[This article appears in INSIGHTS, Vol. 25, No. 11, Nov. 2011] New SEC Guidance on Legality and Tax Opinions in Registered Offerings by Stanley Keller The SEC has issued important guidance on Exhibit 5 legality and Exhibit 8 tax opinions filed in connection with registered offerings. The guidance makes the staff s views on these opinions public for the first time and demonstrates appreciation for customary opinion practice and flexibility in dealing with special situations. Introduction The SEC has provided important guidance to practitioners regarding legal opinions filed in connection with registered securities offerings. On October 14, 2011, Staff Legal Bulletin No. 19 (CF) 1 was issued to make publicly available the Division of Corporation Finance staff s views on Exhibit 5 legality opinions and Exhibit 8 tax opinions filed with registration statements. The SEC staff has long had internal guidance on the requirements for legal opinions but, except for copies taken by former staff members and shared with a few others, this guidance was not generally available. Instead, legal opinion issues only were raised in comment letters. The new guidance now makes the staff s views regarding legal opinions in registered offerings generally available, but it does much more by updating that guidance and recognizing, to the extent consistent with federal securities law requirements, current opinion practice and the practical realities of specific securities offerings. General Observations Before discussing the new guidance in detail, a few general observations will be helpful. Customary Opinion Practice. Customary practice is the foundation for legal opinions given in private transactions. 2 The new guidance, to a greater extent than the SEC staff s historic positions, recognizes the applicability of customary practice to opinions filed in registered offerings. Although the guidance does not state this expressly, the effort to recognize customary practice is clear from some of the views expressed, as described below, and in the references to the TriBar Opinion Committee s reports. Federal Securities Law Requirements. It is important for practitioners to recognize that the requirements of federal securities law impose limitations on common opinion practices that might be acceptable in private transactions. Thus, for a legality opinion to satisfy the statutory requirement, it must cover the applicable law even though in private transactions an opinion recipient, for efficiency, may be willing to accept a so-called as if opinion covering the law of Stanley Keller is a partner in the Boston office of Edwards Wildman Palmer LLP. He is chair of the American Bar Association Business Law Section Committee on Legal Opinions and formerly chaired its Committee on Federal Regulation of Securities.
a jurisdiction the opinion giver is in a position to address even though it is not the governing law. Also, certain assumptions and exceptions that opinion recipients in private transactions may be willing to accept may not be acceptable in opinions filed with the SEC, at least, in some cases, without accompanying disclosure in the registration statement. Flexibility. The new guidance confirms and expands on the SEC staff s willingness to be flexible in accommodating the needs of particular securities offerings, so long as the underlying securities law requirement that an unqualified legal opinion is filed as part of the registration statement as of its effective date is satisfied. Examples of this flexibility, as described below, are opinions on equity securities of non-corporate issuers, the timing of filing of opinions on shelf drawdowns and special procedures for opinions in medium-term note ( MTN ) programs. Legality Opinions Schedule A of the Securities Act of 1933, as provided in Section 7 of that Act, requires in paragraph 23 disclosure of counsel who has passed on the legality of the securities issue and in paragraph 29 the filing of an opinion on the legality of the issue. This requirement is reflected in Item 601(b)(5)((i) of Regulation S-K, and thus is called an Exhibit 5 opinion. The Exhibit 5 opinion, as a general rule, is required to be filed as an exhibit to the registration statement before it becomes effective, and may not be subject to any unacceptable qualifications, conditions or assumptions. Although as a matter of customary practice an opinion speaks as of its date, counsel giving the Exhibit 5 opinion needs to make sure for securities law liability purposes that the opinion is correct as of the effective date. In view of this need, the staff does not require opinions to be updated even if there is a significant delay before the registration statement becomes effective unless there are developments that affect the opinion. Type of Security Capital Stock of Corporations. Exhibit 5 opinions on capital stock of corporations typically take the form of opinions given on stock issuances in private transactions that the shares are validly issued, fully paid and nonassessable. Although Schedule A to the Securities Act and Item 601(b)(5)(i) of Regulation S-K