The March Towards Meaningful Reform for Small and Emerging Growth Companies Moves Forward – House Passes Measures to Open Private Capital Raising and Facilitate an On-Ramp of New IPOs

Building on months of momentum in Congress, on March 8, 2012, the U.S. House of Representatives passed the Jumpstart Our Business Startups (JOBS) Act by a bi-partisan vote of 390-23. A similar bill, S. 1933, has been introduced in the Senate and may be voted on this month. The JOBS Act is intended to address the sharp decline in U.S. public offerings during the last decade and to facilitate capital raising by smaller companies. The provisions of the JOBS Act will, if enacted, represent a watershed change to the laws and regulations governing capital raising for private companies and would create a limited, temporary and scaled regulatory compliance pathway, referred to as an “IPO on-ramp,” for companies going public and newly public companies. The IPO on-ramp is designed to reduce the costs and uncertainties of accessing public capital.


Inspired from the work of the U.S. Department of the Treasury’s Access to Capital Conference in March 2011 and the recommendation of a group called the IPO Task Force, Congressional action has been gaining momentum, culminating in the passage by the House of the JOBS Act.

According to the National Venture Capital Association, from 1990 to 1996, 1,272 U.S. venture-backed companies went public on U.S. exchanges; yet from 2004 to 2010, there were just 324 of those offerings. Participants in the U.S. capital markets have cited a number of reasons for this decline, including electronic trading, eroded profits from trading in smaller cap companies, the ever-increasing compliance burden on public companies and post Sarbanes-Oxley restrictions on research analysts. The JOBS Act includes a number of regulatory and market-based reforms designed to stem the decline and modernizes a regulatory scheme that largely pre-dates the internet.


The JOBS Act contains the following reforms to U.S. securities laws and regulations which, if enacted into law, would:

  • create a new category of issuer emerging growth companies – with limited, scaled relief from various financial reporting, disclosure and governance rules for up to five years after an IPO
  • remove the prohibition on general solicitation in Regulation D for offerings sold only to accredited investors
  • permit non-broker-dealers to operate online or offline exchanges for the trading of privately-placed securities
  • permit “crowdfunding” offerings that raise small amounts of capital from a large number of investors
  • require the SEC to amend Regulation A (or adopt a new similar exemption) to increase the offering limit to $50 million and to make pre-emption of state blue sky qualification requirements available, making Regulation A a viable alternative to Regulation D, particularly where a liquid secondary market is desired
  • increase the threshold number of holders for mandatory registration under the Securities Exchange Act of 1934 from 500 to 2,000, and exclude employees who received securities under an employee compensation plan and “crowdfunding” purchasers from the count

What are emerging growth companies and what relief will they get?

An emerging growth company is a company that has had its first registered sale of securities within its five prior fiscal years and has total annual gross revenues of less than $1 billion and less than $700 million in publicly traded shares.

The JOBS Act provides the following limited, scaled, temporary relief from disclosure, compliance and governance obligations:

  • Compliance with the auditor attestation requirement of Section 404(b) of the Sarbanes-Oxley Act would not be required during the period that a company remained an emerging growth company. As is the case currently for smaller reporting companies and non-accelerated filers, emerging growth companies would be required to maintain adequate internal control over financial reporting and report the assessment of their principal executive officer and principal financial officer as to the effectiveness of such internal control.
  • Compliance with new accounting standards would not be required until such standards apply to companies that are not subject to Exchange Act reporting.
  • Audited financial statements would be required for only the two prior fiscal years rather than the three prior years required for companies other than smaller reporting companies.
  • Say-on-pay and say-on-golden-parachute votes would not be required during the period the company qualifies as an emerging growth company. Smaller reporting companies are currently exempt from these votes until 2013.
  • Rules prohibiting brokers-dealers participating in the offering from publishing research reports on companies until the lapse of 40 days after an IPO would be repealed. Such publications would not be deemed an “offer” of securities and therefore could not represent “gun-jumping.”
  • SEC and stock exchange rules limiting communications by analysts with companies and potential IPO investors would be repealed.
  • “Testing the waters” communications between companies and qualified institutional buyers (QIBs) would be permitted at any time during the IPO process
  • Registration statements could be submitted confidentially to the SEC and need not be publicly available until 21 days prior to the first road show.

What is the elimination of the prohibition on general solicitation?

