A bit over a month ago, I had the privilege of attending a roundtable discussion at NYU on Title II of the JOBS Act. As you may recall, Bob Thompson and I earlier helped the Glom conduct a forum on the JOBS Act, and I asked Usha (who organized the forum) for permission to add this post as an epilogue of sorts (especially since we did not cover Title II in the earlier posts). Thanks, Usha et al., for this opportunity to extend the discussion. Thanks also to Steve Bainbridge for urging me to post on this after I posted on the roundtable on LinkedIn. (This post repeats much of what I said there and adds a bit to it.)
Title II of the JOBS Act includes only one section--Section 201. Among other things, this section takes aim at the general solicitation/advertising prohibitions applicable to offeirngs under Rule 506 of Regulation D under the Securities Act of 1933, as amended (1933 Act). Specifically, the section requires the Securities and Exchange Commission (SEC) to modify the general solicitation/advertising provisions in Rule 502(c) so they will not apply to Rule 506 offerings if all purchasers in the offering are accredited investors. Section 201 also provides for a similar amendment to Rule 144A to allow securities to be offered "to persons other than qualified institutional buyers, including by means of general solicitation or general advertising, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer." This post only addresses the Regulation D part of Section 201 and only raises a few of the many issues to be faced in the rule-making process.
At the June roundtable, many of the most active participants were representatives of investment fund firms (vc, hedge, etc.) and their counsel. The relaxation of the general solicitation rules is of great importance to them because this deregulation has the potential to help their business operations (as investors in portfolio companies) and their ability to solicit investors in their own firms using Rule 506 offerings. The composition of the group enabled a very interesting discussion.
Perhaps the most interesting part of the conversation related to the portion of Section 201(a)(1) of the JOBS Act that directs the SEC to, in its rule-making, "require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission." What might those reasonable steps be? Should the SEC script them out in detail, and if so, how? Should the same rules apply to, e.g., portfolio company offerings and offerings made by repeat financial industry issuers, like hedge funds?
There was a lot of sentiment around the table for having the SEC fashion rules that allow different types of industry players to determine what requirements are reasonable in their circumstances. The means of doing that could range from merely writing a rule that incorporates the reasonableness requirement in some general way, to working with safe harbor provisions that would set a core group of procedures, to using interpretive guidance to fill in details for different types of offerings. This turned out to be a rich conversation that bridged the gap between policy and practice.
We noted in the discussion that the reasonableness requirement in Section 201(a)(1) builds on the "reasonable belief" concept in the accredited investor definition in Rule 501 of Regulation D: "Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person . . . ." I noted in the discussion that a similar framework exists in the due diligence defense provisions in Section 11(b) of the 1933 Act: "after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading . . . ." The processes underlying the successful navigation of this due diligence defense were determined privately, outside the scope of SEC rule-making, and were vetted in enforcement proceedings. So, there is some precedent for leaving these kinds of reasonableness requirements to the actors in the regulatory scheme, subject to an enforcement check, albeit in a different context. It's worth thinking through that analogy more rigorously given the different context, but it is a noteworthy analogy nevertheless (imho). Among the issues to be thought through more carefully are the nature of the regulatory costs (including the costs of legal change) associated with the various proposed regulatory solutions and the bearer of those regulatory costs.
The SEC expects to take up rule-making on this at the end of the month. This means that the rule making on Title II of the JOBS Act will be way behind Congress's schedule. In the mean time, folks still are posting formal and informal pre-comments in the designated area of the SEC's Web site. Although I haven't taken the time to wend my way through all of the commentary and carefully think it through, there are a few recent letters that address some of the issues raised in this post and, in my view, merit attention. These include the letters filed by the National Small Business Association and the North American Securities Administrators Association (to which there have been some replies here and here).
There is much work to be done here. I throw out these ideas as a way of starting a potential conversation. So, if you're interested, have at it.
I'd like to thank all of our participants, and particularly our lead bloggers Joan Heminway and Bob Thompson, for an incredible forum on the JOBS Act. All the posts are collected here. I look forward to continuing the conversation with our fellow bloggers and readers, on the blog, in person, and in future scholarship.
We already have an emerging growth company IPO! According to the Seattle Times
An early-stage Seattle company that went public Wednesday with a $12 million stock offering appears to be one of the first, if not the first, in the nation to make use of the new JOBS Act.
ClearSign Combustion, which is developing technologies to make boilers, furnaces, turbines and other combustion systems more efficient, said it would take advantage of a provision in the new law that allows it to delay adopting new or revised accounting standards.
In its final prospectus, ClearSign also said it might take advantage of other exemptions the law creates for "emerging growth companies," including disclosing less information about executive pay, not letting shareholders vote on pay arrangements and not having outside auditors attest to the effectiveness of its internal controls.
