Preliminary Musings as to the New Rule 415 Regime - Now What?
Here are some initial thoughts and humble suggestions as we all adjust to the “new normal” under 415 (remember our first reactions when Sarbanes-Oxley was passed?). Bottom line: it ain’t the greatest but the sky is indeed not falling and I believe the SEC is not trying to stop these transactions but rather to rein in some excessive players, and we can all adjust.
I apologize in advance for the somewhat lengthy post, but we have been waiting for this for eight months, so I wish to cover a number of implications and a new idea worth considering that can eliminate the issue.
PIPEs Market in General
My partners and others, I am sure, will have much to say about the overall implications of the new 415 interpretations on the PIPE market as a whole, so I will not say much other than that deals for the smallest public companies are probably going to be more difficult to do and more expensive for the issuers. This does not seem likely to quell the strong growing market for PIPE investments in any meaningful way. In fact, through all this tumult over the last eight months the PIPE business in our law firm has only grown busier and stronger, and there is no sign of letting up.
My hope is that the SEC staff concentrates on punishing true bad guys in the market and removes as many restrictions as possible on the legitimate players. While we finally have a new standard, which is good, with deference to those I do respect at the SEC, I believe it went a bit too far and is unnecessarily restrictive as a guard against a few bad apples.
I am also disappointed in their approach to a second registration, and hopefully that will be revisited. To suggest that you can never register more shares until the LATER of six months and the time that substantially all the shares in the first registration are sold seems counter to what the SEC is trying to achieve here (ie effectively saying you can never register more until all the shares are sold from the first registration). It makes much more sense for it to be the EARLIER of these two things.
Reverse Mergers- Virgins Win?
As to reverse mergers, I suppose there is both good and bad news, leading to a conclusion that deals should and will go forward, but with different assumptions and expectations.
The bad news is I had hoped there might be a different clear standard for first registrations following reverse mergers than the standard applied to PIPE investments into already public companies. Since there is essentially no “float” in a post-reverse merged company, limiting registration to any percentage of float is almost meaningless. This will require the first few deals to go through a trial and error process to see what will work. Hopefully within a short time we will have a sense of their attitude and approach.
The good news is, the SEC has acknowledged and recognizes this problem, and on Friday SEC top lawyer David Lynn mentioned the “no float” issue and suggested that they would be more receptive to registering a reasonable number of shares after a reverse merger even where there is no float, following the six-factor test outlined in their old telephone interpretation. I was slightly disappointed that it took a question from the audience for him to address this rather than being part of his prepared remarks.
So what does this mean for shell mergers? Let’s remember the concern that the 415 issue addresses: that individuals with tradeable shares might get substantially diluted by a large resale registration with virtually no notice or disclosure. I have argued to the SEC staff, and they confirmed the logic of the argument, that in a merger with a virgin shell, there are literally no tradeable shares prior to the merger, so this concern simply does not apply at all. Every shareholder, before having tradeable shares, understands what percent of the company will become tradeable. In a trading shell there is more of a concern about diluting the public shareholders of the shell with the registration following the merger.
Thus, I believe that the staff will be more receptive to registering more shares in a registration following a merger with a virgin (ie fully reporting but non-trading) shell than with an already trading shell. Now, there are other perceived advantages to a merger with a trading shell, such as a larger shareholder base and the momentum that an immediate trading market after a merger can provide. But I will leave the rest of the trading vs. non-trading argument for another post.
Some say to me, well you support virgins because you get money from many clients doing it and you have a few yourself. It’s the other way around. I encourage my clients to do it, and also put my own interests into them, because I believe in the value of the vehicle. It is not for every deal but has tremendous benefit and simplicity in many situations. It is, frankly, almost an accident that this new Rule 415 analysis ends up helping the virgin shells, but here we are.
Self-Filings and SPACs Also Win
It appears that a PIPE placed into a private company just before it proceeds with a self-filing of an SB-2 or 10-SB will be more favorably received under 415 than a similar PIPE invested into a shell merger or already public company. This is because the staff is more comfortable that the PIPE has been “completed,” reducing the concern that the investor is an underwriter. This should increase the value of self-filings, so long as PIPE investors are willing to make that large investment in a private company initially (some are prohibited by their fund documents). It appears that the staff will be more willing to register a larger percentage of the stock for resale in this situation.
