On December 4, President Obama signed into law the Fixing America’s Surface Transportation Act (FAST Act). Division G (Financial Services) of the FAST Act seeks to promote capital formation by implementing changes to the federal securities laws and directing the SEC to amend its rules to ease regulatory burdens on capital-raising activities by smaller companies.
The new law largely represents a continuation of Congressional initiatives enacted in 2012 through the Jumpstart Our Business Startups Act (JOBS Act). Among its most noteworthy provisions, the FAST Act introduces additional accommodations for “emerging growth companies,” a category of small issuers created by the JOBS Act, and directs the SEC to extend to “smaller reporting companies” some registration benefits previously available only to larger issuers. Congress also is requiring the SEC to take additional action to simplify and modernize disclosure requirements for Exchange Act reporting and securities offerings. In a less expected reform, the FAST Act creates a new statutory exemption from Securities Act registration for private resales of securities by affiliates and other security holders.
Some provisions of the FAST Act are self-executing and became effective at the date of enactment, while other provisions will require SEC rulemaking to become operative.
The FAST Act may be viewed here.
Accommodations for emerging growth companies
The FAST Act eases three existing SEC requirements applicable to the initial public offering (IPO) process for emerging growth companies. The JOBS Act defines an emerging growth company (EGC) as an issuer that had “total annual gross revenues” of less than $1 billion in its most recent fiscal year. The $1 billion threshold, which is indexed for inflation every five years, is high enough to encompass a sizable majority of the companies that have completed IPOs in recent years.
Shortened period between public filing and IPO road show. The JOBS Act permits an EGC to submit to the SEC its IPO registration statement and all amendments on a confidential basis for review by the SEC staff so long as it publicly files the registration statement and all previously submitted drafts before the start of its IPO road show. The FAST Act reduces from 21 days to 15 days the minimum period during which the IPO registration statement must be on file before the issuer begins the road show. This provision became effective upon enactment. In an announcement concerning the FAST Act issued on December 10, the SEC’s Division of Corporation Finance stated that EGCs with registration statements pending before enactment of the new law or at any later date may take advantage of the provision. The Division confirmed that, for any EGC that will not conduct a road show, the FAST Act also has the effect of shortening from 21 to 15 days the minimum period during which the IPO registration statement must be on file before it becomes effective.
Grace period for loss of EGC status. An EGC that initiates the IPO process, either by submitting a draft registration statement or by filing it publicly, could lose EGC status if it crosses the $1 billion revenue threshold while its registration statement is under review. After the adoption of the JOBS Act, the SEC staff issued guidance stating that, if an issuer is an EGC at the time it publicly files its IPO registration statement but ceases to be an EGC during the SEC review process, the issuer may continue to rely on the EGC rules through the effective date of the registration statement. The FAST Act extends the grace period by providing that if the issuer was an EGC at the time it submitted a confidential IPO registration statement (or, if it did not make a confidential submission, at the time it publicly filed the registration statement) and ceases thereafter to be an EGC, it will continue to be treated as an EGC until the date on which it consummates its IPO or, if earlier, until the end of the one-year period beginning on the date it ceased to be an EGC. This provision became effective upon enactment. The Division of Corporation Finance has stated that EGCs with registration statements pending at time of the new law’s enactment may rely on the new accommodation.
Simplified disclosure requirements relating to financial information. The third accommodation for EGCs enacted in the new law will permit those issuers to omit from their IPO registration statements during the SEC review process historical financial information for fiscal periods that will not have to be included in the registration statement at the time the offering commences. The new law directs the SEC to revise Form S-1 and Form F-1 under the Securities Act to specify that an EGC may omit from a filed or confidentially submitted registration statement financial information for historical periods that are otherwise required by the SEC’s Regulation S-X as long as:
- The omitted financial information relates to a historical period that the issuer reasonably believes will not be required to be included in the registration statement at the time of the offering, and
- Before it distributes a preliminary prospectus to investors, the issuer amends the registration statement to include all financial information required by Regulation S-X at the date of the amendment.
Although the provision will become effective 30 days after the date of enactment (January 3, 2016), the Division of Corporation Finance has stated that it “will not object if EGCs apply this provision immediately.”
