President Obama is expected to sign the Jumpstart Our Business Startups (JOBS) Act within days, giving effect to some of the most significant changes in decades in the rules governing how small companies raise money. The bill enjoyed rare bipartisan support from legislators desperate for some accomplishment in an election year, passing the House with a vote of 390 to 23 on March 8, 2012 and, with amendments, the Senate with a vote of 73 to 26 on March 22, 2012. The House passed the bill again with the Senate amendments on March 27, by a vote of 380 to 41, and sent the bill to the White House for signature.
The JOBS Act is a compilation of several separate bills that originated in the House and that are related only by their relevance to capital formation. The Act:
- creates a new category of issuer called an “emerging growth company” that is subject to streamlined regulatory requirements for initial public offerings and for up to five years after going public;
- eliminates the ban on general solicitation and advertising for offerings under Rule 506 of Regulation D provided that all purchasers are accredited investors and under Rule 144A provided that all purchasers are qualified institutional buyers;
- creates a “crowdfunding exemption” that allows issuers to sell up to $1 million in any twelve month period through a broker or funding portal, provided that the amount sold to any investor does not exceed certain limits tied to the income or net worth of the investor, with a maximum of $100,000;
- increases from $5 million to $50 million the offering limit for small, public offerings exempt from Securities and Exchange Commission (the SEC) registration and reporting requirements; and
- increases the number of shareholders that private companies are permitted to have before requiring registration and reporting under the SEC rules from 500 to 2,000 (provided that registration is also required if the number of nonaccredited investors exceeds 500).
Emerging Growth Company
The JOBS Act defines a new category of company called an “emerging growth company” and frees these emerging growth companies from some of the regulatory burdens applicable to other public companies. An emerging growth company is defined as an issuer that had annual gross revenues of less than $1 billion during its most recently completed fiscal year. Status as an emerging growth company is intended to be a transition phase that eases the company into the full regulatory framework and continues for only five years following a company’s initial public offering. A company may also lose emerging growth company status if it issues more than $1 billion in debt over a three year period or if the value of the stock held by nonaffiliates of the company, known as the “public float,” grows to $700 million or more.
Most existing public companies will not be able to take advantage of the streamlined regulatory requirements applicable to emerging growth companies. Existing public companies that first sold shares in an offering registered under the Securities Act of 1933 with the SEC on or before December 8, 2011, may not be an emerging growth company.
Emerging growth companies won’t have to comply with certain disclosure requirements, some of which were added in recent years by the Sarbanes Oxley Act of 2002 or the Dodd Frank Act of 2010. Set forth below are the most significant requirements that will not apply to emerging growth companies.
- Say on Pay. Most public companies are required to include in their proxy statements a resolution asking shareholders to vote to approve the compensation paid to the company’s executive officers. In addition, these public companies must ask the shareholders to vote on how often (every one, two or three years) the vote on compensation should take place. Emerging growth companies will not have to comply with the say on pay rules.
- Pay vs. Performance. Most public companies are required to include in their proxy statements information that shows the relationship between executive compensation actually paid and the financial performance of the company, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions. Emerging growth companies will not have to comply with the pay vs. performance rules.
- Ratio of CEO comp to Median Comp of Other Employees. The Dodd Frank Act of 2010 requires the SEC to adopt rules obligating public companies to disclose the ratio of the median annual compensation of all employees other than the CEO to the annual compensation of the CEO. The SEC has not yet adopted these rules, but when they do, emerging growth companies will be excluded from the requirement.
- Financial Statements. The registration statements of most public companies must have three years of audited financial statements. Emerging growth companies will be required to provide only two years of audited statements. In addition, emerging growth companies will not be required to comply with new GAAP accounting pronouncements for public companies until the pronouncements are also applicable to private companies.
- Auditor’s Report on Internal Controls. One of the most controversial and costly requirements of the Sarbanes Oxley Act of 2002 requires public companies to engage their auditors to attest to, and report on, management’s assessment of the Company’s internal controls. Emerging growth companies will not be required to provide such auditor attestation reports on internal controls.
- New PCAOB Rules. Emerging growth companies will not be required to comply with rules of the Public Company Accounting Oversight Board (the “PCAOB”) requiring mandatory audit firm rotation or a supplement to the auditor’s report covering additional information about the audit and the financial statements.
