On April 5, 2012, President Obama signed the “Jumpstart Our Business Startups Act,” H.R. 3606 (112^th Cong., 2^nd Sess.), aka the “JOBS” Act.  This law identifies an “emerging growth company” (ECG) as a company with a total annual gross revenues of less than $1 billion during its most recently completed fiscal year.  This “JOBS” Act will provide temporary regulatory relief to small companies, which should encourage them to go public and yet ensure their eventual compliance with regulatory requirements as they grow larger.

Since this will substantially change the federal securities laws, the following lengthy discussion is provided to give more details of a general nature.  This law will benefit many sectors:

• Startups based in the U.S., regardless of the location of their global operations;

• Existing small-to-mid sized businesses seeking expansion capital up to $1.0 million in any 12 months;

• Foreign or domestic investors (particularly “angel” investors) seeking to invest in U.S. private companies, whether or not this involves acquisition of control (“M&A”) or minority investment (venture capital and private equity);

• Financial advisors introducing investors and earning “finder’s fees” and brokerage commission;

• Small public companies, or private companies seeking to increase to 2,000 the number of investors (presently capped at 500) before being required to file an IPO; Employees receiving a company’s securities pursuant to an employee compensation plan exempt from registration requirements under Section 5 of the ’33 Act will not be counted in determining whether the 2,000-investor limit is reached.  JOBS Act, Sec. 501 and 502.

• “Funding Portals” that, as websites or other “portals,” serve as intermediaries for transactions involving the offer or sale of securities for the account of others under new Section 4(6) of the ’33 Act.

Private Emerging Growth Companies. A section of this draft law is captioned the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012,” popularly known by the acronym as the “CROWDFUND Act.”  Under a new Section 4(6) of the ’33 Act, no registration will be required for transactions involving the offer or sale of securities by an issuer (including all entities controlled by or under common control with the issuer).  Such transactions will be limited to:

(A)    a maximum fundraising of $1.0 million under this Section 4(6) during any 12-month period;

(B)     subscriptions by any single investor during any the 12-month period not exceeding (i) the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and (ii) 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000.

Such exempt transactions must be conducted through a broker or “funding portal” that complies with specific requirements, and the issuer must comply with certain specific requirements.  There will be no exemption from liability for securities fraud.

Crowdfunding. In soliciting such “crowdfunding” investors, the brokers or “funding portals” must provide any disclosures (including disclosures related to risks and other investor education materials) that the SEC might require.  Since the investors will be “at risk,” the broker and “funding portals” will need to “ensure that each investor:

(A) reviews investor-education information, in accordance with standards established by the Commission, by rule;

(B) positively affirms that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss; and

(C) answers questions demonstrating–

(i)   an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers;

(ii)   an understanding of the risk of illiquidity; and

(iii) an understanding of such other matters as the Commission determines appropriate, by rule.

The draft law will include substantial protections against abuses and frauds in the solicitation of “crowdfunding” investors.   Such investors need not be “accredited investors” or “institutional investors,” so such protections would impose burdens on the brokers and “funding portals” to

• take measures to reduce the risk of fraud under new SEC rules, including obtaining a background and securities enforcement regulatory history check on each officer, director, and person holding more than 20 percent of the outstanding equity of every issuer whose securities are offered by such person; and
• disclose to the SEC and prospective investors information provided by the issuer at least 21 days prior to the first day on which securities are sold to any investor (or such other period required by the SEC);
• ensure that all offering proceeds are only provided to the issuer when the aggregate capital raised from all investors is equal to or greater than a target offering amount, and allow all investors to cancel their commitments to invest, as the SEC may require by rule;
• protect privacy as required by any new SEC rule;
• not compensate promoters, finders, or lead generators for providing the broker or funding portal with the personal identifying information of any potential investor;
• prohibit its directors, officers, or partners (or any person occupying a similar status or performing a similar function) from having any financial interest in an issuer using its services.

The draft law will also require EGC’s to make certain filings with the SEC, both as to solicitations and annually.  Audited financial statements will be required for solicitation of more than $500,000, and unaudited financial statements will be required for solicitation of between $100,000 and $500,000 in any twelve month period.

The EGC could not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker.  Nor could the EGC compensate or commit to compensate, directly or indirectly, any person to promote its offerings through communication channels provided by a broker or funding portal, without taking such steps under an SEC rule, require to ensure that such person clearly discloses the receipt, past or prospective, of such compensation, upon each instance of such promotional communication.

Large Non-Public Companies. The JOBS Act will also modify “small company capital formation” under Regulation A, which allows a large company to remain nominally private.  These companies could raise up to $50 million a year annual in shares that are transferable.

Public Emerging Growth Companies. Special exemptions will apply to exempt emerging growth companies from several compliance obligations as publicly listed companies and facilitate fund-raising from small investors via the Internet.   Such exemptions will apply until the earliest of three dates:

(1) five years from the date of the EGC’s initial public offering;

(2) the date an EGC has $1 billion in annual gross revenue; or

(3) the date an EGC becomes a `large accelerated filer,’ which is defined by the Securities and Exchange Commission (SEC) as a company that has a worldwide public float of $700 million or more.

