On Friday, September 28, 2012, the Dodd-Frank Investor Advisory Committee of the SEC met (see this agenda) and received an SEC Staff briefing on the JOBS Act. In connection with the Staff briefing, the Committee received an update from Jonathan Ingram, Deputy Chief Counsel and Lona Nallengara, Deputy Director (Legal and Regulatory) in the Division of Corporation Finance. Ingram reviewed the proposal relaxing the prohibition against general solicitation for certain offerings under Rule 506. One of the Committee members inquired whether an issuer’s failure to take “reasonable steps” to verify investor status (even if the investors were indeed accredited) would be considered an insignificant violation of Rule 508 or whether it would result in the loss of the offering exemption. Ingram noted that the proposal did not address Rule 508 in this context. The Committee also discussed prior proposals that had raised the deregulation of offers, and whether the SEC would have the authority to modify the definition of “accredited investor” to add a sophistication element to the definition (to supplement the net worth test). The Committee suggested that the Staff consider adopting a new “Form GS” (for general solicitation) in order to track the types of offerings in which general solicitation is used. The Committee also recommended that material used in a general solicitation be furnished to the SEC at the same time as it is being used. Finally, the Committee suggested that there be a safe harbor for verification. Over the longer term, the Committee suggested that the Commission consider amending the “natural person” prong of the “accredited investor” definition. The Committee also received an update from the Staff on crowdfunding.
The Division of Corporation Finance confirmed that beginning on October 1, 2012, an EGC may submit its confidential draft registration statement through the EDGAR system. Once an issuer chooses to rely on EDGAR submissions, it cannot opt to change to paper submissions through the secure email system. The SEC will provide instructions on transitioning from the secure email system submissions to EDGAR for those EGCs that have submissions pending. See http://www.sec.gov/divisions/corpfin/cfannouncements/drsfilingprocedures.htm.
Former Vice Chairman of NASDAQ, David Weild IV, guest blogs about the importance of tick sizes. David is Head of Capital Markets at Grant Thornton and Founder, Chairman and CEO of Capital Markets Advisory Partners.
Our prior studies served as a call to action that helped focus attention on the plight of capital formation that paved the way for the JOBS Act. We hope that our (my co-authors are Ed Kim and Lisa Newport) new study, “The trouble with small tick sizes: Larger tick sizes will bring back capital formation, jobs and investor confidence,” will do more to fix stock markets to better support entrepreneurs, innovation, economic growth, access to capital and job creation.
While many intuitively knew that stock markets were no longer supporting entrepreneurs at they once had, it wasn’t enough to know it, we had to prove it. So, we set out, with the gracious support of Grant Thornton, the Global Six Audit Tax and Advisory firm, to identify specifically what was causing so the harm to issuers, their access to capital, and in turn, job formation and the U.S. economy.
Our earlier studies (Why are IPOs in the ICU?; Market structure is causing the IPO crisis – and more; and A wake up call for America) (signed into law by President Obama on April 5, 2012) were the first to show:
- The catastrophic drop in small IPOs (sub $50 million in proceeds) that occurred in 1998. This is significant because it was BEFORE Decimalization (2001) and BEFORE Sarbanes-Oxley.
- That the United States listed (NYSE, AMEX and NASDAQ) stock markets have lost listed companies, EVERY single year since the peak in 1997.
- That we have lost over 43.5% of all listed companies from the US stock markets.
“The trouble with small tick sizes” (“tick sizes” are the smallest increment in which a stock may be quoted – 1 penny in today’s market):
- Demonstrates that Regulation ATS (Alternative trading systems) in 1998 caused a loss of over 75% of the economic incentive to support small public companies.
- Calls for The JOBS Act, Part 2 – an increase in tick sizes to better support public companies and to the IPO market.
- Calls for an “Issuer Bill of Rights” (We believe public company managements deserve better representation, better support for their stocks and better transparency into who is trading their stocks)
- Reviews the academic literature and the recent SEC Report to Congress on Decimalization, and
- Documents the many market experts that are joining us in our call for increases in tick sizes – from Academics, to Stock Exchanges and including the Mutual Fund Industry.
Among the many distinctive aspects of the JOBS Act is that we could end up seeing more Congressional hearings on the JOBS Act after it was enacted than before it was enacted. The focus has now shifted from merits of the JOBS Act’s provisions to the pace at which those provisions are going into effect, as well as the manner in which the SEC is seeking to implement the provisions.