require the opinion to address that the shares have been legally issued, the SEC staff accepts the more common formulation that the shares are validly issued. The guidance provides the staff s views on the meaning of each of the terms: Validly issued (or legally issued ) means that the actions required by applicable state corporation law to approve the issuance of the shares have been taken and the shares have been or will be issued in compliance with the requirements of that law, the certificate of incorporation (or equivalent governing document), the bylaws and the authorizing resolutions. Significantly, the guidance reflects the opinion literature in requiring, in order for the shares to be validly issued, that the issuer be validly existing and that the shares are duly authorized, even though those conclusions are typically covered by separate opinions in private transactions. 3 Duly authorized means that the corporation has the power to issue the particular shares under the applicable law, its certificate and its bylaws and that it has taken all necessary action to create that power. 2
Fully paid means that the consideration received or to be received satisfies in both type and amount the requirements of the applicable law, the certificate of incorporation, the bylaws, the authorizing resolutions and any applicable agreement. Under prevailing opinion literature, opinion preparers are not considered responsible for reviewing subscription and similar agreements unless the authorizing resolutions incorporate their terms. Accordingly, the reference in the guidance should be read to mean that an agreement is applicable only to the extent it is relevant under state corporation law to determining the fully paid status of the shares, which would be the case, for example, if the authorizing resolution states that the shares shall be sold for the consideration set forth in the subscription agreement it incorporates by reference. 4 Because the opinion must be filed before the shares are issued, the opinion giver may assume that the corporation will receive the required consideration, for example, by stating as a predicate to the opinion that Upon issuance of shares against payment therefor in accordance with the provision of the Underwriting Agreement,.... Nonassessable means that the holder of the shares is not liable, solely because of its status as a holder, for additional assessments or calls on the shares by the corporation or its creditors. Corporate statutes, like 152 of the Delaware General Corporation Law (DGCL), often define what is necessary for shares to be fully paid and nonassessable. If in fact, the shares are not fully paid, for example, because they are issued as partly paid shares as permitted by the applicable corporation law, or are subject to assessment, as was the case for New York corporations, the opinion may reflect that and will be acceptable as long as the disclosure in the prospectus is adequate. When shares are registered for resale by selling stockholders, a legality opinion is required for those shares. Since the shares are already outstanding, the opinion should indicate that the shares are validly issued, fully paid and non-assessable. A legality opinion in this situation can be difficult for counsel because the issuance of the shares took place in the past and counsel may not have been involved. In some situations, the specific shares being resold may not be identifiable and, as a result, counsel may be in the position of essentially having to be satisfied as to the status of all outstanding shares. Counsel must be prepared to cover the law of the jurisdiction of incorporation (or in the case of non-corporate entities, the jurisdiction of formation) in order to give the legality opinion on equity securities. Counsel who does not generally practice in the applicable jurisdiction can limit the law covered by its opinion to the relevant entity statute, as is typically done by non- Delaware lawyers giving opinions on Delaware corporations under the DGCL. The reference to the statute is understood to include the reported judicial decisions interpreting the statute, and that no longer has to be confirmed expressly. Equity Securities of Non-Corporate Entities. Because the terms fully paid and nonassessable, which are defined in corporate statutes, do not have equivalent statutory meaning in the case of limited liability companies, limited partnerships and business trusts, the staff will accept, in addition to validly [or legally] issued an Exhibit 5 opinion that is the functional 3
