SEC Staff Issues More Guidance on Emerging Growth Companies May 16, 2012

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SEC Staff Issues More Guidance on Emerging Growth Companies May 16, 2012

May 16, 2012

On April 16, the staff of the Securities and Exchange Commission (SEC) Division of Corporate Finance issued guidance in the form of frequently asked questions on the confidential submission process for emerging growth companies. This guidance was addressed in our SEC Flash Report dated April 18, 2012. It addressed such topics as applicability of the confidential submission process to foreign filers, coordinating the confidential submission process with the road show, defining the “initial public offering date,” nature of the confidential submission process and taking the confidential submission public, among other things.

On May 3, the SEC issued more guidance on a variety of topics related to emerging growth companies. While this additional guidance does not represent rules, regulations or statements of the Commission, it reflects the SEC staff’s thinking on matters germane to the rules related to an emerging growth company (EGC).

This Flash Report summarizes some of the points included in the SEC staff’s latest guidance. It covers the following topics:
•    Adoption of IFRS by foreign private issuers
•    Applying the revenue test – Based on most recent fiscal year
•    Applying the revenue test – Considerations for financial institutions
•    Audited financial statements in Forms 10-K or 20-F
•    Compliance with new or revised accounting standards
•    Convertible debt securities
•    Loss of EGC status in the fifth anniversary year
•    Qualifying entities as an EGC
•    Ratio of earnings to fixed charges
•    Restatement of financial statements
•    SEC comment letters and company responses
•    XBRL requirements

These topics are discussed below. It is presumed that readers of this Flash Report understand the basic provisions of the JOBS Act, as highlighted in our March 29 Protiviti Flash Report. The SEC staff’s guidance is available here and is presented in the form of frequently asked questions.

Adoption of IFRS by Foreign Private Issuers

Notwithstanding Section 7(a)(2)(A) of the Securities Act, in order for a foreign private issuer to assert that its financial statements are prepared in compliance with international financial reporting standards (IFRS) as issued by the International Accounting Standards Board, it must include three statements of financial position. Paragraphs 6 and 21 of IFRS 1, First-time Adoption of International Financial Reporting Standards, require a first-time adopter of IFRS to present an opening IFRS statement of financial position at the date of transition to IFRS. This requirement results in the presentation of three statements of financial position. Likewise, a foreign private issuer that is not a first-time adopter of IFRS is required by paragraph 10(f) of International Accounting Standard (IAS) 1, Presentation of Financial Statements, to provide three statements of financial position when it applies an accounting policy retrospectively, makes a retrospective restatement or reclassifies items in its financial statements. If a foreign private issuer is an EGC and is either a first-time adopter of IFRS or required by paragraph 10(f) of IAS 1 to provide three statements of financial position, it must include the three statements of financial position in a registration statement for its initial public offering of common equity securities consistent with the IFRS requirements.

Applying the Revenue Test – Based on Most Recent Fiscal Year

The definition of EGC focuses on the total annual gross revenues for the most recently completed fiscal year. To illustrate, assume a company had more than $1 billion in total annual gross revenues two years ago. For its most recently completed fiscal year, the company’s total annual gross revenues were less than $1 billion. In now contemplating an initial public offering of its common equity securities, this company meets the total annual gross revenues test for an EGC.

Applying the Revenue Test – Considerations for Financial Institutions

The definition of EGC does not include different standards for calculating revenues for different types of issuers. However, the SEC staff notes that for purposes of calculating revenues to determine smaller reporting company status under Exchange Act Rule 12b-2, a specific approach has been developed for financial institutions. Section 5110.2(c) of the Financial Reporting Manual of the Division of Corporate Finance outlines this approach.1 The SEC staff is of the view that a financial institution should use the same approach in determining its “total annual gross revenues” for purposes of determining whether it qualifies for EGC status.

Specifically, under this approach, a financial institution must include all gross revenues from traditional banking activities, e.g., interest on loans and investments, dividends on investments, fees from loan origination, fees from trust and investment services, commissions, brokerage fees, mortgage servicing revenues, and any other fees or income from banking or related services. Such revenues do not include gains and losses on dispositions of investment portfolio securities, although it should include gains on trading account activity if that activity is a regular part of the institution’s operations.

