|June 8, 2012|
Previously published on June 2012
On April 5, 2012, President Barack Obama signed into law the "Jumpstart Our Business Startups Act," or the JOBS Act. The JOBS Act consists of seven unrelated titles, each of which are ostensibly designed to aid in raising capital, ease the regulatory burdens of small and emerging growth companies and spur an increase in the number of initial public offerings in the United States - which has seen a dramatic decline in the last decade - all of which would presumably culminate in job growth and economic growth in the United States. However, it remains to be seen if the JOBS Act can deliver as promised, while still protecting investors. We note that while the bills that ultimately were signed into law as the JOBS Act were the product of bipartisan support in both Houses of Congress and were also supported by President Obama, there are many vocal opponents to the JOBS Act, including ranking members of Congress and former and current members of the SEC. Opponents are concerned about the effect on investor protection due to the loosening of some long-standing rules specifically designed to protect investors, including the now-overturned ban on general solicitations and general advertising under Rule 506 of Regulation D among others, all of which will be discussed below.
Reopening American Capital Markets to Emerging Growth Companies
Title I of the JOBS Act is entitled "Reopening American Capital Markets to Emerging Growth Companies" but is known by the more catchy "IPO On-Ramp." The IPO On-Ramp is designed to encourage companies to go public by either loosening some restrictions for companies going through the IPO process or by creating a phase-in period for other obligations normally affecting new public companies, providing some time to grow large enough to afford the regulatory costs associated with going public.
The IPO On-Ramp creates a new category of issuer called an "emerging growth company," which is any domestic or foreign issuer that has total annual gross revenues of less than $1 billion during its most recently completed fiscal year. It is curious that Congress picked $1 billion as the threshold, as it encompasses an estimated 90% of all public companies, and companies with annual gross revenues of substantially less than that are likely to be able to afford the regulatory costs associated with going public.
An emerging growth company will keep that designation for each subsequent fiscal year until the earliest of (a) the last day of the fiscal year during which it had total annual gross revenues of at least $1 billion (indexed for inflation every five years), (b) the last day of the fiscal year following the fifth anniversary of the date of the first sale of its common stock pursuant to an effective registration statement, (c) the date on which it has, during the previous three-year period, issued more than $1 billion in non-convertible debt or (d) the date on which it meets the definition of a "large accelerated filer."
Any issuer that meets the requirements of an emerging growth company is exempt from certain obligations under the Securities Act of 1933 and the Securities Exchange Act of 1934 that would otherwise apply, including:
Say-on-pay vote and the advisory vote on golden parachute payments;
Any new or revised financial accounting standard until such date private companies are required to comply with such new or revised financial accounting standards;
CEO pay ratio rules that were mandated by the Dodd-Frank Act (but not yet proposed by the SEC);
Rules requiring mandatory audit firm rotation (the PCAOB has published a concept release on this subject to enhance auditor independence, but nothing is as of yet adopted); and
Internal control evaluations and reporting obligations, pursuant to which registered public accounting firms are required to attest to, and report on, the assessment made by the management of the issuer, which exemption was included in the legislation over SEC Chairman Shapiro's objections.
In addition, the requirement to present three years of audited financial statements in the registration statement for the emerging growth company's initial public offering and any other registration statement to be filed with the SEC is decreased to two years of audited financials. Emerging growth companies will be required to include three years of financial statements in their subsequently filed Form 10-K's so long as they are not smaller reporting companies.
Emerging growth companies are also exempt from certain of the executive compensation disclosures to the same extent as smaller reporting companies, the most significant being the exemption from having to prepare and include in an annual proxy statement a compensation discussion and analysis.
The IPO On-Ramp also loosens the limitations that a broker or dealer currently has with respect to publishing or distributing research reports. Brokers and dealers may now publish and distribute research reports about an emerging growth company that is the subject of a proposed registered public offering of its common stock without such reports being deemed an offer to sell a security, even if the broker or dealer is participating or will participate in the registered offering of the securities that are the subject of the report.
