In a change that we believe has gotten little attention to date, in March 2015 NASDAQ updated its publicly available “Frequently Asked Questions” relating to the application of NASDAQ’s shareholder approval rules to net share settled convertible securities issued in private placements.
Under NASDAQ Rule 5635(d), shareholder approval is required prior to the issuance by a NASDAQ listed company of securities in connection with a transaction other than a public offering involving, among other things, the sale, issuance or potential issuance by an issuer of common stock (or securities convertible into or exercisable for common stock) equal to 20% or more of the common stock or 20% or more of the voting power outstanding before the issuance for less than the greater of the book or market value of the stock (the “20% Rule”).
The 20% Rule frequently is in play in private offerings of convertible securities by smaller NASDAQ listed companies. However, because the conversion price of convertible securities is often at a premium to the greater of the book or market price of the underlying stock (particularly in Rule 144A offerings, where a conversion premium of at least 10% to market is required), the 20% Rule often is not an issue for physically settled convertible securities. This has not been the case, however, for net share settled convertible securities (whether mandatory net share settled or flexible net share settled), which NASDAQ has treated differently from physically settled convertible securities. NASDAQ historically has viewed both types of net share settled convertible securities as being issued with a conversion price below the greater of the book or market value of the underlying stock because of the ability of the issuer to settle conversions in whole or in part in cash (effectively treating the cash payment as a return of principal and reducing the conversion price). This NASDAQ position has often resulted in the 20% Rule being applicable to an offering for smaller companies issuing net share settled convertible securities. As a result of its recent change in position, NASDAQ is now treating net share settled convertible securities the same as physically settled securities in terms of assessing whether the conversion price is greater than the book or market value of the underlying stock.
The following is the relevant FAQ, dated March 5, 2015, posted by NASDAQ:
FAQ – Does a flexible settlement provision in a convertible instrument change the way NASDAQ determines whether securities that are convertible into common stock are issued at a discount to market value?
No. A flexible settlement provision in a convertible instrument allows the issuer to settle conversions through payment or delivery of cash, shares of the company’s common stock, or a combination of cash and shares. A convertible instrument with a flexible settlement provision that affects only the form of the settlement, without changing the conversion price of the instrument, will be treated under Rule 5635(d) the same as a convertible instrument with physical settlement only. See also FAQ# 276.
While the FAQ speaks specifically to flexible settlement provisions where an issuer can settle conversions through cash, shares or a combination of both, a NASDAQ representative has told us that NASDAQ’s new position is equally applicable where net share settlement is mandatory. In addition, we understand from NASDAQ that its position is the same, regardless of how the issuer ultimately elects to settle conversions where the securities provide for flexible net share settlement. Issuers will still need to assess whether other provisions of NASDAQ’s shareholder approval rules may be applicable to a particular offering (for example, if the transaction might result in a change of control) or whether other terms of the convertible securities might implicate the 20% Rule (for example, certain conversion price adjustment provisions, any make-whole provisions, or provisions requiring additional cash payments to investors at the time of conversion such as payments for forgone future interest).
The New York Stock Exchange (“NYSE”) historically has taken a similar view that net share settled or flexible net share settled convertible securities should be viewed as being issued with a conversion price below the greater of book or market value. We understand based on a discussion with a representative of the NYSE that the NYSE has also expressly revised its position on this issue to be consistent with NASDAQ.
We view NASDAQ’s and the NYSE’s new position as a very welcome and pragmatic change, which should enhance the ability of smaller issuers to issue net share settled or flexible net share settled convertible securities and access the convertible securities market.
Please contact the Gibson Dunn lawyers with whom you work or Glenn Pollner (212-351-2333), Andrew Fabens (212-351-4034), Stewart McDowell (415-393-8322) or Peter Wardle (213-229-7242) if you have questions.
 While market value will often exceed book value per share, care should be taken to ensure that the conversion price exceeds the greater of the book or market value per share.
 Physically settled convertible securities typically provide for conversions to be settled only in stock (excluding any cash payable in lieu of fractional shares).
 A mandatory net share settled convertible security generally will allow for an investor to receive, upon conversion, a cash payment in an amount up to the principal or stated amount of the security, with the incremental conversion value, if any, paid in stock. A flexible (or optional) net share settled convertible security will generally provide the issuer with the flexibility to settle conversions in cash, stock or a combination of both. Net share settlement provisions are often attractive to issuers because they can significantly mitigate the potentially dilutive effect of the convertible securities.