Interestingly, it appears that ClearSign was set for a traditional IPO in November of this year, looking for $18 million. But it accelerated onto that on-ramp, and went public yesterday, ending up 5%. I can't find the quoted language in the most recent S-1 up on Edgar, but I'm looking into that. Update: It's here.
Right now this is their website. I include a screenshot (my first ever) because I presume it will change:
Perhaps a tad uninformative? Welcome to the brave new world of IPOs!
From Steven Davidoff:
I must admit to being a bit persnickety when it comes to the JOBS Act. I think that whatever the outcome, Congress legislated without much thought or coherence. The example of small IPOs comes to mind. Congress ignored the evidence that decimalization and the demise in analyst coverage caused the decline in small IPOs, a decline which occurred BEFORE Sarbanes-Oxley. Instead public interests groups and the editorial page of the Wall Street Journal successfully turned it into a question of Sarbanes-Oxley and its over-regulation.
I’m also affected by the experience with foreign private issuers which I wrote about in a 2010 article for a University of Cincinnati symposium: Rhetoric and Reality: A Historical Perspective on the SEC's Regulation of Foreign Private Issuers. There I argued that the rhetoric of Sarbanes-Oxley led the SEC to deregulate the foreign private issuer rules. Similar to what occurred with the JOBS Act, the drop in foreign listings in the United States was linked to Sarbanes-Oxley and the rise of the low regulation AIM market. The SEC was forced to respond to this rhetoric.
In reality, as I show in the article, the U.S. was and is largely the world’s only competitor for these listings, and the market came roaring back when BRIC nations began searching for Western IPO outlets, not when the SEC acted to deregulate the market. I also predicted at the time that this deregulation would lead to problems with Chinese issuers, and sure enough I am right (sorry for the all the self-referential credit, but hey, I take what I can get and will stop now). The SEC is now talking about reregulating and the AIM market has collapsed. And that is why I don’t like the IPO on-ramp provisions – I’m not sure that they will do anything, don’t address the specific causes of the small IPO crisis and are repeating at some level the mistakes with the foreign issuer process. Still, in the vein of John C. Coates IV’s testimony on the Bill, I’m willing to admit that it is worth letting these provision go forward as an experiment as there are real complaints about the requirements of being public these days. The JOBS Act doesn’t solve them all but does address some of them. (Brett McDonnell and Erik Gerding have some more thoughtful points on the legislative process earlier in this forum.)
But all of this is griping about the IPO On-Ramp provisions.
As for the private capital raising parts, I’m more optimistic about markets and market participants adapting. The crowd-funding exemption has interesting potential particularly since it preempts most state blue sky laws something which Rules 503 and 504 do not (that is why almost all issuers use Rule 506 as Rutheford B. Campbell has documented). Second, as Andrew Schwartz from Colorado recently noted at a symposium at Ohio State law school, it can also be used for debt (Andrew’s paper from the symposium will be a must read about the future of this exemption). In a low trust environment, it may very well be that crowd-funding functions but not for equity. We’ll see. (Robert Thompson has his own thoughts about the future of crowd funding here and Joan Heminway has more on these provisions here. Joan by the way has been one of the leaders in the academic charge on this provision.)
Beyond crowd-funding, the new $50 million exemption under Section 3(b)(2) looks to be about as useful as Regulation A is (not much) and likely to fail for the same reasons. Too much information is required and there is no blue sky preemption when other avenues like Rule 506 do preempt and have lower information preparation requirements, at least when you go to accredited investors. Not to mention Congress didn’t trust the SEC to get the requirements for its use right so over-legislated the parameters for this exemption. You don’t believe me? Take a look at this summary of 3(b)(2)’s legislative provisions. Crowd-funding also has some serious barriers in the burdens Congress hard-wired into the provision, including background checks and a requirement that trades occur on a platform.
So what would have been the best changes? Outside the private capital-raising arena, the first thing I would do is substantially pare down the general solicitation rules for IPOs. They’re a mess right now as you can see from trying to use, read or teach Rule 433. I’m still not sure about reducing disclosure and other Sarbanes-Oxley requirements, so will have to defer to others on this.
Then for private offerings, let Rule 506 allow for the inclusion of up to a certain amount of unaccredited investors without the bar on general solicitation or the information requirements. The latter requirement is particularly burdensome and essentially requires prospectus level disclosure if you include unaccredited investors. Then give the SEC the power to tinker with the rules on a going-forward basis and add protections for fraud that don’t stifle the exemptions unless necessary. In essence, truly have a crowd-funding experiment, but address the fraud problem through initial monitoring and revision. And it is all about allowing issuers to easily access unaccredited investors, since Rule 506 right now allows for such access to accrediteds. It’s about allowing equal access to capital in the right situation.
