On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the “JOBS Act”). The full formal name for the legislation: “An Act to increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies” and the initials of the popular name that spell out “JOBS” demonstrate Congressional intent to facilitate easier access to capital and thereby create many new jobs.
The JOBS Act makes innovative changes in the regulation of both public and private securities offerings and public company disclosure obligations. As discussed below, some of the changes were effective when President Obama signed the law, while most others will be effective only after, as directed by the JOBS Act, the SEC adopts implementing rules. Among changes effected by the JOBS Act are the following:
• “IPO On-Ramp” for “Emerging Growth Companies.” Congress adopted a strikingly innovative approach to accessing the public markets for a new class of companies known as Emerging Growth Companies (“EGCs”). Generally, any company with annual revenues of less than $1 billion will qualify for EGC status. The various changes in the new law that reduce the costs and burdens of the IPO process and of being publicly owned after the IPO have come to be known as the “IPO On-Ramp.”
• General Solicitation OK in “Revised Rule 506” Private Offerings. In a bold departure from long-standing prohibitions against advertising and general solicitation in exempt private offerings, the JOBS Act directs the SEC to adopt rules to eliminate the prohibitions in private offerings under SEC Rule 506, provided that all investors are “accredited investors” (e.g., individuals with a net worth of more than $1 million).
• “Crowdfunding” – Smaller Investments, Many Investors. A product of social media, “crowdfunding” typically involves using the internet to seek relatively small investments from many investors. Without a change in the law, crowdfunding aimed at profit-making investments violates the securities laws. The JOBS Act approves crowdfunding offerings of up to $1 million in any 12-month period, subject to certain detailed limitations designed to address concerns for investor protection.
• Possible Capital Formation Wildcard – Regulation A+. The JOBS Act gives the SEC broad authority to adopt rules creating a new securities registration exemption for public offerings of “small issues” for up to $50 million in any 12-month period (called “Regulation A+” by commentators). With an almost blank canvas on which to design the new exemption, the SEC has an opportunity to adopt both innovative and ground-breaking improvements to the capital formation process.
What’s Effective Now, What’s Waiting for SEC Rules?
The EGC and IPO On-Ramp changes are currently effective. Most of the remaining principal changes await the adoption of SEC rules. The JOBS Act directs the SEC to adopt rules implementing Revised Rule 506 by July 4, 2012. Currently, therefore, existing prohibitions against general solicitation and advertising continue to apply to Rule 506 transactions. The new law directs the SEC to adopt crowdfunding implementing rules by early December 2012. Currently, various securities laws prohibit crowdfunding securities sales activities. The Regulation A+ exemption will not exist until the SEC adopts the rules to create it, but the JOBS Act does not set a deadline for the adoption of such rules.
Although the SEC has yet to issue any proposed or final rules, the SEC staff has been active in providing helpful guidance in the form of staff answers to “Frequently Asked Questions” regarding the most important provisions of the new law. As of mid-May, the staff had posted nine FAQs at http://www.sec.gov/divisions/corpfin/cfjobsact.shtml. It is a good idea to check www.sec.gov periodically for new or modified FAQs, especially until the SEC begins the more formal process of issuing proposed rules.
IPO On-Ramp for Emerging Growth Companies (EGCs)
It’s no secret that the number of IPOs has declined in the past decade, particularly in comparison to the IPO market in the 1990s. Some critics have asserted that the decline is principally the result of “over-regulation” – pointing to the additional compliance costs and disclosure obligations resulting from the post-scandal reforms mandated by the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. Added to Congressionally-imposed burdens were several SEC disclosure initiatives. Several advisory committees suggested various reforms to lessen the burdens and costs of being a public company and some of the suggestions found their way into the JOBS Act, including in the EGC provisions.
It is especially noteworthy that the EGC definition was not a narrowly drawn legislative gimmick, available only to a small segment of potential public companies. Indeed, approximately 90% of recent IPOs were for companies with less than $1 billion in annual revenues, the principal requirement for EGC status. In contrast to some recent SEC initiatives, the JOBS Act does not exclude from EGC status the typical group of “ineligible issuers,” such as penny stock companies. Apparently, even such risky ventures will be able to qualify as EGCs. However, according to the FAQs, an EGC may not be organized as an investment company (e.g., a mutual fund) or an issuer of asset-backed securities.