- Compensation Disclosure. The SEC’s detailed compensation disclosure rules require extensive disclosure of compensation paid to the Company’s executive officers and directors. In recognition that these disclosure obligations are particularly burdensome on smaller companies, the SEC rules define a category of “smaller reporting companies” and allow these companies to provide less extensive disclosure. The definition of “smaller reporting companies” includes, among other things, a requirement that the value of the stock held by nonaffiliates (the public float) is less than $75 million. The JOBS Act allows emerging growth companiesto comply with same rules as smaller reporting companies.
Tearing Down the Wall between Investment Bankers and Research Analysts. In the aftermath of the tech bubble in 2000, regulators including the SEC and the National Association of Securities Dealers (the NASD) concluded that research analysts contributed to the bubble by touting stocks in order to win investment banking business for their firms. In many cases, the compensation arrangements for research analysts provided an incentive for the analysts to promise favorable research coverage. As a result, analysts frequently wrote research reports that were more favorable than the analyst’s actual, private assessment, leading to unsustainable increases in stock prices. Eventually, poor performance caused the prices to crash, resulting in losses for the investors that had been misled. To address this problem, the SEC, the NASD and stock exchanges adopted rules separating research analysts from the investment banking process and prohibiting compensation of research analysts from the fees earned from investment banking business.
The JOBS Act rolls back some of these restrictions for research analysts providing coverage of emerging growth companies. In connection with initial public offerings of emerging growth companies, brokers and dealers will be able to publish research reports before, during or after the offering even if the broker or dealer is participating in underwriting the offering. In addition, research analysts may participate with the investment banking team in communicating with management of an emerging growth company. Existing rules prohibiting research analysts from soliciting investment banking business will presumably continue to apply.
Confidential Filing of Registration Statements. Generally, when a company files a registration statement with the SEC for an initial public offering, the registration statement becomes publicly available immediately on the SEC’s website. Many companies consider the disclosure of the extensive information in the registration statement to be harmful to the company because of the possibility that it will provide an advantage to competitors or because management may be sensitive to the disclosure of compensation information. In particular, companies are often concerned that if the disclosure is made and the company is unable to complete the offering, the company will have suffered the harm of disclosure without obtaining the benefit of the offering. The JOBS Act addresses this problem for emerging growth companies by allowing such companies to submit a registration statement to the SEC for review confidentially, provided that the initial registration statement and any amendments must be publicly filed with the SEC not later than 21 days before the date on which the issuer conducts a road show.
Testing the Waters. Existing law prohibits companies from communicating with investors about a proposed public offering prior to the filing of the registration statement. The JOBS Act permits emerging growth companies to communicate with accredited investors as defined by Regulation D and qualified institutional buyers as defined by Rule 144A prior to or following the date of filing a registration statement to determine whether they have an interest in a contemplated offering.
General Solicitation in Regulation D, Rule 506 Offerings and Rule 144A Offerings
Since its adoption in 1983, Regulation D has prohibited any private placement offering of securities by any means of “general solicitation or general advertising” which includes communications in newspapers, magazines, or broadcast over television or radio or over the internet. The JOBS Act requires the SEC to revise Regulation D within 90 days after the date of enactment of the JOBS Act to provide that the prohibition on general solicitation or general advertising shall not apply to offers and sales of securities under Rule 506, provided that all purchasers are accredited investors. The new rule will require issuers to take reasonable steps to assure that all purchasers are accredited.
The new rules will allow companies conducting private placements to offer their securities on websites that are accessible to anyone, provided that the company takes reasonable steps to assure that any purchaser is an accredited investor. In addition, the JOBS Act provides that any person that maintains such a website, or any other platform or mechanism that permits the offer or sale of securities by general solicitation or general advertising, will not be deemed a broker-dealer under the Securities Act, provided that such person (a) receives no compensation in connection with the purchase or sale of a security, (b) does not have possesssion of customer funds or securities, and (c) is not subject to a statutory disqualification.
The JOBS Act also requires the SEC to revise Rule 144A within 90 days after the enactment of the JOBS Act to eliminate the prohibition on general solicitation and general advertising in connection with resales to qualified institutional buyers (QIBs) under Rule 144A. The change will permit Rule 144A sellers to offer the securities to persons other than QIBs as long as sales are made only to persons the seller reasonably believes are QIBs.