equivalent of the fully paid and nonassessable opinion and addressing whether purchasers of the securities will have any obligation to make payments to the entity or its creditors, other than the purchase price, or contributions to the entity or its creditors solely by reason of the purchasers ownership of the securities. The TriBar Opinion Committee in its report on opinions on limited liability company interests 5 suggests the following form of Exhibit 5 opinion for LLCs that should be acceptable to the SEC: 6 Upon issuance by the LLC against payment as contemplated by the Registration Statement and Prospectus, the LLC Interests will be validly issued, and holders of LLC Interests will have no obligation to make any further payments for the purchase of the LLC Interests or contributions to the LLC solely by reason of their ownership of LLC Interests. As in the case of shares of corporations, the guidance indicates that validly issued in the case of non-corporate entities requires the entity to be validly existing. Unlike corporations, the guidance states that non-corporate entities are validly existing if they are duly formed. The diligence required to give opinions has not been an area of interest for the SEC staff, and counsel should be able to give the validly issued opinion if they are satisfied that the non-corporate entity is validly existing without having to do the additional diligence required to confirm that it was duly formed. The guidance also notes that duly authorized, which has meaning for corporate shares, has no meaning in the case of non-corporate entities, although its use is not objectionable. Debt Securities. Because debt securities are contractual obligations, the Exhibit 5 opinion must address that they are binding obligations of the issuer. This is the typical enforceability opinion. 7 The guidance recognizes the acceptability of the customary practice of excluding, whether expressly stated or not, bankruptcy and equitable principles. The guidance goes on to recognize many of the aspects of the equitable principles limitation and indicates that stating them expressly will not be objectionable. The same requirements will apply to guarantees of debt securities. The guidance does not address the acceptability of other exceptions. This likely will depend upon the nature of the exception and, in some cases, the adequacy of the disclosure in the prospectus about the significance and consequences of the exception. To avoid delays in processing, counsel will be well-advised to exercise restraint in including non-standard exceptions and in departing from customary usage in formulating their opinions. An American Bar Association report on legal opinions in SEC filings states that exceptions that are not material should not be objectionable or require prospectus disclosure. 8 When the debt securities or guaranty are issued pursuant to an agreement, such as a trust indenture, the opinion does not have to address the enforceability of that agreement or indenture (except to the extent that terms of the debt securities or indenture are set forth in the agreement or indenture). The guidance also discusses the acceptability of assumptions and indicates that overly broad assumptions, especially those that assume away the relevant legal issue or material facts that are readily ascertainable, are not appropriate. However, the guidance recognizes that certain assumptions or qualifications are necessary and appropriate. It cites specifically assumptions that are understood as a matter of customary practice to apply, whether or not stated, and 4
indicates that these can be stated expressly. This guidance on assumptions is not limited to debt securities but applies broadly. For example, included in the list of illustrative assumption is that a pricing committee of the board will have taken action necessary to set the sale price of the securities. The guidance notes that this assumption is typically made when the registration statement is declared effective before pricing occurs in reliance on Rule 430A. This same flexibility should apply to other situations where further action after board authorization that is permitted by the state corporation statute is required to price the securities, such as compliance with a formula in the case of a dividend reinvestment plan or setting of option exercise prices by an authorized officer as some state corporation statutes permit. This flexibility can be helpful in the case of delayed offerings under a shelf registration statement. Counsel must be in a position to cover the law of the jurisdiction governing the debt securities or guaranty, which usually will be the law governing the agreement or indenture, to opine on whether it is a binding obligation. In addition, counsel must be able to cover the law of the issuer s jurisdiction of incorporation or formation because valid existence, power and authorizing action are predicates to a binding obligation opinion. 