United States: The JOBS Act – Congress Rewrites The Securities Laws (Again)

Congress has once again attempted to address the issues it perceives as hurting the U.S. economy by tinkering with the federal securities laws.

In 2010, Congress attempted to remedy a perceived insufficiency of regulation of the U.S. capital markets by adopting the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Dodd-Frank increased the regulation of public companies in a number of ways, including by increasing disclosure obligations, mandating say-on-pay votes, tightening restrictions on private offerings and strengthening corporate governance standards.

Less than two years later, Congress became convinced that the profusion of regulations confronting public and private companies has hampered economic growth. As a result, in March 2012, Congress approved the Jumpstart Our Business Startups Act (JOBS Act), which was then signed into law by President Obama on April 5, 2012. It could be viewed as ironic that the regulation-reducing JOBS Act was enacted before the Securities and Exchange Commission (SEC) has been able to finish writing all of the new rules mandated by Dodd-Frank.

The JOBS Act, which is much shorter than Dodd-Frank (22 pages vs. 849 pages), focuses on easing the regulatory burden on growing private companies and on smaller public companies, referred to as emerging growth companies (EGCs) in the legislation. The JOBS Act amends provisions of both the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act). The principal elements of the JOBS Act:

• Reduce disclosure obligations for public EGCs and perceived barriers to public offerings by EGCs;
• Relax restrictions on Rule 506 and Rule 144A private offerings;
• Create a new Securities Act exemption from registration for "crowdfunded" offerings;
• Create a new Securities Act exemption from registration for offerings under $50 million; and
• Relax the Exchange Act registration requirements.

The JOBS Act generally took effect when signed by President Obama, although some provisions will not have any practical effect until the SEC adopts rules implementing the provisions, as discussed below.

Title I – Reopening American Capital Markets to Emerging Growth Companies

Title I of the JOBS Act provides EGCs with reduced reporting and other regulatory requirements, both before and after they raise capital and/or go public. After going public, EGCs are given several years before they have to comply with all of the reporting requirements under the Exchange Act that apply to non-EGCs.

Section 101 of the JOBS Act defines an EGC as an issuer that had total annual gross revenues of less than $1 billion in its last fiscal year. Thereafter, the issuer remains an EGC until the earliest of:

• the last day of the fiscal year during which its total annual revenues equal or exceed $1 billion (subject to future adjustment for inflation);
• the last day of the fiscal year following the fifth anniversary of its initial public offering (IPO), so long as its IPO occurred after December 8, 2011;
• the day when it has, during the previous three-year period, issued more than $1 billion in non-convertible debt; or
• the day when it is deemed a "large accelerated filer" under the Exchange Act.

Title I then goes on to amend a number of existing securities laws to ease reporting and other regulatory requirements for EGCs.

Executive Compensation

Section 102(a) exempts each public EGC from the say-on-pay and say-on-golden parachute provisions of Dodd-Frank. This means that an EGC will not be required to include in its proxy statement proposals giving shareholders a non-binding vote on executive compensation, including golden parachute compensation of executives in connection with mergers, sales or acquisitions. This exemption applies until the later of (i) one year after the issuer ceases to be deemed an EGC or (ii) three years after the EGC's IPO.

Section 102(a) also exempts public EGCs from having to comply with the disclosure rules that the SEC is required to adopt under Dodd-Frank addressing (i) information showing the relationship between executive compensation and the financial performance (pay for performance) and (ii) the ratio of the chief executive officer's annual compensation to the median annual compensation of all other employees of the issuer (pay equity).

Section 102(c) allows EGCs to provide the same level of disclosure regarding executive compensation as is currently required for smaller reporting companies (generally issuers whose outstanding voting and nonvoting common stock held by non-affiliates has a market value of less than $75 million).

Financial Disclosures and Accounting

Section 102(b) allows EGCs to present two years of audited financial statements in their IPO registration statement (instead of three years as previously required for issuers other than smaller reporting companies). MD&A will only be required for the years that have been audited. In addition, an EGC is no longer required to present selected financial data in any registration statement or periodic report for any period prior to the earliest audited period presented in connection with its IPO.

