So, the Jumpstart Our Business Startups Act (aka the “JOBS Act” … nice touch) is afloat and headed to the Senate for almost certain approval. In mechanical terms, the “JOBS Act” is a “legislative package,” i.e., a series of six interrelated bills affecting startup businesses. If (when) approved, private companies will be able to (1) have a lot more shareholders and therefore stay private longer, (2) raise money from more people with fewer securities law restrictions, and (3) when ready, go public and be public with less regulatory hassle from the SEC.
Terrific political theater, but is it good law and/or good business?
IMHO, parts of the JOBS Act are well done and overdue (principally the “IPO On-Ramp”). As to other parts, well, we’ll see. One thing is for sure … after you get past the political chaff there is a lot of complex lawyering afoot in all of this. Whether or not the JOBS Act stimulates the economy as its supporters say remains to be seen, but one thing is certain … it will create a lot of jobs for lawyers. My thoughts follow below. Of course, this post is based on the JOBS Act as proposed, not as finally enacted. Further, much of the proposed statutory language instructs the SEC to promulgate enabling regulations. Thus, while the broad strokes below are probably correct, details will change as the statute is finalized. Stay tuned.
My thoughts …
“IPO On-Ramp” - The Reopening American Capital Markets to Emerging Growth Companies Act.
A – Technical. Title I of the JOBS Act began as H.R. 3606. The core technical change enacted by Title I is to amend Section 2 of the Securities Act of 1933 to create a new defined term … the “Emerging Growth Company.” In short, an issuer has “Emerging Growth Company” status for five years after its IPO, or until it exceeds $1 billion in annual gross revenue, or until it becomes a “large accelerated filer,” whichever comes first. A “large accelerated filer” is one with a public float of $700M. See Rule 12b-2(b). Thereafter, to effect the contemplated business result(s), the term “Emerging Growth Company” cascades through the Securities Act of 1933, the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 with the net effect of exempting such entities from a host of regulatory requirements. Here’s the scoop …
1 - Quiet Filings. Section 6 of the Securities Act articulates the statutory architecture for filing a registration statement with the SEC. As proposed, Title I would amend Section 6 to allow – for the first time - submission of a registration statement by an Emerging Growth Company for “confidential nonpublic review” by the SEC staff. Though recently limited (see SEC), such “quiet filing” has long been available to foreign issuers. By contrast, in domestic practice “quiet filing” has meant filing a registration statement without issuing a press release, an anachronism given the availability of information today. Since a filed S-1 is almost instantaneously available online - allowing a deep dive into an issuer’s technology, business strategy and financials by global competitors months before there is market certainty - a “quiet filing” takes some of the competitive risk out of an IPO filing for U.S. issuers. Net: Good stuff.
2 - “Testing the Waters” And Other Talk. Section 2(a)(3) of the Securities Act sets forth a long list of actions that are deemed to constitute a “sale” of securities for regulatory purposes. As proposed, Title I would amend Section 2(a)(3) to exclude therefrom “research reports” about an Emerging Growth Company both prior to and immediately after its IPO, even if the analyst works for a bank that is underwriting the offering (i.e., such a report would not be deemed a “prospectus”). Further, Title I would amend Section 5 of the Securities Act and Section 15D (“Securities Analyst and Research Reports”) of the Securities Exchange Act to increase the range of allowable communication between an Emerging Growth Company, prospective institutional investors, and analysts, again both before and after an IPO. The theory behind these changes is that they will allow a company to “test-the-waters” with certain qualified purchasers before incurring the costs of registration. Likewise, the loosening of rules regarding research and analyst communication is intended to increase the amount of information available to the investing public and thus – theoretically – the success of the offering. Net: This is the only part of the On-Ramp that gives me pause. No specific objection I can articulate, but nearly 80 years of securities jurisprudence has focused on limiting the pre-effective chat. In the final analysis, I think this will prove more complex in practice than it appears on paper. We’ll see.
