Confidentially Marketed Public Offerings: Let’s Get Technical

In recent years, confidentially marketed public offerings (CMPOs) have become a preferred financing alternative to more traditional capital raising methods for many issuers. CMPOs are sometimes referred to as “wall-crossed,” “pre-marketed” or “overnight” offerings. Regardless of the terminology, the key feature of a CMPO is that it includes a public offering phase that is intended to satisfy the NASDAQ definition of a “public offering,” thereby avoiding compliance with NASDAQ’s 20 percent shareholder approval rule and other rules discussed below. Due to the speed at which CMPOs are frequently executed and the potential impact of these rules on pricing and structuring, which often change at the last minute, issuers and their advisors need to understand these rules to avoid last minute delays.

Market data indicates that CMPOs are here to stay. A total of 111 CMPOs raising approximately $4.7 billion were completed in 2012, compared to a total of 98 CMPOs raising approximately $4.2 billion in 2011. ¹PlacementTracker, http://www.placementtracker.com (last visited May 10, 2013) (available by subscription only). In addition, a total of 34 CMPOs raising approximately $1.2 billion were completed in the first three months of 2013, compared to a total of 32 CMPOs raising approximately $1.9 billion in the first three months of 2012. ²Id. Although the comparative three month data suggests that deal sizes are smaller in 2013, the total number of CMPOs being completed continues to increase. The smaller deal sizes also suggest that CMPOs are particularly well-suited for small and development stage technology and biotechnology issuers, which tend to have smaller market caps and a need to tap the capital markets with some regularity to fund ongoing research and development and new product launches.

CMPOs typically are marketed to a target group of accredited institutional investors on a confidential basis, and the offering is “flipped” into a public offering shortly before pricing. The public offering phase typically commences after the close of market with the announcement of the offering and the filing of selling documents, which may include a Rule 134-compliant press release, a free writing prospectus, a Form 8-K or a preliminary prospectus supplement (or a combination of these documents), and the offering prices before the market opens the following day. CMPOs price at a discount to the current market price and are documented much like a traditional underwritten offering, with an underwriting agreement, opinions of counsel and a comfort letter. The underwriters and their counsel will also conduct due diligence, including management and auditor due diligence and customer and supplier calls. The level of due diligence may be more or less extensive depending upon the existing relationship between the issuer and its underwriters. In some cases, deal teams can conduct the necessary due diligence and have transaction documents on stand-by for a favorable market window or an opportunistic move in an issuer’s stock price.

The confidential feature of the initial phase and the overnight feature of the public offering phase allow CMPOs to be executed quickly, with some offerings being done in just days from organizational call to pricing, compared to fully-marketed follow-on public offerings that may take from several weeks to months to complete. The confidential feature of the initial phase also allows issuers to test investor appetite for an offering and negotiate pricing and deal terms without publicity or exposure to speculative trading and stock price volatility, which generally accompany a fully-marketed offering. In addition, since the public offering phase is executed after the close of market and the offering prices before the market opens the following day, the stock price is not affected by the announcement of the offering prior to pricing. In general, offering expenses are minimized since CMPOs typically are marketed off the base prospectus included in an effective shelf registration statement and an issuer’s other public filings, rather than a heavily drafted prospectus supplement. In addition, since the shares sold in CMPOs are freely transferable, there is no additional liquidity discount typically imposed by investors who purchase restricted shares in a private placement.

In conducting the confidential phase of a CMPO, and in order to ensure compliance with Regulation FD and insider trading rules, an issuer and its underwriters will obtain confidentiality undertakings from potential investors and an agreement to refrain from trading in the issuer’s securities for a certain period of time. Typically, these undertakings and agreements are solicited orally and are confirmed in writing via email. In some cases, certain investors (e.g., large institutional investors) will agree to receive material non-public information only if the issuer commits to issuing a public “cleansing” statement in the event the offering does not proceed. The purpose of the cleansing statement is to disclose to the public any material non-public information that potential investors have received in confidence, thereby allowing them to resume regular trading activities.

After a potential investor is “brought over the wall” by agreeing to keep information about the offering confidential, the potential investor can receive material non-public information regarding the proposed offering, including the identity of the issuer, offering details and other information, such as business updates and a summary of recent developments. Marketing materials shared with potential investors during the confidential phase typically are limited to an issuer’s public filings, including general “investor presentations” that are already in the public domain. By avoiding the use of written materials, issuers avoid the risk of needing to file these materials publicly in the event the offering does not proceed.

