It’s not often that the House of Representatives votes nearly unanimously on anything noteworthy these days, but that’s exactly what the House did on July 17 in voting 406-4 for the “JOBS and Investor Confidence Act of 2018”, also known on the street as “JOBS Act 3.0”, which is the latest iteration of the effort to improve on the capital markets reform initiative started in the original JOBS Act of 2012. JOBS Act 3.0 consists of 32 individual pieces of legislation that have passed the Financial Services Committee or the House, the substance of several of which I have blogged about previously. If passed by the Senate in some form or another and signed by the President, the reforms included in JOBS Act 3.0 will continue the process of removing unreasonable impediments to capital formation by early stage companies and address perceived problems with the original JOBS Act.

The highlights of JOBS Act 3.0 passed by the House are as follows:

Demo Days: Helping Angels Lead Our Startups Act” or the “HALOS Act”

The bill would direct the SEC to amend Regulation D to make clear that activities associated with demo day or pitch night events satisfying certain criteria would not constitute prohibited “general solicitation” under Regulation D. Specifically, the new exemption would cover events with specified types of sponsors, such as “angel investor groups”, venture forums and venture capital associations, so long as the event advertising doesn’t refer to any specific offering of securities by the issuer, the sponsor doesn’t provide investment advice to attendees or engage in investment negotiations with attendees, charge certain fees, or receive certain compensation, and no specific information regarding a securities offering is communicated at the event beyond the type and amount of securities being offered, the amount of securities already subscribed for and the intended use of proceeds from the offering.

I previously blogged about the issue of demo days and the ban on general solicitation here.

Private Company M&A Brokers: Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2017

The bill would exempt from SEC broker-dealer registration mergers-and-acquisitions brokers that facilitate transfers of ownership in privately held companies with earnings or revenues under a specified threshold. The exemption would not apply to any broker who takes custody of funds or securities, participates in a public offering of registered securities, engages in a transaction involving certain shell companies, provides or facilitates financing related to the transfer of ownership, represents both buyer and seller without disclosure and consent, assists in the formation of a group of buyers, engages in transferring ownership to a passive buyer, binds a party to a transfer of ownership or is a “bad actor”.

Since 2014, private company M&A brokers could at best be guided by an SEC no-action letter, although there had been previous Congressional efforts to codify the protection, which I had blogged about here.

Accredited Investor Definition: Fair Investment Opportunities for Professional Experts Act

The bill would direct the SEC to expand the definition of “accredited investor” under Regulation D beyond the net worth and income test to include individuals licensed as a broker or investment advisor and individuals determined by the SEC to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment.

Venture Exchanges: Main Street Growth Act

Although the JOBS Act created an IPO on-ramp for emerging growth companies, it did comparatively little to address secondary market trading in these companies. This portion of the bill seeks to remedy that shortcoming by providing a tailored trading platform for EGCs and stocks with distressed liquidity. Companies that choose to list on a venture exchange would have their shares traded on a single venue, thereby concentrating liquidity and exempting their shares from rules that are more appropriate for deeply liquid and highly valued stocks. Venture exchanges would also be afforded the flexibility to develop appropriate “tick sizes” that could help incentivize market makers to trade in the shares of companies listed on the exchange.

VC Fund Exemption – Investment Advisor Registration: Developing and Empowering our Aspiring Leaders Act

Dodd-Frank requires private equity and hedge fund managers to register with the SEC under the Investment Advisors Act but allows venture capital fund managers to become “exempt reporting advisors” and be relieved from the regulatory requirements encountered by registered investment advisors. Currently, to qualify under the venture capital fund definition and register with the SEC as an exempt reporting advisor, VCs must ensure that more than 80% of their activities are in qualifying investments, which are defined only as direct investments in private companies.

The bill would require the SEC to revise the definitions of a qualifying portfolio company and a qualifying investment to include an emerging growth company and the equity securities of an emerging growth company, “whether acquired directly from the company or in a secondary acquisition”, for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act.  A company qualifies as an emerging growth company if it has total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year and continues to be an emerging growth company for the first five fiscal years after it completes an IPO unless its total annual gross revenues are $1.07 billion or more, it has issued more than $1 billion in non-convertible debt in the past three years or it becomes a “large accelerated filer”.

Founders often leave startups, voluntarily or involuntarily, and it may be in everyone’s interest to have their shares purchased by other existing shareholders rather than sold to an outsider or held by a disgruntled founder.  VC funds should have the flexibility to be able to buy those shares.  Similarly, the inclusion of emerging growth companies in the category of qualifying portfolio company will benefit the innovation ecosystem by encouraging VC funds to invest further in their portfolio companies post-IPO.

