EXISTING GUIDELINES
Merit Standards for Securities
Offerings
The Division of Securities applies the following general standards in making
determinations under the Ohio Revised Code as to whether or not a proposed
offering of securities of a corporate issuer is to be made on grossly unfair
terms.1 The general
standards, as expressed in these Guidelines, are designed in part to aid the
Division in the exercise of its discretion with respect to the evaluation of a
given application to register securities.2
However, any determination as to the gross unfairness of a particular offering
of securities will be made on a case-by-case basis after evaluating all of the
facts and circumstances of the proposed offering, including the terms and
characteristics, and the proposed plan of distribution, of the security sought
to be registered, in the light of all of these standards, considered
collectively.3 Thus, the
fact that a proposed offering conforms, or appears to conform, to each specific
standard set forth herein does not necessarily mean that the registration
application will automatically be approved.4
Conversely, non-conformity to one or more of these standards will not
necessarily result in the denial of a particular registration application.5
However, the failure to satisfy one or more of these standards will, unless
there are other redeeming features of the proposed offering, be a persuasive
factor in leading the Division to conclude that a proposed offering is to be
made on grossly unfair terms.6
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Underwriter Compensation Policy.7
An offering is grossly unfair if the underwriting commission, discount, or other
remuneration exceeds fifteen percent of the proceeds of the offering. For
purposes of this paragraph, "commission, discount, or other remuneration" shall
at a minimum include the following:
a. The amount designated as commission, discount, or other remuneration in the
registration application;
b. Any accountable or non-accountable expense allowance granted to the
underwriter;
c. Warrants granted to the underwriter;
d. Any remuneration to the underwriter for financial advisory contracts or
consulting contracts, unless the applicant can satisfy the Division that the
contract requires specified duties to be performed at specified intervals and
that such remuneration is not excessive;
e. Future registration rights, rights of first refusal, and indemnification
agreements.
The valuation of underwriters' warrants, future registration rights, rights of
first refusal, and indemnification agreements shall be the valuation used by
the National Association of Securities Dealers.
The National Association of Securities Dealers ("NASD") in Notice to Members
92-28 set forth the following simplified warrant valuation formula:
165 percent - (variable 1)
X (variable 2) = compensation
2
Variable 1 is the underwriter's exercise price, expressed as a percentage of the
public offering price. Variable 2 is the number of securities underlying the
underwriter's warrants, expressed as a percentage of the total number of shares
being offered to the public.
The following table may be utilized where underwriters receive warrants
representing 10 percent of the securities offered.8
|
Warrant exercise price as percent of the public offering price |
|
Compensation value (percent) |
|
100 |
|
3.25 |
|
107 |
|
2.90 |
|
110 |
|
2.75 |
|
115 |
|
2.50 |
|
120 |
|
2.25 |
|
125 |
|
2.00 |
|
130 |
|
1.75 |
|
135 |
|
1.50 |
|
140 |
|
1.25 |
|
145 |
|
1.00 |
|
150 |
|
.75 |
|
155 |
|
.50 |
|
160 |
|
.25 |
|
165 |
|
0 |
Unit offerings where underwriters receive unit purchase options require a few
adjustments. The compensation valuation involves the following steps:
(1) Fully dilute the offering--determine the total number of shares underlying
the units distributed to the public including those shares underlying warrants
within the units;
(2) Divide the shares within the underwriter's unit by the number of fully
diluted shares obtained in step (1);
(3) Divide the number of shares issuable on exercise of the warrants included in
the underwriter's unit by the number of fully diluted shares;
(4) Using the formula calculate the compensation value of the shares to be
valued at the underwriter's unit exercise price. This is the value attributable
to the shares within the unit to be acquired by the underwriter;
(5) Using the formula calculate the compensation value of the shares issuable on
exercise of the underwriter's unit warrants. This is the value attributable to
the shares issuable on exercise of the warrants contained in the unit to be
acquired by the underwriter.
(6) Add the compensation values obtained in steps (4) and (5).9
The examples in NASD Notice to Members 92-28 may assist an applicants
compliance.
