David Feldman's book, Reverse Mergers: Taking a Company
Public Without an IPO, now in its third printing, was published in 2006
by Bloomberg Press (available on http://www.amazon.com).
View David Feldman's reverse merger blog at www.reversemergerblog.com.
Joseph Smith and David Feldman are coauthors of PIPES:
Revised and Updated Edition - A Guide to Private Investments in Public Equity
(Bloomberg Press, 2005) available on http://www.amazon.com.
In the News
Joseph
Smith heavily referenced in a PIPES
Report article about Rule 415. November
15, 2006.
A
Bit of Clarity on Rule 415: SEC Discussion
with Lawyers Sheds New Light on Recent
Inconsistency
By
Joe Gose
The
Securities and Exchange Commission's
newfound interpretation of Rule 415)a)(1)
of the Securities Act of 1933 continues
to flummox the PIPE market, and the
issue dominated panels and informal
discussions during The PIPEs Conference
2006 in New York last week. But Joe
Smith, investor counsel with Feldman
Weinstein & Smith who spoke to SEC
staffers as well as SEC Deputy Chief
Counsel Carol McGee early this week,
suggested that the commission's latest
stance is here to stay for the foreseeable
future.
Rule 415(a)(1) allows issuers to sell
shares on a delayed or continuous basis
in the future if they meet several requirements,
including whether the securities "are
to be offered or sold by or on behalf
of a person or persons other than the
registrant" or an affiliate or a subsidiary
of the registrant. But earlier this
year, the commission began questioning
whether the proposed selling shareholders
in PIPE deals listed In registration
filings were affiliates and whether
the registration statements at that
point were really primary offerings
-- particularly when the smallest of
issuers wanted to raise an amount that
was upwards of half their market capitalization.
Such a ruling would require PIPE investors
seeking immediate resale rights to become
underwriters and sell their shares at
a fixed price, through the SEC's view
doesn't affect larger issuers that typically
can file the less restrictive Form S-3
registration statement.
Over the last several years, the SEC
had generally allowed issuers to register
up to 50% of their public float to cover
investors in a PIPE without interference,
and the agency considered registration
statements with amounts beyond that
on a case by case basis, according to
PIPE experts. But over the last several
weeks, the commission has held up registration
statements when companies attempted
to register around 30% of their public
float.
The SEC informed Smith that after several
years of trying to get comfortable with
stretching a telephone interpretation
made nearly 10 years ago to accommodate
the PIPE market, it was returning to
a literal interpretation, which essentially
states that a proposed resale statement
may in fact be a primary offering depending
on all the facts and circumstances.
The commission confirmed the widespread
supposition that it would especially
scrutinize registration statements that
sought to register shares in excess
of 30% of a company's public float,
though it also reserved the right to
reject filings with a lower percentage.
Among other impressions the SEC made
upon Smith: The commission dislikes
institutional investors compared with
individual investors in such deals,
it dislikes convertible instruments
and warrants, and it particularly dislikes
toxic convertibles. The agency also
has the perception that investors are
flipping unregistered shares in deeply
discounted PIPEs, which has soured its
view of those transactions. But the
SEC is showing favor to deals that include
a lock-up provision on all or some shares
after effectiveness to prevent stock
from flooding the market.
Ultimately, PIPE experts have continually
warned, the SEC's behavior will hurt
small companies the most. "The unfortunate
thing is scores of companies have done
deals over the last six months not knowing
this was coming, and theyre not trapped,"
said Smith, who spoke to the SEC along
with an attorney for an issuer. "Companies
are going to go into default on registration
rights agreements."
McGee and Erick Sirri, the SEC's director
of market regulation, could not be reached.
However, previous discussions with commission
representatives have failed to yield
additional information, though an agency
spokesman has said that the agency had
no plans for formal rulemaking or guidance
surrounding Rule 415(a)(1). The commission
left Smith with the same impression.
Call for Action
Even before the SEC's back-channel confirmation
that it had returned to a more vigorous
application of Rule 415(a)(1), PIPE
Conference participants called for an
aggressive grassroots lobbying effort
of elected leaders to pressure the commission
to either treat registration statements
with more consistency or follow its
own prescribed rulemaking procedures
to give investors and issuers alike
a clear path to what the regulatory
body expects in certain PIPE deals.
At least one PIPE litigation attorney
confirmed that his firm had been approached
by investment funds to potentially take
the SEC to court for the practice. Panel
members also discussed potential alternative
deal structures to sidestep the issue,
such as tranching deals or tapping Rule
430A of the Securities Act of 1933,
"Prospectus in a Registration Statement
at the Time of Effectiveness," which
essentially allows non-shelf eligible
issuers to register shares but price
them after the registration statement
has become effective.
Meanwhile, investors in such deals may
have no other recourse but to avail
themselves of Rule 144 to exit a transaction
after holding the shares for 12 months.
Smith even suggested that funds take
a more active role in the companies
in which they invest.
Some funds, however, have reacted by
scaling back PIPE activity. Case in
point: Cornell Capital, one of the most
active annual PIPE market players over
the last several years, is accelerating
a move toward larger potential PIPE
issuers as well as international investments
in part because of the SECs stance,
said Troy Rillo a managing director
of the firm. He likened the regulatory
environment in the small cap finance
space over the last two years to banging
"heads against the wall." "Given the
level of uncertainty, small companies
are in a lot of trouble," Rillo said.
"We've expanded our scope internationally,
and quite frankly, we think our growth
is outside the U.S."
