Your phone rings. It is Maxwell Smart, General Counsel of your client, CONTROL, Inc.¹ He’s calling on the shoe phone, and the reception is pretty poor. All you hear is something about an “issuance of new securities” and “do we need shareholder approval?” before the line goes dead.

We want you to be prepared when Max calls you back, so here is an overview of the NYSE and Nasdaq shareholder approval rules. The Rules are complex, so buckle up – this is going to get technical.

Summary of the NYSE shareholder approval rules

Under Rule 312.03 of the NYSE Listed Company Manual, shareholder approval is generally required for share issuances in connection with any of the following situations:

• certain equity compensation plans (see NYSE Rule 312.03(a); see also NYSE Rule 303A.08 on the carve-outs from the approval requirements and the topic of equity compensation plans more generally);
  
• change-of-control transactions (see NYSE Rule 312.03(d));
• issuances of common stock, or securities convertible into or exercisable for common stock, to:²
  • directors, officers or “substantial security holders” (“Related Parties”)
  • subsidiaries or affiliates of, or other persons closely related to, Related Parties;
  • companies or entities in which a Related Party has a “substantial direct or indirect interest” (see NYSE Rule 312.03(b));
  • where the number of shares to be issued (or underlying the convertible securities to be issued) exceeds either 1% of the shares outstanding or 1% of the voting power outstanding before the issuance; and
    
• situations covered by the “20% rule,” i.e., a transaction or a series of transactions (but not public offerings for cash or certain “bona fide private financings” – more on both of these points in a bit) where:
  
  • the common stock to be issued in the offering or underlying the convertible securities to be issued in the offering has/will have upon issuance voting power equal to or in excess of 20% of the voting power outstanding before the issuance of the stock; or
  • the number of shares to be issued in the offering or underlying the convertible securities to be issued in the offering are/will be upon issuance equal to or greater than 20% of the number of shares outstanding before the issuance (see NYSE Rule 312.03(c)).
    

Some things to keep in mind about the NYSE rules

• The NYSE does not issue interpretations or guidance on its Rules comparable to Nasdaq’s Staff Interpretive Letters and FAQs. If you have questions on the NYSE rules, let’s talk. The NYSE’s Office of General Counsel will engage in discussions regarding interpretations of the shareholder approval rules.
  
• There is a “financial viability exception” that trumps shareholder approval in all circumstances – this has some ins and outs that we discuss in more detail below.
  
• For the calculations under NYSE Rules 312.03(b) and (c):
  • you should only count shares actually issued and outstanding in the denominator of your calculation (treasury shares or shares held by a subsidiary should be excluded). Shares reserved for issuance on conversion or on exercise of options or warrants should not be counted as outstanding (see NYSE Rule 312.04(d)) although in the change-of-control context, you can add the new acquisition shares to the denominator when evaluating the post-acquisition capitalization to determine if a change-of-control has occurred; and
  • persons with less than 5% of the number of shares or 5% of the voting power are not considered “substantial security holders” and this level of ownership is not a “substantial interest.
    
• The former treasury share exception applicable to NYSE Rules 312.03(b), (c) and (d) was repealed in December of 2006. Under that exception, shareholder approval for securities issuances was only required if the securities were not already listed and shares repurchased and held as treasury shares were still considered “listed.” See “Limited Transition Period” following NYSE Rule 312.03.
• Finally, don’t forget to allow sufficient time to get your supplemental listing application for the shares filed and processed before your closing.
  

More on the NYSE’s 20% rule

There are three exceptions to the NYSE shareholder approval requirement for issuances of 20% or more: a public offering for cash, a bona fide private financing and for distressed companies. These exceptions do not apply to issuances that would result in a change of control. However, the 20% Rule sounds simpler than it proves to be in many cases. Here are a few of the complexities:

• The “public offering” carve out from NYSE Rule 312.03(c) only applies to what the NYSE views as true public offerings; any registered offering won’t necessarily do. Public offerings in this context require an actual marketing process that results in a price for the deal. For example, a registered and underwritten offering to one pre-identified purchaser may not be consistent with the NYSE’s view of a “public offering.” Note one additional twist: under the NYSE Rule you are not able to do certain exchange offers using this exception that you can do under the relevant Nasdaq rule, because the NYSE Rule excludes any “public offering for cash” whereas the Nasdaq Rule does not have the “for cash” requirement. (We discuss Nasdaq in Part II).
• The “bona fide private financing” carve out also has a specific meaning – i.e., a financing that involves (a) a sale of common stock for cash at a price at least equal to the lesser of either the stock’s official closing price or the average official closing price for the previous five days on the NYSE or (b) securities convertible into or exercisable for common stock for cash, if the conversion or exercise price is at least equal to the l lesser of either the stock’s official closing price or the average official closing price for the previous five days on the NYSE. It refers to sales either to a broker-dealer to be resold or sales to multiple purchasers, none of whom (or a group of whom) acquires or has the right to acquire more than 5% of the shares or more than 5% of the voting power before the sale. Once again, Nasdaq does things a bit differently – the relevant Nasdaq’s Rule does not limit these sales to broker-dealers or multiple purchasers as the NYSE’s Rule does.
• For convertible debt that is or may be settled all or in part in cash (for example “net share” settled notes where the principal amount is settled in cash and the conversion value in excess of the principal amount is settled in stock), any stock issuable upon settlement will be issued de facto at below book and market value (in the NYSE’s view). Since the NYSE analyzes the shareholder approval Rules using a “worst case scenario” approach, this generally means that the notional number of shares underlying such a convert will in all cases, excepting very customary anti-dilution adjustments, have to be below the 20% threshold to avoid shareholder approval, even if the likelihood of actual issuances above the threshold is remote. There are some work-arounds for this issue (including caps, undertakings to obtain shareholder approval at a future date or to settle in cash if the result would otherwise be to settle for 20% or more in stock), but the fixes may create their own issues (marketing, accounting, etc.). If you anticipate these types of questions in your deal, let’s talk.