This change has the potential to streamline the preparation of financial statements and reduce the expense of offerings. EGCs generally are required to include audited financial statements only for the two most recent fiscal years, as well as unaudited financial statements for any subsequent interim period. Under the new relief, if an EGC believes that its offering will occur after a date by which it will have to include audited financial statements for a new fiscal year, the EGC may submit its draft registration statement containing audited financial statements only for the fiscal year it expects will have to be included for the offering, and omit audited financial statements for the prior fiscal year it believes will not be required at the time of the offering.
Forward incorporation by reference in Form S-1 by smaller reporting companies
The FAST Act requires the SEC to amend Form S-1 to allow "smaller reporting companies" to incorporate by reference in a registration statement on that form any documents the company files after the effective date of the registration statement. A smaller reporting company is an issuer that (a) has a common equity public float of less than $75 million or (b) if that float is zero, had revenues of less than $50 million for its most recent fiscal year. The Form S-1 amendments permitting “forward incorporation by reference” by these issuers are required to be adopted by the SEC within 45 days after the enactment date (January 18, 2016).
The approval of forward incorporation extends to the smallest class of issuers in the SEC reporting regime registration benefits that previously were available only to larger companies. In the securities offering reforms of 2005, the SEC for the first time permitted issuers not eligible to use Form S-3 to incorporate by reference in their Form S-1 registration statements Exchange Act reports and other materials filed by them before the registration statements became effective. The SEC, however, declined to permit those issuers to incorporate by reference documents filed after the effective date, alluding to the adverse impact on investor protection that could result from forward incorporation by a class of issuers less widely followed by the marketplace than companies eligible to use Form S-3.
The ability to incorporate by reference all Exchange Act filings will make it easier for smaller reporting companies to maintain current shelf registration statements covering continuous primary securities offerings or resale offerings by security holders. In the absence of forward incorporation, such issuers regularly have had to amend their registration statement disclosures to add information contained in their periodic and current reports under the Exchange Act. If the Form S-1 amendments conform to the current requirements for Form S-3, these companies no longer will have to file amended prospectuses under Securities Act Rule 424 or use the cumbersome post-effective amendment process to update information in their Form S-1 registration statements after they have become effective.
Excluded from the new provision, and therefore still not eligible to use forward incorporation by reference, are those issuers that are both not eligible to use Form S-3 and not smaller reporting companies.
Summary page for Form 10-K
The FAST Act requires the SEC, within 180 days after the enactment date (June 1, 2016), to issue rules that permit companies to include a summary page in their annual reports filed on Form 10-K so long as each item in the summary includes a cross-reference to material contained in the report. In commenting on this provision, the Division of Corporation Finance noted that a reporting company currently may include a summary in its Form 10-K report if the summary fairly represents the material information in the report.
Improvement, modernization and simplification of Regulation S-K
Continuing the focus of the JOBS Act, the new law imposes additional rulemaking mandates on the SEC intended to promote capital formation.
The FAST Act requires the SEC, within 180 days of enactment (June 1, 2016), to revise Regulation S-K to (a) further scale or eliminate requirements relating to EGCs, accelerated filers, smaller reporting companies and other smaller issuers and (b) eliminate provisions that are duplicative, overlapping, outdated or unnecessary.
The FAST Act also directs the SEC to carry out a study of the requirements of Regulation S-K to (a) determine how best to modernize and simplify disclosure requirements, emphasizing a company-by-company approach without boilerplate or static requirements while preserving completeness and comparability of information across registrants, and (b) evaluate methods of information delivery and presentation that discourage repetition and disclosure of immaterial information. The SEC is required to submit a report to Congress within 360 days of the law’s enactment (June 1, 2016) that details the findings of its Regulation S-K study, its recommendations on modernizing and simplifying Regulation S-K, and its recommendations on ways to improve the readability of disclosure documents. The SEC already has embarked on a similar Regulation S-K project, called for by the JOBS Act, in which it is evaluating the current disclosure requirements of Regulation S-K to determine how they can be modernized.
The SEC will have 360 days after it submits its report to Congress to issue a proposed rule implementing the recommendations in the report.
The foregoing mandate adds to an already heavy workload for the SEC, which continues to work on studies and rulemaking projects assigned to it by the Dodd-Frank Act and the JOBS Act.
