Many market participants were taken by surprise by the enactment of the Jumpstart Our Business Startups (JOBS) Act. The JOBS Act, HR 3606, was passed by the United States House of Representatives on March 8 2012..
amendment to Title III (providing for the crowdfunding exemption with enhanced investor protections). On March 27, the House of Representatives accepted the Senate's amendment, and on April 5, President Obama signed the JOBS Act into law.1 To many, this may sound like a quick path for legislation, especially when considered in the context of a Congress that seemed virtually deadlocked and unable to reach the consensus required to take action on pressing issues. When considered closely and in context, however, it becomes clear that the Act was the culmination of an at least year-long bipartisan effort in both the House and Senate to address concerns about capital formation and unduly burdensome Securities and Exchange Commission (SEC) regulations.
The JOBS Act affects both exempt and registered offerings, as well as the reporting requirements for certain public issuers. A centrepiece of the Act is an initial public offering (IPO) on-ramp approach for a class of emerging growth companies (Title I), with confidential SEC staff review of draft IPO registration statements, scaled disclosure requirements, no restrictions on test-the-waters communications with qualified institutional buyers (QIBs) and institutional accredited investors before and after filing a registration statement, and fewer restrictions on research (including research by participating underwriters) around the time of an offering. In addition, the JOBS Act directs the SEC to amend its rules to:
- eliminate the ban on general solicitation and general advertising in Rule 506 offerings when sales are only to accredited investors, along with comparable changes to Rule 144A (Title II);
- establish a small offering exemption for crowdfunding (Title III); and
- create a new exemption for offerings up to $50 million (Title IV).
The JOBS Act also raises the holder-of-record threshold
for mandatory registration under the Securities Exchange Act of 1934, as amended (the Exchange Act) (Titles V and VI). In the chapters that follow, we discuss each of these measures in greater detail, but before we do so, it is important to understand the concerns that led legislators to act in concert to adopt the JOBS Act.
The lifecycle for emerging companies in the US For a long time in the US, a company's financing lifecycle was generally fairly predictable. A growing company usually financed its business through investments from friends and family, then perhaps from angel investors, and finally, if the company was successful, from venture capital firms. Given the application of section 5 of the Securities Act of 1933, as amended (the Securities Act)2 to public offerings of securities, a company was required to limit itself to conducting small rounds of financing, relying on various available exemptions from the registration requirements of the Securities Act, and to target principally sophisticated institutional investors. The securities that a company sold in these private, or exempt, offerings were classed as restricted securities, which means that the securities had never been offered pursuant to a registration statement and were subject to certain transfer restrictions. After various successful private financing rounds, the company's management and venture investors would begin to consider an IPO. Once a company was an SEC reporting issuer, it became subject to a comprehensive regulatory framework. Although this regulatory framework may have imposed requirements that seemed onerous (at the time), being a public company offered distinct benefits. Once public, a company generally had many more financing opportunities. Already public companies relied on raising additional capital to finance their growth through follow-on public offerings, underwritten by one or more investment banks. From time to time, an already public company also might conduct a private placement or other exempt offering as part of an overall financing plan. Over time, as the capital markets in the US have undergone changes and as regulations have evolved, the cost-benefit calculus for many companies has changed. Many companies have concluded that going public might not be the most desirable liquidity event and remaining private longer or considering acquisition alternatives might be more appealing. A bit of background on the securities regulatory framework will help illustrate why the analysis changed for many companies.
Securities regulatory framework
A privately held company (or a company that does not have securities that are publicly traded in the US), whether domestic or foreign, that would like to access the US markets first must determine whether it is willing to subject itself to the ongoing securities reporting and disclosure requirements, as well as the corporate governance requirements that are part and parcel of registering securities for a public offering in the US. An issuer may conduct a public offering in the US by registering the offering and sale of its securities pursuant to the Securities Act, and also by registering its securities for listing or trading on a US securities exchange pursuant to the Exchange Act.3 Instead, an issuer may choose to access the US capital markets by offering its securities in an offering exempt from the registration requirements of the Securities Act. Finally, a private company that elects to postpone, or seeks to avoid, becoming a public company may become subject to SEC reporting obligations inadvertently if it has: total assets exceeding $10 million as of the last day of its fiscal year, and a class of equity securities held of record by either 2,000 persons or 500 persons who are not accredited investors (for banks, savings and loan holding companies, and bank holding companies, a class of equity securities held of record by 2,000 or more persons), whether or not that class of equity securities is listed on a national securities exchange.
