- JOBS Act: Congress Attempts to Reduce Regulatory Burdens on IPOs and Private Offerings
- April 2, 2012 | Authors: Laurie A. Cerveny; Robert G. Leonard; Michael P. O'Brien; Charles A. Sweet; Carl A. Valenstein
- Law Firms: Bingham McCutchen LLP - Boston Office ; Bingham McCutchen LLP - New York Office ; Bingham McCutchen LLP - Boston Office ; Bingham McCutchen LLP - Washington Office
Congress has passed and President Obama is expected to sign the Jumpstart Our Business Startups Act, a five-pronged attempt to reduce regulatory burdens on securities offerings and thus facilitate capital formation and job creation, especially by “emerging growth companies.” Although some of the Act’s provisions seem unlikely to advance this goal in a significant way, others should reduce many regulatory pitfalls that have hindered securities offerings — Initial Public Offerings in particular, but also private offerings, including offerings by private funds. The most significant provisions seem likely to be:
New “IPO on-ramp” provisions for “emerging growth companies” (EGCs), that both relax many restrictions on the IPO process for EGCs and reduce, in many cases for five years after the IPO, the burdens imposed on other public companies;
Elimination, when the SEC adopts implementing rules, of the ban on “general solicitation and advertising” in private offerings limited to “accredited investors” or “qualified institutional buyers” as purchasers; and
Raising the permitted number of shareholders of record, before a private company must start filing reports with the SEC.
IPO On-Ramp for Emerging Growth Companies
Title I of the JOBS Act originated from an IPO Task Force, under the auspices of the U.S. Treasury, which looked for ways to address through legislation the sharp fall-off in IPOs in the U.S. over the past decade, both absolutely and relative to other markets. The Task Force concluded that excessive securities law burdens and restrictions, some created over the past decade in reaction to financial scandals, have played a role in this decline, and this part of the Act attempts to address those, by relaxing restrictions on IPOs by EGCs and by granting them a grace period of up to five years from some of the burdens imposed on other public companies.
Any company that had not priced its IPO by Dec. 8, 2011 and had revenues of less than $1 billion in its latest fiscal year can be an EGC. As a general rule, it would remain an EGC until the end of the fiscal year in which occurs the fifth anniversary of the first sale in its IPO. That five-year period would be shortened, however, if in an earlier year the EGC has $1 billion in revenues or a “public float” of its common equity of $700 million.
The legal restrictions imposed on IPOs would be significantly loosened in several respects for EGCs:
The EGC can “test the waters” before any filing, through meetings with qualified institutional buyers or institutional accredited investors;
It can file its registration statement on a confidential basis, but the filing must be made public at least 21 days before the first road show;
It could choose to include only two years of audited financials, rather than three years, in its IPO prospectus and would only need to provide “Selected Financial Data” for those years; and
Limitations on publication of research reports by analysts with underwriters of the IPO would be largely eliminated, as would be restrictions on meetings between those analysts and management of the EGC. Many other restrictions on conflicts of interest on the part of analysts would not be affected, however.1
During the “grace period” of up to five years after the IPO, an EGC would be excused from a number of requirements imposed on most other public companies, including:
The requirement to obtain an attestation report by the EGC’s auditors on its internal controls (but its senior officers would be required to certify those controls, along with the other Sarbanes-Oxley certifications);
The requirement to hold “say-on-pay” votes, or to disclose the ratio of CEO to median employee compensation called for by the Dodd-Frank Act (which the SEC has not yet implemented). Also, they would not be subject to the detailed executive compensation disclosure requirements, including a “Compensation Discussion and Analysis” imposed on most public companies, but rather the reduced requirements that apply to “smaller reporting companies” (those with a public float below $75 million); and
The need to comply with changes in auditing standards, as a general rule, including mandatory auditor rotation, should the PCAOB decide to require that.