Section 102(b) also exempts EGCs from having to comply with any new or revised financial accounting standard otherwise applicable to public companies in any registration statement, periodic report or other report filed with the SEC.

Internal Controls Audit

Pursuant to Section 103, an EGC will not be required to include in its annual report a report of its independent public accounting firm on the EGC's internal control over financial reporting (ICOFR). Each EGC will still be required to maintain ICOFR and to include an assessment by its management of ICOFR in the EGC's annual report.

Auditing Standards

Section 104 amends the Sarbanes-Oxley Act of 2002 so that any rules adopted by the Public Company Accounting Oversight Board (PCAOB) requiring either mandatory audit firm rotation or a supplement to the auditor's report in which the auditor would be required to provide additional information about the audit and the financial statements of an issuer will not apply to audits of EGCs. Furthermore, any additional rules adopted by the PCAOB after the effective date of the JOBS Act will not apply to EGCs, unless the SEC determines that the application of such additional requirements is necessary or appropriate in the public interest.

Research Reports About EGCs

Section 105 of the JOBS Act significantly loosens many of the previously existing restrictions on what investment banks could do when conducting public offerings for EGCs. Many of these restrictions were originally put in place, through SEC regulation or pursuant to settlement agreements, to limit the ability of an investment bank to promote the stock of a company whose stock offering the bank was underwriting. For example, an investment bank participating in an IPO has been prohibited from publishing a research report on the issuer in advance of the IPO. Similarly, a bank could not publish a research report on the issuer for 40 days following the IPO or during the 15 days before and after the release or expiration of any lock-up agreement. There were also rules in place to prevent research from being influenced by the fact that the bank was underwriting an offering, as well to prevent banks from using the promise of favorable research reports to entice issuers to give them underwriting business.

Section 105(a) provides that the publication or distribution by a broker or dealer of a research report about an EGC that is the subject of a proposed public offering pursuant to a registration statement that the EGC proposes to file or has filed with the SEC, including one that has been declared effective by the SEC, will not constitute an offer to sell securities, even if the broker or dealer is participating (or will participate) in the registered offering in question. This will now allow underwriters to write research reports on EGCs even immediately prior to or during an offering. Furthermore, those research reports will not be subject to the same level of liability as the actual offering prospectus.

Section 105(b) prohibits the SEC or any national securities association (e.g., FINRA) from adopting or maintaining any rule or regulation in connection with an EGC's IPO that restricts (i) which associated persons of a broker, dealer or member of a national securities association may arrange for communications between a securities analyst and a potential investor, or (ii) a securities analyst from participating in any communications with the management of an EGC that is also attended by any other associated persons of a broker, dealer or member of a national securities association whose functional role is other than as a securities analyst.

Section 105(d) further prohibits the SEC, FINRA or any other national securities association from adopting or maintaining any rule or regulation prohibiting any broker, dealer or member of a national securities exchange from publishing or distributing any research report or making a public appearance with respect to securities of an EGC either (i) within any prescribed period of time following the EGC's IPO, or (ii) within any prescribed period of time prior to the expiration of any lock-up agreement between the broker, dealer or member of a national securities association and the EGC or its shareholders after the IPO.

Testing the Waters

Section 105(c) authorizes EGCs or any person authorized to act on behalf of an EGC to engage in oral or written communications with potential investors to determine whether those investors might have an interest in a contemplated securities offering, either prior to or following the date that a registration statement is filed for the offering, so long as the potential investors are qualified institutional buyers or institutions that are accredited investors. This effectively removes the traditional concerns that premature communications about an offering might constitute "gun-jumping", so long as the issuer is an EGC and the potential investors receiving the communications are qualifying institutions.

