On April 5, 2012, President Obama signed into law the “Jumpstart Our Business Startups Act” (“JOBS Act”). The JOBS Act sought to improve access to capital for small businesses in an effort to increase job creation and economic expansion. The Act included seven titles, comprised of six separate bills introduced by five different congressional representatives. This article focuses on Title I: Reopening American Capital Markets to Emerging Growth Companies.
Title I sought to encourage public offerings by reducing the disclosure and other requirements for emerging growth companies (“EGCs”) during the Initial Public Offering (“IPO”) process and for a modest period after becoming public. Section 101 of the Title defined an “emerging growth company” as an issuer with less than $1 billion in annual gross revenues during its most recently completed fiscal year. The EGC status was, however, meant to terminate no later than five years from the company’s IPO. Title I, therefore, provided newly public companies with a less costly IPO process and an “On-Ramp” of temporary abatements in regulatory requirements after becoming public.
This article will discuss the public offering process prior to the promulgation of the JOBS Act. The article will review the legislative history of H.R. 3606, the Reopening American Capital Markets to Emerging Growth Companies Act of 2011, and how it became Title I of the JOBS Act. The changes implemented by the Title will be explained, including the justification for each provision. After a general examination of the Title, this article will explore the SEC’s implementation and enforcement of the new provisions of Title I and the early effects on the IPO market.
I. The Costs of Compliance
The Securities Act of 1933 (“Securities Act”) regulates the purchase and sale of securities. Offerings to the public must be registered with the SEC. As part of that process, companies are required to provide investors with the information needed to make an informed investment decision. The 1933 Act also contains rigorous prohibitions on misleading disclosure.
Registration involves a complicated and often expensive process. Registration statements include detailed disclosure about the company’s business and management. The disclosure process requires the input of legal, accounting, and business professionals, adding to the cost of the process. The registration process also involves SEC review, which can result in significant delay. This investment in time and money occurs before a company has raised a single dollar from the IPO.
Public companies are subject to extensive regulation. They must file periodic reports and meet the requirements of the proxy rules. Sarbanes-Oxley imposes on corporate managers the obligation to individually certify the accuracy of its company’s financial statements in periodic reports. The Dodd-Frank Act gives shareholders the right to an advisory vote on executive compensation or “say on pay.” All of these requirements add costs to a company’s operations. The annual amount expended on compliance by public companies averages $1.5 million per year.
As costs have increased, the number of IPOs in America has declined. From 1991 to 1999, the annual number of IPOs averaged 547. From 2000 to 2011, the annual average fell to 192. Only 54 IPOs occurred in 2008. The decline was particularly pronounced among smaller companies. Moreover, companies increasingly delayed the public offering process. The median time from the inception of a company to its IPO was 4.8 years in the 1980s, a period that almost doubled to 9.4 years for issuers going public from 2007 to 2011.
II. The Legislative History of Title I – Reopening American Capital Markets to Emerging Growth
The motivation for the On-Ramp provisions in the JOBS Act arose from the criticism of market professionals about the decline in both the number of IPOs and the number of companies listed on U.S. stock exchanges. “A Wake-up Call for America,” a report issued by the accounting firm Grant Thornton in 2009, analyzed the systemic decline of the U.S. stock markets. A follow-up report identified regulatory changes and “inevitable technology advances” that had impacted the market structure, including on-line trading accounts that caused a shift away from long-term investing in small-cap businesses to high-frequency trading of large-cap companies.
The U.S. Treasury Department convened the Access to Capital Conference in March 2011 to seek advice of market participants on how to restore the IPO market and provide capital to small businesses. A group of private sector professionals at the conference voluntarily formed the IPO Task Force. The Task Force issued a report, Rebuilding the IPO On-Ramp: Putting Emerging Growth Companies and the Job Market on the Road to Growth on October 20, 2011.
The Task Force’s report highlighted the decline in IPOs and provided recommendations to alleviate the problem. The Task Force recommended creating a new category of issuers that would be relieved of some regulatory requirements during the public offering process and for a short period thereafter. The relief would include simplified requirements for a public offering and regulatory relief for five years after an IPO for issuers with annual gross revenues of less than $1 billion and were not a “well-known seasoned issuer.”
