- The JOBS Act and Its Potential Effect on Capital Raising
- April 12, 2012 | Authors: David M. Carter; W. Brinkley Dickerson; David W. Ghegan; Mark Windon Jones; Jacob "Jake" A. Lutz; Patrick W. Macken; David I. Meyers
- Law Firms: Troutman Sanders LLP - Atlanta Office ; Troutman Sanders LLP - Richmond Office ; Troutman Sanders LLP - Atlanta Office ; Troutman Sanders LLP - Richmond Office
In recognition of the declining number of IPOs in recent years and the ever-louder chorus of complaints from smaller companies and entrepreneurs regarding the difficulties in raising capital under current securities laws, Congress recently passed the Jumpstart Our Business Startups, or JOBS Act, which President Obama signed into law on April 5, 2012. The JOBS Act represents the first significant loosening of securities laws since the onset of the financial crisis and the still growing number of new and revised regulations that followed.
The provisions of the JOBS Act fall broadly into two categories: those intended to make the IPO process less daunting for smaller companies and those intended to generally broaden access to capital. An overview of certain key aspects of the JOBS Act is provided below.
We believe that the passage of the JOBS Act represents at least a theoretical step in the right direction. Given the opposition previously voiced by the SEC to many of the provisions of JOBS Act, and the cumulative rulemaking burden placed on the SEC by both the JOBS Act and the Dodd-Frank Act, it remains unclear if the JOBS Act will be successful, at least in the near-term, in producing coherent regulatory reform that is embraced by market participants and that leads to the JOBS Act’s stated goals of increasing American job creation and stimulating economic growth.
Significant Reform of the IPO Process for “Emerging Growth Companies.” The JOBS Act includes a number of provisions designed to ease entry into the capital markets of a new category of issuer — the “emerging growth company” — via reform of the existing rules governing IPOs and a phased application of reporting and governance requirements currently applicable to all public companies upon completion of an IPO. An “emerging growth company” is an issuer that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year. A company can continue as an emerging growth company until the earliest of:
- attaining $1 billion or more in annual gross revenue,
- the end of the fiscal year following the fifth anniversary of the company’s IPO,
- issuance of $1 billion or more in non-convertible debt in a rolling three-year period, or
- being deemed a “large accelerated filer” (that is, having a public float of $700 million or more and having filed SEC reports for at least a year).
Emerging growth company status is only available for issuers that complete their IPO after December 8, 2011.
The JOBS Act revises the IPO process for this new class of issuers in several ways, including:
Confidential Submission of Registration Statements. An emerging growth company may now submit a draft registration statement to the SEC for a confidential review by the SEC staff. The SEC recently released guidance and a set of Frequently Asked Questions for emerging growth companies to submit draft confidential registration statements to the SEC for nonpublic review. This provision is intended to provide a company the benefit of lengthened confidentiality prior to its IPO and greater flexibility in determining whether to withdraw an IPO (without the related stigma) if the review process uncovers significant issues, such as required accounting changes, that make proceeding with the IPO impractical. Under these provisions, an emerging growth company is not required to publicly file its registration statement and related amendments regarding the IPO until at least 21 days prior to embarking on any “road show” for the offering.
Given the current burdens on the SEC staff, their concerns regarding committing resources to offerings that easily could be abandoned and the Staff’s recent decision to cut back on similar confidential reviews for foreign issuers, the success of this provision largely will be dependent on how the SEC chooses to implement the confidential review process. Committing few staffers to conduct reviews, thereby all but ensuring a lengthy process, or a requirement that information from the confidential submissions ultimately be made public could deter emerging growth companies from utilizing the confidential review process.
Testing the Waters before an IPO or Follow-on Offering. Emerging growth companies and persons authorized to act on their behalf now have the ability to engage in oral and written discussions with potential investors that are “qualified institutional buyers” (QIBS) or accredited investors prior to filing a registration statement (whether for an IPO or a subsequent offering). This will allow emerging growth companies to gauge investor interest before committing the significant resources, both financial and personnel, needed for an IPO or subsequent offering. Given the SEC’s current broad definition of what constitutes a “road show,” it will be interesting to see how the SEC interprets this provision in relation to the requirement discussed above regarding the public filing of information by emerging growth companies not less than 21 days before commencing a road show. If not reconciled, it may make the confidential review process unavailable for any emerging growth company that also wants to test the waters.
Reduced Financial Disclosures and Accounting Pronouncements. Emerging growth companies are only required to provide two years, rather than three years, of audited financial statements in their initial registration statement. There are corresponding changes to the MD&A requirements and relaxed standards with respect to selected financial data in follow-on registration statements. In addition, emerging growth companies have a one-time election as to whether to defer or not defer the implementation of new accounting pronouncements unless and until such pronouncements are made applicable to non-public companies.
