On April 5, 2012, President Obama signed the Jumpstart our Business Startups Act (JOBS Act) into law. The JOBS Act was passed on a bipartisan basis by overwhelming majorities in the House and Senate. The Act seeks to remove impediments to raising capital for emerging growth public companies by relaxing disclosure, governance and accounting requirements, easing the restrictions on analyst communications and analyst participation in the public offering process, and permitting companies to “test the waters” for public offerings. The following is an in-depth review of Title I of the JOBS Act related to Emerging Growth Companies.
Introduction – What is an Emerging Growth Company?
The JOBS Act created a new category of company: an “Emerging Growth Company” (EGC). An EGC is defined as a company with annual gross revenues of less than $1 billion that first sells equity in a registered offering after December 8, 2011. In addition, an EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1 billion in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO; (iii) the date on which it has issued more than $1 billion in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more).
EGC status is not available to asset-backed securities issuers (“ABS”) reporting under Regulation AB or investment companies registered under the Investment Company Act of 1940, as amended. However, business development companies (BDCs) do qualify.
The SEC has issued some interpretive guidance. An EGC is defined in both the Securities Act of 1933 and Exchange Act of 1934 as an issuer with “total annual gross revenues” of less than $1 billion during its most recently completed fiscal year. Total revenues are as posted on the Company’s income statement prepared in accordance with US GAAP. In addition, if the financial statements for the most recent year included in the registration statement are those of the predecessor of the issuer; for example, following a reverse merger, the predecessor’s revenues should be used in determining if the issuer meets the definition of an EGC.
The EGC definition, and therefore the benefit of the reduced reporting rules, only applies to Companies that complete its first sale of common equity securities pursuant to an effective registration statement under the Securities Act of 1933 after December 8, 2011. Moreover, in determining EGC status, the SEC counts the sale of common equity securities by selling shareholders pursuant to a resale registration statement.
Moreover, an entity that completes a reverse merger or other transaction which makes it a successor reporting entity would determine its EGC eligibility based on the predecessor entity’s eligibility. That is, if a private operating entity completes a reverse merger with a public company that went public via a registered offering prior to December 8, 2011, it would not qualify as an EGC. However, a Form 10 registration statement would not disqualify an entity from EGC status, as it is filed under the Securities Exchange Act of 1934 and does not result in the sale of common equity.
The SEC is making the determination of whether a Company qualifies as an EGC at the time it makes a submittal asking for such qualification. Accordingly, if a Company filed a registration statement today asking to be treated as an ECG and asking to be allowed to use the scaled-down disclosure requirements and avail itself of confidentiality during the review process, the SEC would confirm that it qualified as of today. If, during the review process, the Company no longer qualifies as an EGC, it would be required to publicly file a new registration statement meeting the full disclosure requirements.
On the other hand, if a Company filed a registration statement prior to April 5, 2012, it would be allowed to amend to provide the scaled-down disclosure. Moreover, if an EGC completed its IPO after December 8, 2011 but prior to April 5, 2012, it may use the scaled-down disclosure in its periodic reports (Q’s and K’s) going forward, as long as it continues to qualify as an EGC. Once a company is established as an ECG, it must follow the accounting standards set forth for an EGC (Section 7(a)(2)(B) of the Securities Act and Section 107(b) of the JOBS Act), but it may voluntarily comply with some of the other regular disclosure requirements. A decision to be an ECG for accounting purposes is irrevocable, and the appropriate transition accounting rules must be filed.
The $1 billion figure may seem high. A report issued by Jay R. Ritter, Cordell Professor of Finance, University of Florida entitled “Initial Public Offerings Sales Statistics through 2011” showed that in 2011, only approximately 13% of IPO companies had sales in excess of $1 billion. However, upon consideration of the fact that Title I of the JOBS Act in essence waters down and eliminates much of the Sarbanes Oxley Act of 2002 (SOX), Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) passed in 2010, and other strict regulatory requirements for companies engaging in a new IPO, the number isn’t high at all. Title I of the JOBS Act eliminates many SOX and other regulatory requirements for newly public companies – that is its goal and point, so its broad application makes sense from that perspective.
Benefits Afforded to an Emerging Growth Company
The particular relief and benefits afforded to an EGC are:
(i) EGCs will only need to provide two years of audited financial statements instead of the now required three years, with the corresponding reduction in their MD&A discussion. In addition, in any registration statement or periodic report, an EGC’s presentation of selected financial data, which would otherwise cover data for the preceding five years, will only need to include the earliest audited period presented in the EGC’s IPO registration statement. The SEC has issued guidance indicating that once an EGC election is made, all financial information that otherwise would require a three-year look back, may be limited to two years, including selected financial information and financial statements of significant related entities.