3 - Limited SOX. Section 404(b) of the Sarbanes-Oxley Act requires that public companies retain an outside auditor to attest to its internal controls and procedures. See AICPA. As proposed, Title I would amend Section 404(b) to exclude Emerging Growth Companies. The purpose of this exemption is to reduce the cost of “being public” for companies that have just undertaken an IPO by eliminating this (expensive) audit requirement. Notably, management liability is unchanged in that Emerging Growth Company executives would still have to certify to the public that their controls are adequate. Net: Continuing liability of executives (which protects the public) while eliminating the gigantic accounting bill (providing cash flow relief to the business) is, IMO, a nice balance of real world practicalities. Good stuff.
4 - No “Say-On-Pay.” A web of federal laws, including Section 14A and Section 14(i) (“Disclosure of Pay Versus Performance”) of the Securities Exchange Act require shareholder votes on executive compensation arrangements, including golden parachutes. See SEC and NYTimes. Existing Section 14A(e) of the Securities Exchange Act creates a regulatory “placeholder” pursuant to which the SEC has authority to exempt issuers from such obligations specifically including when deemed to “disproportionately [burden] small issuers.” Title I drives Emerging Growth Companies through that gap by expressly exempting them from shareholder advisory votes on executive compensation in proposed new Sections 14A(e)(1) and (2). Likewise, the disclosure of pay-vs-performance under Section 14(i) - added to the Securities Exchange Act only recently (as Section 953(a) of the Dodd-Frank Act) – is amended by Title I to expressly exclude Emerging Growth Companies. Net: I personally don’t think the risk in newly public investments is on the executive comp side. At this stage management is playing for massive stock appreciation just like the investing public. So, with the phase-in as the company matures, IMO another good balance of real world practicalities. Good stuff.
5 - Financials – Not So Much. Finally, Title I would amend Section 7(a) of the Securities Act (regarding information required in the IPO registration statement) and in Section 13(a) of the Securities Exchange Act (regarding information required in post-public periodic reports) such that no more than two years of audited financials be required to be disclosed. This change is intended to reduce audit costs relative to the current requirement (five year look back on financials). Net: Good stuff.
B – Practical. There is a tremendous groundswell of support in the business and venture capital communities, and in both political parties, for the passage of the IPO-On Ramp. See NVCA(1) and NVCA(2). Not surprising. As noted above I think that these are logical edits to real world regulatory pressure points for emerging companies. Overall, the IPO On-Ramp is also a vast improvement on (or, depending on your point of view, a logical extension of) the awkward “smaller reporting company” regime created by the SEC in 2008. See Release 33-8876. A “smaller reporting company,” under those rules, was one with less than $75M in public equity float, or less than $50M in annual revenue. See Interpretations. In mechanical terms, the “smaller reporting company” rules poured Regulation SB “small business issuers” into a scaled version of the Regulation SK disclosure requirements applicable to all public companies. Confusing verbiage and rules structure, IMO. The “Emerging Growth Company” moniker of the On-Ramp is a vastly more understandable and practicable rules regime.
“Crowd Funding” – The Entrepreneur Access to Capital Act.
A – Technical. Title III of the JOBS Act began as H.R. 2930. As proposed, Title III adds two new provisions to the Securities Act:
The first of these is a new category of exempt transaction enumerated “Section 4(6)” whereby issuers may sell up to $1M in any 12-month period without registration. The aggregate limit is increased to $2M in any 12-month period if purchasers are provided with the issuer’s audited financial statements. Since startups rarely have audited financials, the $2M limit rule is largely irrelevant. In contrast to the extensive jurisprudence surrounding the Section 4(2) exemption (access to information, sophistication of purchasers, etc.), under the new Section 4(6) the sole purchaser qualification would be a limitation on amount invested, i.e., $10,000 or 10 percent of the investor’s annual income, whichever is less. Oddly, there is apparently no limit on the number of purchasers. So, the Crowd doing the Funding is of theoretically infinite size … ?
The second new provision is a new Section 4A entitled “Requirements With Respect To Certain Small Transactions.” As proposed, Section 4A articulates the conditions for a Section 4(6) transaction, including specific risk factors that must be stated, specific questions that must be directed to prospective purchasers (in short … “do you understand that this is risky stuff?”), an SEC notice requirement, and, notably, a requirement that a third party custodian manage the inflow of investment funds from the offering. Look for lots of marketing pamphlets from law firms on “how to do a 4(6) deal.” Ditto a jostling for custodial duties. As a legal practice point, query whether law firms will look to step into this void. Bad idea, IMO, but that’s another post for another day.
