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Rethinking the Convertible Note: Seed Financing and Restructurings with Variable Price Notes

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Rethinking the Convertible Note: Seed Financing and Restructurings with Variable Price Notes

Capital raising through some type of convertible note instrument has become a common occurrence. It has also become common practice to use one of many publicly available convertible note templates without contemplating the nuances specific to the startup. While there are obvious efficiency gains to the spread of templates, these are of uneven quality. Some older forms of convertible notes (that I call legacy type of notes) are now, in my opinion, inadequate, whereas others such as the KISS documents by 500 Startups, substantially improve on prior practice. My objective is to highlight two areas in most note templates that can be substantially improved and I propose three changes to the open source KISS (debt) documents to illustrate how these changes could be implemented (see the attached modified form of KISS). [1]

These changes arise from the same personal observation that startups often go through multiple “rounds” of convertible note financing and issue notes at different valuation caps before their Series A round. However, all convertible note templates are drafted in one or two ways: either they are meant for discrete, individual investors or, if the notes are to be issued to a plurality of investors, these are drafted as if the capital raising could be finalized in a single seed round of limited duration with uniform pricing. This has two unintended effects: (i) it limits the startup’s flexibility in restructuring the notes through the noteholders’ collective action, and (ii) it causes additional founder’s dilution that was unforeseen at the time the note was drafted. The following changes are meant to resolve these issues, and the final product is an open-ended note of fixed maturity but variable pricing (the “Variable Price Note”).

  1. Easy Note Restructurings with Variable Price Notes
  • The Holdouts Issue

Often new financing is conditional on a restructuring of a startup’s outstanding convertible promissory notes. The restructuring can be more or less extensive, and in any event will require amendments to the notes’ conversion terms or definitional provisions. However, holdouts can make a voluntary debt restructuring very difficult. For this reason, it is often advisable to insert collective action language in the notes to allow for majority action of the noteholders.

Holdouts are well-known figures in the public bond and sovereign debt markets[2]. A holdout is a bondholder (or noteholder) who refuses to accept an offer of conversion from the company in the hope of profiting if the offer succeeds without his participation[3]. The holdout’s “decision rests on the hope that very few others will behave as he does, and that reorganization will improve the firm’s financial condition. If so, he will receive the full face value of his bonds rather than the lower exchange price paid to those who tendered their bonds. When enough bondholders use this reasoning, the offer fails”[4].

[1] This article was originally published on UpCounsel’s blog: Rethinking the Convertible Note.

[2] In preferred stock offerings the holdout issue arises in connection with down rounds. The certificate of incorporation normally allows for the mandatory conversion of preferred stock into common upon a majority class vote of the preferred. This provision is used to cram down preferred stockholders who refuse to participate in the new round.

[3] Lewis S. Peterson, Who’s Being Greedy: A Theoretical and Empirical Examination of Holdouts and Coercion in Debt Tender and Exchange Offers, 103 Yale L.J. 505, 506 (1993-1994).

[4] Lewis S. Peterson, Who’s Being Greedy, 514. See also David Skeel, Why the Class Action Strategy is Worth a Second Look, 22 Int’l Fin. L. Rev. 23 (2003): “Sovereign debt restructuring has repeatedly been stymied by the holdouts of bondholders who hope their peers will agree to take a haircut while they get paid in full… The most exciting development in sovereign debt practice in the past year has been the dramatic increase in the use of so-called collective action or majority voting provisions. These provisions permit a bond to be restructured if a specified majority of the bondholders sign on, and so bind dissenting bondholders to the will of the majority.”

Collective action language is designed to address the holdout issue by binding all members of a predefined group of noteholders to any amendments approved by a voting majority. It will consist at a minimum of two parts: (i) language defining the composition of the relevant group of noteholders and (ii) the amendment section. As explained below, most convertible note templates will restrict the composition of the relevant group of noteholders in one or two ways, thus reducing the ability of the startup to avail itself of collective action.

  • Legacy Notes

I call “Legacy Notes” those convertible note instruments that organize a round of funding around a closing period of limited duration. One could say about Legacy Notes what Paul Graham (one of the founders of Y Combinator) once wrote about fixed-size, multi-investor angel rounds: “I think angels (and their lawyers) organized rounds this way in unthinking imitation of VC series A rounds.[5]” Legacy notes are typically issued as a schedule to a note purchase agreement and define the group of noteholders as the persons that are listed on the schedule of purchasers attached to it. Then the purchase agreement generally requires that any additional sales of notes occur within 90 to 180 days of the initial closing of the sale.

[5] Paul Graham, High Resolution Fundraising, last accessed December 2, 2017.

In a priced round, the closed offering period has a twofold objective: (i) to comfort early investors that later investors will not benefit from the same pricing terms, thereby providing an incentive to invest in the current round rather than in a later round; and (ii) combined with preferred stock protective provisions, to discipline management’s capital raising endeavors. Applied to convertible notes, the first argument is not without reason – one might object that pricing concerns do not apply to convertible notes, but notes often convert at the valuation cap. However, the second is not reflective of the needs and practice of seed stage startups[6]. It’s not just a matter of capital needs being often unforeseeable and marked by urgency. Capital raising is for early stage startups a largely “do it yourself” endeavor that is often completed without the help of a lead investor or financial intermediary. In these circumstances, to require that the company corral all of its investors within a 90 to 180-day period and raise enough cash to last until a priced round can often be unrealistic.

[6] I will not elaborate on the obvious: convertible notes do not traditionally contain protective provisions; the restrictions imposed by a closed offering period does not allow noteholders to exercise control over additional funding rounds.

Legacy Notes are also drafted with the assumption that once a funding round is complete, the startup will move on to a Series A round. This does not accurately reflect the reality of startup financing, because in practice and for entirely legitimate reasons, startups often opt to issue notes for extended periods of time before settling on a priced round. Finally, the practical effect of defining the group of noteholders so restrictively (those that purchase notes within 90 to 180 days of the initial closing) is to compel the startup to issue notes in multiple separate rounds to small groups of investors or even to individual investors, and therefore to entirely forego the benefits of collective action.

  • Fixed Price Notes

Some of the newer forms of notes are issued in series and define the group of noteholders as anyone that holds a note in the series. Because these notes do not rely on a limited closing period, they could be termed “open ended.” However most of these notes require or assume that pricing terms (maturity period, discount, valuation cap and interest rate) remain unchanged within the same series, which intrinsically limits the usability over time of the note and the size of the noteholders’ group. I call these notes “Fixed Price Notes.”

In a convertible note with discount and valuation cap, the discount rate will decrease as the maturity period shortens, while the valuation cap will increase along with the founders’ and investors’ expectations for the startup. In practice, if a startup is able to articulate or provide evidence of increasingly optimistic expectations about the future, it will propose a larger valuation cap to its new investors. However, the Fixed Price Note reflecting the increased valuation cap will have to be part of a new series. The following table exemplifies how different combinations of valuation caps and discounts, within the same fixed 2-year maturity, compel the issuance of multiple Fixed Price Notes series.

