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JOBS Act Helps Make Section 3(b) a Viable Fundraising Alternative

Daniel E. Hannon and John Hempill, Morrison & Foerster LLP


Introduction

On April 5, 2012, President Obama signed the Jumpstart Our Business Startups Act (the "JOBS Act") [1] into law. This legislation is dedicated, among other things, to making it easier for small companies to gain access to capital. In addition to changes to the offering restrictions in Regulation D offerings and the inclusion of an exemption for "crowdfunding," the JOBS Act also effected significant changes to Section 3(b) of the Securities Act of 1933 (the "Securities Act"). Pursuant to Section 3(b), the Securities and Exchange Commission (the "SEC") previously adopted Regulation A, a little used exemption from the registration requirements of the Securities Act. Over the years, Regulation A offerings have dramatically declined - between 1994 and 2004, small companies relied on it only 78 times; in 2010, it was used only three times. [2] The general consensus was that the existing $5 million offering cap was too low to justify the costs associated with making an offering under Regulation A. [3] On top of that, inflation, which caused a 165% increase in the Consumer Price Index during the period from 1980 to 2012, further exacerbated the imbalance between costs and benefits of a Regulation A offering. [4] The availability of Regulation D since 1982, which has proven to be more cost-effective for small offerings than Regulation A, also contributed to its decline.

One of the changes effected by the JOBS Act was to increase the maximum offering amount under Section 3(b) from $5 million to $50 million. This marks the first time since 1992 that the offering threshold for Section 3(b) has been increased, a change that is long overdue in light of rising costs associated with raising capital in the past 20 years. Rather than changing the existing provisions of Section 3(b), the JOBS Act renumbered those provisions as Section 3(b)(1) and added the new provisions as Section 3(b)(2). It is currently unclear from the text of the JOBS Act whether or not the SEC will implement the changes under Section 3(b)(2) as an amendment to Regulation A or as a completely new rule or regulation. The general consensus at this time seems to be that, given that Regulation A is currently seldom used, these changes will ultimately take the form of an amended Regulation A, which we assume for purposes of this article.

The increased offering amount and other changes effected by the JOBS Act were designed to spur the use of the Section 3(b) exemption, but the question still remains whether these changes will actually increase the use of Regulation A by the very companies the changes target.

Regulation A: Background

Regulation A, or the "Conditional Small Issues Exemption," was promulgated by the SEC under Section 3(b) of the Securities Act. It provided, prior to the changes effected by the JOBS Act, an exemption from the registration requirements of the Securities Act for offerings that did not aggregate more than $5 million in proceeds during any rolling 12-month period by a company that was not subject to section 13 or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act") immediately before the offering. There are no restrictions on the types of investors that can participate in the offering. Additionally, securities issued in a Regulation A offering are freely transferable. Both of these aspects of Regulation A are preferable to the requirements of Rule 506 of Regulation D, which limits the number of "non-accredited investors" and deems the securities issued pursuant thereto to be "restricted."

Regulation A is meant to be a less complex, time-consuming and expensive registration and disclosure process than a traditional initial public offering ("IPO"). The proposed issuer must file an offering statement on Form 1-A with the SEC that includes an offering circular and exhibits. The offering circular is a simplified disclosure document that permits issuers to choose between a standard registration-type or a question-and-answer format. Financial statements are required to be prepared in accordance with generally accepted accounting principles, but only issuers that have audited financial statements because they prepare them for other purposes are required to provide audited financial statements.

In addition, companies using Regulation A are permitted to "test the waters" and solicit investor interest in order to determine whether there is sufficient interest in the securities. The "test the waters" provision historically provided a significant advantage to offerings under Rule 506 of Regulation D which, until the changes effected by the JOBS Act, prohibited general solicitation.

With its offering limit of $5 million, however, Regulation A was not as useful as Regulation D was to private companies looking to raise significant capital. Additionally, unlike offerings under Rule 506 of Regulation D, Regulation A offerings did not fall under the umbrella of federal preemption provided by the National Securities Market Improvement Act of 1996 ("NSMIA") and thus were subjected to a costly and labor intensive registration process under the securities laws of any state in which the securities were to be initially sold or subsequently traded. Furthermore, even though Regulation A securities are not deemed "restricted," because of the $5 million offering cap, Regulation A securities ended up being traded in the highly illiquid over-the-counter market, rather than on a national exchange. This resulted in a limited secondary market for the issuer's securities (and, as a result, no investment bank coverage and no hope to move up to a major exchange), as large institutional investors typically only buy exchange-listed securities.

The JOBS Act: Title IV - Small Company Capital Formation

The JOBS Act amends Section 3(b) of the Securities Act by adding a new provision thereunder that increases the aggregate offering amount that the SEC may exempt to $50 million. It further provides that within two years of the date of its enactment, and every two years thereafter, the SEC must review this maximum aggregate offering amount and increase it if appropriate. If the SEC determines not to increase the offering amount cap after its review, it must report to the House Committee on Financial Services and the Senate Committee on Banking, Housing, and Urban Affairs on its reasons for not increasing the amount.