The Task Force suggested modifications to the disclosure requirements. Specifically, the recommendations proposed a reduction in the number of years of financial statements and the accompanying Management Discussion & Analysis (“MD&A”) in an IPO from three to two, relief from new rules implemented by the Financial Accounting Standards Board and the Public Company Accounting Oversight Board (PCAOB), and executive compensation disclosures scaled down to comply with the standards for Small Reporting Companies. The Task Force also suggested that several exemptions would lead to an increase in the number of companies going public. These included exemptions from the: (1) auditor attestations under SOX 404(b), (2) say on pay, say on frequency, and say on parachute votes, (3) conflict minerals disclosure requirements, (4) pay-for-disclosure requirements, and (5) CEO pay ratio requirements.
Other recommendations of the IPO Task Force aimed at improving communication channels for prospective issuers. Recognizing that smaller companies suffered because of a lack of information in the marketplace, the EGCs should be able participate in investor communications before the IPO, overturning some of the prohibitions on gun jumping. These broader communications would allow EGCs to “test the waters” before committing to the full disclosures and costs required of an IPO. The Task Force also recommended that certain restrictions on analyst communications during the offering process be lifted. The Report also called for a system of confidential review of registration statements, allowing companies to obtain SEC comments “without immediately disclosing competitively sensitive or otherwise confidential information.”
Recognizing the unpredictability of market conditions, the Task Force Report did not provide statistics on any increase in IPOs that might result from the recommendations, nor did the Report include any prospective calculations of the impact on IPOs based on these recommendations. Instead, the Report consisted of recommendations by market professionals on what they thought would improve the public offering process. Congress never deferred to these views and, understood that the reforms were uncertain and experimental.
The IPO Task Force report laid the groundwork for H.R. 3606, the Reopening American Capital Markets to Emerging Growth Companies Act of 2011. On December 8, 2011, Representatives Stephen Fincher and John Carney, along with fifty-two additional sponsors, introduced the bill to the House. The bill contained many of the Task Force recommendations aimed at increasing the number of IPOs and allowing improved communication between issuers and investors. Fincher and Carney touted the bill as the vehicle necessary to help small businesses access capital and grow.
On February 16, 2012, the Financial Services Committee approved the bill by a vote of 54 to 1. Before its approval, the Committee added one significant amendment. The Committee agreed to a clarification that issuers who lose their EGC status before the five-year exemption must comply with say on pay the following fiscal year. The Committee approved the bill and issued a Report that specifically referenced the statistics on declining IPOs contained in the Task Force’s presentation.
The bill was further altered on the House floor. On March 7, 2012, the House adopted an amendment that provided a company could not qualify as an EGC if it issued more than $1 billion in non-convertible debt over the last three years. An effort to limit EGC status to companies with revenues less than $750 million was defeated. Likewise, the House rejected an effort to reinstate say on pay for EGCs.
H.R. 3606 was cobbled together with five separate bills into the JOBS Act and passed by the House on March 8, 2012. Upon consideration in the Senate, the JOBS Act was met with strong objection from three senators. Senators Reed, Landrieu, and Levin proposed changes to the JOBS Act; including many of the amendments that had been rejected in the House. The efforts failed and the JOBS Act passed without changes to the On-Ramp provisions. President Obama signed the legislation on April 5, 2012.
III. The Requirements of Title I of the JOBS Act
Section 101 amends the Securities and the Exchange Act to create a new class of issuer, the emerging growth company (“EGC”). An EGC is a company with less than $1 billion in annual gross revenues. EGC status is designed to be temporary. A company remains an EGC until 1) the last day of the fiscal year in which it had annual gross revenues of at least $1 billion, 2) the last day of the fiscal year following the fifth anniversary of the first sale of common equity securities pursuant to an effective registration statement under the Securities Act, 3) the date on which the company issued more than $1 billion in non-convertible debt during the previous period, or 4) the date which the company becomes a “large accelerated filer” as defined in the Exchange Act Rule 12b-2.
EGCs are relieved from certain requirements under the securities laws. They must provide no more than two years of audited financial statements in a registration statement. Moreover, they need not comply with new or updated financial accounting standards until the new standard is made applicable to private companies. They are also subject to reduced disclosure in connection with Item 303 (management’s discussion and analysis).
