From PLI’s Course Handbook
Understanding the Securities Laws 2008
#14665
10
ALTERNATIVES TO TRADITIONAL
PUBLIC OFFERINGS
Michael Kaplan
Davis Polk & Wardwell
2
(NY) 98402/280/GENERAL/course.handbook.alternatives.to.traditional.public.offerings.doc06/11/08 4:38 PM
Alternatives to Traditional Public Offerings
Michael Kaplan
Davis Polk & Wardwell
3
(NY) 98402/280/GENERAL/course.handbook.alternatives.to.traditional.public.offerings.doc06/11/08 4:38 PM
Introduction
SPACs / Reverse Mergers
Rule 144A IPOs
144A Trading Platforms
AIM Listings
PIPEs / Registered Directs
Rights Offerings
Spin-Offs
SPACS/Reverse Mergers
What is a SPAC?

Also known as a “blank check company”

A public shell organized to acquire one or more
businesses or assets


The SPAC raises money in its IPO which it places
in trust until it completes its first acquisition
(usually within 24 months)


May limit target business to an industry or
region, focus on an industry or region, or
have no limit or focus for acquisition
If it cannot find one within 24 months (or
its shareholders vote “no”), it unwinds
A “public” private equity fund set up by a management
team.
Why Do I Care?

Since 2005, 144 SPACs have raised $21 billion and an
additional 72 SPAC IPOs are pending

Completed IPOs with proceeds over $100 million: 2004
(1), 2005 (9), 2006 (11), 2007 (37)

In 2008, to date there have been 7 completed SPAC IPOs
with proceeds over $100 million
Why a SPAC?

A SPAC offers advantages to both management and
investors:
Management:
2

Management team can form SPAC with very
limited capital and without need for sponsor.

SPACs are sold based on management experience
in the industry rather than LBO experience
although we are increasingly seeing private equity
sponsors.

Time to market is shorter than for a first-time
private equity fund and with perceived higher
certainty of execution.

Instead of answering to sponsor, management
answers to a majority independent board of
directors and multiple public stockholders, none of
which are in a controlling position.

Management holds liquid equity and options in a
public company with visible stock pricing rather
than illiquid carried interest paid over time.

On the other hand, management gets no
compensation until acquisition is
completed (no “management fee”).
Investors:

Investors benefit from a less expensive investment
with a fair amount of liquidity.


On the other hand, much of the capital call
is moved up-front.
Because shareholders must vote to approve any
transaction, a SPAC cannot offer the same
certainty of closing to targets, making it a less
competitive bidder in a competitive situation.
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How do SPACs Work?

The management group will invest $25,000 in a SPAC in
exchange for 20% of the equity post-IPO; management is
restricted from monetizing their equity until after the
acquisition is consummated.

The public purchases units (one share of common stock
and one, or sometimes two, warrants).

Most of the proceeds placed in trust pending acquisition.

Remaining proceeds fund expenses during the preacquisition period, including SEC reporting costs,
acquisition due diligence and other expenses.

Management does not get paid a management fee
or other salary until the acquisition closes
(although a management company often gets a
small administrative fee for office space and
administrative services and management does get
reimbursement of out-of-pocket expenses).

In most transactions, management is allowed to
pursue other activities without regard to normal
business opportunity rules.

Following an acquisition, the company becomes a normal
public company.

Rule 419 governs any “blank check company” which is
defined as:

A developmental stage company with no specific
business plan or purpose, other than to engage in a
merger or acquisition with an unidentified
company, that is issuing “penny stock” as defined
under the Exchange Act.

A company with $5 million or more of net
tangible assets is not a “penny stock.”
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

Rule 419 imposes various onerous requirements
on blank check companies, including prohibition
on trading of its common equity until an
acquisition occurs.
A SPAC is exempt from Rule 419 on the basis that its net
tangible assets exceed $5 million; SEC requires filing of 8K with audited financial statements immediately after IPO
to establish exemption.

While not required, SPAC offerings generally
follow the spirit of Rule 419 offerings with a few
significant differences.