OK – so now I’m being overly optimistic
My question, after contemplating Joan's post, is who exactly is going to use the exemption in new section 4(6)? And that will shape any response to Jeff Lipshaw's question as to how this new statute will affect how we teach our courses? Rule 504 already permits issuers to raise up to $1 million and the regulatory requirements are fairly modest. The only thing that got changed in the Senate considerations of what became the JOBS Act, i.e. the only place where there was any push back to the general deregulatory philosophy of the various parts of the bill, was to add additional regulatory protections for crowdfunding offers, both as to issuers and platforms. (A push back that seems warranted given the SEC's experience with Rule 504 deregulation in the late 1990s). What then is the attraction of the Crowdfunding brand as opposed to the existing exemptions? One difference is that state registration requirements don't apply to the new exemption, suggesting further atrophy in the role of state blue sky laws. But that may not be enough to generate a lot of use of this new exemption. Other changes to exemptions made by the JOBS Act may well have a greater impact. The lifting of the ban of general solicitation for Rule 506 offerings will make that offering more attractive to issuers (and also raise concerns about possible fraud that could arise from internet solicitations). The new exemption to be promulgated under new Section 3(b)(2) of the '33 Act--Regulation A on steroids-- will permit exempt public offerings of up to $50,000,000 as opposed to the current $5,000,000 limit. Overall, I don't think the new statute really changes the syllabus very much on the '33 Act part of securities regulation. Any discussion of any of these exemptions fits within the existing structure. The parts of the on ramp that relate to the IPO process (e.g. confidential filing) likewise fit into what I suspect is the existing structure of most securities courses. Some teachers may want to talk about analysts more than in prior years. But the '34 Act part of the securities course is more of a challenge. The continuing growth of obligations of '34 Act companies as to internal controls and governance and the explicit scaling provided for on ramp companies is likely to require new attention on the transactional side of the '34 Act, likely best taught by the use of problems similar to those often used to teach the '33 Act.
The posts so far in the forum have been superb, and allowed me to update my priors on the JOBS Act, which were:
- Changing the number of shareholders required before going public - the forum has convinced me that this looks like it was done randomly, but I understand the impetus. Why should Facebook have to tie itself in knots to avoid going public if it doesn't want to?
- Crowdfunding - I commend Andrew Verstein's paper on this to interested parties, but it all seems like small, if trendy, beer. It's hard to imagine a start-up that gets any escape velocity at all continuing to rely on Kickstarter. I can see crowdfunding working for Instagram, but not for a business that actually needs capital, like, say, an auto-dealer.
- On-ramp - I thought before, and I doubly think now, that this is the very big deal, the total deregulatory tool that will affect many firms and investors. I'm glad Congress provided the opt-out, and nothing in this life is perfect, but it seems to me that we should either believe in our system of securities regulation or we should not. Creating quite a large band of firms that can go public without complying with a big chunk of the securities regs is a strange way to have it both ways. Perhaps Congress views this as a way to test whether the capital markets should be deregulated for all filers. Perhaps Sarbanes Oxley section 404 was a dramatic overreach that has led to a counterreformation that will, in the end, leave us with a lower level of supervision than existed before Enron. But currently, this seems like a strange experiment, rather than a well-thought-out way to ease big firms into the regulatory environment.
I have been sitting back and learning from the other Masters, but I confess to a far more mundane reaction to the JOBS Act, and one that is far more focused on where I live: what do I need to change in my syllabus for the three credit Securities Regulation course in the fall, and who's providing the resources?
When I was a law student in the 1970s, all discussion of the 34 Act (proxy solicitations, private cause of action, Rule 10-5, etc.) was part of the four credit Business Associations class. Ken Scott's three credit Sec Reg class was entirely based on the 33 Act. So I confess that as somebody who quit being a litigator and moved to transactional work as much more satisfying, my bias is toward teaching the transactional aspects of the field, even though the 34 Act is clearly part of what our school expects us to teach. So I teach 10b-5 litigation and insider trading whether I want to or not.
On the transactional side, while a few of our students might actually work for firms or companies in which the regular reporting requirements are part of the day-to-day work of securities lawyers, I think it's more important for most of our students to understand what triggers the registration requirements under the 33 Act - what is a security, the basic registration and prospectus scheme, the exemptions under Section 4 and Reg D, and the control person and resale gotchas. I had already concluded that the increase in the shareholder numerosity trigger under Section 12 was not all that interesting to me, and that crowdfunding would be a nice little separate unit. But it's the "emerging company on-ramp" stuff - both the "testing the market" and the ensuing reporting exemptions - that has me thinking I am going to have to do some major emendation of the unit on the public offerings.