  Time 1 + 6 months + 12 months + 18 months
Note Series Series 1 Note Series 2 Note Series 3 Note Series 4 Note
Maturity Date Time 1 +24 months Time 1 +24 months Time 1 +24 months Time 1 +24 months
Interest Rate 6% 6% 6% 6%
Discount 25% 20% 20% 15%
Valuation Cap $5 million $7.5 million $9 million $12 million

Each of these series will correspond to a discrete group of noteholders for voting purposes.

Most startups have an interest in maximizing their ability to use collective action. Issuing Fixed Price Notes in series seems preferable in this regard than issuing Legacy Notes. However, compared to hypothetical variable price notes or single series financings, Fixed Price Notes expose the startup to a much greater risk that majority noteholders in one or more series might holdout, thereby hindering a restructuring.

  • Variable Price Notes

While there is an intrinsic reason for issuing preferred stock in series, there is no intrinsic reason for issuing notes in separate series. In fact, the nexus between note pricing and note series comes rather indirectly out of the convenience of minimizing the number of series of preferred stock that must be authorized in the startup’s certificate of incorporation. This is because, upon conversion, a note’s effective conversion price will equal the per share liquidation preference and the conversion price for purposes of price-based anti-dilution protection of the applicable series of preferred stock. Ultimately, the certificate of incorporation will authorize as many different series of preferred stock as there are preferred stock conversion prices and effective note conversion prices. So, the thinking goes, if the notes are issued in series with uniform pricing, this will reduce the range of effective conversion prices and consequently the number of different series of preferred stock.

In reality, contrary to belief, drafting a certificate of incorporation with multiple series of preferred stock is not particularly burdensome, so long as each series of preferred stock has identical rights and differs from other series only on pricing. This, of course, reflects ordinary convertible note practice: if the note conversion price is lower than the Series A price, the note will customarily convert into a shadow series of preferred stock with identical rights and privileges as the Series A but different pricing (see for example the definition of “Shadow Series” in the KISS). In addition, now that startups can conveniently automate their cap table management on online platforms, it is possible to issue shares, track all types of equity and model new financing rounds with relative ease. Startups should be able to issue convertible notes with a dozen different combinations of valuation caps and discounts at no significant additional cost. Hence, it is entirely feasible and not cost prohibitive to issue convertible notes with differential pricing, but otherwise identical terms within the same series, and then to convert these notes in correspondingly multiple series of preferred stock. I will call these notes “Variable Price Notes.”

  • Maturity of Variable Price Notes

The original KISS instrument defines the maturity date as eighteen (18) months following the Date of Issuance and allows the latter term to differ in each KISS. Hence a KISS could be issued with multiple maturity dates within the same series and, at least in theory, KISSES of the same series could be issued indefinitely. In practice, KISS instruments rely on the fixed valuation cap to limit the round’s duration, while the fixed discount provides an incentive to group all notes within the same few months’ period. At any time on or after the “maturity date”, a majority in interest of noteholders can elect to either call the note or convert it to stock based on the conversion cap. Because the noteholders are likely to have notes with different maturity dates, “maturity” for the purpose of repayment or conversion can only occur on or after the date that all of the notes held by a majority in interest have reached their respective maturity date.

In Variable Price Notes, the round’s duration is unconstrained by the valuation cap and no incentive to temporally group the notes arises from a fixed discount. This could make the notions of majority in interest and maturity, essentially, moving targets that the startup could alter each time it issues more notes. This is why Variable Price Notes should have a fixed maturity date, which based on my experience could realistically occur anytime between 18 months and 3 years from the date of issuance of the first note in the series.

Back in 2010, Paul Graham argued convincingly that giving startups the flexibility to set different pricing terms for different investors can facilitate their capital raising. See Paul Graham, High Resolution Fundraising. I have now added a substantial argument in favor of higher resolution fundraising from the other end of the pipeline. Startups should be free to issue notes of a same series until the Series A round with multiple different combinations of valuation caps and discounts as a means to maximize collective action, reduce the risk of holdouts, and facilitate note restructurings.

  1. Avoid Unintended Dilutive Language in Legacy Notes

Consider the formula for converting a note under a conversion cap:

Conversion Price =   Valuation Cap / Fully-Diluted Capitalization

Any increase in the denominator, will result in a proportional decrease of the conversion price and a proportional increase in the number of conversion shares issued to the investor. Any arbitrary increase in the denominator will result in an unexpected dilution of the founders.

Now compare this language taken from the definition of “Company Capitalization” in the Y Combinator’s SAFE (hereafter, “Clause 1”):

“Company Capitalization” means the sum, as of immediately prior to the Equity Financing, of: (1) all shares of Capital Stock (on an as-converted basis) issued and outstanding, assuming exercise or conversion of all outstanding vested and unvested options, warrants and other convertible securities, but excluding (A) this instrument, (B) all other Safes, and (C) convertible promissory notes; and (2) all shares of Common Stock reserved and available for future grant under any equity incentive or similar plan of the Company, and/or any equity incentive or similar plan to be created or increased in connection with the Equity Financing.

to this clause, taken from a Legacy Note (hereafter, “Clause 2”)

The Note Conversion Price, however, shall not be greater than the quotient obtained by dividing (x) $6,000,000 by (y) the sum of (1) the total number of shares of Common Stock outstanding (assuming full conversion and exercise of all convertible or exercisable securities other than the Notes) and (2) shares of Common Stock issuable to employees, consultants or directors pursuant to a stock option plan, restricted stock plan, or other stock plan approved by the Board of Directors.

from the perspective of determining the fully-diluted capitalization of the company prior to conversion under the conversion cap.

Clause 1 assumes full conversion and exercise of all convertible securities excluding (1) the very SAFE where the language appears, (2) all other SAFE instruments and (3) all convertible promissory notes regardless of whether they belong to different series or are issued individually. Hence all notes are treated as being part of the same transaction, whether or not they have in fact been issued under the same note purchase agreement or belong in the same series. Clause 2 however assumes full conversion and exercise of all convertible securities other than the Notes, and this term is usually defined in the note purchase agreement as the notes issued pursuant to that agreement. This means that according to Clause 2 we have to include in the fully-diluted capitalization any notes issued outside of a limited closing period, notes of any other series or, if the notes have been issued individually, any note other than a specific note.

Similar to Clause 2, the original KISS instrument excludes from Fully-Diluted Capitalization the conversion contemplated by the applicable provision of Section 2, which I interpret as the KISS instruments of a same series.  As seen above, the KISS series are limited in time by fixed pricing, which favors the issuance of KISS instruments in multiple series.

