Having Trouble Raising Capital?
You know you're not the only one with a problem when Congress and the President agree there is a problem and agree on the solution.
The Jumpstart our Business Startups ("JOBS") Act, signed by the President on April 5, 2012, seeks to create jobs by making it easier for start-up companies to deal with securities laws when raising capital.
Although we are giving an overview of the JOBS Act in this edition of Legal Currents, it is important to note that most of the provisions in the JOBS Act are not yet effective. We have to wait for the Securities and Exchange Commission ("SEC") to write and implement rules which will control the application of those provisions before they become effective. You will need to consult with a knowledgeable securities lawyer before you try to take advantage of any of these provisions.
Basic Securities Issues
When companies raise capital by issuing shares of stock, LLC membership interests, bonds, debentures, or other securities, they must address:
- The Securities Act of 1933 (" '33 Act"), which governs the offering of securities. The two basic principles of the '33 Act are:
- To sell securities, companies either have to register the sale with the SEC or qualify for an exemption; and,
- They must disclose all material facts to potential investors.
- The Securities Exchange Act of 1934 (" '34 Act"), which requires publicly-owned companies to make ongoing disclosures of material facts to the market (on Forms 8-K, 10-Q, 10-K, etc.).
- Similar state securities laws, which in some cases apply in addition to the federal laws, and in some cases do not apply when federal securities requirements are met.
Our existing securities laws are based on the assumption that most people are naïve and should not be solicited to invest in securities until an extensive (and expensive) registration statement has been approved by the SEC which will, theoretically at least, explain all possible risks in excruciating detail. And companies that manage to become registered thereafter must meet extensive (and expensive) reporting requirements to keep current and potential investors informed.
The securities laws make exceptions for potential investors who are thought to be well-to-do and sophisticated. Therefore, people who know lots of rich people have a big advantage when they go about raising capital. They're generally allowed to call up their rich friends and business associates to solicit their participation. They're also allowed to hire an investment banking firm which then calls up its rich clients for the same purpose, but maybe with a more polished solicitation. If one does not know a lot of rich people, or the amount of money needed isn't big enough to interest an investment banker, the securities laws make it difficult for small- and medium-sized businesses to raise capital.
Overview of the JOBS Act
The purpose of the JOBS Act is to improve job creation by making it easier for start-up companies to deal with the '33 Act and the '34 Act when raising capital. The major provisions of the JOBS Act are:
- The "IPO On-Ramp" –– Granting relief for certain "Emerging Growth Companies" in initial public offerings ("IPOs") and in their subsequent reporting and compliance obligations.
- Private Offerings Advertising –– Allowing the general advertising of certain private offerings that are exempt from securities registration.
- "Crowdfunding" –– Allowing companies to obtain limited investments from the general public without registration, but subject to a number of conditions.
- "Small Offerings" –– Providing exemptions for certain smaller offerings of securities.
- Exchange Act Triggers –– Increasing the maximum number of record shareholders that, when exceeded, trigger registration and ongoing reporting requirements under the '34 Act.
- Regulation S-K Study –– Reducing the compliance burdens for Emerging Growth Companies in SEC filings.
- Decimalization Study –– Requiring a study of the possible effects of "decimalization" (trading in increments of a penny) on IPOs and liquidity, and authorizing the SEC to increase the one cent "tick size" for Emerging Growth Companies.
We will address each of these provisions in this article.
One rationale for the JOBS Act is that the Internet has made exchanging information so easy and such a big part of daily life that it should be easier for companies raising capital to let the public know about their business and their offerings –– within certain limits.
The JOBS Act also tries to make it less burdensome for smaller companies to become publicly-held and remain publicly-held. Conversely, the JOBS Act allows smaller businesses to remain private even if they have a relatively large number of shareholders.
The "IPO On-Ramp" Provisions
The IPO On-Ramp provisions do not require future SEC rulemaking to be effective. That said, the SEC has put out answers to FAQs, and no doubt will issue other guidance or rules in the future, so attention should be paid to these developments.