Audited Financial Statements in Forms 10-K or 20-F

The provision in Securities Act Section 7(a)(2)(A) permitting an EGC to file only two years of audited financial statements is limited to the registration statement for the company’s initial public offering of common equity securities. Going forward, for an EGC that is not a smaller reporting company, three years of audited financial statements are required to be included in its Form 10-K or Form 20-F. The SEC staff acknowledges that as a practical matter, an EGC will not be required to include, in its first annual report on Form 10-K or on Form 20-F, audited financial statements for any period prior to the earliest audited period presented in connection with its initial public offering of common equity securities.

To illustrate, assume an EGC with a December 31 fiscal year-end has a registration statement for its initial public offering of common equity securities declared effective during the 3rd  quarter of 2012, the registration statement would include audited financial statements for 2011 and 2010. The issuer’s first annual report, which will be for the fiscal year ending December 31, 2012, and will be filed in 2013, will include audited financial statements covering 2012, 2011 and 2010.

Compliance with New or Revised Accounting Standards

Section 7(a)(2)(B) of the Securities Act provides that an emerging growth company can take advantage of an extended transition period for complying with any “new or revised” financial accounting standard. Often, such extended transition periods apply to private companies. For purpose of this rule:

  • The term “new or revised” financial accounting standard refers to any update issued by the Financial Accounting Standards Board to its Accounting Standards Codification after April 5, 2012, the date of the enactment of the JOBS Act.
  • A foreign private issuer qualifying as an EGC that reconciles its home country GAAP financial statements to U.S. GAAP may take advantage of the extended transition period for complying with new or revised financial accounting standards in its U.S. GAAP reconciliation.
  • An EGC choosing to take advantage of the extended transition period may later decide to “opt in” (i.e., comply with the financial accounting standard effective dates applicable to a non-EGC). Once this decision is made, it is irrevocable, meaning the company cannot “opt back out.” Management’s decision should be prominently disclosed in the first periodic report or registration statement following the decision.

Note that Section 7(a)(2)(B) only provides an accommodation with respect to the effective dates of new or revised financial accounting standards, and only applies if such standards apply to companies that are not issuers. It does not apply to any financial accounting standards (such as segment disclosures or earnings per share computation, presentation and disclosures) that exclude nonpublic entities from their scope. Nor does it allow an EGC to apply financial accounting standards as if it were a nonpublic entity.2

Convertible Debt Securities

In general, all non-convertible debt securities issued over a prior three-year period, whether outstanding or not, are required to be counted against the $1 billion debt limit for an EGC. However, the SEC staff will not object if a company does not count debt securities issued in an A/B exchange offer, as these debt securities are identical to (other than the fact that they are not restricted securities) and replace those issued in a non-public offering. The staff views the A/B exchange offer as, in effect, the completion of the capital-raising transaction.

Loss of EGC Status in the Fifth Anniversary Year

Pursuant to Securities Act Section 2(a)(19)(B), an issuer will lose its EGC status on the “last day of the fiscal year of the issuer following the fifth anniversary of the date of the first sale of common equity securities pursuant to an effective registration statement,” provided that none of the other disqualifying conditions have previously been triggered. This date is determined by looking to the fiscal year during which the fifth anniversary date occurs. The last day of this fiscal year will be the first day that the issuer is a non-emerging growth company, provided that none of the other disqualifying conditions have been triggered. For example, if an issuer with a December 31 fiscal year-end first sold common equity securities pursuant to an effective registration statement on May 2, 2012, it would cease to be an EGC no later than December 31, 2017.