Currently, a company wishing to raise capital through the exemption from registration provided in Rule 506 of Regulation D must not offer its securities by any form of general solicitation or advertising. The prohibition on general solicitation requires investors to be recruited based on pre-existing relationships with the company or an agent of the company that create a reasonable basis to believe that a person would be interested in an investment of the type offered. This rule represents the fundamental divide between registered public offerings, such as IPOs, and exempt offerings, commonly known as private placements.

The JOBS Act would remove the prohibition on general solicitation in Rule 506 private placements provided that all the investors are accredited. The JOBS Act directs the SEC to adopt regulations to require the issuer to take reasonable steps to verify that the purchasers in Rule 506 private placement are accredited. The reform applies only to offerings under Rule 506 and does not directly affect offerings under other exemptions afforded by Regulation D or Section 4(2) of the Securities Act of 1933.

Rule 506 offerings are exempt from state blue sky qualification requirements under the National Securities Markets Improvement Act of 1996 (NSMIA), so the general solicitation that would be permitted by the JOBS Act could not be restricted by states.

In addition, the JOBS Act directs the SEC to amend Rule 144A to permit general solicitations of securities sold under Rule 144A that reach investors who are not QIBs, provided that only QIBs (or institutions reasonably believed to be QIBs) purchase such securities.

What types of exchanges will non-broker-dealers be permitted to operate for the resale of privately-purchased securities?

The JOBS Act would create an exception to broker-dealer registration rules for operating a platform or mechanism to offer, sell and purchase securities originally sold under Rule 506 and for providing certain ancillary services associated with such securities. The permitted ancillary services are due diligence services and providing standardized transaction documents. The exception would apply to online and other types of exchanges.

This exception would apply only if the operator and associated persons receive no compensation in connection with the purchase or sale of securities, do not take possession of customer funds and have not been subject to a “bad boy” disqualification from a self-regulatory organization such as FINRA.

What is crowdfunding, and what activities will the JOBS Act permit?

Crowdfunding is a form of capital raising where groups of people pool money and other resources to achieve a goal, including to fund a small business. As a result of the prohibition on general solicitation and the requirement for companies to register under the Exchange Act if they have over 500 holders of a class of equity securities and over $10 million of assets, crowdfunding in the U.S. through websites and social networks has generally been limited to activities where the investor does not receive securities in exchange for its financial contribution.

The JOBS Act would create a new statutory exemption (Section 4(6) of the Securities Act) for transactions where:

  • less than $1,000,000 of securities are sold during the prior 12 months, or $2,000,000 if the issuer provides investors with audited financial statements
  • the aggregate amount sold to any investor within the prior 12 months does not exceed the lesser of $10,000 or 10% of such investor’s annual income
  • the issuer or an intermediary warns investors of the speculative nature of investments in startups, including illiquidity
  • no resales are permitted for one year except to the issuer or an accredited investor, and the issuer or an intermediary warns investors of this restriction
  • the issuer or an intermediary takes reasonable measures to reduce the risk of fraud
  • the issuer or an intermediary provides the SEC with certain identifying information, a notice of the offering, including the intended use of proceeds (due no later than the day the offering commences), and a further notice of the completion of the offering, including the aggregate offering amount and the number of investors
  • the issuer or an intermediary provides the SEC continuous investor-level access to its website
  • the issuer or an intermediary requires each potential investor to answer questions demonstrating an understanding of the level of risk
  • the issuer or an intermediary states a target offering amount and a deadline to reach the target and discloses the same in the notice provided to the SEC
  • the issuer or an intermediary makes available on its website a method of communication that permits the issuer and investors to communicate with one another
  • the issuer or an intermediary does not offer investment advice
  • all investments are held with a custodian until 60% of the disclosed target offering amount is hit

Intermediaries, if used in the offering, would also be required to perform background checks on the issuer’s principals. Intermediaries would not need to be registered broker-dealers.

It appears that securities sold under the crowdfunding exemption would be “restricted securities” and therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above would apply to private as well as public resales.

Investors who purchase securities in transactions under the crowdfunding exemption would not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption would pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws).

Within 180 days after the enactment of the JOBS Act, the SEC would be required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.

What is the change to Regulation A and what does it mean?

