Proposed Initiatives May Affect Capital Formation and Public Reporting Requirements

Recent regulatory and legislative initiatives relating to capital formation and public reporting requirements, if implemented, would have a significant effect on privately held companies and publicly traded small and emerging businesses. Although the ultimate outcomes and timing of these initiatives are unknown, we expect at least some of them to be adopted in 2012. Because the proposals could materially impact the timing of when a company decides to go public, how it attracts, retains and pays employees, and the manner in which issuers and investment banks conduct offerings, issuers and their advisors should closely monitor developments related to these initiatives.

Prompted by a series of letters in the spring of 2011 between Rep Darrell E. lssa (R-CA), Chairman of the House Committee on Oversight and Government Reform, and Mary L. Schapiro, Chairman of the Securities and Exchange Commission (SEC), in which Chairman lssa criticized perceived regulatory impediments to capital formation, the staff of the Division of Corporation Finance of the SEC (the Division) has committed to undertake a review of certain regulatory provisions, including:

• The shareholder threshold that triggers public company registration and reporting;
• The restriction on general solicitation and advertising applicable to private offerings;
• A potential increase in the offering amount permitted under the Regulation A safe harbor covering small securities offerings; and
• “Crowdfunding” capital-raising strategies.

It is unclear what actions the SEC ultimately will take as a result of the review of its rules. The Division has stated that it is preparing a concept release for consideration by the SEC on the general solicitation and advertising limitations under the Securities Act of 1933, as amended (the Securities Act). In addition, the SEC’s Advisory Committee on Small and Emerging Companies recently approved a recommendation regarding relaxing or modifying the general solicitation and advertising limitations, as discussed below, and will provide the SEC and the Division with preliminary recommendations about other regulations that affect privately held and publicly traded small and emerging businesses in coming weeks.

Certain members of Congress also have introduced bills that would amend the securities laws in a number of the foregoing areas. Several of these bills, as well as the Division’s initiatives, are discussed below. In addition, certain members of Congress have introduced bills that would permit certain emerging growth companies to delay compliance with particular regulatory requirements that involve high costs.

Shareholder Threshold for Public Reporting

Section 12(g) of the Securities Exchange Act of 1934, as Amended (the Exchange Act). Section 12(g) and its related rules require a company with more than $10 million in assets to register any class of its equity securities that, as of the end of a company’s fiscal year, is “held of record” by more than 500 persons. The definition of “held of record” counts as record holders only those persons identified as holders in the records maintained by the company or on its behalf, including the participants in the Depository Trust Company (DTC) (the principal U S securities depositary) listed as holding the securities on the company’s DTC security position listing Since enactment of Exchange Act Section 12(g) and the adoption of the definition of “held of record,” the securities markets have changed substantially Most securities of publicly traded companies are held in nominee or “street name” instead of directly in the name of the beneficial owner. Accordingly, for most publicly traded companies, many shareholders are not individually counted under the definition of “held of record,” but rather their brokerage firm, which has a DTC account that may be holding securities for numerous accounts, will be counted as one holder. However, shareholders of most private companies usually hold their shares directly and are, therefore, counted as “holders of record.”

Deregistration of a class of equity securities under Section 12(g) is permissible when such class of equity securities is held of record by fewer than 300 persons, or by fewer than 500 persons under limited circumstances.

Exchange Act Rule 12h-1 exempts certain classes of securities from Section 12(g) registration. For instance, in 2007, the SEC adopted Rule 12h-1(f), which exempted certain classes of stock options issued to employees as compensation; however, this exemption does not apply to all classes of securities that are used as compensation. Restricted stock units, for example, are not covered by the exemption. [1]

SEC Action. The Division is reviewing the triggers for Exchange Act registration, which necessarily will determine which companies are subject to public reporting obligations According to written testimony presented to a Senate committee by the director and deputy director of the Division on December 1, 2011, the Division is undertaking a study to:

determine whether the current thresholds and standards effectively implement the Exchange Act registration and reporting requirements and what it means to be a “public” company such that an issuer should be required to register its securities and file [annual, quarterly and current reports] with the Commission. The staff has begun a detailed analysis of public company information- including numbers of record and beneficial owners, total assets and public float- to assess the characteristics of public companies The study also will seek to obtain and consider private company information to assess current reporting thresholds.