The Division will also follow Rule 2710(C)(5) of the NASD Conduct Rules in that
the Division will lower the value where the securities are restricted from
sale, transfer, assignment or other disposition for two years or more. (See
also: NASD Conduct Rule 2710(C)(7)(A)(i).)10
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Cheap Stock Policy Statement
11
The term "cheap stock" refers to equity securities of a corporation that have
been issued to promoters, insiders, officers, directors, or five percent
shareholders for consideration less than the proposed public offering price
within the three-year period immediately preceding the date its equity
securities are proposed to be offered to the public. If the applicant has not
demonstrated positive net earnings after taxes and exclusive of extraordinary
items, the three-year period may be appropriately lengthened.
Venture capitalists and other similar financial institutions will not
necessarily be considered "five percent shareholders" for purposes of this
cheap stock policy statement.
A public offering of securities is presumed to be grossly unfair unless cheap
stock is the subject matter of an Escrow and Subordination Agreement acceptable
to the Division. Excluded from the shares subject to the Escrow and
Subordination Agreement shall be that number of shares calculated by dividing
the public offering price per share into the total amount paid in cash, or
property for which a satisfactory value has been established, for such cheap
stock.
The Escrow and Subordination Agreement shall be in effect until the issuer has
provided to the Escrow Agent and the Commissioner of Securities audited
financial statements in accordance with generally accepted accounting
principles showing fully diluted net earnings, after taxes and exclusive of
extraordinary items, of twelve percent of the public offering price per share
over any period of four consecutive quarters, or of six percent of the public
offering price per share over any period of eight consecutive quarters.
Absent fulfillment of the above mentioned earn-out provisions the Escrow and
Subordination Agreement shall be in full effect for a period of five years
after which twenty-five percent of the total amount of escrowed shares shall be
released automatically. An additional 25% increment shall be released on each
of the sixth, seventh and eight anniversaries of the effective date of the
registration. (Copies of the Escrow and Subordination Agreement can be obtained
from the Division.)
The Division will waive the escrow requirement of cheap stock if the audited
financial statements of the issuer indicate a substantial change in the
revenues, earnings, assets, or other business circumstances of the applicant
between the date of purchase of the cheap stock by the promoters, insiders,
officers, directors, or five percent shareholders and the date of the public
offering, that would justify the disparity in price.
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Dilution Policy Statement 12
1. Going Concern: The proposed offering price of securities to be issued
or sold by a going concern is considered to be excessive and therefore grossly
unfair to public investors under this standard if the dilution which would
result from the sale of all of the securities to be outstanding at the
completion of the offering or at the termination of any required escrow
arrangement, if applicable, exceeds an amount equal to eighty per cent (80%) of
the proposed offering price.
2. Promotional Company: The proposed offering price of securities to be
issued or sold by a promotional company is presumed to be excessive and
therefore grossly unfair to purchasers under this standard if the dilution
which would result from the sale of all of the securities to be outstanding at
the completion of the offering or at the termination of any required escrow
arrangement, if applicable, exceeds an amount equal to fifty per cent (50%) of
the proposed offering price.
For purposes of this standard, the term "dilution" means the difference between
the proposed offering price of the security sought to be registered and the
projected net book value per share of the issuer's tangible assets. Dilution is
usually expressed in terms of a percentage of the proposed offering price.
For purposes of this standard, the phrase "projected net book value per share of
the issuer's tangible assets" is used to refer to (a) the sum of (i) the net
book value of the issuer's tangible assets as of the end of the most recently
completed quarter of the issuer's current fiscal year (or, in the case of a
proposed offering of securities by an issuer which is a "start-up company" as
defined in division I(O)(1) of these Guidelines, as of the most recent
practicable date), plus (ii) the aggregate net proceeds (i.e., the aggregate
gross proceeds adjusted by deducting both the commissions to be paid to
underwriters and the selling expenses to be incurred by the issuer in
connection with the offering) to be received by the issuer from the sale of all
of the securities which will be outstanding at the completion of the offering
or at the termination of any required escrow arrangement, if applicable, (b)
divided by the following:
(i) the total number of shares of the issuer which will be outstanding at the
completion of the offering (i.e., assuming that all of the securities being
offered or proposed to be offered, whether or not they are proposed to be
registered or offered in this state, are issued), if the proposed offering is
not subject to the escrow requirements set forth in division V(B) of these
Guidelines; or
(iii) the total number of shares of the issuer which will be outstanding at the
termination of any required escrow arrangement (i.e., assuming that the escrow
requirements are met), if all or a specified percentage of the proposed
offering is subject to escrow requirements set forth in division V(B) of these
Guidelines.