The (probably) unintended effect of adopting Clause 2, rather than Clause 1, is a significant increase in dilution. To quantify the dilutive effect of Clause 2, consider the simplified pre-money cap table below of a fictitious tech startup, StartUp Inc.:

CAP TABLE BEFORE INVESTMENT
Shareholder Common Common Total % Fully
Stock Options Total Diluted
Founder 1 1,000,000.00 1,000,000 42.11%
Founder 2 1,000,000.00 1,000,000 42.11%
Employee 1 125,000 125,000 5.26%
Employee 2 125,000 125,000 5.26%
Unallocated Option Pool 125,000 125,000 5.26%
Total 2,000,000 375,000 2,375,000 100%

 

Let us assume further that during the course of the last year StartUp Inc. has issued $1,000,000 worth of convertible notes to two groups of investors (the Series 1 Notes and Series 2 Notes) at different valuation caps and 20% discount from Series A price:

Convertible Notes Series 1 Notes Series 2 Notes
Principal Amount $500,000 $500,000
Interest Rate 6.0% 6.0%
Valuation Cap $5,000,000 $6,000,000
Discount from Series A share price 20.0% 20.0%
Date of the Convertible Note funding 1/1/2016 4/1/2016
Hypothetical Conversion Date (Series A funding) 1/1/2017 1/1/2017

 

On January 1, 2017, StartUp Inc. raises $2 million from a group of Series A investors at $8 million pre-money valuation. For the sake of simplicity, I will ignore the customary option pool increase.

Applying Clause 1, you would calculate the denominator without assuming that any convertible notes have converted beforehand. The noteholders from the Series 1 and Series 2 groups will receive respectively 251,987 and 206,987 shares of preferred stock upon conversion. The fully diluted cap table would look like this:

 

On the other hand, if the Series 1 Notes and the Series 2 Notes had been issued pursuant to an instrument containing Clause 2, you would need to assume the prior conversion of either the Series 1 Notes or the Series 2 Notes to calculate the conversion valuation cap price of, respectively, the Series 2 Notes and the Series 1 Notes. In this scenario, the Series 1 Notes and the Series 2 Notes would each convert into 21,961 and 21,962 additional shares of stock respectively. This would result in additional dilution to the founders (approximately 74 basis points), and an additional $147,951 worth of stock issued to investors.

Of course, the dilution would have been much greater had all the notes been issued individually.

The “valuation cap” is a hypothetical pre-money valuation at a future date; it denotes a price per share prior to giving effect to the conversion of the notes. It makes little sense to convert a note based on the cap and yet assume the conversion of all outstanding notes other than the one particular note where the language appears. Strangely enough the drafting differences between Clause 1 and Clause 2 may not in fact reflect philosophical differences. As noted above, Clause 2 belongs to a Legacy Note and it may simply erroneously assume that all notes would be issued prior to a qualifying transaction under the same purchase agreement (during the same closing period). In reality, as noted above, startups often go through multiple “rounds” of note issuing before settling on a priced round.

The Variable Price Note modifies the basic KISS instrument to exclude (i) KISSes of the same series, (ii) KISSes of other series and (iii) any convertible securities issued for capital raising purposes, from an accounting of Fully-Diluted Capitalization. I have adopted this last language (“convertible securities issued for capital raising purposes”) from the Series Seed Convertible Note Financing Documents Generator given that there are a few non-debt convertible instruments out there such as the equity type of KISS and the SAFE.

The take away for forward-thinking founders is to never issue notes to discrete individual investors, but always in series; when the latter, to issue the notes in a limited number of series and to define the participating group of noteholders to be as inclusive as possible. Ideally, prior to the Series A round, startups should issue only one series of open-ended notes with variable pricing (the Variable Price Notes).

Reverse Stock Splits – What are they and how to effect them

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What are Stock Splits / Reverse Splits

This post is the second part on my Stock Splits series. The first part is a comparative table of the law on Stock Splits across some selected US and Canadian jurisdictions and can be read here.

Simply stated a stock split (or forward split) is a corporate action, usually effected by amendment to the articles, to increase by a multiple the number of outstanding shares of a class without altering the equity capital of the corporation. Thus, in a 2 for 1 split of a class of par value shares, the corporation will replace each outstanding shares of that class with 2 new shares of half the original par value. The amount of equity capital stays the same, only the number and the value of each share will change. Likewise, in corporations with no par value shares, the market value of the stock should decrease in a manner inversely proportional to the increase in the number of shares.

A reverse stock split (or share consolidation) is the mirror transaction of a forward split. The number of outstanding shares of a class is reduced by a fraction without altering the equity capital of the corporation. For instance, a 5 to 1 reverse stock split of shares of a given class will result in the corporation replacing each block of 5 outstanding shares of that class by a single share of 5 times the par value. Thus the stated par value (or market value in the case of a corporation with no par value shares) will be increased by the converse of the percentage reduction in the number of outstanding shares.

A bit of Comparative Law: how Stock Splits / Reverse Splits are effected

United Kingdom, Delaware

In jurisdictions with mandatory par value stock (e.g. the U.K.) and jurisdictions that encourage par value stock (Delaware), the corporate action effecting the forward / reverse split will have to set both the multiple by which the number of outstanding shares is increased or decreased and the new par value. This implies that the corporate action will always be effected by amendment to the articles (or, in the case of the UK, by filing a new statement of capital[1]) if only to set the new par value and will also give rise to a class vote of the shares whose par value is affected[2].

Canada, Ontario

Jurisdictions with mandatory no-par value stock (e.g. the CBCA and its progeny; California) and jurisdictions that encourage no-par value stock (MBCA), tend to deal with forward / reverse splits in one of two ways.

The Canada Business Corporations Act (CBCA) and its progeny (e.g. Ontario)

Jurisdictions with mandatory no-par value stock (e.g. the CBCA and its progeny; California) and jurisdictions that encourage no-par value stock (MBCA), tend to deal with forward / reverse splits in one of two ways.

The Canada Business Corporations Act (CBCA) and its progeny (e.g. Ontario) handle forward and reverse splits homogeneously: both presuppose an amendment to the articles approved by a special resolution of the shareholders[3]. Having rejected the notion of par value stock, in theory it should have been possible to subdivide / consolidate shares without going through the amendment process. However, the CBCA considers that a stock split is a “fundamental adjustment in the outstanding share capital of a corporation and may therefore be construed as a matter properly allocated to the shareholders”[4]. The amendment will not give rise to special voting rights by the class of shares that is forward/reverse split unless the rights and privileges attached to the shares are somehow affected, viz. in the event of a reclassification.

Model Business Corporations Act

The Model Business Corporations Act (MBCA), California and Alberta handle forward and reverse splits differentially. The latter are always effected through an amendment to the articles. Forward splits are adopted by the board when the corporation has only one class of shares outstanding[5]; however, they require shareholder approval if more than 1 class of shares is outstanding. The reasons for this is that, as we shall see, reverse splits have the greatest potential of mischief; forward splits in single-class shares corporations are innocuous if performed judiciously; whereas forward splits in multiple-class shares corporations can alter the relative position and privileges of a class.

