April 03, 2012
Securities Law Alert
Our most recent alert discusses the Jumpstart our Business Startups Act, or JOBS Act, which passed both houses last week and is expected to be signed into law by President Obama this Thursday, April 5, 2012. The JOBS Act makes changes to the securities laws applicable to certain public issuers, as well as for private placements, and introduces new classes of exempt securities and transactions, including the controversial crowdfunding exemption.
President Obama is expected to sign the Jumpstart Our Business Startups Act, also known as the JOBS Act on Thursday, April 5, 2012, in the White House along with a bipartisan group of lawmakers, including House Majority Leader Eric Cantor. Last week, by an overwhelming bipartisan vote of 380 to 41, the House passed an amended version of the JOBS Act. The JOBS Act cleared the Senate a week earlier by a vote of 73 to 26, also demonstrating strong bipartisan support for the bill. In fact, the legislation was subject to only a handful of amendments during its consideration in the House and Senate. The relatively rapid pace in which the JOBS Act moved through the House and Senate surprised many critics of the legislation as well as Washington observers, who believed that few bills would be passed during this election year. The president has already issued a number of positive statements about the legislation, and he is expected to sign the bill this week.
Nixon Peabody’s Government Relations team, including retired U.S. Representative Thomas Reynolds and Counsel Doug Dziak, worked with congressional proponents of the legislation and key committee members, including Senators Patrick Toomey (R-PA), Charles Schumer (D-NY), Tim Johnson (D-SD), Richard Shelby (R-AL), Tom Carper (D-DE), and Mark Warner (D-VA); House Majority Leader Eric Cantor (R-VA); and Representatives David Schweikert (R-AZ) and Jim Himes (D-CT) to move this bill through the legislative process. We will therefore discuss not just the key provisions of the JOBS Act, but also some of the context that is likely to guide the SEC in its rule-making efforts to implement various provisions of the JOBS Act.
In this Securities Law Alert, we review the most comprehensive reforms introduced by the JOBS Act, in particular:
The JOBS Act creates a new category of issuer—the emerging growth company, or EGC, which is, in any given fiscal year, a public company that had not sold securities pursuant to a registration statement before December 8, 2011, and which had annual gross revenue of less than $1 billion in its previous fiscal year. An EGC can utilize this status for up to five years after its first sale of common equity securities pursuant to an effective registration statement, or until any of the following occurs (if earlier):
Qualifying issuers may also choose to not be treated as EGCs, but once an issuer elects to be treated as an EGC, all provisions applicable to EGCs would become applicable to that issuer.
Easing the IPO process for an EGC
The JOBS Act lowers the burden of disclosure that an EGC would bear in its registration statement during an IPO. Instead of three years of audited financial statements, an EGC would only need to provide two years of audited financial statements. Interestingly, the JOBS Act allows an EGC to make a confidential submission of its draft registration statement to the SEC for confidential non-public review by the SEC. The registration statement must be publicly filed at least 21 days before the first roadshow. Although market realities have removed much of the taint of pulled IPO efforts during the past several years, this confidentiality provision will reduce the concerns that many IPO candidates have regarding the potentially bad optics of a failed attempt at any IPO. Moreover, the provision conceivably moves the IPO process closer to the shelf-registration process in that IPO candidates could file confidentially, receive SEC review, and be ready to pull the trigger on an IPO when the IPO window opens up.
EGCs would also be permitted to “test the waters” by engaging in oral or written communications with potential investors that are qualified institutional buyers or accredited investors to determine whether such investors might have an interest in a proposed offering, either prior to or following the filing of a registration statement, without being subject to current restrictions on pre-offering communications.
Additionally, the JOBS Act requires the SEC, within 180 days, to analyze the provisions of Regulation S-K, the primary source (along with Regulation S-X on financial information) of disclosure information to be included in a registration statement and report to Congress on how Regulation S-K can be modernized and simplified to reduce the costs of disclosure for EGCs.
Private placements concurrent with IPO
One significant change is that an EGC can simultaneously engage in a public offering as well as a private placement of a public equity, or PIPE offering, to accredited investors or qualified institutional buyers, without risking that the discussions with respect to the PIPE offering will be considered the sale of a security without an effective registration statement. As a result of this reform, the question of transactional integration will no longer confound these types of deals for EGCs.
Analyst coverage during IPOs
Currently, the research division of an investment bank participating in an IPO is prohibited from publishing research about that specific issuer. It has long been argued that ethical walls can be established between the research and investment banking divisions in order to allow this. The JOBS Act permits that type of research with respect to EGCs, and protects research reports from being considered part of the “prospectus” or constituting an offer of sale of the securities without an effective registration statement.
