Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The House of Representatives has passed the Senate version of the Jumpstart Our Business Startups Act, or JOBS Act, and President Obama is expected to sign the legislation.  While the long-term impact of the provisions is at this time unknown, some promise to have a more immediate and useful impact than others.

Elimination of Prohibition on General Solicitation for Rule 506 Offerings and Rule 144A Sales.  I think this provision will have the most immediate and direct impact, but may disappoint some.  Basically this means some form of wide solicitation akin to advertising of securities sales will be permitted, so long as the ultimate sale is made only to accredited investors.   An entrepreneur going it alone may be disappointed that he or she is unable to raise money by putting up a web site and advertising the sale of securities.  But for more organized and professional offerings, this provision will allow placement agents to reach out and contact more people more quickly.

Increase in Threshold for Exchange Act Registration.  The JOBS Act increases the threshold for registration under the Securities Exchange Act to 2,000 persons, or 500 persons who are not accredited investors.  Perhaps more importantly, the JOBS Act provides that record holders of securities who received the securities pursuant to an employee compensation plan that was exempt from Securities Act registration are not counted when determining if the foregoing threshold is met.

Elimination of Exchange Act registration for growing companies obviously results in a huge reduction in regulatory burdens.  The provision is not without its challenges.  For instance, how will a company determine how many of its shareholders are not accredited investors?

Smaller companies are likely to find a large shareholder base unruly to manage as well.  In a worst case scenario, founders and management could find themselves ousted from the company or otherwise losing control.  Taking on numerous shareholders can also complicate a venture capital funding or a private equity exit at a later date.  So make sure you really want all those shareholders before you go down this path.

Expansion of Regulation A. Regulation A provided for a simplified registration process for offerings not exceeding $5 million.  It has not been widely used, perhaps because of the size limitation and sometimes onerous requirements under state blue sky laws.    The JOBS Act directs the commission to revise Regulation A by increasing the size of permitted offerings to amounts not exceeding $50 million in any 12 month period.  Benefits in addition to a simplified registration process include the ability to “test the waters” before filing a registration statement and potentially simplified post-sale reporting requirements.

Importantly, the Commission is authorized to eliminate burdensome blue sky regulation if offers and sales are made to “qualified purchasers.”  The SEC has never defined the term “qualified purchaser” in a useful way (outside of the arena of credit default swaps, if you consider that useful).  In 2001, the SEC proposed defining the term “qualified purchaser” in a manner akin to the definition of “accredited investor,” but the rules were never finalized.

The utility of this portion of the JOBS Act rests squarely in the hands of the SEC adopting user-friendly implementing regulations.

Simplifications for Emerging Growth Companies – the IPO On-Ramp.  The JOBS Act simplifies Securities Act registration and subsequent Exchange Act compliance for “emerging growth companies.”  An emerging growth company is almost anyone that was not public in December 2011 and does not have revenues in excess of $1 billion.

While the simplifications are welcome, an issuer will still need to be an exciting company that an underwriter wants to take public, and a company  that will have a public float that allows for ready trading to attract the attention of investors.  The JOBS Act does nothing to solve that problem.  Smaller IPOs may occur, but the business must still be of a size to bear the costs of still significant regulation.  And management and shareholders must still determine that they wish to operate the business under public company scrutiny.

Crowdfunding.  One would think this provision would rank towards the top of the list because of its novelty.  Crowdfunding however, can be conducted only through certain intermediaries – a registered broker or a “funding portal.”  It remains to be seen how many broker-dealers will be interested in transactions under $1,000,000, which is the annual crowdfunding limit imposed by the JOBS Act.  The exact utility of a “funding portal” remains to be seen, but the moniker imposes significant restrictions, such as not being able to solicit sales, compensate employees or agents based on sales and other matters to be determined by the SEC.

Entrepreneurs will be faced with the necessity of filing designated information with the SEC prior to sale and annual SEC filings thereafter.  The broker or funding portal will have to perform a background check on each officer, director and more than 20% owner.  Reviewed financial statements are required if raising more than $100,000 but not more than $500,000, and audited financial statements are necessary for transactions exceeding $500,000.

The likely impersonal nature of raising capital through crowdfunding heightens the risk of accepting funds from disruptive shareholders. Entrepreneurs may not be appreciative of inquiries and complaints from numerous shareholders, whether warranted or unwarranted.  There are risks here as well with respect to loss of control by founders and management, and having numerous shareholders makes venture investments or an exit difficult.

With all of this regulation, crowdfunding may not be a useful source of capital for a small business.

Check frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

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