California Department of Corporations, One Sansome Street, San Francisco

We previously blogged about the potential liability for Facebook, Inc. directors if the company paid too much for the social media start-up company Instagram. Recall that in April, Facebook agreed to acquire Instagram for, at the time, approximately $1 billion with the consideration payable 30% in cash and 70% in Facebook common stock (now, due to the decrease in Facebook’s share price from the stipulated price of $30 per share, the deal is only worth about $650 million). A recent NY Times Deal Book article points out that if the deal fixed the total purchase price rather than the number of shares to be issued, Instagram would have gotten a much better deal due to the depressed Facebook share price. Given the declining share price of Facebook stock, is Facebook’s reduced consideration still fair to Instagram’s shareholders? This is exactly the question that will be determined by the California Department of Corporations which will be conducting a fairness review of the acquisition this Wednesday.

The purpose of this fairness hearing is to allow Facebook to take advantage of a lesser-known exemption from registration under the Securities Act of 1933 known as the “3(a)(10) exemption.” Because Facebook is issuing securities in connection with the Instagram acquisition, the 23 million shares to be issued are required to either be registered or they must be exempt from the registration requirements of the Securities Act. The 3(a)(10) exemption allows companies to issue securities in an exchange transaction without registration provided that either a court or designated state agency finds that the transaction is fair to the recipients of the new securities. This exemption was popular during the tech boom and has both advantages and disadvantages when compared with the most common exemption provided by Rule 506 of Regulation D promulgated under the Securities Act. 

Most smaller companies tend to offer and sell securities on an exempt basis because of the substantial costs of conducting a registered offering. There are a laundry list of exemptions but only a few are of much practical use. Most exempt offerings are structured to take advantage of Rule 506. The popularity of Rule 506 is primarily due to the fact that compliance with the rule also preempts the offering from state registration requirements. Because of the dual regulatory nature of securities, offerings must be exempt both at the federal and state levels which can create additional burdens on issuers since often times the exemptions available at each level are not necessarily coordinated. However, securities offered in reliance on Rule 506 preempt state registration requirements under Section 18 of the Securities Act (other than certain de minimis filings and fees), thereby disposing of any registration issues under state blue sky laws. 

The downside to using Rule 506 is that the purchasers must primarily be “accredited investors” (i.e., high income or high net worth persons) and, for the time being, issuers may not engage in general solicitation or advertising in connection with the offering or sale of the respective securities (although this will change in the near future as a result of the JOBS Act which requires the SEC to amend its rules to permit general solicitation and advertising in certain circumstances as we explained in a prior blog post here; the SEC is scheduled to vote on the newly proposed rules this week).  Additionally, securities issued under Rule 506 are “restricted securities” and are not freely tradable meaning that investors may not immediately resell the securities purchased. 

As mentioned above, the 3(a)(10) exemption only applies certain exchange transactions and is therefore more limited than Rule 506. The availability of the exemption is subject to a merit-based review by a court or authorized governmental entity to approve the fairness of the terms and conditions of the exchange. This exemption was commonly used by publicly held tech companies during the tech boom to acquire other closely held tech companies where many of the shareholders of the closely held targets did not qualify as accredited investors. In addition to being exempt from the registration process at the federal level, securities issued in connection with the 3(a)(10) exemption are, for the most part, freely tradable in the secondary market (some exceptions exist for affiliates). 

The SEC has provided guidance on the 3(a)(10) exemption in Staff Legal Bulletin 3A which sets forth the following requirements for using the exemption: 

  • The securities must be issued in exchange for securities, claims, or property interests; they cannot be offered for cash. 
  • A court or authorized governmental entity must approve the fairness of the terms and conditions of the exchange. 
  • The reviewing court or authorized governmental entity must: (1) find, before approving the transaction, that the terms and conditions of the exchange are fair to those to whom securities will be issued; and (2) be advised before the hearing that the issuer will rely on the Section 3(a)(10) exemption based on the court’s or authorized governmental entity’s approval of the transaction. 
  • The court or authorized governmental entity must hold a hearing before approving the fairness of the terms and conditions of the transaction. 
  • A governmental entity must be expressly authorized by law to hold the hearing, although it is not necessary that the law require the hearing. 
  • The fairness hearing must be open to everyone to whom securities would be issued in the proposed exchange. 
  • Adequate notice must be given to all those persons. 
  • There cannot be any improper impediments to the appearance by those persons at the hearing.

The one potential downside to using the 3(a)(10) exemption is that state laws may still require the offering to be registered at the state level. In Florida, as in California, offerings approved pursuant to the requirements of Section 3(a)(10) are also exempt from state registration requirements pursuant to Section 69W-500.014 of the Florida Administrative Code. Other states may or may not have similar exemptions. Thus, it is important to verify state securities law requirements prior to undertaking a 3(a)(10) exempt offering. 

Given that Facebook is paying a substantial sum for a company with no revenues, it is likely that the California Department of Corporations will find the transaction to be fair to Instagram shareholders which will allow the acquisition to proceed on an exempt basis (at both the federal and state level).

One thing to note is that upon consummation of the acquisition, the newly issued 23 million shares will have a dilutive effect on existing shareholders who have already experienced significant devaluation in their Facebook stock holdings since the company made its initial public offering. With the expiration of lock-up agreements beginning last week and continuing through May of 2013 (which we blogged about last week), the market should likely expect to see further decline in Facebook’s share price in the near future absent any positive news or reports concerning Facebook’s operations and financial condition.