Smaller Reporting Companies (SRCs) and Emerging Growth Companies (EGCs)

A Smaller Reporting Company

On June 28, 2018, the SEC adopted the much-anticipated amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K.

Among other benefits, it is hoped that the change will help encourage smaller companies to access US public markets. The amendment expands the number of companies that qualify as a smaller reporting company (SRC) and thus qualify for the scaled disclosure requirements in Regulation S-K and Regulation S-X.. The SEC estimates that an additional 966 companies will be eligible for SRC status in the first year under the new definition.

As proposed, and as recommended by various market participants, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float.

Once considered a SRC, a company would maintain that status unless its float drops below $200 million if it previously had a public float of $250 million or more. The revenue thresholds have been increased for requalification such that a company can requalify if it has less than $80 million of annual revenues if it previously had $100 million or more, and less than $560 million of public float if it previously had $700 million or more.

The SEC also made related rule changes to flow through the increased threshold concept. In particular, Rule 3-05 of Regulation S-X has been amended to increase the net revenue threshold in the rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K.

The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.”As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act. However, Chair Clayton as directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.

Background

The topic of disclosure requirements under Regulation S-K as pertains to disclosures made in reports and registration statements filed under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) have come to the forefront over the past couple of years. Regulation S-K, as amended over the years, was adopted as part of a uniform disclosure initiative to provide a single regulatory source related to non-financial statement disclosures and information required to be included in registration statements and reports filed under the Exchange Act and the Securities Act.

A public company with a class of securities registered under either Section 12 or which is subject to Section 15(d) of the Exchange Act must file reports with the SEC (“Reporting Requirements”). The underlying basis of the Reporting Requirements is to keep shareholders and the markets informed on a regular basis in a transparent manner. Over the years Regulation S-K has not been kept current with other Rule changes, the arduous reporting requirements for smaller companies has resulted in stifled capital formation and fewer smaller IPOs, and investors have questioned the quality and relevancy of information required to be included in reports.

The SEC disclosure requirements are scaled based on company size. The SEC established the smaller reporting company category in 2007 to provide general regulatory relief to these entities. Prior to this rule change, a “smaller reporting company” was defined in Securities Act rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K, as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

The following table, copied from the SEC rule release, summarizes the scaled disclosure accommodations available to smaller reporting companies:

Regulation S-K
Item	Scaled Disclosure Accommodation
101 − Description of Business	May satisfy disclosure obligations by describing the development of its business during the last three years rather than five years. Business development description requirements are less detailed than disclosure requirements for non- smaller reporting companies.
201 − Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters	Stock performance graph not required.
301 – Selected Financial Data	Not required.
302 – Supplementary Financial Information	Not required.
303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)	Two-year MD&A comparison rather than three-year comparison. Two year discussion of impact of inflation and changes in prices rather than three years. Tabular disclosure of contractual obligations not required.
305 – Quantitative and Qualitative Disclosures About Market Risk	Not required.
402 – Executive Compensation	Three named executive officers rather than five. Two years of summary compensation table information rather than three. Not required: ·         Compensation discussion and analysis. ·         Grants of plan-based awards table. ·         Option exercises and stock vested table. ·         Pension benefits table. ·         Nonqualified deferred compensation table. ·         Disclosure of compensation policies and practices related to risk management. ·         Pay ratio disclosure.
Regulation S-K
Item	Scaled Disclosure Accommodation
404 – Transactions With Related Persons, Promoters and Certain Control Persons16	Description of policies/procedures for the review, approval or ratification of related party transactions not required.
407 – Corporate Governance	Audit committee financial expert disclosure not required in first year. Compensation committee interlocks and insider participation disclosure not required. Compensation committee report not required.
503 – Prospectus Summary, Risk Factors and Ratio of Earnings to Fixed Charges	No ratio of earnings to fixed charges disclosure required. No risk factors required in Exchange Act filings.
601 – Exhibits	Statements regarding computation of ratios not required.
Regulation S-X
Rule	Scaled Disclosure
8-02 – Annual Financial Statements	Two years of income statements rather than three years. Two years of cash flow statements rather than three years. Two years of changes in stockholders’ equity statements rather than three years.
8-03 – Interim Financial Statements	Permits certain historical financial data in lieu of separate historical financial statements of equity investees.
8-04 – Financial Statements of Businesses Acquired or to Be Acquired	Maximum of two years of acquiree financial statements rather than three years.
8-05 – Pro forma Financial Information	Fewer circumstances under which pro forma financial statements are required.
8-06 – Real Estate Operations Acquired or to Be Acquired	Maximum of two years of financial statements for acquisition of properties from related parties rather than three years.
8-08 – Age of Financial Statements	Less stringent age of financial statements requirements.

