Summary and Analysis of Key Changes by Steven L. Brooks President Obama signed the Jumpstart Our Business Startups (JOBS) Act (H.R. 3606) into law on April 5, 2012 (the Act). The Act is primarily designed to remove certain restrictions on the ability of small companies to raise capital in the private markets and to make it easier for some companies to go public. The Act focuses on easing certain securities and regulatory requirements that should make it easier for early stage companies to raise capital consequently creating jobs. For example, under the so called "crowd-funding" provision, the Act will allow companies to solicit capital through the internet in small dollar amounts without having to comply with the registration provisions of federal or state securities laws to obtain an exemption from registration. The Act also removes the long standing prohibition under Regulation D of the Securities Act on general advertising and solicitation for certain private offerings. The bill is actually a combination of six different bills, four of which have been passed by the House already.1 The following is a summary of key provisions of the Act and how they will affect companies seeking capital:
Reopening American Capital Markets to Emerging Growth Companies.
Companies seeking access to the U.S. public equities markets through filing a registration statement and selling securities to the general public face a daunting myriad of complex rules, reporting requirements and restrictions that push public capital out of reach for most companies. So to help companies who may be on the edge of being able to access such markets, the Act creates a new category of companies and then exempts them from or eases some of the most onerous provisions of the financial markets regulations that would otherwise be applicable to all companies without exception. The Act amends the definitions contained in the Securities Act and Securities Exchange Act to include a definition for Emerging Growth Company, defined as an issuer that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year.2 Under the Act, an Emerging Growth Company is exempt from various reporting, accounting and compensation rules applicable to companies seeking capital through the U.S. public equities markets.3 The Act also extends to amend certain provisions covered under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the Sarbanes-Oxley Act of 2002 to remove certain restrictions on reporting companies, such as shareholder approval for executive compensation and certain reporting requirements of SEC registered public accounting firms performing attest engagements. The following are key provisions designed to improve access to capital markets for Emerging Growth Companies:
- Exempted from the requirement to obtain separate shareholder approval for executive compensation, including golden parachute compensation
- Not required to present more than two years of audited financial statements, or any financial data for any period before the earliest audited period presented in order to go public (i.e., in connection with a registration statement).
- Allowed to use accounting standards that do not incorporate new or revised financial accounting standards that were not applicable prior to issuing securities.
- Relaxed prohibitions on communications, including distribution of information by a brokerdealer.
Access to Capital for Job Creators
Companies seeking capital through the private securities markets have long been able to avoid the time and cost associated with raising capital in the public securities markets by complying with certain exemptions from filing a registration statement. For example, the so called private offering exemption of Section 4(2) of the Securities Act provides an exemption from the registration requirements for transactions by an issuer not involving any public offering. Another common exemption is available for any offer or sale of securities to residents of a single state by an issuer who resides in or is incorporated in the same state, known as the intrastate exemption.4 These exemptions have been developed over the years through interpretations by the SEC and the courts and are used broadly today. However, most issuers rely on one or more safe-harbor exemptions promulgated under Regulation D. A detailed review of Regulation D and the available exemptions is beyond the scope of this article. However, one of the key rules underlying each limited offering, with the exception of certain cases under Rule 504 offerings (the Rules), is that offerings exempt under Regulation D are prohibited from the use of general solicitation or general advertising in connection with such offerings. The terms general solicitation and general advertising are not defined in the Rule nor were they discussed in any of the comments adopting the Rules. Multiple SEC no action letters address the prohibition on general solicitation and general advertising with the common theme that whether or not particular activities constitute a general solicitation must always be determined based on the particular facts and circumstances. The Rule restricting general advertising and general solicitation is a pillar of the Regulation D requirements because the spirit of the Rules are such that the SEC will not require registration if securities are offered to or solicited from a private individual or group of individuals with whom the issuer is well acquainted. Section 201 of the Act modifies the Rules to provide that the prohibition against general solicitation or general advertising contained in Section 230.502(c) shall not apply to offers and sales of securities made pursuant to the Rules, provided that all purchasers of the securities are accredited investors.5 The Act requires the Rules to require the issuer to take reasonable steps to verify that purchasers of securities are accredited investors, using such methods as determined by the Commission. It is unclear yet how the Commission will interpret this Rule change. For example, it is unclear whether a particular audience must be carefully screened to insure that an audience must be all accredited investors prior to soliciting an investment or whether the solicitation can be made by any means of general advertising or general solicitation so long as the ultimate purchasers of securities are accredited investors. In either case, it is clear that this Rule change will substantially broaden an issuers ability to obtain investors without having the required substantial preexisting relationships with each of them.
