Emerging Growth Company Status

At the end of last week, the House Financial Services Committee approved two bills, H.R. 3623 and H.R. 4164.

H.R. 3623, titled the Improving Access to Capital for Emerging Growth Companies Act, was introduced by Stephen Fincher (R-TN). H.R. 3623 builds on the successes of Title I of the JOBS Act, which created a new class of publicly traded companies known as Emerging Growth Companies (EGCs). The bill reduces burdensome Securities and Exchange Commission (SEC) registration and disclosure requirements to help EGCs access the capital markets more efficiently, streamline the Initial Public Offering process and allow EGCs to deploy their assets to grow and create jobs. Most significantly, the bill would reduce the 21-day period (during which a confidential submission must be made public) to 15 days.

H.R. 4164, titled the Small Company Disclosure Simplification Act, was introduced by Robert Hunt (R-VA).  H.R. 4164 provides a voluntary exemption for all EGCs and other issuers with annual gross revenues under $250 million from the SEC’s onerous requirements to file their financial statements in an interactive data format knows as eXtensible Business Reporting Language (XBRL). The bill also requires the SEC to conduct a cost-benefit analysis on the XBRL requirement and report to Congress within one year after enactment. H.R. 4164 allows small businesses to spend more time focusing on expanding and creating jobs rather than on redundant SEC compliance requirements.

Practical Law recently published a round-up of 2013 IPOs, which includes useful statistics on the use of various JOBS Act accommodations, industry trends, selling stockholder participation, and exchange listing.

In summary, 81.4% of issuers filed as EGCs and 69.4% submitted their registration statements confidentially.  As PLC notes, only 22 or 14.8% of EGC issuers chose not to avail themselves of the confidential submission process.  To view the full report, click here.

An issuer that is considering or that has commenced an initial public offering (“IPO”) should take special care to familiarize itself with the communications rules applicable to offerings.

First, an issuer should keep in mind that communications may be viewed as impermissible “gun jumping” activities designed to condition the market for the issuer’s securities.  Second, the issuer should bear in mind that it remains liable for oral communications, and the Commission may require that certain information included in interviews, for example, be incorporated into an issuer’s prospectus.  Communications should therefore be closely controlled and vetted by counsel.

Title I of the JOBS Act expands permissible communications during a securities offering by amending the Securities Act to permit an Emerging Growth Company (“EGC”), or any person authorized to act on behalf of an EGC to “test-the-waters” by engaging in oral or written communications with potential investors that are QIBs or institutions that are accredited investors to determine whether such investors might have an interest in a contemplated securities offering.

When?

Test the waters communications may take place before an EGC makes a confidential submission of its IPO registration statement, while the confidential submission is being reviewed, once an issuer has publicly filed, or at any other point in the offering cycle.

Why?

The objective of this provision was to enable EGCs to gauge investor interest earlier in the process, and, thereby, determine whether to move forward with their offerings.  As a result, test the waters communications are not considered “offers” and would not be viewed as “gun jumping.”

How?

An issuer and its underwriters have considerable latitude in structuring their discussions.  For companies in certain sectors, like biotech, where there are complex technologies, a regulatory pathway, etc., a bank may want to set up meetings early in the process so investors can become familiar with the company’s “story.”  In other sectors, it may be preferable to wait until the issuer has gone through at least one or two rounds of comments from the Commission before meetings with investors are scheduled.

What materials are used?

Depending on the stage at which discussions are held, written materials may or may not be used.  If written materials are used, the issuer and its counsel and the underwriter and its counsel must review the materials and approve their use.  The materials must be consistent with the registration statement disclosure and may consist of a slide deck or the draft registration statement.  Written materials should not be left behind.  Materials should not contain information beyond what is provided in the registration statement (i.e., no projections).

The Commission will ask whether test the waters materials were used and will request copies of the materials.  The issuer is liable for statements made in such materials.

If no written materials are used, the working group should agree on a script.

Can orders be obtained?

The underwriter cannot solicit orders during such meetings.  It can only gauge interest and obtain nonbinding indications of interest.

Private versus public

It is important to remember that during such meetings, an investor may manifest interest in investing in the company.  If the issuer intends to complete a private offering prior to completion of the IPO or concurrently with the IPO, the issuer and financial intermediary should be clear with investors as to the type of offering in which they are being asked to participate.  A number of considerations will need to be taken into account—for example, pricing of the securities sold in the private placement; class of securities; “cheap” stock type issues; etc.

