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News April 2, 2012 Issue

JOBS Act "Game Changer" Arrives

The good news is that, come Thursday, when President Barack Obama is expected to sign the JOBS Act into law, small business will get a big boost in its ability to raise capital.

The bad news, however, is that the JOBS Act is missing certain investor protections that may result in an increase in securities frauds.

Thatís the assessment of the Jumpstart Our Business Startups ("JOBS") Act from the legal community and investor advocates alike.

The JOBS Act has lots of support from both sides of the aisle in Congress, from the White House, and from small business and private fund advocates. It also does not lack for criticism or controversy, even before it is official.

Crowd funding draws the heat.

Itís the crowd funding provisions that will cause problems, according to numerous industry advocates. "Crowd funding" is a capital-raising mechanism that typically uses the internet to solicit investors for emerging companies.

Specifically, the newly established exemption from registration for crowd funded offerings will permit an individual to invest up to five percent of their annual income or net worth that is less than $100,000 in one or more start-up businesses that make an on-line offering of securities. The maximum investment amount for these investors is $2,000. The limit increases to ten percent for crowd fund investors with annual incomes or net worth that is above $100,000.

Crowd fund offerings may raise up to $1 million in any twelve-month period without registering the offering under the Securities Act. The JOBS Act requires the offerings to be conducted only through SEC-approved brokers and "funding portals" that are registered with the SEC and comply with requirements such as:

  • Protecting investor privacy;
  • Providing risk of loss disclosures to prospective investors;
  • Requiring investors to demonstrate understanding of investing risks by answering a questionnaire; and
  • Obtaining background checks on the officers, directors and 20 percent or more equity holders of the issuer.

The JOBS Act also expands the exemption in Section 3(b) of the Securities Act, increasing the total dollar value of securities that may be sold by small business issuers from $5 million to $50 million.

"Advocates contend that it is a badly needed way to raise capital and democratize investing Ė letting investors claim a stake in everything from the next Google to a favorite coffee shop," said InvestmentNewsís Mark Schoeff.

"Although start-ups will have to market themselves through third-party portals approved by the SEC, this is like limiting Bernie Madoff to making pitches over the radio," said former U.S. Secretary of Labor Robert Reich.

North American Securities Administrators Association (NASAA) president Jack Herstein, in a letter sent to U.S. Senators last month, said that the states are pre-empted from reviewing these private securities offerings, which in the past have ultimately resulted in a significant number of state securities law violations. Regulation D offering problems were the leading state regulatory problems in 2010, he said.

"Based on the SECís previous track record and their limited resources, this is a mandate the agency is not in a position to fulfill and hence an investor protection disaster waiting to happen," said Herstein.

Calling the JOBS Act as adopted "deeply flawed," Consumer Federation of America director of investor protection Barbara Roper said the bill will "unleash a new wave of damaging fraud in the private offering market, make it easier to commit accounting fraud, reignite the abusive securities analyst practices that fueled the tech stock boom and bust, undermine comparability of financial reporting, and enable the Regulation A small offering exemption to be gamed by mid-sized companies seeking to evade public reporting requirements, to name just a few of its many short-comings."

Regulation D reforms on the way.

The JOBS Act will also eliminate the ban on general solicitation and general advertising under Regulation D with respect to sales of private securities to accredited investors. Longtime advocate for rescinding the 30-year old offering restrictions, the Managed Funds Association (MFA) applauded the change, which it said will help small business growth, spur capital formation, and create jobs in a growing economy. The JOBS Act also includes a number of important provisions that will modernize existing securities laws in a manner that will enhance financial market transparency and investor protection, said the MFA.

The JOBS Act increases the threshold for becoming a reporting company under Section 12(g) of the Securities Exchange Act from 500 to 2,000 shareholders of record, or 500 shareholders of record that are not accredited investors.

Law firm Morrison & Foerster has already launched a blog on its web site called Jumpstarter, "for jumpstarts, upstarts, and start-ups." The site says the JOBS Act creates a transitional on-ramp for emerging growth companies, encouraging them to pursue IPOs, and promoting research on these companies.

"Emerging growth company" is defined in the Act as a company with total annual gross revenues of less than $1 billion in its most recently completed fiscal year.

Companies such as CrowdFund Securities and CrowdCheck have already launched to support the offering and due diligence process for the new market niche.

Timeline for the changes.

The JOBS Act directs the SEC to amend Regulation D within 90 days after the law is enacted, which would be July 4th, if the President signs the Act into law on April 5 as currently scheduled. The same is true for amending Rule 144A to permit broader solicitation for offerings and relax the requirement that all investors must be qualified institutional buyers. The SEC must promulgate rules implementing the crowd funding provisions of the Act within 270 days of its enactment, or by December 31.

SECís new dilemma.

Last fall, the SECís Division of Corporation Finance identified the Regulation D provisions as good examples of rules that had outlived their usefulness.

The Obama Administration had tasked federal agencies earlier in the year with the mission of reviewing their regulations to identify and jettison outmoded and ineffective rules. As part of that initiative, SEC Chairman Mary Schapiro instructed the Division of Corporation Finance to "take a fresh look" at some of the SECís offering rules to develop ideas that may reduce the regulatory burdens on small business capital formation in a way that is consistent with investor protection.

Along the way to adoption however, the JOBS Act loosened some of the restrictions that would have enhanced investor protections. Chairman Schapiro expressed concerns about the bill even as a group of democratic Senators sought unsuccessfully to overcome the billís perceived defects. With its limited resources, "the SEC can barely keep track of Wall Street let alone thousands of internet portals," said Reich. The White House and Senate bear the responsibility for the damage the bill as passed will cause for vulnerable investors and "our fragile capital markets," said Roper.