B – Practical. It is hard to overstate the enthusiasm for Crowd Funding. See Forbes (“The potential for [Crowd Fund] investing to transform that [sic] way startups access capital is staggering.”), Inc.(1) (“[Crowd Funding is] the grease that keeps the gears in the American economy churning.”), and Inc.(2) (“Imagine … [t]he next Steve Jobs being held back by rules from the age of the typewriter. When are we going to give the tools and resources to our job creators? [Crowd Funding] is an innovative way to look outside the box and get up with the times to open up capital markets to new businesses and existing small businesses. It has the potential to be a powerful venture capital model.”).
Nevertheless, IMO the Crowd Funding legislation is ill-advised. As proposed, it strikes me as a quasi-private version of the Spring Street Brewing Company saga. Founded by former Cravath associate Andrew Klein, Spring Street Brewing completed what is generally considered the first internet direct public offering, or “DPO,” in February 1996. For a terrific analysis, see Hass (SoCalLawRev). Though a groundbreaking use of the then brand new “world wide web,” the real success of the Spring Street Brewing DPO is that it opened the world of online investing; in fact, the very next year Mr. Klein shifted his efforts to Wit Capital, the first online investment bank (“fat-cat investing at the click of a mouse”). The microbrewery? Well, as Klein said in a 1999 interview:
[A]lthough we had around 500,000 people who came and saw the [Spring Street] prospectus on our site, only 3,500 of them invested. Yeah, we raised nearly $2 million, but the conversion rate - that is, the rate at which people who heard about the offering and looked at the prospectus were willing to buy in a direct offering - was very, very small. [Why?] Because people aren’t that stupid. … I mean, our beer company was a very decent offering, a perfectly legitimate effort to raise capital. But the average investor is smart enough to know that if there’s not an intermediary who’s in the business of evaluating the company, doing due diligence, and putting its reputation on the line with the company’s reputation, that investors should beware.
So … what about the
idiots investors who put $2M into Spring Street Brewing? According to Crowd Funding evangelist Scott Brown (R-MA):
[S]ome have voiced concerns that [Crowd Funding] is an avenue for fraud and abuse. But, consider this: Americans are allowed to gamble unlimited amounts at casinos, and can send donations to charities halfway around the world with one tap of a trackpad. Yet, we are legally prevented from making even modest investments in job-creating small businesses.
Casinos? Hoo boy.
Putting aside the merits of targeting an unlimited number of unsophisticated investors (“unpreferred retail investors” in Crowd Funding parlance), for a financing capped in practical terms at $1M, as a business matter there is the inconvenient truth that shareholders (1) have legal rights, and (2) create administrative cost/hassle. The online platforms cited as evidence of Crowd Funding power – Peerbackers, IndieGoGo, Kickstarter, PledgeMusic and RocketHub – solicit donations. “Micro-patronage” in industry-speak. Others, like Prosper, broker loans. Thus, missed in the exuberance of selling equity to the general public is the fact that the Crowd doing the Funding thereafter owns the business. As owners …
** They have statutory rights to records and information.
** They have statutory authority to sue in the name of the company (aka a “derivative” suit).
** They have voting rights, and their votes may or may not be needed to undertake various future corporate actions. You have to think that Crowd Funded startup essentials will include: drag alongs (are they enforceable?), voting agreements, and a super-voting class of Common held by solely management (per Facebook). Said another way, some expensive lawyering will be needed to offset the risk that the Crowd will want too much of a say in corporate affairs.
** They are owed a fiduciary duty by both management and majority shareholders. Think Board of Directors and management control group - of a startup with limited resources - vis-à-vis hundreds (thousands? … remember, no cap on numbers) of mom-and-pop, general public, minority shareholders.
** Finally, the Crowd is going to (reasonably) expect management to communicate with them, answer questions and keep them informed. In my view, the Crowd Funding evangelists are ignoring the practical, in-the-trenches administrative burden of carrying a shareholder base of hundreds (thousands?).