95+% of net proceeds deposited in escrow

Fair value of first targeted business to
represent at least 80% of the amount held
in trust

Units issued in SPAC offerings begin
trading on date of IPO
Legal Issues

Disclosure

S-1 principally describes structure, investment
strategy and industry overview


No real MD&A or financial statements
because no operations.
Management

Integrity and experience of management
team is key since SPAC is essentially a
shell company with few other assets.

Background report by independent third
party an important part of due diligence.
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

Acquisitions in contemplation

As a result of one deal announced soon
after pricing of the IPO, the SEC routinely
requests all SPACs to affirm that they
have done nothing to identify a potential
target business.

As a result, a SPAC generally states in its
IPO prospectus that it: (1) has no specific
acquisition under consideration; and (2)
has not been in contact with any
prospective acquisition partner.

If management or sponsor have other
business activities that involve evaluating
investment opportunities, the SEC may be
particularly focused on this point.

As a result, it is critical that no research is
conducted, or external discussions occur,
prior to consumption of the IPO.
Blue Sky laws

If securities are listed on the AMEX, NYSE or
NASDAQ, then the blue sky securities registration
requirements are preempted under the Securities
Act.

If no listing, then Blue Sky laws apply.

Generally, no retail distribution for SPAC
securities traded on the OTC Bulletin
Board is permitted as very few states will
register a “blank check” offering.

Unlimited sales may be made to
institutional purchasers, defined under the
Blue Sky laws to include financial
institutions, insurance companies,
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registered investment companies, pension
funds, etc.


Investment Company Act

Funds held in the trust account are invested in
money market funds and/or U.S. government
securities so that a SPAC is not deemed to be an
investment company under the Investment
Company Act.

A SPAC may not purchase any investment
securities, other than money market funds and/or
U.S. government securities, in order to rely on
Rule 3a-1 under the Investment Company Act.


Resales in the secondary market are not
restricted.
All assets outside the trust account should
be “good assets” for purposes of the
Investment Company Act analysis.
Shell Company rules

Although a SPAC is not governed by Rule 419, it
does constitute a “shell company” under the new
SEC rules effective in August 2005.

A shell company is an “ineligible issuer” and, as a
result, cannot use free writing prospectuses to
convey “time of sale” information.

A shell company is required to indicate its status
as a shell company on the cover page of its Form
10-K, 10-Q or 20-F filings.

As a shell company, a SPAC that is reporting its
initial acquisition of a target business must furnish
information comparable to that required in an IPO
prospectus within four business days. It can no
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longer simply file a Form 8-K containing a brief
description of such acquisition.

The SEC eliminated the use of Form S-8 for shell
companies.


Makes management equity plans more
cumbersome, but not impossible.
Shell companies are excluded from the safe harbor
of Rule 139, which could affect the ability of the
underwriter to participate in future offerings to the
extent it issues research on the SPAC post
acquisition.
SPAC – Reverse Merger

A “Reverse Merger” is where a company seeking to go
public opts, instead of an IPO, to merger with a blank
check company, such as a SPAC, and thereby ends up as a
public company

Perceived advantage is that the process avoids
market risks endemic to IPO issuers

On the other hand, there is a risk that the SPAC
shareholders, who are entitled to a vote, can vote
no



This happened to a significant number of
SPACs in the last year
While process is different than an IPO, SEC rules
require that the SPAC prepare a proxy for the
shareholder approval process which includes S-1
level disclosure about the target, and is subject to
SEC review; process is effectively the same from
an SEC perspective
Negotiating with potential targets
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


SPACs often enter into confidentiality/no-trading
agreements with major investors prior to
announcement of an acquisition in an attempt to
gauge interest.

SPACs will want to get potential targets to waive
claims against the trust. In addition, breakup fees
present issues for SPACs.
Conflict concerns

The sponsor is incentivized to find a deal to avoid
losing its investment.

The underwriter is incentivized to find a deal to
avoid losing its deferred underwriting spread.
Because of resistance from hedge funds threatening to vote
“no” in prior deals, pressure to have investment banks help
in soliciting “yes” votes or helping find investors to buy
the stock that would vote “yes”.