Confidential Submission of IPO Registration Statements

Section 106(a) allows an EGC to file a draft registration statement with the SEC before the date of its IPO for confidential review by the SEC staff, so long as the EGC then publicly files the draft registration statement and all related amendments with the SEC no later than 21 days before the date when the EGC conducts a road show. While this provision does not explicitly require SEC rulemaking, its practical implementation is likely to require changes to SEC procedures and regulations.

Tick Size for EGCs

Pursuant to Section 106(b), the SEC is required to study the impact that decimalization (trading and quoting securities in one penny increments) has had on (i) the number of IPOs since its implementation, (ii) the liquidity for securities of small-cap and mid-cap companies, and (iii) whether there is sufficient economic incentive to support trading operations in these securities in one penny increments. The SEC must submit its findings within 90 days from the enactment of the JOBS Act, and if it finds that trading in EGC securities should be in increments greater than one penny, the SEC may adopt rules increasing the increment to any amount up to $0.10 within 180 days from the enactment of the JOBS Act.

Opt-In Right for EGCs

Section 107 allows EGCs to forego any or all of the exceptions provided under Title I of the JOBS Act and, instead, comply with registration and reporting requirements as if they were not EGCs. If an EGC chooses to forego any of the financial accounting standard exemptions of Title I (described above), it must do so at the time it files its first registration statement, periodic report or other report with the SEC under Section 13 of the Exchange Act, and it must notify the SEC of this decision. Furthermore, an EGC may not choose to be exempt from some of the financial accounting standards but not others; it must choose all or none. Lastly, an EGC that chooses to forego these exemptions in Title I must comply with all financial accounting standards for so long as it remains an EGC; it cannot opt in and out.

Review of Regulation S-K

Pursuant to Section 108, the SEC is required to conduct a review of Regulation S-K and prepare a report within 180 days from the enactment of the JOBS Act that includes specific recommendations on how to streamline the registration process in order to make it more efficient and less burdensome for the SEC and prospective issuers that are EGCs.

Title II – Access to Capital for Job Creators

Section 201 of the JOBS Act removes the prohibition against general solicitation and general advertising for offers and sales of securities made pursuant to:

• Rule 506 of Regulation D, so long as all of the purchasers of securities in such offerings are accredited investors; and
• Rule 144A, so long as the securities are all sold to persons the issuer reasonably believes are qualified institutional buyers.

Section 201 also provides an exemption from registration as a broker or dealer for persons who maintain a platform or mechanism that permits the trading of securities offered and sold pursuant to Rule 506 of Regulation D. To qualify for this exemption, a person cannot (i) receive any compensation in connection with the purchase and sale of the securities offered and sold pursuant to Rule 506, (ii) possess any customer funds in connection with the purchase and sale of those securities and (iii) cannot be subject to, or be associated with anyone who is subject to, a statutory disqualification.

Title III – Capital Raising Online While Deterring Fraud and Unethical Non-Disclose Act of 2012 or the "CROWDFUND Act"

Crowdfunding typically refers to the process of raising capital from a large number of investors who each invest a relatively small amount in the offering. Investors are often solicited online. Prior to the enactment of the JOBS Act, the prohibition on general solicitation and the other requirements of Regulation D made it difficult to find an appropriate exemption to cover a crowdfunded offering. Title III of the JOBS Act, titled the CROWDFUND Act, creates a new exemption from registration under the Securities Act intended to facilitate capital raising through "crowdfunding." As discussed below, implementation of the CROWDFUND Act will require substantial rulemaking by the SEC.

New Section 4(6) Exemption

Section 302(a) of the JOBS Act amends the Securities Act to create a new exemption, Section 4(6), that permits transactions involving the offer or sale of securities by a domestic, non-reporting issuer, provided that: (i) the aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the Section 4(6) exemption during the 12-month period preceding the date of the transaction, is not more than $1 million; (ii) the aggregate amount sold to any investor does not exceed (a) the greater of $2,000 or 5 percent of the annual income or net worth of the investor, if either the annual income or the net worth of the investor is less than $100,000, or (b) 10 percent of the annual income or net worth of such investor, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000; (iii) the transaction is conducted through a broker or funding portal that complies with Section 4A(a) (described below); and (iv) the issuer complies with the requirements of Section 4A(b) (described below).