Final Amendments to Smaller Reporting Company Definition

The SEC has competing goals of protecting investors and the marketplace through requiring companies to provide disclosure needed to make informed investment and voting decisions and promoting capital formation and reducing compliance costs for smaller companies. The SEC believes that by raising the financial thresholds for the smaller reporting company definition and thereby expanding the number of companies eligible to use the available scaled disclosure, it will be satisfying its goals and appropriately responding to comments and recommendations by the Advisory Committee on Small and Emerging Growth Companies, the SEC Government Business Forum on Small Business Capital Formation, Congress and industry commenters.

The SEC summarizes many of these recommendations, initiatives and comments in its rule release. For example, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. The FAST Act, which was passed into law on December 4, 2015, required the SEC to scale or eliminate duplicative, antiquated or unnecessary disclosure requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K.

The SEC considered comments it received to the initial proposed rule release and comments it received in response to the published concept release and request for public comment on Regulation S-K. As indicated above, the new definition of a SRC will now include companies with less than a $250 million public float as compared to the $75 million threshold in the prior definition. In addition, if a company does not have an ascertainable public float or has a public float of less than $700 million, a SRC will be one with less than $100 million in annual revenues during its most recently completed fiscal year. The prior revenue threshold was $50 million and only included companies with no ascertainable public float.

Once considered a SRC, a company would maintain that status unless its float drops below $200 million if it previously had a public float of $250 million or more. The revenue thresholds have been increased for requalification such that a company can requalify if it has less than $80 million of annual revenues if it previously had $100 million or more, and less than $560 million of public float if it previously has $700 million or more.

The SEC also made related rule changes to flow through the increased threshold concept. In particular, Rule 3-05 of Regulation S-X has been amended to increase the net revenue threshold in the rule from $50 million to $100 million. As a result, companies may omit financial statements of businesses acquired or to be acquired for the earliest of the three fiscal years otherwise required by Rule 3-05 if the net revenues of that business are less than $100 million.

Furthermore, the conforming changes include changes to the cover page for most SEC registration statements and reports including, but not limited to, Forms S-1, S-3, S-4, S-11, 10-Q and 10-K.

The following contains a summary of the scaled disclosures available to smaller reporting companies. In addition, the FAST Act, passed into law on December 4, 2015, amended Form S-1 to allow for forward incorporation by reference by smaller reporting companies. A smaller reporting company may now incorporate any documents filed by the company, following the effective date of a registration statement, into such effective registration statement. In what was probably unintended in the drafting, the FAST Act changes only include smaller reporting companies and not emerging growth companies or non-accelerated filers. Other categories of filers, including accelerated and large accelerated filers, were already allowed to forward incorporate by reference. Accordingly, among the other benefits of the current proposed rule change, the number of companies that can utilize forward incorporation by reference in a Form S-1 will increase.

Amendments to Accelerated Filer and Large Accelerated Filer Definitions

The new rules did not change the definitions of either “accelerated filer” or “large accelerated filer.”As a result, companies with $75 million or more of public float that qualify as SRCs will remain subject to the requirements that apply to accelerated filers, including the accelerated timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal control over financial reporting required by Section 404(b) of the Sarbanes-Oxley Act. However, Chair Clayton has directed the SEC staff to make recommendations for additional changes to the definitions to reduce the number of companies that would qualify as accelerated filers.

The public float threshold for an accelerated filer is $75 million. Companies that currently file as an accelerated filer would continue to do so under the new rules, but would be able to benefit from the scaled disclosure requirements available to smaller reporting companies. The filing deadlines for each category of filer are:

Filer Category	Form 10-K	Form 10-Q
Large Accelerated Filer	60 days after fiscal year-end	40 days after quarter-end
Accelerated Filer	75 days after fiscal year-end	40 days after quarter-end
Non-accelerated Filer	90 days after fiscal year-end	45 days after quarter-end
Smaller Reporting Company	90 days after fiscal year-end	45 days after quarter-end

 Statements of Commissioners on Rule Amendment

Commissioners Hester Peirce and Michael Piwowar made public statements regarding the rule change both supporting the amendment but expressing disappointment that it did not also include a change in the definition of an accelerated filer. Both commissioners think it is not enough to reduce regulatory burdens to encourage more companies to go public. Section 404(b) of the Sarbanes-Oxley Act is one of the largest burdens that face smaller public companies and Commissioner Piwowar believes that until that is changed, there will be no improvement in efforts to raise capital by smaller companies. Ms. Peirce goes further, stating that the failure to make a conforming change to the definition of an accelerated filer will actually be confusing to companies. That is, prior to the rule change, a smaller reporting company was always exempted from Section 404(b) compliance; however, now that will not be the case.