(ii) EGCs can report executive compensation as a small business and will not be required to obtain shareholder approval for executive officer compensation. That is, EGCs will not need to solicit say-on-pay or say-on-golden-parachute votes by their shareholders. In addition, they will not need to provide information regarding “internal pay equity” (i.e., the ratio of CEO compensation to the median of compensation for all other employees) as required by Dodd-Frank. An EGC can use the smaller reporting company (i.e., companies with a public float of less than $75 million) executive compensation disclosure (under Item 402 of Regulation S-K) in registration statements, proxy statements, and periodic and other reports. As a result, among other things, EGCs will not have to provide a compensation discussion and analysis (CD&A) or a discussion regarding the relationship of compensation to risk; will be able to limit the disclosure in their summary compensation tables to information regarding three executive officers instead of the usual five, covering only two years instead of the usual three; and will have to provide only three of the seven compensation tables otherwise required (the Summary Compensation, Outstanding Equity Awards and Directors’ Compensation Tables), substituting limited narrative disclosure for the omitted tables.
(iii) EGCs will not need to provide auditor attestation reports in connection with their audits of internal control over financial reporting as required by SOX Section 404. Management’s attestation on internal control for the period covered by each report is still required.
(iv) The JOBS Act offers relief from compliance with new US GAAP public accounting requirements. EGCs will not have to comply with any new or revised financial accounting standards unless and until the standard is likewise applicable to private companies (unless they elect, in their first Exchange Act periodic report or registration statement, to comply with financial accounting standards applicable to non-EGCs, which election is irrevocable). Nor will they have to comply with any rules that may be adopted by the PCAOB requiring mandatory auditor rotation or “enhanced” or supplemented audit reports that would require the auditor to provide additional information or comment about the audit, both concepts that have recently been under consideration by the PCAOB.
(v) The JOBS Act allows the confidential submittal, review and treatment of IPO registration statements with the SEC until just 21 days prior to commencing a road show. The Act permits EGCs to initiate the IPO process by submitting their IPO registration statements confidentially to the SEC for nonpublic review by the SEC staff. The EGC must make the entire filing public at least 21 days before it commences its road show. This confidential process will allow an EGC to defer the public disclosure of sensitive or competitive information and avoid the public disclosure altogether if it ultimately decides not to proceed with the offering. To avail itself of the EGC confidential review process, an EGC identifies itself as such on the cover page of its registration statement.
Although a registrant may avoid public and media scrutiny during the review process, at the time that it must file its public registration statement all comment letters and responses will likewise be made available on the EDGAR system. Accordingly, registrants are advised to treat confidential filings with the same care and professionalism they would with all public filings. In addition, to assist the SEC in this process, the registrant itself will be required to re-file all comment letter responses as correspondence in the EDGAR system.
The confidential treatment process for EGCs is in addition to, and does not supplant, the existing Rule 83 confidentiality request procedure. Rule 83 currently allows persons and entities to request that certain information be kept and remain confidential.
Although this rule is generally used in the context of investigations and administrative proceedings, it is sometimes used associated with information in registration statements and periodic reports filed with the SEC. Since the EGC confidential treatment is temporary (the entire file, including comment letters and responses, will be made publicly available at least 21 days before a road show commences), if an EGC desires Rule 83 confidential treatment, they should follow all Rule 83 procedures and clearly mark any documents or portions of documents for which they are seeking this relief.
(vi) The JOBS Act eliminates restrictions on publishing analyst research and communications while IPOs are under way. Under prior law, research reports by analysts, especially those participating in an underwriting of securities of the subject issuer, could be deemed to be “offers” of those securities under the Securities Act and, as result, could not be issued prior to completion of an offering. The Act provides that publication of a research report does not constitute an offer of securities, even if the investment bank that publishes the research is participating or will participate as an underwriter in the offering. Moreover, under the Act, “research” is defined broadly as any information, opinion or recommendation about a company and includes oral as well as written and electronic communications. This research need not be accompanied by a full prospectus and need not provide information “reasonably sufficient upon which to base an investment decision.” The research need not even be consistent with the prospectus, if there is one. In other words, research providers are free to say just about anything they wish about an IPO candidate, limited only by the general anti-fraud rules.
