On March 27, 2012, the U.S. House of Representatives passed the Jumpstart Our Business Startups Act (JOBS Act), as previously amended by the U.S. Senate.1 The bill has been sent to the President for his signature. The President is expected to sign the bill into law as the White House has publicly expressed its support for the bill.2
While certain provisions of the JOBS Act would be immediately effective upon enactment, other provisions would not be effective until the SEC promulgates rules implementing the provisions. Once the JOBS Act is enacted into law and the required SEC rulemaking is complete, the regulation of securities offerings by both private companies and smaller public companies, as well as the reporting obligations of many newly public companies, will be greatly relaxed.
Supporters of the JOBS Act maintain that its provisions would increase job creation and economic growth by (1) easing the initial public offering (IPO) process for “emerging growth companies” and reducing their regulatory burden, (2) improving the ability of companies to access capital via private offerings and small public offerings without Securities and Exchange Commission (SEC) registration and (3) allowing private companies with a substantial shareholder base to delay becoming a public reporting company. Critics of the JOBS Act, including the SEC, argue that the bill would remove long-standing investor protections that could impede capital formation3 and would change “the balance that existing securities laws and regulations have struck between the transaction costs of raising capital, on the one hand, and the combined costs of fraud risk and asymmetric and unverifiable information, on the other hand.”4
This client alert summarizes key provisions of the JOBS Act.
“IPO On-Ramp” Measures
The JOBS Act would amend the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act) to create a new category of public company known as an “emerging growth company” and relax the IPO process for, and regulatory burden on, these companies. These provisions (generally referred to as “IPO on-ramp” measures) phase-in certain public company regulatory requirements for qualifying companies over a period of up to five years following an IPO and are intended to reverse the decrease in domestic IPOs over the last decade. The IPO on-ramp measures would be effective immediately when the JOBS Act is signed into law and would not be dependent upon SEC rulemaking delays.
“Emerging growth company” defined. An “emerging growth company” would include any company with less than $1 billion of annual gross revenues during the most recently completed fiscal year. The $1 billion revenue threshold would seemingly cover most companies seeking to go public, not merely small or emerging companies. In fact, Dealogic has noted that 98 of the 107 companies that conducted IPOs in 2011 had less than $1 billion of revenue.5 Companies that completed an IPO on or before December 8, 2011 would not qualify as an emerging growth company.
A company would continue to qualify as an emerging growth company until the earliest of:
- the end of the fiscal year in which its annual gross revenues exceeds $1 billion;
- the date on which it has issued more than $1 billion in non-convertible debt during the previous three-year period;
- the date on which it is deemed to be a “large accelerated filer” (generally a company with at least $700 million in public equity float and at least a one year SEC reporting history); or
- the end of the fiscal year following the fifth anniversary of its IPO.
Although not entirely clear, the bill appears to allow companies that trigger public reporting requirements under the Exchange Act by exceeding shareholder of record thresholds, but that do not conduct an IPO, to remain an emerging growth company indefinitely and benefit from the reduced regulatory burden beyond the five-year limit for companies that conduct an IPO.
Easing of IPO requirements. To encourage IPOs, the JOBS Act would permit an emerging growth company to:
- present two, rather than three, years of audited financial statements in its IPO registration statement;
- exclude from its IPO registration statement (and any subsequent registration statements and periodic reports) selected financial data for any period prior to the earliest audited period presented in its IPO registration statement (as opposed to the general requirement to provide five years of selected financial data);
- only provide disclosure in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of its IPO registration statement that corresponds with the financial statements presented elsewhere in the registration statement;
- communicate (orally or in writing), either before or after the filing of a registration statement, with potential investors that are qualified institutional buyers (QIBs) or institutions that are accredited investors to solicit interest in a contemplated securities offering; and
- submit to the SEC a draft IPO registration statement and related amendments for confidential, non-public review, so long as the initial submission and all amendments are publicly filed with the SEC at least 21 days prior to the IPO road show.
Other measures intended to ease the IPO process would:
- remove restrictions on the ability of brokers and dealers to publish or distribute a research report about an emerging growth company that is the subject of a proposed public offering of common equity securities, regardless of whether before or after the registration statement is filed or effective, even if the broker or dealer (e.g., an investment bank) is participating or will participate in the registered offering;
- prohibit any restrictions regarding who may arrange for communications between securities analysts and potential IPO investors;
- allow securities analysts to participate alongside other investment banking representatives in communications with an emerging growth company’s management in connection with an IPO; and
- remove restrictions on the ability of a broker or dealer to publish or distribute any research report or make any public appearance about an emerging growth company’s securities during the standard lock-up period or any other post-IPO period.
