March 29, 2012
On March 27, the House of Representatives of the U.S. Congress overwhelmingly passed the Senate-amended “Jumpstart Our Business Startups Act” (the “JOBS Act”) designed to make it easier for small businesses and entrepreneurs to attract investors and access capital while complying with U.S. securities laws. President Barack Obama is expected to sign the new bi- partisan legislation into law. The new law is intended to make several significant changes to the securities laws by (1) encouraging initial public offerings (IPOs) by “emerging growth companies,” and (2) facilitating the ability of companies to raise capital in private and small public offerings without registration with the Securities and Exchange Commission (SEC), thereby reducing the costs and red tape associated with raising capital. The legislation passed by both houses of Congress is identical to the version initially passed by the House on March 8, with the exception of certain provisions amended to provide for additional investor protections.
The legislation creates a new category of companies – “emerging growth companies.” Under the legislation, these companies are defined as having total annual gross revenue of less than $1 billion and are exempted from certain regulatory requirements until the earliest of four dates we will describe later in this Flash Report. These firms would not have to comply with Section 404(b) of the Sarbanes-Oxley Act (SOX).
During the legislative process, the bill experienced opposition. Some senators tried to reinstate across-the-board investor protections and were successful in adding one amendment that requires websites involved in crowdfunding1 to register with the SEC and demands that companies seeking to raise money in this manner provide information on their financial status, business plans and shareholder risks. SEC chairman Mary Schapiro, institutional investors and consumer advocacy groups expressed concerns that the legislation goes too far in removing SEC oversight, opening the door to repeats of the Enron scandal. The issue expressed is that the new legislation may create greater risks for investors and ultimately could erode confidence in the capital markets.
Determining Eligibility under the Act
The JOBS Act includes easier reporting rules for businesses with less than $1 billion in sales or market capitalization preparing to go public. These “emerging growth companies” would not have to comply with Section 404(b) of the Sarbanes-Oxley Act of 2002 for up to five years. They would also need to submit two years of audited financials instead of three when they file registration statements with the SEC, and would not be required to submit the required five years of financial data, which is also currently required.
The term, emerging growth company (EGC), is defined as follows:
An issuer that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year. Once designated an emerging growth company, a company retains that status until the earliest of:
- The last day of the fiscal year of the issuer following the fifth anniversary of the date of the company’s initial public offering of common equity securities;
- The last day of the fiscal year during which the issuer had total annual gross revenues of $1 billion or more;
- The date on which the issuer has, during the previous three-year period, issued more than $1 billion in nonconvertible debt; or
- The date on which such issuer is deemed to be a “large accelerated filer.”2
The earliest of these four dates defines the limits to the duration of a company’s “EGC status.” The JOBS Act requires that the SEC adjust the above definition for inflation every five years. While it is possible the SEC could provide them, we do not see any transitional provisions in the JOBS Act when a company loses its “EGC status.” For instance, assume an EGC is a December 31 year-end reporting company and, because of an unusual one-time event that was not anticipated, its revenues spiked in the fourth quarter, causing it to exceed the $1 billion threshold. Based on the language included in the JOBS Act, the annual revenue test is as of the last day of the company’s fiscal year. If the company fails to meet that test by exceeding the $1 billion threshold, it loses its “EGC status” as of the end of that year, which would subject it to the attestation requirements of Section 404(b) for that year unless it is exempted as a nonaccelerated filer. These circumstances would require a very keen sense of anticipation, some advance preparation, as well as quick and nimble action on very short notice for the company to engage its external auditor in the Section 404(b) attestation process.3
The effective date of determining an EGC’s status is set forth as follows:
…an issuer shall not be an emerging growth company… if the first sale of common equity securities of such issuer pursuant to an effective registration statement under the Securities Act of 1933 occurred on or before December 8, 2011.
In summary, for purposes of determining EGC status, the provisions of the JOBS Act state that it is to be applied prospectively to all IPOs after December 8, 2011. Therefore, it does not apply to current public companies, i.e., a company cannot be an EGC if it first sold common equity in a registered offering on or before December 8, 2011. Nor would it be applied retroactively to recent new registrants below the thresholds that have not yet filed their second Annual Report on Form 10-K. In essence, the JOBS Act does not affect existing public companies, including small cap, non-accelerated filers. In many respects, the JOBS Act, in effect, gives larger newly public companies qualifying as an EGC the same status as current small cap, non-accelerated filers. The JOBS Act also applies to new foreign filers.