The IPO On-Ramp also expands permissible communications during a securities offering by permitting an emerging growth company or any person authorized to act on its behalf, either before or after the filing of a registration statement, to "test the waters" by engaging in oral or written communications with potential investors that are qualified institutional buyers or institutional accredited investors. Such mechanism allows an emerging growth company to determine whether such investors might have an interest in the contemplated securities offering and the likelihood of success if it decides to move forward with the offering. Prior to the JOBS Act, non-public companies and most public companies were prohibited from communicating with potential investors regarding a proposed offering without having filed a registration statement; such communications are commonly known as "gun jumping." Under these new rules, test the waters communications are not considered gun jumping, allowing emerging growth companies to use these communications to gain insights into the views of institutional investors which could help them raise capital. It remains to be seen how popular this new communications regime will be, in that any communications to test the waters will still be subject to the federal securities laws' anti-fraud rules, which may cause some prospective issuers to think twice before availing themselves of the opportunity.
The IPO On-Ramp also permits an emerging growth company to submit registration statements to the SEC on a confidential basis prior to the date of first sale of common equity securities pursuant to an effective registration statement under the Securities Act (which may be its initial public offering). Since the confidential submission would not be considered a "filing," no filing fee will be due at the time of submission, it would not count as the filing of a registration statement for purposes of Section 5(c) of the Securities Act, the emerging growth company may not rely upon the Rule 134 Safe Harbor permitting public communications during an offering, and the draft may not be signed or include the consent of auditors and other experts, among other things. In the event that an issuer determines to move forward with an offering, those draft submissions and all amendments to the draft submissions would have to be included as an exhibit to the filed registration statement at least 21 days before the issuer conducts any road show as part of the offering. If there is no road show, then the registration statement must include the confidential draft submissions no later than 21 days before the anticipated date of effectiveness of the registration statement. Due to the need to estimate the time period for a road show or to otherwise plan the 21 day period, it is important that any emerging growth company that avails itself of the confidential submission process coordinate with its underwriters and other service providers to prevent non-compliance with these timing requirements, otherwise the company's offering could be needlessly delayed.
The IPO On-Ramp allows emerging growth companies to choose to forgo any exemption provided under the IPO On-Ramp and instead comply with the requirements that apply to issuers that are not emerging growth companies. However, with respect to new or revised financial accounting standards, if an emerging growth company elects to comply with such standards to the same extent as a non-emerging growth company, the choice must be made at the time the emerging growth company is first required to file a registration statement or report under the Exchange Act and notify the SEC of that choice, and the emerging growth company may not selectively comply with some and not other standards.
The IPO On-Ramp requires the SEC to conduct a study examining the transition to trading and quoting securities in one penny increments, which is known as decimalization, to (a) examine the impact that decimalization has had on the number of initial public offerings since its implementation relative to the period before its implementation and (b) examine the impact that the change has had on liquidity for small and middle cap company securities and whether there are sufficient economic incentives to support trading operations in these securities in penny increments. Furthermore, the JOBS Act requires that if the SEC determines that the securities of emerging growth companies should be quoted and traded using a minimum increment of greater than one cent, the SEC may by rule not later than 180 days after April 5, 2012, designate a minimum increment for the securities of emerging growth companies that is greater than one cent but less than ten cents for use and quoting and trading of securities in any exchange or other execution venue. Although this provision of the IPO On-Ramp has not received a lot of press when compared to other titles of the JOBS Act, we believe that this provision could have important and far-reaching consequences for the IPO market of smaller and middle cap companies, as giving a greater economic incentive to support trading operations of these companies could help bring back market makers in those securities which would create liquidity and interest in smaller and middle cap companies.
The IPO On-Ramp also requires the SEC to conduct a review of Regulation S-K to comprehensively analyze the current registration requirements of such regulation and determine how the requirements could be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies.