EGCs are not required to have an independent auditor attest to the company’s internal financial controls. Nor must an ECG abide by any rule of the PCAOB that provides for mandatory rotation of the auditor or requires a supplement to the auditor’s report in order to provide additional information about the audit.  Post-enactment rules adopted by the PCAOB will only apply to ECGs when the SEC has determined that a provision is “necessary or appropriate in the public interest.”
The Act also simplifies the disclosure and approval process for executive compensation. An EGC is subject to relaxed compensation disclosure under Item 402 of Regulation S-K. EGCs are not required to report “pay-versus-performance” data in their proxy statements, are exempt from the “pay-ratio” disclosures of the Dodd-Frank Act, and are not required to provide shareholders with an advisory vote on executive compensation.
The Act also permits EGCs to “test-the-waters” in advance of a public offering by communicating with qualified institutional buyers or institutions that are accredited investors. Some limitations on analyst communications designed to safeguard against conflicts of interest were also removed.
Finally, EGCs are authorized to submit draft registration statements to the SEC for review on a confidential basis. To the extent that the company decides not to go forward with the public offering, the materials remain confidential. The materials are only made public twenty-one days preceding the company’s road show.
The JOBS Act did not make these provisions mandatory. EGCs may decide to forgo the benefits contained in Title 1. With respect to the extension of time for the applicability of new or revised accounting standards, however, an EGC must affirmatively opt into the requirement. Moreover, an EGC must make the election at the time the company files its first registration statement, periodic report, or other reports filed with the Commission under Section 13 of the Exchange Act.
IV. Implementation of Title I of the JOBS Act
Many of the provisions in Title 1 of the JOBS Act took effect immediately without the need for action by the Commission. Moreover, the SEC quickly implemented the system for confidential review of draft registration statements. EGCs can submit these materials via a secure email system. All submissions are to be in PDF format and include a transmittal letter identifying the issuer, the issuer’s status as an EGC, and the type of submission. There is no filing fee. In determining when the materials must be made public, the Staff at the SEC has indicated that “test-the-waters” communications did not qualify as a road show.
The actual practice with respect to the On-Ramp provisions has varied. Confidential review and the “test-the-waters” provisions appear to be widely used. After the enactment of the JOBS Act, the number of confidential filings with the SEC outpaced publicly filed registration statements. One company reportedly met with a large mutual-fund company before its IPO and management used the experience to “hone their pitch to investors.” Another company reportedly declined to go forward with an IPO after investors informed management that they would “place a lower value on the company's stock if it went public before it was profitable.” .
Application of the substantive provisions in the JOBS Act has not been consistent. The exemption from the auditor attestation provision appears to have been popular. Other provisions such as the reduction from three to two years of financial statements and the exemption for new accounting standards have, apparently, been less popular. To the extent they are opposed by investors, these changes could result in lower valuations and higher costs of capital. Other companies have taken an approach that favors using the JOBS Act exemptions, regardless of the possible higher cost in capital. Some have opted to take advantage of the auditor attestation exemption and the reduction in disclosure permitted by the JOBS Act. They have often included a risk factor in the registration statement that warns about the possible negative reaction by investors.
The impact and consequences of the On-Ramp provisions remain uncertain. Nonetheless, the IPO market in 2012 has improved. As of December 13, 2012, 138 companies completed their IPOs, raising a total of $40.7 billion, modest increases from the year before. IPO registrations declined in the fourth quarter of 2012, although this amount does not include companies filing registration statements on a confidential basis.
Confidential review and testing the waters appear to have provided companies with greater flexibility to assess the viability of a public offering. The substantive provisions contained in the JOBS Act, particularly those relating to accounting principles, have engendered negative reaction from some commentators. The majority of the comments resounded with concerns that the Act removed regulation that provided transparency of public companies and without investor protections, there is an increased potential for fraud. Like many new laws, supportive and opposing opinions exist, but the effects in the marketplace remain unknown until tested.
*. J.D. Candidate 2013, University of Denver Sturm College of Law.
. A prospectus must describe the operations, financial condition, and management of the company. Specifically including a description of the company’s properties and business, a description of the securities for sale, three years of financial records certified by independent accountants, and information about the management of the company. The Laws That Govern the Securities Industry, U.S. Securities and Exchange Commission, http://www.sec.gov/about/laws.shtml (last visited Jan. 2, 2013).
