Exchange

As today’s Daily chart makes clear, the flatline first quarter was actually a tale of two halves. Germany and Austria managed growth in the first three months of the year while most of the rest of the euro area shrank (quite rapidly, in Italy and Greece). What’s really striking to me is the slightly longer view:

Real euro-zone output remains 2% below the level of four years ago. Germanyaeveryone’s favourite growth storyahas only barely managed to regain its pre-recession output level and has scarcely done better than France. Double-dip hardly applies for many euro-area economies; “staircase” recession looks more fitting. And Greece, of course, is in a depression from which exit remains a distant hope.

Given the present outlook, one wonders when the euro zone will finally catch back up to 2008; not this year, certainly. In 2013? Ever? Growth could deliver the euro zone from its crisis, but it has been a long time since the euro zone has been able to deliver growth.

Builder confidence has risen sharply in recent months and, as Calculated Risk points out, that typically presages a surge in construction:

A construction-oriented phase of recovery would be most welcome now given the shaky state of export markets. But any rebound in residential investment will be bounded by the Fed’s tolerance for inflation. Indeed, as Joshua Aizenman and Menzie Chinn argue, housing might have ended its long swoon earlier had the Fed been willing to generateaor at least tolerateaa bit more inflation.

aC/The great moderation, forecast uncertainty, and the great recession (Liberty Street)

aC/Some thoughts on institutional capacity in South-Eastern Europe (Fistful of Euros)

aC/Global value chains, trade, jobs, and environment (Vox)

aC/Labor force nonparticipants: So what are they doing? (macroblog)

WHY is poverty so hard to escape? For entire societies, and at the level of the individual, this must be one of the most basic questions that development economists seek to answer. Esther Duflo, MIT professor and one of the authors of the book aPoor Economicsa is probably the best-known development economist working today. Last week, she reflected on this and other questions about the nature of poverty at a duo of lectures at Harvard University.

In her second lecture, she drew upon the body of research which she pioneered and of which she is the leading practitionerathe careful use of randomised trials to measure the effectiveness of development programmesato propose a mechanism that she argued could help explain why poor people remained trapped in poverty. The idea of such poverty traps has a long and distinguished intellectual heritage, but Ms Dufloas provocative argument was that her research and that of others showed that a profound lack of hopeaand not just capital, credit, skills, or foodacould create and sustain a poverty trap. Her argument in that lecture is the subject of this weekas Free exchange column.

One of the examples of such a hopelessness-based poverty trap came from an anti-poverty programme she and her colleagues evaluated in the Indian state of West Bengal

Bandhan, an Indian microfinance institution, worked with people who lived in extreme penury. They were reckoned to be unable to handle the demands of repaying a loan. Instead,Bandhangave each of them a small productive assetaa cow, a couple of goats or some chickens. It also provided a small stipend to reduce the temptation to eat or sell the asset immediately, as well as weekly training sessions to teach them how to tend to animals and manage their households.Bandhanhoped that there would be a small increase in income from selling the products of the farm animals provided, and that people would become more adept at managing their own finances.

The results were far more dramatic. Well after the financial help and hand-holding had stopped, the families of those who had been randomly chosen for the Bandhanprogramme were eating 15% more, earning 20% more each month and skipping fewer meals than people in a comparison group. They were also saving a lot. The effects were so large and persistent that they could not be attributed to the direct effects of the grants: people could not have sold enough milk, eggs or meat to explain the income gains. Nor were they simply selling the assets (although some did).

So what was going on?

Ms Duflo and her co-authors also found that the beneficiariesa mental health improved dramatically: the programme had cut the rate of depression sharply. She argues that it provided these extremely poor people with the mental space to think about more than just scraping by. As well as finding more work in existing activities, like agricultural labour, they also started exploring new lines of work. Ms Duflo reckons that an absence of hope had helped keep these people in penury; Bandhaninjected a dose of optimism.

A provocative argument, backed up by a number of other interesting pieces of evidence, that you can read about in the piece, here.

aC/What Hollande must tell Germany (Financial Times)

aC/How red tape keeps poor people out of jobs (Modeled Behavior)

aC/The Death Star is not worth it (Wonkblog)

aC/Global economy heading downhill? (Fistful of Euros)

What we have here is a chart of 10-year breakevens over time. It’s derived by subtracting the yield on the 10-year inflation-protected Treasury from the nominal 10-year yield, and it gives up an implied inflation rate. And what I’ve done here is illustrate the Fed’s reactions to big downward moves in expected inflation; the Fed has been an active deflation fighter. You’ll note, however, that in the aftermath of Fed interventions, expected inflation coasts up toward the long-term level, of about 2.3%, then inevitably slides down again.

The explanation for this dynamic, as I see it, is that the market thinks the Fed will push inflation up to 2% but no further, and the Fed has not tried to convince the market otherwise. And so what we observe is a cap on the rate of recovery. Will America get QE3? If inflation looks like falling to 2% and below. But it won’t get a faster pace of employment growth unless the Fed signals that inflation at 3% or more for a year or two would be acceptable.

1. That a full percentage point drop in unemployment would not meaningfully change America’s inflation dynamics, or,
2. That the Fed would tolerate a rate of inflation persistently above its 2% target.

Neither looks right to me. And Mr Lahart’s exercise gives us a nice framework through which to see how the Fed is principally responsible for the level of unemployment.

He includes in his post the attached chart, which shows the path of actual and but-for unemployment. Now, we know from research on persistent large output gaps that at high levels of unemployment, the Phillips curve relationship is quite strong. So we would expect a rise in the unemployment rate from 9.4% to 9.8%, like that observed from June to November of 2010, to have a pretty significant disinflationary impact. And indeed, inflation dropped sharply during this period. And it took that significant drop in inflation to cajole the Fed into introducing QE2. Looking at Mr Lahart’s chart, we see that the bump in unemployment in the but-for line is smaller and occurs at a lower level than in the actual series, in which government job losses proceed apace. In the but-for case, inflation probably would not have fallen as much, and the Fed might have waited longer to intervene or have intervened more gently or not at all. And in the absence of intervention, privatejob growth would very likely have deteriorated more, leading to very little net improvement in unemployment.

In other words, because the Fed appears to be overwhelmingly focused on keeping inflation at or just below 2%, efforts to boost employment on the public side may simply crowd out private employment growth.

We can imagine a similar dynamic playing out last year. By last summer, the gap between the two series grows quite large; where the actual series hovers around 9% for most of the year, the but-for rate sinks to 8.5% and below. At that lower level, the Fed would probably have worried that energy-driven inflation would not quickly subside. It’s much harder to imagine the Fed making the current long-term low-rate commitment. With the end-series plummet to 7.1%, it’s almost impossible to imagine them sticking with it.The result, again, would be greater scope for private job loss, due to less activity in construction, less commercial investment, and less of a contribution to net exports from downward pressure on the dollar. Based on the way the Fed has behaved, it seems probable that less government job loss would translate directly into more private job loss. The unemployment rate could not now be 7.1%, because the economic path to that rate at this moment is inconsistent with the Fed’s primary goals.