Applicability: The limitation on the proposed offering price of a
security as a result of the potential dilution in the value of a prospective
purchaser's investment applies to a proposed offering of securities to be made
by either a going concern or a promotional company.
Going Concern. The term "going concern" is used to refer to any issuer
which:
(1) has been continuously engaged in and conducting bona fide business
operations, either directly or through a predecessor or subsidiary, for at
least three (3) fiscal years;
(2) has had substantial revenues from the sale of its products or services or
the use of its assets and substantial net income either from its business
operations or from any other regular, recurring source during each of the three
(3) fiscal years preceding the date on which an application to register its
securities is filed; and
(3) is not otherwise considered a "promotional company" within the meaning of
division I(O)(4) of the Guidelines.
Promotional Company. The term "promotional company" is used to refer to
any issuer which:
(1) has not commenced to engage in or conduct bona fide business operations at
the time an application to register its securities is filed (i.e., a "start-up"
company");
(2) has no significant record of prior business operations or earnings, even
though it has engaged in or conducted some form of limited business operations
before such a registration application is filed (i.e., a "start-up company");
(3) has not had any substantial revenues from the sale of its products or
services or the use of its assets and any substantial net income either from
its business operations or from any other regular, recurring source during each
of the three (3) fiscal years preceding the date on which such a registration
application is filed; or
(4) has not engaged in or conducted business operations of the type or on the
scale contemplated by such a registration application or as a result of the
receipt and use of the proceeds of the proposed offering, even though it has
previously engaged in and conducted business operations, either directly or
through a predecessor or subsidiary, and has earned substantial net income from
its business operations for three (3) or more fiscal years.
Insolvent Issuer Policy 13
Section 1707.44(F) of the Ohio Revised Code states that no person with intent to
deceive shall sell or cause to be offered for sale any securities of an
insolvent issuer, with knowledge that such issuer is insolvent in that the
liabilities of such issuer exceed its assets taken at their fair market value.
This standard shall be deemed violated unless the insolvency of an issuer as
defined, and determined by issuer's most recent audited financial statement, is
prominently disclosed on the front cover page of the final offering circular of
such issuer.
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Options and Warrants 14
The issuance or proposed issuance of options and/or warrants to promoters,
employees, or affiliates of the issuer in connection with a proposed public
offering of equity securities will be presumed to be grossly unfair unless the
issuer's Final Offering Circular indicates that the number of shares covered or
called for by the options and/or warrants previously issued and proposed to be
issued to the above-mentioned persons will not exceed fifteen per cent (15%) of
the total number of shares outstanding at the completion of the proposed
offering for a one-year period commencing on the effective date of the
offering. Excluded for this purpose are all options and/or warrants issued or
proposed to be issued to underwriters, financial institutions, or in connection
with acquisitions, or to all of the security holders of the issuer on a pro
rata basis.
If the issuer cannot comply with the above standard, the Division may accept
language in the Final Offering Circular indicating that such issuer will not
issue further options and/or warrants during the pendency of the registration
in Ohio.
In addition, the Division will also require disclosure in the final prospectus
that the issuer will not grant options or warrants to officers, directors,
employees, promoters, 5% shareholders or affiliates with an exercise price of
less than 85% of the fair market value of the stock.
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Selling Security Holders 15
The Division will requires that all selling security holders pay a pro rata
share of the underwriting commissions and discounts. However, the Division will
require the selling security holders to pay a portion of the offering expenses
based on the percentage of the public offering sold by the selling security
holders.
1. If the selling security holders are selling less than 10% of the securities
to be sold in the public offering, the Division will not require the selling
security holders to pay offering expenses.
2. If the selling security holders are selling more than 10% but less than 50%
of the securities to be sold in the public offering, the Division will require
that the selling security holders pay a pro rata share of all additional
expenses that are the result of the inclusion of their securities in the public
offering.
3. If the selling security holders are selling more than 50% of the securities
to be sold in the public offering, the Division will require the selling
security holders to pay a pro rata share of all offering expenses.
The Division will not require the selling security holder to pay a share of
offering expenses, excluding commissions or discounts given to an underwriter
or dealer, if the selling security holder has a written agreement arrived at
through arm's-length negotiations whereby the issuer has agreed to pay offering
expenses. If the selling security holder is an officer, director or 5%
shareholder or if the written agreement to pay offering expense was not the
result of arm's-length negotiations, then the issuer must demonstrate to the
Division that the written agreement to pay offering expenses was part of a
transaction that was not less favorable to the issuer than could be obtained
from an unaffiliated third party and was approved or ratified by a majority of
the disinterested members of the Board of Directors.
