The "JOBS" Act: Adding Cost and Confusion to the Capital Raising Process

Last week, the House adopted H.R. 3606, THE REOPENING AMERICAN CAPITAL MARKETS TO EMERGING GROWTH COMPANIES ACT OF 2011. Despite the emphasis on raising capital, the short title for the legislation is the JOBS Act (‘‘Jumpstart Our Business Startups Act’’), suggesting that the purpose of the legislation is to spur jobs.

The legislation is really a series of laws that were not adequately integrated together.  There will be enormous uncertainty, harmful consequences and added expense that arise out of the inartful drafting.  Lets look at an example.

Section 12(g) of the Exchange Act provides that companies more than 500 shareholders of record and $10 million in assets (see rule 12g-1) must register with the SEC.  Once registered, the company is subject to the periodic reporting requirements, the proxy rules, the tender offer rules and the beneficial ownership reporting obligations (short swing profits) under Section 16. 

Counting the number of shareholders "of record" is, therefore, very important.  As currently used in the securities laws, the phrase essentially coincides with state law.  It counts as a shareholder anyone whose name appears on the list provided to the company by the transfer agent.  See Rule 12g-5 (shareholder of record includes "each person who is identified as the owner of such securities on records of security holders maintained by or on behalf of the issuer").  For the most part, these are the shareholders who have an actual certificate. 

The approach taken by Congress (it was put in place in 1964) has the benefit of simplicity.  Get a list of shareholders from the transfer agent on the last day of your fiscal year, count the number, if its over 500 (and you have more than $10 million in assets) you are subject to Section 12(g).  If less, you are not. 

The "JOBS" Act is about to make a hash out of this simplicity.  The crowdfunding provision provides that anyone purchasing pursuant to the provision will not be treated as an owner "of  record."  See Section 302 ("For purposes of this subsection, securities held by persons who purchase such securities in transactions described under section 4(6) of the Securities Act of 1933 shall not be deemed to be ‘held of record’.’’).

Another provision proposes to increase the number of record ownes from 500 to 1000.  At the same time, however, Section 502 of that provision provides that record ownership does not include "securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration 10 requirements of section 5 of the Securities Act of 1933.’’.

So, if those provisions are adopted, a company must undertake a far more complicated and difficult calculation in determining whether it must register under Section 12(g).  First the company needs to obtain a list of record owners as of the last day of the fiscal year.  Then the company must count the number of record holders but deduct the number who bought under the crowdfunding exemption or pursuant to certain employee benefit plans.  Companies will either need to maintain these records or will need to recreate them, a likely expensive process that requires the company to figure out how the shares were obtained in the first instance.

Moreover, while employees and crowdfunding purchasers are not shareholders of record, the statute is silent about the status of the holders who buy from these persons.  So a company may not be public (500 shareholders of record) while the shares are held by employees/crowdfunding purchasers but may become public when these share are sold.  This may be true even though the actual number of shareholders has not changed.

By tinkering with the record ownership definition (a completely unnecessary thing to do), the legislation adds to the record keeping requirements of all companies, makes the requirements of Section 12(g) more fluid and harder to police, and potentially discourages companies from issuing shares to employees or using the crowdfunding exemption because the shares, once sold, may trigger an obligation to register under Section 12(g).  Shareholders will no longer have any certainty as to when companies will be required to register as a result of the 500 shareholders of record test.   

In other words, it has the potential to discourage capital raising, the opposite of its purpose. 

J Robert Brown Jr.