Access to Capital for Job Creators
Title II of the JOBS Act, entitled "Access to Capital Job Creators," provides that the prohibition against general solicitation and general advertising contained in Section 502(c) of Regulation D promulgated under the Securities Act, shall not apply to offers and sales of securities made pursuant to Rule 506 of Regulation D, provided that all purchasers of the securities are accredited investors. Rule 506 provides a non-exclusive safe harbor from registration for any private offering of securities for any amount so long as all investors are accredited investors (subject to a 35 person non-accredited investor limit so long as certain statutory information is provided to the potential investors). The restrictions on general solicitations and general advertising have forced entities seeking to rely on Regulation D to take a cautious approach and strictly limit communications about their business and the offering. Proponents of the change argue that it will improve transparency and provide substantial benefit to investors, regulators and the public, by providing more accurate and complete information to the public, increasing communications between the entity and investors, and allowing regulatory agencies and the media to better monitor industry trends and activities.
The revised rule requires the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using methods to be determined by the SEC. A similar lifting of the ban on general solicitation and general advertising was made under Rule 144A with respect to secondary sales of securities so long as securities sold under Rule 144A are sold only to persons that the seller and any person acting on the seller's behalf reasonably believes is a qualified institutional buyer.
The amendment to Rule 506 also provides that any person who offers for sale securities under Rule 506 or permits general solicitations, general advertisements, or similar or related activities shall not be deemed a broker or dealer so long as such person receives no compensation in connection with the purchase or sale of the securities, such person and any person associated with that person does not possess customer funds or securities in connection with the purchase or sale of such securities and such person is not subject to a statutory disqualification under the Securities Act. This amendment encourages the formation of online platforms and forums that would assist in matching investors with companies seeking capital, which are playing an increasingly important role in facilitating capital formation in small companies.
The SEC is required to revise Rule 506 no later than 90 days after April 5, 2012 to provide for such exemption from general solicitation and general advertising. Until rules are adopted by the SEC to implement the lifting of the ban on general solicitation and general advertising, issuers should continue to rely upon historical practices under Rule 506 and Regulation D.
Title III of the JOBS Act is entitled "Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012" or the CrowdFund Act. The crowdfunding provision, one of the most controversial parts of the JOBS Act, provides an exemption from registration under the Securities Act for any transaction involving the offer or sale of securities provided that (a) the aggregate amount sold to all investors during the twelve-month period preceding the date of the transaction is not more than $1.0 million, (b) the aggregate amount sold to any investor does not exceed (i) the greater of $2,000 or 5% of the annual income or net worth of the investor (if either the annual income or the net worth of the investor is less than $100,000) and (ii) 10% of the annual income or net worth of the investor (if either of the annual income or net worth of the investor equal to or more than $100,000), not to exceed a maximum aggregate amount sold of $100,000, (c) the transaction is conducted through an SEC registered broker or funding portal who complies with new Section 4A(a) (discussed further below) and (d) the issuer complies with the requirements under new Section 4A(b) (discussed further below). A registered funding portal is any person that acts as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to the crowdfunding exemption and that does not offer investment advice or recommendations, solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal, compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal, hold, manage, possess, or otherwise handle investor funds or securities or engage in such other activities as the SEC, by rule, determines appropriate. Subject to rulemaking by the SEC, a funding portal shall be exempt from the requirement to register as a broker or dealer, provided that it remains subject to the examination, enforcement, and other rulemaking authority of the SEC, is a member of a national securities association registered under Section 15A of the Exchange Act and is subject to such other requirements as the SEC determines appropriate.
Section 4A(a) provides that the SEC registered broker or funding portal must:
Provide such disclosures, including disclosures relating to risks and other investor education materials, as the SEC by rule deems appropriate.