. David Weild & Edward Kim, Capital Markets Series: A Wake-up Call for America (Nov. 2009), available at http://www.gt.com/staticfiles/GTCom/Public%20companies%20and%20capital%20markets/gt_wakeup_call_.pdf.
. According to a study conducted by the IPO Task Force, in the 1990’s, 80 percent of U.S. IPOs were for small companies raising less than $50 million, compared to the 2000’s, when small company IPOs only represented 20 percent of all U.S. IPOs. Mitchell, supra note 11.
. Carol Sacks & Channa Brooks, IPO Task Force Issues Recommendations to Improve the Capital Markets for Emerging Growth Companies, PRWeb (Oct. 20, 2011), available at http://www.prweb.com/releases/2011/10/prweb8893873.htm.
. The report also recommended that demand for shares in IPOs be incentivized through lower capital gains rates for shares purchased from issuers in certain circumstances. This provision never became law. Id.
. The SEC defines a Small Reporting Company as a company with less than $75 million in public float or less than $50 million in annual revenue. U.S. Securities and Exchange Commission. Smaller Reporting Company Compliance and Disclosure Interpretations (2008), http://www.sec.gov/info/smallbus/src-cdinterps.htm.
. The Committee authorized three additional amendments. Mr. Schweikert’s proposal to require a SEC study on the transitional impact to fraction trading from penny trading and Mr. Garrett’s proposal to require a SEC study on the impact of Regulation S-K were approved. Messrs. Fincher and Carney also offered some technical amendments. H.R. Rep. 112-406 at 282-84 (2012).
. Rep. Jackson Lee suggested the amendment to ensure that the JOBS Act aid small business and not be expanded to remove requisite government oversight on big banks and Wall Street. In addition, Rep. McIntyre proposed and the House approved an amendment providing that the emerging growth company definition be adjusted for inflation. 158 Cong. Rec. H1234-01 (Mar. 7, 2012).
. Mr. Fincher explained that the thresholds in the underlying bill were recommended by the nonpartisan IPO Task Force and that the $700 million public float limitation was already in line with the SEC’s definition of a “large accredited” filer. Id.
. The House also rejected Rep. Waters’ proposed amendment would have required brokers’ research reports and EGCs’ communications with potential investors to be filed with the SEC. Rep. Jackson Lee also proposed to limit “test the waters” communications to qualified institutional buyers only and prohibit communications with less sophisticated accredited investors; this amendment was rejected. Rep. Jackson Lee withdrew her proposal to require a filing fee for the SEC’s review of draft confidential registration statements. Rep. Connolly’s proposal to include a provision to conduct a study of the bills affect on oil and gas price speculation was also rejected. Id.
. The four bills that the House of Representatives previously passed in November 2011 were H.R. 2930, H.R. 2940, H.R. 1070, H.R. 4088 and a fifth bill, H.R. 2167 that the Financial Services Committee approved in October of 2011. 158 Cong.Rec. S1581-02 (Mar. 8, 2012).
. The Senators proposed to reduce the threshold for an EGC to $350 million and require the say-on-pay advisory vote by shareholders on executive compensation. See INVEST Act, 158 Cong. Rec. S1742-01, WL 874798 (Mar. 15, 2012). Additional On-Ramp amendments included the removal of pre-IPO communication with accredited investors, inclusion of a fee for filing confidential draft registration statements, and the mandatory filing of written “test the waters” communications with the SEC. Id.
. The only changes in the Senate were to the crowdfunding provision. The bill passed in the Senate as amended on March 22, 2012, and passed both chambers on March 27, 2012. 158 Cong. Rec. S1977 (Mar. 22, 2012); 158 Cong. Rec. H1598 (Mar. 27, 2012).
. Companies that would otherwise qualify as an EGC but registered with the SEC prior to December 8, 2011 are barred from this new classification. Jumpstart Our Business Startups Act, Pub. L. No. 112-106 § 101.
. The PCAOB issued a concept release addressing the issue of auditor independence, but no such rule has been adopted. Public Company Accounting Oversight Board, PCAOB Issues Concept Release on Auditor Independence and Audit Firm Rotation (Aug. 16, 2011), http://pcaobus.org/news/releases/pages/08162011_openboardmeeting.aspx.