EGC status generally continues after an IPO for at least one year, and possibly as long as five years. EGC status will terminate upon the first to occur of (1) the end of a fiscal year in which gross revenues are $1 billion or more; (2) any date on which the issuer has outstanding more than $1 billion in non-convertible debt; (3) the last day of the issuer’s fiscal year in which the market value of the issuer’s outstanding common equity owned by non-affiliates (a/k/a the public float) equals or exceeds $700 million; or (4) the fifth anniversary of the first sale under the EGC’s IPO. The logic underlying these relatively liberal transition rules is that once one of the EGC termination targets has been hit, the company should have grown to be large enough to bear the extra public company burdens and costs that follow the loss of EGC status.
An EGC making a public securities offering on or after December 9, 2011 may take advantage of the IPO On-Ramp’s innovative reductions in regulatory complexity, which apply both to the public offering process and to life after the IPO as a public company. They include: (1) confidential registration statement filing with and review by the SEC; (2) scaled-down disclosures, such as two (instead of three) years of audited financial statements and reduced executive compensation disclosures; (3) permission to distribute research reports during the registration process and to involve research analysts in the IPO process; (4) ability to “test the waters” in communications before and during the registration process with institutional accredited investors and Qualified Institutional Buyers (QIBs, as defined under Rule 144A, are generally large institutions with at least $100 million in securities under management); (5) no requirement to include an auditor attestation of the issuer’s internal controls as required by Section 404 of the Sarbanes-Oxley Act of 2002; and (5) temporary exemption from new or revised auditing standards.
As noted above, a key benefit for an EGC in an IPO is that the investment banker’s research analysts will be allowed again to participate in the IPO process (including publishing reports). The analysts will be allowed to have open lines of communication with the senior officers of the company, the investment bankers who are handling the offering and prospective investors. In our view, allowing these previously prohibited activities should better enable the development of trading markets for EGCs and thus create greater incentive for investment bankers to underwrite EGC IPOs.
Also as noted above, EGCs may file confidentially with the SEC IPO registration statements and pre-effective amendments. If an EGC elects to make a confidential filing, then once the company decides to proceed with the offering, these confidential filings would all need to be filed publicly no later than 21 days prior to the commencement of the IPO roadshow. In recent years, some otherwise well-qualified IPO candidates may have been reluctant to proceed with an IPO, because of the potential negative publicity from “baring one’s soul” publicly in a publicly available registration statement filing and later having to pull the offering because of a hiccup in the markets or other challenge. Confidential filing may prove to be the change that encourages certain issuers and their investment bankers to explore more substantively the IPO option.
As counsel to issuers, we view all of these changes as welcome and reasonable reductions in the cost and complexity of going public and being publicly owned. However, the IPO On-Ramp for EGCs will be successful only if vibrant public trading markets follow EGC IPOs. Whether the IPO On-Ramp ultimately proves to spur substantially more IPOs will largely depend on whether quality investment banking firms are prepared to take EGCs public and work to develop active trading markets for their stock. Keep in mind that EGCs comprise a class of companies that quality investment bankers very likely would not have been willing to take public under the regulatory regime in effect prior to enactment of the JOBS Act. Time will tell if quality firms will choose to underwrite EGC IPOs and support EGCs in the post-IPO market.
“Revised Rule 506” Private Offerings with General Solicitation
Currently, under the Securities Act of 1933 (the “1933 Act”), any offer or sale of securities must either be registered with the SEC or qualify for an exemption from registration. When unregistered transactions fail to comply with applicable registration exemptions, every investor may have the right to rescind his or her investment. Also, regulators may bring enforcement actions seeking fines, injunctive relief and forcing rescission – and bring criminal actions in aggravated situations. Liability is often imposed personally on officers, directors and principal owners, as well as others with personal involvement in the unsuccessful transaction. Therefore, everyone involved in unregistered securities offerings should be highly motivated to assure exemption compliance.
By far, the most popular securities registration exemption for private offerings is that provided under Rule 506 of SEC Regulation D. Compliance with Rule 506 requires satisfaction of a number of detailed conditions and requirements. In this summary, we consider only one of these requirements: the current prohibition (i.e., until the SEC issues final rules under the JOBS Act) against using any means of general solicitation or general advertising. Engaging in such prohibited activities may jeopardize an otherwise exempt Rule 506 offering, giving rise to the full spectrum of adverse consequences noted above.
Over the years, practitioners, regulators and disappointed investors and their counsel have theorized, debated and litigated over what conduct will (or will not) violate the prohibitions. Despite the effort of skilled counsel and advisors, there remains a considerable degree of uncertainty (and risk) in evaluating conduct regarding the prohibitions against general solicitation and general advertising.