Ensure that each investor (a) reviews investor education information in accordance with SEC standards, (b) positively affirms that the investor understands that the investor is risking the loss of the entire investment and that the investor could bear such a loss, and (c) answers questions demonstrating an understanding of the level of risks generally applicable to investments in start-ups, emerging businesses and small issuers, an understanding of the risk of liquidity and an understanding of such other matters as the SEC determines appropriate by rule.
Take such measures to reduce the risk of fraud with respect to the transactions as established by the SEC by rule, including obtaining a background and securities enforcement regulatory history check on each officer, director and person holding more than 20% of the outstanding equity of every issuer whose securities are offered by such person under the crowdfunding exemption.
Not later than 21 days prior to the first day on which securities are sold to any investor or such other period as the SEC may establish, make available to the SEC and potential investors any information provided by the issuer pursuant to this rule (as described below).
Ensure that all offering proceeds are only provided to the issuer when the aggregate capital raised from all investors is equal to or greater than the target offering amount and allow all investors to cancel their commitments to invest as the SEC shall by rule determine appropriate.
Make such efforts as the SEC determines appropriate by rule to ensure that no investor in a twelve-month period has purchased securities pursuant to this section that in the aggregate from all issuers exceed the crowdfunding offering investment limits.
Take such steps to protect the privacy of information collected from investors as the SEC shall by rule determine appropriate.
Not compensate brokers, finders, or lead generators for providing the broker or funding portal with personal identifying information of any potential investor.
Prohibit its directors, officers, or partners from having any financial interest in an issuer using its services.
Meet such other requirements as the SEC may by rule prescribe for the protection of investors and in the public interest.
The crowdfunding exemption is limited to domestic issuers that are not public companies, investment companies or certain companies exempt from the definition of investment companies. Section 4A(b) provides that any issuer of securities availing itself of the crowdfunding exemption:
Will be required to file with the SEC and provide to investors and the relevant broker or funding portal, and make available to potential investors:
the name, legal status, physical address, and website address of the issuer;
the names of the directors, officers and each person holding more than 20% of the shares of the issuer;
a description of the business of the issuer and the anticipated business plan of the issuer;
a description of the financial condition of the issuer, including the income tax returns filed by the issuer for the most recently completed year (if any) and financial statements of the issuer certified by the principal executive officer of the issuer to be true and complete in all material respects for targeted offerings of $100,000 or less, financial statements reviewed by an independent public accountant, using professional standards and procedures for such review or standards and procedures established by the SEC by rule, for such purpose for targeted offerings of more than $100,000 but not more than $500,000, and audited financial statements for targeted offerings of more than $500,000;
a description of the stated purpose and intended use of the proceeds of the offering;
the target offering amount, the deadline to reach the target offering amount, and regular updates regarding the progress of the issuer in meeting the target offering amount;
the price to the public of the securities or the method for determining the price, provided that, prior to sale, each investor shall be provided in writing the final price and all required disclosures, with a reasonable opportunity to rescind the commitment to purchase the securities; and
a detailed description of the ownership and capital structure of the issuer.
May not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker.
May not compensate or commit to compensate any person to promote its offerings through a broker or funding portal without taking steps to ensure that such person discloses the past or prospective receipt of such compensation.
Not less than annually, file with the SEC and provide to investors reports of the results of operations and financial statements of the issuer.
The crowdfunding rules provide that any person who purchases a security in a crowdfunding transaction may bring a rescission action against an issuer to recover the consideration paid for such security (with interest, but less the amount of any income received thereon), or for damages if such person no longer owns the security, in the event the issuer violates the antifraud provisions of the securities laws, provided that the purchaser did not know of such untruth or omission.
Securities issued pursuant to a crowdfunding transaction may not be transferred by the purchaser of such securities for one year, unless transferred to the issuer of the securities, to an accredited investor, as part of an offering registered with the SEC, to a member of the family of the purchaser, or in connection with the death or divorce of the purchaser or other similar circumstances.