On September 13, 2012, two key House subcommittees held a joint hearing on the implementation of the JOBS Act. The Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs of the House Committee on Oversight and Government Reform, chaired by Representative Patrick McHenry (R-NC), and the Subcommittee on Capital Markets and Government Sponsored Enterprises of the House Committee on Financial Services, chaired by Representative Scott Garrett (R-NJ), questioned a panel consisting of an academic, a small business representative and potential beneficiaries of the JOBS Act. In addition to Robert Thompson, a professor at the Georgetown University Law Center and Jeffrey Van Winkle of the National Small Business Association, the panelists included Alison Bailey Vercruyesse, founder and CEO of 18 Rabbits, a producer of granola and granola products, Rory Eakin, co-founder and COO of CircleUp, and Naval Ravikant, CEO of AngelList. The panel evaluated the progress of the SEC’s implementation of the JOBS Act, and in particular the removal of the ban on general solicitation in Rule 506 offerings under Title II and the crowdfunding exemption under Title III.
While the panelists were largely supportive of the JOBS Act and the flexibility that it will bring to capital-raising efforts, there was an underlying concern that, particularly with respect to the crowdfunding exemption, the SEC’s implementation through rulemaking could make the costs and burdens too onerous for the types of companies who would find the exemption attractive. The panelists, perhaps to the consternation of certain of the members of the subcommittees, did not seem too concerned with the pace of the SEC’s rulemaking, with some panelists expressing the view that the SEC should take an approach which ensures that they get the rulemaking right, so that the JOBS Act provisions are workable and achieve the objectives of promoting capital formation.
The members themselves touted the bipartisan effort which brought about the JOBS Act, and then devolved into partisan bickering about the pace of the SEC’s efforts to implement the Act. In this regard, much focus was placed on the SEC’s shift toward adopting Title II rules through a traditional notice and comment process, rather than going straight to interim final rules. Further, there was some debate among the members regarding the extent to which the SEC should be prioritizing JOBS Act rules over rules required under the Dodd-Frank Act, including the extent to which the majority members were seeking to delay Dodd-Frank Act implementation while at the same time pushing forward with the JOBS Act.
Perhaps the most insightful commentary of the hearing came from Representative Waters (D-CA), who expressed some concern that Ms. Vercruyesse, the founder of 18 Rabbits, was taking time away from running her business to testify on the implementation of the JOBS Act. Representative Waters stated “you don’t need to be sitting up here in Congress for hours talking about whether or not they’re moving fast enough.”
No SEC officials were present at the hearing, and it is unlikely that we will see any change in course at the SEC or any legislative initiatives coming out of this hearing.
The SEC Advisory Committee on Small and Emerging Companies met on September 7, 2012 in San Francisco to continue its dialogue on capital formation and other issues affecting emerging companies. The agenda for the meeting, as well as background materials, and presentation materials are available on the SEC’s site, at http://www.sec.gov/info/smallbus/acsec.shtml.
The background materials included a number of interesting studies, including various academic papers that provide different perspectives on the challenges affecting the IPO market. Certain studies posit that small firm IPOs have generated disappointing returns, and smaller firms are at a competitive disadvantage (compared to larger firms) in achieving speed-to-market and achieving economies of scale. A disappointing thesis. We read with interest an article titled, “The Twilight of Equity Liquidity” by Professor Jeff Schwartz (available at http://www.sec.gov/info/smallbus/acsec/acsec-backgroundmaterials-090712-schwartz-article.pdf) which considers the need for a new “lifecycle model” for companies, to promote growth while providing sufficient safeguards for investors. This would build on the JOBS Act “on ramp” approach and also address market structure issues that may be affecting adversely smaller and emerging companies.
When the SEC finalizes proposed rules that eliminate the prohibition on general solicitation and general advertising, private funds will be free to jump in and publicly offer their securities, right?
Not so fast, especially if the private fund is a commodity pool under the Commodity Exchange Act.
Among other things, Section 201(a)(1) of the JOBS Act mandated the SEC to revise Rule 506 of Regulation D under the Securities Act to eliminate the prohibition against general solicitation and general advertising for offerings to accredited investors. Section 201(b) of the JOBS Act amends Section 4 of the Securities Act of 1933 to clarify that offerings made under Rule 506 won’t be considered public offerings under the federal securities laws if they rely on the exemption.
Private funds, including hedge funds that are also commodity pools, typically rely on Section 4(a)(2) and Rule 506 to offer their interests without registration under the 1933 Act. Private funds also generally rely on exclusions from the definition of an investment company provided by either Section 3(c)(1) or 3(c)(7) of the Investment Company Act. But, as a condition to rely on either of these exclusions, the issuer must be one that is not making and does not propose to “make a public offering” of its securities.