Implications for dual-track transactions

In the past, when an issuer was contemplating a dual track IPO/M&A process, the applicable restrictions on communications (pre-filing, and while in registration), made it difficult for the issuer to pursue actively M&A opportunities, because the issuer had to wait until fairly late in the offering process to pursue such conversations.  The additional flexibility for communications during the pre-filing and registration phase will facilitate dual-track discussions.

In a recent speech (see http://www.sec.gov/news/speech/2013/spch041913laa.htm), SEC Commissioner Aguilar addressed the “scale back” of disclosures in connection with the JOBS Act, and the role of institutional investors in the capital markets.  Commissioner Aguilar cited a paper noting that institutional investors were better at avoiding the worst-performing investors—presumably based on their analysis of financial information made available by public companies.  He noted that the JOBS Act reduces the amount of information required to be made public by emerging growth companies.  This raises a number of interesting questions.  The accommodations available to EGCs under Title I of the JOBS Act relate principally to scaled back executive compensation disclosures.  Would more fulsome executive compensation disclosures be helpful or informative to investment decisions? It is unlikely that more robust compensation disclosures would be essential to an investment analysis.  Title I also permits EGCs to present two years of financial information in their filings.  Perhaps it could be argued that two rather than three years of data would make a difference to an initial investment analysis; however, there is no data yet that would substantiate whether there is a measurable difference to institutional investor decisions based on the availability of a third year of data.  Before concluding that the relatively modest scaled disclosures available to EGCs pose an issue, should we consider whether institutional investors simply have resources to conduct their own analysis, and have access to information (often from investment banks) that is not available to retail investors?

Practical Law Company (PLC) recently published a useful survey (online version accessible here: http://us.practicallaw.com/7-522-8947?q=&qp=&qo=&qe) of the compensation practices adopted by 52 emerging growth companies, or EGCs.  Of those surveyed, 41 EGCs disclosed their post offering director compensation policies.  Of these, 40 will pay annual retainer fees to directors, generally in cash.  The amounts of the annual retainer payments were reported to vary from $10,000 to $120,000.  The survey also noted that, of the 41 EGCs that disclosed their policies, 27 are not paying meeting fees, and 14 pay meeting fees generally.  The survey provides additional details regarding compensation for committee meetings that may be of interest to EGCs.

Any milestone, such as an anniversary, provides an opportunity for reflection and evaluation.  At the one-year anniversary of the JOBS Act, preliminary experience gives reason for some optimism.  The centerpiece of the JOBS Act, the “IPO on-ramp” provisions contained in Title I, have proven quite useful.  The SEC Staff’s guidance in the form of Frequently Asked Questions (or FAQs) promptly filled the gaps in the legislation and helped facilitate prompt reliance on these new provisions.  It would be too soon to draw conclusions regarding the impact of the on ramp on IPOs in general, and smaller IPOs in particular.  The provisions relating to the Exchange Act threshold, which also were immediately effective, have already been relied upon by many smaller banks to suspend their ongoing reporting.  Most of the other provisions of the JOBS Act await further SEC rulemaking.  Below we provide a very brief “cheat sheet” of the status of the various provisions.  We believe that it is fair to say though that the JOBS Act has already had a profound effect on capital formation by restarting an important dialogue on SEC disclosure requirements and permissible communications that seemed to come to an end just after the Securities Offering Reform in 2005, when attention turned to executive compensation disclosures, corporate governance concerns, and ultimately the financial crisis.  The JOBS Act also has served to bring greater general awareness of the important changes that have taken place in the last decade in the way that promising companies choose to finance their growth.  Finally, even for the non-securities lawyers among us, the JOBS Act has focused attention on the divide between public and private offerings—challenging all of us to think more closely about the appropriateness of certain existing regulations that seem more and more “artificial” in the face of social media and other developments.

Title I (the IPO on-ramp)