Elimination of Restriction on General Solicitation
Title II of the JOBS Act requires the SEC to eliminate the current restriction on “general solicitation and general advertising” in connection with offerings under Rule 506 of Regulation D, and to clarify that there is no ban on general solicitation in offerings made pursuant to Rule 144A. In order for the elimination of the general solicitation prohibition to apply in a Rule 506 offering, the issuer would have to take reasonable steps to verify that all purchasers in the offering are “accredited investors.” Similarly, in order for the elimination of the general solicitation prohibition to apply in a Rule 144A offering, the issuer would have to take reasonable steps to verify that all purchasers in the offering are “qualified institutional buyers.”
Currently, it is a requirement of most private placement exemptions from the registration requirements of the 1933 Act, including Rule 506 and (in the view of the staff of the SEC) Rule 144A, that there be no “general solicitation and general advertising” with respect to the offering. This restriction generally prohibits the use of advertising, newspaper or magazine articles, public Internet websites, media broadcasts, mass email campaigns, and public seminars or meetings to sell the offering. By eliminating the prohibition on general solicitation in two of the most widely used private placement exemptions, the JOBS Act will permit the use of a much broader array of marketing tools to be used in connection with private offerings.
These changes also will eliminate a variety of fine distinctions that have bedeviled issuers and securities practitioners alike. For example, the difference between a communication that impermissibly “conditions the market” for the securities, and is therefore a prohibited general solicitation, and ordinary course factual communications for the benefit of customers, employees and existing shareholders, is often unclear. Inadvertent communications that are determined after the fact to have crossed the line can delay or disrupt a private offering. Because the filing of a registration statement is deemed to be a general solicitation, it has sometimes been difficult for an issuer to engage in a private placement concurrently with a public offering. The JOBS Act should eradicate these issues in connection with Rule 506 and Rule 144A offerings.
The Act requires the SEC to adopt rules implementing these changes within 90 days after it is signed by the President. One possible issue may be whether the SEC’s rules will require more in the way of “reasonable steps” to determine accredited investor status than is now customary.
Title II also will permit the operation of certain private placement platforms without requiring the operator to register as a broker-dealer under the 1934 Act. Online and other platforms that facilitate Rule 506 offerings will be permitted, so long as the operator and its associated persons do not receive compensation for the purchase or sale of the offered securities, do not have possession of customer funds or securities, and are not subject to statutory disqualification.
Increased Shareholder Threshold for 1934 Act Reporting
Titles V and VI of the Act will significantly increase the number of shareholders that a company may have before it is required to register under the 1934 Act and begin filing periodic reports, effective immediately upon signing of the Act.
Section 12(g) of the 1934 Act currently requires a company to register under the 1934 Act and begin periodic reporting within 120 days after the end of any fiscal year at which it has more than $10 million in assets and a class of equity securities that is held of record by 500 or more persons. A company may deregister and cease reporting only when its shareholders of record fall below 300 persons (or, when its total assets do not exceed $10 million, 500 persons).
Title V will increase the registration threshold for most companies by requiring registration only when the company has more than $10 million in assets and a class of securities that is held of record either by 2,000 or more persons, or by 500 or more persons who are not accredited investors. The increase to 2,000 holders will not be of much help to issuers that do not know whether their record holders are currently accredited investors. Unless the SEC adopts some helpful rule on this point, these issuers will need to consider the lower 500 holder threshold, although they will benefit from the exclusion of certain employee shareholders, described below.
For banks and bank holding companies, Title VI will require 1934 Act registration when they have a class of equity securities held by 2,000 or more persons. These entities will be permitted to deregister and cease reporting when their shareholders of record fall below 1,200 persons.
In all cases, employees who received their securities pursuant to exempt transactions under employee compensation plans will not be counted as shareholders of record, for purposes of these calculations. This provision does call for SEC rule-making, but it is not obvious that issuers must wait for those rules in order to rely on it.
The relatively weak market for IPOs over the past several years, among other factors, has led many developing companies to fund themselves through private offerings for extended periods, while equity compensation has become a key means of compensating employees. These trends have resulted in some private companies bumping up against the requirement for 1934 Act registration long before they are ready for an IPO. These sections of the Act should substantially alleviate this problem.
Regulation A Offering Cap Raised from $5 million to $50 million.
