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Legal Alert: Update on the Dodd-Frank and JOBS Acts: Recent Enactments & Outstanding Actions

Bryan A. Jacobs, James C. Kennedy, F. Mark Reuter and Allison A. Westfall
April 6, 2015

While several years have passed since the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and the Jumpstart Our Business Start-Ups Act (“JOBS Act”) took effect, several  high-profile provisions of each act have not yet been implemented as final rules await adoption by the Securities and Exchange Commission (“SEC”). This advisory reviews certain provisions of each act and summarizes other related securities regulation developments.

Status of Dodd-Frank Implementation Process

Dodd-Frank took effect July 21, 2010. Since the enactment of the act, the SEC has adopted—out of the 395 total rulemaking requirements—final rules as to 231 of the provisions, proposed rules as to 73 others and has not yet proposed rules as to another 91 provisions.

Below is a brief summary of the current status of proposals yet to be adopted, with a focus on the major corporate governance and executive compensation provisions:

  • Section 972 (“Company Leadership Structure”) requires the SEC to adopt rules requiring companies to disclose their current leadership structure, why they have chosen to either combine or separate the roles of CEO and Chairman of the Board and why they believe their structure is the most appropriate for the company. Companies with a combined CEO/Chairman position must also disclose whether or not they have a lead independent director. Final rules have not yet been adopted.
  • Section 957 (“Broker Voting Prohibitions”) requires the SEC to adopt rules directing the securities exchanges to prohibit broker discretionary voting with respect to executive compensation, including say on pay and say on parachute, or “any other significant matter.” The SEC has approved the listing rules issued by NYSE and by NASDAQ but has not issued a rule as to the meaning of “other significant matter.”
  • Section 953 (“Executive Compensation Pay for Performance Disclosure”) requires the SEC to adopt rules requiring companies to disclose, either in narrative or graphic form, the relationship between executive compensation actually paid and the companies’ financial performance taking into account the company’s stock price performance. Proposed rules are expected by October 2015.
  • Section 953 (“Executive Compensation Internal Pay Ratio Disclosure”) requires the SEC to adopt rules requiring companies to disclose: (1) the median of the annual total compensation paid to all employees excluding the CEO; (2) the annual total compensation paid to the CEO; and (3) the ratio between (1) and (2). Companies may supplement these three disclosures with narrative discussion if they so choose. All employees of the company or any of its subsidiaries as of the last day of the prior fiscal year must be included. The “median employee” may be identified based on total compensation using either the company’s full employee population or a statistical sample of that population. Proposed rules were issued in September 2013 and final rules are expected by October 2015.
  • Section 954 (“Clawback Policy”) requires the SEC to adopt rules prohibiting the securities exchanges from listing companies that fail to implement a clawback policy providing for the recoupment of any incentive-based compensation paid to current and former executive officers in the three years preceding a financial restatement in excess of what would have been paid to the executive officer under the restated financials. Proposed rules are expected  by October 2015.
  • Section 955 (“Hedging Policy”) requires the SEC to adopt rules requiring companies to disclose in their proxy statements whether or not they permit the purchasing of financial instruments (including prepaid variable forward contracts, equity swaps, collars and exchange funds) to hedge or offset any decreases in the market value of company equity securities granted as compensation to or otherwise held by, employees or directors.  Proposed rules were issued on February 9, 2015.

Despite the absence of final adopted rules for these provisions of Dodd-Frank, some companies have made the decision to adopt adhering policies and procedures, resulting in a pool of examples that may merit consideration. Our firm advises clients to remain mindful of the Dodd-Frank requirements and the SEC’s proposed timing for implementation of required rulemaking and would be glad to discuss with you.

Status of the JOBS Act: Crowdfunding

On April 5, 2012, the JOBS Act was enacted. The crowdfunding portion of the JOBS Act amends the Securities Act of 1933 (“Securities Act”) to add a new registration exemption intended to allow capital raising from a large number of people in relatively small amounts through the internet and other social media outlets. On October 23, 2013, the SEC issued proposed rules and forms that would implement the crowdfunding provisions; however, final rules have not yet been adopted. Under the proposed rules, a company may utilize the crowdfunding exemption if: (1) the total amount sold by the issuer to all investors during the preceding 12 months does not exceed $1 million; (2) the total amount sold to any single investor by the issuer during the preceding 12 months does not exceed the greater of $2,000 or 5% of the annual income or net worth of that investor (if the annual income or net worth is below $100,000) or 10% of the annual income or net worth if the annual income or net worth is greater than $100,000; (3) the transaction is conducted through a broker or funding portal; and (4) the issuer complies with the requirements of new Section 4A(b) of the Securities Act covering disclosure requirements.