New statutory registration exemption for private resales
One of the more unexpected provisions of the FAST Act is the codification of the informal “Section 4(a)(1½)” exemption for private resales of securities by affiliates and other security holders. The SEC and the courts have long recognized that a hybrid exemption from registration under the Securities Act exists for private resales that satisfy some of the established standards for sales under both (a) Section 4(a)(1) of the Securities Act by security holders who are not statutory “underwriters” and (b) Section 4(a)(2) of the Securities Act by issuers making private offerings. The absence of a formal exemption for private resales that bridges the gap between the two statutory exemptions, however, has inhibited these transactions because of uncertainty regarding the requirements that must be satisfied. New Section 4(a)(7) of the Securities Act, which was added by the FAST Act and became effective upon enactment, eliminates the uncertainty by establishing precise standards for private resale transactions.
Alternative to other resale exemptions. Once a public or private offering of securities has been completed, each subsequent transaction in the securities by a holder must either be registered under the Securities Act or qualify for an exemption from registration. Section 4(a)(7) is available to exempt from Securities Act registration private resales of “restricted securities” that were acquired from the issuer or an affiliate in transactions not involving a public offering and – although not the focus of the exemption – securities that were issued in transactions registered under the Securities Act.
For resales of securities of public companies outside the context of capital-raising transactions, the new exemption likely will not afford a meaningful alternative to Rule 144 under the Securities Act, which provides a safe harbor from registration for resales into the public market of restricted securities and “control securities” held by affiliates of the issuer. Where Rule 144 is available, Section 4(a)(7) often will not be an attractive resale method because of the new exemption’s many conditions and because securities purchased in Section 4(a)(7) resales, unlike those purchased under Rule 144, will have the status of restricted securities. Instead, the principal appeal of Section 4(a)(7) is expected to be its availability as a more certain alternative to Section 4(a)(1½) for the exemption of private resales of securities issued in unregistered offerings not conducted in reliance on Rule 144A under the Securities Act.
Private resales of restricted securities sold by public and private companies raising capital commonly have been accomplished (a) pursuant to Rule 144A for resales of the securities by the initial purchasers to qualified institutional buyers (QIBs) or (b) pursuant to the Section 4(a)(1½) exemption for resales of the securities by the original investors to accredited investors. Rule 144A transactions typically are underwritten by investment banks acting as the initial purchasers, and often are viewed as being more liquid than traditional private placements due to their larger issue size, book-entry format (with transfer restrictions to QIBs implemented as part of their registration in the DTC clearing system), more stringent due diligence requirements and greater perceived reputational involvement by the investment banks. In contrast, transactions in which resales are made in reliance on the Section 4(a)(1½) exemption occur more commonly in the traditional private placement market, where investment banks act as placement agents rather than as purchasers. In these transactions, physical securities typically are required, and resales often are effected through the use of transferee certifications. Although the secondary market for the securities sold in traditional private placements generally is less liquid than the secondary market for Rule 144A transactions, those securities may be resold to accredited investors as well as to QIBs.
Section 4(a)(1½) provides an exemption for resales of privately placed securities under circumstances that largely conform to conditions and procedures under Section 4(a)(2) employed by the issuer in originally placing the securities. This resale exemption is now codified in Section 4(a)(7), which exempts from registration private resales of securities to accredited investors if such resales also satisfy the section’s other requirements.
Conditions of Section 4(a)(7). The new exemption requires compliance with general conditions and, if the issuer of the securities is neither subject to Exchange Act reporting requirements nor a foreign private issuer exempt from those requirements, compliance with an information condition.
