Regulation A+, an exemption from registration that took effect in 2015 and allows small companies to issue stock to the general public, presents interesting questions of corporate governance.
The maximum offering size of $50 million means that most Reg A+ issuers will not qualify for listing on a national exchange, which means that they will not be subject to the minimum corporate governance requirements contained in the national exchanges’ listing standards.
This has led to some criticism of Reg A+ offerings on corporate governance grounds. In a recent comment letter, state securities regulators charged that Reg A+ issuers often:
- Lack independent directors or limits on conflicts of interest,
- Broadly indemnify managers or disclaim manager fiduciary duties,
- Do not afford shareholders customary voting rights, or
- Impose mandatory arbitration or forum selection clauses for investor lawsuits.
These governance terms are common and unremarkable in privately held companies. Entering the public markets should logically require some greater investor protections, but requiring Reg A+ issuers to provide the same corporate governance standards as exchange-listed companies seems contrary to Congress’s intent in authorizing Reg A+ to “help small companies gain access to capital markets without the costs and delays associated with the full-scale securities registration process.”
Is there a sensible middle ground of corporate governance standards for unlisted Reg A+ issuers that both protects investors and is less burdensome than what exchange-listed issuers must provide?
Director independence is a critical aspect of investor protection because it can prevent unfair self-dealing by conflicted managers. Not every conflicted transaction is unfair; greater enterprise value can be achieved by allowing companies to proceed with conflicted transactions with mechanisms in place to manage the conflicts than by disallowing all conflicted transactions outright.
The most obvious way to manage conflicts is to recuse the conflicted manager(s) from their regular role in approving a transaction and instead grant approval powers to other unconflicted managers. This concept underlies Section 144 of the Delaware GCL, which shields related party transactions from challenge if they are approved by a majority of disinterested directors.
This mechanism necessarily entails the existence of disinterested – which usually means independent – directors. NYSE and Nasdaq require a majority of independent directors. OTC Markets requires issuers to have at least two independent directors for inclusion on their premium platform.
But requiring full-time independent directors is not the only way to manage conflicts, and Reg A+ is supposed to provide cheaper alternatives to full-scale registration. Small issuers may have difficulty finding suitable people willing to serve as independent directors – and face potential public company shareholder litigation – without paying large-issuer director fees.
Another way to achieve similar results is to provide for an ad hoc conflicts committee to form and act only when a potential related party transaction is actually contemplated. Reg A+ already requires issuers to disclose related party transactions in periodic filings, so identifying which transactions require committee approval is easy. In most cases, the committee will never need to be formed, and when it is needed, the ask of its members is less onerous than full-time directorship, and they can be compensated accordingly.
Ad hoc directors will not be familiar with the specific operations of the company, but they should be familiar with how to evaluate a related party transaction. Numerous Delaware professional services firms offer low-cost independent director services, including on an ad hoc basis. Those service providers have traditionally targeted special purpose bankruptcy remote entities for use in secured finance transactions, but they can also be used by Reg A+ issuers to reduce the costs of having public shareholders.
Indemnity & Exculpation
Section 102(b)(7) of the Delaware GCL limits the ability of Delaware corporations to reduce director liability below a certain threshold, but there is no such limit imposed on Delaware LLCs, which many Reg A+ issuers are. “State of the art” indemnification and exculpation provisions in privately-held Delaware LLCs routinely reduce the fiduciary duty liabilities of their managers and members to zero, foreclosing most attempts by investors to hold managers accountable for malfeasance.
Some limit similar to Section 102(b)(7) should be required to protect public investors in Reg A+ LLCs.
Most breach of fiduciary duty claims involve some form of conflict of interest, which can be addressed by requiring approval of a conflicts committee as discussed above. Providing a safe harbor from conflicts-based claims when the conflicts committee process is followed – and allowing such claims where the process is not followed – accomplishes the delicate balance of both providing managers with greater clarity as to their potential exposure and providing public shareholders with meaningful protection against unfair self-dealing.
Another common category of breach of fiduciary duty claim is based on a failure to remedy known internal control deficiencies, a so-called Caremark claim. These claims are difficult to successfully bring because they require management to ignore known red flags, a hopefully rare occurrence. Merely negligent oversight without proof of a known deficiency is not enough.
An exculpatory clause that tracks the requirements of a Caremark claim would again set a nice balance between clearly defining manager exposure and protecting public investors from inexcusable oversight failures. Providing that mismanagement claims are precluded unless damages are caused by a manager failing to remedy a known internal control deficiency would accomplish this.
The pitfalls of dual-class voting rights – where voting rights are retained by founders and withheld from public investors – have been written about at length in recent months, particularly in light of the failed WeWork IPO. Investor advocates have argued that dual-class voting structures insulate management from accountability and market discipline, creating entrenched “corporate royalty.” Proponents argue that such insulation is a good thing, allowing managers to execute long-term business plans without interference from short-term investors.
Without taking sides on whether dual-class voting is good or bad, it is sufficient to point out that it is currently permitted and in place at many of the most widely held fully-registered exchange-listed companies, including Google, Facebook, and Lyft, and the exchanges have thus far resisted efforts to ban the practice via exchange listing standards. Imposing a greater restriction on the capital structure of Reg A+ issuers than is required of fully-registered exchange-listed companies is contrary to Congress’ intent to lower the burdens of going public with Reg A+.
Arbitration & Forum Selection
Another hot topic in corporate governance circles is whether issuers may require shareholders to bring claims in arbitration or in the issuer’s preferred court venue. In the last year alone: (a) Delaware Vice Chancellor Laster ruled that companies can only dictate where claims challenging their internal corporate affairs are brought, and that a forum selection clause purporting to limit where disclosure-based claims under federal securities laws may be brought is invalid; (b) SEC Chair Clayton issued a special statement accompanying a no-action letter addressing whether Johnson & Johnson could exclude a shareholder proposal seeking to require arbitration from its proxy materials on the grounds that doing so would violate state law; and (c) J&J shareholders filed suit in federal court to challenge the same no-action ruling.
Whatever the outcome of this unsettled legal topic, it seems unlikely that it will turn on whether the issuer seeking to impose forum restrictions is fully registered or has used Reg A+. In either event, the SEC will need to qualify the offering. If the SEC is uncomfortable with allowing an issuer to impose forum restrictions, it can make that comment just as easily in reviewing a Form 1-A (for Reg A+ offerings) as it can in reviewing a Form S-1. Reg A+ will not be any “worse” than full registration in terms of investor protection in this respect.
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Reg A+ is still in its early years, with issuers looking for ways to keep the incremental costs of having public investors below the incremental benefits of accessing public capital. Corporate governance costs are a big part of that calculus, but a practical approach along the lines discussed above could be a way forward.
This post comes to us from Michael Friedman, head of trading at LEX Markets, a recently-founded platform for trading Reg A+ securities issued by commercial real estate companies. He was previously general counsel at proprietary trading firm Trillium and a partner at the law firm of Winston & Strawn.