None of the 415 issue affects SPACs, since their money is raised through a primary offering not subject to Rule 415 analysis. SPACs, which have grown dramatically, face other challenges from the SEC, including long delays in getting proxies approved for deals awaiting shareholder approval. But it appears they will continue apace undaunted, and this is a good thing. Also, smaller SPACs, again with no 415 problem, may develop as an interesting alternative to virgins and trading shells, which will continue to face the problem at some level.
How about a Form S-4 in Reverse Mergers? Might just work..
Another approach worth considering that some have begun talking about is to register shares to be issued in a reverse merger under an S-4 registration statement. There would be no limit on the number of shares registered because S-4 involves a primary offering, not a secondary. The problems are (1) that the SEC has to review and approve your S-4, and a merger registration is notoriously annoying and (2) you have to wait to close your reverse merger while they do, which could be several months. However, an S-4 approach should be quicker than a self-filing, which still may undergo 415 review. With the S-4 route you do need a shell to merge into that would be the subject of the registration, whereas in a self-filing no third party is necessary. So weigh your own pros and cons.
Ideally, if a PIPE investor is willing to invest prior to the S-4, you will have raised your money just the same as in a merger with a virgin shell and subsequent resale registration. In both cases there is no trading until a registration is approved, so where that investment is available there may not be much difference, except that the S-4 has the benefit of allowing you to register without limitation.
This approach would be exactly what the SEC is hoping everyone will do – turn secondaries that seem large into primaries. Might be another nice application for the virgins, and would eliminate the 415 issue in a reverse merger with a trading shell.
Conclusion
In sum, I’m happy that the uncertainty is mostly over in this area. We all wish the standard would have been higher, but at least we now have one. It’s workable for most players, and reverse mergers will continue.
In truth, any investor in a PIPE into a reverse merger who was betting on the importance of having tradeable shares within a few months and then in fact trading those shares, made the wrong bet. Most of our clients who invest in reverse mergers understand that it is “public venture capital” and they need to have a longer-term outlook with respect to liquidity. Thus, in reverse mergers, this is simply less of a major concern in most cases. Since the average market capitalization in reverse mergers has hit about $60 million, it also won’t be long before most become eligible for short-form registration and are exempt from the 415 analysis.
So I guess I don’t have to recall all the copies of my book after all…
I apologize in advance for the somewhat lengthy post, but we have been waiting for this for eight months, so I wish to cover a number of implications and a new idea worth considering that can eliminate the issue.
PIPEs Market in General
My partners and others, I am sure, will have much to say about the overall implications of the new 415 interpretations on the PIPE market as a whole, so I will not say much other than that deals for the smallest public companies are probably going to be more difficult to do and more expensive for the issuers. This does not seem likely to quell the strong growing market for PIPE investments in any meaningful way. In fact, through all this tumult over the last eight months the PIPE business in our law firm has only grown busier and stronger, and there is no sign of letting up.
My hope is that the SEC staff concentrates on punishing true bad guys in the market and removes as many restrictions as possible on the legitimate players. While we finally have a new standard, which is good, with deference to those I do respect at the SEC, I believe it went a bit too far and is unnecessarily restrictive as a guard against a few bad apples.
I am also disappointed in their approach to a second registration, and hopefully that will be revisited. To suggest that you can never register more shares until the LATER of six months and the time that substantially all the shares in the first registration are sold seems counter to what the SEC is trying to achieve here (ie effectively saying you can never register more until all the shares are sold from the first registration). It makes much more sense for it to be the EARLIER of these two things.
Reverse Mergers- Virgins Win?
As to reverse mergers, I suppose there is both good and bad news, leading to a conclusion that deals should and will go forward, but with different assumptions and expectations.
The bad news is I had hoped there might be a different clear standard for first registrations following reverse mergers than the standard applied to PIPE investments into already public companies. Since there is essentially no “float” in a post-reverse merged company, limiting registration to any percentage of float is almost meaningless. This will require the first few deals to go through a trial and error process to see what will work. Hopefully within a short time we will have a sense of their attitude and approach.
The good news is, the SEC has acknowledged and recognizes this problem, and on Friday SEC top lawyer David Lynn mentioned the “no float” issue and suggested that they would be more receptive to registering a reasonable number of shares after a reverse merger even where there is no float, following the six-factor test outlined in their old telephone interpretation. I was slightly disappointed that it took a question from the audience for him to address this rather than being part of his prepared remarks.
