The JOBS Act and the Capital Raising Process (Adding Confusion and Cost under Section 12(g))
The JOBS Act will not universally facilitate capital raising. It imposes categorical rules that will raise costs. An example is Section 501.
This provision raises the threshold for companies becoming public under Section 12(g) of the Exchange Act. Added in 1964 to require companies in the OTC to file periodic reports, the provision required registration with the Commission (and the filing of periodic reports) of any company with $1 million in assets and 500 shareholders "of record." The former was raised to $10 million by rule, but the 500 shareholders of record requirement remained unchanged (although slightly modifed by the SEC to include brokers and banks with shares in a depository).
The problem with the threshold was not that it was too low, but that it looked to record owners rather than beneficial or street name owners. A company could have thousands of beneficial owners but less than 500 shareholders "of record." As a result, the threshold had no meaningful relationship to the actual number of investors in the company.
A legislative fix, therefore, was arguably necessary. The fix by Congress, however, did not address the central problem, but instead added costs and complications to the process. Section 501 reaffirmed the "of record" standard while raising the number from 500 to 2000. Because companies already had the ability to have 2000 street name investors while keeping the number of "of record" owners below 500, this change was not likely to have much effect. But Congress went one step further and added a provision providing that companies would be required to register under Section 12(g) if they had more than "500 persons who are not accredited investors (as such term is defined by the Commission)."
This provision will require private companies to monitor the number of shareholders of record. That does not reflect a change. In addition, however, they will have to monitor whether shareholders "of record" are accredited or unaccredited. That means that non-public companies will have to ask transfer agents to maintain records on the type of shareholder owning shares. This will no doubt add to the fees charged by transfer agents.
This may slow the transfer process and require additional paperwork whenever shares are sold. Once shares have become freely transferable, however, determining the nature of the investor will almost be impossible. With trades taking place in the secondary market, there will be no way to monitor the accredited/unaccredited status of investors. Perhaps companies or their transfer agents can contact shareholders "of record" after they have acquired the shares but in addition to the costs of doing so, shareholders may not respond.
Moreover, it is not unusual for private companies to have some freely transferable shares. Shares can become freely transferable either as a result of a registered offering (perhaps by a company that at the time had less than $10 million in assets) or as a result of the removal of restrictions on an exempt sale (perhaps under Rule 144). Where the accredited/unaccredited status cannot be verified, companies will in effect have to treat all purchasers as unaccredited. In effect, therefore, Congress as all but reinstated the 500 shareholders of record standard under Section 12(g).
But it is even more complicated than that. The JOBS Act provided that "held of record" does not include "securities held by persons who received the securities pursuant to an employee compensation plan in transactions exempted from the registration requirements of section 5 of the Securities Act of 1933.’’ Section 503 gives the SEC the authority to "adopt safe harbor provisions that issuers can follow when determining whether holders of their securities received the securities pursuant to an employee compensation plan in transactions that were exempt from the registration requirements of section 5 of the Securities Act of 1933."
The provision is not entirely clear but it seems to apply only to the employees who acquired the shares under the requisite compensation plan ("persons who received the securities"), not those who bought them from the employees. So companies can exclude from the 2000/500 unacredited threshold employee shareholders, but once the employees sell the shares companies must include any new owner holding shares "of record" in the 2000/500 thresholds.
All of this means that private companies will find the record keeping requirements associated with share ownership becoming more complicated and will find themselves paying more to transfer agents. Moreover, these complications will not apply only to private companies close to the 2000/500 thresholds. Any private company that may become public in the future will need to maintain the records and pay the additional costs.