Because the accounting treatment of share dividends and forward splits in regard to no-par value shares is the same, the MBCA assimilates the two. Forward splits require shareholder approval only in the event that the corporation has more than 1 class of shares: inter-class share dividends will require the special approval of the class of shares to be issued[6] whereas intra-class dividends will require the special assent of the class that is being forward split[7]. The MBCA requires that the articles state the number of shares that the corporation is entitled to issue and assimilates a reverse split to an amendment of the articles reducing the number of authorized shares[8]. Thus, in corporations with only one class of shares, forward splits will be effected by an amendment to the articles according to the procedure set forth in §10.03; and in corporations with more than one class of shares, will give rise to class voting rights for the class of shares that is being reverse split[9].

California

Similarly to the MBCA, California allows single-class share corporations to implement forward stock splits with sole board approval[10]. Class voting is limited to reverse-splits and, for some reason, explicitly excludes forward splits from the realm of reclassifications that give rise to special voting rights[11]. In any event, forward splits in multiple-class share corporations require shareholder consent.

Alberta

Following the Saskatchewan lead, the amended Alberta Business Corporations Act (ABCA) adds a new section 27.1 on stock splits in the corporate finance section of the statute. For some reason that escapes me it also leaves s. 173 ABCA on fundamental changes unmodified. The confusing effect is compounded by the lack of proper terminological distinction between splits and reverse splits or subdivisions and consolidations. In any event, the net effect seems to be the following:

  • where the corporation has only 1 class of shares outstanding, the Board of directors may decide to effect stock subdivisions and consolidations either by Board resolution under s. 27.1(1) ABCA, in which case it will have to notify the shareholders after the fact pursuant to s. 27.1(3) ABCA, or under the traditional process of amendment set forth by s. s. 173(1)(f) ABCA, in which case shareholder approval will be required;
  • where, however, the corporation has more than 1 class of shares outstanding, subdivisions and consolidations always require a separate vote by each class of shares outstanding (not merely the classes directly concerned).

Saskatchewan

As we have already noted, shares of a class can be split or reverse split into the same or a different class of shares. In no-par value stock jurisdictions, intraclass forward / reverse splits can in theory be effected without directly varying any of the fundamental rights attaching to shares. Inter-class forward / reverse splits however will always change the rights and privileges of the class that is being forward / reverse split and potentially affect other classes as well. That is why during the 1992 revision of its corporation law, the province of Saskatchewan had amended its then s. 167(1)(g)[12] on amendments to articles of incorporation to remove the reference (still present in the CBCA) to intra-class forward / reverse splits. In its stead it created a new s. 25.1 in the corporate finance section which allowed a corporation to effect intra-class forward / reverse splits by adopting of a special shareholder resolution without amending the articles.

British Columbia

Likely influenced by the history of its corporate law, British Columbia‘s new Business Corporations Act (2002) (BCA) is by and large the most rational as far as forward/reverse splits are concerned. Upon incorporation, the founders file a notice of articles and articles of the company. The notice of articles contains a description of the authorized share structure of the company[13], namely: the classes of shares, the maximum number of shares that it is authorized to issue for each class or a statement that there is no maximum number, the par value of any shares with par value or a statement identifying the no-par value shares as such[14]. The articles will set out most other important information about the company, notably for each class of shares the special rights and restrictions attached to the shares of that class[15].

Section 54 of the BCA empowers a BC corporation to subdivide or consolidate its share capital. If the subdivision or consolidation would render the information on the notice of articles incorrect or incomplete, then the company must effect that change by altering the notice of articles. In other words, if the subdivision / consolidation results in a change in the authorized share structure the company must proceed through amendment. Thus, a company will take this route if it wants to subdivide / consolidate par value shares.

Whenever the subdivision / consolidation would render information on both the notice of articles and the articles incorrect or incomplete, the company must seek shareholder authorization to amend both documents. Any inter-class forward / reverse split (reclassification) will result in such an amendment.

Unless the articles provide otherwise, alterations to the notice of articles and the articles must be authorized by special resolution of the shareholders[16]. Inter-class forward / reverse splits will be subject to special voting rights of the holders of shares of the class whose rights are being prejudiced[17].

Finally, whenever the subdivision / consolidation does not alter the authorized share structure and does not require an amendment to the articles, the company must seek shareholder authorization in the manner set forth by the articles or by special resolution if the articles do not specify another type of resolution. This situation covers any intra-class forward / reverse splits of no-par value shares. Note that the Table 1 model articles do not specify the type of resolution and thus most BC single-class companies will likely proceed in this manner.

[1] Companies Act 2006, s. 619
[2] DGCL, §242(b)(2)
[3] CBCA, 173(1)(h); OBCA, 168(1)(h)
[4] Industry Canada. Canada Business Corporations Act Discussion Paper: Proposals for Technical Amendments. Ottawa: Industry Canada, 1995, p. 73-74
[5] MBCA, §10.04(a)(4)
[6] MBCA, §6.23 (b)
[7] MBCA, §10.04(a)(4)
[8] MBCA, comment to §6.23
[9] MBCA, §10.04(a)(4)
[10] California Corporations Code, §902(c)
[11] California Corporations Code, §903(a)(2)
[12] Which corresponds to current CBCA 173(1)(h)
[13] BCA, s. 11(g)
[14] BCA, s. 53
[15] BCA, s. 12(2)(b)
[16] BCA, s. 257, 259(4)
[17] BCA, s. 61

How to de-quote securities from Pink Sheets

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How to de-quote securities from Pink Sheets by adopting stock transfer restrictions

A while back I wrote about proposed Multilateral Instrument 51-105 and wondered that quite a few Canadian issuers with shares quoted on Pink Sheets would have to, somehow, “privatize” by de-quoting their stock. There are a few ways to go about doing this, but only one that does not entail buying out all of the outstanding stock, making extensive securities disclosures on both sides of the border and creating undesirable tax liabilities. I propose that these Canadian issuers de-quote their securities from Pink Sheets by reclassifying their outstanding securities into restricted shares of stock.

Assumptions

This is not a one-size fits-all solution; it responds to a precise set of legal, regulatory and financial constraints. It only applies to Delaware corporations whose one class of outstanding common shares (Common Shares) are held of record by less than 300 persons, and I will assume that these holders of record represent 1000 beneficial security holders. Furthermore, the issuer is neither a reporting issuer in a Canadian jurisdiction nor currently a SEC reporting issuer, having filed a Form 15 to terminate a Section 12(g) registration under the Securities Exchange Act of 1934 (Exchange Act) and suspend its Section 15(d) reporting requirements in relation to the Common Shares. Although a majority of shareholders are resident in Canada, more than 40% of the Common Shares are held by US residents, the majority of whom are not accredited investors.

S. 202(b) – No retroactive application of transfer restrictions

The transaction I propose is molded by two major legal constraints. The first derives from § 202(b) of the Delaware General Corporation Law (DGCL) which makes validly adopted transfer restrictions unenforceable with respect to priorly issued securities unless the holders of the securities are parties to an agreement or voted in favor of the restriction. The second concerns the availability of the exemption from registration provided by Section 3(a)(9) (Exchange Exemption) of the Securities Act of 1933 (Securities Act).