Reduced post-IPO regulatory burden. For as long as it remains an emerging growth company, a company would:
- be exempt from the requirement to obtain an auditor attestation report on its internal control over financial reporting as required by Section 404(b) of the Sarbanes-Oxley Act of 2002 and related SEC rules, but would be required to maintain internal control over financial reporting and file CEO and CFO certifications as exhibits to its Form 10-Ks and 10-Qs;
- not be required to comply with any new or revised financial accounting standard until the date that a private company is required to comply with the accounting standard;
- not be required to comply with any rules adopted by the Public Company Accounting Oversight Board (PCAOB) that require mandatory audit firm rotation or a supplement to the auditor’s report where the auditor provides additional information about the audit and the financial statements;6
- not be required to comply with any additional PCAOB rules adopted after the JOBS Act’s enactment date unless the SEC determines otherwise;
- be exempt from the requirement to hold a say-on-pay vote or a say-on-frequency vote;
- be exempt from the requirement to provide golden parachute disclosures in certain merger proxy statements and to hold a corresponding say-on-golden parachute vote;
- be exempt from the requirement to provide the pay versus performance and ratio of CEO pay to median employee pay disclosures that will be required by the SEC once they promulgate rules later this year;7and
- be permitted to provide scaled executive compensation disclosure in accordance with the SEC’s rules applicable to smaller reporting companies (generally companies with less than $75 million of public equity float).
Relaxation of Restrictions on General Solicitation and General Advertising
The JOBS Act would mandate that the SEC relax existing restrictions on the use of general solicitation and general advertising in connection with private securities offerings pursuant to Securities Act Rule 506 of Regulation D if all of the purchasers are accredited investors and the company takes reasonable steps to verify the purchaser’s accredited investor status (using methods to be determined by the SEC). In addition, online and other platforms that permit the offer or sale of securities, general solicitations or general advertisements for Rule 506 offerings would be exempt from broker/dealer registration requirements under the Exchange Act so long as certain conditions are met.
The SEC would also be required to revise Securities Act Rule 144A to provide that securities sold under the exemption may be offered to persons that are not QIBs, including by means of general solicitation or general advertising, if the securities are only sold to persons that the seller reasonably believes are QIBs.
The JOBS Act would permit eligible companies to raise capital pursuant to crowdfunding efforts (i.e., allow a large group of people to make limited investments in a company, usually via the Internet) without registration under federal or state securities laws if:
- the aggregate amount of all securities sold to investors in reliance on the crowdfunding exemption during any 12-month period does not exceed $1 million;
- the aggregate amount sold to any investor in reliance on the crowdfunding exemption during any 12-month period does not exceed (1) the greater of $2,000 or five percent of the investor’s annual income or net worth (for investors with either an annual income or net worth of less than $100,000) or (2) ten percent of the investor’s annual income or net worth with a cap of $100,000 (for investors with either an annual income or net worth of $100,000 or more);
- the securities are sold through a broker or funding portal8 that complies with certain requirements, including registering with the SEC as a broker or funding portal and registering with any applicable self-regulatory organization; and
- the company satisfies numerous other investor protection requirements, including (1) filing with the SEC and providing to potential investors and the relevant broker or funding portal information that includes the company’s anticipated business plan, financial condition, financial statements and ownership and capital structure, (2) a prohibition on advertising the terms of the offering except for notices that direct investors to the broker or funding portal and (3) filing with the SEC and providing to investors at least annually reports of the company’s results of operations and financial statements as determined by SEC rulemaking.
The JOBS Act would:
- prohibit reliance on the crowdfunding exemption by (1) non-US companies, (2) companies subject to public company reporting requirements, (3) investment companies and companies excluded from the definition of investment company by Sections 3(b) or 3(c) of the Investment Company Act of 1940 and (4) any other company that the SEC determines appropriate;
- impose liability for material misstatements and omissions on the company and any director, partner, principal executive officers, principal financial officer and controller or principal accounting officer of the company or any other person that offers or sells the company’s securities pursuant to the crowdfunding exemption;
- restrict the transfer of securities by investors in a crowdfunding offering for one year, unless the securities are transferred (1) back to the company, (2) to an accredited investor, (3) as part of an SEC-registered offering or (4) in the SEC’s discretion, to a family member of the investor or in connection with the investor’s death or divorce;
- subject securities acquired in a crowdfunding offering to other limitations as the SEC deems necessary; and
- require the SEC to adopt rules that exempt a registered funding portal from the requirement to register with the SEC as a broker or dealer under the Exchange Act under certain circumstances.