Equity-Based Crowd-funding
The Act also provides for a new category of a transactional exemption, to be added under Section 4 of the Securities Act, for transactions involving the offer or sale of securities provided the offering meets three conditions: (i) the aggregate amount sold to all investors is not more than $1,000,000.00, (ii) the aggregate sold to any investor does not exceed the greater of $2,000.00 or 5% of the annual income or net worth of such investor (if either the annual income or the net worth of the investor is less than $100,000.00), and 10% of the annual income or net worth of such investor, not to exceed a maximum amount sold of $100,000.00 (if either the annual income or net worth of the investor is more than $100,000.00), and (iii) the transaction is conducted through a broker or funding portal that complies with certain requirements with respect to intermediaries and issuers. The crowd-funding exemption has already spurred crowdfunding based exchanges whereby small companies are pooled into a single fund and equity in the fund is offered to investors through online funding portals. Under the crowd-funding exemption, investors are not required to be accredited in order for the offering to qualify for state preemption (discussed below). Known as the crowd-funding exemption, this provision of the Act has drawn some controversy. Advocates contend that crowd-funding is a way to democratize investing by allowing small businesses to raise capital over the internet and allow small businesses to raise capital from more established sources. Critics contend that the crowd-funding exemption will not be adequately regulated and will encourage fraudulent investment schemes. The SEC is required to establish rules under the crowd-funding exemption. The Act imposes several requirements on issuers and intermediaries of funding portals. Requirements on intermediaries: Any person acting as an intermediary in a transaction involving the offer and sale of securities under the crowd-funding exemption is required to register with the SEC as either a broker, or a funding portal6 and any national securities exchange, registered securities association or registered clearing agency.7 Intermediaries are also required to provide such disclosures relating to risks and other investor education materials as the Commission shall by Rule, determine appropriate. There are also a host of provisions inserted by the Senate designed to reduce occurrences of fraud and misconduct. Such provisions are more subjective in nature. Intermediaries, including funding portals, must:
- Ensure each investor reviews investor education information;
- Affirm that the investor understands that the investor is risking the loss of the entire investment;
- Affirm that the investor could bear such a loss;
- Require investors to answer questions demonstrating an understanding of the level of risk generally acceptable to investments in startups, emerging businesses, and small issuers, and the risk of illiquidity;
- Obtain a background check in securities enforcement on each officer, director and person holding more than 20% of an issuers outstanding equity;
- Not later than 21 days prior to the first sale of securities, make all information provided by the issuer (as set forth immediately below) available to each investor;
- Ensure that all offering proceeds are only distributed after the target offering amount has been reached (i.e. a contingent offering);
- Ensure the privacy of information collected from investors;
- Not compensate promoters, finders, or lead generators for providing the broker or funding portal with the personal identifying information of any potential investor; and
- Not have any officers, directors, or partners etc. from having any financial interest in issuer utilizing its services [as an intermediary].
We expect the Commission to publish a detailed and comprehensive set of regulations to implement the crowd-funding portion of the Act, which will likely include additional requirements. Requirements on issuers: Issuers are required to file with the Commission, provide to investors and the relevant intermediary, and make available to potential investors very simple information concerning the issuer. Such information includes information that would otherwise be presented in a detailed term sheet, private offering memorandum or prospectus of an issuer that would otherwise be undertaking a Rule 504 or Rule 506 private offering such as:
- A description of the business of the issuer and the anticipated business plan of the issuer;
- A description of the financial condition of the issuer including depending upon the offering amount either tax returns, reviewed financials or audited financials;
- A description of the stated purpose and use of the proceeds;
- 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; and
- A description of the ownership and capital structure of the issuer.
In addition to the information filing, issuers are prohibited from advertising the terms of the offering, except for notices which direct investors to the funding portal or broker. The issuer must also carefully disclose amounts paid to compensate any person to promote the offering through the intermediary and after the funding has closed, not less than annually, file with the Commission and provide to investors reports of the results of operations and financial statements of the issuer. The SEC is expected to publish detailed guidance for each of the above requirements. In order to allow a funding portal to act as an intermediary for the sale of securities, the Act also provides an exemption for funding portals from the requirement to register as a broker dealer under the Securities and Exchange Act. Certain requirements are placed on funding portals in order to qualify for the exemption. Most importantly, the funding portal is required to be a member of the National Securities Association and is not allowed to (i) offer investment advice or recommendations, (ii) solicit purchases, sales or offers to buy the securities offered or displayed on its website or portal, (iii) compensate employees, agents or other persons based on the sale of securities, and (iv) hold, manage, possess or otherwise handle investor funds or securities. Importantly, the Act includes the crowd-funding exemption (new Section 4(6) of the Securities Act) as a preempted security for purposes of state securities laws.8 The Act adds a security issued under the crowd-funding exemption to the list of covered securities under Section 18(b) of the Securities Act. A covered security is exempt from the requirement of any state laws with respect to, registration or qualification of securities, or registration or qualification of securities transactions. The Act clarifies that state preemption applies solely to registration, documentation and offering requirements. Preemption does not apply to states authority to take enforcement actions with regard to an issuer, funding portal or any other person or entity using the crowdfunding exemption. The Act also restricts states from imposing filing fees other than filing fees required by the Securities Commission of the state of the principal place of business of the issuer or any state in which purchasers of 50% or greater of the aggregate amount of the issue are residents. Funding portals are also exempt from any state enforcement action against registered funding portals with respect to its business as such.