With regard to § 202(b) DGCL, one can circumvent the constraint by merging the corporation whose stock is outstanding (Parent) with and into a wholly-owned subsidiary (Merger Sub, the surviving corporation). In the merger, each outstanding Parent Common Share would be converted into the right to receive a Merger Sub restricted common share. Because the merger occurs after the creation of the restrictions to the Merger Sub common shares and the Parent Common Shares cease to exist as a result of the merger, the restrictions bind all holders of the Merger Sub common shares. See: Shields v. Shields, 498 A.2d 161 (Del. Ch.), appeal denied, 497 A.2d 791 (Del. 1985).

From our point of view there is but one problem with this type of transaction: there is no identity between the issuer of the securities surrendered (Parent) and the issuer of the securities received by the exchanging stockholders (Merger Sub). This entails that the Section 3(a)(9) exemption is inapplicable and, pursuant to Securities Act Rule 145, the merger is a registerable event under Section 5 of the Securities Act (I leave the extended discussion of the notion of “sale” in Section 2(a)(3), Rule 145 and of the unavailability of the change of domicile exception thereunder to another setting).

How to adopt transfer restrictions while preserving the Exchange Exemption

The solution to this apparently insoluble conundrum is, in effect, quite simple. Whereas only consenting shareholders are bound by newly adopted transfer restrictions, it is unnecessary for the purposes of the transaction that all shareholders consent to or vote in favor of the adoption of new transfer restrictions to their already issued stock; it is only necessary that enough shareholders accept the restrictions to render the buyout of the non-consenting shareholders by the corporation economically feasible.

In other words, the issuer can submit a proposal to the stockholders that they adopt the merger of a wholly-owned subsidiary into the parent corporation (the surviving corporation), in the course of which each share of Common Stock then held by a shareholder of record will be cancelled and converted into the right to receive, at the election of the shareholder, either (i) the newly restricted stock or (ii) cash . At the same time, the conclusion of the transaction can be made conditional on a relatively high percentage of shareholders accepting the stock consideration or, conversely, on the company not being required to acquire more than a defined number of shares for cash either pursuant to the terms of the merger or pursuant to dissenters’ rights of appraisal.

The shareholders that vote in favor of the restrictions receive the new restricted stock; those that do not are cashed out. Because the issuer of the securities surrendered is the same as the issuer of the newly issued restricted securities (the parent being the surviving corporation), there are no peculiar obstacles to the application of the Exchange Exemption. Because some shareholders will be cashed out, the Board will be well advised to adopt procedural protections likely to establish the entire fairness of the transaction, such as a special committee or a majority of the minority provision.

How not to trigger Exchange Act reporting obligations

Another concern needs to be addressed. Simply put, restricted shares cannot be held in a brokerage account. This will set off an undesirable chain reaction: upon effecting the conversion, the broker will cease to hold the shares in street name and their overt ownership will revert back to the ultimate beneficiary; the number of record holders of common stock will increase to more than five hundred persons and this, in turn, will automatically trigger Exchange Act reporting requirements under section 12(g). The solution is to reclassify the issuer’s stock in two or more classes in the course of the merger. As indicated above, I have laid out an assumption that the issuer has more than 1,000 beneficial shareholders. We will therefore reorganize the issuer’s equity capital into one or more new classes of preferred stock of less than 2000 overall shareholders and 500 non-accredited shareholders each in order not to trigger Exchange Act registration requirements. Furthermore, because the issuer’s reporting obligation in relation to the Common Shares were suspended under section 15(d) of the Exchange Act, it will be prudent to limit holding of the new class of common shares by less than 300 holders of record.

This type of conversion can be effected in a typical tiered structure. Under the terms of the agreement of merger, at the effective time of the merger:

  • each share of Common Stock then held by a shareholder of record who as of the record date for the meeting of shareholders (the “Record Date”) held x or more shares of Common Stock will be cancelled and converted into the right to receive, at the election of the shareholder, either: (a) one share of the newly authorized restricted New Common Stock, or (b) the per share cash consideration of $P;
  • each share of Common Stock then held by a shareholder of record who as of the Record Date held more than y but less than xshares of Common Stock will be cancelled and converted into the right to receive, at the election of the shareholder, either: (a) one share of the newly authorized restricted Class A Preferred Stock, or (b) the per share cash consideration of $P;
  • each share of Common Stock then held by a shareholder of record who as of the Record Date held y or fewer shares of Common Stock will be cancelled and converted into the right to receive, at the election of the shareholder, either: (a) one share of the newly authorized restricted Class B Preferred Stock, or (b) the per share cash consideration of $P.

As a result, after the broker-dealers cease to hold the shares in street name, the following will reflect the distribution of shareholders of record per class of stock:

Table 1: Distribution of shareholders of record
Stock Class Stockholders of Record
New Common Stock less than 300
Class A Preferred Stock less than: 500 non-accredited or 2000 overall
Class B Preferred Stock less than: 500 non-accredited or 2000 overall

Conclusion

I have proposed above a simple and inexpensive way of de-quoting stock from Pink Sheets that can be used by some Canadian issuers to avoid becoming subject to MI 51-105. The merit of the method proposed lies entirely in the fact that no securities disclosures need to be made on either side of the border. On the U.S. side, the transaction can be shielded by the Exchange Exemption, and in this respect the issuer will be well advised to follow expert guidance from legal counsel on how to organize the logistics of the solicitation. On the Canadian side, the issuer is not a reporting issuer and thus the transaction is not subject to MI 61-101 Protection of Minority Security Holders in Special Transactions. The only formalities applicable to the transaction will derive from Delaware corporate law: the adoption of procedural protections likely to establish the entire fairness of the transaction; and the application of directors’ fiduciary duties to disclose all facts germane to the transaction in relation to the stockholder vote.

MI 51-105 – an Unorthodox Solution for Canadian Issuers Quoted in the U.S. OTC Markets

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MI 51-105 – an Unorthodox Solution for Canadian Issuers Quoted in the U.S. OTC Markets

The Canadian Securities Administrators (the “CSA”), except the Ontario Securities Commission[1], announced that Multilateral Instrument 51-105 respecting Issuers Quoted in the U.S. Over-the-Counter Markets (“MI 51-105” or the “Instrument”) will finally become effective on July 31, 2012[2]. The Instrument subjects to continuous disclosure and other regulatory obligations any issuer whose securities are quoted only on a US OTC market and that has a significant connection to a Canadian jurisdiction. Those companies that are OTC reporting issuers under MI 51-105 will have to quickly get up to speed in order to prepare and file any disclosure documents on SEDAR as required.

1. Application

MI 51-105 applies to any OTC Issuer with a significant jurisdictional nexus with Canada. An OTC Issuer is an issuer that has a class of securities which are quoted on any U.S. over-the-counter markets or are reported on the grey market, but is not an issuer that has a class of securities listed on a North-American stock exchange[3]. An OTC Issuer becomes subject to the requirements of MI 51-105 ( hence, an OTC Reporting Issuer) if it is directed or administered from a jurisdiction in Canada, promotional activities are conducted in or from a jurisdiction in Canada, or it distributed seed shares[4] in Canada prior to obtaining a ticker symbol. The Instrument also applies to an OTC Issuer that is already a reporting issuer in a Canadian jurisdiction at the time the regulation comes into force.