Now there is an alternative story. One could argue that the Fed is primarily focused on deflation prevention and is unwilling to pushinflation above 2%, but that if other factors drove and kept it there, it would not immediately act to slow growth. In this story, fiscal stimulus is a critical ingredient in recovery, accomplishing an important task that should fall to the Fed but which the Fed has determined not to complete. I am sceptical of this story. If the recovery continues to chug along, however, we may soon find out which is closer to the mark.

aC/Central banks should do much more (Economists’ Forum)

aC/How polarization cooked Congress’s pork (Prawfsblog)

aC/How economics can save you from pirates (Atlantic)

aC/Google gets license to operate driverless cars (CNN)

And some, I’m somewhat stunned to find out, allege that there is noausterity. Veronique de Rugy posts a chart showing what appears to be just a tiny drop in spending across some euro-zone countries and no drop at all among others (Britain is thrown in, for good measure). Austerity is mostly a myth, she claims, and what austerity there has been has come from tax increases, which don’t count. No less an authority than Tyler Cowen quickly gloms on to the argument.

This is nonsense, as a quick check of the data reveals. The supposed absence of austerity in Ms de Rugy’s figures is mostly a product of poor graph scaling and a reliance on nominal, absolute figures. If we instead turn to data from the International Monetary Fund’s WEO database we see, first and foremost, that budget balances are in the process of improving dramatically:

Progress through last year is quite striking, given that the crisis only began in earnest in 2010. It has occurred despite truly pitiful growth (and ongoing recession in Greece). And there is more to come.

But what of the complaint that this is all due to tax increases, which don’t count, for some reason? That, too, is mistaken:

The spending cuts are there, in spades. Of course, the importance of spending cuts in episodes of austerity derives from the view that they are more likely to “stick” than tax rises, and that they are critical in generating “expansionary austerity”. But this is no iron law of fiscal consolidation. Rather, as a recent IMF paper pointed out, it is due to the fact that central banks are more likely to accommodate spending cuts with aggressive easing than they are tax rises.

The austerity is there. If it isn’t working out as many expected, that’s either because what they expected was unreasonable, or because the central bank isn’t doing its part.

aC/The frequent fliers who flew too much (Los Angeles Times)

aC/Invisible hand, greased palm (New Yorker)

aC/Central bank reserve creation (Vox)

aC/On labor force participation (Mike Konczal)

While it has fluctuated considerably, the labour force is only slightly larger now than in December, 2007, when the recession began. Yet in January, 2008, the Congressional Budget Office reckoned it would be some 5m larger by now, or 159.5m (see chart). What happened to those 5m people? Why aren’t they showing up as unemployed? Some are discouraged workers or other people who want to work but arenat counted as unemployed; but I reckon they account for only one third of the missing 5m.

So what about the others? Is it early retirement? Disability? Returning to school? Illegal immigrants returning home (or failing to enter the country in the first place)? Or were they never there to start with – the labour force simply isn’t growing as quickly as we thought it should, for demographic or other reasons? Whichever it is, it is a troubling sign that our economic potential could be a lot lower than we thought just a few years ago. And that’s the real bad news from todayas report.

I’m going to disagree. The real bad news in Friday’s jobs report is that the conversation has once again focused on the possibility of a decline in potential. The real danger is that policymakers will conclude that this is right and give up on countercyclical policy as a result, when in fact most of the seemingly structural deterioration in the labour market is entirely fixable.

I don’t disagree that structural unemployment can become a problem, but there is little evidence that it is developing in America. What structural employment there is is mostly of the “cyclical structural” sort; it’s associated with underwater homes and unemployment insurance, which will become less of a drag as recovery continues. I don’t disagree that hysteresis is a riskathat over time skills and labour-force attachment will erode, making it harder than ever to get the unemployed back into gainful employment. For the moment, at least, I think that these problems are less dire than they look in the American context. The labour force is growing; it’s up about 1.3m since hitting a bottom in 2010. And consider this chart, which shows the annual change in employment (red) and the labour force (blue):

Several things stand out. One is a long-run downward trend. That’s associated, first, with the end of the great female surge into employment and, second, with the aging of the population. The CBO’s labour-force projections include a downshift due to aging that was forecast to intensify from the late 2000s on.

Next, however, we notice that labour-force growth is cyclical. The slowdown in growth from the late 1970s to the early 1980s, which corresponds to the last recesssion responsible for a period of double-digit unemployment, was actually a bit larger than what has been observed this time around. In thinking about what the CBO missed in its 2008 projection, the answer is pretty clear: a deep recession. It’s not at all clear that the recent decline is permanent, however. Brad Delong muses:

A straight-line extrapolation from the 2000 through the 2007 business-cycle peaks says that “natural” labor-force participation today is 66.8% of the adult population. Bumping that up by 0.2% points because comparing the 2000 to 2007 peak overstates the demographic decline and bumping it up a further 0.2% points for decreased desired early retirement as a consequence of the vanishing of $8 trillion in home equity values would give us a current “natural” labor-force participation rate of 67.2%. But let’s take 66.8%-67.2% as our range.

Actual labor-force participation is lower in depressed times than its natural rate: People drop out of the labor force when they think they cannot find jobs. Since World War II, labor-force participation has fallen about 1/3 as much relative to trend as the employment-to-population ratio has fallen relative to trend. Given the current state of the employment-to-population ratio, we would predict that the current labor-force participation rate would be 1.5% points below its natural rate. That gives us a predicted labor-force participation rate today of 64.3%-64.7%. Instead, our labor-force participation rate is 63.6%.

That is a gap of 0.7%-1.1% points of the adult population: people who really ought to be in the labor force right now, but who are not. Are they now part of the “structurally” non-employed who we will never see back at work, barring a high-pressure economy of a kind we see at most once in a generation? Probably.

That’s disturbing, of course, but it immediately scales down the size of the problem. The gap is not 5m, as a look at the CBO’s projections might lead one to assume, but more like 1m-2m. Not coincidentally, the number of Americans on disability insuranceawhich has come to function as a sort of loose, but more permanent form of unemployment insuranceais up 1.6m from 2007. That, I think, it quite close to the full extent of the long-term unemployment problem. Again, that’s a problem, but it’s not a catastrophe. Most of the employment gap is susceptible to faster growth. Many of those now on unemployment insurance would have soon left the labour force anyway through retirement. Others could be brought back through a combination of disability-insurance reform and a tight labour market.

What about that tight labour market? On Friday, I tweeted that there was no structural unemployment in America that couldn’t be eliminated in a late 1990s-style labour market. This prompted a wave a responses from individuals arguing that if America has to count on a once-in-a-lifetime internet boom for such growth, then it rightly should be called structural. This, however, confuses the macro with the micro. There were a number of microeconomic trends underway, including the first stirrings of the internet economy, that made the late 1990s a prosperous era. What made the period a job-richtime was accommodative Fed policy; nominal GDP growth averaged well above 6% from 1997 to 2000. After falling about 2.5% in 2009, by contrast, it rose just over 4% in 2010 and just below 4% in 2011. That’s below trend at a time in which the economy ought to be catching upto where it previously was.