Regulation A currently provides an exemption from registration for offerings of up to $5 million per year by non-reporting companies. Regulation A requires the submission of a simplified offering document to the SEC, and the SEC may comment upon them. Regulation A permits “testing the waters” communications. Securities sold under Regulation A are not “restricted securities,” so the investor can immediately sell such securities publicly, at least theoretically. Issuers who sell securities under Regulation A do not automatically become subject to reporting under the Exchange Act. Regulation A offerings are subject to state blue-sky qualification laws. Regulation A is rarely used today because of the low $5 million offering cap and the associated regulatory burdens.

The JOBS Act would require the SEC, within one year of enactment of the JOBS Act, to amend Regulation A (or adopt a new exemption) to increase the offering cap to $50,000,000 of securities sold in the prior 12 months in reliance on the exemption. The exemption would continue to permit testing the waters communications, permit offering the securities publicly, and provide that securities sold in the offering are not restricted securities. The exemption would require issuers availing themselves of the modified exemption to file audited financial statements with the SEC annually and allow the SEC to impose additional conditions, including periodic reporting requirements. The exemption would be available for equity securities, debt securities, convertible debt securities and guarantees.

Securities sold under the modified exemption would be added to the list of covered securities under NSMIA, but only if they are offered and sold on a national securities exchange or offered and sold only to “qualified persons” as the term is defined by the SEC. NSMIA was adopted in 1996 and pre-empted state blue-sky qualification laws for securities sold to qualified persons. The SEC proposed a definition for “qualified persons” in 2001, but never adopted a definition. If the SEC does not adopt a definition in connection with the amendments to Regulation A required by the JOBS Act, issuers would have to choose between blue sky compliance and becoming listed on a stock exchange, assuming they qualify for listing. Becoming listed on a stock exchange would in turn require issuers to report under the Exchange Act, which may eliminate many of the advantages of Regulation A over a registered public offering.

Depending on the regulations the SEC adopts, Regulation A may become a viable means for a company to conduct a “mini-public offering” and have a public trading market in its securities. The continuing market for reverse mergers into public shell companies, sometimes referred to as alternative public offerings, demonstrates a demand for small companies to establish public markets in their securities. The ability to raise up to $50 million publicly and the potential not to be subject to Exchange Act reporting could make Regulation A a superior alternative public offering method.

What are the changes to the triggers for Exchange Act registration?

Section 12(g) of the Exchange Act and its related rules require a company with more than $10 million in assets and more than 500 holders of record of any class of its equity securities to register under the Exchange Act and begin complying with disclosure and financial reporting compliance obligations applicable to public companies.

The JOBS Act would increase the holder threshold to 2,000 holders, provided no more than 500 are unaccredited investors. The JOBS Act would also exclude from the "held of record" test securities held by persons who received them pursuant to employee compensation plans and securities held by persons who purchased them in transactions under the crowdfunding exemption.

The holder of record threshold for banks and bank holding companies would increase to 2,000, with no limit on the number of unaccredited investors.

Is there anything else?

Yes. The JOBS Act orders the SEC to conduct a study examining its decimalization rules adopted in 2001. These rules required securities quotations in pennies rather than fractions of a dollar, and thus were intended to decrease trading transaction costs. Many blame these rules, among others, for the decline of public offerings. The argument is that decimalization has reduced the bid-ask spreads from market-making to a level that makes trading desks unprofitable for all but the largest investment banks, and that in turn has caused post-IPO stocks to be illiquid and eliminated most regional and “boutique” banks from the IPO market.

The JOBS Act also directs the SEC to conduct a review of Regulation S-K and “determine how such requirements can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies.”

What will happen next?

Recent press reports indicate that the Senate is likely to take up the companion S. 1933 this month. President Obama has announced his support for the JOBS Act and, given its overwhelming bi-partisan support, passage seems likely in this election year.

What should I do now?

The JOBS Act is not currently law, so existing laws, regulations and rules applicable to capital raising and public reporting remain in effect. Issuers with ongoing offerings or offerings about to commence must continue to comply with existing laws, regulations and rules.

The changes that would be implemented by the JOBS Act, if adopted, will fundamentally change the methods companies have used to raise capital for the last 30 years. While there will certainly be significant changes in the markets for growth capital, it is too early to predict how markets, issuers and intermediaries will react to the rule changes. For example, it is too early to predict what impact general solicitation will have on the success of Rule 506 offerings or whether the new crowdfunding exemption or Regulation A exemption will become viable fundraising alternatives for companies seeking growth capital and/or public markets in their securities.

