April 25, 2012
The JOBS Act: Providing New Issuers a Less-Regulated "On Ramp" to 1934 Act Obligations
Posted by Robert B. Thompson

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.

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