The IPO On-Ramp is available only to an "Emerging Growth Company," defined as a securities issuer that:
- Had less than $1 billion in annual gross revenue during its immediately preceding fiscal year (to be adjusted for inflation every five years);
- Either has not yet made a registered sale of common equity securities, or has only done so in the last five years;
- Has not issued more than $1 billion in non-convertible debt securities in the preceding three years; and,
- Is not a "large accelerated filer" under the '34 Act. Generally, a company becomes a large accelerated filer when its common equity held by non-affiliates reaches $700 million.
Unfortunately, companies that made registered offerings of their common equity securities before December 8, 2011 are excluded from this definition –– the JOBS Act provides no "emerging growth" relief for those companies.
A company will cease to be an Emerging Growth Company in the fiscal year after it ceases to satisfy the above criteria. It is important to note, consistent with the second bullet point above, that a company will cease to be an Emerging Growth Company in the sixth fiscal year after it registers a common equity offering even though its annual revenue remains under $1 billion and it does not become a large accelerated filer.
Under the JOBS Act, Emerging Growth Companies receive the following special benefits for their IPOs under the '33 Act:
- They are allowed to "test the waters" for interest in their IPO from high net worth investors who are "Qualified Institutional Buyers" or "Accredited Investors" so they can try to ascertain a level of interest before incurring the expense of registration.
- They are allowed to receive a "confidential nonpublic review" from the SEC of their draft registration statements, rather than having to make the drafts available to the public in an electronic filing. This change preserves a company's confidentiality while the review is ongoing, and presumably allows the draft statement to never be made public if the company decides to cancel the offering. But the initial drafts submitted will have to be publicly filed 21 days before a "road show" if the offering goes forward.
- Prohibitions on "sell-side research" are eased. Regulators may not impose "quiet periods" and other restrictions on communications by research analysts associated with firms participating in the offering. Note, however, that there are a number of research analyst rules that will not be affected, and concerns about liability under Rule 10b-5 will remain, so these changes may or may not have a significant effect on offerings.
Emerging Growth Companies will also receive the following assistance with their reporting and compliance burdens under the '34 Act:
- Some relief on audited financial statement and "management discussion and analysis" requirements for years prior to registration;
- Exemption from the requirement that auditors attest to the company's internal controls report. This exemption can result in significant cost savings;
- Exemption from future requirements of audit firm rotation is expected to be issued by the Public Company Accounting Oversight Board ("PCAOB");
- Exemption from any future PCAOB audit principles not applicable to public companies. Note, however, that companies must opt-in or opt-out on an all-or-none basis; they cannot pick and choose among different accounting standards;
- Exemption from "Say-On-Pay" and "Say-On-Golden-Parachute" requirements; and,
- On executive compensation disclosure:
- Exemption from upcoming Dodd-Frank Rules on disclosure of CEO pay relative to median pay for company employees; and,
- Permission to meet less onerous "smaller reporting company" requirements for general executive compensation disclosures, which include:
- Omitting the "compensation discussion and analysis" requirements;
- Presenting data for fewer executive officers; and,
- Omitting some of the required tables.
The Private Offerings Advertising Provisions
These changes may be of the most significance to smaller companies seeking capital –– but not until the SEC issues rules that make them effective.
"Regulation D" allows for certain offerings of securities to be exempt from '33 Act registration. Regulation D's Rule 506 is the provision most commonly used because there is no limitation on the amount of money that may be raised or the number of investors, provided no more than 35 investors are not "Accredited Investors."
The term "Accredited Investors" includes certain entities, as well as individuals, with (a) an individual or joint net worth exceeding $1,000,000, or (b) individual income of $200,000 in the two prior years (or $300,000 jointly with a spouse), and an expectation of that level of income in the current year. Recent changes to the Accredited Investor definition exclude an individual's primary residence from the net worth calculation, and also exclude debt owed on the primary residence except debt (a) incurred within 60 days prior to purchase of the securities, or (b) in excess of the property's estimated fair market value.
One condition of any Regulation D offering under current law is that "neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or advertising."
The JOBS Act requires the SEC to revise Regulation D's Rule 506 to eliminate this restriction provided the issuer reasonably determines that all purchasers are Accredited Investors. It also requires the SEC to adopt rules for what steps an issuer must take to reasonably determine that an investor is an Accredited Investor. The current Rule 506 does not provide criteria for these determinations.