The SEC’s long-awaited rule proposals implementing Section 201(a) recognize the issue. The SEC unambiguously stated that it believes that Congress, in adopting Section 201(b) of the JOBS Act, intended to let privately offered funds make a general solicitation under amended Rule 506 “without losing either of the exclusions under the Investment Company Act.”
While the JOBS Act addresses private offerings for purposes of the federal securities laws, it does not specifically address how the Section 201(a) would apply to regulation of commodity pools that are exempt from registration under the CEA.
In particular, consider CFTC rule 4.7 and rule 4.13(a)(3), which exempt certain hedge funds and other commodity pools from the CEA’s registration requirements. A fund can rely on rule 4.7(b) only if it “offers or sells participations in a pool solely to qualified eligible persons.” It is not clear whether this condition prohibits marketing to the public, as contemplated in the proposed amendments to Rule 506. Similarly, a fund can rely on the de minimis exception, rule 4.13(a)(3), only if the pool interests are exempt from registration under the 1933 Act “and may not be marketed in public in the United States.”
The result is that the CFTC’s rules are not in harmony with the federal securities regulations. That is, private funds that invest only in securities and security-based swaps, may engage in general solicitation and advertising, while private commodity pools, including those that rely on the rule 4.13(a)(3) de minimis exception, would not be able to engage in general solicitation and advertising.
The Managed Funds Association makes a cogent argument in its July 17, 2012 comment letter to the CFTC concerning harmonization of compliance obligations under JOBS Act and CFTC regulations.
We hope the CFTC gives serious consideration to the MFA’s comment.
We have previously written about FINRA Rule 5123 (see http://www.mofo.com/files/Uploads/Images/120615-FINRA-Rule-5123.pdf) which will apply to private placements in which a FINRA member firm participates. On September 5th, FINRA announced that the rule will become effective on December 3, 2012 for offerings commencing after such date. See the full notice at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p163707.pdf
FINRA Rule 5123 applies to a “private placement” which means, “a non-public offering of securities conducted in reliance on an available exemption from registration under the Securities Act.” However, the Rule does not apply to securities offered pursuant to Section 4(a)(2) (formerly known as 4(2)) or to offerings exempt pursuant to Section 3 of the Securities Act. Offerings sold only to certain categories of investors, such as “institutional accounts”, “qualified purchasers”, QIBs or entities composed solely of QIBs, and institutional accredited investors, are excluded from the application of the rule. Similarly, offerings involving certain types of securities are also excepted from the rule’s application—these include non-convertible debt or preferred stock.
The rule requires that a FINRA member that sells a security in a private placement must submit to FINRA (or have submitted on its behalf) a copy of any private placement memorandum, term sheet or other offering document, including any materially-amended versions thereof used in connection with such sale, within 15 calendar days of the date of first sale. If no such disclosure document exists, the member must prepare a notice filing identifying the private placement and the participating members, stating that no disclosure document was used, and file it with FINRA within the filing deadline. The notice filing requirement does not establish any review and approval process by FINRA for private placements. FINRA Rule 5123 provides confidential treatment to all documents and information filed pursuant to the rule. The filing and notice requirements will provide FINRA with greater insight into the types of private offerings that are being conducted by member firms, and will provide an opportunity for FINRA to ensure that member firms have appropriate policies and procedures in place for private offerings.
Grant Thornton has published a report on tick sizes, available here http://www.sec.gov/info/smallbus/acsec/acsec-backgroundmaterials-090712-weild-article.pdf. The report discusses two alternatives to customize tick sizes. These alternatives are likely to be discussed during the meeting of the SEC Advisory Committee on Small and Emerging Companies today.
Under Title I of the JOBS Act, an emerging growth company may confidentially submit a draft registration statement for an initial public offering for nonpublic review, provided that the initial confidential submission and all amendments are publicly filed with the SEC no later than 21 days prior to the issuer’s commencement of a road show. The confidential submission process has proven to be a popular aspect of the JOBS Act’s IPO on-ramp provisions, given that emerging growth companies can go through a substantial portion of the SEC review process without (immediate) public disclosure of changes made in response to SEC Staff comments.