Companies and entrepreneurs should monitor this situation closely and expand their medium- and long-term thinking around capital raising to accommodate the changes that appear to be imminent.

What if you have questions?

For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.

John Tishler (858-720-8943,, Louis Lehot (650-815-2640,, Edwin Astudillo (858-720-7468,, Jason Schendel (650-815-2621,, Camille Formosa (650-815-2631, and Nina Karalis (858-720-7466, participated in drafting this posting.


This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.


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Romania court nullifies law changing electoral system

[JURIST] The Constitutional Court of Romania [official website, in Romanian] on Wednesday rejected a law that would have changed the country’s electoral system, deeming it unconstitutional. The proposed system, which is based on first-past-the-post voting, would have replaced the mixed majority and proportional system currently in place. It was planned to be implemented for the upcoming November elections. The ruling leftist Social Liberal Union (SLU) had passed the proposed change that would have given its leader and the country’s Prime…


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The Problem with Bankruptcy Isn’t Attorneys’ Fees – It’s Executive Incompetence

In the Wall Street Journal, staff writer, Jacqueline Palank discusses the Justice Department’s attempt to control fees that bankruptcy lawyers seek. Creditors and employees may, at times, be a bit disgruntled by such fees. So, now, the U.S. Trustee Program appears to be entering the fray.

Before going further, it should be noted that i) any fee sought by an attorney must first be approved by the client going into bankruptcy; ii) the fee cannot be paid before a Bankruptcy Court Judge approves the fee request; iii) the legal fees most often are a pittance compared to the debts of the company and thus have little or no impact on either the creditors or the employees. In fact, the current proposal is limited to companies whose assets and debts exceed $50 million, hardly your "normal" bankruptcy.

The only reason for focusing on the legal fees is that this is a topic that makes good reading in the tabloids, including the WSJ. While the quoted hourly rate received by some attorneys seems high, it is insignificant in comparison to the compensation received by incompetent CEOs and others in the C-suite offices. Why don’t the tabloids focus on the cause of the bankruptcy? Why not focus on the compensation of the management team, which often is at astronomically higher multiples compared the lowest paid employees of the company? Why not seek redress against the management that is responsible for bringing the company to its knees? Although this focus may have more positive economic impact, it clearly is not sexy enough to sell many papers.

The U.S. Trustee is proposing, according to the writer, several new approaches to control lawyers’ fees, including:

    Though the lawyer applicant must disclose his/her hourly rate now, the Justice Department wants the lawyer to disclose the lowest, highest and average hourly rates the law firm charges in all its matters.

    The Department wants the lawyer applicant to create and disclose to the Court a budget for legal expenses. This budget would, necessarily, disclose to all involved, including the creditors who are adversaries of the bankrupt, the client’s planned legal strategy.

In the 1960s, the Supreme Court ruled that it was anti-competitive for bar associations to maintain a listing of suggested fees for different types of work. Such a listing, in particular, helped younger and newer lawyers set their fees at rates that were more in line with more senior lawyers. Not having such a list would compel lawyers to set their own fees, the theory being that lawyers would then be more competitive with one another to the consumers’ benefit.  The Trustee by its first proposal ignores this. The existing disclosure already provides information that tends to be anti-competitive. Law firms can see what others are charging and price their own services accordingly, causing rates to slowly increase in lockstep over the years.

Intruding into the fees charged for practice areas, such as general business matters, estate planning, tax work, and other areas of work performed by the firms who also do bankruptcy work has no bearing on the special expertise of large company bankruptcy lawyers. No area of law other than bankruptcy requires such disclosure for court approval. Fees are left to be negotiated between attorney and client. Other than precedent, there is no reason disclosure should be made here either and the process should not be extended. “Transparency” is a bogus issue. There is no backroom conspiracy on how bankruptcy fees are charged. All the proceedings are public and must be approved by the Court before attorneys are paid anything.

Budgets are good. I recommend them to my attorney-clients with whom I consult. Budgeting is a process, however, between the client and the attorney. By requiring that bankruptcy budgets, which reveal legal strategy, be made public, the U.S. Trustee is saying that bankrupt companies have no rights. They have no right to advocacy; they have no right to develop a strategy that might affect creditors’ claims; and they have no right of confidentiality. This is clearly contrary to the U.S. Constitution and our entire judicial system. While the bankrupts, and their inept management, may have proceeded down an economically unwise path, they still have rights to seek the best windup of affairs in their economic environment.