Small Company Capital Formation
The Act also amends the exemption under Regulation A of the Securities Act (exempting certain securities, as opposed to transactions) for companies seeking smaller amounts of capital. Under the Act, the Commission shall by Rule or Regulation add a new class of securities to be exempted in accordance with the following terms and conditions:
- The aggregate amount of all securities offered and sold within the prior twelve month period and relying on such exemption shall not exceed $50,000,000.00;
- Such securities may be offered and sold publicly;
- Such securities shall not be restricted securities, thus allowing resale of such securities;
- An issuer may solicit interest in the offering prior to the filing of any offering statement, on such terms and conditions as the Commission may prescribe;
- The issuer is required to file audited financial statements with the Commission annually; and
- The Commission shall prescribe other terms and conditions to include the filing of an offering statement with the Commission and distribute it to prospective investors.
Only equity securities, debt securities, and debt securities convertible or exchangeable to equity interests, including any guarantees of such interests are exempted under the Act. The new exemption will also be added to the list at Section 18(b)(4) as a covered security for purposes of state securities law preemption; provided, however, that such security is offered or sold on a national securities exchange, or offered or sold to a qualified purchaser as defined by the Commission pursuant to paragraph 18(b)(3). It is interesting to note that this new covered securities definition includes a Section 3(b) exemption since previously the only covered securities exemption that exists for non-registered securities are for exemptions under Regulation D under Section 4(2) of the Securities Act (i.e., for transactional exemptions by an issuer not involving any public offering).
Private Company Flexibility and Growth and Capital Expansion
The final two provisions of the Act include revisions to Section 12(g) of the Securities Exchange Act of 1934. The Act increases the threshold total amount of assets a company may have prior to registering its securities from $1,000,000.00 to $10,000,000.00 and the threshold number of investors from 750 persons to 2,000 persons, or 500 persons who are not accredited investors. The Act also exempts from having to include in the number of persons holding securities, securities held by persons who received the securities pursuant to employee compensation plan and transactions exempted from the registration requirements of the Securities Act. This change is also applicable to banks and bank holding companies.
Observation
While the Act is clearly designed to open capital markets, spur investment activity, and remove restrictions on small companies looking to raise capital, it will require ongoing interpretation and compliance with the fundamental provisions of the securities laws that remain intact and are revised in part by the Act. Companies, investors, and most importantly funding portals should be aware of these rules and conduct their activities accordingly. The new rules should greatly help smaller companies and will produce the desired results if all parties comply with not only the letter of the Act, but also the spirit of the Act. We have represented clients with regard to compliance with securities laws and enforcement actions on a regular basis and are able to advise clients on the rapidly evolving revisions implemented under the Act. If you have questions or comments, please do not hesitate to contact any of the attorneys listed above.
1 Access to Capital for Job Creators Act (H.R. 2940); Entrepreneur Access to Capital Act (H.R. 2930); Small Company Capital Formation Act (H.R. 1070); and Private Company Flexibility and Growth Act (H.R. 2167). The JOBS Act also includes H.R. 4088, the Capital Expansion Act, which would increase the number of shareholders able to invest in community banks from 500 to 2,000. 2 Indexed for inflation every 5 years based on Consumer Price Index. 3 A company may choose to forgo such exemptions and instead comply with the requirements that apply to an issuer that is not an Emerging Growth Company. Section 107(a). 4 Section 3(a)(11) of the Securities Act. 5 The definition of an accredited investor may be found at Regulation 230.501(a). 6 As defined Section 3(a)(80) of the Securities Exchange Act of 1934. 7 Any applicable self regulatory organization defined in Section 3(a)(26) of the Securities Exchange Act of 1934. 8 Section 18(b)(4) of the Securities Act. This Alert is provided to Clients and friends of the Firm. If you have questions regarding any of the items discussed, please contact one of the following attorneys: Steven L. Brooks, M. Sean Evans, John F. Griffee IV, Robert T. Smith. This Friday, Eldredge & Clark, LLP publication should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney on any specific legal questions you may have. download the article here