“Crowdfunding” generally refers to raising money from lots of people, each contributing a small amount, typically via the internet. Websites such as Kickstarter use crowdfunding to raise money through donations for nonprofits or artistic projects, but federal securities laws have until now prohibited the sale of securities through crowdfunding. The JOBS Act creates a “Crowdfunding Exemption” that allows companies to sell securities without registration under the Securities Act, provided that (a) the aggregate amount sold by the issuer during the preceding 12 month period does not exceed $1 million, (b) the aggregate amount sold to any investor during the preceding 12 month period does not exceed certain limits tied to the income or net worth of the investor, with a maximum of $100,000; (c) the transaction is conducted through an intermediary that is either a broker or a funding portal that complies with registration, disclosure and other requirements; and (d) the issuer complies with various filing and disclosure requirements.
Crowdfunding Intermediaries. The JOBS Act requires all crowdfunding offerings to take place through an intermediary that is required to comply with rules designed to prevent fraud. Intermediaries must be registered with the SEC as either a broker or a funding portal and also registered with any applicable stock exchange or self regulatory organization. The intermediary is obligated to ensure that each investor is aware of the risks of the investment and take measures to reduce the risk of fraud, including obtaining a background check on each officer, director and 20 percent shareholder of the issuer. Intermediaries are prohibited from compensating promoters, finders or lead generators for referring potential investors. In addition, an intermediary must prohibit its own directors, officers or partners from having any financial interest in any issuer using its services.
The JOBS Act defines a “funding portal” as any person acting as an intermediary in an offering pursuant to the crowdfunding exemption, that does not:
- offer investment advice or recommendations;
- solicit purchases, sales or offers to buy the securities offered 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.
Required Issuer Disclosure. Issuers seeking to take advantage of the crowdfunding exemption must file with the SEC and provide to investors and the intermediary disclosure regarding:
- the name, legal status, physical address, and website address of the issuer;
- the names of the directors, officers and each 20% shareholder of the issuer;
- the issuer’s business and anticipated business plan;
the issuer’s financial condition, including
- if the amount being raised is $100,000 or less, income tax returns and financial statements of the issuer certified by the principal executive officer as true and correct;
- if the amount being raised is more than $100,000 but not more than $500,000, financial statements reviewed by a public accountant;
- if the amount being raised is more than $500,000, audited financial statements;
- use of proceeds;
- the target offering amount, the deadline to reach the target offering amount and regular updates on progress in meeting the target;
- offering price or method for determining the price;
- ownership and capital structure of the issuer; and
- such other information as the SEC may prescribe for the protection of investors.
The intermediary is required to make the issuer’s disclosure material available to the SEC and to potential investors not later than 21 days prior to the first day on which securities are sold to any investor.
Target Offering Amount. Every crowdfunding offering must include a minimum offering amount, determined by the issuer, that must be reached before any proceeds are delivered to the issuer. This “target” offering amount must be disclosed to investors and the intermediary is obligated to ensure that all offering proceeds are provided to the issuer only when the target offering amount is reached.
Limits on Investor Purchases. The aggregate amount sold to any investor is subject to limits based on the income or net worth of the investor. If either the annual income or the net worth of the investor is less than $100,000, the investor may not purchase more than the greater of $2,000 or 5 percent of the annual net income or net worth of such investor, as applicable. If either the annual income or net worth of the investor is equal to or more than $100,000, the investor may not purchase more than 10 percent of the annual income or net worth of such investor, up to $100,000.
Resale Restrictions. Securities issued pursuant to the crowdfunding exemption may not be transferred during the one year period following the date of purchase, except to the issuer, an accredited investor, a family member of the purchaser, in connection with the death or divorce of the purchaser or as part of an offering registered with the SEC.
Liability for Misstatements and Ommissions. Issuers and their directors and certain officers will be liable for claims by purchasers if in connection with the offer or sale of securities pursuant to the crowdfunding exemption the issuer makes an untrue statement of material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading.