Does one teach the standard Section 5 IPO process and then "on ramp" as a variant? Is the reality that most IPOs involve companies below the $1 billion annual revenue threshold enough to make the on-ramp the default teaching module? Do we need to wait and see whether companies opt out of the on-ramp? Inquiring minds want to know. Thoughts?
UPDATE: I think my pedagogical conundrum is making the same point as David Zaring's insightful third bullet point in the post just above mine. Do I teach the system or the exception? I kind of thought the system engendered by Section 5 made sense the way it was, and stood the test of time.
Bob has done yeoman's work in introducing the first three days of this forum. (Do I hear applause in the background? I think so.) Today, it's my turn to introduce the final key piece of the JOBS Act: the CROWDFUND Act, the subject of Title III of the JOBS Act.
I will not try to unpack crowdfunding as a whole in this post. I will leave that to the articles I cited in my initial post for this forum and to many Web-based destinations with which you may be familiar (or can easily find). Suffice it to say, crowdfunding involves the use of the Internet to solicit funding for businesses and projects from the faceless Internet "crowd." It's the fund-raising variant of crowdsourcing; the effective use of social media to connect businesses and projects with potential and actual funding sources.
Instead, I will focus this post on the basic elements of crowdfund investing--the offer and sale of securities to the crowd over the Internet--as contemplated and permitted under the CROWDFUND Act. Set forth below are the key regulatory components mandated in the CROWDFUND Act, all of which are subject to significant definition, interpretation/illumination, and enhancement by the SEC (within 270 days after the date of enactment of the JOBS Act).
The Basic Parameters for Issuers and Investors
The CROWDFUND Act establishes a new exemption from registration under the Securities Act of 1933 (the "1933 Act"). The new exemption allows issuers to sell up to $1 million of securities in a 12-month period (looking back) without 1933 Act registration. Under the exemption, an investor is limited in the amount he, she, or it can invest. If an investor's annual income or net worth is less than $100,000, the investor may invest up to the greater of $2,000 or 5% of that annual income or net worth. If an investor's annual income or net worth is equal to or more than $100,000, the per-investor cap equals 10% of the annual income or net worth, not to exceed a maximum aggregate amount sold of $100,000. These dollar amounts must be revisited by the SEC at least every five years.
Issuers must be "qualified" in certain respects in order to offer securities in a crowdfunded offering. Specifically, an issuer must be organized under and subject to the laws of a U.S. state or territory or the District of Columbia, and public companies, investment companies, and "bad boys" (issuers that have committed certain violations--e.g., securities law violations) need not apply.
Finally, issuers must subject themselves to a new Section 12(a)(2)-type liability regime. Oh, and for the purposes of this new material misstatements and misleading omissions liability, the term "issuer" includes the issuer's directors or partners, CEO, and CFO. So, any of them can be held liable as a primary violator.
Investors are subject to a one-year transfer restriction on any securities acquired in a crowdfunded offering, except for transfers to the issuer, to accredited investors, in a registered offering, to a family member, on death, or on divorce. And, as you know from Bob's post and my post on the new Section 12(g) thresholds and exemptions under the JOBS Act, record holders of securities issued in a crowdfunded offering are not counted for purposes of those thresholds.
A Mandated Role for Intermediaries
Crowdfunded offerings must be conducted through a specified intermediary--either a registered broker or a registered funding portal--a new type of registered, regulated entity created under the CROWDFUND Act by amendment of both the 1933 Act and the Securities Exchange Act of 1934 (the "1934 Act"). Under the 1934 Act, these funding portals have a limited scope of permitted activities, and while they are are exempt from registration as a broker or dealer, they are subject to regulation as members of national securities associations, to some extent. In essence, the broker or funding portal is a registered, regulated mandatory participant responsible for advertising and marketing and conducting the offering.
- ensuring investor review of required investor-education materials and understanding of the risk of the offering,
- implementing fraud risk reduction of some kind,
- funneling issuer information to the SEC and investors,
- ensuring that the offering proceeds are held until a specific funding target is met,
- ennsuring compliance with the investment limits (per-investor caps) described above,
- instituting investor privacy protections,
- not selling investor information, and
- preventing self-dealing by its principals.
The required involvement of a registered broker or funding portal, together with the misstatements and omissions liability and mandatory disclosures included in the CROWDFUND Act, constitute the key investor and market protection tools provided for in the legislation.
Interactions with State Blue Sky Laws
I cannot resist picking up where Usha left off . . . . What about "Road to Nowhere?" As a Talking Heads fan, I cannot resist that one. And that shoe may fit. (Oops. Mixed metaphor there.)
