[authors: Michael E. Slipsky, David R. Krosner]
Earlier this year, President Obama signed the Jumpstart Our Business Startups Act (commonly known as the JOBS Act) into law. As the somewhat repetitive name implies, the JOBS Act’s ultimate goal is to spur job creation by easing the federal securities regulation burden on small businesses.
The JOBS Act takes a five-pronged approach to achieving its goal, by (1) creating an “on-ramp” to public company status for certain “emerging growth companies,” (2) easing the prohibition on general solicitation and advertising in connection with private securities offerings, (3) permitting limited use of “crowdfunding” techniques in private securities offerings, (4) increasing the dollar-limit on Regulation A “mini public offerings,” and (5) enabling issuers to stay private longer by increasing the number of shareholders an issuer may have before it is required to register its stock under the Securities Exchange Act of 1934.
Each of these five provisions is discussed in more detail below.
Public Company “On-Ramp” Provisions
In an effort to reduce the regulatory burdens imposed by going public, the JOBS Act creates a new class of issuers called “emerging growth companies” or EGCs. An EGC is defined as a company with less than $1 billion in gross revenues; however, EGC status is not available to issuers who sold shares of their common stock in an IPO occurring on or prior to December 8, 2011. An issuer’s EGC status is subject to phasing out upon (a) the EGC exceeding $1 billion in annual gross revenue, (b) the fifth anniversary of the EGC’s IPO, (c) the EGC issuing, during the prior 3-year period, more than $1 billion in non-convertible debt, or (d) the EGC becoming a “large accelerated filer.”
Issuers seeking to go public stand to benefit from EGC status in the following ways:
Less financial information required. EGCs are only required to present 2 years of audited financial statements (as opposed to 3 years for non-EGCs), and the JOBS Act provides similar relief from requirements to provide selected financial data and management's discussion and analysis for years prior to those covered by the audited financials.
“Testing the Waters” permitted. An EGC may communicate with qualified institutional buyers and institutional accredited investors in order to “test the waters” either prior to or after the initial filing of its registration statement with the SEC.
Research reports permitted. The JOBS Act eliminates the post-IPO “quiet period” for EGCs, allowing investment banks to publish and distribute research reports about EGCs that propose to go public or are in the process of doing so.
Confidential Submission of Draft Registration Statements. EGCs are permitted to begin SEC registration by submitting draft registration statements for nonpublic review prior to the initial public filing. This process allows an EGC to get a better understanding of the SEC staff’s potential concerns with a proposed IPO before the EGC is required to air its proverbial “dirty laundry” in the initial public filing of its registration statement.
Scaled-Down Governance and Disclosure Requirements. The JOBS Act dramatically scales down other regulatory requirements for EGCs.
For example, ECGs are generally exempt from the Dodd-Frank Act’s “say-on-pay” requirements and several of its executive compensation disclosure requirements.
ECGs are also exempt from the Sarbanes-Oxley Act’s requirement to have an independent auditor attest to the ECG’s internal financial controls.
Additionally, ECGs are not required to comply with new or revised financial accounting standards until such standards are broadly applicable to private companies.
The ECG “on-ramp” provisions became effective immediately upon enactment of the JOBS Act, and Poyner Spruill attorneys have already seen clients and related parties take advantage of the benefits afforded by them.
Easing the Prohibition on General Solicitation and Advertising in Connection with Private Securities Offerings
Private companies seeking to raise capital often rely upon the registration exemption contained in Rule 506 of Regulation D. Prior to enactment of the JOBS Act, the Rule 506 exemption permitted issuers to sell securities to “accredited investors” (i.e., those deemed sufficiently sophisticated to not require the protection that registration would otherwise afford them) and up to 35 non-accredited investors in unlimited amounts with no mandatory disclosure requirements for any accredited investors, provided that the issuer refrained from engaging in general solicitation or advertising in connection with the offering.