Regulation A is a hybrid — an exemption from registration for private companies that includes a hallmark of registered offerings: an offering document that must be publicly filed with and is subject to comments from the SEC staff. While a Regulation A offering statement can be considerably shorter than the prospectus for a registered IPO, the prospect of public disclosure, attendant greater legal and accounting expenses and a reluctance to engage with the SEC staff, while conventional exemptions avoid those, have contributed to making Regulation A virtually a dead letter in recent years. Other factors that have militated against use of Regulation A include:
An offering cap of $5 million;
No preemption of state “blue sky” registration requirements, unlike a Regulation D private offering, or a conventional IPO that is to be listed on Nasdaq or another exchange. Blue sky expenses can be considerable, particularly if offers are to be made in more than one or two states.
Title IV of the Act attempts to animate Regulation A by raising the offering cap to $50 million, but does not address in any significant way its other perceived negatives. In fact, it adds a few new burdens on issuers that undertake such an offering. There would be blue sky preemption, but as a practical matter only if the issuer registers on a stock exchange, which would make it a full-fledged public company (but probably able to qualify as an Emerging Growth Company, as discussed above). The additional burdens include:
Imposing the civil liabilities of Sec. 12(a)(2) on any person offering these securities. This stringent standard, which has been limited to registered offerings, imposes liability if an offering document is found to have been materially misleading, unless the defendant can carry the burden of establishing an affirmative “due diligence” defense;
Authorizing the SEC to require audited financials in the offering statement;
Directing the SEC to require the issuer to file audited financials with the SEC annually; and
Authorizing the SEC to require the issuer to make available to investors and file additional periodic disclosures.
Retooled Regulation A will become available only when the SEC adopts implementing rules and the Act imposes no deadline on the SEC for doing that, unlike under some of the other Titles. While the increased cap of $50 million should cause more issuers and advisers to consider it, the new burdens will cut the other way, and it remains to be seen whether this new exemption will significantly enhance capital-raising.
Title III of the Act, as passed by the House, would have created a largely unregulated exemption for offerings up to $1 million ($2 million for issuers providing certain financial information to investors), which could have been made over the Internet, among other means. This raised alarm bells on the lack of protections from abuse by scam-artists, which resulted in the Senate substituting its own version of Title III. It heavily regulates this exemption, which is capped at $1 million and is the version included in the Act. This exemption requires the SEC to adopt implementing rules, and the Act directs the SEC to do that within nine months (270 days) after the Act is signed.
Any investors will certainly be better protected under the final version, but the restrictions and burdens on any issuers that might want to use this exemption are so extreme that it remains to be seen whether it will see much use. To touch on a few of these:
Issuers would have to file with the SEC and provide to investors specified information for even the smallest offerings. For instance, for an offering of $100,000 or less, the issuer would be required to file and provide its latest income tax returns (if any) and financial statements certified as true and complete by its principal executive officer. Moreover, they would be required to continue to file financial and other information with the SEC and provide it to investors at least annually, under rules to be adopted by the SEC.
Offers could be made only through a registered broker/dealer or through a “funding portal” — a new regulated category that must be created by SEC rules and would require membership in an SRO.
Not only the issuer, but each of its directors or partners and certain of its senior executives, would face personal liability under a stringent standard that parallels the liability provisions that have been limited to public offerings. If any of these are found to have made any materially misleading communication, orally or in writing, they will face personal liability to investors, unless they can carry the burden of establishing an affirmative “due diligence” defense.
Although not all five prongs of the Act will have equal significance, the IPO on-ramp provisions, in particular, should remove or lessen many of the disincentives that have contributed to the decline in IPOs in the U.S. Moreover, the relaxation of restrictions on general solicitation in private offerings and the increase in the permitted number of shareholders before registration with the SEC should make many private offerings easier. SEC rulemaking and marketplace reactions to these changes will ultimately determine their utility.
1 The amendments in Title I that exclude “research reports” as defined in the Act from being “offers or sales” for purposes of Sections 2(a)(10) and 5(c) of the Securities Act, thereby removing the research reports from the definition of “prospectus,” may make possible the issuance of pre-IPO research on EGCs. It is unclear, however, what liabilities may attach to research that is published by a broker-dealer while it is participating in a public offering of an EGC’s equity securities, which suggests that firms proceed cautiously, for now.