By Alexander J. Davie, Esq.
It has been almost a year since Congress passed the Jumpstart Our Business Startups Act (JOBS Act), which was a law designed to ease the securities law burdens on startups and high growth companies raising capital. The JOBS Act is divided into six main sections called “titles.” This article examines the impact that each title of the law has had over the last year.
Title I—The “IPO On-Ramp”
Title I of the JOBS Act, also known as the “IPO On-Ramp,” creates a new concept called an “emerging growth company,” which is defined roughly as a company with less than $1 billion in revenue. An emerging growth company (EGC) enjoys an easier path to an initial public offering (IPO) through a number of changes to the IPO process. EGCs also have scaled-down securities compliance obligations for up to five years after the IPO.
The IPO On-Ramp was effective upon passage of the JOBS Act. Unlike many of the other provisions of the JOBS Act, the IPO On-Ramp is generally favored by the venture capital (VC) community because they believe that it will help make the process of going through an IPO easier, less expensive, and less risky for the company, consequently making it easier for a VC to exit from its investment (which, in the end, is the way VCs actually make money). Skadden, Arps, Slate, Meagher & Flom LLP did a comprehensive study on the effects of the IPO On-Ramp in January 2013 and found that EGCs made considerable use of some of the IPO On-Ramp’s provisions and have been able to mitigate some of the risks associated with the IPO process. Overall, the IPO On-Ramp should be characterized as a modest success.
Title II—General Solicitation for Rule 506 Offerings
Title II makes two distinct changes in the law related to privately offered securities. First, it contains a provision instructing the SEC to revise its rules to remove the prohibition against general solicitation (i.e., public advertising) for private offerings conducted under Rule 506 of Regulation D, as long as all purchasers are accredited investors (i.e., wealthy investors) and the issuer takes reasonable steps to verify that each purchaser is an accredited investor. Second, it exempts from broker-dealer registration certain online angel investment platforms.
The provision repealing the ban on general solicitation in Rule 506 offerings has not yet gone into effect because of delays in the SEC’s rulemaking process, generating considerable friction between some members of Congress and the SEC. After much delay, the SEC finally issued the provision’s implementing regulations on July 10, 2013. In the finalized regulations, the SEC provided a non-exclusive and non-mandatory list of methods of verifying the accredited investor status of natural persons who are purchasers which would constitute “reasonable steps” under the exemptions requirements. Beyond that, the SEC stated that whether the verification steps taken are reasonable would depend “on the particular facts and circumstances of each transaction.” The SEC did give extensive suggestions and examples of what reasonable steps would be required in various situations in its commentary to the regulations. The regulations will still not go into effect until September 2013, at the earliest, so it is still impossible to measure the impact of this provision of the JOBS Act.
The provision related to online angel investment platforms became effective upon passage of the JOBS Act. An online angel investment platform is an interactive website which matches startups with potential accredited investors. Generally, federal securities law requires anyone in the business of “effecting” securities transactions on the account of others to register as a broker-dealer. Registering as a broker-dealer is an arduous and difficult process and carries an extremely high compliance burden. Thus, if online angel investment platforms were required to register as a broker-dealer, it would likely put many of them out of business. Prior to the passage of the JOBS Act, these platforms existed in a legal gray area.
Unlike the rest of Title II, this provision does not require SEC implementing regulations to be effective, and therefore is already in effect. So can the exemption for angel investment platforms be used now? Yes, with one caveat. It could certainly be argued that most uses of such a platform constitute an impermissible general solicitation, and thus the platforms must still wait for the regulations related to easing the restrictions on general solicitation to take effect. Recently, in an August 30, 2012, opinion letter (which was subsequently released publicly), K&L Gates LLP opined to AngelList LLC, the operator of an online angel investment platform, that companies posting information to accredited investors on the AngelList website are not engaged in a general solicitation because for 15 years SEC no-action letters have permitted similar websites that provided even more extensive services and information about offerings to accredited investors without raising general solicitation concerns. Of course, K&L Gates’ opinion letter does not carry the force of law, so no one can be completely safe in relying on it.
Overall, there have been some fairly positive developments when it comes to online angel investment platforms. Some of these have been the result of the JOBS Act and some the result of further development of existing law. In either case, these are positive steps forward for the startup community and this area represents probably the most promising change brought about by the JOBS Act.
Title III is the so-called “crowdfunding” law. Probably the most well-known of all the provisions in the JOBS Act, it creates a new exemption from securities laws for offerings conducted over the Internet in an amount up to $1 million per year on the condition that the issuer and the offering meet a long list of conditions, which include limits on how much a person can invest in startups in any particular year, certain advertising restrictions, and disclosure requirements. It also provides for a new type of securities intermediary called a “funding portal” which would operate the websites through which crowdfunding offerings would be conducted. Securities sold under the crowdfunding exemption would not be transferrable by the purchaser for a one-year period beginning on the date of purchase, except in certain limited circumstances.
There has been next to no activity from the SEC on crowdfunding. Title III itself required the SEC to issue implementing regulations by December 31, 2012. As of July 2013, there are no signs that the rules will be issued any time soon. In addition, after the SEC issues its rules, FINRA, the regulatory authority that will oversee the fund portals, will also need to act to create its own rules governing intermediaries. Therefore, it is unlikely that there will be a working crowdfunding exemption prior to 2014 at the earliest.
