuance or corporate action, the Exchanges will consider the economics of the proposal as a whole and the specific voting rights sought to be granted. Guidance and commentary on the rules specifically “strongly recommends” that a company consult with the Exchange prior to taking any action that could violate the rule.
Rights to Nominate or Designate a Director
The Exchanges will closely review any agreements or issuances to investors that include the power to designate or nominate a director beyond their share ownership. For example, should a company allow an investor to nominate or designate directors at a level which is disproportionately greater than its ownership position, Nasdaq would view that corporate action as disparately reducing the voting power of the other shareholders. For example, if the investor has a 30% ownership interest in the company, it could nominate or designate 30% of the members of the board. The number of directors can be rounded up to next whole number. However, rounding up would not be acceptable where the investor has less than a 50% ownership position but rounding up would allow the investor to nominate or designate a majority of the board.
Likewise, any agreement for the nomination or designation of directors must take into account subsequent reductions in the investor’s voting power. As such, if the investor’s ownership position materially declines, whether through sales by the investor or additional issuances by the company, the investor’s nomination or designation rights should be concomitantly reduced (this is sometimes called a “step-down”). In addition, the agreement with respect to directors should include a minimum level below which the investor would lose these rights.
Dual Classes of Stock
Commentary and guidance in the rules specifically allow for the listing of companies with a dual-class structure, including a class of super voting stock. Where a company has been listed with a dual-class structure, additional issuances of existing super voting stock, including through direct issuances, dividends, or stock options, would not violate the rule.
The listing of companies with multiple classes of stock has been a heavily debated topic over the last few years compounded by the rise of tech IPO’s that have gone so far as listing non-voting shares (Snap, Inc., for example). Facebook and Alphabet have dual-class stock structures. Although listed common shareholders have voting rights, the insiders hold substantial control with super-voting preferred stock.
Regulators and insider insiders such as hedge funds and proxy firms have all addressed the issue, with strong opinions. SEC Commissioners Robert Jackson and Kara Stein have both given speeches on the subject. Some company insiders have given into the pressure, such as Zynga’s founder Mark Pincus, who last year announced he will convert his super-voting preferred stock into common stock, eliminating the company’s dual-class structure. For more on this, see HERE.
In December 2018, the Harvard Business Review issued an article concluding that any ban on a dual-class structure would do more harm than good, encouraging tech and other companies to stay private and preventing retail investors’ access to important investments, regardless of the voting rights. I agree. Although clearly the debate around dual-class structures raises some important points, including issues where control securities are inherited by less capable heirs, I remain an advocate for a free-market system. In the free-market system, it is likely that if management that holds super-voting shares does not perform, the underlying business will lose value, consumers will stop buying the product, and institutions will stop owning the stock and investing. The corporate insiders would then be under self-preserving pressure to be acquired by a stronger competitor with a better management team.
SEC Former Rule 19c-4
The voting rights rule is based on the former SEC Rule 19c-4 and, as such, the Exchanges specifically indicate that if an issuance had been allowable under the former rule, it will be allowed by the Exchange. In 1988 the SEC adopted Rule 19c-4 which, in effect, amended the listing standards of stock exchanges to prohibit most forms of dual classes of stock. However, in 1990 the rule was struck down by the D.C. circuit court as going beyond the authority of the SEC, leaving class structure as a matter of state law.
During the fight for Rule 19c-4, the SEC argued it had the power to regulate class structure under the proxy rules. The court, however, found that the proxy rules can only address disclosure and procedure but do not extend to federal regulation over substantive shareholder voting. It is unclear how the SEC will navigate around the court ruling if it again attempts to regulate dual- or multiple-class structures.
Rule 19c-4 specifically allowed the following (including if there are multiple classes of stock): (i) the issuance of securities in a registered IPO; (ii) the issuance of securities in a registered IPO with voting rights that are not greater than an already outstanding class of securities of that company; (iii) the issuance in a merger or acquisition transaction as long as the class of securities issued does not have voting rights greater than an already outstanding class; or (iv) a corporate action under state law that allows for the limitation of voting rights above a specified threshold without prior approval of the independent shareholders (state law anti-takeover statutes).
Financially Distressed Companies
The Exchanges may be more flexible in allowing the issuance of a different class of securities for a company that is financially distressed. A company seeking relief as financially distressed must inform the Exchange in writing and describe the proposed transaction in detail, including the identity of the investors. Nasdaq provides a list of examples of information that should be discussed in the letter, including: (i) the facts and circumstances that led to the company’s predicament; (ii) how long the company will be able to meet its current obligations, such as payroll, lease payments, and debt service, if it does not complete the proposed transaction; (iii) the company’s current and projected cash position and burn rate; (iv) other alternatives; (v) why a step transaction will not work; (vi) would the company file for bankruptcy without the transaction; (vii) the impact to operations while waiting for shareholder approval; (viii) why the company didn’t enter into a transaction sooner; (ix) demonstrate that the transaction will rescue the company; (x) demonstrate that the company will continue to meet Nasdaq’s listing requirements; and (xi) explain changes in voting power.
The Exchange will specifically consider whether the proposed recapitalization is part of a plan to rescue the company and as such, the voting rights are consistent with the new investors’ reasonable expectations for protection of their investment. Approval is more likely if the new class of stock mirrors traditional preferred stock, such as a convertible preferred stock that allows the holders to vote on an as-converted basis.
The Exchanges will accept any action or issuance relating to the voting rights structure of a non-U.S. company that is in compliance with the Exchange’s requirements for domestic companies or that is not prohibited by the company’s home country law.
Consequences for Violation
As with all Exchange rules, consequences for the violation of the voting rights rule can be severe, including delisting from the Exchange. Companies that are delisted from an Exchange as a result of a violation of these rules are rarely ever re-listed.
Laura Anthony, Esq.
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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