Under the JOBS Act, a research report is defined broadly to mean a “written, electronic, or oral communication that includes information, opinions, or recommendations with respect to securities of an issuer or an analysis of a security or an issuer, whether or not it provides information reasonably sufficient upon which to base an investment decision.” The regulatory easing from the JOBS Act should not mean that research reports can be prepared without recourse. The analysts and their investment banks still would be subject to the antifraud provisions of the federal securities laws. The JOBS Act further prevents the SEC or any national securities association (e.g., FINRA) from adopting or maintaining rules preventing research analysts from attending meetings with the management of an EGC that is going public. Restrictions on publication of research during specific periods during the IPO, such as following the expiration of the lock-up period, are also lifted as to EGCs.
Ongoing disclosure and compliance
Post-IPO, the JOBS Act further exempts an EGC from certain periodic disclosure and governance requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including:
Proxy rules and disclosure of executive compensation: While an issuer is an EGC, it need not comply with the recently adopted “say on pay,” “say on frequency,” and golden parachute disclosure rules introduced by the Dodd-Frank Act. An EGC also need not include pay for performance disclosure in its proxy statement (that is, disclosure of the relationship between financial performance and executive compensation). With respect to disclosure of executive compensation in its periodic reports, an EGC is placed on the same reduced-disclosure footing as a “smaller reporting company” (essentially, issuers with a public float below $50 million or revenues below $40 million).
Internal controls: One of the more burdensome provisions of the Sarbanes-Oxley Act, or SOX, is the requirement that issuers maintain internal controls over financial reporting and that the issuer’s auditors must attest to and report on management’s internal controls. This auditor attestation requirement has already been eliminated for companies that are not accelerated filers, and now is further relaxed so that EGCs will not be required to have its auditors attest to and report on its internal controls. While reports as to the economic impact of Section 404 vary, this JOBS Act provision could reduce annual compliance costs of an EGC by more than $1 million.
Financial disclosure: An EGC need only present the financial data under Item 301 of Regulation S-K from the time of its earliest audited financial statements presented in connection with its IPO (as opposed to five years of selected financial data for most other public issuers). The discussion in the management’s discussion and analysis (“MD&A”) section of the issuer’s periodic reports is correspondingly limited to financial statements from this period.
Accounting and auditing standards: An EGC will be exempt should the PCAOB adopt rules mandating audit partner rotation, or requiring the inclusion of an “auditor report and analysis” format of report by the auditor. An EGC will not be required to comply with any new or revised accounting standards until such changes also become applicable to private companies.
Presently, any non-public issuer that has assets of over $10 million and equity securities (other than exempted securities) held of record by 500 or more persons as of the end of its fiscal year automatically becomes subject to the reporting obligations of the Exchange Act. Historically, this provision has been an impediment to large private companies that wished to provide equity-based compensation to a large number of employees. It also impeded capital formation by early stage technology and biotech companies that found it necessary to rely on successive “angel” rounds of financing from individual accredited investors. Inadvertent noncompliance with the registration requirement, as was experienced by Google at the time of its IPO, required complicated, costly, and embarrassing rescission offers to fix. In another prominent case, the secondary market trading in Facebook raised similar concerns as to whether the company was inadvertently headed toward being required to register its common stock under the Exchange Act.
The JOBS Act raises the shareholder limit from 499 shareholders to either 2,000 persons, or 500 persons who are not accredited investors. Furthermore, the JOBS Act also excludes from this numerical threshold persons who received the equity securities pursuant to an employee compensation plan in a transaction that was exempt from the registration requirements of the Securities Act of 1933 (the “Securities Act”). Lastly, holders of securities issued in an exempt crowdfunding transaction (see below) are also not counted in determining the numerical threshold.
The JOBS Act leaves it to the SEC to define the term “employee compensation plan” and other technical issues relating to the application of the statute, if it is signed by the president. Senator Toomey, in a statement included in the March 29, 2012, Congressional Record, states that “employee compensation plan” should be interpreted broadly and should include, but not be limited to, a written compensatory benefit plan or contract as defined under Rule 701. Rule 701 is commonly relied upon by private companies in connection with the issuance of equity securities to their employees in exempt transactions. Senator Toomey also stated that the term “employee,” as used in Title V of the JOBS Act, was intended to include persons who are current or former employees of the issuer, as well as other persons, such as surviving spouses or family members, who inherit equity securities from the employee, so long as the securities were originally issued to an employee in a transaction that was exempt from the registration requirements of the Securities Act.
In addition, the ability of bank holding companies to deregister is eased by the JOBS Act. Presently, a reporting company would only be able to deregister once it has fewer than 300 shareholders of record, which will continue to be the case for most issuers. This number, however, will be increased to 1,200 for bank holding companies, which may permit a number of bank holding companies to “go dark.” Care should be taken, however, to look through record owners that are nominees, such as the Depositary Trust Company.