The Fed allowed such rapid growth in the late 1990s because unusual macro circumstances at the time placed substantial downward pressure on broad prices: oil was dirt cheap, a strong dollar was reducing import costs, and China was a net disinflationary force at the timeaits cheap products dominated its impact on commodity prices. Core prices hung just a shade over 2% for much of the period. In the absence of those disinflationary forces, a rate of nominal GDP over 6% would probably correspond to a higher inflation rate. And since the Fed seems to have, if anything, become moreintent on maintaining a strict 2% limit on inflation, it has been unwilling to do more, leading to disappointing nominal (and real) GDP growth, and correspondingly disappointing employment and labour-force growth.

So let’s be clear; the primary evidence for permanent loss of potential is the slow recovery in the size of the labour force, which would appear to be largely due to cyclical variation. We are notseeing a surge in labour costs, or prices generally, indicating that the economy is actually running up against capacity constraints. The Fed could have taken the approach that it would seek above-trend growth, as one normally expects to see after a recession (especially a deep one), and then step on the brakes if it became apparent that potential had been lost, that real growth was falling consistently short of trend while inflation was accelerating. That would have made a lot of sense, given the real economic costs of prolonged high unemployment.

That’s not what the Fed has done. Instead, it’s been happy to accept at- or below-trend growth, despite the fact that the large remaining output gap has quickly translated shocks into worrisome disinflationary pressure. Now the public is increasingly willing to read Fed failure as a loss of potential. If the Fed comes to agree, it may begin to fear that it has less room to boost the economy, it may consequently boost the economy less, and it may therefore ensure that the output gap persists until it does indeed become permanent.

This is self-induced paralysis: the fear that trying to do things to fix current problems will generate consequences worse than the present problems, all evidence to the contrary. It’s frustratingagalling, evenathough I suppose at this point we shouldn’t find it surprising.

One last point: a country to which tens of millions of people around the worldaincluding highly skilled, ambitious, educated workersawould gladly move is one that never has to worry about slowing labour force growth. If we’re going to diagnose America’s ills, let’s diagnose them correctly.

But Ken [Rogoff] is basically buying into the German-preferred frame that it’s all about fiscal irresponsibility, which is completely wrong for everyone [except Greece] — above all for Spain, the heart of the crisis. … It’s really frustrating that a completely, demonstrably false narrative about the crisis continues to dominate the discourse.

Interestingly, economists from the periphery are more critical. Here is Irish economist Philip Lane and his conclusion in a paper (together with AgustAn BA(c)nA(c)trix) entitled “Fiscal Cyclicality and EMU”:

This paper has empirically examined the cyclical patterns in fiscal policy over 1980 to 2007 for the set of EMU member countries. …[T]he clear deterioration in the cyclical conduct of fiscal policy after the creation of EMU is reflective of the weaker incentives to maintain fiscal discipline once inside the monetary union. In relation to the financial cycle, the additional infl uence of both credit growth and net capital flows on fiscal outcomes supports the case for taking a broad view of the cyclical conduct of fi scal policy and underlines the difficulties in assessing the true structural fiscal position at any point in time.

In overall terms, insufficiently-countercyclical fiscal patterns during the pre-crisis years (the failure to run sufficiently-large surpluses) was surely a contributory factor to the subsequent crisis … In relation to the current reforms of European economic and fiscal governance, one key message is that improving the cyclical conduct of fiscal policy for EMU member countries is an important policy objective … In addition, there is a clear linkage between the monitoring of excessive imbalances and fiscal surveillance, in view of the sensitivity of the fiscal cycle to the financial cycle.

This is not to say that the German narrative is correct, of course: fiscal policy is just one of many factors. And it certainly is not correct that austerity is helpful now. But austerity isn’t the answer right now precisely because in a monetary union, each country has to run its own (non-monetary) stabilisation policy. Besides policy tools like regulation, this does include fiscal policy: in downturns, countries have to run appropriately large fiscal deficits; during booms, however, countries need to run massive surplusesaespecially if the boom in question, like those in Ireland and Spain, is built on real estate, banking and capital inflows (what Mr Lane calls the “financial cycle”). Such financial boom periods affect fiscal revenues temporarily, and are likely to go into reverse gear once the boom ends:

[A]sset price booms do not only raise revenues from asset-related taxes but also lead to generalised revenue growth, due to the wealth effect of increasing asset values on consumption. … [A] current account deficit should improve revenues from indirect taxes, since net capital in flows finance a higher level of domestic absorption …

Credit growth affects revenues through several channels. First, the positive impact of credit growth on domestic asset and property prices improves revenues through the direct and indirect channels … Second, credit growth may fuel a greater volume of asset market turnover, which raises revenues from transactions taxes. Third, if credit growth is associated with a shift in the composition of production towards the construction sector and other nontradables, this may alter the composition of the tax base to the extent sectors differ in the distribution of income between wages and profi ts and in composition of spending between taxable domestic spending and non-taxed exports. Fourth, credit growth may be associated with infl ation and/or real exchange rate appreciation (an increase in the relative price of nontradables) and thereby raise revenues, since tax systems are not fully infl ation-indexed.

What would have happened, had Spain and Ireland run appropriate surpluses? Matthew O’Brien is sceptical that it would have made much of a difference. Olivier Blanchard is somewhat cautious, too, albeit regarding the effect of fiscal policy on the current account, not the business cycle. I am more optimistic, especially if we include other regulatory tools aimed at real estate and banking. Mr Lane further argues that it would have increased the fiscal room available during the crisis, too. But it seems hard to make a macroeconomically convincing case that Spanish and Irish fiscal policy before this crisis was appropriateadespite the surpluses.

The insight that the fiscal policy stance in the periphery prior to this crisis was insufficiently countercyclical also allows for a more convincing argument against the German emphasis on austerity: if they criticise the periphery’s fiscal policy before the crisis on macroeconomic grounds, they should be in favour of more fiscal stimulus and less austerity now.

Let me explain. The sharp deceleration in employment growth in the last two months probably does not point to a sudden slowing in economic growth but rather tells us that the more brisk pace of growth earlier this year was unsustainable because much of it was due to warm weather. A useful gauge is the number of people not working because of weather. Morgan Stanley says this tally was unusually low during the winter, but in April it returned to normal levels. This suggests the weather payback effect is largely over.

A second factor technical factor is that there were only four weeks between the March and April periods during which the Bureau of Labour Statistics counted the number of jobs, which often reduces the measured total of new jobs created. And finally, while the decline in employment as measured by the household survey was troubling, it does not portend weakness ahead; household employment has run well ahead of payroll employment in the last 12 months and some retracement was in store.

Now for the bad news. The fact that things were never so great simply reinforces the picture of underlying sluggishness. True, the slide in the unemployment rate a a full percentage point since September a owes mostly to rising employment (as measured by the household survey). But the decline in unemployment has been helped by the failure of the labour force to grow more quickly. After growing for several months, it shrank in April. While it has fluctuated considerably, the labour force is only slightly larger now than in December, 2007, when the recession began. Yet in January, 2008, the Congressional Budget Office reckoned it would be some 5m larger by now, or 159.5m (see chart). What happened to those 5m people? Why aren’t they showing up as unemployed? Some are discouraged workers or other people who want to work but arenat counted as unemployed; but I reckon they account for only one third of the missing 5m.