Ms. Peirce points to a poignant example from the comment letters. A group of biotech companies rightfully stated that money spent on compliance is less money spent on research and development and that investors in a smaller biotech company are more interested in getting FDA approval than the auditors’ blessing on internal controls.

On the upside, Chair Clayton has committed to continue to review this matter and work on changes to the definition of accelerated filer and/or changes to the requirements of 404(b) compliance.

A Emerging Growth Company

The first of emerging growth companies (“EGC’s”) will begin losing EGC status as the five-year anniversary of the creation of an EGC has now passed. Those companies that will lose status as a result of the passage of time are almost unilaterally not pleased with the impending change and concurrent increase in regulatory compliance.

Background

Title I of the JOBS Act, initially enacted on April 5, 2012, created a new category of issuer called an “emerging growth company” (“EGC”).  An EGC is defined as a company with total annual gross revenues of less than $1,070,000,000 during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. An EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1,070,000,000 in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO (for example, if the issuer has a December 31 fiscal year-end and sells equity securities pursuant to an effective registration statement on November 2, 2012, it will cease to be an EGC on December 31, 2017); (iii) the date on which it has issued more than $1,070,000,000 in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more).

The primary benefits of an EGC include scaled-down disclosure requirements both in an IPO and periodic reporting, relief from the auditor attestation requirements in Section 404(b) of the Sarbanes-Oxley Act, confidential filings of registration statements, certain test-the-waters rights in IPO’s, and an ease on analyst communications and reports during the EGC IPO process.

Since the passage of the JOBS Act, the FAST Act provided additional benefits to an EGC, including the omission of certain historical financial statements in registration statements, a benefit that the SEC has now extended to all companies. Moreover, the ability to file confidential registration statements has also been expanded to include all companies.

Many but not all of the benefits available to an EGC are also available to a smaller reporting company. For a summary of the scaled disclosure available to an EGC as well as the differences in disclosure requirements between an EGC and a smaller reporting company..

However, more than 85% of IPO’s since passage of the JOBS Act have been completed by EGC’s, a large percentage of which will not qualify as a smaller reporting company. Currently a smaller reporting company is defined as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

In June 2016 the SEC published proposed amendments to the definition of a smaller reporting company to include companies with less than a $250 million public float as compared to the $75 million threshold in the current definition. In addition, if a company does not have an ascertainable public float, under the proposed amendment a smaller reporting company would be one with less than $100 million in annual revenues. Once considered a smaller reporting company, a company would maintain that status unless its float drops below $200 million or its annual revenues below $80 million.

This rule is listed as being in the final rule stage on the most recent SEC Regulatory Agenda, but it is unknown what changes will be included in such final rule. The June 2016 proposal specifically declined to amend the public float threshold qualifications for “accelerated filer” and “large accelerated filer,” while eliminating the exclusion for smaller reporting companies. As a result, under the current proposed rule change companies with $75 million or more in public float would still be subject to the accelerated filer rules, including shorter periods in which to file their periodic reports and the requirement to provide auditor attestation over internal controls under Section 404(b) of the Sarbanes-Oxley Act of 2002.

Accordingly, a company that exits EGC status and does not qualify as a smaller reporting company will either be a non-accelerated filer, accelerated filer or large accelerated filer with the concurrent disclosure requirements. The following chart summaries the categories:

CATEGORY OF FILER	PUBLIC FLOAT1 TO ENTER STATUS	REVNEUES2 TO ENTER STATUS	CRITERIA TO EXIT STATUS	PUBLIC FLOAT TO RE-ENTER STATUS	REVENUES TO RE-ENTER STATUS
Emerging Growth Company (EGC)	N/A	<$1 billion	Revenues >$1 billion 5th anniversary of IPO3 Non-convertible debt > $1 billion Float > $700 million	N/A	N/A
Smaller Reporting Company	<$75 million	<$50 million4	Float > $75 million	<$50 million	<$40 million
Non-Accelerated Filer	<$75 million	N/A	Float > $75 million	<$50 million	N/A
Accelerated Filer	>$75 million but <$700 million	N/A	Float <$75 million or > $700 Million	<$500 million but > $50 million	N/A
Large Accelerated Filer	>$700 Million	N/A	Float <$700 million	N/A	N/A

1 Public float is calculated as of the last business day of the company’s most recently completed second fiscal quarter.

2 Revenues as reported in the company’s most recently completed fiscal year

3 Ineligibility begins on last day of the fiscal year in which the 5th anniversary occurs.

4 Revenue test applies only if public float is zero.

Real-world Impact

Under Section 404(a) of the Sarbanes-Oxley Act, companies are required to include in their annual reports on Form 10-K a report of management on the company‘s internal control over financial reporting (“ICFR”) that: (i) states management‘s responsibility for establishing and maintaining the internal control structure; and (ii) includes management‘s assessment of the effectiveness of the ICFR. Section 404(b) requires the independent auditor to attest to, and report on, management‘s assessment.in order to review, report on and attest to management’s ICFR, an auditor must, in essence, independently audit the ICFR.