While crowdfunding offerings would be exempt from registration with state securities commissions, the state securities commissions would retain the authority to investigate and take enforcement action against any company or intermediary for fraud, deceit or other unlawful conduct. In addition, the state of the company’s principal place of business and any state in which purchasers of fifty percent or more of the aggregate amount of the crowdfunding offering are residents would be permitted to require a notice filing and an associated fee in connection with the offering.9
Increased Regulation A Offering Exemption
The SEC would be required to adopt rules to expand the Regulation A small offering exemption for private companies by increasing the aggregate amount of equity securities, debt securities, convertible debt securities and guarantees that could be offered and sold over a 12-month period from $5 million to $50 million. Unlike offerings pursuant to the crowdfunding exemption, offerings pursuant to the expanded Regulation A exemption would be subject to registration under state securities laws unless the securities are (1) offered or sold on a national securities exchange or (2) offered or sold to qualified purchasers.
Increased SEC Registration and “Going Dark” Thresholds
Companies that are not banks or bank holding companies. The number of shareholders of record that would trigger public company reporting requirements under the Exchange Act would increase from 500 to 2,000 shareholders provided that the shareholders of record that are not accredited investors total less than 500.
Banks and bank holding companies. The number of shareholders of record that would trigger public company reporting requirements under the Exchange Act for banks and bank holding companies would increase from 500 to 2,000 shareholders without regard to the number of shareholders of record that are not accredited investors. In addition, the threshold for terminating public company reporting requirements (generally referred to as “going dark”) for banks and bank holding companies would increase from 300 to 1,200 shareholders of record.
Exclusions from shareholder of record calculation. The shareholder of record calculation for any company would exclude (1) employees that received company securities pursuant to an employee compensation plan in a transaction exempt from the Securities Act’s registration requirements (e.g., Securities Act Rule 701 offerings) and (2) purchasers of securities pursuant to the crowdfunding exemption. The SEC would be required to adopt rules to exclude purchasers of securities pursuant to the crowdfunding exemption and to revise the definition of “held of record” in its rules to exclude eligible employees.
The exclusion of shares held by eligible employees would encourage companies to provide equity compensation to their employees without having to worry about triggering public company reporting requirements as a result. However, this may not hold true in practice due to the increase in secondary private trading markets and the bill’s silence on the treatment of transferees of the employee’s shares, which presumably would be included in the shareholder of record calculation. Companies issuing shares pursuant to the crowdfunding exemption would be faced with similar concerns about triggering public company reporting requirements if the purchasers transfer their shares.
Impact of JOBS Act
Assuming the President signs the JOBS Act into law this week, it is too early to assess its full impact, especially as SEC rulemaking will affect the implementation of large portions of the law. However, we offer the following initial impressions.
IPOs. Like many other commentators we question how effective the bill would be in resurrecting the domestic IPO pipeline. The JOBS Act is somewhat schizophrenic on this point. While certain provisions would ease the IPO process by relaxing regulatory burdens, others would allow companies to not only stay private longer if they meet the greatly relaxed reporting thresholds and are not otherwise looking for an IPO exit but also increase their ability to raise capital without SEC registration.
However, for those companies that do choose to go public, the IPO on-ramp measures would be immediately effective and reduce the costs and regulatory burden associated with going public, as well as some of the costs of being a public company (as long as the company continues to qualify as an emerging growth company), which could accelerate the decision to go public. Also, the “test the waters” provisions would allow emerging growth companies to determine whether there was sufficient interest from institutional investors before incurring the time and expense associated with an IPO. Moreover, allowing emerging growth companies to submit a draft IPO registration statement confidentially would allow them to commence SEC review of a registration statement without publicly disclosing sensitive company information until they are sure they are ready to conduct an IPO.
Crowdfunding. The JOBS Act would legalize crowdfunding, although the type of crowdfunding permitted is different than the type of crowdfunding currently seen on sites such as Kickstarter. Currently, any individual (whether or not an accredited investor) can donate money to a company in exchange for goods or a product discount, but not equity. The legalization of what may be better referred to as “crowdinvesting” could help many small and early stage private companies that are currently unable to raise funds from angel investors or venture capital funds to obtain financing to fund operations between their startup days and the time when they could successfully raise money from angels or venture capital funds.