  • This Title was immediately effective, so no SEC rules were required for this title to take effect.
  • The “IPO on-ramp” provisions generally have proven helpful for companies undertaking IPOs:
    • The SEC Staff immediately put out guidance in the form of FAQs.
    • Market participants have been cautious in relying on some of the accommodations available to EGCs; however, over time, market practice may shift.
    • Most EGCs are still presenting three years of financial information (instead of the permissible two years).
    • Most EGCs are taking advantage of the ability to present abbreviated executive compensation disclosures.
    • Most EGCs are taking advantage of the ability to submit their IPO registration statements for confidential review by the SEC, and relying on the confidential process for at least one or two rounds of SEC comments, before the first public filing.
    • EGCs also are benefiting from the delayed phase-in of other costly compliance requirements, like the Sarbanes 404 attestation requirement.
    • Now, at the one-year anniversary, a fair number (just over 100) of EGC IPOs have been completed.
    • Statistics indicate an increase in smaller IPOs, which, in part, was one of the desired outcomes of the JOBS Act.
  • In addition to providing a new approach for EGC IPOs, Title I also addresses analyst research issues, and requires that the SEC undertake several studies.
  • Research
    • Even after the JOBS Act, the unlevel playing field remains as to research, as a result of the Attorney General Settlement, the terms of which have not been modified.
    • FINRA modified its rules in accordance with the JOBS Act.
    • Most investment banks now have settled (informally) on a 25-day post IPO quiet period before publishing research following completion of an IPO.
    • There is no evidence that investment banks are interested in releasing pre-deal research reports for EGCs.
    • Additional regulatory changes would be needed in order to promote additional research coverage for EGCs.
  • Studies
    • The SEC published the required decimalization study and held a decimalization roundtable; a consensus has formed that a pilot program should be initiated for larger tick sizes.
    • The required study on Regulation S-K has not been delivered.

Title II (Private placements)

  • The SEC proposed rules in August 2012 to carry out the JOBS Act mandate to relax the ban on general solicitation
    • The comment period closed in October 2012; however, the rules have not been finalized.
    • There was vigorous comment on the SEC’s proposed rules, with some commenters advocating the adoption of a safe harbor relating to the measures that would be deemed “reasonable” to verify the status of investors; the adoption of content restrictions or guidelines for materials used in general solicitation; and a reexamination of the “accredited investor” threshold.
    • We anticipate that the SEC will seek to finalize the rules in the spring, and seek to finalize the “bad actor” provisions (required to be adopted for Rule 506 offerings by the Dodd-Frank Act) contemporaneously
  • Matchmaking sites
    • There were no rules needed in respect of the broker-dealer registration exemption for matchmaking sites
    • The SEC Staff put out guidance in the form of FAQs addressing various matters relating to the types of entities that might engage in these activities without subjecting themselves to broker-dealer registration.
    • The SEC Staff issued two no-action letters addressing the applicability of the exemption in the context of VC platforms.

Title III (crowdfunding)

  • No SEC rule proposal as yet (SEC missed deadline)
    • The SEC Staff published FAQs regarding the crowdfunding exemption.
    • FINRA has provided a form for collecting information about funding portals.
    • Concerns remain about the extent to which the crowdfunding exemption as contemplated by the JOBS Act could be used by ventures to raise small amounts of capital in a cost-efficient manner.

Title IV (Regulation A+ or Section 3(b)(2))

  • No SEC rule proposal as yet.
  • Now, pending legislation would mandate that the SEC take action by a date certain.

Titles V & VI (Exchange Act threshold)

  • These provisions relating to the Exchange Act threshold were immediately effective; SEC rulemaking was not required.
  • Many banks (over 100, according to published reports) have taken advantage of these provisions to suspend their SEC filings.
  • The SEC is expected to provide guidance regarding various “holder of record” issues.

What should you expect in the coming months?  We anticipate that the SEC will move ahead with finalizing the rules required under Title II to address general solicitation in certain Rule 506 and Rule 144A offerings.  We expect that this will be accompanied by the final “bad actor” rules required under the Dodd-Frank Act.  The discussion about general solicitation is likely to cause the SEC to revisit the “accredited investor” definition—perhaps resurrecting parts of the SEC’s 2007 “larger accredited investor” standard.  Given the complexities to be addressed by the SEC and FINRA in connection with creating a framework for crowdfunded offerings and funding portals, we anticipate that a proposal relating to crowdfunding may not be released until the second half of 2013.  As we have already seen from meetings of various advisory committees, more attention likely will continue to be focused on rationalizing the disclosure requirements and the communications rules applicable to smaller public companies and companies that might have qualified for EGC status (but for the date of their initial offering of equity securities).  Given the higher registration thresholds under the Exchange Act, we may continue to see the development of a trend toward staying private longer, and the growth of markets designed to provide liquidity to investors in those companies.  Given the press of other business under both the JOBS Act and the Dodd-Frank Act, we may not see a proposal for exempt public offerings under Title IV in 2013.  Lastly, we would hope that the momentum toward encouraging capital formation that was created by the JOBS Act will not be lost in its second year of existence, and we will instead see continued dialogue—coupled with regulatory and market action—that is oriented toward creating opportunities to put capital to work companies of all sizes.

