On October 15, 2012, the SEC staff submitted to Congress the report (the “Report”) required by Section 504 of the JOBS Act on the SEC’s authority to enforce Rule 12g5-1(b)(3) under the Securities Exchange Act of 1934 (the “Exchange Act”). Section 504 of the JOBS Act required that the SEC examine its enforcement authority and determine whether new enforcement tools were needed to enforce the antievasion provision contained in Rule 12g5-1(b)(3). The Report concluded that the enforcement tools available to the SEC were adequate, and the staff did not make legislative recommendations for any additional tools.
Section 12(g) of the Exchange Act, as amended by the JOBS Act on April 5, 2012, requires an issuer2 to register its securities with the SEC and file periodic and current reports if it has total assets exceeding $10 million and a class of equity securities (other than an exempted security) that is “held of record” by either (i) 2,000 persons or (ii) 500 persons who are not “accredited investors.”3 Prior to the enactment of the JOBS Act, an issuer with more than 499 record holders was subject to the Exchange Act’s registration and reporting requirements. Rule 12g5-1(b)(3) of the Exchange Act, which is intended to prevent evasion of Section 12(g), requires an issuer to count beneficial owners as record holders if the issuer knows or has reason to know that a form of holding securities is being used primarily to circumvent Section 12(g).
According to the Report, the increased record holder threshold has raised concerns that special purpose vehicles (“SPVs”) established to pool investor funds and purchase interests in unregistered companies may be used to facilitate evasion of the Exchange Act’s registration and reporting requirements. Specifically, an issuer would have significantly fewer record holders if it were to count an SPV (rather than each investor in such SPV) as a single record holder for purposes of Section 12(g). The Report noted, however, that the increased record holder threshold may actually reduce circumvention concerns in respect of Section 12(g), although it acknowledged that the limit of 500 non-accredited investors could “prove to be a new area for possible circumvention efforts using special purpose vehicles.” The Report ultimately concluded that since the changes to the threshold were recently enacted, more time was needed before the impact (including the impact on possible circumvention efforts) could be assessed and, therefore, did not suggest any particular legislative recommendations regarding enforcement at this time.
Notably, despite coming to the conclusion that the SEC’s enforcement tools were sufficient, the Report discussed a number of challenges that make detecting and pursuing violations based on Rule 12g5- 1(b)(3) difficult. For example, according to the Report, it may be difficult to determine that an SPV was formed “primarily” to circumvent registration as there may be other reasons for holding securities through an SPV, including “to avoid triggering rights of first refusal or other contractual transfer restrictions common in private companies, to earn fees, to provide a service to clients, for tax or liability structuring or for some other purpose other than to circumvent Section 12(g).” In such situations, according to the Report, the SEC would need to prove that circumvention is a primary purpose rather than an ancillary effect of such form of holding. The Report also noted that it would be reasonable to assume that the “primarily” element of the rule would not ordinarily be met in situations where the issuer and its insiders and controlling stockholders were not involved in setting up such form of holding. Similarly, the Report observed that there are evidentiary challenges relating to the “knows or has reason to know” element of Rule 12g5-1(b)(3). The SEC staff noted that this would also turn, in part, on how involved the issuer was in creating or administering the SPV and that, absent any involvement by the issuer, it would be much harder to prove this element of the rule.
The Report also noted that Rule 12g5-1(b)(3) has rarely been invoked by the SEC or in private litigation.
For further discussion of the implications of the JOBS Act for private funds, please see the March 23, 2012 Davis Polk Client Newsflash, Senate Passes Legislation To Raise the 500 Shareholder Threshold for SEC Registration and To Relax General Solicitation Prohibition in Reg D Offerings.