In an April 6, 2011, letter to Chairman Issa, Chairman Schapiro also indicated that any review would evaluate the recent trend of using special purpose vehicles (SPVs), formed either by the issuer and a sponsor or by firms unaffiliated with the issuer, to hold private company securities and the important policy issues raised by these structures:

For example, should our rules count the holders of the SPV in determining whether registration under Section 12(g) should be required? Should that be the case only if the issuer is involved in forming the SPV? If SPV investors are not counted, does this approach undermine the goals of Section 12(g)7 Should our rules under Section 12(g) be amended to address these questions, whether to provide additional certainty or to require registration without regard to the purpose of the SPV? On the other hand, does the formation of these SPVs and investors’ interest in them suggest underlying problems with our rules that should be addressed? If the SPVs are traded on private markets, should some level of information be required? These are important questions that I look forward to considering. [2]

Congressional Action. Bills have been proposed in both the House and the Senate to raise the shareholder threshold for registering under Section 12(g) and address related matters. For instance, on June 14, 2011, Rep David Schweikert (R-AZ) introduced the “Private Company Flexibility and Growth Act” (H R 2167) in the House. The legislation seeks to amend Section 12(g) to:

• Raise the current 500-shareholder threshold to 1,000 shareholders; and
• Exempt shares held by persons who received their shares pursuant to exempt transactions under an employee compensation plan from counting toward the new, 1,000-shareholder threshold.

The legislation also would require that the SEC adopt safe harbor provisions that issuers could use to determine whether holders of their securities received the securities pursuant to an employee compensation plan in a qualifying exempt transaction.

The House Financial Services Committee approved the Schweikert legislation on October 5, 2011, as amended. Further consideration of the legislation by the House has not yet been scheduled.

On November 8, 2011, Sen. Pat Toomey (R-PA) introduced a companion measure to the bill pending in the House. The Toomey legislation, also entitled the “Private Company Flexibility and Growth Act” (S 1824), would amend Section 12(g) to:

• Raise the current 500-shareholder threshold to 2,000 shareholders; and
• Exempt shares held by persons who received their shares pursuant to exempt transactions under an employee compensation plan from counting toward the new 2,000-shareholder threshold.

The legislation contains a safe harbor provision similar to the one set forth in H.R. 2167. In addition, S 1824 would liberalize the provisions related to exiting the Exchange Act reporting system by amending Exchange Act Sections 12(g)(4) and 15(d) to raise the current 300-shareholder threshold to 1,200 in the case of a bank or bank holding company. This legislation was referred to the Committee on Banking, Housing and Urban Affairs on November 8, 2011, and was the subject of a committee hearing on December 1, 2011, and a subcommittee hearing on December 14, 2011. Other than as noted above, the House and Senate bills pro­ pose no additional changes to the definition of “held of record.”

Other bills seeking amendments to Section 12(g) and related provisions have been introduced in Congress. (See, for example, S 1600 (which would raise the 500-shareholder threshold in Section 12(g) to 2,000 shareholders for banks and bank holding companies and raise the 300-shareholder exit thresholds in Sections 12(g)(4) and 15(d) to 1,700 shareholders in the case of banks and bank holding companies); and S 556 and H. R. 1965 (each dividing the shareholder threshold that requires registration under Section 12(g) into (i) 2,000 shareholders of record if the issuer is a bank or bank holding company and (ii) 500 shareholders of record if the issuer is neither, and requiring termination of a security registration in the case of a bank or bank holding company if the number of shareholders of record is reduced to fewer than 1,200). The House overwhelmingly approved H. R. 1965 on November 2, 2011, and referred it to the Senate where no further action has occurred.)

Raising the shareholder threshold for Exchange Act registration would benefit private companies by precluding application of the Exchange Act registration and reporting provisions on a schedule that may be inconsistent with the companies’ goals and priorities. Furthermore, the exemption for shares held by persons who received such shares pursuant to exempt transactions under an employee compensation plan could affect how a company attracts, retains and pays its employees.

