U.S. Legal Issues For Non-U.S. Equity Derivative Market Participants: A Primer - Part 2
General Prospectus Delivery Requirement (a) Ordinary Sales Under Rule 144
When shares are offered or sold in the U.S. market, the Securities Act effectively requires that either (i) the offer and sale of the shares must be registered with the SEC, and a current prospectus that meets SEC requirements must be delivered to the buyer before the buyer purchases the security, or (ii) an exemption from the registration requirement must be found.
(a) Ordinary Sales Under Rule 144
Shares owned by senior officers or directors, or by large shareholders with some degree of control over the company, are subject to additional restrictions, as are shares that are originally sold under a private placement exemption.
Offers and sales of ADRs or shares in the U.S. market by senior officers, directors, large shareholders, and anyone who originally bought their shares in a private placement would generally require registration with the SEC, unless they qualified for the safe harbor under Rule 144. Such ADRs or shares are usually in physical form, and usually have restrictive legends on them that prevent the transfer agent from transferring them to a new holder. Before they can be sold in the U.S., the following requirements must be met:
* the issuer must have filed the periodic reports required by the SEC for at least 90 days prior to the sale;
* the dealer cannot solicit buyers for the shares, unless it has committed to a firm price without any prior solicitation other than the very limited solicitation permitted by the rule;
* the total number of shares to be sold, when combined with sales by the same person or certain related persons in the past 3 months, does not exceed the greater of (a) 1% of the outstanding shares of the same class worldwide, and (b) the average weekly trading volume in the U.S. for the four calendar weeks preceding the proposed sale; and
* a Form 144 must be sent to the SEC by the client no later than the trade date, with details about the seller and the number of shares proposed to be sold.
In addition, if the seller originally received the shares in a private placement, the seller must have held the shares for 1 year before selling them.
(b) Ordinary Sales Under A Registration Statement
An alternative to selling under Rule 144 is for the issuer to prepare a registration statement to cover offers and sales of the shares by the client and file that with the SEC. The advantage this method has is that it allows the dealer to solicit buyers for the shares and it allows the client to sell as many shares as the issuer has registered on the client’s behalf. The disadvantages are the time and cost of preparing the registration statement, and the liability that the seller and the dealer will have to buyers when the dealer sells the shares and delivers the prospectus to them.
The SEC’s rules for registered offerings have recently changed dramatically, and non-U.S. issuers that have a worldwide equity float of at least USD700 million, and meet several other criteria, may now qualify for so-called well-known seasoned issuer status, which may expedite offerings by such issuers (DW, 10/29/04).
(c) Hedging Trades
The SEC has issued two interpretive letters since 1999 that are helpful for hedging trades relating to Rule 144 ADRs or shares.
The first letter basically says that if a pre-paid forward is executed for a client in compliance with all of the Rule 144 requirements above and the dealer borrows shares to do its short sales, the shares pledged by the client to the dealer can be used to cover the dealer’s short positions through share borrowing from the client or at maturity, and are freely tradable in the hands of the dealer if delivered by the client. Accordingly, it would be appropriate to remove any restrictive legends from the pledged shares.
The second letter says that if the dealer’s hedging sales of borrowed shares are registered with the SEC on Form F-3 or S-3, and a prospectus that adequately explains the possible hedging trades is delivered to buyers of the full number of shares in connection with the dealer’s short sales, the client’s shares can be used to cover the dealer’s short positions through share borrowing from the client or at the maturity of the trade. The second letter affords more flexibility as to the type of hedging trade, the number of shares sold, and the ability to solicit buyers for the shares but has the disadvantages of registration described above. The second letter allows the dealer to borrow the client’s shares from the outset and execute its short sales with those shares, but that brings in additional complexity relating to the aggregate number of shares that can be delivered by the client in physical settlement, loaned by the client, or pledged by the client and rehypothecated by the dealer.
One issue on large registered hedging trades that require prospectus delivery for more than one or two days is the question of what happens if the issuer becomes aware of material nonpublic information concerning itself or its shares, and cannot permit the dealer to continue to use the prospectus. This needs to be negotiated in advance.