Where is the on-ramp taking these emerging growth companies? Does it prepare them for success or failure in the public company realm? What is the real purpose of the on-ramp? Sure, it improves access to the public markets for smaller issuers by cutting costs of compliance (including, among other things, the diversion of management and board time and resources to the satisfaction of some public disclosure obligations). But why do we want to encourage issuers to become public based on their size (as opposed to other or blended atributes)? Said another way, why should we back off on compliance requirements because an issuer has low gross revenues (or a small market capitalization or limited non-convertible debt issuances or any other measure of limited size)? How does this tyoe of deregulation help promote investor protection and the maintenance of the integrioty of the securities markets? (I.e., how do I explain this to my students?) Good things do not always come in small packages, right . . . ?
Erik's post heads down this path a bit. Leaving aside matters of market efficiency, the temporary suspension of public company disclosure requiremnts certainly makes one think about whether some of the existng requirements are necessary even for larger issuers. Perhaps this will be an experiment that helps show us how and where we have over-regulated. Or perhaps the savings that small issuers will realize through the IPO on-ramp provisions will be offset by a higher volume of shareholder litigation (successful and unsuccesful) for inadequate disclosures of material fact.
It also is important to note that an issuer may or may be in a position in which it can take advantage of all of the benefits of the on-ramp. The nature of the issuer, the nature of the offering (and its underwriters), or contractual obligations with previous funders, for example, may prevent an issuer from availing itself of each on-ramp advantage. Accordingly, the cost benefits of the on-ramp may not be fully realizable, and it therefore may not be as advantgaeous as Congress anticipated.
Reading the mandatory disclosure chapter of Easterbrook and Fischel's The Economic Structure of Corporate Law, I was struck by this passage:
The securities laws may be designed to protect special interests at the expense of investors. They possess many of the characteristics of interest-group legislation. Existing rules give large issuers an edge, because many of the costs of disclosure are the same regardless of the size of the firm or the offering. Thus larger or older firms face lower flotation costs per dollar than do smaller issuers.
Based on limited knowledge (much enhanced by Bob's helpful history of the JOBS Act), I had the sense that JOBS was a product of luck and interest group politics, warnings of the SEC and John Coffee be damned (He testified to Congress: "There is no need for such an open-ended exemption, largely benefitting larger firms or for such a dramatic retreat from the principle of transparency that has long governed our securities markets in order to spur job creation at smaller firms."). I am certainly struck, as Bob is, by the lack of cost-benefit analysis in picking the numbers for the on and off ramps for emerging growth company status.
But I guess the counterargument is that the whole of securities regulation is a product of interest group politics, and it's all tilted in favor of big companies. JOBS Act is just a rare case of the little guy triumphing over establishment Goliath.
I'm not sure I buy it. We'll all know more after empirical studies on how the companies who opt out of the on-ramp (and into the regular securities disclosure regime) fare compared to those companies who choose emerging growth company status. I'm wondering how many years of data we need for these studies to be meaningful. And I'm hoping for some really bad titular puns. Like "Highway to Hell." Or "No Exit for Investors." Or "The Utility of Signaling When Merging onto U.S. Stock Markets." Or...OK, I'll stop now.
Of the three most visible changes made by the JOBS Act---crowdfunding, the on ramp, and the changes to 12(g)—the “On Ramp” is likely to have the largest impact. It introduces a scaling of the obligations under the Securities Exchange Act of 1934 (the ’34 Act) well-beyond any use of that concept up to this point. Companies that have less than $1 billion in revenue at the time they go public (a breakpoint that likely covers almost all companies going public now, although not Facebook and a small number of others) will be able to avoid a significant number of ’34 Act obligations for up to five years. The On Ramp proposal tracked a different path than the other bills that got wrapped into the JOBS Act over the winter of 2010-11. It follows on earlier efforts to encourage more IPOs in the United States, which have not recovered from their post dot.com crash blues. A task force from the private sector, including Silicon Valley, put out a proposal in the fall of 2011, which got support from both the Obama administration and members of Congress and sailed through the legislative process with greater ease than perhaps any proponent has a right to expect in contemporary Washington. “Emerging growth companies” going public after December 8, 2011 can use the new legislation.