The changes to the registration and deregistration thresholds may be further impacted by the rise of secondary-market trading platforms for securities of private companies. These platforms, primarily Second Market, Inc. and SharesPost, Inc, are intermediaries that match buyers and sellers of private company securities. Some of the platforms, such as SharesPost, act only as bulletin boards where buyers and sellers can meet and may charge users a fee for the service. Other platforms, such as SecondMarket, are broker-dealers registered with the SEC and the Financial Industry Regulatory Authority (FINRA); these platforms facilitate the trades, provide transaction documents and charge a commission on each trade. Secondary trading in private company securities has become increasingly popular and enables founders, employees, venture capitalists and other early investors to exit an investment in a private company during the increasingly longer period before the company goes public or is acquired In addition, secondary trading may enable companies to delay going public and incurring the attendant costs and burdens (including those imposed by the Sarbanes-Oxley Act) by providing some measure of liquidity in their securities. Active trading on the secondary trading platforms, however, has the potential to increase the number of shareholders in private companies, causing challenges for some private companies to stay below the 500-shareholder threshold for Exchange Act registration. [3]

In her April 6, 2011, letter to Chairman lssa, Chairman Schapiro noted the Division’s focus on secondary trading activity:

[t]he staff also is currently monitoring the secondary trading activity on a variety of online trading platforms, many of which are facilitating the trading of securities of private companies Trading that develops on online trading platforms can be beneficial in that it can provide much desired liquidity to investors, which can assist in attracting investors to smaller private companies This benefit, however, must be balanced with investor protection concerns that can be raised when there is a lack of information available to investors about these private companies Trading markets, including these online platforms, can operate more efficiently where adequate information is available to investors. In the absence of an informed market, concerns can be raised that pricing of securities may be influenced by conflicted market participants who may be buying and selling for their own account as well as facilitating transactions for other buyers and sellers.

The Exchange Act registration and reporting provisions are designed to protect and inform investors in the secondary public trading markets. While the asset threshold under Section 12(g) has been raised a number of times over the years, the shareholder threshold has not been similarly revised upward Given the substantial changes in the securities markets since the enactment of Section 12(g) in 1964, we believe that revising the thresholds under Section 12(g) with a view to more properly balancing the costs and benefits to issuers and investors is appropriate at this time.

The Restriction on General Solicitation and Advertising in Private Offerings

Section 4(2) and Rule 506. Under the Securities Act and the Restriction on General Solicitation and Advertising. Offers and sales of private company stock, like all offers and sales of securities, must be either registered or exempt from registration under the Securities Act Section 4(2) of the Securities Act, a commonly used exemption, exempts “transactions by an issuer not involving any public offering.” In 1962, the SEC stated in Securities Act Release No. 4552, the “Nonpublic Offering Exemption,” that whether a transaction involves a public or private offering is essentially a question of fact and necessitates consideration of all surrounding circumstances, including such factors as the relationship between the offerees and the issuer and the nature, scope, size, type and manner of the offering. The SEC further noted that public advertising of an offering is incompatible with a claim of a private offering.

Rule 506 of Regulation D under the Securities Act is a nonexclusive safe harbor that guarantees the availability of the private offering exemption set forth in Section 4(2) Rule 502(c) of Regulation D prohibits general solicitation or advertising of the unregistered offering by the issuer or any person acting on its behalf. This prohibition extends to advertisements, articles, notices or other publication in any U S newspaper, magazine or similar media (including the Internet); broadcasts over US television or radio (also including the Internet); and any seminar or meeting in the US to which attendees have been invited by any general solicitation or advertisement. One important factor in analyzing whether a general solicitation has occurred is whether the investors had a preexisting, substantive business relationship with the issuer or broker-dealer involved. Some commentators cite the ban on general solicitation and advertising as a significant impediment to capital formation.