The JOBS Act expands the Rule 506 registration exemption by directing the SEC to promulgate rules that eliminate the prohibition on general solicitation and advertising; provided that all purchasers in the Rule 506 offering are “accredited investors.”
On August 29, 2012 (a mere 8 weeks later than the deadline established by Congress), the SEC proposed a new Rule 506(c) to implement these changes. Final rules are expected to be released this month.
Under the proposed rules, general solicitation and advertising would be permitted in Rule 506 offerings if the following requirements are met:
“Reasonable steps” must be taken to verify that the purchasers are accredited investors; and
All purchasers must either meet the definition of “accredited investor” set forth in Rule 501(a) of Regulation D or the issuer must reasonably believe that they do so.
Proposed Rule 506(c) does not specify any means of verifying that purchasers are accredited investors. Rather, issuers are instructed to consider the facts and circumstances of each transaction, including the following factors:
The type of purchaser and the type of accredited investor that the purchaser claims to be;
The amount and the type of information that the issuer has about the purchaser; and
The nature of the offering (i.e., the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount).
The SEC’s proposed approach appears to have achieved flexibility but at a cost of subjectivity and uncertainty. Assuming that the final rules take a similar approach to investor verification, issuers who wish to rely upon Rule 506(c) will need to consult closely with their legal advisers in crafting an accredited investor verification process that will pass regulatory muster.
It is important to note that the proposed rules would also preserve the existing provisions of Rule 506, so that issuers could choose to conduct Rule 506 offerings without the use of general solicitation and advertising, and, therefore, without being subject to the new accredited investor verification rules under Rule 506(c).
Issuers should not rely on Rule 506(c) in conducting securities offerings until the SEC releases its final rules.
The JOBS Act adds a new Section 4(6) to the Securities Act of 1933, which creates a new registration exemption for certain “crowdfunding” offerings made by private U.S. issuers.
“Crowdfunding” generally refers to a method of raising capital by soliciting relatively small investments from a relatively large group of investors, typically via the internet. The Section 4(6) exemption allows an eligible issuer to raise up to $1 million over a 12-month period from an unlimited number of investors, subject to the issuer’s satisfaction of several key conditions:
Individual investment limits for lower income/net worth investors. For an investor with an annual income or net worth of less than $100,000, such investor’s total purchases during the 12-month period may not exceed the greater of $2,000 or 5% of the investor’s annual income or net worth.
Individual investment limits for higher income/net worth investors. For an investor with an annual income or net worth of $100,000 or more, such investor’s total purchases during the 12-month period may not exceed 10% of the investor’s annual income or net worth, not to exceed a maximum aggregate amount of $100,000.
Use of broker or funding portal required. The crowdfunding offering must be conducted through an SEC-registered broker or a “funding portal” that complies with the exemption’s requirements.
A “funding portal” is defined to mean an intermediary that does not (1) offer investment advice or recommendations; (2) solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; (3) compensate employees, agents or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; (4) hold, manage, possess, or otherwise handle investor funds or securities; or (5) engage in any other activities hereafter prohibited by rules adopted by the SEC.
No advertising; required disclosures. Issuers utilizing new Section 4(6) must not advertise the terms of the offering and must file prescribed disclosure documents with the SEC.
While Section 4(6) has been enacted into law, the crowdfunding exemption will require SEC rulemaking before it can become effective as a practical matter. The JOBS Act set a December 31, 2012 deadline for the SEC to promulgate the implementing rules. To date, the SEC has not released any proposed rules.
Although the crowdfunding exemption will allow issuers to tap previously unavailable pools of smaller investors, it remains to be seen whether the benefits of crowdfunding techniques will outweigh the potential costs and burdens.
For example, a successful crowdfunding offering could result in an issuer having a large number of unsophisticated investors in its shareholder base, which may increase the issuer’s administrative burden in conducting its corporate governance processes, make it more difficult to attract institutional investors, and/or increase the difficulty of consummating M&A transactions or other material transactions that require shareholder approvals. In addition, most issuers will likely discover that it is difficult to attract significant investments from large groups of unknown purchasers.