The Staff of the SEC’s Division of Corporation Finance has been discussing the JOBS Act at recent conferences, including the Practising Law Institute’s 44th Annual Securities Regulation Institute in New York and the American Bar Association’s Business Law Section Fall Meeting in Washington, DC.  David Lynn was the moderator of a JOBS Act panel at the PLI Annual Securities Regulation Insitute and he was a panelist on a JOBS Act panel at the ABA Business Law Section Fall Meeting.

The Staff has indicated at these conferences that they are hard at work on the rulemaking projects mandated by the JOBS Act, which include the adoption of changes to Regulation D and Rule 144A pursuant to Title II, the crowdfunding exemption contemplated by Title III, the Regulation A+ exemption contemplated by Title IV, and particular rules regarding Exchange Act registration/deregistration requirements contemplated by Titles V and VI. As is always the case, the Staff spoke for themselves and the views they expressed did not represent the views of the Commission or other members of the Staff.

The Staff was unable to provide any precise commentary on the timing of JOBS Act rules. It appears unlikely that the SEC will meet the 270 day deadline imposed for the Title III crowdfunding exemption, although the Staff is continuing to work hard on formulating proposals for the Commission.  Based on the Staff’s comments, it may be very difficult for a Title III rule proposal to be issued between now and the end of 2012.  Practitioners on panels at both programs noted some of the significant headwinds that are present for implementing a workable crowdfunding exemption, particularly given the complexity of the statutory requirements, as well as some of the significant practical considerations for issuers who engage in exempt crowdfunding offerings.

With regard to the SEC’s proposal to amend Rule 506 and Rule 144A to remove the ban on general solicitation and advertising (provided that, in the case of Rule 506, the issuer takes reasonable steps to verify that all purchasers are accredited investors), the Staff acknowledged some of the comments which have been submitted calling on the Commission to, among other things, adopt the Dodd-Frank – mandated bad actor rules at the same time the changes to Rule 506 are adopted, impose restrictions on the form and content of general solicitation materials, and to establish a non-exclusive safe harbor with respect to the reasonable steps to verify requirement. The Staff emphasized that the Commission’s approach was to propose a framework that could be implemented quickly in accordance with the directive in the statute, and then the Commission and its Staff could monitor the use of the exemption to determine if further changes would be necessary at some point down the road.  While the Staff did not acknowledge the point, it may be the case that the extent and nature of the comments received on the Title II proposal may prevent the Commission from moving forward quickly to adopt workable amendments to Rule 506. No matter how the rule changes ultimately come out, the Staff indicated that a multi-Division team of Staffers will evaluate the market practices with regard to verification of accredited investor status and general solicitations.

On the topic of Title IV implementation, the Staff has indicated that it is working on a term sheet for a Regulation A+ proposal, and is considering either leaving existing Regulation A intact and adopting a new Securities Act Section 3(b) exemption, or updating existing Regulation A to reflect the parameters contemplated by Title IV.  Efforts at the state level to create a streamlined process for dealing with Regulation A+ offerings were discussed, as well as the possibility for some exemption from Exchange Act registration in the context of a listed security sold pursuant to a Regulation A+ exemption.

With regard to the Exchange Act registration amendments in Titles V and VI, the Staff has indicated that it is actively working on recommendations for a rule that would establish when securities obtained in an employee benefit plan can be excluded when counting the number of holders of record. This rulemaking involves quite a few issues, although the Staff is trying to keep the rule as simple as possible. The Staff noted its efforts through the FAQs and the no-action letter process to clarify the application of the Exchange Act registration/deregistration provisions, and to provide appropriate relief where necessary in the case of deregistration of bank holding companies.

On the implementation of Title I, the Staff discussed their guidance on the “IPO On-Ramp” provisions, including the recent guidance on applying the Title I provisions in the context of exchange offers and mergers. The Staff noted that further FAQs are unlikely at this point, although if issuers have questions they should contact the Office of Chief Counsel.  The Staff noted that while some have commented on how the confidential submissions process has reduced visibility into the IPO pipeline, the Staff was not planning on making any information available about confidential submissions given their obligations to maintain the confidentiality of those submissions.  The Staff did note that the confidential submission has been widely embraced since the enactment of the JOBS Act, with over 100 EGCs submitting draft registration statements on a confidential basis (one-third have gone public).  The Staff noted that EGCs are frequently flipping to publicly-filed registration statements after the first confidential submission, thereby avoiding running up against the 21-days-before-the-roadshow filing deadline.  While the Staff noted that a draft registration statement must be complete when submitted confidentially, the Staff has found no problems with the completeness of draft registration statements submitted to date.  The Staff acknowledged that they will need to make some rule changes to integrate the IPO on ramp provisions into existing SEC rules, although it is not expected that these rule changes will be proposed any time soon.