Once indications of interest have been obtained during the confidential phase, the issuer will wait until the close of market to announce the offering and file selling documents. The selling documents will contain any material non-public information previously disclosed to potential investors during the confidential phase, if any. The underwriters will then initiate the public offering phase of the CMPO to market the offering more broadly to institutional and retail investors. Selling efforts may continue well into the evening and the offering is priced and final deal terms are announced before the market opens the following day. Following pricing, the offering settles and closes like a traditional underwritten public offering.

Many issuers undertaking CMPOs have smaller market caps that may implicate SEC rules regarding the amount of securities that may be offered and sold in a primary offering. In addition, the public offering phase of a CMPO will need to meet certain criteria to qualify as a “public offering” under the rules of NASDAQ. If a CMPO does not qualify as a “public offering” for NASDAQ purposes, additional NASDAQ rules will be implicated, including the shareholder approval rule referred to as the “20 percent rule.” These SEC and NASDAQ rules can be highly technical and nuanced and are subject to various interpretations, informal guidance and FAQs. Issuers and their advisors need to understand these rules to avoid last minute delays. So, let’s get technical.

The ‘Baby Shelf Rule’

All issuers contemplating a CMPO will need to have an effective registration statement. They also will need to understand whether there are any limitations on the size of the proposed offering imposed by federal securities laws. In general, if an issuer has an aggregate market value of voting and non-voting common stock held by non-affiliates of $75 million or more, the issuer can offer up to the maximum amount of securities available under the registration statement. ³SEC Form S-3, General Instruction I(B)(1), available at http://www.sec.gov/about/forms/forms-3.pdf. However, if an issuer has an aggregate market value of voting and non-voting common stock held by non-affiliates of less than $75 million, the issuer can offer up to one-third of that market value in any trailing 12-month period. ⁴SEC Form S-3, General Instruction I(B)(6)(a), available at http://www.sec.gov/about/forms/forms-3.pdf. This one-third limitation is typically referred to by practitioners and advisors as the “baby shelf rule,” and the aggregate market value of voting and non-voting common stock held by non-affiliates is typically referred to as “non-affiliate float.”

In calculating the non-affiliate float, issuers are allowed to look back 60 days from the measurement date and select the highest of the last sale prices or the average of the bid and ask prices on the principal exchange, while using a share number as of the measurement date. ⁵SEC Form S-3, Instruction to General Instruction I(B)(1), available at
http://www.sec.gov/about/forms/forms-3.pdf; see also SEC Div. of Corp. Fin., C&DI No. 116.06 (Feb. 27, 2009), available at http://www.sec.gov/divisions/corpfin/guidance/safinterp.htm.

The capacity under the baby shelf rule is measured immediately prior to the offering and is re-measured on a rolling basis in connection with subsequent offerings. ⁶SEC Div. of Corp. Fin., C&DI No. 116.22 (Aug. 11, 2010), available at http://www.sec.gov/divisions/corpfin/guidance/safinterp.htm. When measuring for a later offering, only the amount actually sold in prior offerings is counted against the baby shelf rule. ⁷Id. The ability to re-measure on a rolling basis can benefit issuers by increasing capacity under the baby shelf rule if the stock price is trending up, but it can also limit capacity if the stock price is trending down.

Being subject to the baby shelf rule is not a permanent condition, and SEC rules allow issuers to emerge from this status if the non-affiliate float exceeds $75 million at the time of re-measurement. ⁸SEC Form S-3, Instruction 3 to General Instruction I(B)(6), available at http://www.sec.gov/about/forms/forms-3.pdf.

The ‘Public Offering’ Rule

As noted above, the key feature of a CMPO is that it includes a public offering phase that satisfies the NASDAQ definition of a “public offering,” thereby avoiding compliance with the 20 percent rule. The 20 percent rule, which applies to any proposed sale that does not qualify as a “public offering,” requires an issuer to obtain shareholder approval when it sells 20 percent or more of its outstanding common stock (or securities convertible into common stock) or voting power at a discount to the greater of the market price or book value per share of common stock. ⁹NASDAQ Stock Market Rule 5635(d), available at http://nasdaq.cchwallstreet.com/NASDAQTools/PlatformViewer.asp?selectednode=chp percent5F1 percent5F1 percent5F4 percent5F3&manual= percent2Fnasdaq percent2Fmain percent2Fnasdaq percent2Dequityrules percent2F.