Conversely, an OTC Issuer ceases to be an OTC Reporting Issuer if: (a) its business has not been directed or administered, and promotional activities have not been carried on, from a Canadian jurisdiction for at least one year and more than one year has passed since the ticker-symbol date[5]; (b) a class of its securities has become listed on a North-American stock exchange[6]; or (c) the issuer receives an order from the securities regulatory authority in the jurisdiction that it is no longer a reporting issuer in that jurisdiction[7]. For some reason, the above criteria do not apply in Quebec and the OTC Reporting Issuer must apply to have its reporting issuer status revoked by to the Autorité des marchés financiers in a discretionary process.

2. An Alternative Road for Ending the OTC Reporting Issuer Status

The Instrument fails to contemplate that a class of securities may cease altogether to be quoted on the U.S. over-the-counter market and hence that the issuer may cease to be qualified as an OTC Issuer (being generally assumed that it is at the very least impractical to remove a class of securities from quotation on OTC Markets). Yet as I have explained in a previous post, this result can be attained by reclassifying the outstanding common stock of a non-reporting Delaware issuer into two or more classes of restricted shares of stock.

In order to comply with the rule against the retroactive application of transfer restrictions at § 202(b) of the Delaware General Corporation Law , the issuer can submit a proposal to the stockholders that they adopt the merger of a wholly-owned subsidiary into the parent corporation (the surviving corporation), in the course of which each share of common stock then held by a shareholder of record will be cancelled and converted into the right to receive, at the election of the shareholder, either (i) the newly restricted stock or (ii) cash. At the same time, the conclusion of the transaction is made conditional on a relatively high percentage of shareholders accepting the stock consideration or, conversely, on the company not being required to acquire more than a defined number of shares for cash either pursuant to the terms of the merger or pursuant to dissenters’ rights of appraisal. The shareholders that vote in favor of the restrictions receive the new restricted stock; those that do not are cashed out.

In the course of the merger, the issuer’s stock is also reclassified into one or more classes of preferred stock of less than 2000 overall shareholders and 500 non-accredited shareholders each in order not to trigger Exchange Act registration requirements. Furthermore, in the event that the issuer’s reporting obligation in relation to its class of common stock were suspended under section 15(d) of the Exchange Act, it will be prudent to limit holding of the new class of common stock by less than 300 holders of record. At the end of the operation, the formerly free trading class of common stock of the issuer is restructured into one new class of restricted common stock and one or more distinct classes of restricted preferred stock. Hence, the issuer’s securities are no longer quoted on the OTC markets. Thereafter, the issuer would need to obtain an order from the securities regulatory authority in the relevant Canadian jurisdiction that it is no longer an OTC reporting issuer in that jurisdiction.

Finally it is important to note the following. As we shall see, from July 31, 2012 any OTC Issuer subject to MI 51-105 will be ipso facto a reporting issuer under applicable Canadian securities legislation. Whereas before the entry into force of MI 51-105, a non-reporting issuer would have been able to complete the above reclassification without any securities disclosures on either side of the border; after the Instrument will become effective, the transaction will at a minimum be subject in Canada to MI 61-101 Protection of Minority Security Holders in Special Transactions.

3. Disclosure Requirements

The first objective of MI 51-105 is to introduce continuous disclosure requirements for OTC Reporting Issuers and by the same token reduce these markets’ traditional exposure to illicit promotional campaigns[8]. OTC Issuers that are not SEC filers must meet the same periodic disclosure requirements that apply to other domestic reporting issuers, notably under National Instrument 51-102 Continuous Disclosure Obligations and, for oil and gas issuers, under National Instrument 51-101 Standards of Disclosure for Oil and Gas Activities. OTC Issuers that are SEC filers can comply with the disclosure requirements by using the reports they already file with the SEC. Insiders of OTC Reporting Issuers must file insider reports on SEDI and directors, officers, promoters or control persons must file personal information forms (PIF). In addition to normal disclosure requirements, OTC Issuers are required to disclose information about their promoters, their engagement and compensation in the form of Form 51-105F2 Notice of Promotional Activities. Issuers should note that, in British Columbia, the introduction of new disclosure requirements for OTC Reporting Issuers had been followed by substantial disclosure compliance reviews which in many cases resulted in the issuance of cease trade orders against nonconforming issuers.

4. Resale Restrictions

Another important objective of the Instrument is to introduce restrictions to resales to prevent the occurrence of illicit activities and manipulative practices. These requirements are in addition to existing resale limitations provided by United States securities laws. Seed shares acquired after MI 51-105 has become effective can only be traded within a reorganization or merger transaction, or if: the security is properly legended; the trade is effected by a person through a registered investment dealer from an account registered in the name of that person; and the trade is executed in a OTC market in the United States. The legend must state the following: “Unless permitted under section 11 of Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets, the holder of this security must not trade the security in or from a jurisdiction of Canada unless (a) the security holder trades the security through an investment dealer registered in a jurisdiction of Canada from an account at that dealer in the name of that security holder, and (b) the dealer executes the trade through any of the over-the-counter markets in the United States of America.”

Private placement securities acquired after the OTC Reporting Issuer has received a ticker-symbol can only be resold after a 4-month period has passed either from the date of the original distribution or the date a control person distributed the security. Additional restrictions apply: a person can only trade up to 5% of the OTC reporting issuer’s outstanding securities of the same class in any given 12-month period; the person must trade the security through a Canadian-registered investment dealer, who executes the trade through an OTC market in the US; there is no unusual promotional effort; no extraordinary commissions are paid for the trade; and the security bears a legend stating: “The holder of this security must not trade the security in or from a jurisdiction of Canada unless the conditions in section 13 of Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets are met.” Finally, MI 51-105 also creates additional restrictions to the issuance of securities for services to the issuer’s directors, officers, or consultants.

5. Transition

On the day that MI 51-105 comes into force, on July 31, 2012, an OTC Issuer that satisfies the conditions set forth in s. 3 of MI 51-105 will be ipso facto a reporting issuer under applicable securities legislation and will immediately become subject to disclosure obligations. However, the Instrument provides a transition period for OTC reporting issuers that are not SEC filers. The obligation to file annual financial statements, related MD&A and annual certificates applies only to financial years beginning on or after January 1, 2012, and the filing deadline expires 120 days after the end of the financial period. A company with a December 31 year-end would have until April 30, 2013 to file. The obligation to file interim reports applies to interim periods that begin on or after January 1, 2012 and end after July 31, 2012. For a company with a December 31 year-end, the first interim period after July 31 would fall on September 30, and the filing deadline would expire 60 days later. As announced in response to comments to the proposed regulations, “Canadian securities regulatory authorities will generally not grant exemptive relief to a reporting issuer to extend a continuous disclosure filing deadline to enable an issuer to avoid a default [9].”