Phased Application of Disclosure Requirements. An emerging growth company does not have to immediately comply with several of the SEC’s current and proposed disclosure obligations that have been viewed as reasons for staying private. This includes:
- permitting emerging growth companies to provide the more limited executive compensation disclosures allowed for current “smaller reporting companies” (which means, among other things, not including a CD&A section in a proxy statement),
- eliminating the say-on-pay vote requirement, the frequency of the say-on-pay votes requirement and the say-on-golden parachutes requirement,
- providing exemptions from the yet to be finalized Dodd-Frank rules regarding a comparison of executive compensation to the company’s performance and the comparison of the CEO’s compensation to the median compensation of all other employees, and
- providing exemptions from obtaining auditor attestation of the emerging growth company’s internal controls and to any PCAOB adopted rule requiring mandatory audit firm rotation (to the extent such a rule is actually adopted by the PCAOB).
We have often questioned the value of some of these disclosures, especially when compared to the burdens imposed on issuers to comply with them. While we continue to hold out hope that reasonableness will prevail and that some or all of these overly burdensome requirements will be eliminated or greatly scaled back for all issuers, exempting emerging growth companies from them at least represents an acknowledgment of the issues they create and represents a first, but hopefully not last, step in remedying the over-reactions flowing from the financial crisis.
Relaxed Limitations regarding Analyst Research and Communications. The JOBS Act makes a number of changes to the law currently governing research analysts in connection with IPOs. The JOBS Act now permits analysts to publish research reports regarding an emerging growth company prior to the filing for an IPO, even if the research analyst’s firm is participating or expects to participate in the offering. It also requires FINRA, the primary regulator of broker-dealers, to relax its current rules limiting publication of such reports after the completion of an IPO. This is a significant departure from the current requirement that prohibits any publication prior to an IPO (it may be deemed an “offer” by the SEC) and limits publications after an IPO until at least 40 days following the offering. In addition, the JOBS Act requires FINRA to rescind current rules that prohibit research analysts from participating in meetings with management of an emerging growth company alongside investment banking personnel.
These relaxed rules with respect to research analyst participation in the IPO process for emerging growth companies represent perhaps the most surprising changes within the JOBS Act. Many of these rules, and the market practices emerging from them, resulted from the bursting of the dot-com bubble in 2000 and the resulting spotlight pointed on potential conflicts of interest when an analyst publishing a report is from the same investment bank that is fighting to be the lead on an IPO. Further, the current limitations in market practice stem as much from the SEC’s 2003 global settlement with many of the leading investment banks following the dot-com bust, as much as current rules, and it is unclear what impact, if any, the JOBS Act will have on the global settlement. At the very least, the global settlement gives the SEC a method to substantially limit the impact of these provisions if they continue to be as troubled by them, as Chairman Mary Schapiro indicated in her letters to Congress regarding the JOBS Act.
Each revision discussed above for emerging growth companies is available immediately now that President Obama has signed the JOBS Act into law. Given the conflicting language in several of the provisions and the large gray areas created by others, however, we expect most issuers will wait until the SEC issues guidance or interpretations with respect to the new provisions before there is widespread adoption.
Reforms to Other Capital Raising Rules. In addition to trying to create an IPO “on-ramp” for emerging growth companies, the JOBS Act also includes a number of provisions designed to make it easier for all companies to raise capital.
Allowing General Solicitations in Some Private Placements. Within 90 days of enactment, the JOBS Act requires the SEC to amend Rule 506 promulgated under Regulation D of the Securities Act, one of the most used exemptions from registration under the Securities Act, to permit offers and sales of securities under Rule 506 through the use of general solicitation or advertising, provided that all purchasers are accredited investors. The SEC must make similar amendments to Rule 144A (also within 90 days of enactment of the JOBS Act) to allow offers to persons other than QIBs, including through general solicitations or advertising, so long as the securities are sold only to persons that the issuer reasonably believes are QIBs. The relaxation of the general solicitation and advertising provisions is a welcome change and removes one of the thorniest issues associated with private placements. We believe these reforms will provide more certainty and allow a company to continue to communicate with the market while undertaking a private placement without fear of running afoul of the current no-solicitation and advertising provisions that might jeopardize the offering. Allowing for general solicitations and advertising also will provide issuers with additional flexibility in raising capital by allowing them to conduct concurrent public and private offerings.
It is interesting to note that while the provisions of the JOBS Act with respect to Rule 144A require an issuer to have only a “reasonable belief” that an investor is a QIB, the JOBS Act provisions calling for amendments to Rule 506 require the SEC to adopt rules requiring the issuer to take “reasonable steps to verify” an investor’s accredited status. Again, this is an area where the ultimate effect of the JOBS Act reforms will depend on the specific manner in which the SEC implements the statutory provisions.