Legal constraints / SEC concerns

Purchase of stock from investors by founders also raises
potential issues in certain circumstances. SEC
enforcement is currently focused on potential violations of
Regulation M, Rule 13e-4, Regulation 14D and Regulation
14E as a result of such purchases.

Use of projections in roadshow.
Rule 144A IPOs
What is a 144A IPO?

Process substantially similar to an IPO

Shares are sold in a broadly distributed offering to
institutional investors on a private placement basis
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
Roadshow similar to a typical IPO roadshow and
includes typical IPO buyers (principal difference
is no retail since it is a private placement)

Shares are traded among institutional investors through
DTC after the offering

Principal difference from an IPO is no SEC review until
after the offering

Accessing the market prior to SEC review can
save 8-12 weeks

Issuer agrees to file a resale registration statement and
apply for listing on an exchange after the offering so that
shares can eventually be publicly traded

Documentation is substantially the same as the
documentation for a traditional IPO

Content of offering memorandum substantially the
same as a traditional IPO prospectus

Comfort letters, opinions and other documentation
is substantially the same as in a traditional IPO
Why Do I Care?

Approximately 100 144A IPOs have been completed

Size and volume of transactions and number of market
participants has increased significantly in last few years
How Do 144A IPOs Work?

Resale Shelf and Piggyback Rights

Resale shelf
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
Issuer covenants to file a resale shelf
within 90 days and cause it to be effective
within 180 days


Piggyback rights

144A buyers have the right to sell in the
IPO subject to customary underwriters’
cutback



Penalty for failure is typically loss
of special bonus to management
or, less frequently, liquidated
damages
Piggyback rights apply only to the
IPO and not subsequent offerings
Lock-ups

Issuer agrees to a typical traditional IPO 180-day
lockup

144A buyers agree to a 60-day lockup that
commences at the time of the traditional IPO

Designed to protect the eventual
traditional IPO

Issuer is permitted to suspend the resale
shelf registration statement during this
period to enforce lock-up
Listing

Issuer covenants to apply for listing on NASDAQ
or the NYSE in connection with the resale shelf

Difficulty in meeting the listing
requirements if 144A IPO is not followed
by a traditional IPO
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
NYSE requires 2,000 holders of
round lots

NASDAQ NMS requires 400
holders of round lots

NASDAQ Small Cap requires 300
holders of round lots
Sarbanes-Oxley

Sarbanes-Oxley requirements do not begin to
apply until the resale shelf registration statement is
filed




Nonetheless, for marketing reasons many
issuers voluntarily comply with certain
items such as:

Securing at least one independent
board member and undertaking to
have 2 more within 90 days and a
majority within 180 days (i.e., the
requirements applicable if it had
been a traditional IPO)

Creation of an audit committee
and compensation committee

Creation of internal audit function
Compliance with Section 404 (management
assessment of internal controls) is not required for
a new registrant until its second annual report on
Form 10-K
Implication of SEC position on PIPEs (see later)

Presumption that resale registration statements
covering 30% or more of the outstanding shares
are primary offerings
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

Position aimed at “toxic” convertible
securities

Large number of selling securityholders is
a helpful fact
If the offering is deemed to be a primary

Sellers need to be listed as “underwriters”

Shelf registration statement not available
for S-1 issuers
144A Trading Platforms

Major banks are in the process of developing private
electronic trading platforms.

For example, Goldman has developed GSTrUE, a
private 144A trading system; other banks formed
OPUS system.

Hedge funds and private equity groups are
beginning to explore alternative ways to raise
permanent capital without submitting to the public
disclosure required following an IPO.

Shares are sold pursuant to Rule 144A but no commitment
to register like a traditional 144A IPO.

Improve reporting and governance requirements to
replicate certain SEC rules

Note: Section 12(g) of 34 Act can require registration
if >500 holders; platforms generally police this
AIM Listings

AIM is the alternative market of the London Stock
Exchange, which was launched in 1995.
13

Unlike most other markets, AIM does not stipulate
minimum listing criteria.