SEC Action. The Division is reviewing the restrictions the SEC’s rules impose on communications in private offerings, in particular those on general solicitation and advertising In analyzing whether to recommend changes to the restriction, as noted above, the Division is preparing a concept release for the SEC’s consideration and eventually will seek public comment on the costs and benefits of retaining or relaxing the restrictions on general solicitation and advertising. The testimony by the division director and deputy director noted above stated, “[t]he Commission could seek views from all interested parties on a number of issues related to the restriction on general solicitation, including specific protections that could be considered if the restriction is relaxed and the types of investors who would be most vulnerable if it is relaxed. Of course, in considering whether to recommend that the Commission make changes to the rules restricting general solicitation, we will remain cognizant of our investor protection mandate.”

On January 6, 2012, the SEC’s Advisory Committee on Small and Emerging Companies approved a recommendation that the SEC “take immediate action to relax or modify the restrictions on general solicitation and general advertising to permit general solicitation and general advertising in private offerings of securities under Rule 506 where securities are sold only to accredited investors.”

Congressional Action. Bills have been proposed in both the House and Senate with respect to elimination of the ban on general solicitation and advertising in private offerings. On September 15, 2011, Rep Kevin McCarthy (R-CA) introduced the “Access to Capital for Job Creators Act” (H R 2940) in the House that seeks to:

• Amend Section 4(2) to exempt transactions by an issuer not involving any public offering, “whether or not such transactions involve general solicitation or general advertising;” and
• Direct the SEC to revise its rules to provide that the prohibition against general solicitation or advertising contained in Regulation D shall not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors.

The House overwhelmingly approved H .R. 2940 on November 3, 2011, and the bill was referred to the Senate, where no additional action has occurred.

On November 9, 2011, Sen. John Thune (R-SD) introduced a companion measure to the House bill that also is entitled the “Access to Capital for Job Creators Act” (S 1831). The legislation, identical to H. R. 2940, was referred to the Committee on Banking, Housing and Urban Affairs on November 9, 2011, and was the subject of a committee hearing on December 1, 2011, and a subcommittee hearing on December 14, 2011.

Eliminating or modifying the ban on general solicitation and advertising in connection with private placements is hardly a new concept and has been considered by the SEC previously. Whether a transaction qualifies for an exemption from the Securities Act registration requirements should depend on the status of the purchasers, rather than on the number or status of offerees or the method by which an issuer locates potential offerees and purchasers. An offering in which the ultimate purchasers are accredited or “sophisticated” investors should qualify for a Securities Act exemption, regardless of the means by which such purchasers were located. The focus should be on the protection of actual purchasers. An offeree does not suffer actual loss merely by virtue of having been offered securities unless he or she becomes a purchaser As a result, from a policy point of view, offerees do not require the protection of the Securities Act. Purchasers, however, either do or do not need the protection of Securities Act registration, based on their financial wherewithal, investment sophistication, relationship to the issuer, institutional status and access to information.

In view of technological advances, including the Internet, it may be both unnecessary and unrealistic to retain any restrictions on “offers” and “general solicitation and advertising” with respect to securities being sold in private offerings. The rationale for continuing to condition private offering exemptions on the absence of general solicitation and advertising is undermined by the public availability of information about private offerings released by third parties. For example, the Internet has made information concerning private offerings, including secondary price quotes, securities ratings, rating agency offering reports and analyst research reports, immediately and widely accessible. Use of today’s technologies to permit broader access to information in connection with private offerings should not hinder the SEC’s ultimate goal of investor protection and would permit smaller companies to reach more potential investors at a lower cost. Of course, if general solicitation and advertising is deemed permissible, it also could impact more mature companies that engage in Rule 144A offerings.

Potential Increase in the Offering Amount Permitted Under Regulation A

Regulation A. Regulation A under the Securities Act provides an exemption from the registration requirements for offerings of up to $5 million per year by nonreporting issuers. Although an offering document must be filed with the SEC, the information requirements are simpler than those in registered offerings Issuers also may “test the waters” for interest before committing to an offering. In addition, Regulation A does not require that the offering be made to a certain type of investor, and securities offered and sold are not transfer-restricted. Regulation A. however, is not used widely, primarily because of the $5 million annual cap, the filing requirement (including potential review) and the lack of preemption from state registration under Securities Act Section 18.

SEC Action. The Division is considering recommending that the SEC increase the offering amount permitted under Regulation A.