The legalization of crowdfunding should not obviate the need for private companies to raise funds from angels or venture capital funds as those sources of capital still can provide value beyond a capital infusion - namely, contacts, management guidance and experience. Moreover, the $1 million annual fundraising limitation means the crowdfunding exemption would have limited utility to all but the smallest and earliest stage companies. However, some commentators have expressed concern over whether companies that issue equity pursuant to the new crowdfunding exemption could be shunned by angels and venture capital funds in subsequent attempts to raise larger amounts of capital due to the diverse and unconnected nature of the shareholder base resulting from crowdfunding offerings. Among other things, a diverse base of shareholders with voting rights could make shareholder approval very difficult for subsequent corporate actions such as additional fundraising rounds, mergers and acquisitions.
Another concern raised is that the investor protection requirements associated with the crowfunding exemption may discourage use of the exemption. Due to the numerous investor protection requirements, including filing financial statements (that must be audited in certain circumstances) and other information with the SEC in connection with the offering and filing annual financial statements and other information with the SEC, and the limit on the amounts that can be raised, some eligible private companies may determine the cost of complying with the exemption is prohibitive and seek to rely on other registration exemptions to raise capital. Further, required SEC rulemaking could add to the investor protection requirements set forth in the bill.
Whether the various concerns surrounding crowdfunding are valid will be borne out over time as the SEC issues rules implementing the crowdfunding provisions and market practices develop.
Private placements. The ability to use general advertising and general solicitation once the SEC revises its rules should provide companies (both public and private, large and small) and investment funds relying on Securities Act Rules 144A and 506 with greater access to capital as they will be able to reach additional QIBs and accredited investors.
Regulation A offerings. As Regulation A has historically been a little used exemption, only time will tell if the increase in the offering thresholds once the SEC revises its rules will entice private companies to rely on the new rules in lieu of conducting an IPO or relying on another registration exemption. As the bill would require companies relying on the exemption to file audited financial statements with the SEC and authorize the SEC to adopt rules that require periodic disclosures of the company’s operations and financial condition, companies may decide to continue to rely on other registration exemptions when offering securities.
Assuming the JOBS Act is enacted into law this week, only certain provisions, including the IPO on-ramp measures, would be immediately effective. Companies would have to wait to take advantage of the JOBS Act’s other provisions until the SEC adopts implementing rules. Pursuant to the JOBS Act, the SEC would be required:
- within 90 days of the enactment date to revise Securities Act Rules 144A and 506 to allow general solicitation and general advertising;
- within 270 days of the enactment date to adopt rules to implement the crowdfunding exemption and related provisions;
- within one year of the enactment date to adopt rules to implement the increased public company reporting and going dark thresholds for banks and bank holding companies;
- to adopt rules to implement the changes to Regulation A required by the bill (the bill does not contain a rulemaking deadline); and
- to revise the definition of “held of record” in its rules to implement the bill’s exclusion of employees who acquire securities pursuant to an employee compensation plan (the bill does not contain a rulemaking deadline).
In addition, the SEC would be required to study and submit a report to Congress on (1) how the current registration requirements in Regulation S-K can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for emerging growth companies and (2) the impact that decimalization (i.e., trading and quoting securities in one penny increments) has had on the number of IPOs and on the liquidity for small and middle capitalization company securities.10
With the SEC already inundated with rulemaking requirements under the Dodd-Frank Act, we wonder how realistic it is to expect the SEC to satisfy the rulemaking deadlines set forth in the JOBS Act. In fact, SEC Chairman Mary Schapiro recently noted in a letter to Senators Tim Johnson and Richard Shelby that “H.R. 3606 requires a series of new, significant Commission rulemakings with time limits that are not achievable. For example, the rulemaking for the crowdfunding section has a deadline of 180 days…I believe a deadline of 18 months would be more appropriate for rules of this magnitude.”11 While the final bill would extend the crowdfunding rulemaking deadline to 270 days, that deadline is half of the time period Chairman Schapiro believes is appropriate. If the SEC’s Dodd-Frank Act rulemaking schedule is any indication, companies may have to wait for final rules implementing the JOBS Act beyond the statutory deadlines.
For the JOBS Act provisions that are not immediately effective, companies must continue to comply with existing laws and regulations regarding capital formation until the SEC adopts final rules. However, companies should stay tuned to developments regarding SEC rulemaking pursuant to the JOBS Act and should begin to consider how the bill would impact their future capital raising efforts.