In addition, the JOBS Act provides that the SEC may, upon such terms and conditions as it determines necessary in the public interest and for investor protection, require an issuer utilizing this new provision to make periodic disclosures regarding itself, its business operations, its financial condition, its use of investor funds, and other appropriate matters. The offering circular used in such an offering will be subject to the civil liability provisions of Section 12(a)(2).

Finally, the JOBS Act amends Section 18(b)(4) of the Securities Act to include in the definition of "covered security" (which is largely exempt from any state regulatory jurisdiction) a security that is exempt from registration pursuant to "a rule or regulation adopted pursuant to section 3(b)(2) and such security is - (i) offered or sold on a national securities exchange; or (ii) offered or sold to a qualified purchaser, as defined by the Commission…with respect to that purchase or sale." In addition, the bill requires that the Comptroller General conduct a study on the impact of state securities laws on offerings made under Regulation A and report its findings to the House Committee on Financial Services and the Senate Committee on Banking, Housing, and Urban Affairs within three months of enactment of the JOBS Act.

Benefits of Regulation A Reform

The reforms to Regulation A effected by the JOBS Act, in addition to improving the accessibilityof Regulation A, may also help jump-start the small IPO (i.e., non-Facebook) market for emerging companies that has all but disappeared over the past decade.

The lower cost associated with the use of a simpler offering circular under Regulation A by itself was not enticing in light of the low $5 million offering cap (as well as that a Rule 506 offering to only accredited investors has no minimum disclosure requirements other than the standard anti-fraud protections). By raising the cap to $50 million, a Regulation A offering now can be a real alternative to a traditional IPO. The streamlined offering and disclosure requirements under Regulation A, when combined with the higher offering cap afforded by the JOBS Act, makes Regulation A a real option for smaller companies who cannot afford to "make the bet" of fronting all the costs associated with a traditional IPO.

Increasing the cap under Regulation A also provides the opportunity for companies relying on this offering method to meet the requirements to list on a national securities exchange, thereby obtaining "covered security" status under amended Section 18(b)(4) of the Securities Act and an exemption from costly compliance with state securities laws. [5] By listing on a national exchange, these companies would also be able to avail their securities of a more robust secondary trading market (and analyst coverage) than the over-the-counter market.

In addition, while some investors might initially balk at the prospect of purchasing securities pursuant to a Regulation A offering when the initial financial disclosures are not audited, investor confidence should generally be fostered by the requirement that the issuer file audited financial statements with the SEC on an annual basis thereafter. The cost of having to prepare these annual audited financial statements should be weighed by the issuer against its not being restricted in a Regulation A offering to the type of purchasers it can have, as compared to an offering under Rule 506 of Regulation D.

Finally, the "test the waters" provision of Regulation A remains an important benefit to issuers by enabling them to gauge investor interest before incurring the majority of costs associated with an offering. However, Title II of the JOBS Act requires the SEC to revise Rule 506 within 90 days to provide that companies can use general solicitation in connection with private securities offerings. Still, the requirement that all purchasers of such securities be accredited investors remains, which enables Regulation A to maintain an advantage because its "test the waters" provision does not include any such restriction on the types of purchasers.

Conclusion

It remains to be seen whether companies considering a securities offering will find Regulation A the better option after the changes to it effected by the JOBS Act. Regulation D will probably remain more attractive to early stage companies because of the reduced disclosure requirements (at least for a Rule 506 offering to all accredited investors under current standards). On the other hand, Regulation A would be more attractive to late stage companies who wish to truly access the public markets. In any case, the Regulation A reforms contained in the JOBS Act represent an important step toward increasing the attractiveness of Regulation A to small companies and making it a viable and useful tool for capital-raising.


[1] See H.R. 3606.

[2] See H. Rep. No. 112-206 at 3.

[3] Id.

[4] Id.

[5] This measure will also help Regulation A to compete with Regulation D (specifically, Rule 506), which NSMIA exempts from state securities registration.

John Hempill, Partner, jhempill@mofo.com

John Hempill acts as general outside counsel for a number of privately and publicly held companies in a variety of industries. He has extensive experience in private and public finance, ranging from representing private emerging growth companies, venture capital funds and strategic investors in seed rounds and later stage private financings, to representing public companies and investment banks in public offerings, as well as 144A and PIPEs financings.

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Daniel E. Hannon, Associate in the Corporate Group in the New York office, dhannon@mofo.com

Mr. Hannon received his J.D., cum laude, from Hofstra University School of Law where he worked on the Hofstra Law Review and interned at the Law Reform Advocacy Clinic. Mr. Hannon previously worked at Morrison & Foerster as a summer associate and for the Honorable Karen V. Murphy, Nassau County Supreme Court.

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Morrison & Foerster LLP

Morrison & Foerster (www.mofo.com) - a global firm of exceptional credentials. Its clients include some of the largest financial institutions, investment banks, Fortune 100, technology and life science companies. It has been included on The American Lawyer's A-List for seven straight years, and Fortune named it one of the "100 Best Companies to Work For." MoFo lawyers are committed to achieving innovative and business-minded results for its clients, while preserving the differences that make it stronger. This is MoFo. Visit at www.mofo.com.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Morrison & Foerster, LLP. This work reflects the law at the time of writing April 2012.