So what about the others? Is it early retirement? Disability? Returning to school? Illegal immigrants returning home (or failing to enter the country in the first place)? Or were they never there to start with – the labour force simply isn’t growing as quickly as we thought it should, for demographic or other reasons? Whichever it is, it is a troubling sign that our economic potential could be a lot lower than we thought just a few years ago. And that’s the real bad news from todayas report.

But the models used to arrive at that conclusion rely on some often strict and unrealistic assumptions (as even the modelers responsible for them have been known to acknowledge). And some economists are experimenting with new models that develop a different role for taxes on capital, as this week’s Free exchange column explains:

In a new NBER working paper, Thomas Piketty of the Paris School of Economics and Emmanuel Saez of the University of California at Berkeley poke different holes in the conventional view. The old models, they point out, ignore inheritances. In the real world inheritances strongly influence income levels, particularly among the very rich. Mr Romney recently reinforced this very point by exhorting students to borrow from parents if necessary. Taxes on wages and salaries are inadequate to the task of limiting inequality because they punish those who owe high incomes to greater ability and effort, rather than to inheritances. Messrs Piketty and Saez also question the scale of the threat to growth. They point to ratios of capital to output, which are surprisingly stable over time despite tax swings. Their model finds that the optimal tax rate on inheritance could be 50-60% or more.

Inheritance taxes are a minor source of government money, accounting for less than one percentage point of the 8-9% of GDP in revenues that Messrs Piketty and Saez estimate is raised by capital taxes. But taxing capital gains or corporate income, which is responsible for much of the rest, is also justifiable, they say. The often-fuzzy line between income from capital and labour means a large gap in relative tax rates breeds tax avoidance. When wage taxes are high and capital taxes are low, firms simply shift compensation from salaries to stock options and dividends, cutting revenue without boosting growth. All told, capital-tax rates as high or higher than those on labour may make sense, they think.

Of course, the higher rates on capital income aren’t necessarily the place to start when looking for new revenueanot when the American tax system is so shot through with inefficient loopholes. And setting questions of efficiency aside, high rates of capital-income taxation will still strike many as a bad idea thanks to the threat of tax competition. In the absence of coordination across countries, footloose companies can simply go shopping for the tax regime they find most attractive.

Background

While courts have long recognized a private right of action for securities fraud under Section 10(b) of the Exchange Act, the Supreme Court held in Morrison that Section 10(b) does not apply to the purchase or sale of non-U.S.-listed securities outside the United States. Prior to Morrison, federal courts applied Section 10(b) to transnational securities fraud if a sufficient level of conduct occurred in the United States (the “conduct test”) or conduct occurring outside the United States had a foreseeable and substantial effect within the Untied States (the “effects test”). In Morrison, the Supreme Court rejected these tests in favor of a “transactional test,” which limited Section 10(b) to fraud in connection with the purchase or sale of a security listed on a U.S. exchange and the purchase or sale of any other security in the United States.

In response to Morrison, Congress added Section 929P(b) to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), which restored the conduct and effects tests for civil and criminal actions brought by the SEC and the Department of Justice (“DOJ”), respectively. With respect to private rights of action, however, Section 929Y of the Dodd-Frank Act required the SEC to solicit public comment and conduct a study to determine the extent to which the conduct and effects tests should apply in such cases.

The Study

The study outlines three legislative options for applying the conduct and effects tests to private rights of action for transnational securities fraud. The first is to apply the SEC and DOJ versions of the tests, which (according to the study) “would involve policy trade-offs that could carry significant implications” for investor protection and international comity — a principle of customary international law that recognizes the validity of foreign law.

An alternative approach (and one that the SEC advocated in Morrison) is to narrow the conduct test by imposing a “direct injury requirement,” which would require the plaintiff to show that the injury resulted directly from conduct within the United States. A disadvantage of this approach is that it could pose challenges for international comity because it would allow “foreign investors [to] receive remedies that their governments have determined not to provide . . . .” A second alternative is to limit the conduct and effects tests to U.S. investors, though this would permit “application of Section 10(b) to securities transactions that occur on foreign securities exchanges, which a number of foreign governmental authorities have opposed.”

The study also outlines four options for supplementing and clarifying the transactional test adopted by the Supreme Court in Morrison. The first option is to allow private actions for the purchase or sale of any security that is of the same class of securities registered in the United States. This would provide a bright-line standard based on U.S. registration, but could have the unintended consequence of discouraging foreign issuers from registering in the United States.

A second option is to allow private actions against securities intermediaries (e.g., broker-dealers and investment advisors) that engage in securities fraud while purchasing or selling securities overseas for U.S. investors. District courts interpreting the transactional test under Morrison have held that Section 10(b) no longer applies to such transactions, even in cases where the securities intermediary resided in and engaged in fraudulent conduct in the U.S. or traveled to the U.S. frequently to meet with the U.S. investor.

A third option is to allow private actions for investors who can demonstrate that they were induced to engage in the transaction while in the United States. According to the study, such a “fraud in the inducement” test would not raise international comity concerns because it would require a showing of actual reliance and would therefore preclude use of the “fraud on the market” theory, which “has been a source of criticism from foreign government authorities when it is applied to transnational securities frauds involving overseas transactions.”

A fourth option is to allow private actions if either party to the transaction made or accepted the offer to sell or purchase the securities while in the United States. This would further Morrison’s goal of establishing a bright-line standard for liability by clarifying when an off-exchange transaction takes place.

Criticism

Apart from noting in passing that the SEC “has not altered its view in support of” the direct injury requirement, the study offers little in terms of specific recommendations. In a sharply worded dissenting statement, SEC Commissioner Luis Aguilar argued that the study “fails to satisfactorily answer the Congressional request, contains no specific recommendations, and does not portray a complete picture of the immense and irreparable investor harm that has resulted” from Morrison.

Although the study identifies a number of policy considerations that Congress may consider in determining whether to enact legislation extending the transnational scope of private actions under Section 10(b), the reluctance of the SEC staff to provide explicit recommendations renders the immediate impact of the study unclear. As noted in the study, “a final option would be for Congress to take no action” at all, in which case lower federal courts would continue to interpret and refine the transactional test under Morrison.

For further information, please contact John Stigi at (310) 228-3717 or Dan Brooks at (202) 469-4916.

The provisions of the JOBS Act represent a watershed change to the laws and regulations governing capital raising for private companies. Some of the provisions – such as the “IPO on-ramp” provisions and the increase in the number of holders triggering mandatory registration and public reporting under the Securities Exchange Act of 1934, are effective immediately. Others, including the new crowdfunding exemption, the removal of the ban on general solicitation for offerings under Rule 506 to accredited investors and Rule 144A to QIBs, and the new exemption modeled on Regulation A, will require SEC rulemaking before they come into force.

