“She never gives in. She just changes her mind.” – Billy Joel

The specter of over-regulation, onerous reporting requirements, and the implementation of Sarbanes Oxley, including SOX Section 404 (concerning internal financial controls), have often been cited as inducing flight from U.S. capital markets to more liberal markets in the United Kingdom, Bombay and elsewhere.
Fearing the worst, the Securities and Exchange Commission has spent the last several years attempting to improve liquidity in all U.S. securities markets in an effort to control this flight and to attract companies and corporate finance functions to our shores.
Recent revisions to SEC Rule 145, which regulates mergers and asset acquisitions (but not share exchanges), carry forward the SEC’s effort to liberalize our securities markets. Although the SEC has not rolled back all relevant regulation, it has addressed one impediment to sales of private companies to public companies. Restrictions on the resale of public stock obtained by major stockholders of target companies in merger and asset deals have been all but abolished.

Knotty technicality

It is important to clarify a knotty technicality. Although in common parlance we say that “shares” are registered, technically speaking we register the transactions pursuant to which the shares are issued. Transactions in which there is an offer or sale of securities to the public must be registered under U.S. securities laws.
If an acquisition target has a large enough number of shareholders, then the issuance of acquiror’s stock to those target shareholders, in a stock-for-stock exchange, clearly is understood as an offer and sale to “the public.” Stock-for-stock transactions fall outside Rule 145.
But what about sales of businesses that were structured as, say, a merger or an asset sale? In a merger, the two companies decide to undertake a corporate transaction (the merger) and, without taking any particular action such as agreeing to sell or buy any share of stock, a shareholder of the target receives newly minted acquiror shares. Was this an offer or sale?
Alternately, if a target company were to transfer all of its assets and business to an acquiror, and that target were to receive shares of the acquiror, and then if that target were to distribute the acquiror’s shares to target’s shareholders, could it be said that the target shareholders were involved in an offer or sale of acquiror’s shares?
The argument that, in the case of a merger or asset transaction, the shareholders of the target were not involved in the offer or sale of the security was officially codified by the SEC in its original Rule 133.
The Rule provided that in most cases (the exceptions related to very closely held targets), where a vote of the shareholders authorized a merger or asset sale, the target shareholders were not involved in the offer or sale of a security and, consequently, the transaction issuing acquiror’s shares did not have to be registered.
In 1972, observing the free flow of unregistered acquiror shares coming into the marketplace by reason of mergers and asset sales, the SEC abruptly reversed course, and declared in then-new Rule 145 that, indeed, mergers and asset transfers did involve an offer and sale of acquiror’s securities, which in turn might require registration under the ’33 Act.
I don’t suggest that other exemptions from registration of the merger or asset transfer transaction might not have been available. But if there were no other exemptions, the acquiror was now required to register the transaction in which it issued shares to the target shareholders.

The other shoe

Perhaps Rule 145 registration requirements were not a particularly desirable result for the acquiror, but, alas, there was more. Rule 145 went on to say that persons who were affiliates of any party to a Rule 145 transaction would be “statutory underwriters.”
Enter yet another arcane piece of analysis. There is an exemption from the registration requirements of the ’33 Act for any transaction that does not involve an issuer, underwriter or dealer.
Let us say you are a very large shareholder of a target company, and you receive acquiror shares in a merger or asset sale. At first blush, there would seem to be no impediment to your ability to resell those shares. After all, you are certainly not the issuer, and let’s assume you are not a professional securities dealer. Since you are not Merrill Lynch, you also are not an underwriter, right?
You may not be an underwriter in the traditional sense, but under Section 2(11) of the ’33 Act you can become a “statutory” underwriter – that is, you can simply be declared by the SEC to be an underwriter.
And if you are an underwriter, you cannot resell your shares without registration. The original registration of the merger or asset sale does not suffice. The registered transaction was the issuance of the shares by the acquiror, not a transaction by which those shares are resold into the marketplace by the target’s shareholders.
This problem arose only in connection with larger shareholders of the target, shareholders who were “affiliates.” An affiliate is a person who controls, is under the control of or is under common control with, any other party to the transaction. Major shareholders of targets were affiliates of the target, and under Rule 145 became statutory underwriters and had no automatic right to resell their shares of the acquiror even though the underlying merger or asset sale was registered.
This did not mean that target affiliates were banned from reselling their shares. The shares might be leaked out through resale provisions, and affiliates often attempted to negotiate a resale registration statement to promptly register a transaction in which these affiliates could resell to the public their acquiror shares.
But in many cases, affiliates nonetheless found themselves in an illiquid situation, with neither an exemption nor a registration right to solve their problem.

2008 rule revision

In February 2008, the SEC, like the fickle object of Billy Joel’s song, changed its mind and simply amended Rule 145 to reverse the presumption that affiliates in mergers or in asset sale acquisitions were statutory underwriters. This placed affiliates (practically speaking, large target shareholders) on the same footing as smaller shareholders. Since they were not issuers, and not dealers, and now were no longer decreed to be “underwriters,” their shares were immediately available for unrestricted resale.
It is interesting to see how the SEC justifies the relaxation of significant regulatory constraints, particularly Rule 145 resale regulations that have been in place for 35 years. The SEC’s adopting release for the Rule 145 amendments speaks of removing “what we believe are unnecessary restraints on resale of securities by parties, or their affiliates, to a merger. The amendments to Rule 145 will reduce costs incurred by companies, parties to the transaction, and their affiliates to comply with the resale and other restrictions of the Rule.”
However desirable it might be to remove the resale restrictions for affiliates, as the Commission has done, these explanations are really not reasons. To say that amendments to Rule 145 will “reduce costs” is a curious argument: You could reduce costs almost entirely by eliminating all SEC regulation.
Further, the statement that the removed restraints on resale are “unnecessary” simply assumes the conclusion. Yet this is the only explanation contained in the SEC’s analysis of the “benefits” of their Rule 145 amendment in an adopting release running 109 pages.
In the adopting release’s discussion of the “promotion of efficiency, competition and capital formation,” a discussion mandated by the ’33 Act itself when the SEC promulgates rule changes, there is again just a single paragraph concerning Rule 145.
The Commission notes that individuals holding acquiror’s securities will no longer be presumptive underwriters even if they are affiliates, and this amendment “should improve the competitiveness of many smaller entities in permitting them to resell securities without restrictions that were imposed by the Rule before the amendments that we are adopting.”
How do smaller target entities become more competitive when they are being acquired, or how does their competitiveness improve when the targets themselves, or their affiliates, can freely resell shares of acquiror stock?
Is it really true that entrepreneurs in the U.S. will become better competitors, and domestic capital formation fostered, because five years hence the shares they might receive in an acquisition transaction they might undertake will be structured in such a way that they might be receiving shares of a publicly tradable class, for which they might be unable to negotiate an alternate method to achieve liquidity?
The continuous flow of company information to the public under Securities Exchange Act of 1934 disclosures is rendering the entire process of registering transactions for the issuances of securities obsolete.
This column has predicted the time will come when no company need register any transaction for the sale of its stock, and no investor need hold those shares prior to resale in any manner, provided the issuer has been complying with the continuous disclosure requirements of the ’34 Act.
Permitting immediate resale of all shares received in mergers and asset acquisitions is one step in that direction.