Regulation A+ “Mini Public Offerings”
At present, Regulation A provides a registration exemption for issuers seeking to raise up to $5 million within a 12-month period. In light of that $5 million offering limit, Regulation A’s relatively onerous regulatory requirements (e.g., an offering circular must be filed with and approved by the SEC, and the offering must comply with state securities laws) have rendered it an unpopular option for prospective securities issuers.
The JOBS Act attempts to make Regulation A more attractive to issuers by directing the SEC to either amend Regulation A (or create a similar exemption) so as to increase the offering limit to $50 million per each 12-month period (with such amount to be subject to biannual SEC review and adjustment). Furthermore, provided that the securities are offered or sold on a national securities exchange, or are offered or sold to “qualified purchasers,” they will be deemed to be “covered securities” and thereby exempt from state securities law regulation.
Securities law practitioners and commentators have been informally referring to these portions of the JOBS Act as “Regulation A+.”
Issuers may come to view Regulation A+ as a viable alternative to Rule 506, which is currently the most popular registration exemption for private issuers. Regulation A+ will offer the following potential advantages over Rule 506:
No wealth/income threshold for investors. Regulation A+ will permit sales to non-accredited investors, unlike Rule 506 offerings, which must be restricted to accredited investors in order to avoid mandatory disclosure requirements and the prohibitions on general solicitation and advertising.
Unrestricted securities. Securities issued under Regulation A+ will not be subject to resale restrictions (except to the extent that they are held by affiliates of the issuer).
Public offering. Unlike Rule 506 (even as amended by the JOBS Act to permit general solicitation and advertising in limited circumstances), Regulation A+ permits a true public offering and sale of securities as a matter of course.
Thus, Regulation A+ may appeal to issuers who want to avoid the restrictions imposed by Rule 506 but who do not want to incur the expenditures of time and money that would be required by a full-blown public offering and/or who do not wish to become subject to the ongoing public reporting requirements of the Securities Exchange Act of 1934.
As noted above, Regulation A+ will require SEC rulemaking in order for the revised exemption to be implemented and become effective; however, the JOBS Act did not include a target deadline for such rules, nor has the SEC announced a timeframe for doing so.
Private Holder Cap Increase
In general, prior to the changes adopted by the JOBS Act, the Securities Exchange Act of 1934 required issuers to register a class of securities with the SEC if such securities were held of record by at least 500 people and the issuer had assets in excess of $10 million.
The effect of such registration is to burden the issuer with a number of public reporting obligations, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statements on Schedule 14A, even if the issuer’s securities are not listed on a securities exchange. Thus, if the 500-holder/$10 million in assets threshold is crossed, a purportedly “private” issuer can be required to disclose a great deal of information to the public (and its competitors) but without the concomitant advantages of having access to the public capital markets.
The preexisting 500-holder/$10 million assets threshold, which had not been increased since 1996, had become increasingly troublesome for private companies who prefer to raise capital in private securities offerings and/or who utilize stock-based compensation plans to attract and retain employees—i.e., after completing several rounds of financing and implementing an employee equity compensation plan, a private company may find itself perilously close to the 500-holder cap, particularly if the company’s stock is being traded on one of the secondary markets that specialize in pre-IPO securities.
The JOBS Act addresses these concerns by increasing the holder threshold to 2,000 holders of record, provided that no more than 499 of those holders are non-accredited investors. Importantly, the JOBS Act amends the definition of “held of record” to exclude securities held by persons who received them pursuant to an employee compensation plan. Similarly, securities sold in exempt crowdfunding offerings are excluded from the “held of record” definition. As a result of these revisions, private companies should have significantly more flexibility in determining when and how they will become subject to SEC reporting obligations.
The increased holder thresholds became effective upon enactment of the JOBS Act; however, the amendments to the “held of record” definition will require SEC rulemaking, which has not yet occurred and which is not subject to any specified deadline.