PIPE fitting

Given current market conditions and the lack of available credit, public companies seeking to raise capital are likely to rely less on public offerings and debt incurrences and increasingly on private investments in public equities. Generally, in a PIPE transaction, an issuer sells newly issued restricted securities -- typically, common shares, warrants to purchase common shares, debentures, convertible preferred shares or some combination -- to an accredited investor by way of a private placement and agrees to have the acquired securities (or the securities issuable upon exercise or conversion of the acquired securities) registered, and thus freely tradable by the investor, within some specified period of time.

One critical step in the legal analysis of any proposed PIPE transaction is the determination of the applicability of stock exchange rules. Both New York Stock Exchange- and Nasdaq-listed issuers are subject to the so-called 20% rule, which generally provides that shareholder approval is required prior to the issuance of any common shares, or securities convertible into or exercisable for common shares, at a price less than the greater of book or market value if the common shares represent or will upon conversion or exercise represent 20% or more of the issuer's common shares or voting power (calculated without regard to any shares issued in the PIPE transaction).

The 20% rule is implicated where an investor seeks to purchase a substantial stake in a target company, such as a controlling interest, that is sufficiently sizable so as to exceed the thresholds prescribed by the 20% rule. In such an instance, the PIPE transaction is typically structured by simultaneously issuing two series of preferred stock -- a first series that is immediately convertible for less than 20% of the issuer's outstanding common shares and a second series that is convertible for additional common shares once shareholder approval is obtained. Such a structure ensures compliance with the 20% rule because no more than 20% of the issuer's outstanding common shares will be issued without first obtaining shareholder approval. Note that common shares issued under the first series would not be entitled to participate in the shareholder vote to authorize convertibility of the second series.

Investors are usually willing to enter into a two-series preferred-share transaction if they believe that shareholder approval will ultimately be obtained. Where the target is an NYSE-listed issuer, investors frequently attempt to incentivize shareholders to approve the transaction by including in the terms of the security sold in the transaction an alternative outcome -- a "penalty" or "sweetener" -- depending on the result of the shareholder vote.

Examples include a conversion price that decreases or a dividend rate that increases if shareholder approval is not obtained or restrictive covenants that continue to apply if shareholder approval is not obtained. Recognizing the beneficial or detrimental effects of the alternative outcome on the issuer, shareholders will typically vote in an economically rational manner and approve the transaction.

Investors in Nasdaq-listed issuers are in some instances prohibited from using penalties and sweeteners to incentivize shareholders to approve a transaction. Nasdaq has stated in its interpretive materials that "the presence of an alternative outcome has a coercive effect on the shareholder vote and thus may deprive shareholders of their ability to freely exercise their vote."

Nasdaq will, however, permit a transaction with an alternative outcome "provided that no common shares are issued prior to the vote." Said another way, it is acceptable under Nasdaq rules for an issuer to agree to a penalty or sweetener after the shareholder vote (depending on whether shareholders approve the transaction) as long as no common shares can be issued before the shareholder vote (regardless of whether shareholders ultimately approve the transaction).

Whether acting as counsel to an investor or a public company issuer considering a PIPE transaction, it is important to be mindful of, and to ensure compliance with, relevant stock exchange rules. It is usually advisable to contact the relevant exchange prior to entry into the purchase agreement to discuss the terms of the transaction and the applicability of exchange rules regarding shareholder approval.

Angelo Bonvino is a partner and Derek B. Meilman is an associate in the M&A group of the corporate department at Paul, Weiss, Rifkind, Wharton & Garrison LLP.