9 Primary counsel may rely on an opinion of local counsel to give these opinions, in which case local counsel s opinion would also be filed but no consent of local counsel need be filed and it need not be named in the registration statement, or it may assume that these predicates exist, in which case both local counsel and primary counsel would be named in the registration statement and would have to consent to being named. The responsibility of primary counsel for the local counsel opinion may be greater under the reliance approach than under the assumption approach. The consent of counsel is required by Section 7 of the Securities Act and relates to counsel s potential status as an expert. The SEC does not permit counsel to deny that it is an expert but counsel may state in the opinion that its consent is not an admission that it is an expert. In addition, counsel may not limit who may rely on its opinion, as is often done in private transactions. Options, Warrants and Rights. Because options, warrants and rights are contractual obligations, the Exhibit 5 opinion must address their status as binding obligations under their governing law. In addition, if the underlying security is being registered, the opinion must address its legality. The requirement to address the legality of the underlying security applies equally to convertible and exchangeable securities. Because of their different nature and uncertainties as to their enforceability in particular circumstances, different treatment is permitted for rights under shareholder rights plans (poison pills). The guidance states that a legality opinion is required for these rights when a registration statement is filed for common stock to which the rights relate although qualifications that normally would be unacceptable may be included. The guidance refers to the opinion on the rights as a binding obligation opinion. However, since the rights are not separate from the shares to which they relate, a typical form of opinion is that the shares, together with the associated rights, will be validly issued and the shares will be fully paid and non-assessable. 10 This formulation should satisfy the legality opinion requirement. The guidance indicates that the staff will not object if the opinion on the rights states that (i) it is not addressing a determination a court may make on whether the board would be required to redeem or terminate, or take other action with respect to, the rights, (ii) directors are assumed to have met their fiduciary duties and (iii) the opinion addresses the rights in their entirety and not any particular provision or the effect of the invalidity of any provision on the rights in their entirety. 5
Units. When units are registered, for example a unit consisting of a share of common stock and a warrant to purchase a share of common stock, the Exhibit 5 opinion must address the legality of the unit and of each component (i.e., the common stock and the warrant). The staff usually expects a binding obligation opinion on the unit, but if counsel believes a legality opinion similar to the opinion on the common stock is appropriate as a matter of state law (e.g., validly issued, fully paid and non-assessable ), it can raise that with the staff. Foreign Issuer Securities. The guidance provides that Exhibit 5 opinions for shares of capital stock of a foreign corporation must address whether the shares are validly (or legally) issued, fully paid and non-assessable just as is required for shares of a U.S. corporation and as those terms are understood for U.S. corporations even if the applicable foreign law does not use those terms. However, if the term non-assessable is not used under the foreign law, that term need not be used. One can expect that the same principle would apply to other terms, such as fully paid, and the same flexibility shown toward LLCs and other non-corporate entities should similarly apply to shares of foreign issuers. If the meaning of these terms under foreign law differs from the meaning under U.S. law, the prospectus should describe any material difference, but the opinion need only address the meaning under U.S. law. The legality opinion also could cover the terms under foreign law, but in that case their meaning, if different than under U.S. law, should be explained. These requirements can present difficulties for foreign counsel, who do not necessarily understand SEC requirements or the meaning of U.S. law, and therefore U.S. counsel should plan to work closely with foreign counsel to arrange for the necessary Exhibit 5 opinion. Opining counsel must be able to address the law of the foreign jurisdiction of incorporation or organization. When the foreign issuer s shares are represented by American depositary receipts (ADRs) for American depositary shares (ADSs), the Exhibit 5 opinion must cover the ADSs, which the SEC treats as a separate security, and, depending on the nature of the ADR program, the underlying foreign issuer shares. In an unsponsored ADR program, the opinion must state that the ADSs will be validly (or legally) issued and will entitle the holders to the rights specified in the ADR and deposit agreement. If the deposited foreign issuer shares also are registered, as they would be in a sponsored ADR program, there should be both a legality opinion on the ADSs and on the deposited foreign shares. Because counsel must be able to address the applicable governing law, there typically will be two opinions. Specific Transactions The SEC guidance addresses the process and timing of legality opinions in certain specific situations that create special problems. In doing so, it demonstrates the flexibility the staff has shown in dealing with these special situations. Shelf Offerings. Because shelf registration statements, particularly universal shelves, contemplate offerings of securities, often with undefined terms, on a delayed basis in the future, which may occur with frequent and rapid takedowns, it is not possible for counsel to file an unqualified legality opinion before the registration statement becomes effective. To address this situation, the SEC staff permits a qualified opinion containing assumptions regarding the future issuance of the registered securities to be filed prior to the registration becoming effective, so long as it is understood that an unqualified opinion will be filed at the time of any takedown from 6