Congressional Action. Bills have been proposed in both the House and Senate that would require the SEC to create a new exemption from registration under the Securities Act, similar to Regulation A. but with additional conditions and an increased offering amount On March 14, 2011, Rep David Schweikert (R-AZ) introduced the “Small Company Capital Formation Act of 2011” (H R 1 070) that seeks to:

• Raise the cap in the exemption for small issuances under Section 3(b) of the Securities Act from $5 million to $50 million in any 12-month period;
• Add a clearly specified litigation remedy (Section 12(a)(2) of the Securities Act);
• Mandate that the SEC require the issuer to file audited financial statements with the SEC annually;
• Authorize the SEC (i) to require an issuer that has made an exempt offer to make periodic disclosures available to investors regarding the issuer, its business operations, its financial condition and its use of investor funds; and (ii) to provide conditions for the suspension and termination of such a requirement with respect to that issuer; [4] and
• Require the SEC (i) to review and increase biennially such offering amount limitation, as appropriate, and (ii) to report to certain congressional committees on its reasons for not increasing the amount if it determines not to do so.

The House overwhelmingly approved H. R. 1070 on November 2, 2011, and the bill has been referred to the Senate for consideration.

On September 12, 2011, Sen. Jon Tester (D-MT) introduced a companion measure to the House bill that also is entitled the “Small Company Capital Formation Act of 2011” (S 1544). The bill is identical to H. R. 1070 and was referred to the Committee on Banking, Housing and Urban Affairs on September 12, 2011. The committee conducted a hearing on the legislation on December 1, 2011, but has taken no further action.

H. R. 1070 and S 1544 may be helpful in that they raise the cap for issuances under the exemption, while adding additional investor protections, such as a litigation remedy under Section 12(a)(2) for false or misleading statements or omissions set forth in the offering document or oral communications involved in the offer or sale of securities, as well as access to annual audited financial statements of the issuer. In addition, Regulation A offerings may be marketed to an unlimited number of retail investors (the bills do not appear to change this). However, the fact that an issuer may still have to file an offering document subject to staff review may continue to limit use of such an exemption in the future. (Under the bills, the SEC will be able to decide whether or not to require the filing of an offering document.) Pursuing an offering under Rule 506 of Regulation D (which has no cap on the amount that may be offered, does not require staff review and is not subject to Section 12(a)(2) liability) may be more attractive to issuers.

Crowdfunding

Background. “Crowdfunding” describes a capital-raising strategy whereby groups of people pool money, composed of small individual contributions, to support accomplishment of a particular goal. Crowdfunding initially was developed to fund projects such as charitable endeavors, films, books and music recordings.The persons providing such funding were more like contributors than “investors” because they were persons donating money without the right to participate in any profits. Because these crowdfunding efforts did not involve the offer and sale of a security, they did not raise issues under the federal securities laws. Today, there is increasing interest in crowdfunding as a means of offering investors an ownership interest in an early-stage or small company.

SEC Action. The Division is reviewing the regulatory questions posed by new capital-raising strategies and, according to the Senate testimony of the director and deputy director, “has been discussing crowdfunding, among other capital raising strategies, with business owners, representatives of small business industry organizations, and state regulators. ” Some of the questions under consideration include:

• What limits should govern the amount of funds that may be raised by an entity and invested by an individual;
• What information should be required to be made available to investors;
• How, and to what extent, should there be regulatory oversight with respect to the websites that facilitate crowdfunding investing;
• What restrictions should be placed on participation by those that have been involved with prior securities fraud;
• Should an SEC filing or notice be required; and
• Whether securities purchased in a crowdfunding transaction should be freely tradeable.

Congressional Action. Bills have been proposed in both the House and Senate that would exempt from the Securities Act registration requirements certain crowdfunding transactions. On September 14,2011, Rep Patrick T McHenry (R-NC) introduced the “Entrepreneur Access to Capital Act” (H R 2930) that seeks to

• Create a new registration exemption for an offering amount up to $2 million ($1 million if the company does not have audited financial statements) within any 12-month period, with a maximum investment per investor of the lesser of $10,000 or 10 percent of the investor’s annual income within any 12-month period;
• Treat securities offered as “covered securities,” thereby preempting state authority to register the securities;
• Amend Section 12(g)(5) to exclude holders of crowdfunded securities from the definition of “held of record” with respect to mandatory registration of secur1t1es;
• Provide for an exemption for intermediaries from broker-dealer registration under the Exchange Act; and
• Restrict transfer of securities issued and sold under such exemption for one year (unless the securities are sold to the issuer or an accredited investor).