Corey Ribotsky, managing director for
The N.I.R. Group, the most active PIPE
investor in the micro cap arena, reported
that his firm was reining in the size
of its investments. "As weve gotten
bigger, we've added more deals and have
told analysts to pared down even further
the amount of money that some of these
companies are looking for," he says.
"If the companies cant live with it,
we move on the next transaction."
Inconsistent Treatment
Still, the SECs inconsistency in applying
its interpretation is perhaps most troubling
to investors. Investors and attorneys
alike recounted recent deals in which
a company registered 50% or more of
its outstanding shares without receiving
Rule 415 comments from the SEC. in fact,
PIPE issuers who are registering 100%
or more of their market caps are achieving
effectiveness in tranched deals -- as
the companies fulfill registration requirements,
they receive a round of financing. The
N.I.R. Group is a regular practitioner
of such transactions. Most recently,
for example, the fund manager closed
a $2 million variable price convertible
debt deal with Jackson Rivers Co., a
wireless machine to machine infrastructure
firm that's focused on serving the oil
and gas companies in Nigeria. The issuance
amount represented a whopping 460% of
the companys $435,000 market cap at
closing. The parties reached a definitive
agreement in late March that featured
three separate closings: $700,000 in
early April upon the execution of transaction
documents; $600,000 a few weeks later
after the company filed a registration
statements effectiveness, which occurred
in mid-October.
Reverse merger closings with parallel
PIPE transactions -- often referred
to as APOs (alternative public offerings)
-- continue to clear registration statement
reviews rather quickly and generally
without Rule 415 comments. Infosmart
group, which closed a $7.65 million
reset convertible debt deal in conjunction
with a reverse merger in September,
filed its initial Form SB-2 on Sept.
15 and the SC declared it effective
less than a month later. The Hong Kong
high density DVD manufacturer had a
market cap of some $2.9 million at the
closing, and the issuance represented
268% of the cap. Sandelll Asset Management,
CIM Dividend Income Fund, European American
Perinvest Group and Gottbetter Capital
lead a broad coalition of investors,
placing $1 million each in the deal.
Still, Smith and other PIPE experts
predict that SEC will target such deals
for the same Rule 415 treatment. "The
investors in APOs transactions are certainly
aware of the issue," said Timothy Halter,
president of Halter Financial Group,
an investment bank that specializes
in reverse mergers and coined the APO
term. "But no matter what, they have
ability to sell under Rule 144, so they
can begin to get liquidity even if the
shares aren't registered after 12 months."
Plus, he said, APOs typically involve
companies that already generate earning,
ad that makes investors more comfortable
with the notion of holding shares for
loner periods. On average, the APO transactions
he has worked on involve issuers that
have registered between 10% and 30%
of their public float, he added.
Cooling Trend?
While the SEC's heretofore vague policy
has brought howls from PIPE market participants,
it has yet to materially affect the
interest in PIPE deals in companies
below a $75 million float, the threshold
below which issuers are not eligible
for a simplified S-3 registration process.
If one looks at the subset of these
companies -- those with market caps
(as opposed to public float) under $75
million, such issuers have closed 227
non-Rule 144a PIPEs in 2006 through
Oct. 31, which accounted for 17% of
all PIPEs closed in that time span,
according to PrivateRaise, a PIPE research
firm that tracks deals of more tha n$1
million. That's roughly on par with
the 216 deals that made up 19% of the
PIPE market last year over the same
period. Moreover, the average raise
has increased to about $10.7 million
this year from $9.5 million last year.
Still, the predicted slowdown may be
starting to reveal itself: Companies
with less than a $75 million market
cap issuing more than 30% of that cap
have only closed four deals in the first
half of November -- about 11% of all
PIPE deals in the month -- well off
the average pace of 25 a month through
October of this year. At the same time,
the price of deals has remained relatively
consistent throughout the year -- investors
have received an average discount of
about 9% thus far in November compared
with 13.4% between the close of the
first half of 2006 and Oct. 31, and
11.3% in the frst half of the year,
according to PrivateRaise and accounting
for outliers.
But PIPE experts predict that it won't
take long before investors and issuers
hit a roadblock in negotiations, particularly
as more investors experience delays
in obtaining freely-tradable shares
and start demanding deeper discounts
and more warrant coverage. "It's a very
competitive business environment right
now, and unfortunately, investors are
going to be a lot harsher," Smith said.
"There could be a Mexican standoff for
the next six months."
PIPE players looking for alternatives,
he suggested, may want to examine Rule
430A. under the rule, Form S-1 and SB-2
issuers can register shares at an undetermined
price in a non-underwritten offering.
The company then can gather investors
after the filing becomes effective and
set a fixed price in a post-effective
amendment. In return, investors immediately
receive freely tradable shares. But
the rule doesn't allow issuers to sell
any leftover hares at a later date:
if the company has registered 10 million
shares, but can only find buyers for
7 million shares, for example, it must
file a new registration statement to
sell any additional shares beyond the
initial 7 million. Repeating such a
process could become cumbersome and
expensive, however, because micro cap
issuers can't incorporate other information
by reference into the subsequent registration
filings.
To date, no PIPE players have explored
Rule 430A to Smith's knowledge, but
other than requiring investors to wait
a year and avail themselves of Rule
144 to sell PIPE shares or moving to
London's Alternative Investment Market,
where poor overall liquidity is an issue,
he sees few alternatives for small PIPE
issuers going forward.