Summary of the Nasdaq shareholder approval rules

Under Rule 5635 of the Nasdaq Listing Rules, shareholder approval is generally required for share issuances in the situations listed below:

• issuances of securities in connection with an acquisition of another company (see Nasdaq Rule 5635(a)) if:
  • other than in the context of a public offering for cash, due to the present or future issuance of stock (including stock underlying convertible securities) (a) the stock or convertible securities to be issued has/have or upon issuance will have voting power of at least 20% of voting power outstanding before the issuance of the stock or convertible securities or (b) the number of shares to be issued is/will be at least 20% of the number of shares outstanding prior to the issuance of the stock or convertible securities; or
  • a director, officer or “substantial shareholder” (see Nasdaq Rule 5635(e)(3)) (a) has a 5% or greater interest (or collectively a 10% or greater interest) and (b) the new issuance of common stock or convertible securities could result in an increase in outstanding shares or voting power of 5% or more;
• change-of-control transactions (see Nasdaq Rule 5635(b)) – note that Nasdaq presumes a change of control if a holder acquires 20% of the outstanding shares, calculated on a pro forma basis;
• certain stock option or purchase plans or equity compensation arrangements (see Nasdaq Rule 5635(c); Nasdaq IM-5635-1). Note that Nasdaq takes a broad view of “equity compensation arrangements” – this concept may pick up a lot more than people expect (e.g., share issuances to existing investors that have board representation) and ends up covering much of what is included in NYSE Rule 312.03(b); and
• situations covered by the “20% rule,” i.e., transactions (other than public offerings) involving the sale or issuance (or potential issuance) by the company of stock (or securities convertible or exercisable for stock) at a price below the lesser of either the closing pricing or the average closing price for the previous five days on Nasdaq.com, which together with sales by officers, directors or substantial shareholders, is at least 20% of the outstanding shares or at least 20% of the voting power prior to the issuance (see Nasdaq Rule 5635(d)).
  

Some things to keep in mind about the Nasdaq rules

There are some important points to note on the Nasdaq rules:

• There is a “financial viability exception” that trumps shareholder approval in all circumstances – we discuss that in more detail below.
• For all calculations under the Nasdaq rules:
  
  • you should only count shares actually issued and outstanding as outstanding – treasury shares, shares held by a subsidiary and shares reserved for issuance on conversion or on exercise of options or warrants should not be counted (see Nasdaq Rule 5635(e)(1)). When determining the number of shares issuable in a transaction (as opposed to shares already outstanding), all shares that could be issued are included, regardless of whether the shares are currently treasury shares;
  • persons with less than 5% of the number of shares or 5% of the voting power are not considered “substantial shareholders” (see Nasdaq Rule 5635(e)(3)); and
  • shareholder approval is not required for any issuance if it is part of a court-approved reorganization under the federal bankruptcy laws or foreign laws (see Nasdaq Rule 5635(e)(5)).
• The question of what is a “public offering” carved out from the 20% Rule comes up from time to time. Nasdaq has explained that a broadly marketed firm commitment underwritten securities offering registered with the SEC is generally a public offering, as is any other registered offering that is publicly disclosed and distributed in the same general manner and extent as a firm commitment underwriting. Rule 144A offerings are not regarded as meeting the criteria for a “public offering” by Nasdaq. If you are in doubt, let’s talk.
• Unlike the NYSE, Nasdaq issues Staff Interpretive Letters and FAQs on its rules.
• Finally, don’t forget the notice requirements of Nasdaq Rule 5250(e), which, among other things, requires 15 days advance notice prior to issuing common stock or securities convertible into common stock greater than 10% of the total shares outstanding.

The financial viability exception to both the NYSE and Nasdaq rules

Both the NYSE Rules (see NYSE Rule 312.05) and Nasdaq Rules (see Nasdaq Rule 5635(f)) provide for a financial viability exception to the shareholder approval rules.

To take advantage of this exception, a company has to show that:

• the delay in securing stockholder approval would seriously jeopardize the company’s financial viability; and
  
• the company’s audit committee has expressly approved reliance on the exception.

Under both the NYSE and Nasdaq rules, a company using this exception must mail a notice to its stockholders not later than ten days before the issuance to alert them that the company is using the exception with the approval of its audit committee. Among other things, you will need to work closely with the NYSE or Nasdaq to get approval in advance, and that approval is not easy to obtain. Both NYSE and Nasdaq will expect a showing that the delay in obtaining shareholder approval will create a very real risk of bankruptcy. If you are considering invoking this exception, let’s talk.
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¹    With apologies to Mel Brooks and Buck Henry, creators of the TV series.

²    If the Related Party is only a related party because (a) the person is a substantial security holder and (b) the issuance relates to a sale of stock for cash at a price at least equal to the stock’s book and market values, then shareholder approval is not required unless the number of shares of stock to be issued (or the number of shares into which the securities may be convertible or exercisable) exceeds either five% of the number of shares outstanding before the issuance or five% of the voting power outstanding before the issuance. See NYSE Rule 312.03(b). Note that there is no comparable provision under the Nasdaq rules. As described in more detail below, those Rules apply only in connection with an acquisition.