We have previously blogged about the original House version of the Act and the changes the Senate adopted, which changes were enacted into law. This article discusses the full Act as enacted.

Background

The U.S. House of Representatives passed the Act (H.R. 3606) on March 8, 2012 by a vote of 390-23. Despite opposition from SEC Chairman Mary Schapiro and many organizations, the Senate bypassed its normal committee process and passed the JOBS Act, with a substantially revised section on crowdfunding, on March 22, 2012. The Senate vote was 73-26. On March 26, 2012, the House passed the Senate version of the bill by a vote of 380-41. As noted above, President Obama signed the Act into law on April 5, 2012.

Overview

The JOBS Act is organized in Titles. The major titles are summarized below

Title I – IPO on-ramp provisions

• New category of issuer: emerging growth company (EGC)
• Allows EGCs to file registration statement confidentially and “test the waters” with large institutional investors
• Eliminates most restrictions on research publications
• Reduces financial reporting and executive compensation disclosure obligations for EGCs 

Implemenation: Effective immediately

Title II – Relief from ban on general solicitation

• Removal of ban on general solicitation for Rule 506 offerings provided all purchasers are accredited
• Removal of ban on general solicitation for Rule 144A offerings provided all purchasers are reasonably believed to be QIBs

Implementation: Exemption from broker-dealer registration for operation of a general solicitation portal (subject to conditions) SEC directed to revise Regulation D rules within 90 days; broker-dealer registration provisions effective immediately.

Title III – Crowdfunding

• Crowdfunding exemption through funding portals for offerings up to $1 million  

Implementation: SEC directed to issue rules within 270 days.

Title IV – New “mini-public offering exemption

• New exemption for private offerings up to $50 million, modeled on Regulation A

Implementation: SEC directed to issue rules to create exemption. No deadline set.

Titles V and VI – Relaxation of mandatory Exchange Act registration standard for record holders

• Increases number of record holders triggering mandatory registration to 2,000, no more than 500 of which may be unaccredited
• Excludes holders of employee benefit plan securities
• Increases thresholds for bank holding companies

Implementation: Effective immediately.

What are the IPO on-ramp provisions?

The JOBS Act creates a new category of issuer — an emerging growth company, or EGC. An EGC is a company that has had its first registered sale of securities within its five prior fiscal years and has total annual gross revenues of less than $1 billion (subject to inflationary adjustment by the SEC every five years) and less than $700 million in publicly traded shares. Issuers that had their first registered sale of securities on or before December 8, 2011 are not eligible to be an EGC.

The JOBS Act provides the following relief from disclosure, compliance and governance obligations for EGCs:

• Registration statements can be submitted confidentially to the SEC and need not be publicly available until 21 days prior to the first road show. The SEC has indicated it will shortly publish guidelines for confidential submission. Note that if an offering is going to proceed to a road show, the initial confidential filings will still become public, which will allow public comparisons between the initial filed documents and later filed documents.
• Publication of research about an EGC by a broker-dealer is not considered an offer of securities, even if the broker-dealer is participating in the IPO. Broker-dealers have been restricted from publishing research reports during a “quiet period” following an IPO, and that quiet period will no longer apply to EGCs.
• SEC and stock exchange rules limiting communications by analysts with companies and potential IPO investors must be repealed.
• “Testing the waters” communications between companies and qualified institutional buyers (QIBs) are permitted at any time during the IPO process.
• The IPO registration statement need only include audited financial statements (and corresponding management discussion and analysis) for the two prior fiscal years rather than the three prior fiscal years required for companies other than smaller reporting companies, and subsequent reports under the Exchange Act need not include years earlier than those required in the IPO registration statement.
• Exchange Act reports and registration statements after the IPO registration statement will require summary financial information only for the periods starting with the earliest year of audited financial statements presented in the IPO registration statement[1]. Until now, such information has been required for the five prior fiscal years.
• Say-on-pay and say-on-golden-parachute votes are not required during the period that the company qualifies as an EGC. Smaller reporting companies are currently exempt from these votes until 2013.
• EGCs may use the scaled executive compensation disclosures currently permitted for smaller reporting companies. They may therefore include compensation information for fewer executive officers, omit the Compensation Discussion & Analysis (CD&A) and omit some of the compensation tables, including the burdensome table of Golden Parachute Compensation.
• Compliance with the auditor attestation requirement of Section 404(b) of the Sarbanes-Oxley Act is not required for the period that a company remains an EGC. This extends the relief from attestation from the current two years post-IPO to up to five years. EGCs are still required to maintain adequate internal control over financial reporting and to report the assessment of their principal executive officer and principal financial officer as to the effectiveness of such internal control.
• EGCs may pick and choose (opt-in) amongst the scaled disclosure provisions.
• Compliance with new accounting standards is not required until such standards apply to companies that are not subject to Exchange Act reporting.
• The SEC is ordered to conduct a study of the effect of decimal quoting of securities on IPOs and liquidity for smaller companies and report to Congress within 90 days.
• The SEC is ordered to conduct a review of Regulation S-K to “determine how such requirements can be updated to modernize and simplify the registration process and reduce the costs and other burdens associated with these requirements for issuers who are emerging growth companies,” and then report its findings to Congress 180 days after enactment.

What will the IPO on-ramp provisions mean to companies considering going public and the market new offerings?

The IPO market is characterized not only by legal requirements but also market realities and long-standing customs. Markets can change rapidly and unpredictably. Customs are typically slow to change in response to relaxation of legal requirements. It is not clear at this point what effect the relaxation of these rules will have an companies proposing to go public via a traditional IPO. Some of the uncertainties include:

• Will confidential filing increase the willingness of companies to file for an IPO in more uncertain market conditions?
• Will confidential filing affect the timing for clearance of SEC comments?
• Will companies eschew confidential filings because of the loss of public exposure that can lead to acquisition offers (the “dual track”)?
• Will broker-dealers involved in an IPO be comfortable publishing research close in time to an IPO? Will investors consider those reports to be credible?
• How will the test the waters provisions interface with the confidential filing provisions?
• What controls will issuers and underwriters develop to protect themselves from liability that might be associated with test the waters communications?
• Will the market be comfortable with only two years of audited financial statements and no unaudited financial data for prior years?
• Will the market be comfortable with the scaled executive compensation disclosures?
• Will the relaxation of these rules meaningfully reduce the costs and risks of going public?
• Will the elimination of the “ethical wall” between investment bankers and analysts, and possible future changes to decimalization quotation of securities, encourage boutique investment banks to re-enter the IPO business?
• Will the market accept public offerings from smaller and/or earlier stage issuers, which tend to have a higher risk profile?

What is the elimination of the prohibition on general solicitation?

Currently, a company wishing to raise capital through the exemption from registration provided in Rule 506 of Regulation D cannot offer its securities by any form of general solicitation or advertising. The prohibition on general solicitation requires investors to be recruited based on pre-existing relationships with the issuer or an agent of the issuer that creates a reasonable basis to believe that a person would be interested in an investment of the type offered. This rule has represented the fundamental divide between registered public offerings, such as IPOs, and exempt offerings, commonly known as private placements.

