Strictly Business

The U.S. House of Representatives voted earlier today (March 8, 2012) to pass the Jumpstart Our Business Startups (JOBS) Act.  The bill is actually a compilation of six separate measures that have been proposed in Congress (and in some instances already passed in the House) which loosen securities restrictions on smaller companies.  Here are brief summaries of each measure:

The Reopening American Capital Markets to Emerging Growth Companies Act (H.R. 3606; the rest of the bills were added to this one).  This bill is also known as the “IPO On Ramp” and it creates a new category of company called an “emerging growth company,” which is defined roughly as a public company with less than $1 Billion in revenue.  An issuer that is an emerging growth company as of the first day of a fiscal year will continue to be one until the earliest of (i) the last day of the fiscal year during which the issuer had $1 billion in annual gross revenues or more; (ii) the last day of the fiscal year following the fifth anniversary of the issuer’s IPO date; or (iii) the date in which the issuer is deemed to be a large accelerated filer, defined by the SEC as an issuer with more than $700 million in public float. In addition, a company would not be considered an emerging growth company if it has issued more than $1 billion in non-convertible debt over the prior three years.  An emerging growth company would enjoy more lax regulation by the SEC.  For instance, the bill would allow emerging growth companies to defer compliance with Section 404(b) of the Sarbanes-Oxley Act until the company is no longer considered an emerging growth company.  Section 404(b) requires the company’s auditor to report on and attest to management’s assessment of the company’s internal controls, a requirement that carries high compliance costs. In addition, the bill would only require emerging growth companies to provide audited financial statements for the two years prior to their IPO rather than three years. The bill also exempts emerging growth companies from new corporate governance requirements within the Dodd-Frank Act, namely the so-called “say on pay” requirement and the requirement that public companies calculate and disclose the median compensation of all employees compared to the CEO.  The bill would remove restrictions prohibiting investment banks that underwrite a company’s IPO from publishing research on emerging growth companies and would  expand the range of permissible pre-filing communications to “qualified institutional buyers” or “accredited investors.”

The Access to Capital for Job Creators Act (formerly H.R. 2940).  As discussed in a previous post, this bill essentially removes the general solicitation prohibition on offerings made under Rule 506 of Regulation D.

The Entrepreneur Access to Capital Act (formerly H. R. 2930).  This is the “crowdfunding” bill, which I’ve discussed at length in the following posts: Is action forthcoming on a crowdfunding exemption to Federal securities laws?; Bill Creating Crowdfunding Exemption from Securities Registration Passes U.S. House of Representatives; What does the future hold for crowdfunding legislation?; Implications of the Pending Startup Crowdfunding Bill.

The Small Company Formation Act (formerly H. R. 1070).  This bill would increase the offering threshold for companies exempted from SEC registration under Regulation A from $5 million to $50 million. It would also preempt state blue sky laws with regards to such offerings if they are traded on a national exchange.   Regulation A is a little used exemption from registration that permits an exempt public offering using a type of “short form” registration.  It is rarely used for two reasons: (i) it has a limit of $5 million and (ii) there is no preemption and so the offerings are subject to blue sky laws.  This bill would eliminate both of these obstacles.

The Private Company Flexibility and Growth Act (formerly H.R. 2167).  This bill raises the number of shareholders a company can have before it is forced to go public from 500 to 1,000.  In addition, it also excludes employees from counting against this limit.  More details can be found on a previous post on this topic: Bill Introduced in Congress to Permit Private Companies to Stay Private for Longer.

The Capital Expansion Act (formerly H.R. 4088).  This bill raises the number of shareholders permitted to invest in a community bank from 500 to 2,000.  The issue here is that community banks are often forced to engage in expensive Exchange Act reporting because they have over 499 shareholders.  This bill would remove this expense for many of them.