In most private offerings, certain restrictions must be placed on resales of the securities issued. Rule 144A of the '33 Act generally governs resales of restricted securities. The Private Offerings Advertising portion of the JOBS Act requires the SEC to issue rules allowing advertising of these resales, provided all purchasers are sophisticated institutions that meet the definition of "Qualified Institutional Buyers."
The SEC also must issue rules exempting from broker-dealer registration certain persons who maintain platforms or mechanisms for negotiating Rule 506 and Rule 144A securities and meet certain conditions.
These rules were to have been issued before July 4, 2012, but the SEC could not meet that deadline. They will be considered at the August SEC meeting. The SEC could issue an "interim final temporary" rule that would apply while the public comment process is ongoing, or it could wait for the comment process to be completed before issuing rules that would make this provision effective.
The Crowdfunding Provision
The Basics –– Investment Limits and Intermediary Requirement
"Crowdfunding," the idea of selling small securities offerings in small increments, may have received the most hype of all of the JOBS Act provisions. It will not be effective until the SEC issues rules to implement it. "Crowdfunding" will provide for exemptions from both the '33 Act and the '34 Act, and preempt state securities laws, but will be subject to a great number of conditions.
A Crowdfunding issuer may sell no more than $1 million in securities in any 12-month period, with each investor limited to investments of:
- For an investor with an annual income or net worth of less than $100,000 – the greater of $2,000 or 5% of the annual income or net worth of the investor; and,
- For an investor with an annual income or net worth greater than $100,000 – 10% of the annual income or net worth of the investor, subject to a $100,000 limit.
These dollar amounts will be subject to consumer price index adjustment every five years.
Another basic limitation is that Crowdfunding may be conducted only through intermediaries who must be registered brokers or registered as "funding portals." A "funding portal" is a new type of intermediary that will be registered with the SEC and for which the SEC will establish a separate regulatory scheme. Funding portals, unlike most brokers, will not:
- Offer any advice or recommendations about securities;
- Solicit any offers to buy securities;
- Compensate personnel based on sales of securities; or,
- Handle any customer funds.
Crowdfunding Conditions Imposed on Issuers
Conditions imposed on Crowdfunding issuers include:
- Initial disclosures, which must be filed with the SEC, including:
- Basic corporate information and website;
- The identity of each person holding 20% or more of the issuer's shares;
- Income tax returns;
- Financial statements, which must be reviewed by a CPA if more than $100,000 is raised and which must be audited if more than $500,000 is raised;
- A business description;
- A business plan;
- The price or the method of determining the price;
- The purpose and intended use of the proceeds of the offering;
- The target amount of the offering and the deadline to reach that amount, with ongoing updates on the progress in reaching the targeted amount;
- A description of the ownership and capital structure of the issuer, including:
- Detailed information on classes of securities, comparing their differences, and explanations of how rights under the securities being offered could be materially limited, modified, qualified, or diluted;
- How principal shareholders of the issuer could adversely affect the purchasers of the securities being offered;
- The issuer's plans for future valuations of its securities;
- The general risks of minority ownership, including risks of sales of the issuer or its assets, corporate actions, and transactions with related parties; and,
- Such other information the SEC may require by rule;
- A requirement for certain ongoing reports to investors and filings with the SEC (subject to any exceptions the SEC establishes by rule ), including:
- Reports on the results of operations; and,
- Annual financial statements;
- The opportunity for investors to rescind a commitment to purchase securities when provided with final disclosures and the final price of the securities;
- A restriction on any advertising of the terms of the offering, other than notices directing potential investors to the intermediary;
- Limitations on promoter compensation to be established by the SEC, and disclosures of the compensation received;
- A one-year restriction on resale of the securities, with certain exceptions including sales to Accredited Investors; and,
- Disqualification rules that will be substantially similar to current disqualifications under securities laws for persons barred by regulators from certain financial activities because they have been found to have violated laws prohibiting fraudulent or deceptive conduct, or convicted of securities violations.