In general, a firm commitment underwritten offering registered with the SEC will be considered a “public offering” for NASDAQ purposes. ¹⁰NASDAQ IM-5635-3 , available at http://nasdaq.cchwallstreet.com/NASDAQTools/PlatformViewer.asp?selectednode=chp percent5F1 percent5F1 percent5F4 percent5F3&manual= percent2Fnasdaq percent2Fmain percent2Fnasdaq percent2Dequityrules percent2F. However, since CMPOs can be distinguished from traditional firm commitment underwritten public offerings in several respects, including with respect to the confidential marketing phase and the abbreviated public offering phase, issuers will need to confirm that the public offering phase qualifies as a “public offering” for NASDAQ purposes. NASDAQ has identified the following factors that it will consider in evaluating whether a CMPO qualifies as a “public offering”:

• the type of offering (including whether the offering is conducted by an underwriter on a firm commitment basis, or an underwriter or placement agent on a best-efforts basis, or whether the offering is self-directed by the issuer);

• the manner in which the offering is marketed (including the number of investors offered securities, how those investors were chosen and the breadth of the marketing effort);

• the extent of the offering’s distribution (including the number and identity of the investors who participate in the offering and whether any prior relationship existed between the issuer and those investors);

• the offering price (including the extent of any discount to the market price of the securities offered); and

• the extent to which the issuer controls the offering and its distribution. ¹¹Id.

None of the above factors is dispositive, and the relative weight of each factor may vary depending on the facts and circumstances of a particular offering. Given the potential variations in size, pricing, marketing efforts and allocation from offering to offering, it should not be surprising that there is a dearth of definitive guidance on the application of these factors. However, based on informal guidance from NASDAQ and transaction experience, the following general points can be used to guide the “public offering” analysis:

• firm commitment underwritten offerings are viewed more favorably by NASDAQ than offerings underwritten on a “best efforts” basis;

• the offering price should be within a range that represents a typical discount for comparable companies, and departures from the range will need to be supported by offering-specific facts;

• the offering must be actively marketed to both institutional and retail investors (the issuance of a pre-pricing press release announcing the offering is helpful evidence of active marketing);

• there is no bright-line rule requiring a minimum number of retail investors to purchase securities in the offering;

• there is no bright-line rule limiting the number of institutional investors who purchase securities in the offering;

• there is no bright-line rule requiring the offering to be allocated among institutional and retail investors according to certain percentages;

• insider participation is generally viewed unfavorably, although NASDAQ recognizes that certain limited insider participation might support marketing efforts by demonstrating management commitment to the issuer; and

• issuer control over marketing efforts and the allocation of securities is viewed unfavorably.

At the end of the day, NASDAQ will analyze the facts and circumstances of each offering to determine whether an issuer has conducted a “public offering.” Since there is no “one size fits all” approach to this analysis, issuers and their advisors need to analyze carefully the facts and circumstances of their offerings to determine whether they will qualify as a “public offering.” In addition, NASDAQ encourages its issuers to consult with staff in order to determine if a particular offering will be considered a “public offering” for purposes of the 20 percent rule. ¹²Id. Based on transaction experience, an open dialogue with NASDAQ early in the CMPO process can help identify problematic facts that may be remedied when executing the transaction.

Failure to comply with the 20 percent rule may result in a public reprimand or a potential de-listing.

The Other 20 Percent Rule

A frequently overlooked NASDAQ rule is the rule requiring an issuer to obtain shareholder approval prior to any sale or potential sale of securities that may result in a change of control. ¹³NASDAQ Stock Market Rule 5635(b), available at http://nasdaq.cchwallstreet.com/NASDAQTools/PlatformViewer.asp?selectednode=chp percent5F1 percent5F1 percent5F4 percent5F3&manual= percent2Fnasdaq percent2Fmain percent2Fnasdaq percent2Dequityrules percent2F. According to NASDAQ, a “change of control” occurs when an investor or group of investors would own, or have the right to acquire, 20 percent or more of the outstanding shares of common stock or voting power and that ownership position or voting power would represent the largest ownership position of the issuer. ¹⁴NASDAQ OMX Listing Center, Frequently Asked Questions, available at https://listingcenter.nasdaqomx.com/Material_Search.aspx?cid=71&mcd=LQ&sub_cid=118,98,96,99,100,94. This shareholder approval rule typically is referred to by practitioners and advisors as the “change of control rule.” As with the 20 percent rule, there is an exemption from the change of control rule for a transaction that qualifies as a “public offering.” In the context of a CMPO, the “public offering” exemption can be particularly useful since some of the typical investors are existing stockholders, some of which may hold significant equity positions before and after the offering.

