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

restrictions
Feb 20, 2012, Author: Mario Naim

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 whollyowned 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
issuers 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
issuers 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 issuers 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.