An issuer qualifying for “EGC status” may forego reliance on any exemption available to it. For example, if the issuer has competitors that are already reporting companies, for competitive reasons, it may choose to provide more robust disclosures. However, if the EGC chooses to comply with financial reporting requirements applicable to non-emerging growth companies, it must comply with all of the requirements. In other words, it cannot opt in or opt out of specific requirements – it is either all in or all out, with no ability to cherry-pick compliance. Furthermore, any election by the company to take advantage of its right to claim “EGC status” must be made at the time it files its first registration statement or Exchange Act report. If the company chooses to disclose beyond what is required of an EGC, it cannot revert back to claim an EGC exemption later on.
A Synopsis of the Act’s Requirements
In effect, the JOBS Act exempts EGCs for up to their first five years on the public market from the compliance burdens of SOX Section 404(b), which is the attestation requirement of the internal controls provisions of SOX. These companies will still have to comply with Section 404(a), meaning they must file an internal control report beginning with their second annual report following going public, and comply with other provisions requiring disclosures and certifications pertaining to the control environment (these disclosures and certification requirements are discussed later).
In addition to SOX, the JOBS Act is intended to reduce the costs of going public by providing newly public companies with a temporary reprieve from other SEC regulations by phasing in certain regulations over a five-year period, thereby allowing smaller companies to go public sooner and permitting a more streamlined reporting approach for smaller issuers. With respect to going public, the JOBS Act:
- Expands the eligibility requirements of SEC Regulation A to include companies conducting direct public offerings of up to $50 million, meaning the aggregate share offering amount a company can make before it must register the offering with the SEC has been increased from the prior threshold of $5 million.
- Requires the SEC to revise Rule 506 of Regulation D, which bans general solicitation and advertising in offerings that are exempt from registration under this rule, to permit general solicitation in direct public offerings, thereby broadening the investor base.
- Allows an EGC to engage in oral or written communications with qualified institutional buyers and institutional accredited investors (as defined in Rule 501 of the Securities Act) in order to gauge their interest in a proposed IPO either prior to or following the first filing of the IPO registration statement.
- Exempts from registration under the 1933 Securities Act transactions involving the offer or sale of securities by an issuer over a 12-month period of either (a) $1 million or less, or (b) if the issuer provides potential investors with audited financial statements, $2 million or less, with both amounts adjusted by the SEC for inflation.4
- Removes SEC regulations preventing small businesses from using advertisements to attract investors and increases the number of shareholders that can invest in a private company to 2,000, or 500 who are not accredited investors, without triggering SEC reporting requirements.5
The above provisions provide more flexibility for companies to “test the waters” in the investor community. During the time it takes to pursue an IPO, an issuer may need to conduct a private placement in order to raise capital to permit it to continue to carry out its business plans and to cover the expenses associated with preparing for the IPO. While the SEC has provided additional interpretive guidance that has provided greater certainty for issuers that must complete a private placement to institutional investors while they are pursuing an IPO, the ability to “test the waters” adds further flexibility, particularly as market conditions change.
With respect to reporting to the SEC, the JOBS Act:
- Permits the EGC to submit a draft registration statement on a confidential basis to the SEC staff for confidential nonpublic review prior to public filing, so long as the initial confidential submission, and any required amendments, are made public at least three weeks before the issuer’s commencement of a road show.
- Permits an equity IPO registration statement with two years of audited financial statements (versus the prior three-year audited financial statement requirement.6
- Omits selected financial data (which is currently required for up to five years of data) for any periods preceding the earliest audited financial statements included in the initial registration statement, including within its selected financial data or in its MD&A disclosure for those periods.7
- Allows an EGC to adopt any new or revised accounting standards using the same timeframe as private companies if the standard applies to private companies.8
- Provides that an EGC may comply with the SEC's executive compensation disclosure requirements on the same basis as a smaller reporting company (generally public float less than $75 million).9
- Exempts an EGC from certain provisions of the Dodd-Frank Act, including current and future executive compensation-related disclosures, e.g., the “say-on-pay” vote requirement, the advisory vote on golden parachute payments requirement (“say-on- golden-parachutes”), the requirement to disclose the relationship between executive compensation and the financial performance of the company ("pay-for-performance"), and the CEO pay-ratio disclosure requirement.
- So long as it retains its EGC status, exempts the issuer from complying with:
- The internal control attestation requirements of Section 404(b) of SOX.10
- Any future PCAOB rules that might be adopted relating to mandatory audit firm rotation or supplemental auditor discussion and analysis reporting.
The JOBS Act would also implement a number of changes relating to research reports and other communications relating to EGCs.