Obligations from the ’34 Act that Can Be Avoided During the On Ramp Period. A company that comes under the ’34 Act incurs a series of regulatory obligations. Most visible are the disclosure requirements that are part of the securities and corporations courses that we teach. This includes periodic obligations under 10-K and 10-Q as well as other information required in 8-K fillings, proxy solicitations, or tender offers. In addition to disclosure, companies subject to the ‘34 Act have seen increases in other duties such as those regarding internal controls or corporate governance. The On Ramp speaks to each of these as well as to obligations imposed in the public offering process itself. The list of regulations that emerging growth companies can skip includes the following:
· Avoiding compensation disclosures such as those requiring comparison of pay versus performance, and making other compensation disclosures the same as for smaller reporting companies;
· Eliminating governance requirements such as “say on pay” shareholder voting rights added by Dodd Frank legislation in 2010;
· Reducing the burdens of various internal control requirements by freeing these companies from the internal controls attestation required by Sarbanes Oxley §404(b), reducing their exposure to newly revised accounting standards, reducing required audited financials to two years, and creating a transition period for PCAOB requirements on auditor rotation and certain other independent audit requirements;
· Loosening some ’33 Act procedures for raising new capital, for example, by allowing “test the waters” communications with qualified institutional buyers and accredited investors in advance of filing a registration statement for a public offering, allowing confidential filing of registration materials with SEC, so that initial staff concerns can be resolved without publicity, and permitting post-offering communications to support the offering, including through the expiration of lock-ups;
· Allowing sell-side investment analysts to participate more extensively in public offerings notwithstanding a variety of restrictions currently in place, including some that were the product of the research analyst scandals of a decade ago.
Definition of Emerging Growth Companies. The definition of companies who come within this new term is fairly straightforward: a company going public after December 2011 which has revenue of less than $1 billion dollars. The test of when a company leaves emerging growth status and returns to the regular ’34 Act world is a good bit more complicated. Four metrics are used, three based on various definitions of size, and one based on time after public offering. Thus an emerging growth company remains in that status until the earliest of: (1) reaching $1 billion in annual gross revenues; (2) achieving a total market capitalization of more than $700 million; (3) issuing more than $1 billion in non-convertible debt securities within a three year period; or (4) five years from the date of the first public sale of common equity pursuant to a registered public offering.
Of the four metrics, the second has the most current visibility. The $700 million public float is breakpoint for becoming a ‘large accelerated filer” under the ’34 Act and a “well-known seasoned issuer” under the ’33 Act. Thus, it has already become a breakpoint for companies that subjected to more intense regulation and that use is likely to grow more pronounced following this legislation. It is likely that we are heading more an explicit two level system of disclosure. Don Langevoort and I discuss this trend and the theories that might inform such an approach in a forthcoming article here.
What is interesting from a regulatory perspective is that there are other breakpoints that are currently used to scale regulation under the ’34 Act that Congress chose not to use. For example, the definition for “accelerated filer” is based on a market capitalization of $75 million. Less than two years ago Congress chose this breakpoint in defining smaller companies, whether doing an IPO or not, who would be exempt from having to implement the auditor certification of internal controls under Section 404(b) of Sarbanes Oxley. Congress in Dodd Frank also required the SEC to study whether the breakpoint for 404(b) compliance should be extended to companies with an annual float below $250 million. The SEC staff study opined that would not be good policy. The JOBS Act not only takes the opposite view as the SEC staff, but it blows well by the numbers considered by the Congress in 2010 to put the breakpoint at a number almost three times higher and uses it for a much larger set of obligations. And, of course, this number was picked without any of the cost-benefit analysis that the D.C. Circuit and some members of Congress are using to hamstring multiple topics of SEC rule-making.
The reach of this regulatory break is extended somewhat by the built in time lag for being booted out of emerging growth company status once you cross the one of the exit thresholds. This doesn’t happen until you have been subject to SEC reporting for at least twelve months, have filed at least one annual report with the SEC (which will occur sometime after 12 months) and had the requisite market capitalization as of the last business day of the company’s most recently completed second quarter.
Opt Out. There is an opportunity for emerging growth companies to opt out of the exemption (and thereby opt-in to the regular disclosure obligations.) Thus, we have a test of how mandatory disclosure, internal governance, and corporate governance provisions are viewed by various market participants. To the extent that transparency, internal controls, and governance add value, we should see companies opt for this choice, in something like a race to the top. If they don’t or if there are other incentives that push companies the other way, there is also the potential for a race to the bottom. It seems likely that we will see newly public companies make both choices giving professors and financial economists an opportunity to empirically test various competing theories. The opt-out choice becomes complicated as to financial reporting in the JOBS Act requires that the choice must be made to all of the financial disclosures as a group at the time of going public.
Effect on IPOs. This part of the JOBS act was pitched as an effort to encourage American IPOs. To that extent it makes several changes in the procedures of IPOs including letting issuers test the waters in their marketing and talk confidentiality to the SEC prior to registration documents being revealed. A significant change is to free analysts from some of the restrictions imposed after the analysts scandal a decade or so ago, which some believe has led to a fall-off of analyst covering stock of companies after their public offering turn has dampened the incentives for companies to pursue an IPO. This is a dramatic change, but it does not remove a large part of the analyst restrictions that were put in place, so that the impact will need further attention.