The SEC clarified that any offers or sales of securities purporting to rely on the crowdfunding exemption before the SEC adopts final implementing rules are unlawful under the federal securities laws. Therefore, there has not yet been widespread use of the new crowdfunding exemption. Although the SEC has not adopted final rules, states have begun to enact intrastate crowdfunding exemptions. To date, the following states have adopted crowdfunding exemptions: Alabama, Washington D.C., Idaho, Indiana, Maine, Michigan, Pennsylvania, Texas, Washington, Wisconsin, Massachusetts, New Mexico and Oregon. Colorado and Minnesota have rules pending in their respective legislatures and Mississippi has recently proposed rules.

Status of the JOBS Act: Regulation A+

On March 25, 2015, the SEC adopted rules and forms related to the offer and sale of securities under Section 3(b) of the Securities Act (known as “Regulation A+”) as required by the JOBS Act. Regulation A+ is the term used to refer to the former Regulation A, which was not widely used by issuers for various reasons, including that offerings under former Regulation A could not exceed $5 million in any 12-month period and securities under Regulation A were not “covered securities” and therefore had to comply with state blue sky laws. Regulation A+ is intended to be an expanded and modernized version of the former Regulation A. The amended regulation will be effective 60 days after publication of the final rules in the Federal Register.

Regulation A+ is available to issuers organized in and with their principal place of business in the US or Canada. Non-Canadian foreign issuers, Business Development Companies (“BDCs”) and Exchange Act reporting companies are not permitted to use Regulation A+. The rules create two tiers of offerings: (1) offerings of up to $20 million in a 12-month period, including up to $6 million on behalf of selling stockholders that are affiliates of the issuer; and (2) offerings of up to $50 million in a 12-month period, including up to $15 million on behalf of selling stockholders that are affiliates of the issuer. The final rules limit the amount of securities that can be sold by selling stockholders at the time of the issuer’s first Regulation A+ offering and during the following 12 months to no more than 30% of the aggregate offering price of any particular offering. Similar to the Securities Act registration process, issuers may submit a draft offering statement for non-public review and may make submissions via EDGAR. Tier 2 offerings are exempt from state blue sky laws; however, Tier 1 offerings are not exempt.

The amended rule permits an issuer to obtain indications of interest from any potential investors both before and after filing the offering statement. Issuers are required to prepare an offering statement which consists of company information, an offering circular, and contain a section on risk factors, executive compensation, MD&A and two years of financial statements. Issuers conducting a Tier 2 offering must provide audited financial statements in compliance with US GAAP or PCAOB standards. Tier 1 issuers are not subject to any ongoing reporting requirements other than summary offering information and to report the termination or completion of the offering, but Tier 2 issuers must file reports on EDGAR similar to those required for Exchange Act reporting companies. A Tier 2 issuer may exit the reporting regime either (1) when it becomes subject to Exchange Act reporting requirements; or (2) at any time after completing reporting for the fiscal year in which the offering statement was qualified if it has filed all ongoing reports required by Regulation A+, there are fewer than 300 record holders of the securities that were offered and there is no ongoing Regulation A+ offering.  

Since Tier 1 offerings are not exempt from blue sky laws, our firm recommends that issuers consider whether to take advantage of the multi-state coordinated review program for Regulation A+ offerings recently launched by the North American Securities Administrators Association (“NASAA”). Under the NASAA program, issuers are required to file Regulation A+ offering materials with the states by emailing the required documents to the administrator of the coordinated program who will be responsible for drafting and circulating comment letters and seek resolution of those comments with the issuer and its counsel. NASAA proposes a 21 business day turnaround for completion of the program.

Update on Regulation D

Regulation D is a set of rules under which an issuer may conduct limited offers and sales of securities without having to register the offering with the SEC under the Securities Act. Rule 506 is the most frequently used safe harbor under Regulation D and one of the most important means of raising capital in the US. On July 10, 2013, the SEC adopted important amendments to the Regulation D safe harbor from registration requirements. The amendments, in part: (1) eliminated the prohibition on general solicitation and general advertising for certain offerings under Rule 506; and (2) disqualify offerings from relying on the Rule 506 safe harbor if any felons or other specified “bad actors” are involved in the offering.

The amendment added Rule 506(c), which allows an issuer to use general solicitation in connection with a Rule 506(c) offering, if: (i) all of the purchasers of the securities are accredited investors, as defined in Rule 501 of Regulation D; (ii) the issuer takes reasonable steps to verify that all of the purchasers are accredited investors; and (iii) all of the terms and conditions in Rule 501 (definitions), Rule 502(a) (integration) and Rule 502(d) (limitations on resale) are satisfied. Whether the steps taken to verify the accredited investor status are reasonable is an objective, principles-based determination which should, in part, take into consideration the nature and type of purchaser the accredited investor claims to be, the amount and type of information the issuer has about the purchaser and the nature and terms of the offering. However, the steps taken by an issuer to verify the purchaser’s status will be deemed reasonable if it performs an income test, performs a net worth test, obtains third-party confirmation or sells to an existing Rule 506(b) accredited investor.