General conditions. Each resale transaction made in reliance on Section 4(a)(7) must satisfy the following conditions, some of which mirror the requirements for a private offering pursuant to the safe harbor under Section 4(a)(2) afforded by Rule 506(b) of Regulation D:
- Each purchaser of the securities must be an accredited investor as defined in Rule 501 of Regulation D
- The securities may not be offered or sold by any form of general solicitation or general advertising
- The seller of the securities may not be the issuer or a direct or indirect subsidiary of the issuer
- Neither the seller of the securities nor any agent receiving selling compensation may be a “bad actor” subject to disqualification under Rule 506(d)(1) of Regulation D or Section 3(a)(39) of the Exchange Act
- The issuer must be “engaged in business,” rather than in the organizational stage or in bankruptcy, and may not be a blank check, blind pool or shell company that has no specific business plan or purpose or has indicated that the issuer’s primary business plan is to engage in a merger or combination of the business with, or an acquisition of, an unidentified person
- The securities to be sold may not be part of an unsold allotment to a broker or dealer acting as an underwriter
- The securities must be part of a class that has been authorized and outstanding for at least 90 days before the resale transaction
Information condition for resales of securities of non-reporting companies. In addition, if the issuer is neither subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act nor a foreign private issuer exempt from reporting pursuant to Rule 12g-3-2(b) under the Exchange Act, the issuer must, upon the seller’s request, make available to both the seller and a prospective purchaser designated by the seller a “reasonably current” statement that includes the following information:
- The issuer’s name and address
- A statement of the nature of the business of, and the products or services offered by, the issuer
- The names of the issuer’s directors and officers
- The issuer’s most recent balance sheet and profit and loss statements and similar statements for the prior two fiscal years or portions thereof in which the issuer has been in operation
- If the seller is a control person, the nature of the seller’s affiliation with the issuer and a certification by the seller that it has no reasonable grounds to believe that the issuer is in violation of the securities laws or regulations
Any financial statements required to be delivered in a transaction relying on Section 4(a)(7) must be prepared in accordance with U.S. generally accepted accounting principles, unless the issuer is a foreign private issuer, in which case the financial statements may be prepared in accordance with GAAP or International Financial Reporting Standards issued by the International Accounting Standards Board.
Section 4(a)(7) also requires the statement to disclose (a) the title and class, par or stated value, and number of shares or outstanding amount of the class of securities being sold as of the end of the issuer’s most recent fiscal year, (b) the name and address of the transfer agent or other person responsible for transferring securities of the issuer and (c) the names and compensation of any registered broker, dealer or agent to be paid any commission or other remuneration in connection with the offering or sale of the securities.
Status of acquired securities. A Section 4(a)(7) resale transaction is deemed not to be a “distribution” for the purposes of Section 2(a)(11) of the Securities Act. Securities acquired under Section 4(a)(7) will be deemed to have been acquired in a transaction not involving any public offering and, as a result, will have the status of restricted securities within the meaning of Rule 144.
Unlike the Section 4(a)(1½) exemption, Section 4(a)(7) does not impose a holding period on an acquiring purchaser before it may resell the securities. Affiliates of the issuer (other than subsidiaries), including control persons who are individuals, that satisfy the requirements of Section 4(a)(7) will be able to sell the securities under the new exemption without regard to the volume and manner of sale restrictions imposed on affiliate resales under Rule 144.
Looking ahead. Some Congressional supporters of the new exemption expect that, by providing certainty as to legal status of resales where none previously existed, Section 4(a)(7) will contribute to the development of a more active secondary market in privately placed securities. Representative Carolyn B. Maloney, for example, expressed the view that the exemption will provide investors with “confidence that they are complying with the law when they resell private securities to other sophisticated investors” and will improve the state of the law in this area by “establishing minimum standards . . . that will protect investors, foster transparency and make [the private] market stronger.”
The exemption will have a broad reach by reason of its availability to any security holder that is not the issuer or one of its subsidiaries. Moreover, securities sold pursuant to the exemption will be deemed “covered securities” exempt from registration under state Blue Sky laws, although, as noted, they will be considered restricted securities in the hands of purchasers.
Section 4(a)(7) affords selling security holders greater legal certainty than the Section 4(a)(1½) exemption that private resales will be undertaken in compliance with the Securities Act. Some of the conditions of Section 4(a)(7), however, may be more restrictive than those observed in some applications of Section 4(a)(1½), which, because it is uncodified, is not uniformly construed in market practice. Section 4(a)(7) states that it is not the exclusive means of establishing an exemption from registration for transactions covered by it. This presumably preserves the ability of sellers in private transactions to continue to rely on the Section 4(a)(1½) exemption. It remains to be seen whether market participants will continue to rely on Section 4(a)(1½) instead of the newly codified exemption that covers the same types of transactions. In light of the uncertainty regarding the circumstances in which resale participants may rely on the uncodified exemption, we would expect that the market will move from reliance on Section 4(a)(1½) to compliance with Section 4(a)(7) for resales of securities issued in traditional private placements.