The House overwhelmingly approved H. R. 2930 on November 3, 2011, and the bill was referred to the Senate. The Committee on Banking, Housing and Urban Affairs conducted a hearing on the bill on December 1, 2011.

On November 2, 2011, Sen. Scott P Brown (R-MA) introduced the “Democratizing Access to Capital Act of 2011” (S 1791). The bill differs from H.R. 2930 in a few important respects, including:

• Individual investments would be limited to $1,000 per person per year, with an aggregate offering cap of $1 million during any 12-month period; and
• The entity raising the money must be incorporated under and subject to state law, and a “crowdfunding intermediary” must be used.

On November 2, 2011, the bill was referred to the Committee on Banking, Housing and Urban Affairs, which conducted a hearing on the bill on December 1, 2011.

Presumably, the exemption provided for by these bills would be used by early stage issuers seeking many small investors. Issuers could solicit retail investors through the Internet, with no requirement to provide a meaningful disclosure document and no prior SEC review. Not only do the bills provide for an exemption from Securities Act registration, they also provide an exemption from broker-dealer registration under the Exchange Act. The latter exemption may provide significant opportunities for fraudulent sales activities, including so-called “boiler room” scams. At a minimum, we believe broker-dealer registration of the crowdfunding intermediary should be considered as well as reasonable limitations on the intermediary’s solicitation activities. In addition, the bills do not address integration. Use of the crowdfunding exemptions, as drafted, may prevent the issuer from utilizing other exemptions for six months.

Some have criticized these measures, such as:

[o]ne million dollars is a low ceiling, and Rule 504 already permits a similar level of sales to unsophisticated retail investors. The only difference is that under Rule 504, an issuer cannot make a general solicitation without providing a disclosure document that satisfies state “Blue Sky” law requirements. Under proposed Section 4(6), state law would be preempted (and the retail shareholders who acquire these securities would not count toward the Section 12(g) threshold for “reporting” company status). Possibly, this provision would be used by some small companies because it freely permits general solicitation, but a ceiling set at the lesser of $10,000 or 10 percent of annual income is confining, and would in my Judgment make most fly-by-night issuers still prefer Rule 504. [5]

The foregoing regulatory and legislative initiatives seek to encourage economic growth by more efficiently facilitating capital formation at a time when smaller companies are struggling to raise funds amid regulatory and economic pressures. As noted above, although the ultimate outcomes and timing of these initiatives are currently unknown, we expect at least some of them to be adopted in 2012. As the proposed bills move forward, it is possible that amendments will be introduced that attempt to synthesize the efforts of the SEC and Congress.

Endnotes

[1] However, in response to the increased use of restricted stock units as compensation for employees, the staff of the Division provided no action relief initially to Facebook, Inc. and then to Zynga Inc. and Twitter, Inc. from the registration requirements of Exchange Act Section 12(g) for classes of restricted stock units issued under certain circumstances.
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[2] The investment in Facebook by The Goldman Sachs Group, Inc. (Goldman) in January 2011 highlighted the issues surrounding Section 12(g). Goldman used a special purpose vehicle to raise and invest funds in Facebook. In practice, such an SPV, even though it may represent hundreds or thousands of individuals, potentially could be considered a single-record holder for purposes of Section 12(g).
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[3] SecondMarket, Inc. generally has modified its practices to help private companies manage Section 12(g)-related issues.
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[4] Although the bill does not explicitly make a company that conducts an offering under this exemption subject to the Exchange Act registration and reporting requirements, any such company would be required to file audited financial statements with the SEC annually, and other periodic disclosure would be required to the extent that the SEC directs.
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[5] http://www.sec.gov/info/smallbus/sbforum111711-materials-coffee.pdf.
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