Presently, the SEC Staff accepts draft registration statements in a text-searchable PDF file submitted through a secure e-mail system. Last week, the SEC adopted a new EDGAR Filer Manual, which contemplates confidential EDGAR submissions of draft registration statements. Once the programming is completed for these changes, draft registration statements and amendments to draft registration statements will be submitted via EDGAR using submission form types DRS and DRS/A, respectively. We have heard from the SEC Staff that the necessary changes to the EDGAR system should be completed by some time in October. In the meantime, emerging growth companies should continue to use the secure e-mail system for their draft registration statement submissions.
Over the last few weeks, many commentators have written about the potential for widespread fraud and abuse in connection with Rule 506 offerings in which general solicitation is used. Some of these commentators have noted that if general solicitation is permitted, additional safeguards should be implemented in order to protect accredited investors. The argument seems to go more or less as follows: the securities laws prevented general solicitation from being used in connection with private offerings made to sophisticated purchasers and mandated that where general solicitation was permitted (i.e., public offerings), certain disclosure standards had to be met in order to ensure that investors had adequate information on which to base their investment decision. And, the argument continues: if general solicitation is permitted in connection with certain exempt offerings, then the accredited investor standard should be revisited and certain disclosures should be mandated in order to protect investors.
We have a little trouble following these arguments. Indeed, an exemption from registration has always been available in the case of certain private offerings made to a limited number of financially sophisticated investors that have some relationship to each other and to the issuer, have access to information about the issuer, and no general solicitation is used. It was determined that in the case of such offerings, financially sophisticated investors could fend for themselves. Was their ability to fend for themselves dependent on the fact that no general solicitation was used? If general solicitation is used, would it render otherwise financially sophisticated investors unable to fend for themselves? We’ll come back to this question.
A bit of history first: the notion of deregulating offers (relaxing the ban against general solicitation) is not a new idea that was rashly suggested and was not given careful consideration. Relaxing the prohibition against general solicitation and general advertising has been suggested and considered for the better part of twenty years. Not sure we would say that taking two decades to effect this change is “rushed.”
The proposed rules regarding Rule 506 offerings using general solicitation do require that additional steps be taken to verify the status of those investors that are actually purchasing securities. This is intended to address the concerns raised by certain legislators in connection with their consideration of the JOBS Act. Issuers (or the broker-dealers acting on their behalf) will be required to evidence the steps they took to verify the status of investors. On this basis, it is difficult to understand how investors that are subjected to general advertising or solicitation efforts but do not participate in offerings are harmed. One might be able to understand that certain classes of TV viewers might be harmed by watching advertisements for sugary cereals or “jumbo-sized” meal deals (although someone, presumably older and more nutritionally-aware, still has to make the decision to visit a store and make the purchase decision) or by being exposed to excessively violent television programs. However, it is a little harder to draw parallels with investing. Is the point that listeners will be de-sensitized to hearing about investment opportunities? Or, that merely listening will do harm? Not everyone that listens to a compelling or aggressive sales pitch for a security will qualify as an accredited investor, or will be deemed to be a customer for which the investment is appropriate based on investment objectives and other criteria.
A couple of commentators have also noted that it is the “accredited investor” standard that may be deficient. For some time now, we have relied on the utility of the “accredited investor” threshold as one that is useful in identifying a class of investors that has the financial wherewithal to make certain investments and that possess, either on their own or with the assistance of a purchaser representative, the ability to make investment decisions. It is true that the “accredited investor” definition uses financial tests as a proxy for assessing sophistication, and, perhaps, that’s a crude and imprecise test. We have never implemented investor standards that require testing or screening for financial literacy. Does the fact that general solicitation will be permitted really require revisiting of all of our investor standards? And, if we were to revisit the “accredited investor” test, then should we revisit the other investor standards contained in the securities laws? If we don’t believe that accredited investor self-certification is reliable, would it be reasonable to rely on the accuracy and reliability of any “financial literacy” test? Don’t the know-your-customer and suitability obligations mitigate any potential risks that securities would be recommended to customers for which such purchases would be inappropriate?
Some have suggested that it may be useful to require a “warning label” on the offered securities, or impose a “cooling off” period during which investors who were generally solicited (and presumably vetted and determined to be accredited) could re-consider their investment decision. This is not the first time that a “cooling off” period has been suggested in connection with securities offerings. In fact, we’ve seen this suggested in connection with mortgage-backed and asset-backed offerings, as well as with accelerated book build transactions marketed principally to institutional investors. The rationale given is that the marketing of transactions moves too quickly to permit careful consideration of investment opportunities—so, we should slow down the pace of the market, but facilitate capital formation? Interesting.