For the first time since he was appointed in 2014, Rick Fleming, who heads the Securities and Exchange Commission’s Office of the Investor Advocate, is urging the rejection of a rule proposal, reacting to a plan submitted by the New York Stock Exchange. “The exchanges may have come to expect little scrutiny from investors of their routine proposals,” he said in a statement. “Those days are now over.”
The ofice was created to examine how rule changes sought by self-regulatory organizations, including the national securities exchanges, could affect investors. The NYSE’s proposed rule change would exempt early stage companies—defined as reporting less than $20 million in revenue or the first two years of its incorporation—from needing to obtain shareholder approval before selling additional shares to insiders and other related parties, including those holding 5 percent or more of common stock.
The NYSE currently requires shareholder approval prior to a listed company’s issuance of additional shares where the number of shares to be issued to officers, directors and substantial security holders exceeds 1 percent of either the number of shares of common stock or the voting power outstanding before the issuance. The proposal would exempt early stage companies from seeking shareholder approval before issuing up to 20 percent of outstanding shares to related parties and their affiliates provided the audit committee )or a comparable committee comprised solely of independent directors) reviews and approves of the transactions. Cash sales to a related party, equal to or greater than 20 percent of the issuer’s common stock, would remain subject to existing shareholder approval provisions.
“NYSE’s proposed rule change is inconsistent with investor protection,” Fleming wrote in his pointed recommendation to the Commission. Among his concerns: shares could be sold to substantial security holders at a discount, and those sales would no longer require shareholder approval; and officers and directors could obtain a significantly larger share of ownership control by paying the then-current market price for additional shares in a private transaction, without a vote of the existing shareholders.
“When new shares are sold at a discount from the greater of book or fair market value, it results in economic dilution,” Fleming wrote. “Shareholders could find that their percentage of equity ownership has been reduced and that insiders or other related parties of the issuer now control that additional voting power. This dilution of ownership control could ultimately result in decisions that are adverse to the interests of the original shareholders.”
“When the recipient of new shares is a related party, it creates a risk that the company may be engaging in a ‘sweetheart deal’ that is motivated by a conflict of interest,” he added. “Under these circumstances, where a transaction with a related party creates a heightened risk of significant harm to existing shareholders, those shareholders should be given the opportunity to evaluate the merits of the transaction and to vote on whether to approve it. The NYSE proposal would strip this right from them.”
The NYSE, in its proposal, says the change is needed because shareholder approval in private placements is expensive and time consuming. The change would also allow it to better compete with with NASDAQ and an affiliated exchange that already permit early stage companies to raise capital in a similar manner. Adequate protection is afforded to shareholders because any transaction will require the review and approval of the audit committee or a comparable committee, it says.
Fleming took issue with both competitive concerns and the reliance on these oversight committees. “Although the audit committee performs many critical functions that serve to protect the interests of investors, an audit committee will not always reach the same conclusion as shareholders regarding the best interest of the company,” he wrote. “Just as shareholder approval is the standard for equity compensation plans, shareholder approval should be required for sales of shares to related parties.
The proposal, Fleming added, “reflects something of a race to the bottom amongst the exchanges.”
“While it may be true that other exchanges are less strict in their requirements for shareholder approval of related party transactions, we believe the Commission should be encouraging the exchanges to enhance their standards, not devolve to the lowest common denominator because of competitive concerns,” he wrote. “It is inadvisable to create what could be considered a de facto second tier on the NYSE, with lower corporate governance standards for smaller companies. It could lead to significant investor confusion about the listing standards on the exchange, as investors may be surprised to learn that some companies do not follow the same standards of accountability.”