The Act also eliminates existing restrictions on publishing research following an IPO or around the time the IPO lockup period expires or is released. Currently, under rules of FINRA and the SEC, underwriters of an IPO cannot publish research for 25 days after the offering (40 days if they served as a manager or co-manager), and managers or co-managers cannot publish research within 15 days prior to or after the release or expiration of the IPO lockup agreements (so-called “booster shot” reports). The Act requires FINRA and the SEC to eliminate these restrictions with respect to EGCs. As a result, any research analyst will be able to publish at any time after an EGC IPO, including immediately after the offering. Moreover, the SEC has indicated that FINRA is considering eliminating all quiet periods currently imposed by the Nasdaq Stock Market and NYSE.
(vii) The JOBS Act permits EGCs, and any person acting on its behalf, to test the waters by engaging in pre-filing communications with qualified investors regarding interest in the offering. As an EGC would not have filed any documents or requests with the SEC at this stage, it will be up to the EGC to determine whether it qualifies as an EGC prior to commencing test-the-waters communications. Under current rules, “well-known seasoned issuers,” or WKSIs, can engage in similar test-the-waters communications, but smaller, less mature public companies and pre-IPO companies cannot. These new test-the-waters communications can be oral or written, and can be made either before filing a registration statement or after. They can be made in connection with an IPO or any other registered offering. These communications will still be subject to anti-fraud rules.
(viii) The JOBS Act waives many conflict of interest restrictions on three-way communications between research analysts, investment bankers and company management. Current limitations trace back to the “global settlement” of 2003, in which several key investment banks agreed to these restrictions as part of a settlement of claims arising out of the dot-com bust. The restrictions were designed to address perceived conflicts of interest involving analysts and investment bankers, particularly the perception that bankers sometimes promised their clients favorable research to win underwriting business, while analysts supported their firms’ investment banking businesses by issuing favorable research on companies they did not believe in.
The Act requires FINRA and the SEC to roll back certain restrictions related to the IPOs of EGCs. The Act expressly prohibits the SEC and FINRA from adopting or maintaining restrictions on who can arrange communications between a securities analyst and a potential investor, or restrictions on research analysts and investment bankers meeting together with an EGC. Under the JOBS Act, analysts may attend meetings with management of EGCs and investment bankers; however, analysts are still prohibited from soliciting investment banking business, offering to change recommendations in exchange for investment banking business, and publishing research with which they personally disagree. Analysts may also attend initial meetings between investment bankers and potential underwriting clients and explain analyst services, outline research programs and answer follow-up questions, all of which was previously prohibited.
An analyst may now talk with potential investors regarding an IPO, but cannot be directed to do so by investment bankers. Similarly, bankers can arrange, but not participate in, communications between analysts and their clients. An analyst may now participate in presentations by management of an EGC to a sales force and provide input, including industry trends and information they have garnered through their research. However, analysts may still not participate in a road show.
As for participants to the global settlement, a court order will be required to lift the restrictions for those firms. Other restrictions will remain in place, such as analyst certification requirements, limitations on compensation practices, prohibitions on banker input into research, and provisions relating to budgeting and oversight of the research function.
Both SOX and Dodd-Frank had a devastating financial impact on smaller public companies, and are a great deterrent to those thinking of going public. The benefits of going public include access to capital markets and to obtain financing for growth and acquisitions and hopefully make money for shareholders and investors. On the downside are the tremendous costs of maintaining compliance with the Securities Exchange Act of 1934 reporting requirements. Those costs are not just financial; the time costs on management are also tremendous. In fact, once public, the bulk of time spent by senior management involves dealing with being public, whether it is making sure internal controls are effective, reviewing transactions for disclosure requirements, reviewing draft 10-Q, 10-K’s and 8-K’s, or dealing with investment bankers and shareholder relations issues.
Even prior to making the decision to go public, the perceived costs are a deterrent. The JOBS Act, and in particular Title I granting an IPO on ramp and reporting relief to EGCs, will alter that perception enough to cause an influx of IPOs. In fact, the first quarter of 2012 saw the biggest jump in new IPO filings since 2007. That is what we know about. Since EGCs can now submit registration statements confidentially, we do not know how many have done so and are on the IPO on ramp right now.
Attorney Laura Anthony
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Merger & Corporate Attorneys
Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public companies as well as private companies intending to go public on the over-the-counter market, including the OTCBB and OTCQB. For nearly two decades, Ms. Anthony has dedicated her securities law practice to being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.
Ms. Anthony’s focus includes, but is not limited to, crowdfunding, registration statements, PIPE transactions, private placements, reverse mergers, and compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, as well as the proxy requirements of Section 14. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for corporate changes such as name changes, reverse and forward splits and change of domicile.
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