For “emerging growth companies” that are publicly listed with the SEC, they will be exempt from the requirements

• under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, for separate shareholder approval of executive compensation, including golden parachute compensation;

• under the Securities Act of 1933 (’33 Act), from
  • the obligation to present more than two years of audited financial statements in order for its registration statement, with respect to an initial public offering of its common equity securities, to be effective; and
  • the duty to refrain from engaging in oral or written communications with potential investors that are qualified institutional buyers or institutions that are accredited investors to determine whether such investors might have an interest in a contemplated securities offering, either before or after the filing of a registration statement with the SEC;

• under the ’33 Act and the Securities and Exchange Act of 1934 (’34 Act), from disclosing in any other registration statement to be filed with the Securities and Exchange Commission (SEC), financial data for any period before the earliest audited period presented in connection with its initial public offering;

• under the Sarbanes-Oxley Act of 2002, from
  • obtaining audited financial statements from a registered public accounting firm that attests to, and reports on, any assessment of internal controls made by the emerging growth company’s management,
  • rules requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the issuer’s financial statements (auditor discussion and analysis), and
  • future SEC rules that are generally applicable to publicly traded companies, unless the SEC decides otherwise and determines that their application to emerging growth companies is necessary or appropriate in the public interest, after considering the protection of investors and whether the action will promote efficiency, competition, and capital formation.

Specifically, publicly listed “emerging growth companies” will be allowed before its initial public offering date, to submit to the SEC a draft registration statement for confidential nonpublic review by SEC staff before the public filing.  However, the EGC will have to publicly file the initial confidential submission and all amendments to it with the SEC within 21 days before the issuer conducts a “road show.” (A “road show” is an offer that contains a presentation regarding an offering by one or more members of the issuer’s management and includes discussion of the issuer, its management, and/or the securities being offered.)

Broker-dealers and emerging growth companies will be exempted from certain restrictions on conflicts of interest and from any SEC or registered national securities association (i.e., FINRA) rule or regulation prohibiting any broker, dealer, or member of a national securities association from publishing or distributing any research report, or making a public appearance, with respect to the securities of an emerging growth company.

Certified public accountants (“CPA’s”) will be exempt, if the SEC so decides, from certain other requirements, so that new GAAP standards would not apply to publicly traded emerging growth companies unless the same standards apply to non-public companies.

The SEC will be required to determine how the requirements of Rule S-K (relating to IPO’s) can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies.

Thus, the EGC’s will be allowed to gauge the interest in potential IPOs by permitting greater pre-filing communications to institutional and qualified investors to determine whether an IPO is likely to be successful. All of the antifraud provisions of the securities laws still apply, however, and the delivery of a statutory prospectus before securities are sold in an IPO will still be required.

Opportunities for New “Funding Portals. ” The JOBS Act will legitimize new web-based businesses such as SecondMarket.com to support trading in the shares of securities exempt from registration with the SEC under new Section 4(6) of the ’33 Act.

• The SEC will adopt a rule that exempts, conditionally or unconditionally, a “registered funding portal” from the requirement to act as a broker or dealer.  In return, the “registered funding portal” will remain subject to the examination, enforcement and rulemaking authority of the SEC.  JOBS Act, Sec. 304(a).  Such portals would be exempt from local state Blue Sky laws except in the U.S. state or U.S. possession where organized.  JOBS Act, Sec. 305(d).

• By new definition, the term `funding portal’ means any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to section 4(6) of the Securities Act of 1933 (15 U.S.C. 77d(6)), that does not—

(A) offer investment advice or recommendations;

(B) solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal;

(C) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal;

(D)  hold, manage, possess, or otherwise handle investor funds or securities; or

(E)  engage in such other activities as the Commission, by rule, determines appropriate.

In effect, such portals are information intermediaries.  They cannot solicit purchases or sales of the securities “displayed or referenced” on a website.

• While “funding portals” are prohibited from compensating “employees, agents or other persons [presumably finders] on a success-fee basis.  However, the owners could be earn profits based on success fees earned by the “funding portal” from listing information about Section 4(6)-exempt securities, including those of Emerging Growth Companies.  Such “funding portals” could evolve into the equivalent of unregulated exchanges since they could list prices of securities sold and serve as a reference point for individual buyers and sellers.

Limited De-regulation of Securities Markets. Overall, the JOBS Act will dismantle many regulatory burdens on private companies seeking private equity investment and small public companies.  It represents an acknowledgment that Sarbanes-Oxley and Dodd-Frank laws have increased compliance requirements and costs painfully without benefit.  It will accelerate IPO’s for companies with less than $1 billion in revenue and $700 million in publicly trade stock to avoid new accounting rules, external audits on their internal controls under Sarbanes-Oxley, “say on pay” shareholder review of executive compensation and rules on conflicts of interest by analysts.  The results may mirror those of London’s AIM (Alternative Investment Market), where laxer disclosure and audit standards may confuse investors between hype and substance.

Buyer Beware. By relaxing many important disclosure requirements for private equity investments, the JOBS Act may open the floodgates to securities fraud by hucksters and “boiler-room” promoters.  This law does not repeal anti-fraud laws.  However, the new law does encourage prudent investors to inquire and investigate before investing.

For further information, contact William Bierce or Colin Harley at Bierce & Kenerson, P.C.