6. Planning the future

Clearly, the Instrument’s disclosure requirements will impose a significant new burden on currently non-reporting OTC Markets issuers, and a decision on whether to continue to be a reporting company will undoubtedly be a high priority issue for these issuers and their advisers. I have provided above an unorthodox course of action precisely to this end. In the immediacy, however, the first item on the agenda should be to start preparing the interim reports and laying the groundwork for the first annual audited financial statements. Audited financial statements will be required in any event, whether the Issuer resolves to remain a reporting company or whether it attempts instead to cease to qualify as an OTC Reporting Issuer.

[1] The province of Ontario did not participate in proposed MI 51-105, having decided that it could not evidence abusive activity being conducted in Ontario in relation to OTC issuers. Of course one could only come to this conclusion by ignoring what is arguably one of the single largest fraudulent use of shell corporations in Canadian history. See: Ontario Securities Commission Amended Statement of Allegations, In the Matter of Irwin Book et al., (January 4, 2012) at http://www.osc.gov.on.ca/en/Proceedings_soa_20120104_boocki.htm (last visited on July 25, 2012).
[3] The instrument enumerates seven organized stock exchanges, namely (i) TSX Venture Exchange Inc.; (ii) TSX Inc.; (iii) Canadian National Stock Exchange; (iv) Alpha Exchange Inc.; (v) The New York Stock Exchange LLC; (vi) NYSE Amex LLC; and (vii) The NASDAQ Stock Market LLC. However, as the CSA pointed out following the comment period, an issuer will be able to obtain relief by demonstrating that a specific exchange has similar oversight and governance requirements as the listed exchanges. This should cover the situation of issuers dually quoted on a US OTC market and on AIM or Frankfurt.
[4] A seed share being a security issued before the issuer is first assigned a ticker-symbol.
[5] The change of status does not occur automatically upon the change of circumstances. The issuer is required to notify its regulator by filing Form 51-105F1 Notice – OTC Issuer Ceases to be an OTC Reporting Issuer.
[6] In which case the issuer must file Form 51-105F4 Notice – Issuer Ceases to be an OTC Reporting Issuer. In Quebec, the issuer must apply to the securities regulatory authority to have its status as an OTC reporting issuer revoked in order to cease to be an OTC issuer.
[8] See: BC Notice 2007/24, BCSC Response to Abusive Practices in British Columbia Involving US Over-the-Counter Markets (June 25, 2007). This document is still to this day the most complete public policy statement about MI 51-105 and its predecessor, BC Instrument 51-509.

New Proposed Rules for Canadian Issuers Quoted in the US OTC Markets

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Note: for a post on the current version of M.I. 51-105 see here.

Canadian securities commissions (except the OSC) have published new proposed rules for Canadian issuers that have securities quoted on the US over-the-counter markets (the OTC Rule)[1]. The OTC Rule derives from BC Instrument 51-509. The latter was designed in 2008 to combat abuse of the US OTC markets, Pink OTC Market and OTC Bulletin Board, by British Columbia promoters[2]. The OTC Rule extends the new regulatory environment to most Canadian provinces.

The US OTC markets reputation as “speculative” and opaque markets has been an obstacle to their usefulness to Canadian issuers. In fact, relatively few Quebec issuers have securities quoted solely on Pink Sheets. The OTC Rule complements, from the Canadian side of the border, recent efforts by the SEC and the markets themselves to weed out abuses and increase transparency. The US OTC markets could become extremely valuable to small Canadian issuers as an additional and cheaper source of equity capital than traditional stock markets. Hopefully the implementation of a specifically tailored and uniform rule across most Canadian jurisdictions will help accomplish the objective.

Purpose

The stated objective of the OTC Rule is to reduce the occurrence of pump and dump schemes and the misuse of shell companies, by improving disclosure by Canada-based issuers and promoters and creating special restrictions on the resale of shares sold in private placements.

Application

The Rule applies to any OTC Issuers with a significant jurisdictional nexus with Canada. An OTC Issuer is an issuer whose securities are quoted on any U.S. over-the-counter markets (except those issuers that are also listed on TSX, TSX-V, CNSE, NYSE, NYSE-Amex, Nasdaq[3]) or whose trades in securities are reported on the grey market[4].

An OTC Issuer is subject to the rule if it is directed or administered from a Canadian province, promotional activities are conducted in or from a Canadian province, or it distributed seed shares in Canada prior to obtaining a ticker symbol (OTC Reporting Issuer). Legitimate US issuers will need to evaluate whether their Canadian directors create an unwanted jurisdictional nexus to a Canadian jurisdiction.

Conversely, an OTC Issuer ceases to be a reporting issuer if the above activities have ceased for more than a year. In Québec, the OTC Reporting Issuer must apply to the AMF to have its status revoked.

The OTC Rule would apply to an OTC Reporting Issuer that is a reporting issuer in Canada.

Disclosure Requirements

OTC Issuers that are not SEC filers must meet the same periodic disclosure requirements imposed on other domestic reporting issuers, notably under National Instrument 51-102 Continuous Disclosure Obligations and, for oil and gas issuers, under National Instrument 51-101 Standards of Disclosure for Oil and Gas Activities.

Insiders of OTC Reporting Issuers must file insider reports on SEDI. Directors, officers, promoters or control persons must file personal information forms (PIF).

OTC Issuers that are SEC filers can comply with the disclosure requirements by using the reports they file with the SEC.

In addition to normal disclosure requirements, OTC Issuers would also be required to disclose information about their promoters, their engagement and compensation in the form of Form 51-105F2 Notice of Promotional Activities.

Resale Restrictions

Due to long standing neglect from regulators, resales were always a sticking point in OTC financings: seed shares often came to magically form the float of new companies; and other private placement shares were often renegotiated with no regard for Canadian resale rules.

Seed shares can only be traded within a reorganization or merger transaction, or if: the security is properly legended; the trade is effected by a person through a registered investment dealer from an account registered in the name of that person; and the trade is executed in a OTC market in the US.

The legend must state the following: “Unless permitted under section 11 of Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets, the holder of this security must not trade the security in or from a jurisdiction of Canada unless (a) the security holder trades the security through an investment dealer registered in a jurisdiction of Canada from an account at that dealer in the name of that security holder, and (b) the dealer executes the trade through any of the over-the-counter markets in the United States of America.”

Private placement securities acquired after the OTC Reporting Issuer has received a ticker-symbol can only be resold after a 4-month period has passed either from the date of the original distribution or the date a control person distributed the security. Additional restrictions apply: a person can only trade up to 5% of the OTC reporting issuer’s outstanding securities of the same class in any given 12-month period; the person trades the security through a Canadian-registered investment dealer, who executes the trade through an OTC market in the US; there is no unusual promotional effort; no extraordinary commissions are paid for the trade; and the security bears a legend stating:

The holder of this security must not trade the security in or from a jurisdiction of Canada unless the conditions in section 13 of Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets are met.