To gain admission

requires an admission document that include
information about the company’s directors, their
promoters, business activities and financial
position.

document is not pre-vetted by the exchange or
regulatory authorities but by a nominated advisor

the offering is done as an institutional placement
to avoid the need to prepare a public offering
document that would require approval by the U.K.
regulatory authorities

Was popular, but many now view as sub-optimal due to
minimal liquidity and trading

Ongoing Obligations

interim and full-year financial performance
announcements

developments that might impact future
performance and/or share price

generally no requirement for documentation or
shareholder approval for acquisitions or
dispositions
Legal Issues

For U.S. companies, securities must currently be in
certificated form to comply with the category 3 restrictions
under Regulation S.

May be of limited use to U.S. companies to avoid
registering with the Securities and Exchange Commission.
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
If the number of record holders exceeds 500 at the
end of a company’s fiscal year, the company must
register under Section 12(g) of the Securities
Exchange Act of 1934.
PIPEs

A Private Investment in Public Equity

Involves a private placement under Section 4(2) of
either common stock or convertible securities


Typically done at a discount to market
price
Investment bank acts as placement agent, but
investors buy directly from the issuer and are
responsible for their own due diligence

Purchasers pay issuer directly; with
proceeds deposited in advance and held in
escrow until closing when all fund
together

Historically, purchasers committed to buy prior to
filing a registration statement, but closing was
conditioned upon effectiveness to allow immediate
resale

Today, PIPEs investors buy privately, with an
obligation to file a resale registration statement
after closing
Registered Directs

Effectively a registered PIPE

Investment bank acts as agent as opposed to
principal
15

Placement fee typically comparable to applicable
underwriting spread

Transactions are typically $5 to $50 million, principally in
the biotech and health care space

Typically involves pre-marketing


Because of potential statutory underwriter liability if the
bank is named in the prospectus or participates in
marketing the diligence procedures are comparable to an
underwritten transaction


Presents same issues as PIPEs
Disclosure opinions, comfort letters, etc.
Logistical issues with closing similar to a PIPE

Accounts need to deposit money in advance

Cash needs to be held in escrow until all accounts
have funded
Registered Directs / PIPEs

Legal issues

Regulation FD / selective disclosure

Gun jumping
Regulation FD / Selective Disclosure

Information provided under NDAs to avoid Regulation FD

Content of material non-public information

Existence of transaction

Transaction terms
16


Timing issues


Account will be restricted from trading once
brought over the wall
NDAs


Format

Oral with email confirmation versus
written

Negotiation of written NDAs can be time
consuming
Release from NDA



Other information such as earnings
If deal happens

Upon announcement?

Time for market to absorb the
confidential information?
Potential disclosure issue if deal aborted
Registered Direct

Does issuer have a shelf or other suitable
registration statement?

Ability of WKSIs to make pre-filing offers
pursuant to Rule 163

Only available for the issuer

Facilitation of meetings by
bankers raises issues
17

Safe harbor for communications 30 days before
filing pursuant to Rule 163A



Filing obligation for FWPs
PIPEs

No gun-jumping issues

NYSE and NASDAQ shareholder approval
requirements



Exception for “bona fide” private
financings at the greater of book or market

If not through a broker-dealer then
no single purchaser can acquire
over 5%

If through a broker-dealer can be
to a single purchaser
Change of control is a separate issue
Resale Registration Statements for PIPEs


Not available for references to the offering
For small companies that are not eligible for shelf
primary offerings, SEC has taken view that PIPES
resale is effectively a primary offering and thus
cannot be done on a shelf basis. General guideline
is that sale of more than 30% of outstanding float
is a primary offering
Hedging Issues for PIPEs

Many PIPES investors have sold shares into the
public market (these shares are borrowed from
others) right after purchasing the restricted shares
in the PIPES offering
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
SEC has taken the view that if the borrow is
covered by shares from the PIPES offering (once
registered for resale), then the initial sale was an
illegal public distribution of the shares bought in
the PIPES offering

Three courts have rejected this view but SEC has
not abandoned the position
Rights Offerings

Rights are distributed to shareholders entitling them to
subscribe for common stock

Purchase price is at a discount to the market price

Typically registered (required in the case of a U.S. public
company)
Who Does Rights Offerings?