Qualifying Entities as an EGC

The SEC staff noted that the following entities qualify as an EGC:

  • Companies with public debt: A company that has issued only debt securities pursuant to an effective registration statement on or before December 8, 2011, may qualify if its annual total gross revenues for its most recently completed fiscal year were less than $1 billion and none of the disqualifying conditions have been triggered. Note that the effective date for the definition of an EGC focuses only on whether the first sale of common equity securities pursuant to an effective registration statement occurred on or before December 8, 2011.
  • Business development companies: BDCs are a category of closed-end investment companies that are not required to register under the Investment Company Act but are regulated pursuant to Sections 55 through 65 of that Act. These entities invest in startup and emerging growth companies for which they make available significant managerial experience, and are subject to many of the disclosure and other requirements from which Title I provides exemptions, including executive compensation disclosure, say-on- pay votes, MD&A and Section 404(b) of the Sarbanes-Oxley Act.

The SEC staff noted that the following entities do not qualify as an EGC:

  • Asset-backed securities issuer: An ABS issuer under Regulation AB is an issuer, usually a trust, which acquires and holds a discrete pool of financial assets, such as credit card receivables, car leases or loans. By their terms, these assets liquidate over a specified time period. These issuers are subject to an entirely separate disclosure and reporting regime under Regulation AB that is designed to address their particular structure and operations. Many of the specific exemptions in Title I for an EGC are exemptions from requirements to which ABS issuers are not subject.
  • Registered investment companies: These companies registered under the Investment Company Act are externally managed pooled investment vehicles that are subject to an entirely separate disclosure and reporting regime that is designed to address their particular structure and operations. Again, many of the specific exemptions from the disclosure and other requirements contained in Title I for an EGC are exemptions to requirements to which registered investment companies already are not subject.
  • Successor to certain reverse mergers: An issuer which completes a transaction that results in it becoming the successor to its predecessor’s Exchange Act registration and reporting obligations pursuant to Exchange Act Rules 12g-3 and 15d-5, and the predecessor company was not eligible to be an EGC because its first sale of common equity securities pursuant to an effective registration statement occurred on or before December 8, 2011.

Ratio of Earnings to Fixed Charges

For certain offerings, Item 503(d) of Regulation S-K requires an issuer that is not a smaller reporting company to present its ratio of earnings to fixed charges for each of the last five fiscal years and the latest interim period for which financial statements are presented in the registration statement. Although Title I does not include any provision addressing the existing requirement to disclose the ratio of earnings to fixed charges, the SEC staff recognizes that requiring the ratio to be disclosed for periods prior to those included in the financial statements or selected financial data could impose burdens inconsistent with the intent of the provisions of Title I. Consequently, the staff will not object if an EGC presents in a registration statement its ratio of earnings to fixed charges for the same number of years for which it provides selected financial data disclosures in accordance with the JOBS Act.

Restatement of Financial Statements

Assume an EGC submits a draft registration statement on a confidential basis under Section 6(e) of the Securities Act. Assume further that, after the initial submission, the company discovers a material error in one or more of its financial statements and restates and confidentially submits a draft amendment to the registration statement to correct the error and disclose the restatement. In this case, the EGC would be required to include the restatement disclosures in its financial statements until its financial statements are updated for the next annual period. ASC 250-10-50 requires that “when prior period adjustments are recorded, the resulting effects…on the net income of prior periods shall be disclosed in the annual report for the year in which the adjustments are made and in interim reports issued during that year subsequent to the date of recording the adjustments.” ASC 250-10-50 further states that “[f]inancial statements of subsequent periods shall not repeat the [restatement] disclosures.”3

SEC Comment Letters and Company Responses

The SEC staff will publicly release its comment letters on confidential draft submissions, and the issuer’s responses, after the registration statement is effective. To assist in this process, the staff request EGCs to resubmit, on EDGAR, their response letters using the submission type “CORRESP,” when they first file their registration statements on EDGAR.

XBRL Requirements

As Title I doesn’t provide an exemption from the XBRL requirements, an EGC is required to comply.

Summary

This latest guidance continues the SEC staff’s ongoing efforts to clarify the application of the JOBS Act in accordance with the intent of Congress.

1See for this manual.
2Note that some non-U.S. jurisdictions have a separate set of financial accounting standards for nonpublic entities.
3FASB ASC 250 addresses “Accounting Changes and Error Corrections.”

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