The JOBS Act removes a significant liability risk from Rule 506 transactions by eliminating the prohibition against general solicitation and general advertising in Revised Rule 506 transactions (if all investors are accredited investors). Such welcome relief is not free from possible complications in at least three distinct areas.
First, Revised Rule 506 will come alive only after the SEC adopts rules implementing the new exemption. Will the SEC remove the prohibitions entirely, or will there be some limitations? Will the staff be comfortable in a world where exempt “private” offerings may be promoted to the general public on internet websites, Facebook postings, Twitter messages and late night cable TV infomercials?
The second source of possible complications comes from the fact that Revised Rule 506 requires all investors to be accredited investors. The definition of “accredited investor” is set forth in SEC Rule 501(a) and is comprised of eight different categories of individuals and entities, such as banks, insurance companies, corporations, trusts or other artificial entities with assets in excess of $5 million, wealthy or high income individuals meeting certain financial standards and any entity all of whose owners are accredited investors. Generally, an individual qualifies as an accredited investor if (i) the individual’s net worth (or net worth jointly with such person’s spouse) exceeds $1 million (exclusive of the value of the primary residence) or (ii) the individual’s annual income exceeds $200,000 (or $300,000, when considered jointly with such person’s spouse).
The JOBS Act gives the SEC specific instructions regarding the rules for Revised Rule 506 dealing with the requirement that all investors be accredited investors:
Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. (emphasis added)
The SEC’s rule-making for Revised Rule 506 promises to be closely followed by all parties. Some pundits have suggested that the SEC is required by the JOBS Act to adopt rules that will not permit any form of investor self-certification to satisfy the statutory “reasonable steps to verify” instruction. Others have suggested that the final rules can be harmonized with the current accredited investor definition language of Rule 501(a).
The third area of concern arises because Revised Rule 506 eliminates the prohibition against general solicitation and general advertising. Currently, if there is a technical failure to satisfy one or more requirements of a private offering structured to comply with Rule 506, the transaction may be able to “fall back” on and claim compliance with the statutory private offering exemption under Section 4(a)(2) under the 1933 Act. However, because the Section 4(a)(2) statutory private offering exemption prohibits the use of general solicitation or general advertising to attract investors, there will be no “falling back” to claim compliance with the statutory private placement exemption from a defective Revised Rule 506 offering that uses general solicitation or general advertising.
It is important to remember that the implementing rules for Revised Rule 506 are not yet in effect. Thus, issuers must wait for the final rules before it will be permissible to employ general solicitation or general advertising in a Rule 506 accredited-investor-only offering.
The JOBS Act also created a new private placement securities registration exemption known as the crowdfunding exemption. As noted above, “crowdfunding” typically involves using the internet to seek relatively small investments from many investors who are not necessarily accredited investors. Prior to the JOBS Act, it was highly doubtful that a crowdfunding transaction aimed at producing a profit for investors could satisfy applicable federal and state securities laws. Such laws prohibited seeking out investors through the use of general solicitation or general advertising. To circumvent the prohibitions, some crowdfunding offerings sought “donations” rather than investments. It was asserted that without any profit motive “non-securities” were the subject of the crowdfunding activities not subject to any federal or state securities law.
The JOBS Act crowdfunding exemption offers the promise of a revolutionary departure from the establishment practices for capital raising activities. In order for crowdfunding transactions actually to get underway, however, the SEC will need to adopt implementing rules. The crowdfunding portions of the JOBS Act include several pages of “instructions” concerning the substantive content of the rules the SEC is to adopt, including:
1. Issuer qualification. Crowdfunding is not available for SEC reporting companies, registered investment companies, certain private investment funds or foreign companies. The SEC is also directed to adopt rules to disqualify “bad actors” (i.e., companies or individuals with a history of past regulatory problems or adverse outcomes with securities activities). Generally, any other U.S.-based issuer may use crowdfunding.
2. $1 million limit per 12 months. Crowdfunding transactions are limited to proceeds totaling $1 million in any 12-month period. The $1 million cap is reduced dollar-for-dollar by any other sales of securities to investors during the preceding 12-month period.
3. Use broker dealers or “funding portals.” Crowdfunding transactions may be effected only through the use of SEC registered broker-dealers or funding portals (a new class of financial intermediary to be registered with the SEC and regulated by a self-regulatory-organization such as FINRA, the organization that regulates virtually all broker-dealers doing business in the U.S.).