Not later than 270 days after April 5, 2012, the SEC is required to issue such rules as it determines may be necessary or appropriate for the protection of investors to carry out the crowdfunding exemption, including to establish disqualification provisions under which an issuer shall not be eligible to offer securities pursuant to the crowdfunding exemption and a broker or funding portal shall not be eligible to effect or participate in transactions pursuant to the exemption.
The SEC is also mandated, by rule not later than 270 days after April 5, 2012, to exempt securities acquired pursuant to a crowdfunding offering from the provisions of Section 12(g) of the Exchange Act.
Although offerings relying on the crowdfunding exemptions and funding portals are generally exempt under state blue sky law, states will still have antifraud oversight with respect to any such offerings, and under certain circumstances are permitted to require notice filings and fees in relation thereto.
The crowdfunding rules have received a lot of press, in part because of its novelty when compared to historic securities offering alternatives, in part because of the fear of abuse by bad actors, and in part because of the success of similar business models that do not sell securities such as Kickstarter, Inc. Regardless of the amount of press we are seeing, there is still much uncertainty about crowdfunding and whether it will take its place as a legitimate form of capital formation. The SEC has publicly stated that no person may rely on the crowdfunding rules until the SEC has adopted the rules mandated by the JOBS Act, which will not be at least until the end of 2012. Furthermore, in the quest to protect investors, it is likely that the SEC will include in the new rules additional safeguards not otherwise contemplated by the JOBS Act but not impermissible, which may have the effect of stifling a crowdfunding market that would otherwise develop. There is also the possibility that crowdfunding as it is currently proposed will not work as well as it is intended, similar to the original Regulation A (discussed below), because the threshold of $1.0 million is too low for broad-based use by issuers, there are significant costs to implement a crowdfunding offering, there may not be enough financial incentive to attract the intermediaries that are required to facilitate the offerings, and issuers who otherwise would use crowdfunding will instead rely on more customary ways to raise money, such as Regulation D.
We can only hope that any rules adopted by the SEC are sensible and are an attempt to strike the right balance between capital formation and investor protection, and not a reaction against a funding alternative the SEC is unfamiliar with or suspicious of.
Small Company Capital Formation
Title IV of the JOBS Act, entitled "Small Company Capital Formation," is designed to breathe new life into the existing limited offering exemption known as Regulation A. Regulation A is a little used offering alternative, primarily due to the expense in preparing the required Form 1-A, the relatively limiting $5 million cap on the amount that may be raised, and the added expense of having to register the offering under blue sky laws. Title IV changed the existing paradigm by increasing the offering limit from $5 million to $50 million, and making the securities sold pursuant to Regulation A "covered securities," thus exempting them from most blue sky laws if the securities are offered and sold on a national securities exchange or to qualified purchasers. The amendments also codify the following:
The securities sold in any such offering shall not be "restricted" securities.
The civil liability provision in Section 12(a)(2) shall apply to any person offering or selling such securities.
The issuer may solicit interest in the offering prior to filing any offering statement, on such terms and conditions as the SEC may prescribe in the public interest or for the protection of investors.
The SEC shall require the issuer to file audited financial statements with the SEC annually.
Such other terms, conditions, or requirements as the SEC may determine necessary in the public interest and for the protection of investors.
Only equity securities, debt securities, and debt securities convertible or exchangeable to equity interests, including any guarantees of such securities, may be offered and sold pursuant to the revised exemption.
The SEC is also permitted by rule or regulation to require an issuer to make available to investors and file with the SEC periodic disclosures regarding the issuer, its business operations, its financial condition, its corporate governance principles, its use of investor funds, and other appropriate matters. The SEC may also provide for the suspension and termination of such a requirement with respect to that issuer.
