Congress has moved the line determining which companies must meet the obligations under the Securities Exchange Act of 1934 (the ’34 Act) for the first time in almost 50 years. The traditional section 12(g) standard of 500 shareholders of record is now four times as large (with a wrinkle for counting unaccredited investors described below). This broadening of the space where companies can stay outside of ’34 Act regulation was part of the very deregulatory JOBS Act signed by President Obama on April 5, 2012. The breadth of impact of the section 12(g) amendment, however, is muted because the 500 record shareholder threshold that was changed is only one of three that trigger ’34 Act obligations. The other two are sufficiently inclusive that they will continue to capture most companies that came under the old standard. However, as the Facebook pre-IPO financing of a year ago illustrates, financial innovation may make it much easier to take advantage of this new deregulatory space.
The statutory changes. The JOBS Act amends section 12(g) in four different ways. First the 500 shareholders of record standard is now bifurcated and will only capture companies with either: a) 2000 shareholders of record; or b) 500 record shareholders not accounting accredited investors. Thus a company could have 1999 accredited investors, or 499 unaccredited investors and 1500 accredited investors or 300 unaccredited investors and 1699 accredited investors as record shareholders and stay outside of the ‘34 Act obligations. Companies that have this number of record shareholders must also have $10 million in assets, which did not change under the recent legislation. Second, the definition of record shareholders will not include shares issued pursuant an exemption to employees under the Securities Act of 1933. Third, the Act requires the SEC to exempt from Section 12(g) securities acquired pursuant to a crowdfunding offering that was created by the JOBS Act. Fourth, and more limited, banks and bank holding companies are provided special treatment as to when they can exit Section 12 status. While companies in general are not able to exit the ’34 Act obligations until after their record shareholder number dips below 300, for banks and bank holding companies they can do so when they are below 1200. Look for an exodus of banks from ’34 Act reporting status.
Motivation for the change. While the definition of who must meet ’34 Act obligations has not changed since 1964, when the 12(g) size limit was added to the prior triggers based on stock exchange listing or a registered public offering, the burden of the ’34 Act obligations that follows from crossing this line have grown substantially. Traditionally, the primary ’34 Act burden has been various disclosures, via periodic reporting, proxy disclosures or tender offer information that must be shared. For this reason companies subject to the ’34 Act are often called reporting companies because that is what they must do. And the disclosures are more intrusive than in prior decades. But the burdens of the Act have broadened beyond disclosure. With the passage of the Foreign Corrupt Practices Act and then Sarbanes Oxley, reporting companies have to satisfy sometimes intense obligations as to internal controls. With the massive securities legislation that followed the last two financial crises, the amount of corporate governance obligations that accrues to reporting companies also has grown- e.g. say on pay, requirements as to audit and compensation committees, and other governance provisions. Put simply, companies have more reasons than ever to avoid or delay having to comply with some or all of these provisions. Facebook in the winter of 2010-11 provided a stark example as it neared the statutory threshold and was said to pursue a plan that would bundle a large number of new investors into one collective entity to count as only one record shareholder so as to stay on the private side of the regulatory line.
Legal constraints on using the new deregulated space. Just because you fall below the 2000 record shareholder threshold or one of the other metrics described above, does not mean that you can avoid the regulations of the ’34 Act. In fact there are three gateways into the Act which operate independently of one another. In addition to the 12(g) threshold, a company is also subject to the Act whenever it has securities listed on a national securities exchange or makes a public offering of securities registered pursuant to the ’33 Act. The reporting company obligations are similar for those coming in through any of the gateways although a company doing a registered public offering, but not a stock exchange listing or meeting the 12(g) shareholder test is not made subject to the proxy rules. Most companies tend to list on an exchange when they go public so this difference does not have high practical effect currently.
Finance constraints on using the new deregulated space. The independence of these three gateways for ’34 Act regulations means that practically the only companies that can effectively prosper in this new deregulated space are those that do not need the liquidity for their shareholders provided by the trading opportunities on a stock exchange and do not need the capital that can be obtained through a public offering. In the time since 1964, that has not seemed to be an especially large number (although reliable information is hard to come by) but financial innovation of recent years has definitively increased the potential number of occupants of this space. For example, the number of years prior to a company’s IPO has increased significantly over the last decade or more. In the interim, companies have found other sources of capital—private equity or venture funds—to meet their growth needs. For liquidity, advances in technology and changes in regulation have made it possible for new platforms to meet the need. SecondMarket and SharesPost represent a trading business outside of exchanges with a volume already past several billion in share traffic. The number of companies outside the ’34 Act coverage is likely to be higher than it has been since 1964 when larger companies with shares traded over the counter were brought within the ’34 Act.
Areas of concern going forward. As the JOBS Act has broadened the deregulated space under the ’34 Act, it has continued to use “record” shareholding to define that line. Thus, the number of shareholders who are counted are those on the books of the company. If shares are held in “street name”, for example, or through any other intermediary, they would not be counted and the potential for evasion should seem evident. Since after the 1964 legislation, the SEC has had an anti-evasion rule to address efforts to avoid the record threshold limit and the JOBS Act calls on the SEC to study whether additional enforcement tools are needed. More generally, there is reason to question whether relying on record shareholder making any sense in our modern electronic economy where use of street names is so easy. Using market capitalization and public float seems to have more potential going forward. More generally, there is reason to worry whether stock exchange listing is a viable metric for ’34 Act coverage going forward giving the changes in trading platforms mentioned above. It is this gap in current views about the “publicness” that Don Langevoort and I explore in our article on “Publicness in Contemporary Securities Regulation” here. A second area of concern that teachers ought to keep in mind is the growing importance that the accredited investor term will have and the impact of coming SEC rule-making on the topic. At the moment, the term is used for determining ability to comet within exemptions under the 1933 Act. The JOBS Act thrusts it into a much broader use in which companies will need to make a count of their shareholders at the end of each of their fiscal years before they go public. This task will be more difficult than it has been in the ’33 Act context and likely will raise questions that are not yet visible to us. This may push us toward a bifurcated public markets, one with just accredited investors where there will be no regulation and the other for unaccredited investors where there will be the traditional regulation of the ’34 Act.
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