the shelf. The guidance gives examples of some of these assumptions, and practitioners are usually creative in coming up with more. To accommodate the difficulty of getting an unqualified opinion on file prior to the actual sale upon a takedown, such as in connection with an at-the-market offering, the staff will allow the unqualified opinion to be filed no later than the closing date for the offering of the securities. The filing can be made by an immediately effective post-effective amendment under Rule 462(d) solely to add exhibits or by a Form 8-K or 6-K that is incorporated by reference into the registration statement. 11 One type of shelf offering that has created particular difficulties is a medium-term note (MTN) program because of the frequency of takedowns, sometimes without the involvement of counsel. The guidance addresses MTN programs specifically and recognizes the need for an alternative opinion practice. It offers as one alternative the ability to file a forward-looking opinion with the MTN prospectus supplement that assumes the securities will be legally issued and then including counsel s unqualified opinion on a specific takedown in the pricing supplement itself, provided that counsel s consent to its opinion being included in a future pricing supplement is included in the forward-looking opinion. This procedure avoids the need for a separate filing of the unqualified opinion. The guidance indicates that other alternatives may be acceptable and should be discussed with the staff. Acquisitions and Other Fundamental Change Transactions. When an acquisition shelf registration statement is used, a qualified opinion with assumptions can be filed before the registration statement becomes effective. Upon filing of a post-effective amendment for a specific transaction, the staff expects an unqualified legality opinion to be filed as an exhibit to the post-effective amendment. If no post-effective amendment is required for the transaction, the unqualified opinion can be filed by post-effective amendment or by a Form 8-K or 6-K. If the issuer is required to obtain shareholder approval for the transaction or share issuance either under state corporation law or stock exchange listing requirements, the opinion may assume that the required shareholder approval is obtained, but the staff expects an unqualified opinion to be filed no later than the closing date of the transaction. In a change in staff position, if the issuer s charter needs to be amended to increase the number of authorized shares or to create the class or series of shares to be issued in the registered offering, the opinion can assume that the requisite actions will be taken, but an unqualified opinion is expected to be filed no later than the closing date of the offering. Similarly, if a reincorporation is contemplated prior to completion of the offering, the legality opinion may assume that the requisite actions for reincorporation will occur, but again an unqualified opinion is expected no later than the closing date of the offering. Prospectus disclosure of any of the requisite actions as a condition of the offering is required. Tax Opinions Item 601(b)(8) of Regulation S-K requires opinions on tax matters in certain specified circumstances, essentially when tax consequences are material to an investor and a representation as to tax consequences is set forth in the filing. The so-called Exhibit 8 opinion can be given by either a lawyer or an independent certified accountant, or the requirement can be satisfied by a suitable specific letter ruling from the Internal Revenue Service. 7
When a Tax Opinion Is Required. In addition to specified situations such as real estate ventures and roll-up transactions, the general test for when a tax opinion is required is based upon the materiality of the tax consequences. The guidance gives as examples of transactions that involve material tax consequences (i) acquisitions and similar transactions (such as stock for stock mergers and spin-offs) that are represented to be tax-free, (ii) transactions offering significant tax benefits to investors (such as tax shelter offerings) and (iii) transactions where the tax consequences are so unusual or complex that investors need the benefit of an expert s opinion to understand the tax consequences in order to make an informed investment decision (such as debt offerings with unusual original issue discount issues, certain rights offerings and certain offerings by foreign issuers where disclosure of