Despite the new amendments to Regulation D, it seems that most small to medium-sized companies with previous experience raising capital under Rule 506 are concluding that it is more efficient to raise new funds from existing investors under Rule 506(b) than to use general solicitation to attract new investors and be forced to comply with the accredited investor verification requirements of Rule 506(c). However, early-stage start-up companies without prior experience using Rule 506 are more likely to use Rule 506(c) offerings, which allows expanded reach through the general solicitation provisions. If utilizing Rule 506(c) to raise capital, our firm advises clients to consider implementing a written communication policy specifying the authorized representatives to speak on the issuer’s behalf and include procedures to control and monitor those communications. Companies should also clearly define the scope of the general solicitation communications and the procedures for vetting and approving all communications in advance. Our firm also recommends pre-screening potential investors at an early stage of the offering with simple questionnaires to determine accredited investor status. Issuers should also prepare and utilize a simple bad actor questionnaire to disseminate to all of issuer’s “covered persons” under Rule 506(d).

SEC Enforcement Approach: The “Broken Windows” Strategy

The SEC has previously announced that it intends to pursue a “broken windows” strategy for securities enforcement. In other words, the SEC intends on prosecuting even minor violations of the federal securities laws in order to prevent wrongdoers from engaging in even more egregious conduct. The theory is that when a window is broken and someone fixes it, it is a sign that disorder will not be tolerated. When a broken window is not fixed, it is a signal that no one is either looking or cares, and so an environment of disorder and crime will follow. In particular, the SEC has used this enforcement strategy on Form 3 and Form 4 beneficial ownership reports.

In October of 2014, the SEC commenced 34 cease-and-desist actions against public companies and their insiders, alleging violations under Sections 13 and 16 of the Exchange Act, for failing to timely report information about holdings and transactions in company stock. The SEC also prosecuted a wave of cases brought against firms for short sale violations. Both of these types of violations are considered to be more minor compared to others, as they do not require intent and firms or individuals can be charged even if they inadvertently violated the rules.

The SEC’s motivation behind its new enforcement strategy comes from the desire to restore its public image, which remains tainted ever since the financial meltdown and other high-scale Ponzi schemes. However, some critics believe that the “broken windows” approach is fundamentally flawed. By going after smaller offenses, it artificially inflates the SEC’s enforcement actions and gives the appearance of being tough on bad actors, leaving little or no resources left to go after the large-scale fraud that perpetuated the financial meltdown.

SEC Enforcement Update: Dodd-Frank Whistleblower Actions

On April 1, 2015, the SEC brought its first ever action against an employer for creating a “chilling effect” to the whistleblower process by the language used in the company’s confidentiality agreements. Under Dodd-Frank, the SEC is given the power to reward successful whistleblowers and to go after companies that attempt to stifle them. Previously, the SEC had indicated that it would be looking into companies’ employment agreements that may violate Dodd-Frank’s whistleblower provisions. The confidentiality agreements of KBR, Inc. were the target for a recent enforcement action.

Dodd-Frank prohibits employers from taking measures through confidentiality, employment, severance or other types of agreements that may silence potential whistleblowers before they can reach out to the SEC. While working as a U.S. military contractor, KBR began using confidentiality agreements during its internal investigations run by private investigators. The agreements prohibited employees from discussing any of the particulars of the interviews or the subject matter discussed during the interviews without the prior authorization of the company’s law department. Any unauthorized disclosure of such information would be grounds for disciplinary action. KBR was forced to settle the action for $130,000. However, since this is the first enforcement action of its kind, the next company is not likely to get off with such a small fine. The SEC has effectively put companies on notice that they are serious about what employers say in their employment, confidentiality and severance agreements and that any impediment to the whistleblower process will be strictly enforced.  

Our firm advises clients to review their current employment, severance, confidentiality or other related agreements for similar language and to ensure that the company is not directly or indirectly prohibiting or discouraging employees from reaching out to the SEC or other enforcement agency to report securities violations.

With respect to the Dodd-Frank and the JOBS Act, the SEC has been active with rulemaking but, as indicated above, much more remains to be done to fully implement each act. We will continue to monitor the SEC’s activities with respect to Dodd-Frank, the JOBS Act, enforcement and other securities regulations. To ensure that you are current on recent activities, subscribe to our Corporate and Securities Blog by entering your email address in the sidebar at http://corporate-securities.kmklaw.com/.

KMK Legal Alerts are intended to bring attention to developments in the law and are not intended as legal advice for any particular client or any particular situation.  Please consult with counsel of your choice regarding any specific questions you may have.

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