If enacted, the JOBS Act would also amend the securities laws in ways that may impact other companies (i.e., the changes would not be restricted to EGCs). For example, the legislation would raise the thresholds for a nonlisted bank or bank holding company to terminate its Exchange Act registration from 300 shareholders of record to 1,200 shareholders of record (the same thresholds would apply for automatic suspension of a nonlisted bank’s or bank holding company's reporting obligations arising from registration under the Securities Act).
The JOBS Act requires the SEC to study and report its findings to Congress on the following (the deadline for reporting to Congress is noted parenthetically below and represents the timeframe after enactment of the Act):
- The effects that trading and quoting securities in $.01 increments (known as decimalization) has had on IPOs and the liquidity of small- and mid-capitalization securities (within 90 days);
- The SEC’s nonfinancial statement disclosure requirements included in Regulation S-K to determine how they can be revised to simplify the registration process and reduce the costs for EGCs (within 180 days); and
- The SEC’s authority to enforce its rules relating to the determination of "holders of record" (within 120 days).
In addition, the SEC is required to provide online education and conduct outreach to inform relevant constituencies in the marketplace about the impact of the JOBS Act.
Also, Congress has mandated the U.S. Comptroller General to study the impact of state securities regulations (i.e., the so-called "Blue Sky Laws") on public offerings by private companies under Regulation A. The Comptroller General is required to submit its findings to Congress within three months after enactment of the Act.
Impact on Prospective IPO Candidates
Companies planning an IPO need to pay attention to the JOBS Act requirements. For purposes of the Section 404(b) exemption, it would be a mistake to presume a five-year exemption is a given. A company that qualifies as an EGC needs to understand what is likely to happen to its business during the five-year exemption period. The “EGC status” only applies until the earliest of four dates – the five-year anniversary of the initial IPO, the year the company reports annual revenues of $1 billion or more, the date the company can look back on having issued more than $1 billion in nonconvertible debt over a three-year period, or the year the company is deemed to be a “large accelerated filer.” Therefore, if a company exceeds the threshold of one of the EGC tests in Year 3 after going public, it will need to be prepared to comply with Section 404(b) unless the SEC provides interpretive relief in the form of a transition period. Accordingly, a prospective IPO candidate expecting to qualify as an EGC will want to evaluate its plan for growing the business after going public to ascertain if and when it might lose its “EGC status” prior to the five-year anniversary date, and to put monitoring processes in place to be able to react to changes, midyear, so that it is able to comply in the first year for which compliance is required. We believe a proactive stance is the preferred approach.
With respect to an IPO candidate, the JOBS Act does not take away the need for preparedness on the following:
- Proactively preparing the financial reporting close process and the effectiveness of upstream processes, systems and internal controls in ensuring the quality of financial reports and ability to function as a public company. To this end, following are some examples of relevant considerations:
- Ensuring requisite skills to forecast effectively and technical acumen to understand the application of relevant accounting principles
- Ensuring there is a reliable and efficient financial close process
- Ensuring the company has a robust regulatory and corporate governance understanding and an efficient internal control environment so that initial and ongoing SOX compliance can be achieved
- Reviewing the IT systems environment and infrastructure to ensure the company is able to handle its projected growth in the business
- Ensuring the registration statement process is managed effectively and does not distract from running the business
- Reviewing key functions and skills needed to facilitate anticipated sustainable, scalable growth as a public company
- The JOBS ACT does not absolve an EGC of its responsibilities under SOX Sections 302 and 906, nor does it relieve management of the responsibility to comply with Section 404(a) of SOX. Following is a thumbnail sketch of management’s responsibilities:
- Upon going public, the disclosures and executive certifications required by Sections 302 and 906 must be filed in quarterly and annual filings under the 1934 Act, effective immediately. The initial focus of these requirements is on disclosure controls and procedures.
- Regarding internal control over financial reporting, management must disclose each quarter any material changes occurring in the internal control environment.
- Beginning with the second Annual Report on Form 10-K filing after going public, management must issue its internal control report, pursuant to the requirements of Section 404(a), which includes the company’s assertion on the effectiveness of internal control over financial reporting.
- Once the first internal control report is issued, subsequent executive certifications issued quarterly, as required by Section 302, must incorporate language regarding internal control over financial reporting, in effect adding additional certifications for management to make.
The message is clear. IPO aspirants still must prepare themselves for “prime time.” For critical processes, they should conduct walkthroughs to ensure that the key controls are identified. Testing the operating effectiveness of controls should be conducted in high- risk areas. And appropriate documentation should be created to support management’s assertion that internal control over financial reporting is effective. While not as rigorous as the attestation requirements of Section 404(b), there are nonetheless important disclosure and certification requirements for companies qualifying as an EGC. The only difference is they will not be subject to the demands of the attestation process for up to five years, so long as they retain their status as an EGC during that period.
