How a Company Raising Community Capital Can Avoid SEC Reporting Status

Publicly traded companies and other SEC reporting companies have a heavy reporting burden. Such a company must file a comprehensive annual report with audited financials, as well as quarterly reports, interim reports when anything material happens, and a detailed proxy statement in advance of each annual shareholder meeting. The company’s principal shareholders must file reports disclosing their stock holdings; and the company’s officers and directors must file a series of reports disclosing their holdings. It goes on and on; and the costs add up quickly.

The most obvious (and perhaps most common) way to become an SEC reporting company is to do an IPO, or initial public offering, by filing a registration statement with the SEC. Even if a company never does an IPO, it may still register its securities to trade on a national stock exchange and thereby become a reporting company.

In those situations, becoming an SEC reporting company is part of the plan, and they do it only when it makes economic sense to take on that additional regulatory burden. But it’s also possible for a company to become an SEC reporting company inadvertently, without ever intending to take on these obligations. That brings us to the infamous Section 12(g).

The Rule: Section 12(g)

Section 12(g) of the Securities Exchange Act of 1934 requires an issuer to register under the 1934 Act and become a reporting company if it has total assets (not net assets) exceeding $10 million AND has a class of equity securities held of record by either

1. 2,000 persons, or
2. 500 persons who are not accredited.

There are a couple of exceptions. For example, shareholders who receive their stock under an exempt employee compensation plan don’t count for this purpose.

However, a company that raises capital broadly from its community might easily have more than 500 non-accredited investors. And particularly if the company owns real estate, it may well be at risk of hitting these triggers, even if it makes no sense to incur the cost of becoming a reporting company.

Strategies for Avoiding Reporting Company Status

But while a company can inadvertently become an SEC-reporting company, there are several strategies available to help companies avoid hitting those Section 12(g) triggers:

1. Issue debt securities. Investors in debt investors (i.e. lenders) don’t count toward the Section 12(g) triggers. A company could offer both debt and equity securities in the same offering. If a company expects a large number of investors, a lower minimum for debt investors could nudge those who are investing small amounts into the debt securities, which would leave more room in the cap table for equity investors investing larger amounts.
2. Offer multiple classes of equity, with no one class having more than 500 non-accredited investors. In Section 12(g)(5), the term “class” is defined as including “all securities of an issuer which are of substantially similar character and the holders of which enjoy substantially similar rights and privileges.” A company that wants to offer two or more classes of securities should be careful that the two classes are sufficiently different to not be treated as the same class for this purpose. So, for example, common and preferred stock would probably be considered different classes. But two series of preferred stock that differ only as to their dividend or liquidation preference might not be different enough to be treated as different classes.
3. Issue a class of equity that is redeemable at the election of the company if in danger of hitting the Section 12(g) triggers. The idea here is that if needed, the company could redeem shares held by just enough of its shareholders to avoid hitting those triggers. Such a redemption feature could be included in the subscription agreement or in the organization’s charter documents (i.e. articles of incorporation).
4. Use Regulation Crowdfunding to raise capital. Investors in a Reg CF offering don’t count toward the count of equity investors under Section 12(g), as long as the company: 
   1. Is current in its annual reports under Reg CF (and in most cases there is just one annual report to file after concluding a Reg CF offering),
   2. Uses a transfer agent registered with the SEC, and
   3. Has total assets not exceeding $25 million.
5. Use Regulation A to raise capital. Investors in a Reg A Tier 2 offering also don’t count toward the count of equity investors in Section 12(g) if the company:
   1. Is current in its Reg A reporting obligations,
   2. Uses a transfer agent registered with the SEC, and
   3. Has a public float of less than $75 million (referring to the value of securities as to which there is a secondary trading market) or, if it has no public float, has annual revenues less than $50 million.

Terminating Reporting Company Status

Once a company becomes an SEC reporting company (whether intentionally or inadvertently), it can terminate reporting status only if it has fewer than 300 holders of record of the registered class of security (regardless of whether they are accredited), or fewer than 500 holders if its assets are less than $10 million.

But how does a company with more than 500 shareholders bring that number down? If a company has issued stock with a redemption right exercisable by the company, as described above, that would be the simplest method. But if it has no such redemption right, there are at least two additional mechanisms the company might consider: 

1. Do a tender offer to repurchase stock from smaller investors. This would require considerable resources in order to pay the repurchase price (since many or even most of the investors might accept the tender offer) and may be feasible only for a company that can line up substantial financing.
2. Do a reverse stock split and cash out the smallest investors. If a company has a large number of shareholders who hold just a handful of shares, a reverse stock split may be a way to effectively cash out those small shareholders, while keeping the larger shareholders on its cap table. For example, if the company does a one-for-ten reverse split (i.e., issuing one new share for every ten older shares), any holder of nine or fewer shares can be cashed out.

Final Thoughts

For many, the Section 12(g) triggers just don’t make sense. After all, why should a small locally-focused company risk becoming an SEC reporting company? The National Coalition for Community Capital (NC3) has put forward a proposal that would amend Section 12(g) to increase the asset threshold to $25 million, adjust the shareholder count to 2,000 shareholders regardless of whether they are accredited, and add a third prong to the test such that a company only becomes subject to SEC reporting if, in addition, there is a significant secondary market for its securities.

But for now, the law is what it is, and businesses would be wise to plan carefully around Section 12(g). Note that there are additional complications, exceptions, and caveats for all of the strategies described above, so a company should not venture down any of those paths without good legal counsel.

Naturally, nothing here should be considered legal advice. Please contact us for more information on this topic.