Stephen M. Honig, The Daily Record Newswire
We are all aware of the substantial retrenchment of SEC enforcement mandated by the 2012 JOBS Act (“Act”), which contemplates crowd-funding and permits public advertising of certain “private placement” transactions.
But equally important is the impact of the Act on ‘34 Act reporting.
Some history
The primary impact of registering under the ‘34 Act is “reporting.” A registrant files an initial Form 10 describing the company, its management and its risks — the kinds of disclosure required in a stock offering.
Registration triggers further disclosure: annual Form 10-K, quarterly reports on Form 10-Q updating financials, monthly (or more frequent) Form 8-K for material developments. This continuing flow of information facilitated past relaxation of regulation in issuance of new securities by reporting companies.
Registration under the ‘34 Act also brings a panoply of marketplace protections: federal proxy rules; the Williams Act, regulating takeovers and requiring filings by shareholders attaining 5 percent ownership; officer, director and 10 percent shareholder short swing profit recapture under Section 16.
Will the proportion of new public companies, which would be required to register under prior practice but not under the Act, shrink by reason of the new thresholds? There is no way to be certain, but we can speculate.
‘34 Act registration originally was required only of companies traded over a national exchange. Developments in our market system made it clear that companies attracting shareholder interest were not necessarily listed on exchanges, and in 1964 Congress promulgated Section 12(g) of the ‘34 Act, requiring any issuer with 500 record holders and assets over $1 million to register.
By subsequent rule making, the financial threshold increased to $10 million. That was the state of play until the JOBS Act.
Registration constricted
The Act intended to loosen regulation of securities markets, under the belief that regulation impeded finance, and thus impeded job creation.
The Act modified the trigger for subjecting companies to ‘34 Act registration. A company now must register if it has $10 million of assets and at least 2,000 record equity holders or at least 500 record shareholders who are not accredited.
The headcount for securities holders has thus quadrupled; the old 500 shareholder test now only relates to non-accredited investors (with less than $1 million of net worth or who fall below certain annual income levels).
Based on Exchange Act Rule 12g5-1, the SEC does not count beneficial owners whose securities were held by brokers, dealers or banks (a rule designed to simplify counting and provide objectivity).
The only record holder whose beneficial holders are counted is Cede and Co. (street name for Depository Trust Co.), which holds what the SEC describes as “the vast majority of U.S. equity securities.”
This counting method always has materially under-counted investors, in that a single broker/dealer holding through Cede constitutes one holder even though it holds for many customers.
The Act changes present counting methodology so as not to count shareholders under two significant new exclusions: employees receiving securities in un-registered compensation plans, and shareholders investing pursuant to crowd-funding.
Although employees receiving plan shares or investors in crowd-funding are more likely to be non-accredited (and thus count toward the 500-person non-accredited shareholder trigger), the exclusion of these shareholders from the 2,000 count may reduce significantly the number of companies required to register under the ‘34 Act.
Devil’s in details
Will the proportion of new public companies, which would be required to register under prior practice but not under the Act, shrink by reason of the new thresholds? There is no way to be certain, but we can speculate.
First, although a company is not required to register, a company may elect to register. Query whether underwriters will obtain covenants to require registration under the ‘34 Act, as a condition of an IPO. An underwriter concerned with the after-market might seek such an undertaking.
A company itself also might attempt to facilitate liquidity in the after-market. (Absent such registration, the only mandated source of information to the street is Rule 15c2-11, which requires registered broker/dealers to possess certain minimal information about a company before it effects a trade. This protection is slight; the disclosure falls short of ‘34 Act standards, will not apply to a companies whose shares have been quoted at least 12 business days during the previous 30 calendar days, and does not apply to unsolicited orders submitted by a customer without broker/dealer suggestion.)
Shares obtained by employees under compensation plans or purchasers under crowd-funding may be both more likely to be non-accredited and less likely to deposit those shares into the hands of brokers or banks; particularly through crowd-funding, it is possible that the number of record shareholders will increase substantially, thus increasing toward both new thresholds — 2,000 shareholders and 500 non-accrediteds.
Another way to think about impact is to analyze current registrants. While present ‘34 Act registrants will continue to be registered (they are not thrown out of the system by the Act), we can analyze demographics of current registrants to determine whether, if this cohort went public in the future, they would fall within or without the ‘34 Act registration requirements as modified by the Act.
For 2011, shareholder data was available for 2,524 section 12(g) registrants. Only 318 had more than 2,000 record shareholders. Consequently, only 13 percent would be required to register with the SEC under the new 2,000 shareholder threshold.
If these mathematics hold for future public companies, then over time the percentage of registered companies will decline. Since many of these new companies may be founded on cutting-edge innovation with respect to which more rather than less information in the marketplace would be desirable, the availability to the retail investor of important information may decline materially.
How will a company know (or not know) whether a shareholder is accredited? Or whether a shareholder has purchased shares through a compensation plan or through crowd-funding? Or whether a shareholder who was accredited is no longer accredited, or vice-versa? Or whether a shareholder who has purchased from any other shareholder (a crowd funder, an employee receiving shares under a plan, or anyone else) is or is not now an accredited shareholder? (This is even more difficult to unravel than the determination of whether someone is an accredited investor at the single moment of a stock sale for purposes of new Rule 506(c) discussed in the October column, which new rule permits advertising only where all purchasers are accredited.)
A company under the Act must determine whether a large and diverse population of purchasers, including secondary or indirect purchasers, holds a certain economic status.
Another complication arises under present Rule 12g5-1(b)(3), providing that beneficial owners will be counted as record owners if the company knows or has reason to know that the record form of ownership is used primarily to circumvent ‘34 Act registration.
What about the company that strongly suspects that it may have more than 2,000 record shareholders or over 500 unaccredited shareholders? What if management suggests that friendly folks go into the marketplace and “roll-up” a lot of these shares into a single entity?
In such an instance, which is not unheard of historically, questions of whether the company has reason to know that such a form of ownership is used primarily to circumvent headcount are presented.
The report
Those interested in tracing the scant authority relating to the application of Rule 12g5-1(b)(3) should read the SEC’s “Report on Authority to Enforce Exchange Act Rule 15g5 and Subsection (b)(3),” issued Oct. 15 and available on the SEC website.
The origin for the report was a requirement in the Act that the SEC transmit to Congress recommendations for new enforcement tools needed to prevent evasion of ‘34 Act registration.
The report tells Congress that the commission needed no new tools (legislation) to meet its enforcement obligations under the revised ‘34 Act registration regime, possessing all the tools it needs through present SEC regulation.
Although one footnote in the report promises regulatory guidance on treating transferees of crowd-funding purchasers, the report does not otherwise contemplate upfront guidance to companies.
Clearly, what is intended is SEC back-end enforcement, if a company has failed to comply. This is a departure from an activist position sometimes taken by the SEC in its regulatory
efforts.
The SEC notes that it has the power to subpoena, to bring civil and punitive actions, to act on whistleblower information, and to enjoin, all without necessity for additional congressional tools. Whether back-end enforcement will work in such a complex regulatory milieu, absent up-front SEC guidance, remains to be seen.
Conclusion
It may be that the JOBS Act amendments to the ‘34 Act will have more significant impact than the more-publicized liberalization of offering practices under the ‘33 Act.
By impacting the continuous level of public information, or lack of information, available for a large number of companies in the future, the JOBS Act represents both a step backward from a regulatory standpoint and a material impediment to the SEC’s “continuous disclosure” concept.
Whether these amendments will at least have the benefit of spurring capital formation and creating jobs remains to be seen.
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Stephen M. Honig practices at Duane Morris in Boston.