Foreign issuers



Not unusual method for raising capital outside the
U.S. due to statutory preemptive rights in many
jurisdictions
Micro cap issuers

OTC and other micro cap issuers use it as a
method to raise capital without the need of an
underwriter

Deals typically less than $25 million
Controlled companies

To avoid allegations from the public that the terms
of the investment were not fair, financial sponsors
and other controlling shareholders seeking to
19
invest equity sometimes structure the investment
as a rights offering

Companies emerging from bankruptcy


Many of the largest rights offerings have been
done by companies concurrent with their
emergence from bankruptcy
Of the 25 rights offerings filed in 2007

8 were foreign issuers

8 were micro/small cap issuers

7 were controlled companies

2 were emerging from bankruptcy
How do you do a Rights Offering?

Offer needs to be registered with the SEC on the
appropriate form

S-1 or S-3 for US issuer and F-1 or F-3 for a
foreign issuer

Registration statement is subject to potential
review like any other registration statement


Note WKSIs can use an automatically
effective registration statement and avoid
review risk
NYSE requirements – Rule 703

file a listing application, if possible, at least two
weeks before effectiveness

notice to holders at least 10 days before the record
date for the distribution of rights
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

if at all practicable, have the registration
statement become effective six business days
before the record date

subscription period must be at least 16 days after
mailing
Blue sky rules

The pre-emption of Blue Sky laws does not apply
to warrants or rights, so the offering will need to
comply with Blue Sky laws
Standby Commitments


Backstop or “standby” underwriting commitment

In the context of foreign issuers and issuers
emerging from bankruptcy there is generally a
desire for certainty that the rights will be exercised.
Accordingly, there is typically a “standby”
underwriting commitment from an investment
bank.

Prior to the adoption of Regulation M in 1997,
there were very specific rules that limited purchase
and sale activities of a standby underwriter in a
rights offering. Regulation M effectively
deregulated rights offerings and eliminated these
requirements.
Investor commitment

In the context of a controlled company, the
controlling shareholder typically agrees to
purchase any shares not purchased by the public.

Even in the context of a controlled company, there
is a role for an investment bank as “dealer
manager” for the rights offering.
21
Business Considerations in Structuring Rights Offerings

Price



The larger the discount to the current market price,
the more aggrieved shareholders are likely to be –
which can lead to litigation
Transferability of rights

If rights are transferable, then shareholders
uninterested in subscribing could sell the rights,
leading to a market in the rights and increasing the
likelihood of full subscription

Controlling shareholder would generally prefer to
make rights non-transferable to maximize its
ability to purchase in the offering

Standby underwriter would prefer transferability
Under-subscription allocation

Unexercised rights are generally allocated to
subscribing holders pro rata based upon

The number of rights requested or

The number of rights allocated

Allocating unexercised rights
based on the number of rights
allocated will increase the
allocation to large shareholders
and is therefore generally
preferred by controlling
shareholders
Spin-Offs

What is a spin-off?
22



Dividend of the stock of a subsidiary to the
parent’s shareholders, resulting in a separation of
the subsidiary from the parent and creation of a
new public company
What is the motivation for a spin-off?

Corporate “clarity” and focus

Market effects
Overview of areas of law and practice involved

Spin-off entails a dividend of the stock of the
subsidiary under state dividend law

Shareholder approval issues

Usually not required; if >50% of parent
assets, may be disposition of
“substantially all” assets needing vote

Many spin-offs are intended to be achieved on a
tax-free basis

The spin-off will need to be analyzed under
applicable fraudulent conveyance criteria

The distribution of the stock to public shareholders
needs to comply with applicable securities laws

It is the SEC's view (in Staff Legal
Bulletin No. 4) that the subsidiary does
not have to register a spin-off under the
Securities Act when:

the parent shareholders do not
provide consideration for the
spun-off shares;
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


the spin-off is pro-rata to the
parent shareholders;

the parent provides adequate
information about the spin-off and
the subsidiary to its shareholders
and to the trading markets;

the parent has a valid business
purpose for the spin-off; and

if the parent spins-off "restricted
securities,“ it has held those
securities for at least one year
A split-off (where parent stock is exchanged for
subsidiary stock) must be registered on
Form S-4
Structuring considerations in separating parent and
distributed equity

Allocation of: assets, liabilities, management
24