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Private Placement of Publicly Traded Equity Securities as Consideration in an M&A Transaction after the JOBS Act

An issuer with equity securities that are publicly traded often seeks to use its equity securities as consideration in an acquisition of another business.  If the target business is privately held, the acquirer may seek to privately place the equity securities with the owners of the target rather than registering the securities due to the lead-time required for the registration process or for other reasons.  The following discussion addresses many of the securities law issues that public companies should consider when using privately placed equity as acquisition currency, including a discussion of upcoming changes in the private placement landscape precipitated by the Jumpstart Our Business Startups Act (“JOBS Act”), signed into law by President Obama on April 5, 2012.

Regulation D Compliance and “General Solicitation” Prohibition


Section 4(2) of the Securities Act of 1933 exempts “transactions by an issuer not involving any public offering” from the registration and prospectus delivery requirements of Section 5 of the Securities Act.  Regulation D under the Securities Act (and particularly Rule 506 thereunder) provides a commonly relied upon safe harbor for private placement transactions, including for issuances of equity securities as consideration in business combinations.  Rule 506 of Regulation D permits an issuer to sell an unlimited amount of its securities in a private placement to an unlimited number of “accredited investors” (as defined in Rule 501) and up to 35 non-accredited investors.  Under Rule 506, each investor that is not an accredited investor, either alone or with his purchaser representative(s), must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.  As a result, to confirm satisfaction of the investor suitability standards of Regulation D, the acquirer must determine whether the sellers are accredited investors or meet the financial and business sophistication requirements.  The acquirer can make such determination by contacting each seller and requesting that each seller complete and return an investment questionnaire.  If any seller is not an accredited investor, the acquirer can arrange for the appointment of a purchaser representative for such seller.  If there are more than 35 non-accredited investors or an unsophisticated non-accredited seller will not consent to the appointment of a purchaser representative, the acquirer must be prepared to pay the consideration to such seller(s) in cash or register the entire issuance of securities.
In its current form, Rule 506 also requires that offers and sales must satisfy all of the general terms and conditions of Rules 501 through 503 of Regulation D.  Under Rule 502(c), one of the conditions to the availability of Regulation D is that the securities not be offered or sold by any form of “general solicitation.”  The SEC has stated that the determination of the presence or absence of a general solicitation is dependent on the facts and circumstances of each particular case.  The SEC has taken positions in published materials that mailing written offers to acquire securities would not be deemed to constitute a general solicitation for purposes of Rule 502(c) if the issuer or its agent (a) has a pre-existing relationship with the persons to whom the offer is directed of a nature that would enable the issuer to be aware of the financial circumstances or sophistication of such persons and (b) believes that such persons have such knowledge and experience in financial and business matters that such persons are capable of evaluating the merits and risks of the proposed investment.  In circumstances where the number of sellers is large and the acquirer has not been exposed to all of them during the negotiation process for the acquisition, the seller will not have a pre-existing relationship with each seller.  Without this pre-existing relationship, acquirers historically have risked failing to comply with Rule 502(c)’s prohibition on general solicitation if the acquirer directly contacted each seller to determine such seller’s investor suitability.
While this prohibition against general solicitation in Rule 502(c) historically has limited the ability of companies to issue privately placed equity securities to potential investors, including sellers in M&A transactions, forthcoming changes to Regulation D required by the JOBS Act will relax the restrictions on general solicitations in private placements under Rule 506.  Specifically, Title II of the JOBS Act directs the SEC to revise Rule 506 to remove the prohibition against general solicitation or general advertising in offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors.  The JOBS Act also mandates that the SEC’s rule revisions require issuers to take “reasonable steps” to verify that investors are accredited investors, using methods as determined by the SEC.  The revisions to Regulation D required by the JOBS Act must be completed within 90 days following enactment of the JOBS Act, or July 4, 2012.
After the revisions to Regulation D are implemented and the general solicitation prohibition is eliminated for private placements conducted in reliance on Rule 506 in which all investors are accredited, issuers will be less restricted in the methods they may use in reaching out to potential investors, and concerns over whether a particular communication constitutes a “general solicitation” or that inadvertent general solicitation will make the Rule 506 safe harbor unavailable will be eliminated.  In M&A transactions where the acquirer utilizes Rule 506, the acquirer will be free to contact directly all potential sellers in order to determine investor suitability, regardless of whether there is any pre-existing relationship.  Importantly, however, even though Rule 506 provides that up to 35 non-accredited investors may invest if the non-accredited investors or their purchaser representative meet certain sophistication criteria, the JOBS Act’s relief from the restrictions on general solicitation applies only if the purchasers of the securities are all accredited investors.  Therefore, if the acquirer engages in a general solicitation of the potential sellers and finds that some of the equity owners of the target are not accredited investors, the acquirer will only be able to rely on the Rule 506 safe harbor if such owners do not receive equity consideration in the private placement (i.e., the acquirer must be prepared to pay the consideration in cash to sellers that are not accredited investors).


Other Regulation D Issues Applicable in M&A Transactions
The acquirer should ensure that the Regulation D offering of securities to the sellers is not integrated with any other securities offerings of the acquirer that would cause Regulation D not to be available for the private placement of securities to the sellers.  In addition, the acquirer must file with the SEC a notice of sales on Form D no later than 15 calendar days after the first sale of the securities.  Finally, the acquirer should be aware that its transfer agent will likely require an opinion of counsel with respect to the validity of the private placement as a condition to functioning as exchange agent or transfer agent with respect to the securities issued to the sellers.
Resales of Privately Placed Securities


Because the issuance of securities in the private placement is not registered under the Securities Act, such securities are “restricted securities” under Rule 144 of the Securities Act and are subject to holding period requirements and other resale restrictions.  If the sellers demand liquidity in the securities prior to expiration of the applicable holding period, the acquirer can agree to file and cause to be declared effective within a certain time period a resale registration statement.  The parties may negotiate penalty interest provisions that will apply if the acquirer does not meet filing and effectiveness deadlines for the resale registration statement. 

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