- Like operating processes, financial reporting processes can accomplish stated objectives either efficiently or inefficiently. IPO aspirants would still benefit from a top- down, risk-based approach, and often need advice on how to implement it. Not only would this approach support management’s assertions in the annual internal control report, but the improved efficiencies in the financial reporting process and the upstream business processes providing “feeds” into the financial reporting process will conserve time, improve quality and save money.
- Historically, nonaccelerated filers that are not subject to the attestation requirements of Section 404(b) often need advice on how to streamline their documentation. This opportunity also applies to prospective IPO candidates expecting to qualify as an EGC.
- Depending on the IPO aspirant’s longer-term growth objectives, it may still want to go through the SOX compliance exercise in a thorough manner, particularly if it expects to exit its “EGC status” sooner than five years. This means its SOX compliance process will likely be subject to attestation when the company is no longer an EGC. Waiting for that day to come without advance preparation makes little sense and can present some significant problems. These companies will likely need someone to advise them on the path to follow, particularly if their external auditors make any requests or provide any observations regarding internal control matters in the interim.
- With respect to filing an internal control report, the question often arises as to the effort expected of the company by the SEC staff for management to be in a position to support its assertion regarding the effectiveness of internal control over financial reporting. The answer is no different from any small cap company, and is provided by the SEC staff in its interpretive guidance to management on complying with Section 404.11
Given the above considerations, we advise a company to prepare for current and future compliance and to have its house in order. There are many factors and preparations that contribute to an organization’s success in reaching a state of confidence around public company readiness. From transparency, to the pace and complexity of changing regulations, to all that’s required from an infrastructure and back-office perspective, the checklist to prepare appropriately for an IPO today can seem endless. While the JOBS Act provides some relief for companies qualifying as an EGC, the CEO and CFO must still certify the financial statements in accordance with Sections 302 and 906 of SOX. The company must still file an internal control report in accordance with Section 404(a) of SOX. The company’s financial statements are still subject to audit, and auditors can conclude that a material weakness in internal control exists if they propose material adjustments to the company’s financial statements. Last, but certainly not least, the company can lose its “EGC status” within the five-year period following going public. If it does, it will want to be ready for the rigor of the attestation process under Section 404(b) as and when required, and to evaluate changes that could accelerate the need to comply.
At the end of the day, management credibility is the key variable in terms of historical performance and providing an achievable business plan. It is important to recognize up front the time commitment of the IPO process and plan accordingly (e.g., additional personnel). The JOBS Act notwithstanding, we caution companies against taking shortcuts with respect to their financial reporting processes and internal controls. Get it right. Make no mistake, even for an EGC, there will be intense scrutiny on disclosure. Airtight financials, appropriate registration statement disclosures, effective IPO disclosure and credible financial presentations set the standard for future disclosure as a public company. That is why it would be prudent to consider the necessary steps around some type of reasonable SOX compliance approach, taking into consideration the high-risk areas, to reduce the risk of future errors or unwanted surprises to an acceptable level. Leaders willing to take on financial reporting risk without an appropriate review process are exposing themselves and their companies to unnecessary reputation risk.
The intent of the JOBS Act is to ease regulatory burdens on smaller companies and facilitate capital formation. It aims to ease the access to capital for very small companies, improving the availability and flow of information for investors before and after an IPO. It streamlines the reporting to the SEC for companies that complete IPOs and qualify as EGCs, providing them an “on-ramp” (or phasing-in of disclosure requirements). It mandates that the SEC educate prospective issuers about how to succeed in this new capital markets environment.
Companies planning an IPO should continue to be proactive in preparing their financial reporting close processes and improving the effectiveness of their upstream processes, systems and internal controls in ensuring the quality of financial reports. A critical first step in this proactive approach is an initial assessment of the necessary pre-IPO activities through the establishment of a sustainable compliance function that addresses the company’s regulatory requirements. Such an approach also necessitates a sustainable infrastructure to support anticipated growth and the ongoing and evolving reporting and compliance requirements of a public company. The JOBS Act does not change the need for a balanced review of a company’s IPO readiness and the remediation of identified issues that address core risk areas specific to both the company and the broader industry. These risk areas may apply to many dimensions of the company’s processes, systems and internal controls. To sum it up: While the JOBS Act makes the “job” of going public easier, there is still a “job” to do.