Crowdfunding Conditions Imposed on Intermediaries
Conditions imposed on intermediaries include requirements that the intermediary:
- Provide investor education materials and give disclosures to be established by SEC rule as to risk and other matters;
- "Ensure" that each investor reviews the investor education materials in accordance with standards to be established by the SEC;
- "Positively affirm" that the investor:
- Understands the risk of losing the investor's entire investment; and,
- Can afford to bear that loss;
- Require the investor to answer questions "demonstrating" an "understanding" of:
- The level of risk in start-ups, emerging businesses, and small issuers;
- The risk of illiquidity; and,
- Other matters to be established by the SEC;
- Take measures to reduce the risk of fraud in accordance with SEC rules, including background checks on directors, officers, and owners of 20% or more of the issuer;
- Make the information provided by the issuer available to the SEC at least 21 days prior to the first sale of securities, and make the information provided by the issuer available to each investor at least 21 days prior to that investor's purchase of securities. The SEC may establish different periods;
- Ensure that offering proceeds are made available to the issuer only when the target is reached or exceeded, and allow investors to cancel their commitments to invest as the SEC determines by rule;
- Make efforts to ensure that no investor has exceeded investment limitations to be imposed by the SEC by rule;
- Protect investor privacy to the extent required by the SEC;
- Refrain from providing any promoter, finder, or lead generator with compensation;
- Prohibit its directors, officers, and partners from having any financial interest in the issuer; and,
- Abide by any other rules enacted by the SEC.
The Uncertain Future of Crowdfunding
Despite the hype surrounding Crowdfunding, this type of offering may be impractical for many companies. The $1 million limitation is an obvious issue. Also, small companies may not wish to publicly disclose their financial statements and may not wish to deal with the number of shareholders that the low investment limits might create.
In addition, the Crowdfunding conditions and limitations will be fleshed out in SEC rulemaking, and the SEC is empowered to impose additional limitations and conditions which may be onerous. Given all the details in the JOBS Act, and the further details to be expected in the rules issued by the SEC, the Crowdfunding offering documents will probably require a great deal of work by accountants, lawyers, and other professionals.
The SEC rulemaking will have to address a lot of complicated questions. For example, if a company has no prior-year audited financial statements when it seeks to raise money, will it be allowed to use Crowdfunding? If not, is Crowdfunding even an option for start-ups? It also is unclear how a Crowdfunding capital raise will affect or be affected by other capital raises, such as private offerings under Regulation D.
Under the JOBS Act, these rules are due December 31, 2012. The SEC already announced, however, that it does not expect to be able to issue the rules by that date.
Furthermore, the JOBS Act specifically adopts a standard of liability for improper or omitted disclosures in Crowdfunding offerings that is, at best, duplicative of existing law, but may be interpreted to provide standards of liability in addition to those currently existing under the securities laws generally.
On a positive note, Crowdfunding investors will not count against the shareholder cap for '34 Act registration. (See the discussion below under "Exchange Act Triggers.")
Small Offerings
The JOBS Act amends Section 3(b) of the '33 Act to require that the SEC issue rules that will exempt "small offerings" from registration under certain conditions.
Prior to the JOBS Act, Section 3(b) of the '33 Act allowed the SEC to provide exemptions from registration if certain conditions were met, subject to an aggregate $5,000,000 limit. The SEC issued "Regulation A" under this Section, but this exemption is not often used because of various requirements and limitations.
The JOBS Act requires the SEC to issue rules, which some are calling "Regulation A+," that will allow a company to issue exempt securities under the following terms and conditions:
- An aggregate limit of up to a $50 million per year (to be adjusted every two years);
- The securities issued will be "covered securities" so that state law registration requirements will be preempted;
- The exempt securities will be limited to equity, debt, and convertible debt securities;
- A public offering and sale will be allowed;
- The exempted securities will not be subject to resale restrictions imposed by the current securities laws, but the anti-fraud provisions of current securities laws will apply;
- "Testing the waters" will be allowed, subject to conditions to be imposed by the SEC by rule;
- Audited financial statements will be required to be filed with the SEC; and,
- Other terms and conditions to be imposed by the SEC must be satisfied. The SEC is specifically authorized to:
- Require offering statements to contain such content as it deems appropriate;
- Impose disqualification provisions it deems appropriate; and,
- Require periodic disclosures it deems appropriate.