Section 5 of the Securities Act sets forth the registration and prospectus delivery requirements for securities offerings.4 In connection with any offer or sale of securities in interstate commerce or through the use of the mails, section 5 requires that a registration statement must be in effect and a prospectus meeting the prospectus requirements of section 10 of the Securities Act must be delivered before sale.5 This means that the Securities Act generally requires registration for any sale of securities, although it also provides exemptions or exclusions from this general registration requirement. The purpose of the Securities Act is to ensure that an issuer provides investors with all information material to an investment decision about the securities that it is offering. The registration and prospectus delivery requirements of section 5 require filings with the SEC and are intended to protect investors by providing them with sufficient information about the issuer and its business and operations, as well as about the offering, so that they may make informed investment decisions. These apply to offerings that are made to the general public (regardless of the sophistication of the offerees). The SEC presumes that distributions not involving public offerings (or widespread distributions) do not raise the same public policy concerns as offerings made to a limited number of offerees that have access to the same kind of information that would be included in a registration statement. That information can be conveyed by providing disclosure or by ensuring that the offerees have access to the information. There are a number of regulatory restrictions on communications for issuers that undertake a public offering, given that the SEC always has emphasised that the prospectus should be the principal document used by investors in making their investment decisions.
IPO and Exchange Act registration
In connection with an IPO of securities, an issuer must provide extensive information about its business and financial results. The preparation of the registration statement is time-consuming and expensive. Once the document is filed with the SEC, the SEC staff will review it closely and provide the issuer with detailed comments. The comment process may take as long as 60 to 90 days once a document has been filed with, or submitted to, the SEC. Once all of the comments have been addressed and the SEC staff is satisfied that the registration statement is properly responsive, the registration statement may be used in connection with the solicitation of offers to purchase the issuer's securities. Depending upon the nature of the issuer and the nature of the securities being offered by the issuer, the issuer may use one of various forms of registration statement. Once an issuer has determined to register its securities under the Securities Act, the issuer usually will also apply to have that class of its securities listed or quoted on a securities exchange, and in connection with doing so will register its securities under the Exchange Act. The Exchange Act imposes two separate but related obligations on issuers: registration obligations and reporting obligations. If an issuer becomes subject to the reporting requirements of the Exchange Act, the issuer remains subject to those requirements until, in the case of exchange-listed securities, those securities are delisted, or, in the case of securities listed by reason of the issuer's asset size and number of record holders, the issuer certifies that it meets certain requirements.
Once an issuer conducts an IPO in the US or has a class of securities listed or traded on a national securities exchange, the issuer will be generally subject to the reporting requirements of the Exchange Act. Issuers that have have undertaken an IPO or that are SEC-reporting companies also will become subject to many other rules and regulations.
Over time, the regulatory burdens for public companies have increased. In 2002, following a series of widely reported corporate scandals involving fraudulent accounting practices and governance abuses, the US adopted legislation affecting all public companies, the Sarbanes-Oxley Act of 2002.6 It imposed a broad series of requirements relating to corporate governance, enhanced public disclosure, and the imposition of civil and criminal penalties for wrongdoing. Sarbanes-Oxley and its associated rules:
- require that CEOs and CFOs certify the accuracy and completeness of their companies' periodic reports and impose criminal penalties for false certification;
- require the establishment and regular evaluation of disclosure controls and procedures, and internal control over financial reporting designed to ensure the accuracy and completeness of the information reported to the SEC and for the preparation of financial statements;
- require the establishment by all listed companies of an independent audit committee;
- require the disgorgement of compensation by CEOs and CFOs following an accounting misstatement that results from misconduct;
- impose limitations on trading by officers and directors during retirement plan blackout periods;
- prohibit the extension of credit to related parties; and
- require the SEC to review a registrant's filings once every three years.
Although relief from compliance with certain of these requirements was provided to smaller companies, increased compliance costs and increased liability may have had a chilling effect on IPOs.
To (or not to) go public
Many commentators have noted that, over time, the US capital markets have become less competitive and the number of companies seeking to go public has declined. For example, prior to the enactment of the JOBS Act, in communications from Congressman Darrell Issa, chairman of the House Committee on Oversight and Government Reform, to Mary Schapiro, chairman of the SEC (discussed further below), Issa noted that the number of IPOs in the US plummeted from an annual average of 530 during the 1990s to about 126 since 2001, with only 38 in 2008 and 61 in 2009.7 The number of companies listed on the main US exchanges peaked at more than 7,000 in 1997 and, as of the date of the letter, had been declining to about 4,000.8 Meanwhile, the letter cited that the value of transactions in private-company shares had grown, almost doubling in 2010 to $4.6 billion from about $2.4 billion in 2009, and was expected to increase to $6.9 billion for 2011.9 Other reports published during the same time period cited similar statistics and highlighted that smaller companies were disproportionately affected, with most IPOs that completed involving larger companies and a significant offering size. Although commentators would have been ready to stipulate that the number of IPOs had declined, there would be little agreement regarding the causes for the decline. Quite a number of different theories have been advanced to explain this phenomenon. Academics active in this area have grouped the theories into two broad categories: first, those attributing the decline to regulatory overreach; and second, those attributing the decline to changes in the ecosystem or market structure changes.