The SEC is required, every two years, to review the $50 million offering amount limitation and increase such amount as the SEC determines appropriate. If the SEC determines not to increase such amount, it is required to report to the Committee on Financial Services of the House of Representatives and the Committee on Banking, Housing, and Urban Affairs of the Senate on its reasons for not increasing the amount.
Private Company Flexibility And Growth
Title V of the JOBS Act is entitled "Private Company Flexibility and Growth." This title amends Section 12(g) of the Exchange Act to increase the thresholds pursuant to which a company would be required to register under Section 12(g) of the Exchange Act from 500 record holders to either 2,000 record holders or 500 record holders who are not accredited investors. A company that is registered under Section 12(g) is required under the Exchange Act to file with the SEC periodic reports such as annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and be subject to the proxy rules. The determination would be made within 120 days after the last day of its first fiscal year ended on which the issuer has total assets exceeding $10 million. The definition "held of record" shall not include securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of Section 5 of the Securities Act of 1933. These exclusions will likely make it more complicated and difficult to determine the number of shareholders of record a particular company has at any given point. It is also not clear how to treat these exempted shares if they are subsequently sold by or otherwise transferred from the original holder.
This title requires the SEC to adopt safe harbor provisions that issuers can follow when determining whether holders of their securities received the securities pursuant to an employee compensation plan in transactions that were exempt from the registration requirements of Section 5 of the Securities Act. These rules will therefore be very important to companies that need to monitor their record holders if they are approaching the thresholds for Section 12(g) registration, as any mistake in counting could potentially cause a company to inadvertently become a reporting company.
This title also requires the SEC to examine its authority to enforce Rule 12g5-1 to determine if new enforcement tools are needed to enforce the anti-evasion provision contained in subsection (b)(3) of the rule, and shall not later than 120 days after April 5, 2012, transmit its recommendations to Congress.
It is ironic that the same act that created the IPO On-Ramp to facilitate IPOs also provides a method to delay companies from being forced to go public by increasing the record holder threshold for registration under Section 12(g) of the Exchange Act.
Title VI of the JOBS Act is entitled "Capital Expansion." The title further amends Section 12(g) of the Exchange Act to require a bank or a bank holding company with total assets exceeding $10 million and a class of equity security (other than an exempted security) held of record by 2,000 or more persons to register under the Exchange Act. Such bank or bank holding company may deregister if the number of record holders falls below 1,200. The SEC is required to issue final regulations to implement this title and the amendments made by this title within one year of enactment.
Outreach On Changes To The Law
Title VII of the JOBS Act, entitled "Outreach on Changes to the Law," is the shortest title of the JOBS Act. Pursuant to the title, the SEC is directed to provide online information and conduct outreach to inform small and medium sized businesses, women owned businesses, veteran owned businesses, and minority owned businesses of the changes made by the JOBS Act.
Only time will tell if the JOBS Act has the intended effect envisioned by Congress, in part because we must still await substantial rulemaking from the SEC before issuers and their advisers can take advantage of the opportunities that the JOBS Act has to offer. It is uncertain as to when the SEC will move forward with its rulemaking and implementation under the JOBS Act. The SEC still has not completed all rulemaking initiatives called for under the Dodd-Frank Act, and SEC Chairman Shapiro has publicly stated that some of the time limits set forth in the JOBS Act are aggressive and may not be achievable within the indicated time limits. Furthermore, SEC Chairman Shapiro has made no secret of her belief that much of the JOBS Act weakens investor protection, so it is likely that any SEC rulemaking will move towards protecting investors by adding regulations to the extend the SEC has the authority to do so. It will also take time to see if the loudest critics of the JOBS Act will be vindicated as a result of any scandals stemming from the loosening of existing regulations to protect investors. We at Herrick, Feinstein believe that the JOBS Act includes some very good ideas to balance what has arguably been over-regulation and the requirements for over-disclosure (and the resulting costs) over the past ten years, but believe the jury is still out as to whether any of it will truly spur an IPO boom or assist companies to more easily obtain capital.