New Section 4(A) of the Securities Act

Intermediaries. Section 302(b) creates a new Section 4A of the Securities Act that requires a person acting as an intermediary in a transaction pursuant to the Section 4(6) exemption described above to:

• register with the SEC as a broker or a funding portal¹;
• register with any applicable self-regulatory organization;
• provide such disclosures, including disclosures related to risks and other investor education materials, as the SEC decides, by rule, to be appropriate;
• ensure that each investor:
• • reviews investor-education information, in accordance with rules established by the SEC;
  • positively affirms that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss; and
  • answers questions demonstrating –
  • • an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers;
    • an understanding of the risk of illiquidity; and
    • an understanding of such other matters as the SEC rules may require;

• take such measures to reduce the risk of fraud with respect to such transactions, as established by SEC rules, including obtaining a background and securities enforcement regulatory history check on each officer, director, and person holding more than 20 percent of the outstanding equity of every issuer whose securities are offered by the intermediary;
• not later than 21 days prior to the first day on which securities are sold to any investor (or such other period as the SEC may establish), make available to the SEC and to potential investors any information provided by the issuer pursuant to this new rule;
• ensure that all offering proceeds are only provided to the issuer when the aggregate capital raised from all investors is equal to or greater than a target offering amount, and allow all investors to cancel their commitments to invest, as the SEC rules may require;
• make such efforts as SEC rules may require appropriate to ensure that no investor in a 12-month period has purchased securities offered pursuant to the Section 4(6) exemption that, in the aggregate, from all issuers, exceed the investment limits set forth in that exemption;
• take such steps to protect the privacy of information collected from investors as SEC rules may require;
• not compensate promoters, finders, or lead generators for providing the broker or funding portal with the personal identifying information of any potential investor;
• prohibit its directors, officers, or partners (or any person occupying a similar status or performing a similar function) from having any financial interest in an issuer using its services; and
• meet such other requirements as SEC rules may prescribe for the protection of investors and in the public interest.

Disclosure Requirements. Section 4A(b) of the new rule requires an issuer who relies on the Section 4(6) exemption to file with the SEC, provide to investors and the relevant broker or funding portal, and make available to potential investors:

• information about the issuer, including a description of its business and the stated purpose and use of proceeds of the offering;
• the names of its directors and officers and more than 20 percent shareholders;
• a description of the financial condition of the issuer, including, for offerings that, together with all other offerings of the issuer under Section 4(6) exemptions within the preceding 12-month period, have, in the aggregate, target offering amounts of:
• • $100,000 or less
  • • any income tax returns filed by the issuer for the most recently completed year; and
    • financial statements of the issuer, certified by the principal executive officer of the issuer to be true and complete in all material respects;

• the target offering amount, the deadline to reach the target offering amount, and regular updates regarding the progress of the issuer in meeting the target offering amount;
• the price to the public of the securities or the method for determining the price, provided that, prior to sale, each investor must receive in writing the final price and all required disclosures, with a reasonable opportunity to rescind the commitment to purchase the securities;
• a description of the ownership and capital structure of the issuer, including:
• • terms of the securities of the issuer being offered and each other class of security of the issuer, including how those terms may be modified, and a summary of the differences between the classes of securities, including how the rights of the securities being offered may be materially limited, diluted, or qualified by the rights of any other class of security of the issuer;
  • a description of how the exercise of the rights held by the principal shareholders of the issuer could negatively impact the purchasers of the securities being offered;
  • the name and ownership level of each existing shareholder who owns more than 20 percent of any class of security of the issuer;
  • how the securities being offered are being valued, and examples of methods for how such securities may be valued by the issuer in the future, including during subsequent corporate actions; and
  • the risks to purchasers of the securities relating to minority ownership in the issuer, as well as the risks associated with corporate actions, including additional issuances of shares, a sale of the issuer or of assets of the issuer, or transactions with related parties; and

• any other information as SEC rules may prescribe for the protection of investors and in the public interest.