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Use of Proceeds 16
The Issuer’s prospectus, offering circular or Form U-7 must specifically
disclose how the offering proceeds will be applied and the amount allocated to
each business purpose. The use of proceeds section must include disclosure of
how funds will be allocated for the minimum and maximum offering amounts if the
offering is not a firm commitment. Issuers may include disclosures in a tabular
form with amounts and percentages of the offering proceeds listed for each
allocation or purpose. The issuer also must disclose the order or priority in
which the offering proceeds will be used for the stated business purposes. See
Ohio Administrative Code 1301:6-3-06 (D)(5) and 1301:6-3-09(D).
If an issuer’s business plan or operations include contingencies that may
require changes in the specified use of the offering proceeds, the issuer must
disclose that the application of the offering proceeds may be subject to change
and discuss the specific factors that may require changes in the allocations of
the offering proceeds. Not more than 25% of the offering proceeds may be
allocated to working capital or general corporate purposes.
If the offering is not firmly underwritten, the Division may require an escrow
of proceeds to insure the issuer has sufficient funds to complete its business
plan and the objectives disclosed in the prospectus, offering circular or Form
U-7. See Ohio Administrative Code 1301:6-3-09(C) and 1301:6-3-091(E).
Blind Pool and Blank Check Offerings Prohibited
The Division shall refuse any registration if the issuer is in the development
stage with either no specific business plan or purpose or if the issuer was
formed engage in mergers or acquisitions with unidentified companies or other
entities. See R.C. 1707.131(B).
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Subordinate Voting Rights Policy
17
A proposed public offering of equity securities to be made by an issuer, which
has or proposes to have more than one class of equity securities outstanding
after the offering, is presumed to be grossly unfair if the securities of the
class to be offered for sale to the public do not have equal voting rights on
all matters as to which a vote of the security holders is otherwise permitted
by law or the charter documents, including the election of directors, unless
the final offering circular of such issuer prominently discloses the unequal
voting terms of the class to be offered for sale to the public on the front
cover page of the issuer's final offering circular.
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Blank-Check Preferred Policy
18
A proposed public offering of securities to be made by an issuer which has or
proposes to have preferred stock issued or issuable with rights, preferences,
and privileges to be determined by the Board of Directors without further
action by stockholders is presumed to be grossly unfair unless the final
offering circular prominently discloses within the description of such
preferred stock that "the Board of Directors without shareholders approval can
issue preferred stock with voting and conversion rights which could adversely
affect the voting power of the common shareholders."
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Insider Loan Policy 19
The Division may refuse any registration where the prospectus, offering
circular, or Form U-7 does not disclose that any outstanding loan from the
issuer to an officer, director, five percent shareholder, manager, trustee, or
general partner will be repaid within six months of the offering, excluding
loans or extensions of credit by a bank.
The prospectus, offering circular or Form U-7 must also disclose that all future
loans by the issuer to officers, directors, five percent shareholders,
managers, trustees or general partners will be for a bona fide business purpose
and approved by a majority of the disinterested directors, managers, trustees
or general partners or will be a transaction with a director or an executive
officer permitted under section 13(k) of the “Securities Exchange Act of
1934,”116 Stat. 787, 15 U.S.C.A. 78m, as amended.
“Five percent shareholder” is defined to include a beneficial owner of five
percent or more of any issuer’s securities. “Bank” is defined to include banks,
trust companies, savings and loan associations, savings banks and credit unions
organized or incorporated under the laws of the United States, any state of the
United States, Canada, or any Canadian province. See R.C. 1707.131(A) and
(C)(2).
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Future Transactions with Affiliates
20
The Division may refuse any registration where the prospectus, offering circular
or Form U-7 does not disclose that any future transactions with officers,
directors, five percent shareholders, managers, trustees or general partners
will be on terms no less favorable to the issuer than could be obtained from an
independent third party. “Five percent shareholder” is defined to include a
beneficial owner of five percent or more of any issuer’s securities. See R.C.
1707.131(A) and (C)(1).