Net: IMO, bona fide control issues arising from a large, unsophisticated shareholder base plus the administrative cost of managing same plus management liability exposure to same plus likely disinterest of mainline venture investors in all of the foregoing … together offset the advantages of $1M in funding. Thus, I would say that the proposed Crowd Funding legislation is ill-advised in practical, real world business terms. My guess is that most venture backed startups will avoid the process, rendering the law largely irrelevant to mainstream business backed by professional money.
Title 5 and Title 6
“500-Shareholder Rule” - The Private Company Flexibility and Growth Act and The Capital Expansion Act.
A – Technical. Title V and Title VI of the JOBS Act began as H.R. 2167 and H.R. 4088, respectively. I have no opinions on the latter, which deals with the number of shareholders permitted to invest in a community bank. The former, however, directly impacts emerging company practice. As proposed, Title V amends Section 12(g)(1)(B) of the Securities Exchange Act – aka the (in)famous “500-Shareholder Rule.” As it exists today, the “500-Shareholder Rule” subjects a company to the full panoply of SEC “public company” reporting when it reaches $1M in assets and 500 “shareholders of record.” H.R. 2167 appears to be the simplest of the proposed amendments, i.e., it amends Section 12(g)(1)(B) by increasing the asset threshold to $10M (non-controversial), and, the shareholder threshold from 500 to (a) 2,000 total or (b) 500 non-accredited “shareholders of record,” whichever comes first. The real action, however, lies in how the new rule defines “shareholders of record.” Under existing law the term has its plain English meaning (essentially holders of outstanding securities). The JOBS Act dramatically alters this calculus in two ways: First, under Title V, employees are excluded if they receive their securities under equity compensation plans (Query: what’s a “plan” for this purpose?). Second, hidden in Section 302 of Title III (Crowd Funding), is the nuance that persons who purchase shares in a Section 4(6) Crowd Funding transaction are not counted either. In technical terms, Title III (not Title V) amends Section 12(g)(5) of the Securities Exchange Act to exclude Crowd Funding shares.
So … Putting that all together: The number of all (accredited and non-accredited) holders of capital shares minus employees minus Crowd Funders must be less than 2,000; and the number of non-accredited holders of capital shares minus employees minus Crowd Funders must be less than 500. Here’s my question: Since there are no limits on the number of Crowd Funders, can an issuer (1) raise money from, say 10,000 non-accredited Crowd Funders, (2) issue shares to say, 1,000 non-accredited employees, and still (3) be exempt from public company reporting? Sounds crazy, but that’s how I read it … .
B – Practical. As with Crowd Funding, it is hard to overstate the excitement about changing the 500-Shareholder Rule. See Bloomberg (“The 500 shareholder rule is outdated, overly restrictive, and limits U.S. job creation and American global competitiveness.”). Google, Twitter, Zynga and Facebook – variously forced to go public, structure contorted beneficial ownership arrangements and/or seek an SEC exemption – are generally cited as the poster children for rule’s negative impact. See Deal and DealBook. Much is made of the fact that the 500-Shareholder Rule was first articulated in 1964, the year in which Section 12(g) was added to the Securities Exchange Act. Since then, as the argument goes, the size of the stock market, the number of corporations and the number of investing shareholders have all grown substantially, thus changing the meaning of what constitutes a “public market,” thus driving a need to increase the 500 shareholder threshold.
** First, obviously the stock market is bigger today than in 1964, as is the size of a now global investing public. Try watching television for any particular 30 minute period without seeing an ad for online investment services. That said, I personally don’t see a straight line between that data and the number of shareholders in a privately-held company that indicates an investor footprint of sufficient size to warrant public reporting. So, the “1964 = old = bad” argument? I don’t get it.
** Second, by focusing on the “old = bad” angle, I think much of the debate in the blogosphere misses the core issue, i.e., how many shareholders does a private company have to have before it should be deemed to have a public market for its shares? In this regard, the JOBS Act properly takes a hatchet to employee shares. This is the Google, Twitter, Zynga and Facebook problem: companies growing at meteoric speed and issuing gobs of employee stock and options that “count” in the “public market” calculus. To this extent, Title V is good stuff and overdue.