Other Issuer Requirements. Section 4A(b) requires issuers relying on the Section 4(6) exemption to conduct a crowdfunded offering to:

• refrain from advertising the terms of the offering (except for notices that direct investors to the funding portal or broker);
• not compensate or commit to compensate, directly or indirectly, any person to promote its offerings through communication channels provided by a broker or funding portal, without taking any steps SEC rules may require to ensure that such person clearly discloses the receipt, past or prospective, of any compensation, upon each instance of promotional communication;
• not less than annually, file with the SEC and provide to investors reports of the results of operations and financial statements of the issuer, as SEC rules may require, subject to such exceptions and termination dates as those rules may establish; and
• comply with such other requirements as the SEC may, by rule, prescribe, for the protection of investors and in the public interest.

Liability. Section 4A(c) of the Securities Act creates a private right of action for material misstatements in, or material omissions from, an offering document or oral communication involved in the offer or sale of securities.

Resale Restrictions. The resale of securities issued pursuant to Section 4(6) is restricted for one year by new Section 4A(e) of the Securities Act (unless the securities are resold to the issuer, an accredited investor, as part of a registered offering or to a family member of the purchaser under limited circumstances).

Exclusion from Section 12(g) Trigger

Section 303 of the JOBS Act requires the SEC, by rule, to exempt conditionally or unconditionally, securities acquired pursuant to the Section 4(6) exemption from the provisions of Exchange Act Section 12(g). As a result, an issuer conducting a crowdfunded offering under Section 4(6) will not be required to count the investors in the offering when determining whether the total number of equity owners of the issuer requires registration under the Exchange Act.

Blue Sky

Section 305 of the JOBS Act adds securities issued in a Section 4(6) offering to the definition in Section 18(b)(4) of the Securities Act of "covered securities". As a result, state securities (or Blue Sky) regulators are pre-empted from requiring that offering of these securities be registered under state law. The states can require that issuers relying on Section 4(6) file a notice with the relevant states, but Section 305 limits the instances in which a state can charge a filing fee for these notices. Furthermore, the antifraud provisions of Blue Sky laws will still apply to offerings under Section 4(6). Section 4A(d) of the Securities Act now requires the SEC to make available, or to cause the relevant broker or funding portal to make available, to the state securities administrators copies of the disclosure information filed by issuers with the SEC in connection with a Section 4(6) offering.

SEC Rulemaking

The CROWDFUND Act includes a number of provisions requiring the SEC to adopt rules implementing the new statute. The legislation generally gives the SEC 270 days to adopt these rules, although we have seen from Dodd-Frank that the SEC does not always meet the rulemaking deadlines imposed by Congress. The SEC's rulemaking will need to address a number of Section 4(6) issues, including among other things: disclosures required, excluded issuers, calculation of dollar amounts, filing mechanics and rules for funding portals.

Title IV – Small Company Capital Formation

Previously, Section 3(b) of the Securities Act gave the SEC the authority to create additional exemptions for offerings of securities from the Securities Act by reason of the small amount involved or the limited character of the public offering; provided however, that no issuance of securities was to be exempted where the aggregate amount of the offering to the public exceeds $5 million.

Section 401 of the JOBS Act amends Section 3(b) of the Securities Act to require the SEC to adopt rules adding a new exemption. This exemption would apply to offering of up to $50 million in a 12-month period. The terms and conditions of the new exemption would include the following:

• the aggregate offering amount of all securities offered and sold within the prior 12-month period in reliance upon the new exemption cannot exceed $50 million (subject to periodic increase for inflation);
• the securities may be offered and sold publicly (i.e., general solicitation would be permitted);
• the securities will not be considered restricted securities under Rule 144;
• the civil liability provisions of Section 12(a)(2) of the Securities Act would apply;
• the issuer may solicit interest in the offering prior to filing any offering statement, on terms and conditions that the SEC will prescribe by rule;
• the SEC must require the issuer to annually file audited financial statements; and
• in adopting implementing rules, the SEC may impose other terms and conditions as it determines to be necessary, such as requiring the filing and distribution to prospective investors of an offering statement containing specific disclosures or requiring certain periodic disclosures about the issuer, its business operations, its financial condition, its corporate governance principles, its use of investor funds and other appropriate matters.