These requirements are in addition to existing resale limitations provided by US securities laws.

Transition

Non-SEC filers will be given additional time to comply with the new disclosure requirements.

Effect on existing Québec Issuers

According to my own analysis of the data, as of June 15, 2011, 217 Quebec issuers had 228 securities quoted on PK, 195 of which were either listed on an organized exchange (most commonly TSX or TSX-V) or a SEC reporting issuer. Of the remaining 33, 4 complied with the Pink OTC Markets Group’s Guidelines for Providing Adequate Current Information while 29 had gone dark; 13 of the latter were inactive due to bankruptcy or regulatory action.

In other words, the number of Quebec-based issuers likely to be impacted by the rule is relatively small (20 issuers). These issuers draw very little benefit from their status because of the lack of liquidity of the market for their stock, of existing restrictions on US resales under Rule 144 and finally because of the sheer psychological (and sometimes, for Canadian investors, logistical) obstacles of investing into a Pink Sheet stock. Most of these issuers (at least those that are active and can afford it) should seek to become entirely private before the OTC Rule is adopted.

[3] Note the absence of the London Stock Exchange and Frankfurt Stock Exchange listed issuers.
[4] Trades by broker-dealers of securities that are not formally quoted on the OTC markets. For instance, broker-dealers may trade on Pink OTC Markets the securities of a Canadian issuer that is listed on AIM.

Comparative Law of Stock Splits

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In appearance, the law of stock splits varies wildly from jurisdiction to jurisdiction, but it moves in fact, with a certain lag across jurisdictions, in the same direction as corporate capital rules. The table that follows provides an overview of the legal treatment of stock splits under the continent’s major corporate laws plus the UK (to exemplify the effective regulation of stock splits as part of a system of capital rules).

Table 1: Reverse stock splits per jurisdiction
Jurisdiction Share capital – Limited/Unlimited Par Value Stock Issuance Subdivisions (Forward Splits) Consolidations (Reverse Splits)
MBCA Limited, fixed in certificate of incorporation 1 Optional2 Board of directors3 Board of directors, unless the corporation has more than 1 class of shares outstanding4 Amendment to the articles of incorporation5
Delaware Limited, fixed in certificate of incorporation6 Optional, in practice always par value Board of directors7 Amendment to certificate of incorporation8 Same as subdivision9
California Limited, fixed in certificate of incorporation10 No Board of directors Amendment to the articles. However, if only 1 class of shares is outstanding, the amendment is adopted by the board11 Amendment to the articles
Canada Optional, unlimited is default No12 Board of Directors Amendment to articles. Requires resolution adopted by 2/3 of votes cast by shareholders13 Same as subdivision
Alberta Optional, unlimited is default No14 Board of directors15 • Where only 1 class of shares issued, either Board of directors or Amendment to articles 16; • If more than 1 class of shares issued, shareholders class vote by special resolution17 Same as subdivision.
British Columbia Optional18 Optional19 Board of directors20 • If shares have par value, the subdivision is effected by an alteration to the notice of articles. The alteration to the notice of articles is authorized by the type of resolution specified in the articles or, if the articles do not specify the type of resolution, by a special resolution21. • If shares do not have par value, the subdivision is authorized by the type of resolution specified in the articles or, if the articles do not specify the type of resolution, by a special resolution22 Same as subdivision: • Par value shares23; • No par value shares24.
Ontario Optional, unlimited is default25 No26 Board of Directors27 Amendment to articles. Requires resolution adopted by 2/3 of votes cast by shareholders28 Same as subdivision
Québec New Optional, unlimited is default29 Optional, no par value is default30 Board of Directors31 Board of directors, except: • Squeeze-out transactions32; • If more than 1 class of shares issued and splitting affects rights of class33; • requires amendment to articles to reduce par value34. Same as subdivision
Quebec Old Optional, unlimited is default35 Optional, no par value is default36 Board of Directors Board, unless requires amendment to articles to reduce par value37 Same as subdivision
Saskatchewan Optional, unlimited is default38 No39 Board of Directors40 Special resolution adopted by shareholders; no need for amendment to articles41. Same as subdivision
UK Unlimited. However, in a private company with more than 1 class of shares and public companies, directors can only issue shares up to amount authorized from time to time by shareholders. Yes42 • Private company with 1 class of shares: Directors43; • Private company with more than 1 class of shares and public companies: directors if prior authorization44; • Subject to statutory right of preemption45. Conditional on shareholders’ prior authorization46 Same as subdivision
[1] MBCA, § 2.02(a)(2).↩
[2] MBCA, § 2.02(b)(2)(iv).↩
[3] MBCA, §6.21.↩
[4] MBCA, §10.05(4)(a).↩
[5] MBCA, §10.04(a)(4).↩
[6] DGCL, § 102(a)(4).↩
[7] DGCL, § 161.↩
[8] DGCL, §242(a)(3); 242(b).↩
[9] DGCL, §242(a)(3); 242(b).↩
[10] CALIFORNIA CORPORATIONS CODE, 202(d), (e).↩
[11] CALIFORNIA CORPORATIONS CODE, 902 (c), 903(a)(2).↩
[12] CBCA, 24(1).↩
[13] CBCA, 173(1)(h).↩
[14] ABCA, 26(1).↩
[15] ABCA, 27(1).↩
[16] ABCA, 27.1(1).↩
[17] ABCA, 27.1(2).↩
[18] BCBCA, 53(b).↩
[19] BCBCA, 52(2)(a)(i).↩
[20] BCBCA, 62v.↩
[21] BCBA, par value in notice of articles: s.11(g) and 53(c); alteration to notice of articles: s. 54(1)(e) and s. 54(3)(a); procedure to alter notice of articles 257(2)(b).↩
[22] BCBA, subdivision of shares without par value: 54(1)(f); procedure to effect change: 54(3)(c).↩
[23] BCBA, par value in notice of articles: s.11(g) and 53(c); alteration to notice of articles: s. 54(1)(g) and s. 54(3)(a); procedure to alter notice of articles.↩
[24] BCBA, consolidation of shares without par value: 54(1)(h); procedure to effect change: 54(3)(c).↩
[25] OBCA, 5(1).↩
[26] OBCA, 22(1).↩
[27] OBCA, 23(1).↩
[28] OBCA, 168(1)(h).↩
[29] LSAQ, 43.↩
[30] Ibid.↩
[31] LSAQ, 52.↩
[32] LSAQ, 90(1).↩
[33] LSAQ, 90(2).↩
[34] LSAQ, 92.↩
[35] LCQ, 123.12(4).↩
[36] LCQ, 123.12(5).↩
[37] LCQ, 123.101, 123.103.↩
[38] SBCA, 6(1).↩
[39] SBCA, 24(1).↩
[40] SBCA, 28(1).↩
[41] SBCA, 25(1).↩
[42] CA 2006, s 542(1).↩
[43] CA 2006, s 550(a).↩
[44] CA 2006, s 551.↩
[45] CA 2006, s 561.↩
[46] CA 2006, s 618.↩