Don’t worry about the lawyers’ hourly rates once the bankruptcy petition is filed. They are regulated first, by the client, and second, by the Court. Who is watching the compensation of the management team before the company entered bankruptcy? Why are inept executives not punished with fines, or worse, for malfeasance and negligent management tactics? Why are they allowed to benefit so expansively at the expense of their workers? Why don’t the tabloids focus their sharp light there? Oh, I forgot, the tabloids need to sell papers, they are part of the industrial complex that both Presidents Washington and Eisenhower warned us about as they left office.  Perhaps the fact that quite a few newspapers and newspaper chains (Tribune Co. and papers in Detroit, Denver, Minneapolis, Philadelphia and many other cities) have been mismanaged and had to file for bankruptcy has something to do with it, too.


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“Caveat Emptor” Is No Way to Practice Law

In the Opinion section of today’s Wall Street Journal, two fellows from the Brookings Institute espouse their philosophy for deregulating the legal profession:  Let anyone practice law; whether they’ve gone through law school or not, and allow anyone to own a law firm.

These are not new ideas, but the assertion that these ideas are the key to lowering costs of delivery of legal services is misplaced.

First, the licensing of lawyers is to protect the public; they are not there to protect the interests of lawyers. For example, an individual must be competent to represent and advocate for the interests of a client.  It’s the same principle as licensing doctors.  Incompetence either in court or in the operating room can cost people their lives.

Second, technology provides many avenues to reduce legal costs. Removing the licensing requirements has no impact on this issue. Yes, requiring a license does cost money and does cost time (opportunity costs for the student), but it also impacts the quality of services delivered … just as in the case of medicine (oh yes, and plumbing), etc. Why not remove licensing requirements for everyone in everything, from medicine, to plumbing, to driving a car. Licensing assures a minimum standard of quality. Licensing requirements in specific areas of human endeavor are society’s way of self-protection. Caveat emptor is acceptable, but not to the degree apparently desired by the authors of the Brookings report.

If lower legal costs are the objective, the argument should focus more on the pricing modalities as they impact the cost of legal services rather than the governance of the law firm. We’ve talked about this on previous occasions.

Third, the underlying premise that licensing provides an insurmountable barrier to entry and substantially raises costs by controlling supply might be true if one doesn’t look at the facts of recent and current reality. There are many more lawyers than the current demand can accommodate.  Many lawyers cannot find work. Thus, it is illogical to suggest that licensing is the cause for higher legal costs. Those lawyers who are working often provide legal services at lower rates than they used to charge. Even large law firms find significant resistance to raising their rates. Are legal expenses high? Yes, but compared to what? How low should these prices be before they are acceptable? And, if there is no regulation, we might likely see larger law firms pattern their pricing after one another, just as the unregulated airlines currently do, so that the benefit of lower costs would not be evident.

There is no price regulation now in the airline industry. Yet, it’s remarkable how similar airline prices are. Yes, there are a few low cost airlines such as Southwest. And, yes, there are also lower cost law firms as we sit here today, even with the regulations we have in place. The only benefit of the authors’ "non-licensing" proposal would be the destruction of minimum standards of quality. Caveat emptor might be acceptable if the public had a way of knowing what the quality standards should be … but they don’t and they won’t.

Combining other skills such as accounting into one organization (the old "multi-discipline" argument) is not required … many law firms already work closely with allied professionals for the benefit of clients. This is merely a non-issue.

Dewey, which went into Bankruptcy Court last night, did not fail for lack of credit. The firm had been extended bank lines of credit. It failed for lack of effective management. It’s unlikely that investors or others would have given Dewey more money if they understood the true nature of the firm’s economics and governance. Thus, this is also a non-issue for the authors’ arguments.

In sum, law firms function no differently from all other businesses. Good, solid business decisions must be made to attract customers/clients and operate cost-effectively. Dewey failed on both counts. The arguments put forth by the authors would not have changed this outcome. But, in the terms of business, by going into bankruptcy, the firm may be able to disgorge its unfunded pension obligations and become a viable candidate for acquisition by another large firm.  That’s when the principle of caveat emptor really comes into play – as a normal risk that businesses take every day.


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