The JOBS Act requires the SEC, within 90 days of enactment, to remove the prohibition on general solicitation in Rule 506 private placements provided that all the investors are accredited. The JOBS Act directs the SEC to adopt regulations to require the issuer to take reasonable steps to verify that the purchasers in Rule 506 private placements are accredited. The reform applies only to offerings under Rule 506 and does not directly affect offerings under other exemptions afforded by Regulation D or Section 4(2) of the Securities Act of 1933.

Rule 506 offerings are exempt from state blue sky qualification requirements under the National Securities Markets Improvement Act of 1996 (NSMIA), so the general solicitation that is permitted by the JOBS Act cannot be restricted by states.

In addition, the JOBS Act directs the SEC, within 90 days of enactment, to amend Rule 144A to permit general solicitations of securities sold under Rule 144A that reach investors who are reasonably believed to be QIBs.

What types of exchanges are non-broker-dealers permitted to operate for the sale of Rule 506 securities?

The JOBS Act creates an exception to broker-dealer registration rules, effective immediately, for operating a platform or mechanism to offer, sell and purchase securities sold under Rule 506 and for providing certain ancillary services associated with such securities. The permitted ancillary services are due diligence services and providing standardized transaction documents. The exception applies to online and other types of exchanges.

This exception applies only if the operator and associated persons receive no compensation in connection with the purchase or sale of securities, do not take possession of customer funds and have not been subject to a “bad boy” disqualification from a self-regulatory organization such as FINRA.

What will the elimination of the prohibition on general solicitation and requirements for broker-dealer registration for Rule 506 portals mean?

As noted above, the prohibition on general solicitation has been the fundamental divide between public and private offerings. There will remain important differences between public offerings and private placements, but the line of contrast will be significantly blurrier.

Public offerings generally have significantly greater investor protection mechanisms, including SEC review, involvement of at least one (and usually many) underwriter intermediaries, due diligence performed by both the issuer’s and the underwriters’ legal counsel, audited financial statements, and strict liability under the securities laws for issuers, and, subject to a due diligence defense, for underwriters and directors.

These investor protection mechanisms are in part responsible for the high costs of IPOs – a problem the JOBS Act has tried to address. The JOBS Act will therefore allow companies that have raised money under Rule 506 (i.e., most funded emerging growth companies) to greatly expand the audience of potential investors. That may make it easier for such companies to raise capital, particularly those whose business is interesting to the public at large. That may also make it more practical for emerging growth companies to accept smaller investments from accredited investors, which may incentivize more people to invest. However, it remains to be seen whether accredited investors recruited via general solicitation will be willing to invest, on the whole, substantial sums in riskier companies that are, for the most part, issuing illiquid securities[2]. If investors have an appetite for these securities, early stage companies will benefit greatly from this provision of the JOBS Act.

The JOBS Act requires the SEC rules to address verification of the accredited status of investors who are generally solicited. It is not clear how burdensome those rules will be or what will be the consequences if issuers fail to observe all of the requirements or if investors lie about their status and the lie is not detected. We note that the JOBS Act language relating to Regulation D, Rule 506 requires investors “are accredited,” whereas the corresponding language for general solicitation of Rule 144A offerings requires only that the issuer “reasonably believe” that the investors are QIBs. The rules the SEC adopts here may become important to the practical utility of general solicitation in Regulation D offerings.

Sophisticated angel investors and venture capital funds usually negotiate for certain control rights in connection with their investments. It is unclear what types of investor control mechanisms might occur in private placements solicited generally or what effect those might have on issuers or investors.

There are a number of potential downsides to the elimination of the prohibition on general solicitation and the opening of portals to firms that are not broker-dealers.

All other things equal, companies that have been through a “capital markets scrub” (i.e., the due diligence performed by multiple intermediaries in the IPO process) are less risky than ones that have not. Moreover, the manner of soliciting public offerings is significantly restricted in the securities laws, whereas the means of general solicitation for Rule 506 offerings under the JOBS Act are unrestricted. Absent SEC rules that restrict the manner of general solicitation (which the SEC might not be able to adopt or enforce) or further lawmaking, telemarketing, infomercials and other practices historically associated with extreme investor risk and fraud. Communities of persons who are more likely to be accredited but not necessarily sophisticated investors, like retirees, would seem particularly vulnerable.

FINRA has recently been enforcing rules it believes require broker-dealers to conduct extensive due diligence in private placement transactions. These FINRA positions may help eliminate some of the abuses many fear from the JOBS Act to the extent broker-dealers are involved in private transactions. However, Title II of the JOBS Act expressly allows portals for the general solicitation of Rule 506 offerings to be operated by firms that are not registered broker-dealers. The JOBS Act imposes no due diligence requirements on these firms (compare to the requirements for funding portals for crowdfunding offerings, discussed below).

It is not clear that the change to Regulation D, Rule 506 required by the JOBS Act will change many SEC rules and interpretations that might limit general solicitations. These include rules and interpretations intended to ensure that offerings started as private finish as private and offerings started as public finish as public.

All of this means that on one hand, some and possibly many emerging growth companies will find it easier to raise capital from accredited investors, while on the other hand the public will likely receive many more and varied solicitations for investment opportunities that are riskier and more susceptible to fraud than has been the case for many decades.

What is crowdfunding, and what activities does the JOBS Act permit?

Crowdfunding is a form of capital raising where groups of people pool money and other resources to achieve a goal, including to fund a small business. As a result of the prohibition on general solicitation and the prior requirement for companies to register under the Exchange Act if they have over 500 holders of a class of equity securities and over $10 million of assets, crowdfunding in the U.S. through websites and social networks has generally been limited to activities where the investor does not receive securities in exchange for its final contribution.

The JOBS Act establishes the new crowdfunding exemption, which is designated as Section 4(6) of the Securities Act, with the following parameters:

• The aggregate proceeds from all investments in the issuer, including amounts sold under the crowdfunding exemption during the preceding 12 months, must be less than $1,000,000.
• The aggregate amount invested by any investor in all issuers pursuant to the crowdfunding exemption must not exceed a limit determined on a sliding scale based on net worth or annual income. The limit is 5% of net worth or annual income that is less than $100,000 (or $2,000, if greater than the 5% calculation), and 10% of net worth or annual income that is $100,000 or more. No investor may invest more than $100,000 in an issuer pursuant to the crowdfunding exemption. Income and net worth are to be calculated in the same fashion as the tests for accredited investors. Accordingly, equity in a principal residence is excluded from net worth.
• The transaction must be conducted through an intermediary that is either a registered broker-dealer or “funding portal.”
• Funding portals are not required to register as broker-dealers, but are subject to SEC registration and must be members of a national securities association, such as FINRA.
• The intermediary must provide disclosures, including disclosures related to risks and other investor education materials (as determined by SEC rules).
• The intermediary must ensure that investors review investor-education information (as determined by SEC rules).
• The intermediary must ensure that investors answer questions demonstrating that they understand the risks of investing in startups, including the risk of loss of the entire investment, and that each investor can afford such loss.
• The intermediary must provide the disclosures to the SEC and to investors at least 21 days prior to accepting any investments.
• The intermediary must take fraud-prevention measures to be determined by SEC rules, including background checks of officers, directors and 20% holders.
• The intermediary must ensure that proceeds are not released to issuers until a set target amount is reached and must allow investors to withdraw their commitment in accordance with SEC rules.
• The intermediary must take steps to be determined by SEC rules to ensure that each investor has not exceeded its crowdfunding limit in a 12-month period, which as noted above applies to all investments in all issuers under the crowdfunding exemption.
• The intermediary must take steps to ensure the privacy of information collected from investors in accordance with SEC rules.
• Intermediaries cannot pay finders fees.
• Directors, officers and partners of the intermediary may not have a financial interest in the issuer.
• The issuer must make the following mandatory disclosures to the SEC, the intermediary and investors:
  • identifying information about the issuer, including its website
  • the names of officers, directors and 20% shareholders
  • a description of the business and the anticipated business plan
  • a description of the financial condition of the issuer, with scaled requirements depending on the target amount of the offering.
    • For offerings of $100,000 or less, the income tax return for the last completed year and financial statements certified by the principal executive officer to be true and correct
    • For offerings of $100,000 to $499,999, financial statements reviewed by an independent public accountant
    • For offerings over $500,000, financial statements audited by an independent public accountant
  • the intended use of proceeds
  • the target offering amount, the deadline to meet the target offering amount, and regular updates regarding the progress of the issuer toward the target
  • the price or the method of determining the price, and if the price is not fixed, a reasonable opportunity for the investor to rescind its commitment once the price is determined
  • detailed information about the capital structure of the issuer, the securities being offered and the risks associated with those securities
  • how the securities being offered are being valued, and how they might be valued in the future in connection with a corporate transaction
• The issuer may not advertise the terms of the offering except for notices which direct investors to the intermediary.
• The issuer may not compensate finders except in accordance with SEC rules that will ensure the recipient clearly discloses such compensation.
• The issuer must file annual reports of results of operations and financial statements with the SEC and provide to investors, in accordance with SEC rules.
• No resales are permitted for one year except to the issuer, an accredited investor, a member of the investor’s family or pursuant to a registered offering.
• The exemption is available only for U.S. issuers that are not investment companies and are not subject to periodic reporting under the Exchange Act.
• The issuer and its directors, partners, principal executive officer, principal financial officers and controller/principal accounting officer will be liable to investors for any material omissions or misstatements unless they can sustain the burden of proof that they did not know, and in the exercise of reasonable care, could not have known, of such untruth or omission.

It appears that securities sold under the crowdfunding exemption will be “restricted securities” and will therefore subject to Rule 144 restrictions for public resales. It appears that the one-year restriction on resale described above applies to private as well as public resales.

Investors who purchase securities in transactions under the crowdfunding exemption do not count against the holders of record test that triggers reporting obligations for companies under Section 12(g) of the Exchange Act. Moreover, offerings under the crowdfunding exemption pre-empt state blue-sky qualification laws (though the SEC must make information available to the states to facilitate state enforcement of anti-fraud laws). States may require notice filings, but only a state in which purchasers of an aggregate of 50% or more of the securities being offered reside may charge a fee in connection with such notice. States also may not regulate funding portals except for enforcement of anti-fraud laws.

Within 270 days after the enactment of the JOBS Act, the SEC is required to adopt rules for the crowdfunding exemption, including rules disqualifying “bad boys” from using the exemption.

Will crowdfunding be a viable means for emerging growth companies to raise capital?

The crowdfunding exemption ultimately passed into law is more restrictive in many ways than existing Rule 504 under Regulation D. Rule 504 permits an issuer to raise up to $1 million during a 12-month period with no mandatory disclosures, no investor qualifications and no limits on individual investments. Rule 504 also has no limits on general solicitation and does not restrict resales so long as the offer is qualified in at least one state. Offerings under Rule 504 are not pre-empted from state regulation.

The crowdfunding exemption in the JOBS Act appears more restrictive than Rule 504 in every respect except:

• the $1,000,000 limit in the crowdfunding exemption may not be subject to integration with future offerings, whereas the Rule 504 limit is subject to integration with future offerings;
• Rule 504 offerings are subject to state regulation, so offerings need to be qualified or determined to be exempt in each state in which the offering will occur; and
• shareholders who purchase securities under Rule 504 are included in the count of record holders for mandatory Exchange Act registration.

In our experience, few emerging growth companies use Rule 504 because the $1,000,000 limit is too low to meet anticipated funding needs and because of the costs and delays of the blue-sky process. We question whether emerging growth companies would find the crowdfunding exemption attractive, and whether intermediaries will find the business sufficiently profitable to justify the regulatory burden.

What is the new Regulation A-like exemption and what does it mean?

Regulation A currently provides an exemption from registration for offerings of up to $5 million per year by non-reporting companies. Regulation A requires the submission of a simplified offering document to the SEC, which the SEC comments upon. Regulation A permits “testing the waters” communications. Securities sold under Regulation A are not “restricted securities,” so the investor may immediately sell such securities publicly, at least theoretically. Issuers who sell securities under Regulation A do not automatically become subject to reporting under the Exchange Act. Regulation A offerings are subject to state blue-sky qualification laws. Regulation A is rarely used because of the low $5 million offering cap and the associated regulatory burdens.

The JOBS Act requires the SEC to amend Regulation A or adopt a new exemption to increase the offering cap to $50,000,000 of securities sold in the prior 12 months in reliance on the exemption. Within 2 years of the enactment of the JOBS Act, and for every 2 years thereafter, the JOBS Act directs the SEC to review the offering cap and allows the SEC to increase it. The exemption permits “testing the waters” communications and permits offering the securities publicly, providing that securities sold in the offering are not restricted securities. The exemption requires issuers availing themselves of the modified exemption to file audited financial statements with the SEC annually and allows the SEC to impose additional conditions, including periodic reporting requirements. The exemption is available for equity securities, debt securities, convertible debt securities and guarantees.

Securities sold under the modified exemption are added to the list of covered securities under NSMIA, but only if they are offered and sold on a national securities exchange or offered and sold only to “qualified persons” as the term is defined by the SEC. NSMIA was adopted in 1996 and pre-empted state blue-sky qualification laws for securities sold to qualified persons. The SEC proposed a definition for “qualified persons” in 2001, but never adopted a definition. If the SEC does not adopt a definition in connection with the amendments to Regulation A required by the JOBS Act, issuers would have to choose between blue-sky compliance and becoming listed on a stock exchange, assuming they qualify for listing. Becoming listed on a stock exchange would in turn require issuers to report under the Exchange Act, which may eliminate many of the advantages of Regulation A over a registered public offering. The JOBS Act does however require the Comptroller General to conduct a study on the impact of blue-sky laws on Regulation A offerings and report on its findings within three months after enactment of the JOBS Act.