Title IV—Regulation A+
Title IV instructs the SEC to create a new securities registration exemption similar to the little-known exemption called Regulation A except with a higher offering limit. Regulation A exempts a public offering of up to $5 million from the registration requirements of the Securities Act. Regulation A offerings are similar to registered offerings in that an offering statement must be filed with the SEC, securities can be offered publicly, an offering document similar to a prospectus (although simpler) is required, resales are not restricted, and investors need not qualify as “accredited investors.” Federal securities laws do not preempt state regulation of offerings under Regulation A, which means that such offerings are not exempt from state securities registration requirements. As a result, Regulation A is rarely used because the cost of registering the offering in each state where it is offered is usually too high for an offering as low as $5 million.
Title IV requires the SEC to add a new exemption similar to Regulation A with a maximum offering amount of $50 million per year (commonly referred to a “Regulation A+”). In addition, securities issued under the new Regulation A+ will be exempt from state registration requirements if they are offered or sold on a national securities exchange. With the increased offering limit and the ability to avoid state registration requirements, Regulation A+ may become a more attractive and cost effective way for medium sized companies to raise capital. Like Titles II and III, Title IV has not yet gone into effect because of delays in the SEC’s rulemaking process and it is unclear when the SEC will act.
Titles V and VI
Titles V and VI make it easier for companies to remain private and avoid having to become a public reporting company. Prior to the passage of the JOBS Act, if a company had over $10 million in assets and any class of its equity securities was held by 500 or more shareholders, it was required to become a public reporting company, which essentially forced the company to conduct an IPO. The JOBS Act increased the number of shareholders a company may have before the registration requirement is triggered in two ways. First, it increased the threshold so that it is triggered if the company has either (i) 2,000 or more persons or (ii) 500 or more persons who are not accredited investors (except for a bank holding company, for which the threshold is a straight 2,000). Second, it provided that shareholders who received their shares through an employee compensation plan or crowdfunding are not to be counted towards these limits. These provisions took effect full upon passage of the JOBS Act, though some minor rulemaking related to clarifying the provisions related to employee compensation plans still needs to be performed by the SEC.
The Impact of the JOBS Act
What is most striking about the JOBS Act is how little effect it has actually had thus far. This is because the SEC has failed to issue the implementing regulations that actually make many of the most important provisions of the act effective. Much of Title II and all of Titles III and IV are not self-effecting and until the SEC issues regulations, they have no force or effect in law.
What is causing the regulatory paralysis? The central issue is that there are two completely different mindsets at work when it comes to the world of capital formation. On one side, there is the view that we need to deregulate the issuance of securities for startups, small companies, and high-growth companies because compliance with current securities laws are too complex and difficult for small companies. Compliance requires companies to hire legal counsel that is highly specialized (and thus expensive) at the precise point in time when they are least able to afford to do so. According to this viewpoint, making securities laws less onerous would make it more likely that good ideas will be able to obtain needed investment, creating economic growth. This was the central premise behind the JOBS Act.
Others, however, view securities regulations as necessary, are in place to prevent fraud, and loosening them is only likely to increase fraudulent behavior. In addition, advocates for stringent securities laws argue that, while some offerings may not be fraudulent, most potential investors are not in a position to evaluate whether startup investments are a good allocation of capital or whether they are too risky. In this view, the potential for fraud plus most people’s inability to evaluate investments has three negative effects: (i) investors will suffer from losses that they cannot bear economically (i.e., the elderly widow who loses her life savings in a risky venture); (ii) because of the widespread losses that people will incur due to fraud and bad business ventures, over time, people will become less willing to invest because of fear of such losses; and (iii) because there will be large numbers of amateur investors investing in things that they have no way of evaluating, capital will actually get misallocated, which will hurt economic growth.
The difficulty arises from the fact that both of these perspectives have merit. Securities laws are complex. They are often difficult to comply with, and the severe consequences for failure to comply with them deter entrepreneurs from seeking investors for their ventures. The high cost of legal services and significant amount of compliance is often way out of proportion to the budgets of many startups. It is also true that fraud presents a serious problem and is quite common. The public policy concerns underlying both of these viewpoints are good ones and the facts motivating both viewpoints are not mutually exclusive. Rather than discussing the issue in terms of more vs. less regulation, we should be discussing this issue in terms of smarter regulation that specifically targets the things we are trying to prevent (like fraud) and does not prevent the types of things that we regard as positive (like useful allocations of capital). This should be the focus of the discussion as the JOBS Act is implemented.
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Alexander J. Davie. Esq. is a corporate and securities attorney based in Nashville, Tennessee. He has worked extensively with entrepreneurs, startups, and emerging companies on all aspects of their businesses, including company formation, business planning, mergers and acquisitions, vendor and customer contracts, corporate governance, debt and equity financings, and securities offerings. In addition, Mr. Davie has represented investment advisors, securities brokers, hedge funds, private equity funds, and real estate partnership syndicators in numerous private offerings of securities and in ongoing compliance. Mr. Davie began his career in 2003 at Ballard Spahr LLP and later at Hangley Aronchick Segal Pudlin & Schiller, both of which are based in Philadelphia, Pennsylvania. Beginning in 2008, he served as vice president and general counsel to a private investment fund manager until 2011, when he returned to private practice and founded Riggs Davie PLC.