The JOBS Act requires the SEC to amend its rules under Regulation D under the Securities Act (“Regulation D”), the safe harbor under which many exempt offerings are conducted. Rule 506 of Regulation D can be considered the lynchpin of the private equity, venture capital, and angel investor industries, as it allows private placements of securities without a dollar ceiling as long as the conditions of the safe harbor are met. One of the current conditions is that there be no general advertising or general solicitation in connection with the offering. The JOBS Act requires the SEC to revisit this rule and exclude Rule 506 from the general solicitation and general advertising restrictions, as long as the actual purchasers are all accredited investors. This relaxation of the private placement rules, which would be applicable to all issuers, is likely to introduce some level of advertising in Rule 506 offerings and may change some of the Rule 506 capital raising techniques.
The rationale behind the change, as articulated by Rep. Darrell Issa, in his March 22, 2011, letter to SEC Chairman Mary Schapiro, is that (i) the ban on general solicitation and general advertising restricts and complicates the share issuance process, particularly in view of technological changes that have occurred since the rules were adopted (for example, references to a pending private placement on a website may be considered a general solicitation); and (ii) the potential harm that may realistically result to an unaccredited investor by the receipt of an advertisement by an issuer of unregistered securities that is targeted at accredited investors is minimal, so long as the securities are only sold to accredited investors.
Rule 144A under the Securities Act allows resale of securities to “qualified institutional buyers,” generally large institutional investors. One of the current conditions is that there be no general advertising or general solicitation in connection with the offering. The JOBS Act requires the SEC to revisit this rule and exclude Rule 144A from the general solicitation and general advertising restrictions, as long as the actual purchasers are all qualified institutional buyers.
The SEC has been given 90 days to so amend Regulation D and Rule 144A. We will provide further information on these new regulations as they are released.
Since the changes to the nonsolicitation rule in private placements will open the door to use of various media to advertise securities, corresponding changes have been made to the broker-dealer registration provisions of Section 15(a)(1) of the Exchange Act. These changes describe the range of activities in which a placement agent or other intermediary may engage without making it subject to federal registration, subject to fulfilling certain criteria described below. This includes maintaining a platform or mechanism for the purchase or sale, or negotiation or general solicitations, general advertisements, or similar or related activities with respect to a sale of securities. An intermediary may also co-invest in the securities without running afoul of the broker-dealer regulations, and can also provide ancillary services, which includes due diligence services (as long as it does not include investment advice or recommendations) and providing standardized documents. Standardized documents from the National Venture Capital Association, a network of venture capital professionals, have been gaining significance in venture capital transactions, and providing a link to these documents online is a service offered by some of the secondary markets. NVCA was one of the supporters of the bill, as was SecondMarket, one of the trading platforms that have emerged as online secondary markets for investments in startups and smaller non-public company securities.
The standard to fulfill in order to be able to rely on the exemption from broker-dealer registration is quite low; an intermediary need only show as to itself and its associates:
This change will remove the cloud that has hung over a number of market participants who assisted in raising capital, provided they can meet the new three-prong test.
Perhaps the most anticipated and controversial aspect of the JOBS Act is the introduction of a new private placement exemption called crowdfunding. Under this exemption, proposed to be embodied in Section 4(6) of the Securities Act, an issuer can raise up to $1 million dollars within a 12-month period without registering with the SEC. Although the exemption can be used in conjunction with other exemptions, the Section 4(6) exemption cannot be utilized by an investment company, an issuer that is already an SEC reporting issuer, or an issuer that is not organized in one of the United States or the District of Columbia. Intended to facilitate raising (principally online) small amounts of capital from a large group of investors, the Section 4(6) exemption also places a limit on how much the issuer may raise from a single investor in any one-year period, which is tied to that person’s annual income or net worth (and capped at $100,000 that an issuer can raise from any one investor in a given year).
One of the significant changes that the Senate made to the JOBS Act after it was passed by the House was to introduce a level of SEC oversight on both the issuer utilizing a Section 4(6) exemption, as well as the funding portal or other intermediary in the sale of the securities. In addition, the final bill clarified that transactions exempt under new Section 4(6) may still be subject to state securities regulation, which may severely limit the utility of these provisions for many smaller issuers. These changes and other limitations and provisions of the crowdfunding exemption will be discussed in a forthcoming Securities Law Alert.
Regulation A under Section 3(b) of the Securities Act currently allows small capital raises of less than $5 million if certain conditions are met and filings made. The JOBS Act seeks to increase this threshold by introducing a new class of exempted securities, with a threshold of $50 million in any year, which can be sold publicly, and which would not be “restricted securities” allowing their free transfer in resale transactions. The SEC is required to establish rules or regulations as to the offering statement or related document that will need to be filed with the SEC and the periodic reports that will be required from an issuer relying on this exemption. Securities issued in reliance on this rule or regulation to qualified purchasers and offered on a national securities exchange would be covered securities causing state securities or blue sky laws to be preempted in those circumstances. Regulation A offerings, which are subject to SEC review but at the regional office level, rather than Washington, D.C., Corporate Finance staff, have not been used much for capital raising over the last several decades. We will wait and see if the JOBS Act reform spurs increased use of this capital raising technique.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.