Depending on the regulations the SEC adopts, this new exemption may become a viable means for a company to conduct a “mini-public offering” and have a public trading market in its securities. The continuing market for reverse mergers into public shell companies, sometimes referred to as alternative public offerings, demonstrates a demand for small companies to establish public markets in their securities. The ability to raise up to $50 million publicly and the potential not to be subject to Exchange Act reporting could make the new Regulation A-type exemption a superior alternative public offering method.

Note however that the JOBS Act does not exclude holders of securities sold under this exemption from the count of holders for Exchange Act registration. Unless the SEC adopts rules to do so, companies that use this exemption may find that they quickly become subject to Exchange Act reporting. Many companies may impose contractual trading restrictions to prevent this from happening.

What are the changes to the triggers for Exchange Act registration and what do they mean?

Section 12(g) of the Exchange Act and its related rules required a company with more than $10 million in assets and more than 500 holders of record of any class of its equity securities to register under the Exchange Act and begin complying with disclosure and financial reporting compliance obligations applicable to public companies.

Effective immediately, the JOBS Act increases the holder threshold to 2,000 holders, provided no more than 500 are unaccredited investors. The JOBS Act also excludes from the “held of record” test securities held by persons who received them pursuant to employee compensation plans and securities held by persons who purchased them in transactions under the crowdfunding exemption. Within 120 days after enactment of the JOBS Act, the SEC must determine if new enforcement tools are needed to enforce the anti-evasion provisions of the rule, and report its recommendation to Congress.

The holder of record threshold for banks and bank holding companies has increased to 2,000, with no limit on the number of unaccredited investors.

As a result of these changes, the many companies that have in recent years come close to or exceeded the prior 500-holder limit will have substantial room to add more investors without needing to accelerate an IPO or register under the Exchange Act without an IPO. This change will also expand the practicality of the more liberal private offering rules under the JOBS Act.

With companies able to maintain their status as non-reporting companies for longer, and with more holders that may want liquidity, we may see more demand for secondary markets trading in private placement securities.

What should I do now?

Companies and entrepreneurs who rely on outside capital should immediately consider what these legal changes might mean to their capital raising plans. The considerations are complex and will be different for every company. We urge companies and entrepreneurs to consult with legal counsel before changing any of their plans and actions in response to the JOBS Act. Companies that believe they will benefit from attracting a larger number of investors will need to consider the disadvantages of a large shareholder base, including increased administrative cost, more difficulty with certain fundamental transactions like sale of the company or restructuring, and potentially becoming less attractive to traditional investors like venture capital funds.

Private companies that already have a substantial shareholder base should think about what possibilities are now open to them given more headroom on the number of holders. In some cases, changes may be needed to shareholder and investor agreements either to facilitate or prevent secondary markets in their shares.

Given some of the delays for required rulemaking and uncertainties as to how markets will react to these changes, the provisions of the JOBS Act will generally mean evolutionary rather than revolutionary changes to capital raising plans for most issuers for the time being. But revolutionary changes may not be far off.

What if you have questions?

For any questions or more information on these or any related matters, please contact any attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Lawyers on this page.

John Tishler (858-720-8943, jtishler@sheppardmullin.com), Louis Lehot (650-815-2640, llehot@sheppardmullin.com), Edwin Astudillo (858-720-7468, eastudillo@sheppardmullin.com), Jason Schendel (650-815-2621, jschendel@sheppardmullin.com), Camille Formosa (650-815-2631, cformosa@sheppardmullin.com) and Nina Karalis (858-720-7466, nkaralis@sheppardmullin.com) participated in drafting this posting.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.

[1] The JOBS Act is not clear whether the relief from summary financial information applies to the IPO registration statement, though such relief seems consistent with Congressional intent given the provisions relating to later registration statements and Exchange Act reports.

After an extensive investigation into Citigroup’s marketing of collateralized debt obligations (“CDOs”), the SEC filed a complaint charging Citigroup with negligent misrepresentation under 15 U.S.C. §§ 77q(a)(2) and (3). Simultaneously, the SEC and Citigroup presented a proposed consent judgment, pursuant to which Citigroup agreed to (1) pay $285 million into a fund for investors in a pool of CDOs marketed by Citigroup, (2) entry of an order enjoining it from violating the Securities Act of 1933 and (3) establish procedures to prevent future violations and make periodic compliance demonstrations to the SEC.

The district court rejected the settlement for three reasons. First, it reproved the SEC’s “long-standing” policy of entering into consent judgments without requiring the defendant to admit or deny the underlying allegations, because a settlement “without any admissions [of liability] serves various narrow interests of the parties, but not the public interest.” Second, it held that the settlement was unfair because it unreasonably “impose[d] substantial relief [on Citigroup] on the basis of mere allegations.” Third, it held that the settlement disserved public interest because “without admission of liability, a consent judgment involving only modest penalties gives no indication of where the real truth lies.”

The SEC appealed and moved for a stay of the proceedings in the district court pending its appeal. Citigroup joined with the SEC in all of its arguments.

The Second Circuit considered and rejected each of the district court’s reasons for refusing to approve the consent judgment. The district court found that the settlement offended public interest because Citigroup’s penalty was merely “pocket change,” and the SEC got nothing but a “quick headline.” The Second Circuit held that this determination was flawed because it assumed Citigroup’s liability and gave no deference to the SEC’s wholly discretionary policy choice of whether to settle with Citigroup or pursue it through litigation. The Court indicated it had no reason to doubt that the SEC had taken the public interest in to account because the settlement called for payment by Citigroup of $285 million, “which would be available for compensation of investors who lost money.”

The Court rejected the district court’s characterization of the settlement as “unfair” to Citigroup, noting that contradicted the district court’s concurrent assessment of the settlement amount as “pocket change” and a “mild and modest cost of doing business” for Citigroup. Furthermore, the Court noted that a district court’s legitimate concern does not include protection of “a private, sophisticated, counseled litigant from a settlement to which it freely consents.”

Finally, the Court rejected the district court’s determination that it had no basis to assess the underlying facts absent an admission of liability by Citigroup, referring to the “substantial evidentiary record,” and the SEC’s provision of information regarding how the evidence supported the proposed consent judgment.

The Court held that the movants demonstrated a strong likelihood of success in overturning the district court’s ruling. Considering the remaining prongs of the test, the Court observed that the parties would suffer irreparable harm without a stay, reasoning that the district court’s requirement of an admission from Citigroup essentially precluded any possibility of settlement, leaving the parties no option but to incur substantial costs of litigating their dispute. Lastly, the Court explained that the SEC’s assertion that “its settlement is in the public interest and that its access to a stay so as to protect the settlement is also in the public interest” should not be questioned or rejected by a court “without substantial reason for doing so,” and went on to find no such reason.

Citigroup demonstrates the Second Circuit’s unwillingness to intrude upon the realm of executive agencies. The decision clearly admonished the district court, and warned against interference with or dictating the terms of the arrangements made between public regulatory agencies and the business entities they regulate, even when such entities are the focus of intense public scrutiny about its business practices.

For further information, please contact John Stigi at (310) 228-3717 or Sarah Aberg at (212) 634-3091.