So what does this mean for shell mergers? Let’s remember the concern that the 415 issue addresses: that individuals with tradeable shares might get substantially diluted by a large resale registration with virtually no notice or disclosure. I have argued to the SEC staff, and they confirmed the logic of the argument, that in a merger with a virgin shell, there are literally no tradeable shares prior to the merger, so this concern simply does not apply at all. Every shareholder, before having tradeable shares, understands what percent of the company will become tradeable. In a trading shell there is more of a concern about diluting the public shareholders of the shell with the registration following the merger.
Thus, I believe that the staff will be more receptive to registering more shares in a registration following a merger with a virgin (ie fully reporting but non-trading) shell than with an already trading shell. Now, there are other perceived advantages to a merger with a trading shell, such as a larger shareholder base and the momentum that an immediate trading market after a merger can provide. But I will leave the rest of the trading vs. non-trading argument for another post.
Some say to me, well you support virgins because you get money from many clients doing it and you have a few yourself. It’s the other way around. I encourage my clients to do it, and also put my own interests into them, because I believe in the value of the vehicle. It is not for every deal but has tremendous benefit and simplicity in many situations. It is, frankly, almost an accident that this new Rule 415 analysis ends up helping the virgin shells, but here we are.
Self-Filings and SPACs Also Win
It appears that a PIPE placed into a private company just before it proceeds with a self-filing of an SB-2 or 10-SB will be more favorably received under 415 than a similar PIPE invested into a shell merger or already public company. This is because the staff is more comfortable that the PIPE has been “completed,” reducing the concern that the investor is an underwriter. This should increase the value of self-filings, so long as PIPE investors are willing to make that large investment in a private company initially (some are prohibited by their fund documents). It appears that the staff will be more willing to register a larger percentage of the stock for resale in this situation.
None of the 415 issue affects SPACs, since their money is raised through a primary offering not subject to Rule 415 analysis. SPACs, which have grown dramatically, face other challenges from the SEC, including long delays in getting proxies approved for deals awaiting shareholder approval. But it appears they will continue apace undaunted, and this is a good thing. Also, smaller SPACs, again with no 415 problem, may develop as an interesting alternative to virgins and trading shells, which will continue to face the problem at some level.
How about a Form S-4 in Reverse Mergers? Might just work..
Another approach worth considering that some have begun talking about is to register shares to be issued in a reverse merger under an S-4 registration statement. There would be no limit on the number of shares registered because S-4 involves a primary offering, not a secondary. The problems are (1) that the SEC has to review and approve your S-4, and a merger registration is notoriously annoying and (2) you have to wait to close your reverse merger while they do, which could be several months. However, an S-4 approach should be quicker than a self-filing, which still may undergo 415 review. With the S-4 route you do need a shell to merge into that would be the subject of the registration, whereas in a self-filing no third party is necessary. So weigh your own pros and cons.
Ideally, if a PIPE investor is willing to invest prior to the S-4, you will have raised your money just the same as in a merger with a virgin shell and subsequent resale registration. In both cases there is no trading until a registration is approved, so where that investment is available there may not be much difference, except that the S-4 has the benefit of allowing you to register without limitation.
This approach would be exactly what the SEC is hoping everyone will do – turn secondaries that seem large into primaries. Might be another nice application for the virgins, and would eliminate the 415 issue in a reverse merger with a trading shell.
Conclusion
In sum, I’m happy that the uncertainty is mostly over in this area. We all wish the standard would have been higher, but at least we now have one. It’s workable for most players, and reverse mergers will continue.
In truth, any investor in a PIPE into a reverse merger who was betting on the importance of having tradeable shares within a few months and then in fact trading those shares, made the wrong bet. Most of our clients who invest in reverse mergers understand that it is “public venture capital” and they need to have a longer-term outlook with respect to liquidity. Thus, in reverse mergers, this is simply less of a major concern in most cases. Since the average market capitalization in reverse mergers has hit about $60 million, it also won’t be long before most become eligible for short-form registration and are exempt from the 415 analysis.
So I guess I don’t have to recall all the copies of my book after all…
posted by David N. Feldman at
1/29/2007 11:00:00 AM
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