Many studies indicate that companies are waiting longer to go public as a result of anticipated costs associated with Sarbanes-Oxley compliance, as well as the additional costs associated with being a public company. For example, a public company must incur costs for directors and officers insurance, director compensation (especially audit committees), and disclosure controls and SEC reporting costs. Foreign issuers may be wary of the increased liability that comes with being an SEC-reporting company, as well as of the litigious environment in the US. Many executive officers of privately-held companies also are concerned that going public will limit their flexibility. As officers of a public company, they are required to make very difficult decisions, including decisions regarding financial reporting, accounting estimates, and accounting policies, while they are subject to more scrutiny and more risk as a result of their choices. Given the prospect of shareholder litigation and other litigation concerns, their determinations become fraught with risk. Earnings pressure and the need to respond to many constituencies (such as research analysts, large institutional holders, and aggressive hedge fund holders) may affect the decision making processes. This may inhibit their desire to take risk and may lead them to be more conservative than they otherwise would be. A survey found that, in fact, the principal reason given by senior managers of privately-held companies for remaining private is that they would like to preserve decision-making control.10 In addition, actually conducting an IPO will be time-consuming and expensive given the disclosure and financial statement requirements.
Over time, more financing alternatives have developed for issuers. An issuer could choose to avail itself of one of the exemptions from registration and conduct private offerings. There have been many regulatory changes that provided greater legal certainty as to the availability of private offering exemptions, such as the safe harbours contained in Regulation D, especially Rule 506. In large measure, as a result of these changes, a number of securities offering methodologies involving exempt offerings have developed and become increasingly popular. Many of these offering methodologies have come to resemble the process used for public distributions of securities. Investors have become more receptive to participating in private placements and owning so-called restricted securities as the limitations on hedging or transferring restricted securities have been relaxed. More different types of investors are willing and eager to participate in private placements undertaken by promising companies. These now include, in addition to venture capital funds, private equity funds, family offices, sovereign wealth funds, insurance companies, pension funds, and cross-over funds. More recently, private secondary markets have developed that provide liquidity opportunities for holders of the securities of private companies to sell their positions.
Other commentators and academics note that a variety of market structure changes may be the cause of or may contribute to the decline of IPOs, especially smaller company IPOs. During the 1990s and early 2000s, consolidation in the investment banking sector led to the disappearance of many boutique or speciality investment banks that had as their focus financing transactions for smaller companies. Some commentators point to the drop in bid-ask spreads that took place following decimalisation in 2001. In 2003, as a result of the fallout from the dot- com boom, rules and regulations were adopted that imposed restrictions on research analyst coverage and required the separation of research and investment banking activities. The burdensome regulations imposed significant compliance costs on investment banks with research activities and changed the nature of research coverage. As a result, the fewer, larger investment banks that remained after industry consolidation focused their resources on covering fewer companies (usually giving preference to larger, well-capitalised companies). These various factors seemed to change the economics associated with smaller company IPOs and tend to favour IPOs by larger, more established companies. Also, the view developed that larger companies, with a longer track record and more predictable earnings histories, make better public companies or are better able to function as public companies.
The SEC has tried to keep pace with changes in the capital markets and has consistently introduced reforms that sought to balance investor protection needs with the need to provide issuers with access to capital. Since the early 1980s, the SEC has undertaken a number of steps to facilitate capital formation. The SEC has, among other changes, created and modified the integrated disclosure system, instituted and expanded the continuous and delayed offerings processes, permitted the electronic submission of most SEC filings, and generally tried to accommodate the needs of both large and small issuers. In 2005, the SEC undertook a series of changes related to securities offerings and offering-related communications, referred to as securities offering reform. Although this reform benefited principally the largest and most sophisticated issuers (well-known seasoned issuers or WKSIs), the changes also expanded the range of permissible communications, even during IPOs.