The vote was lopsided and the White House has indicated that it is supportive, so the bill has a decent chance of become law.  That said, don’t let the lopsidedness of the vote fool you.  There is genuine opposition to these bills in the Senate that has been building for some time.  There are some significant concern that the legislation will increase the incidence of securities fraud, particularly for senior citizens.  Therefore, stay tuned.

———————————–

© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Previous, I summarized the Entrepreneur Access to Capital Act (H.R. 2930), a bill which provides for a crowdfunding exemption to the registration requirements of federal and state securities laws.  The bill was recently passed by the U.S. House of Representatives, and now awaits U.S. Senate action.  In this post, I’ll provide some of my thoughts on what is to come.

Will it pass?

Predicting the future is usually a futile effort, but I do believe that this bill (or something like it) has a good chance of becoming law.  If you had asked me this same question a year ago, or even six months ago, I would have told you that it has no chance.  The political climate over the last few years has favored the tightening of securities laws, not their deregulation, due in no small part to the perceived excesses of the securities industry in the events leading up to the financial crash in 2008.  What I hadn’t counted on was the cumulative effect of three years of high unemployment on the political process.  Politicians are desperate for a solution to reduce unemployment and consequently legislation that promises to reinvigorate the entrepreneurial sector has found rare bipartisan support.  Of course, the Republican gains in the Congress in 2010 helped significantly as well, given that the need for business deregulation is an article of faith within the Republican party.  As a result of these factors, the House passed the bill overwhelmingly in a rare bipartisan vote.  The White House has also signaled that it supports the effort.  The only remaining piece to the puzzle is Senate passage.

The U.S. Senate could choose to take up H.R. 2930 itself, or proceed with its own version, the Democratizing Access to Capital Act of 2011 (S. 1791), which is sponsored by Sen. Scott Brown (R – MA).  S. 1791 is remarkably similar to the House bill.  Given the bipartisan support for the concept, I think it is highly likely that a crowdfunding bill will pass the Senate, though it will likely differ in small or major ways from the House legislation.  These differences will need to be reconciled in conference committee, and then the reconciled bill will need to be passed again by each house.  However, neither political party has drawn a line in the sand about any of the particular differences and most of them are rather technical.  Therefore, there currently aren’t any major impediments to a final bill being passed before the end of 2012.  My prediction, therefore, is that we will see a crowdfunding exemption passed into law by the end of next year.

How will its implementation affect its usefulness?

Assuming the bill passes, it must also be implemented by SEC regulations.  It is crucial to understand that the SEC has significant power to determine how useful a crowdfunding exemption could be.  If the SEC’s regulations make it difficult to use, then no one will use it and the effort will be for naught.  If the SEC issues regulations that are friendlier to issuers, then the exemption could be highly useful.  For instance, here are some open issues that will need to be addressed and could drastically affect the ability of companies to use the exemption effectively:

• How will income be measured?  The bill requires that investors invest no more than the lesser of $10,000 or 10% of their annual income.  It further provides that an issuer or intermediary may rely on a certification of annual income provided by an investor.  This leaves several unanswered questions: (1) How will income be measured?  By the previous calendar year?  By an average of several of the previous calendar years? (2) Will the investor’s spouse’s income be included? (3) Is the limit subject to each of the spouses separately or are the amounts invested by each spouse considered in aggregate towards the limit?  (4) Will the certification ask for any kind of documentation to establish the income of the investor or does the investor merely provide a number which the issuer or intermediary can accept without question?  If so, is it reasonable for an issuer to accept that someone in a low paying field claims he or she makes $150,000 a year?  All of these questions will need to be addressed by SEC regulations, and the more specifically it does so, the more beneficial it is for issuers and intermediaries because bright-line tests remove business uncertainty.
• What will be the permissible activity of intermediaries?  The bill establishes a new category of participant in the capital markets called an “intermediary.” No definition of an “intermediary” is provided in the legislation, but presumably an intermediary would operate a website which administers the crowdfunding offering.  The  bill specifically exempts intermediaries from the broker-dealer registration requirements under the Securities Exchange Act of 1934.  There are a number of unresolved questions: (1) What activities may an intermediary engage in?  Are they simply passive participants, or may they engage in active sales efforts?  (2) How may they be compensated?  Are their fees limited to flat fees to use their platform or can compensation be varied depending on the success of the offering (i.e. a success fee or a fee in proportion to the amount of securities actually sold)? (3) Finally, how will state broker-dealer registration requirements apply?  Will they be required to register as broker-dealers and their employees as broker-dealer agents with the states they operate within?[1]
• Will issuers also be permitted to conduct a simultaneous offering under Rule 506 of Regulation D to accredited investors?  The bill itself says that use of the crowdfunding exemption does not prevent an issuer from raising capital through other methods.  Therefore, a simultaneous Rule 506 offering will not preclude the use of a crowdfunding offering.  Unfortunately, the use of a crowdfunding offering may preclude the use of Rule 506.  Regulation D provides that other offerings conducted near in time to a Regulation D offering are considered part of the Regulation D offering (i.e. they are integrated).  Since a crowdfunding offering would not be in compliance with Rule 506 (because it was conducted via a general solicitation and the securities were offered to non-accredited investors), the Rule 506 exemption relied upon for the offering would be invalidated.  Unless the SEC alters the integration provisions of Regulation D, companies may be unable to conduct an angel financing round near the same time as a crowdfunding offering.
• The bill requires issuers or intermediaries to “take reasonable measures to reduce the risk of fraud.”  It will be up to the SEC to spell out what those reasonable measures are.  The SEC could leave it with a relatively subjective standard, or they could provide a safe harbor which contains a number of measures an issuer or intermediary can take that will assure it that it has complied with this requirement.  A safe harbor would be far more preferable to an open-ended standard, since certainty is required for any securities registration exemption to be truly useful.  The bill also requires that the issuer or intermediary require potential investors to answer questions demonstrating their understanding of the level of risk involved with investing in a startup.  It also requires an intermediary to conduct a background check on the issuer’s principals.  Both of these requirements could also jeopardize the usefulness of the exemption if the SEC does not provide a safe harbor or otherwise objective criteria for meeting these obligations.

As you can see, even if the crowdfunding exemption bill passes as is, there will still be any number of issues unresolved until the SEC fills in the gaps in the legislation through interpretive regulations.  These regulations could greatly facilitate the usefulness of this new exemption, or could eviscerate its usefulness, causing it to be used as often as Rules 504 and 505 of Regulation D.[2]

Footnotes

[1] This issue of whether state registration requirements apply to intermediaries is very complex and merits its own post.  This issue has been around for some time, because there is an analogous situation pertaining to Rule 506 offerings.  Some states require the officers who conduct a Reg. D offering to register as “issuer agents,” but such requirements may be preempted by federal law.

[2] Rules 504 and 505 are other exemptions contained within Regulation D.  They tend not to be used very often because, unlike Rule 506, there is no federal preemption of state registration requirements, subjecting offerings conducted under this rule to numerous state regulations.

Form D is a document that the SEC requires a company to file when it issues securities in a private placement under Regulation D.  It must be filed with the SEC within 15 days of the first sale of a security in a private placement.  In addition, for offerings made under Rule 506 (the most frequently used part of Regulation D), an issuer must also file a copy of Form D (along with a filing fee) with the securities administrator of each state in which purchasers of the securities reside within 15 days of the first sale within each state.  Overall, Form D is a relatively simple document to complete and file; however, it’s very easy for a small company to overlook filing one, especially if it doesn’t use qualified legal counsel for its securities offering.  I frequently get asked about what happens when an issuer fails to file Form D or if the issuer files it late.  This post describes what consequences can and cannot occur.