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Debt Service 21
A proposed public offering of securities of either preferred stock or debt
securities will be considered to be made on grossly unfair terms unless the
issuer prominently discloses a ratio of earnings to fixed charges or a ratio of
earnings to combined fixed charges and preferred stock dividends (calculated in
accordance with Regulation S-K, Item 503, under the Securities Act of 1933) of
at least 1.00 for the three most recent fiscal years and the latest interim
period preceding the date of effectiveness of such public offering.
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General Standards on Debt-to-Equity Ratio
22
A proposed public offering of either preferred stock or debt securities which is
to be made by a going concern or a promotional company of the type described
above is considered to be grossly unfair to public investors under this
standard if the aggregate amount of all preferred stock (other than
convertible, participating preferred stock) and the aggregate principal amount
of all long term debt obligations and securities to be outstanding at the
completion of the proposed offering exceeds the product of three (3) times the
net book value of the issuer's tangible assets as of the end of the most
recently completed quarter of the issuer's current fiscal year.
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Organizational and Offering Expense Policy
23
A proposed offering of securities to be made by or on behalf of an issuer or an
underwriter is presumed to be grossly unfair to purchasers under this standard
if the total selling expenses to be incurred or paid in connection with the
sale of all securities which will have been sold at the completion of the
offering or at the termination of any required escrow arrangement, if
applicable, exceed the limits set forth in the following schedule on the
maximum amount of expenses which may be incurred or paid:
| Aggregate Selling Price |
Maximum Total Selling Expenses (Underwriters'
Commission* plus other Selling Expenses) |
| under $250,000 |
20% |
| $250,000 - $500,000 |
19% |
| $500,001 - $1,000,000 |
18% |
| $1,000,001 - $1,500,000 |
17% |
| $1,500,001 - $2,000,000 |
16% |
| over $2,000,000 |
15% |
*Underwriters' compensation in issuer or underwriter distributions shall not
exceed fifteen per cent (15%) in any event (see Paragraph 1).
The term "selling expenses", when used to refer to the selling expenses of an
issuer, means the amount of all expenses incident to the offering (other than
underwriters' commissions and other compensation) which are customarily
incurred, paid, or borne by or on behalf of the issuer in connection with the
sale of the securities being offered, even though such expenses are paid
through an underwriter or a selling shareholder. Such term includes, but is not
limited to, the following: (1) the cost of preparing, printing, and filing
registration applications, registration statements, prospectuses, offering
circulars, and other documents used in registering securities, including any
registration fees and other expenses associated therewith; (2) the amount of
any attorney's fees and expenses (except those charged by an underwriter's
counsel) incurred or paid in connection with the offering; (3) the amount of
any accountant's or auditor's fees and expenses incurred or paid in connection
with the offering; (4) the amount of the fees and charges of any transfer
agents, registrars, indenture trustees, escrow agents, depositories, engineers,
appraisers, or other professional or technical experts; (5) the cost of
authorizing, preparing, and printing certificates for securities and other
documents relating thereto, including taxes and stamps; (6) the salaries of all
affiliates of the issuer whose employment activities consist primarily of
registering or selling securities; (7) the amount of all direct clerical and
administrative expenses incurred or paid by the issuer in registering or
selling securities; (8) the amount of all printing, advertising, traveling, and
promotional expenses incurred or paid by the issuer in registering or selling
securities; and (9) any other cost directly or indirectly borne by the issuer
in respect of the sale of the securities being offered.
24
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ENDNOTES
1 Ohio Securities Bulletin, June 1973. These standards are also reprinted in the
Ohio section of the Blue Sky Law Reporter (CCH) and in H. Friedman, Ohio
Securities Law & Practice __ (2d ed. 1996), as supplemented.
2 Id.
3 Id.
4 Id.
5 Id.
6 Id.
7 Ohio Securities Bulletin, May 1986.
8 NASD Notice to Members 92-28.
9 NASD Notice to Members 92-28.
10.NASD Conduct Rule 2710(C)(5).
11 Ohio Securities Bulletin, April 1987.
12 Ohio Securities Bulletin, June 1973.
13 Ohio Securities Bulletin, May 1986.
14 Id.
15 Ohio Securities Bulletin, Issue 1, 1993.
16 Ohio Securities Bulletin, 2003:1-2.
17 Ohio Securities Bulletin, May 1986.
18 Id.
19 Ohio Securities Bulletin, 2003:1-2.
20 Ohio Securities Bulletin, 2003:1-2.
21 Id.
22 Ohio Securities Bulletin, July 1973.
23 Ohio Securities Bulletin, July 1973.
24 Id.