Implementation of Crowdfunding Rules. The JOBS Act adds a new section, Section 4(6), to the Securities Act that will allow companies to offer and sell up to $1 million of securities over a rolling 12-month period without registration under the Securities Act through “crowdfunding” transactions. Crowdfunding is the term used to describe the capital-raising strategy whereby small individual investments are pooled to reach the ultimate capital raising goal. To qualify for this new exemption the issuer must satisfy a number of conditions, including:
- limiting the total investment by an investor to the greater of $2,000 or 5% of the investor’s annual income or net worth, if the investor’s annual income or net worth is less than $100,000, or the lesser of $100,000 or 10% of his or her annual income or net worth, if the investor’s annual income or net worth is $100,000 or greater
- requiring the transaction to be conducted through a broker or “funding portal” created pursuant to the provisions of the JOBS Act
- limiting any advertising with respect to the offering, other than notices directing investors to a funding portal, and
- requiring the filing with the SEC (and distribution to investors) of certain, limited information about the issuer and its financial condition, including audited financial statements for offerings of more than $500,000.
Shares issued pursuant to the crowdfunding exemption will be subject to transfer restrictions for one year unless they are sold back to the issuer, a family member, an accredited investor or pursuant to a registration statement.
The JOBS Act tasks the SEC with filling in many of the details with respect to the new crowdfunding provisions via rules to be adopted within 270 days of enactment of the JOBS Act. However, given the relatively low ceiling on the amount that can be raised and the conditions that must be satisfied to rely on the crowdfunding exemption, at this point we believe it is unlikely that this new exception will become widely used.
Increasing Thresholds that Trigger Exchange Act Reporting. Currently, a company is required to commence public company reporting under the Exchange Act if it has assets in excess of $10 million and any class of its equity securities are held of record by more than 500 persons. The JOBS Act amends this provision to increase the thresholds for companies, other than banks and bank holding companies, to a class of equity securities held of record by either 2,000 persons or 500 or more persons that are not accredited investors (the $10 million asset component remains the same). The provisions also require the SEC to exclude from the calculation shareholders who received their shares pursuant to the issuer’s benefit plans (assuming the benefit plan shares were issued pursuant to a valid exemption). For banks and bank holding companies, the threshold is 2,000 persons without regard to their accredited status and their ability to terminate their SEC reporting obligations has also been broadened (see our related E-Alert Impact of JOBS Act on Banks and Bank Holding Companies for additional information).
The increase in the thresholds that trigger public company reporting (which became effective upon enactment of the JOBS Act) should be helpful to companies by allowing them to continue to raise capital from a broader investor group before subjecting themselves to the public company reporting regime. In addition, given that in the current trading environment (as opposed to the 1930’s when these rules were first adopted), “street holders” far outweigh record holders for most companies, many expected the modernization of this rule to focus on the number of beneficial holders. Continuing to look only at “record holders,” while antiquated, should provide issuers with more time before they cross the increased threshold, as will the elimination from the calculation of holders of shares acquired under the benefit plans. However, the addition of a maximum of 500 unaccredited investors into the provision may outweigh any benefits created by the other changes. When the accredited investor determination must be made and how it can be made are questions that still must be answered by the SEC. Unfortunately, the JOBS Act did not provide any specific deadlines for the SEC to make such determinations.
Expansion of Regulation A. The JOBS Act also requires the SEC to amend the provisions of Regulation A under the Securities Act (or to implement a similar, new exemption) to significantly increase the amount of capital that can be raised during any rolling 12-month period under the provision from $5 million to up to $50 million. Regulation A has represented a relatively little-used exemption for capital raising. The benefits of relying on Regulation A, such as freely tradable shares, have not been enough to overcome the negatives, such as the low cap on the amount of capital that could be raised, especially when compared to other available exemptions such as Rule 506. Given that one of the biggest limitations in relying on Rule 506, the prohibition of general solicitations, also was modified by the JOBS Act, it does not appear that the increase in the amount of capital that can be raised under Regulation A will do much to increase the use of this provision. Although implementation of this aspect of the JOBS Act is dependent on SEC rulemaking, the JOBS Act does not provide specific deadlines for SEC action.
The JOBS Act represents an acknowledgement by the federal government that our securities registration requirements are out of touch with the current capital raising environment and need to be updated if we want to continue to foster the growth of businesses. However, given the reservations previously expressed by the SEC to many of the provisions and the significant latitude provided to it to implement many of the provisions and/or to fill in the gaps common in significant legislation, it is questionable whether and how soon any of the intended impacts will be felt by issuers. This is especially true given the SEC’s existing rulemaking obligations under the Dodd-Frank Act. Regardless of the ultimate impact, it does reflect a significant step forward from Congress’ reaction to the financial crisis and may signal the potential for more reforms to come on the capital raising front.