** Third, while I can’t say that 500 shareholders is the correct standard, I also don’t know how or why 2,000 total holders or 500 non-accredited holders is right either. The new number choices strike me as arbitrary as the old one. I will say this, however: After you factor out the employees, 500 shareholders is a lot of people. 2,000 is a lot more. Managing 1,999 non-employee shareholders – answering their questions, responding to their requests for information, keeping them informed of events as corporate laws require, soliciting their vote(s) when necessary and generally managing their expectations – is a big job. If a privately-held company has so many shareholders that it requires an internal investor relations function isn’t it, like, “public-ish”? Just a thought.
** Finally, assuming you back the employees out of the calculation, who benefits from massive 2,000+ shareholder, privately-held companies loathe to dive into the public markets? Certainly not mainline venture capital investors with presumptively extended liquidity paths. In that regard, it’s no surprise that some of the biggest supporters of a “2,000-Shareholder Rule” are the purveyors secondary markets (SecondMarket and SharesPost). The secondary market phenomenon is a topic for another day, but two comments are apropos here: (1) many people – myself included – believe that much secondary market activity defies the spirit if not the letter of the federal securities laws, and (2) the way venture capital documents are drafted companies generally have an effective veto over who can and cannot sell into the secondary market and as a result some issuers are “gaming” who “gets” to “cash out.” Regarding the former (securities laws), the word on the street has long been that the SEC is aware of the abuses but under orders from the Obama Administration to let it slide – for now. To my knowledge, only one investigation has transpired to date (see Bloomberg). Regarding the latter (issuers letting “friends” cash out), this is almost certainly actionable on a variety of legal theories. No one has sued anyone (yet) because for the time being everyone wants to play nice and get liquid. However, with 2,000 shareholder companies floating around – with active secondary markets - look for that legal ground to be plowed sooner rather than later.
Title 2 and Title 4
Reg D and Reg A – The Access to Capital for Job Creators Act and The Small Company Capital Formation Act.
A – Technical. Title II and Title IV of the JOBS Act began as H.R. 2940 and H.R. 1070, respectively. The latter is noncontroversial and probably not greatly relevant to tech startups; as proposed Title IV amends Regulation A under the Securities Act to increase the offering threshold for companies exempted from SEC registration from $5M to $50M. Conversely, Title II plows new securities law ground … As proposed, the core change effected by Title II is to amend Regulation D under the Securities Act to say that (1) offerings exempt under Rule 506, in which (2) all purchasers are accredited investors, can (3) be effected without regard to the general advertising and general solicitation restrictions of Rule 502(c). Various conforming changes then ripple through the Securities Act. So, in English … 35 accredited purchasers, no dollar limit on the offering, with general advertising/solicitation = OK under Rule 506.
B – Practical. Personally, I’m hard pressed to see the merits of abolishing the general solicitation rule in any context. Remember, the latter is there to protect investors and issuers (the former from fraud, and the latter from lawsuits for failure to disclose material information in said solicitations). Barry Silbert, CEO of SecondMarket explained it thus in a House Subcommittee hearing on September 21, 2011:
[T]he general solicitation prohibition unnecessarily limits the pool of potential investors, thereby restricting companies’ ability to raise capital to fuel growth … [I]f only accredited investors are eligible to purchase unregistered securities, shouldn’t we strive to maximize the pool of accredited investors that have access to the offering? [S]ophisticated, accredited individual and institutional investors have greater capacity for risk and do not require the enhanced protections provided to the average retail investor.
The phrase “the devil is in the details” was created for situations like this. Should it be adopted as proposed, abuse of the new rule as well as increased instances of outright fraud are, IMO, a given. Ditto hand-wringing by lawyers for legitimate offerings on the subject of what must be disclosed in a “Rule 506 General Solicitation” to minimize issuer and management liability. Does issuer’s counsel hold a sort of quasi-drafting session for solicitation material, or just wash his or her hands of it as a non-legal business matter? Since it goes to the exemption, hard to imagine the latter. Further, what happens to third party legal opinion practice? Rote for 506 deals today, but if the rule goes through as proposed look for much rumbling over exceptions and assumptions in what were once routine transactions. Net: By allowing unregistered general solicitation Congress is cutting to the core of the federal securities law regime. IMO, this will create more problems than it will solve and create more jobs in the legal industry than any other sector. Crank up the legal budget for these deals.