foreign and U.S. tax provisions is material to U.S. purchasers). On the other hand, just describing a transaction as taxable does not require a tax opinion, although prospectus disclosure might be necessary. This guidance should assist practitioners determine when an Exhibit 8 tax opinion is required. Form of Tax Opinions. The guidance recognizes the alternatives of long-form and shortform Exhibit 8 tax opinions that are commonly in use. A long-form opinion is the full tax opinion on a standalone basis. It is filed as an exhibit and summarized in the prospectus. A short-form opinion confirms that the tax disclosure in the prospectus, which is stated as the opinion of the named counsel or accountant, is the opinion of that counsel or accountant. Substantive Considerations. The Exhibit 8 opinion only needs to address material federal tax consequences. Investors can be told to seek advice from their own tax advisors on state tax consequences. In describing the tax discussion, the prospectus should avoid terms such as certain or principal tax consequences, and if any descriptive term is used, it should be material. The opinion should identify the material tax consequences being addressed and express an opinion and the basis for it rather than just describing the tax law or assuming the tax consequences at issue. If counsel cannot opine on a material tax consequence or there is uncertainty, perhaps because of a lack of authority or conflicting authority, the opinion should state clearly what is not being opined on and the reason for not doing so, along with the possible alternatives and risks. If it is in a position to do so, counsel could give a should or more likely than not opinion, explaining why a will opinion cannot be given. 12 Some tax lawyers have expressed concern over the need to explain why only a should rather than will opinion can be given in view of the relatively high threshold required to be able to give a should opinion. It is important to note that the guidance on tax opinions essentially codifies the SEC staff s previous internal guidance. Timing Considerations. As with legality opinions, tax opinions as a general rule must be filed before the registration statement becomes effective. The timing flexibility for legality opinions on shelf registrations also applies to tax opinions. In addition, in an acquisition transaction designed to be a tax-free reorganization, the tax opinion need not be filed before effectiveness if the merger agreement includes a non-waivable condition for an opinion at closing that the transaction is a tax-free reorganization, the required opinion is described in the prospectus and the opinion is filed before closing. If the closing condition is waivable, an opinion must be filed before effectiveness and the issuer must undertake to recirculate and 8
resolicit if the condition for a favorable tax opinion is waived and the change in tax consequences is material. Conclusion The new SEC guidance on legality and tax opinions is a welcome addition to the learning on opinions in registered offerings. It will be an invaluable resource for practitioners. The SEC staff is to be commended for making its positions on these important topics known and generally available, and for doing so in such a clear and direct way, both recognizing the significance of customary opinion practice to the extent consistent with federal securities law requirements and demonstrating the flexibility to deal with situations to which the requirements do not readily fit. 1 Available at http://www.sec.gov/interps/legal/cfs1b19.htm. 2 See Statement on the Role of Customary Practice in the Preparation and Understanding of Third-Party Legal Opinions, 63 Bus. Law. 1277 (2008). 3 See Special Report of the TriBar Opinion Committee: Duly Authorized Opinions on Preferred Stock, 63 Bus. Law. 921 (2008). 4 The discussion of non-corporate entities in the guidance does not refer to applicable agreements. 5 Supplemental TriBar LLC Opinion Report: Opinions on LLC Membership Interests, 66 Bus. Law. 1065 (2011). 6 The TriBar suggested form does not refer to obligations to creditors but that should not matter since in most states, like Delaware, creditors rights are derived through enforcement of the LLC s rights. The SEC has confirmed that the TriBar form is acceptable. 7 TriBar takes the position that the terms valid, binding and enforceable have the same meaning. See TriBar Opinion Committee, Third-Party Closing Opinions, 53 Bus. Law. 591 (1998) at 3.1. 8 Legal Opinions in SEC Filings, 59 Bus. Law. 1505 (2004) at p. 1509. 9 See Special Report of the TriBar Opinion Committee: The Remedies Opinion Deciding When to Include Exceptions and Assumptions, 59 Bus. Law. 1483 (2004) at n. 22. 10 See Legal Opinion Newsletter of ABA Section of Business Law Committee on Legal Opinions, December 2006 Issue at p. 6, available at http://apps.americanbar.org/dch/committee.cfm?com=cl510000. 11 See also Securities Act Rules CDI 221.05 (Aug. 14, 2009). 12 For analogous positions regarding certain tax opinions, see Treasury Department Circular No. 230 (Rev. 8-2011) at 10.35. 9