Special Purpose Crowdfunding Vehicles: Crowdfunding Amendments Act

One of the perceived defects of the rules governing equity crowdfunding under Regulation CF is the ineligibility of investment vehicles. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors under Regulation D to invest in a special purpose vehicle whose only purpose is to invest in an operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules.  Due to the fear of having to collect thousands of signatures every time shareholder consent is required for a transaction, higher-quality issuers with other financing options are less likely to crowdfund without a single-purpose-vehicle. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

The bill would allow equity crowdfunding offerings under Reg CF through special purpose vehicles that issue only one class of securities, receive no compensation in connection with the offering and are advised by a registered investment adviser.  Special-purpose-vehicles allow small investors to invest alongside a sophisticated lead investor with a fiduciary duty to advocate for their interests. The lead investor may negotiate better terms and represent small investors on the board.  Retail investors don’t enjoy these benefits under Reg CF.

On June 28, 2018, the Securities and Exchange Commission issued a release amending the definition of “smaller reporting company” (“SRC”) to expand the number of reporting companies eligible for relaxed or scaled disclosure. The change is estimated to benefit nearly 1,000 additional small public companies currently outside the SRC definition. But equally noteworthy in the SRC release is that the Commission staff has been directed, and has begun, to formulate recommendations to the Commission for possible changes to another definition, that of “accelerated filer”, to reduce the number of companies that qualify as accelerated filers in order to further reduce compliance costs. That change would likely be more significant than expanding the SRC definition because “accelerated filer” status triggers the expensive requirement to obtain auditor attestation for management’s assessment of internal control over financial reporting.

Background

Smaller Reporting Company

The Commission established the SRC category in 2008 in an effort to provide general regulatory relief for smaller companies. SRCs are allowed to provide scaled disclosures under Regulation S-K and Regulation S-X. Under the previous SRC definition, SRCs generally were companies with less than $75 million in public float (i.e., aggregate market capitalization of a company’s shares held by non-affiliates). Companies with no public float − because they have no public equity outstanding or no market price for their public equity − were considered SRCs if they had less than $50 million in annual revenues.

Examples of scaled disclosure available to SRCs are two year management discussion and analysis comparisons rather than three years, no compensation discussion and analysis and no risk factor disclosure in Exchange Act filings. A table summarizing the scaled disclosure accommodations for SRCs can be found in the Annex at the bottom of this post.

Under previous rules, SRCs were also automatically excluded from being categorized as “accelerated filers” or “large accelerated filers”, the requirements of which are discussed below. As a result, existing public float thresholds in the accelerated filer definition aligned with the public float threshold in the SRC definition.

Accelerated Filer

In December 2005, the SEC voted to adopt amendments that redefined “accelerated filers” as companies that have at least $75 million, but less than $700 million, in public float, and created a new category of “large accelerated filers” that includes companies with a public float of $700 million or more. In addition to the requirement to file periodic reports on an accelerated basis, accelerated filers must also have their auditor provide an attestation report on management’s assessment of internal control over financial reporting under Section 404(b) of Sarbanes-Oxley.

The determinations of public float thresholds for SRC and accelerated filer status are both made as of the last business day of a registrant’s most recently completed second fiscal quarter for purposes of the following fiscal year.

Amendments to Smaller Reporting Company and Accelerated Filer Definitions

The new rules define SRCs as companies with less than $250 million of public float, as compared with the $75 million threshold under the previous definition. The final rules also expand the definition to include companies with less than $100 million in annual revenues if they have either no public float or a public float of less than $700 million. This reflects a change from the revenue test in the prior definition, under which a company would be categorized as an SRC only if it had no public float and less than $50 million in annual revenues.

The final rules will become effective September 10, 2018.

The amended SRC thresholds are summarized in the following chart:

Criterion

Current Definition

Revised Definition

Public Float Public float of less than $75 million Public float of less than $250 million
Revenue Less than $50 million of annual revenue and no public float Less than $100 million of annual revenues and:

  • no public float, or
  • public float of less than $700 million

The increase in SRC public float thresholds will lead to a dramatic expansion in companies eligible for scaled disclosure. The Commission estimates that 966 additional registrants will be eligible for SRC status in the first year under the new definition. These registrants estimated to be eligible in the first year comprise 779 registrants with a public float of $75 million or more and less than $250 million, 26 registrants with no public float and revenues of $50 million or more and less than $100 million, and 161 registrants with revenues below $100 million and a public float of $250 million or more and less than $700 million.

The SRC amendments also eliminate the automatic exclusion of SRCs from accelerated filer status. The definitions of accelerated filer and large accelerated filer are based on public float, but previously contained a provision excluding SRCs from accelerated filer status. As a result, raising the SRC public float threshold without eliminating that provision effectively would raise the accelerated filer public float threshold as well.