Final Note: Erosion of the New Deal
In 1932 Roosevelt swept to power with an electoral victory that is stunning by today blue state/red state standards. In 1936, the electoral map was even more so. Roosevelt used his electoral mandate (control of Congress helped) to usher in the “New Deal,” a cluster of legislative activity intended to deal with the national financial debacle of the time.
Some pieces of New Deal legislation served their purpose and were repealed (e.g., rules creating the Civilian Conservation Corps and Public Works Administration). Some were doomed by the politics of the day (e.g., the Civil Works Administration, see Slate). Others were ruled unconstitutional by the Supreme Court (e.g., the Agricultural Adjustment Act of 1933 and the National Industrial Recovery Act of 1933), leading to FDR’s ill-advised and doomed “court packing” maneuver. Finally, a lot of the “New Deal” still exists today … the Banking Acts of 1933 and 1935 (creating the Federal Deposit Insurance Corporation), the Securities Act of 1933, the Securities Exchange Act of 1934, the Social Security Act of 1935, the National Labor Relations Act of 1935, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.
Notable by its absence in the above discussion is the “Glass-Steagall Act,” a confusing term that variously refers to (1) 1932 legislation put forth by Henry Glass (D-VA) and Henry Steagall (D-AL) related to the Federal Reserve, or (2) the entire Banking Act of 1933, or (3) Sections 16, 20, 21 and 32 of the Banking Act of 1933 dealing broadly with the separation of commercial and investment banking, or (4) Sections 20 and 32 of the Banking Act of 1933 dealing specifically with the ability of commercial banks to participate in securities underwriting and investment. Historically, references to “Glass-Steagall” and the “Glass-Steagall Act” have meant the four provisions of the Banking Act drawing a line between commercial and investment banking. However, it was Sections 20 and 32 thereof – federal statutes expressly forbidding commercial banks from underwriting activity - that were (dubiously) repealed by the Gramm-Leach-Bliley Act of 1999. Consumer advocates draw a straight line between the repeal of Glass-Steagall and the financial crisis of the late 2000’s. See Kuttner and Weissman. Some – primarily those in the banking industry – dismiss the assertion. Me? I’m with Elizabeth Warren: FDIC insurance, Glass-Steagall’s separation of investment banking and SEC regulations provided “50 years without a crisis,” and generally kept banks from doing “crazy things.”
What’s the point?
The JOBS Act variously tinkers with and takes a hammer to two pillars of the New Deal – the Securities Act and the Securities Exchange Act. Most of the tinkering – such as the IPO On-Ramp and the proposal to exclude employees from the 500-Shareholder Rule – represents thoughtful, intelligent adjustment of the regulatory framework to emerging company business reality. By contrast, “hamfisted” is how I would characterize the rulemaking that enables (1) unfiltered, unlimited solicitation of unregistered investments, (2) Crowd Funding, and (3) creation of private-company behemoths with thousands of “unpreferred retail” shareholders trading in a murky online world of secondary sales. As to the latter changes, John Coates’ JOBS Act testimony was correct IMO … any decrease in the transactional costs of raising capital effected by these changes is illusory. See Coates.
For reasons that I personally don’t understand, there seems to be a groundswell of belief that the New Deal was a bad thing. “Bad for business” is an oft articulated point of view and one that permeates JOBS Act political discussion. My view is that the 1929 Crash and ensuing Great Depression was bad for business. So was the S&L crisis, Enron, and the subprime mortgage meltdown. All failures to regulate properly, not failures of over-regulation. My view is that the federal securities laws should be bad for bad business and short-term profiteering. They should also prevent people from doing crazy things. Some parts of the JOBS Act qualify … others don’t.
Stay tuned … .
© david jargiello 2012 all rights reserved