4. Restrictions on funding portals. The statute provides that funding portals will not be permitted to recommend particular investments or pay any person transaction-based compensation (i.e. commissions that are typically received by broker-dealers).
5. Limits on amount invested. The per investor limit depends on the net worth of the investor. For investors with a net worth of less than $100,000, the limit is the greater of $2,000 or 5% of annual income or net worth. For investors with a net worth of $100,000 or more, the limit is 10% of annual income or net worth, but no more than $100,000.
6. No investor wealth or sophistication. Investors do not have to be accredited investors or possess any particular financial or investment expertise or sophistication. Investors may not exceed the applicable 12-month crowdfunding investment limit discussed above. Broker-dealers or funding portals are required to take certain steps to assure that investors understand the risks of the investment and the disclosure materials provided to them.
7. Broker-dealer and funding portal responsibilities. In dealing with investors, crowdfunding intermediaries (broker-dealers and funding portals) are charged with several affirmative responsibilities, such as (i) providing certain information required to the SEC and to investors and ensuring investors review it, (ii) running background checks on the issuer’s principals to reduce the risk of fraud, (iii) making sure offering proceeds are distributed only when the designated funding targets are achieved, (iv) taking steps to ensure the privacy of investor information, and (v) not accepting transaction-based compensation or allowing any investment in the issuer by the intermediary company or its employees or affiliates.
8. Investors do not “count” as “holders of record.” Crowdfunding investors are not “counted” in determining the number of holders of record that trigger entry into the SEC’s periodic reporting system for public companies. However, crowdfunding issuers nevertheless will have post-offering obligations to make certain filings with the SEC.
9. Filings with SEC. Crowdfunding issuers, with the assistance of their crowdfunding intermediaries, are required to prepare, file with the SEC and provide to investors certain information, including (i) basic corporate, corporate governance and business description information, (ii) financial information which will range from tax returns to audited financial statements depending on the size of the offering, (iii) information about the issuer’s officers and directors and owners of more than 20% of the issuer, (iv) information about the offering, including the method of determining the offering price and (v) materials providing a reasonable opportunity to rescind the purchase.
10. One year restriction on resale. Resale of the securities purchased in crowdfunding transactions is restricted for one year after purchase, unless sold to an accredited investor or the issuer, is part of an SEC-registered offering or is transferred to a family member as a result of death, divorce or similar event.
11. Restrictions on issuer advertising and solicitation. Issuer advertising and general solicitation is permitted, but it must be limited to directing prospective investors to the broker-dealer or funding portal handling the offering.
12. Anti-fraud provisions. There are several anti-fraud provisions applicable to persons involved in crowdfunding transactions intended to protect crowdfunding investors.
As detailed as the crowdfunding requirements listed above may seem, they are only a summary of the applicable statutory provisions. In addition, virtually each of the areas discussed above is subject to modification by the SEC’s rule-making process. It is far too soon to know if crowdfunding will become an effective capital raising mechanism or if the statutory details and final rules will result in a little-used exemption, gathering dust in the statute books. We remain hopeful that the final rules will not overly burden issuers and their financial intermediaries.
As noted above, the statute calls for crowdfunding final rules to be adopted by early December 2012. Meeting this deadline looks to be a daunting task, especially because crowdfunding attracted quite a few critics as the JOBS Act moved through Congress. The critics, including senior SEC personnel, expressed serious concerns about the potential for crowdfunding to become the latest scam to defraud investors.
Given the amount of public interest in crowdfunding, we too are concerned that unscrupulous promoters will use the internet to offer “JOBS Act-approved” crowdfunding. We caution all our clients and friends to remember that there is currently no legal way to effect any crowdfunding transaction.
Other JOBS Act Reforms
The JOBS Act includes a number of other reforms that are not reviewed in this summary. They include (1) classifying securities issued in Revised Rule 506, crowdfunding and Regulation A+ transactions as “covered securities” exempted from substantive regulation by state securities laws and regulators; (2) allowing general solicitation and advertising in certain Rule 144A transactions, per rules to be adopted by the SEC; (3) increasing the “holders-of-record” threshold that triggers required entry into the periodic reporting regime for public companies under the Securities Exchange Act of 1934; and (4) exempting certain “matching services” from having to register as broker-dealers, provided they do not receive transaction-based compensation and meet certain other criteria.