Two Studies to Watch For. The JOBS Act requires the SEC to undertake two studies that may generate additional policy discussion of interest to teachers in this area. One is a study of “tick sizes”, the increments which dealers and market makers use to post quotes for buying and selling of securities. Over the last decade and a half, the spread between the “bid” and “ask” quotes that was often a quarter of a point on widely traded securities has declined to a penny or less. Some of this is because of technological change, but some think it has also contributed to less analysts’ coverage for smaller stocks. The other study is a Congressional call for the SEC to comprehensively analyze Regulation S-K, the key hub of the disclosure regime, including focusing on reducing costs and burdens for emerging growth companies.
The architecture of the JOBS Act is very Frank Gehry – it flaunts its flashy surfaces for cheap crowd-pleasing thrills but displays little structural sense. The statute upends the traditional structure of securities law without any grounding in engineering principles. I fear we will now be living in a legal edifice that leaks and sags (and hopefully not anything worse).
Let me illustrate this with two examples. First, Title I of the statute grants exemptions to “emerging growth companies” for various securities disclosure, auditing standards, and internal controls. Again, “emerging growth companies” is a fancy label for companies with less than a billion in annual revenue. This contrasts starkly with the way in which securities law has evolved over the years to lessen the disclosure of larger companies – think integrated disclosure, shelf registration, WKSIs, etc. etc. This traditional structure makes sense not because we want to favor big companies, but because market efficiency means investors are more likely to have information on these companies.
The JOBS Act emerging company exemptions flip this logic of market efficiency on its head. Thanks to Title I, we are now going to get less disclosure and less auditing on companies about which the markets already have less information and are less efficient. Like Gehry, the architects of the JOBS Act chip away at the foundations.
Second, Bob Thompson pointed out yesterday that in redrawing the “publicness” line for what constitutes a reporting company, Title V is making “accredited investor” definition do more work. To recap, the statute replaces the old 500 shareholder of record standard for when a company needs to file reports under the ’34 Act with a threshold of either (i) 2,000 persons or (ii) 500 persons who are not accredited investors. Bob draws our attention to the potential concerns with the growing importance of the accredited investor standard.
This concern should be underscored. The JOBS Act is making this one definition do too much work or, to belabor the architecture metaphor a little more, to carry too much of the structural load of securities law. Legal scholars and practitioners have long questioned whether the accredited investor definition – particularly net worth and income standards for natural persons -- is too rough a proxy for the capacity of investors to make sophisticated decisions or bear financial risk. As the load that this definition must bear increases, so too should our urgency in seeking alternative pillars or proxies for sophistication and risk-bearing ability.
It is also critical to rethink whether the purpose of this standard – or securities laws generally – is really to protect unsophisticated investors from markets or – more provocatively – to protect financial markets from unsophisticated investors. But that kind of thinking won’t win votes.
The constant political pressure on securities laws makes over-reliance on the accredited investor definition particularly worrisome. When boom times come back, investors, politicians, and financial firms will want to relax the definition of accredited investor to let more of the public share in the bounty. And when one definition does double and triple duty in the regulatory framework, it becomes harder to predict the rippling consequences of changing that definition. We’ve seen with the use of credit rating agencies the dire consequences of creating single points of failure in the architecture of financial regulations.
We've also seen in the last ten years, how creating exemptions and exceptions to part of financial regulations (even if they look innocuous by themselves) can have systemic effects, as money flows to the point with the lowest regulatory tax. That is the real problem with many of the JOBS Act provisions -- from the IPO on-ramp to crowdfunding: it creates leaks in the regulatory framework. Let's hope that doesn't it damage the structural integrity.
Photo of Frank Gehry's Fred and Ginger House in Prague, by Dino Quinzani, subject to Creative Commons ShareAlike 2.0 Generic License:
I will refrain here (at least for now) from choosing one of Brett's three "stories" and from commenting on Erik's many good points (except to say that the lack of supporting evidence for any policy objective that Congress may have had in mind is frustrating--if not shocking). Rather, I will focus on one of the changes to Section 12(g) of the Securities Exchange Act of 1934 in the context of teaching the law of business associations and U.S. securities law.
As Bob notes, The main change to Section 12(g) is that the aggregate number of record shareholders triggering registration of a class of securities under Section 12(g) has been increased from 500 to 2000, as long as no more than 500 shareholders are unaccredited investors. Bob also notes that two classes of security holders are not counted for purposes of determining the 2000-shareholder and 500-shareholder limits under this new rule: crowdfunding investors (which we'll post more about on Thursday) and holders of employee benefit plan securities exempt from registration under the Securities Act of 1933. Although the intent of the exemption in each case is clear, the drafting in each case refers to exempting securities rather than their holders. (David, the JOBS Act is full of not-so-very-good drafting. Thanks for highlighting that point and offering examples.)