. Jumpstart Our Business Startups Act, Pub. L. No. 112-106 § 104. The PCAOB can only implement a new rule that affects EGCs after the SEC has considered the protection of investors and determines that the action will “promote efficiency, competition, and capital formation” (emphasis added).
. EGCs are entitled to the “smaller reporting company” status, which allows EGCs to comply with the scaled disclosure requirements under Item 402(m)-(r) of Regulation S-K instead of the more exhaustive requirements under Item 402(a)-(k) and (s).
. Jumpstart Our Business Startups Act, Pub. L. No. 112-106 § 105. Section 105(c) of the JOBS Act amended Section 5 of the Securities Act that prohibited any offer, sales, and deliveries of securities prior to a company filing a registration statement. EGCs may now “test-the-waters” by communicating with qualified institutional buyers or accredited investors to gauge interest in the offering prior to filing a registration statement.
. Analysts representing an EGC are no longer restricted based on “functional role” and may meet with investors. Id. § 105(b). The JOBS Act amends Section 15D of the Exchange Act, which effectively allowed national securities exchanges to adopt conflict of interest rules for securities analysts. See Andrew L. Fabens, et. al., JOBS Act Changes the Public & Private Capital Markets Landscape, Gibson Dunn (May 23, 2012), http://www.svb.com/Publications/Best_Practices/Public_Policy/Jobs-Acts/.
. A road show is defined in Rule 433(h)(4) of the 1934 Act as “an offer…that contains a presentation regarding an offering by one or more members of the issuer’s management…and includes discussion of one or more of the issuer, such management, and the securities being offered.”
. U.S. Securities and Exchange Commission, Instructions for Submitting Draft Registration Statements for Confidential/Non-public Review (2012), http://www.sec.gov/divisions/corpfin/cfannouncements/cfsecureemailinstructions.pdf.
. U.S. Securities and Exchange Commission, Jumpstart Our Business Startups Act Frequently Asked Questions: Confidential Submission Process for Emerging Growth Companies (Apr. 10, 2012), http://www.sec.gov/divisions/corpfin/guidance/cfjumpstartfaq.htm.
. Emily Chasan, Confidential Filings Outpacing Public Ones, Wall Street Journal (May 30, 2012), available at http://blogs.wsj.com/cfo/2012/05/30/confidential-ipo-filings-outpacing-public-ones/?mod=wsjcfo_hphook.
. HII indicated that implementation of the On-Ramp provisions could be a risk because it “cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make [its] Class A common stock less attractive to investors.” HII also noted in a risk factor that after its status as an EGC expires, management will likely need to devote additional efforts and expenses to ensure compliance with securities laws. Id.
. There were 134 IPOs in 2011 that raised $35.5 billion. A large contribution to the volume of funds raised in 2012 can be attributed to the Facebook IPO, which raised $16 billion alone. PwC, 2012 IPO Market Surpasses 2011, Despite Slowdown in Fourth Quarter Activity, Says Pwc (Dec. 19, 2012), http://www.pwc.com/us/en/press-releases/2012/q4-ipo-watch-press-release.jhtml.
. Letter from Jeff Mahoney, General Counsel, Council of Institutional Investors to Ms. Elizabeth M. Murphy, Secretary, Securities and Exchange Commission (Aug. 9, 2012), http://www.sec.gov/comments/jobs-title-i/reviewreg-sk/reviewreg-sk-2.pdf.
. Members of the CFA Institute submitted a letter expressing the organization’s concern that provisions of the JOBS Act removed investor safeguards and asked that the SEC gather public opinion and conduct a cost benefit analysis during the final rulemaking process, implement a conspicuous label to designate a company’s status as an EGC, and maintain the disclosures required by Regulation S-K. Letter from Kurt N. Schacht, Managing Director, Standards and Financial Market Integrity, CFA Institute & Linda L. Rittenhouse, Director, Capital Markets Policy, CFA Institute to Ms. Elizabeth M. Murphy, Secretary, Securities and Exchange Commission (Aug. 16, 2012), http://www.sec.gov/comments/jobs-title-i/general/general-199.pdf.