Accordingly, the Commission had also considered increasing the public float thresholds in the accelerated filer definition, consistent with the changes to the SRC definition, to reduce compliance costs and maintain uniformity across relevant rules. Opponents viewed a parallel increase in the accelerated filer thresholds as a weakening of investor protections. Some cited a 2011 Staff Section 404(b) Study finding that accelerated filers subject to Section 404(b)’s attestation requirement had a lower restatement rate compared to non-accelerated filers not subject to Section 404(b). But supporters argued that the attestation requirement is particularly costly for SRCs and that audit costs associated with Section 404(b) divert capital from core business needs. One maintained that a Section 404(b) audit represents over $1 million of capital diversion. Another cited the same 2011 Staff Section 404(b) Study which estimated that companies with a public float between $75 million and $250 million spend, on average, $840,276 to comply with Section 404(b). Interestingly, one commenter that stated that its public float was more than $75 million but less than $250 million estimated that relief from Section 404(b) would result in a 35% reduction in compliance costs whereas there would be no material change in such costs from the SRC amendments qualifying him for scaled disclosure as an SRC.

In the final rules release, the Commission determined to eliminate the exclusion of SRCs from accelerated filer status, effectively deciding not to increase the accelerated filer thresholds.

As indicated in the chart below, the increase in the SRC thresholds coupled with the elimination of the automatic exclusion of SRCs from accelerated filer status (i.e., no increase in the accelerated filer threshold) means good news/bad news for companies with a public float between $75 million and $250 million: they benefit from scaled disclosure (unlike under previous rules), but must continue to provide auditor attestations to management’s assessment of the effectiveness of internal control over financial reporting, an enormously expensive proposition.

 

But as I mentioned at the top of this post, auditor attestation relief may be on the way.  SEC Chairman Clayton has directed the Commission staff to formulate recommendations for possible changes to the accelerated filer definition to reduce the number of companies that fall under its requirements, including the auditor attestation requirement. Perhaps, the staff will recommend to increase the accelerated filer public float threshold to $250 million from its current $75 million. That would appear to bring far more practical regulatory relief than the expansion of the SRC definition.

 

Annex

Smaller Reporting Company Scaled Disclosure

 

Regulation S-K

Item Scaled Disclosure Accommodation
101 − Description of Business May satisfy disclosure obligations by describing the development of the registrant’s business during the last three years rather than five years. Business development description requirements are less detailed than disclosure requirements for non-SRCs.
201 − Market Price of and Dividends on the Registrant’s Common Equity and Related Stock performance graph not required.
301 – Selected Financial Data Not required.
302 – Supplementary Financial Information Not required.
303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)

Two-year MD&A comparison rather than three-year comparison.

Two year discussion of impact of inflation and changes in prices rather than three years.

Tabular disclosure of contractual obligations not required.

305 – Quantitative and Qualitative Disclosures About Market Risk Not required.
402 – Executive Compensation

Three named executive officers rather than five.

Two years of summary compensation table information rather than three. Not required:

·      Compensation discussion and analysis.

·      Grants of plan-based awards table.

·      Option exercises and stock vested table.

·      Pension benefits table.

·      Nonqualified deferred compensation table.

·      Disclosure of compensation policies and practices related to risk management.

·      Pay ratio disclosure.

404 – Transactions With Related Persons, Promoters and Certain Control Persons Description of policies/procedures for the review, approval or ratification of related party transactions not required.
407 – Corporate Governance

Audit committee financial expert disclosure not required in first annual report

Compensation committee interlocks and insider participation disclosure not required.

Compensation committee report not required.

503 – Prospectus Summary, Risk Factors and Ratio of Earnings to Fixed Charges No ratio of earnings to fixed charges disclosure required. No risk factors required in Exchange Act filings.
601 – Exhibits Statements regarding computation of ratios not required.

Regulation S-X

Rule Scaled Disclosure
8-02 – Annual Financial Statements

Two years of income statements rather than three years. Two years of cash flow statements rather than three years.

Two years of changes in stockholders’ equity statements rather than three years.

8-03 – Interim Financial Statements Permits certain historical financial data in lieu of separate historical financial statements of equity investees.
8-04 – Financial Statements of Businesses Acquired or to Be Acquired Maximum of two years of acquiree financial statements rather than three years.
8-05 – Pro forma Financial Information Fewer circumstances under which pro forma financial statements are required.
8-06 – Real Estate Operations Acquired or to Be Acquired Maximum of two years of financial statements for acquisition of properties from related parties rather than three years.
8-08 – Age of Financial Statements Less stringent age of financial statements requirements.