Although the two letters above permit a wide variety of hedging trades, most dealers have also developed other hedging structures that comply with relevant law.
Sales Or Hedging Trades Outside The U.S. (Regulation S)
Some of the issues discussed above become less burdensome if the client’s shares can be sold or hedged outside the U.S. This exception is not as readily available to some Latin American and Chinese issuers, because of the relative importance of the U.S. trading market when compared to the local market.
The SEC has three categories for measuring how interested it is in non-U.S. offerings. The least restrictive category, Category One, applies when there is no “Substantial U.S. Market Interest” in the underlying.
There is no SUSMI for the equity of a non-U.S. company if the issuer reasonably believes that in its most recent fiscal year, the U.S. exchanges and quotation systems did not constitute the single largest market for the class of security being offered, and either:
* less than 20% of all recorded trading in that class took place on U.S. exchanges and quotation systems, or
* at least 55% of such trading took place on securities markets in a single non-U.S. country.
If there is no SUSMI in the class of equity being offered, the SEC will consider the issuer to be a Category One issuer and will not apply significant restrictions to sales of the shares outside the U.S., so long as: (i) the shares are sold in offshore transactions through the facilities of established exchanges and (ii) U.S. buyers are not solicited. Many European companies with ADRs are Category One issuers.
If there is SUSMI in the class of equity being offered, and the related ADRs are traded on a U.S. exchange or NASDAQ, the issuer will be considered Category Two, and substantial additional restrictions will apply to sales and hedging trades. Many Latin American and some Chinese issuers are in Category Two.
Another exemption to the registration requirement is Rule 144A, which allows placements to institutional buyers with portfolios of USD100 million or more (“QIBs”). Securities sold under Rule 144A are subject to the Rule 144 restrictions described above, in terms of sales into the US retail market, but can be sold freely among QIBs. Rule 144A placements are often done concurrently with sales under Regulation S.
In the U.S., short sales have generally been prohibited on a downtick. This rule sometimes has the effect of forcing the traders to take longer to execute the initial delta of a down side hedging trade than would otherwise be the case.
Recently, the SEC decided to temporarily exempt the stocks of certain U.S. issuers from the rule. For trades of ADRs in the U.S. market, however, this exemption is only available between the close of the consolidated tape and the open of the consolidated tape the next day.
U.S. bankruptcy law is relatively clear and favorable to derivatives transactions between two U.S. counterparties. Local insolvency law, however, is likely to apply when a U.S. dealer faces a non-U.S. client or trading vehicle. In many cases, local law is unclear and local counsel may need to be retained to determine the treatment of the derivatives trade, as well as how the dealer or its affiliate may perfect a security interest in the client’s collateral.
Before entering into a trade, the dealer should determine that the client is sophisticated enough to understand the trade, and that the trade is appropriate, given the client’s financial means and goals. Clients should be encouraged to retain and consult their own accounting, tax, estate planning, legal and other advisors as needed.
U.S. Commodities Laws
In order to minimize the risk of violating U.S. commodities laws, it is helpful, in a potentially cash-settled trade, if the client is an eligible contract participant, i.e., the client has total assets of more than USD10million, or is hedging an exposure and has total assets of more than USD5million. Other exemptions may be available if needed.
The dealer should take steps to assure itself that the transaction does not violate applicable local law, especially the laws of jurisdictions in which the client resides or has citizenship, and the jurisdiction in which the issuer is organized. If Regulation S is used for hedging trades or outright sales, the rules of the non-U.S. exchange on which the sales are executed of course need to be followed.
This list is only meant to cover some of the most frequently encountered issues. Other issues may apply, such as tax, margin regulations, currency regulations, and special regulations affecting issuers in industries such as financial services or utilities.
This week’s Learning Curve was written by Steve Gray, a director in the legal department at Credit Suisse in New York and James Rothwell, partner at Davis Polk & Wardwell. It is only a summary and not legal advice.