Insider Participation

A further NASDAQ rule requires shareholder approval prior to the issuance in a private placement of common stock (or securities convertible into common stock) to officers, directors, employees, consultants or affiliates of those parties at a price less than the current market price. ¹⁵NASDAQ Stock Market Rule 5635(c), available at http://nasdaq.cchwallstreet.com/NASDAQTools/PlatformViewer.asp?selectednode=chp percent5F1 percent5F1 percent5F4 percent5F3&manual= percent2Fnasdaq percent2Fmain percent2Fnasdaq percent2Dequityrules percent2F. NASDAQ considers discounted sales to insiders to be a form of “equity compensation” requiring shareholder approval. ¹⁶NASDAQ OMX Listing Center, Frequently Asked Questions, available at https://listingcenter.nasdaqomx.com/Material_Search.aspx?cid=71&mcd=LQ&sub_cid=118,98,96,99,100,94. As with the 20 percent rule and the change of control rule, there is an exemption for issuances to insiders at a price less than the current market price in a transaction that qualifies as a “public offering.” However, as noted above, insider participation in an offering is generally viewed unfavorably by NASDAQ in connection with the “public offering” analysis.

Other Considerations

FINRA Compliance

CMPOs will likely require compliance with FINRA’s corporate financing rule. ¹⁷FINRA Rule 5110, available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=6831. In 2010, FINRA introduced a same-day clearance process that significantly streamlined the pre-offering and review process for registered offerings by issuers that otherwise do not qualify for an exemption under corporate financing rule. ¹⁸FINRA Rule 5110(b)(7), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=6831. One of the exemptions available to issuers is based, in part, on the size of issuers’ public float. ¹⁹FINRA Rule 5110(b)(7)(C)(i), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=6831. Since many issuers for which CMPOs will be an appealing financing method may have smaller market caps, they will not be eligible for an exemption and will need to obtain FINRA clearance for their offerings. The same-day clearance process requires various representations and certain information, including the participating FINRA members’ names and items of compensation. While it is possible to clear a shelf registration statement and prospectus supplement on the same day, it is highly recommended that the shelf registration statement be cleared in advance when it is initially filed with the SEC. The streamlined nature of the same-day clearance process has contributed to the efficiency of CMPOs, but it remains a critical work stream and requires careful preparation and coordination to avoid unnecessary delays.

Listing Application

NASDAQ requires issuers to submit an application for the listing of additional shares at least 15 days prior to undertaking certain offerings. ²⁰NASDAQ Stock Market Rule 5250(e)(2), available at http://nasdaq.cchwallstreet.com/NASDAQTools/PlatformViewer.asp?selectednode=chp percent5F1 percent5F1 percent5F4 percent5F3&manual= percent2Fnasdaq percent2Fmain percent2Fnasdaq percent2Dequityrules percent2F. Issuers contemplating a CMPO should consider submitting an application well in advance of the proposed offering, even if the final deal size and type of offering is subject to change. NASDAQ has demonstrated a willingness to waive the advance submission requirement, provided that the issuer in question does not have a history of last-minute submissions.

The New York Stock Exchange

The NYSE has similar versions of the 20 percent rule, the change of control rule and the rule regarding discounted sales to insiders, together with available exemptions for an offering that qualifies as a “public offering” under the rules of the NYSE. In addition, the NYSE has its own requirement regarding submitting an application for the additional listing of shares prior to undertaking certain offerings. Issuers listed on the NYSE should consult with their advisors regarding applicable NYSE rules.

Conclusion

CMPOs are a very effective financing alternative to more traditional capital raising methods and they appear to be here to stay. Issuers contemplating a CMPO should inform themselves of the rules described in this article and should ensure they hire advisors well-versed in the nuances of the rules.