There is no deadline for the SEC to issue these rules. Given that the SEC cannot meet the deadlines established for other JOBS Act rules, it seems unlikely that these will be issued any time soon.
Exchange Act Triggers
Companies with over $10 million in assets and which have a certain number of "record holders" of a class of securities must register under the '34 Act and file periodic reports (Forms 8-K, 10-Q, 10-K, etc.). In determining how many "record holders" a company has for purposes of triggering Exchange Act registration, it is important to note that shares held with brokers generally are held in "street name," so that only one "record holder" is shown for numerous shareholders.
Under prior law, a company generally became subject to '34 Act registration if it had over $10 million in assets and a class of equity securities held of record by 500 or more persons. The JOBS Act raises this limit to 2,000, or 500 shareholders who are not "Accredited Investors." It also generally excludes from the computation securities held by persons who received them as employee compensation. However, once Exchange Act registration has been triggered, companies generally may not de-register until they have less than 300 record holders.
There are special rules for banks and bank holding companies. The cap is 2,000 holders of record, without the lower threshold for record holders who are not Accredited Investors. Also banks and bank holding companies may de-register if their record holders drop below 1,200.
These provisions are effective immediately, but SEC rulemaking is expected to address how some of the changes will be implemented and to establish some safe harbors for holder of record determinations.
Regulation S-K Study
The JOBS Act requires the SEC to conduct a comprehensive study of Regulation S-K, which is the set of rules that lists the voluminous information required in SEC filings, and make recommendations to reduce these compliance burdens for Emerging Growth Companies. The report is required to include "specific recommendations" on "how to streamline the registration process" to "make it more efficient and less burdensome" for "prospective issuers who are emerging growth companies."
The report is due in early October.
Decimalization Study
"Decimalization" of the stock market "tick size" (i.e., trading securities in one penny increments) was implemented in 2001. The rationale for decimalization was that fractional tick sizes (often 1/8 of a dollar) created an artificially wide spread that reduced competition in providing quotations and delivered excessive compensation to market makers.
Ten years later, many hold decimalization responsible for the enormous decline in small company IPOs. The concern is that trading in one penny increments leaves no incentives for investment bankers and others involved in IPOs to take smaller companies public, with the result that small companies find it very difficult to gain access to public capital markets.
The JOBS Act required the SEC to conduct a study of decimalization. Congress also empowered the SEC to implement a "tick size" for Emerging Growth Companies that could be higher than a penny but less than a dime.
The SEC staff issued that report on July 20, 2012. The report generally concluded that it was difficult to isolate tick size from other factors that may have contributed to the decline of small company IPOs, and suggested more study be undertaken and more input sought before any rules are adopted increasing tick size for Emerging Growth Companies.
Conversely, on July 5, 2012, the SEC approved a pilot initiative to allow the New York Stock Exchange to offer quotes in increments of less than a penny so that the NYSE could compete with non-public "dark pools" in which sub-penny trading regularly occurs.
Summary
The JOBS Act may result in great improvements for capital-hungry small- to medium-sized companies, but:
- Whether the IPO On-Ramp's burden relief substantially increases capital raised by companies remains to be seen.
- Allowing general advertising to Accredited Investors in private offerings may hold the most promise for companies, but the SEC first must adopt rules.
- "Crowdfunding" has received much hype, but the monetary limitations and offering conditions imposed by current law and the forthcoming rules may limit its usefulness.
- The Small Offerings exemption may offer great capital-raising opportunities for companies, but we must await SEC rules to see if the burden reduction is substantial.
- The Exchange Act triggers will greatly reduce compliance burdens on companies whose future capital raises create shareholders of record that exceed 500, and may be helpful to some which are already registered under the '34 Act.
- The Regulation S-K study may result in some regulatory filing relief for Emerging Growth Companies.
- At least for now, tick sizes for Emerging Growth Companies will continue to be decimalized, which may limit access to capital.
It is unfortunate that it's going to take months just to "connect the cables" necessary to provide this important "jumpstart" to the economy.
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