Sections 502 and 503 of the JOBS Act contain the exemption for employee benefit plan securities. The central mechanism for the exemption is a an enhancement to the definition of the "held of record" requirement that Bob describes in his post:
For purposes of determining whether an issuer is required to register a security with the Commission pursuant to paragraph (1), the definition of ‘held of record’ shall not include securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of section 5 of the Securities Act of 1933.
The SEC is required to (1) engage in applicable rulemaking (note here to David about more bad drafting in Section 503, where Congress appears to be directing the SEC to revise a statutory provision already amended in the preceding section) and (2) "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 transactions that were exempt from the registration requirements of section 5 of the Securities Act of 1933."
I have a teaching observation about Sections 502 and 503 of the JOBS Act. A number of subsidiary points flow from it. My observation is that, as Bob noted about the "accredited investor" definition, the employee benefit plan exemption from the Section 12(g) shareholder threshold puts more pressure on teaching exemptions appicable to employe benefit plan securities. So, for those of you who give short shrift to Rule 701 under the Securities Act of 1933 and for those of you who may not discuss the potential use of Section 4(2), the Rule 504 and Rule 505 exemptions, and the Rule 506 safe harbor in the employee benefits context, you may want to rethink things . . . . Based on my personal practice experience, I always have covered these matters to some extent, but they now take on more importance for all of us.
A nice way to raise and debate the relevant issues in class is to note how Google effectively made the same mistake ten years ago that Ralston Purina made a half-century earlier: issuing unregistered securities to employees without the availability of applicable exemptions for the related offers and sales. Since all of us who are law professors likely teach the Ralston Purina case in Business Associations or Securities Regulation or both courses, the Google matter is an easy way to engage the class with the relevant statutory, regulatory, and decisional law. After covering Ralston Purina and Rule 701, I point the students to the more recent facts involving Google's pre-public-offering unregistered issuances of stock options as described in the Cease and Desist Order in In re Google, Inc. and David C. Drummond. Through lecture or discussion, one can do a lot with this material. The potential reliance on Rule 701, Rule 506, and Section 4(2) in the issuance of options is discussed in the Cease and Desist Order. This, in and of itself, is valuable because it allows the students to see the (mis)use of multiple exemptions by an issuer and to consider/debate how exemptions of that kind could be better coordinated. Also, professional responsibility issues (competence, zealous advocacy, etc.) can be raised from, or working off of, the Google fact pattern. And now, in a post-JOBS-Act world, this whole mess becomes useful for another reason: shareholders acquiring securities under a valid exemption will not be included in the Section 12(g) calculation of shareholders (and, as noted above, the SEC must promulgate safe harbor provisions for use by issuers in this context).
Admittedly, I do not typically have enough time in class to unpack all of these aspects of the Google matter. But perhaps I should make time, now that there is one more reason why this material is salient. There is one big problem, however. Where do I cut existing course material to fit this and the other aspects of the JOBS Act into my courses? [Audible groan] Any and all suggestions are welcomed. . . .
FYI, here is an additional perspective on the Ralston Purina case and the JOBS Act for those who (like me) just love that case.
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.
This is going to be the least substantial post in this forum by far, but ....
One strange thing about the statute, as Gaston de los Reyes has pointed out to me, is the part of it where Congress directs the SEC to add language to its regulations ... and basically provides the language! Why not just make that part of the statute? And that's just one of the admittedly somewhat arid administrative law mysteries provided by the move. Does the SEC have to take comment on its amendment to the regulations? Probably, though it isn't clear what purpose the comment would serve. Could a court view the language lifted from the statute as arbitrary if the SEC doesn't explain why it is using it? You can think up more of these all day. Anyway, have a look at Section 401(a) of the Act (and section 201 is somewhat similar):
The Commission shall by rule or regulation add a class of securities to the securities exempted pursuant to this section in accordance with the following terms and conditions:
(A) The aggregate offering amount of all securities offered and sold within the prior 12-month period in reliance on the exemption added in accordance with this paragraph shall not exceed $50,000,000.
(B) The securities may be offered and sold publicly.
(C) The securities shall not be restricted securities within the meaning of the Federal securities laws and the regulations promulgated thereunder.
(D) The civil liability provision in section 12(a)(2) shall apply to any person offering or selling such securities.
There are other parts of the section, to be sure, where the SEC has some discretion. But I suspect that Congress expects to see these exact words in the CFR soon, which seems like unnecessary agency commandeering, though there's nothing illegal about it.