Preemption of State Law. The JOBS Act defines securities issued pursuant to the crowdfunding exemption as “covered securities” not subject to state laws with respect to registration, documentation or offering requirements. States will have authority to regulate and enforce state laws with respect to fraud or deceit, unlawful conduct by a broker or dealer and unlawful conduct by an intermediary, issuer or custodian.
Increase in the Number of Shareholders Permitted Without Registration.
Before the JOBS Act, a company was required to register under the Securities Exchange Act of 1934 and begin the burdensome process of filing reports with the SEC as a public company if, at the end of its fiscal year, the company had at least $10 million in assets and a class of equity security held of record by 500 or more persons. Many private companies have been forced by this provision to become public companies before they were ready as the number of shareholders increased with the issuance of shares in financing transactions and also as equity compensation to employees. The JOBS Act amends this provision, requiring private companies to register if, at the end of its fiscal year, the company has at least $10 million in assets and a class of equity security held of record by either (i) 2,000 persons, or (ii) 500 persons who are not accredited investors. Under the JOBS Act, banks and bank holding companies don’t have to register unless they have, at the end of the fiscal year, at least $10 million in assets and a class of equity security held of record by 2,000 or more persons.
Importantly, the JOBS Act instructs the SEC to revise the definition of “held of record” to exclude from the count securities received pursuant to an employee compensation plan in an exempt transaction and securities purchased by persons pursuant the crowdfunding exemption. Since these are two of the most likely avenues for the issuance of securities to nonaccredited investors, a company may have a significant number of nonaccredited investors that will not be counted against the 500 shareholder limit (or the 2,000 shareholder limit) described above.
SEC to Adopt Rules Increasing Ceiling for Regulation A-Type Offerings to $50 Million
Section 3(b) of the Securities Act of 1933 grants the SEC authority exempt certain offerings from the registration requirements of the Act provided the protections of the Securities Act are not necessary “for the protection of investors by reason of the small amount involved or the limited character of the public offering . . .” Pursuant to this exemption, the SEC originally adopted Regulation A in 1936 with an offering limit of $100,000 and then increased the offering limit from time to time through the years, most recently to $5 million in 1992. The JOBS Act amends Section 3(b) of the Act to require the SEC to adopt rules providing for an an offering of up to $50 million.
While it is not clear whether the SEC will amend Regulation A or adopt an entirely new regulation to comply with this mandate, the resulting exemption is likely to be similar in many respects to the current Regulation A. Regulation A permits the offering to be sold publicly and the shares sold to trade freely and the JOBS Act provides the same for the new exemption. One of the most significant advantages of Regulation A is that it does not obligate the issuer to comply with the public company filing requirements under the Securities Exchange Act. The new exemption under the JOBS Act also does not require compliance with the existing public reporting regime, but states the SEC shall require the issuer to file audited financial statements with the SEC annually and may require an issuer to file with the SEC periodic disclosures. The extent of the reporting requirements will depend upon what the SEC requires in its regulations. One of the disadvantages of Regulation A is the lack of preemption of state law, requiring issuers to comply with applicable state regulation in each state in which the offering takes place. Securities sold pursuant to the new exemption under the JOBS Act will not be subject to state registration or exemption requirements, provided that the securities are offered and sold on a national securities exchange or offered and sold to a qualified purchaser, as that term is defined by the SEC.
Although many provisions of the JOBS Act are statutory changes that will become effective upon enactment, the JOBS Act also requires the SEC to revise or make rules to implement certain provisions which will not be effective until such rules are adopted. In addition, the JOBS Act instructs the SEC to conduct several reviews of existing regulations with a view to streamlining additional regulations for emerging companies. The provisions relating to emerging growth companies are largely statutory and will become effective upon enactment. The change to Rule 506 of Regulation D eliminating the ban on general solicitation requires an SEC rule to be adopted within 90 days of the enactment of the JOBS Act and won’t be effective until the new rule is adopted. The framework for the crowdfunding exemption is contained in statutory changes that will become effective upon enactment, but the SEC is required to adopt rules governing many of the detailed requirements of the exemption which will likely delay availability of the exemption. The SEC is also required to adopt rules to create the new small offering exemption under Section 3(b) for offerings up to $50 million. The changes to the number of shareholders that private companies may have before they are forced to file as a public company are statutory changes that will become effective upon enactment, but the changes to the definition of “held of record” require SEC rulemaking.