The first consequence an issuer might be concerned about is losing the federal private placement exemption and consequently be in violation of securities laws by improperly selling unregistered securities.  Thankfully, a failure to file a Form D does not result in the loss of the federal registration exemption.  The SEC has issued guidance on this in Question 257.07 of the Securities Act Rules Questions and Answers of General Applicability.  While filing Form D is a requirement for using a registration exemption under Regulation D, it is not a condition to qualifying for the exemption.  Instead, the only potential consequence on the federal level is that the SEC could take action against the issuer and seek to have the issuer enjoined from future use of Regulation D under Rule 507.  If the violation is willful, it could also constitute a felony.[1] Despite the fact that Form D is not a condition to being exempt under Regulation D, I would caution issuers to not take their responsibility to file Form D lightly.  Often when an issuer is sued in court, the plaintiff will accuse the issuer of violating the federal registration requirements of the Securities Act.  In such instance, the issuer will bear the burden of proof to prove that the securities offering met an exemption under Regulation D.  While courts have explicitly stated that failing to file Form D does not create a private right of action, an issuer may be assisted in meeting its burden of proof that the securities were issued pursuant to an exemption under Regulation D by producing a properly filed Form D.[2]  Therefore, while failing to file Form D may not result in the SEC seeking penalties against an issuer for selling unregistered securities, it could put an issuer at a disadvantage in civil litigation by eliminating one piece of evidence that an issuer can use to build their case that they substantially complied with Regulation D.  In addition, the SEC may seek substantial penalties against an issuer who has failed to properly file Form D.

The other question an issuer may be concerned about is what are the consequences for failing to file Form D at the state level.  Most Regulation D offerings are conducted through Rule 506.  When an issuer makes use of Rule 506 to issue securities, those securities are considered “covered securities,” and state registration requirements are preempted.  However, states are permitted to require that the issuer file a copy of the Form D (along with a filing fee) with the state securities administrator if the issuer has sold its securities to the state’s residents.  Is the preemption of state securities registration requirements in a Rule 506 offering lost if the issuer fails to file with a state?  The SEC’s position is that it is not.  Under Question 257.08 of the Securities Act Rules Questions and Answers of General Applicability, the preemption is not conditioned on properly making a notice Form D filing with a state.  One word of caution: some states take the opposite position.  The Wisconsin Department of Financial Institutions for instance takes the position that if a Form D is filed late in Wisconsin, the issuer must find another exemption or register the security.[2]  My personal opinion is that if the Wisconsin Department of Financial Institutions ever took the case to court and claimed that a Rule 506 offering needed to be registered because a Form D was late, Wisconsin would lose that case, as courts have repeatedly held that failure to make a notice filing does not strip the offering of the status of a “covered security.”[3]  But taking such a case to court would be expensive.  In addition, there can still be significant consequences on the state level beyond losing a registration exemption for an issuer who fails to make required notice filings.  States can issue fines or even stop orders, preventing further sales of securities by an issuer.  Arkansas, for example, is one state that has been particularly aggressive in issuing fines for late Form D filings.

The good news here is that if an issuer accidentally fails to file a required Form D when conducting an offering or files it late, that will not invalidate the private placement registration exemption, which would potentially be a catastrophic event for an issuer.  However, the SEC and state securities administrators can still issue fines and prevent an issuer from engaging in future private placements, so issuers still need to be diligent in making all required securities filings when conducting private placements.

Footnotes

[1] See Hamby v. Clearwater Consulting Concepts, Lllp, 428 F.Supp.2d 915, 920 (E.D. Ark., 2006).

[2] In a court trial, the issuer would have to produce additional evidence to show substantial compliance with Regulation D, such as subscription documents that evidenced an inquiry into whether the investors were accredited or sophisticated.

[2] See http://www.wdfi.org/fi/securities/regexemp/exemptions/23_19_506.htm

[3] See for example Chanana’s Corp. v. Gilmore, 539 F.Supp.2d 1299 (W.D. Wash., 2003) for an example of a case where a court concludes that a late filing does not cause a security to lose its status as a “covered security.”

———————————–
© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.