In December 2004, the SEC established the Advisory Committee on Smaller Public Companies to 'assist the SEC in evaluating the current securities regulatory system relating to disclosure, financial reporting, internal controls, and offering exemptions for smaller public companies.'11 The Advisory Committee charter stated that its objective was 'to assess the impact of the current regulatory system for smaller companies under the securities laws of the United States and to make recommendations for changes.'12 The Advisory Committee considered the effect of many new regulatory requirements on smaller public companies, as well as capital-raising alternatives for smaller companies. In 2006, it issued its final report, containing 33 recommendations, many of which focused on capital formation, including a recommendation that a new private offering exemption from the Securities Act registration requirements be adopted that would not prohibit general solicitation and advertising for transactions with purchasers that do not need all the protections of Securities Act registration requirements. The Advisory Committee noted that the ban on general solicitation in a private offering resulted in excessive concern about the offeree who may never actually purchase securities, rather than on protection of the actual investors. The Advisory Committee also noted that, given the pace of technological change, the ban had become outmoded and limited issuers from using the internet and other tools to communicate with potential investors. This was not the first time that a recommendation had been made to ease the prohibition on general solicitation. In 2007, practitioners that were members of an American Bar Association Committee submitted a letter to the SEC containing recommendations for a comprehensive overhaul of the securities laws governing the private placement of securities.13 The letter cited problems with the private offering process that impacted capital formation. In May 2007, the SEC approved publication of eight releases designed to update and improve federal securities regulations that significantly affect smaller public companies and their investors. Ultimately, the holding period requirements under Rules 144 and 145 were shortened, making restricted securities more liquid, and smaller public companies gained limited access to the use of shelf registration statements.
Although all of these reforms modernised the securities offering process, streamlined communications requirements, and addressed certain of the concerns related to private or exempt offerings, the reforms did not squarely address the IPO process, nor did they address many of the thorniest issues arising in exempt offerings.
Proposed changes post-Dodd-Frank
In the aftermath of the financial crisis, and following adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act (generally known simply as the Dodd-Frank Act) in 2010, there was renewed focus on the effect of regulation on the competitiveness of the US capital markets and on entrepreneurship and emerging companies. As attention in the US turned to promoting economic activity, the dialogue related to regulatory burdens and their effect on capital formation took on a new sense of urgency.
On March 22 2011, House Committee on Oversight and Government Reform chairman Issa sent a letter to SEC chairman Schapiro. The letter raised concerns about whether the current securities regulatory framework had a negative impact on capital formation, leading to the dearth of IPOs in the United States, as well as the extent to which SEC regulations potentially limited other capital-raising activities by small and emerging companies.14 The letter from Issa also sought specific information regarding economic studies conducted by the SEC staff in these areas, along with information concerning the consideration of costs and benefits in connection with SEC rulemakings. Issa's letter discussed these statistics and raised questions about five topics: the decline of the US IPO market, the communications rules in connection with securities offerings, the 499 shareholder cap under section 12(g) of the Exchange Act, organisational considerations, and new capital-raising strategies.
In her response dated April 6 2011, Schapiro stated she had requested that the SEC staff take a fresh look at the agency's rules in order to develop ideas for the SEC about ways to reduce the regulatory burdens on small business capital formation in a manner consistent with investor protection.15 Schapiro outlined a number of new SEC initiatives in her response, including SEC staff review of (i) the restrictions on communications in initial public offerings; (ii) whether the general solicitation ban should be revisited; (iii) the number of shareholders that trigger public reporting, including questions regarding the use of special purpose vehicles; and (iv) the regulatory questions posed by new capital-raising strategies, such as crowdfunding. Schapiro also indicated that the SEC was in the process of forming a new Advisory Committee on Small and Emerging Companies, which was subsequently convened.
1 Jumpstart Our Business Startups Act, Pub. L. No. 112-106.
2 Securities Act of 1933, 48 Stat. 74 (May 27 1933), codified at 15 USC § 77a et seq.
3 Securities Exchange Act of 1934, 48 Stat. 881 (June 6 1934), codified at 15 USC § 78a et seq.
4 15 USC § 77e.
5 15 USC § 77e(b).
6 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified in various sections of 15 7 U.S.C. and 18 U.S.C.), § 301, 302, 404, 406, 407 and 906.
9 See id.
10 See http://online.wsj.com/article/ SB100014240527487046300045762491822751345 52.html?KEYWORDS=%22new+stock+rules%22
11 See James C. Brau & Stanley E. Fawcett, Initial Public Offerings: An Analysis of Theory and Practice, 61 J. FIN. 399 (2006), available at http://papers.ssrn.com/sol3/ papers.cfm?abstract_id=530924
12 Securities Act Release No. 33-8514, 87 S.E.C. Docket 1138 (February 28 2006); Exchange Act Release No. 34-50864, 84 S.E.C. Docket 1340 (December 16 2004).
13 Advisory Committee on Smaller Public Companies, Charter, available at http://sec.gov/info/smallbus/acspc.shtml
Letter from Keith F. Higgins, Chair, ABA Committee on Federal Regulation of Securities, to John W. White, Director, Division of Corporation Finance (March 22, 2007), available at www.abanet.org/buslaw/committees/CL410000pub/ comments/20070322000000.pdf
14 See www.knowledgemosaic.com/resourcecenter/ Issa.041211.pdf
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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