Under this new exemption, only the following types of securities may be exempted: equity securities, debt securities and debt securities convertible or exchangeable into equity securities, including any guarantees of those securities. Finally, unlike offerings made pursuant to the crowdfunding exemption described above, unless the securities offered pursuant to this new exemption are offered or sold on a national securities exchange or to qualified purchasers, offerings of those securities will be subject to state Blue Sky securities laws.

The new exemption created by Section 401 can be seen as an extension of the existing Regulation A exemption. In fact, some observers are referring to the new exemptions as the "Regulation A+" exemption. Time will tell whether the new exemption will actually get much use or whether it will turn out to be as seldom used as the existing Regulation A exemption.

Title V - Private Company Flexibility and Growth

Currently, Section 12(g) of the Exchange Act, together with its related rules, requires a company with more than $10 million in assets to register any class of its equity securities that, as of the end of its fiscal year, is "held of record" by 500 or more persons. Deregistration of a class of equity securities under Section 12(g) is permissible when that class of equity securities is held of record by fewer than 300 persons or, under limited circumstances, by fewer than 500 persons. For most publicly traded companies, many shareholders are not individually counted under the definition of "held of record" because they hold their shares in "street name," and SEC rules do not look through the financial intermediary to the beneficial owner. Shareholders of most private companies, however, usually hold their shares directly and, therefore, are counted as "holders of record."

Section 501 amends Section 12(g)(1)(A) of the Exchange Act to increase the registration trigger from 500 shareholders to 2,000 shareholders, so long as no more than 499 of them are non-accredited investors. Additionally, Section 12(g)(5) of the Exchange Act has been amended to state that "the definition of 'held of record' will not include securities held by persons who received the securities pursuant to an employee compensation plan" in transactions exempt from registration.

Section 501 also requires the SEC to adopt safe harbor provisions that issuers can follow when determining whether holders of their securities received the securities pursuant to an employee compensation plan in an exempt transaction. These changes to the Section 12(g) registration trigger may give private companies some additional breathing room before they have to worry about choosing between an IPO and a mandatory Section 12(g) registration. Issuers will, however, have to figure out how to determine at the end of each year which of their investors are accredited.

Title VI – Capital Expansion

Similar to Section 501, Section 601 of the JOBS Act increases the Section 12(g) registration trigger for banks and bank holding companies. Banks and bank holding companies with more than $10 million in total assets used to have to register a class of securities as soon as that class was held of record by more than 500 persons. Section 601 increases this number to 2,000 record holders. Furthermore, banks and bank holding companies are now permitted to deregister a previously registered class of securities when the number of record holders drops below 1,200, as opposed to the old floor of 300 record holders.

Title VII – Outreach on Changes to the Law

Section 701 of the JOBS Act requires the SEC to provide information online, and conduct outreach to small and midsized companies, about the JOBS Act and the changes that will likely ensue.

Conclusion

The JOBS Act is essentially an effort to increase the number of offerings, especially IPOs, by focusing on the supply side – that is by encouraging issuers to take the plunge by lowering perceived barriers. Some observers, including some major investor groups, remain unconvinced. They believe that the decrease in offerings in recent years had more to do with the demand side – that is willingness of investors to invest in early stage, typically riskier companies.

It is safe to say that the JOBS Act is going to have a great impact on the capital raising process going forward. It is, however, too early to determine whether that impact will be the one intended by Congress.

Footnote

1 Title III, Section 304 defines a funding portal as any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others pursuant to the Section 4(6) exemption that meets certain conditions (including not offering investment advice or recommendations, not soliciting purchases, sales or offers to buy securities offered or displayed on its website or portal, and not compensating employees and others based on their solicitation or sale of securities).

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