A dearth of information and guidance is available on an auditor’s duties under Section 404(b), including PCAOB Auditing Standard No. 5.  Although many estimates exist, based on a high-level review, there is some consensus that the average annual cost of Section 404(b) compliance for a company with a public float between $75 and $250 million is in excess of $250,000 and sometimes much higher.

At a meeting of the SEC Advisory Committee on Small and Emerging Companies (“Advisory Committee”) on September 13, 2017, an executive of a biotechnology company that is losing EGC status and will not qualify as a smaller reporting company pled for relief. Of all the changes that his company will face, the auditor attestation requirements under Section 404(b) of the Sarbanes-Oxley Act loom large.

Sutro Biopharma CEO William Newell gave a presentation to the Advisory Committee advocating for the increase in the definition of a smaller reporting company, as proposed, but also continuing to exempt smaller reporting companies from Section 404(b) compliance.  Sutro is pre-revenue, as are many bio-pharma companies. Companies that are pre-revenue, but that may have a large public float, currently are required to comply with Section 404(b) with funds that would otherwise be used for growth, including increased staffing.

Also, Sutro is currently private and cites burdensome compliance costs as a deterrent to accessing public markets. The SEC has publicly talked about the need to energize the U.S. IPO market, including in a speech by Chair Jay Clayton and one by Commissioner Michael Piwowar.

There is some hope for these companies. The current SEC administration is supportive of capital-raising efforts and decreased, unnecessary regulation, for companies both large and small. The pending Financial Choice Act would increase the threshold for compliance with Section 404(b) to companies with a public float of $500 million or more. The SEC Government-Business Forum on Small Business Capital Formation encourages both the change to the definition of smaller reporting company and increase in threshold for compliance with Section 404(b).

Differences between EGC and Smaller Reporting Company Disclosure Requirements

The scaled-down disclosures for smaller reporting companies and emerging growth companies include, among other items: (i) only 3 years of business description as opposed to 5; (ii) 2 years of financial statements as opposed to 3; (iii) elimination of certain line-item disclosures, such as certain graphs and selected financial data; and (iv) relief from the 404(b) auditor attestation requirements. However, although similar, there are differences between the scaled disclosure requirements for an emerging growth company vs. a smaller reporting company. In particular, the following chart summarizes these differences:

Scaled Disclosure Requirement	Emerging Growth Company	Smaller Reporting Company
Audited Financial Statements Required	2 years in a Securities Act registration statement for an IPO of common equity. 3 years in an IPO of debt securities. 3 years in an annual report or Exchange Act registration statement, unless the company is also an SRC.	2 years.
Description of Business (Item 101)	Standard disclosure requirements apply.	Development of its business during the most recent three years, including: form and year of organization; bankruptcy proceedings; material reclassification, merger, sale or purchase of assets; and description of the business. Not required: seasonality; working capital practices; backlog; or government contracts. Names of principal suppliers. Royalty agreements or labor contracts. Need for government approval of principal products and services. Effect of existing or probable governmental regulations.
Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters (Item 201)	Standard disclosure requirements apply.	Not required to provide the stock performance graph.
Selected Financial Data (Item 301)	Not required to present selected financial data for any period prior to the earliest audited period presented in initial registration statement.	Not required.
Supplementary Financial Data (Item 302)	Not required until after IPO.	Not required.
MD&A (Item 303)	May limit discussion to those years for which audited financial statements are included.	May limit discussion to those years for which audited financial statements are included. Not required to comply with contractual obligations table requirements in 303(a)(5).
Quantitative and Qualitative Disclosures about Market Risk (Item 305)	Standard disclosure requirements apply.	Not required, but related disclosure may be required in MD&A.
Extended Transition for Complying with New or Revised Accounting Standards	May elect to defer compliance with new or revised financial accounting standards until a company that is not an “issuer”894 is required to comply with such standards. Any decision to forgo the extended transition period is irrevocable.	Standard disclosure requirements apply.
Internal Control over Financial Reporting (Item 308)	Not required to provide attestation report of the registered public accounting firm. Not exempt from Item 308(a), but newly public company is not required to comply until it either has filed or has been required to file an annual report for the prior fiscal year.	Non-accelerated filers, a category that includes SRC’s, are not required to provide an attestation report of the registered public accounting firm.
Executive Compensation Disclosure (Item 402)	Permitted to follow requirements for SRC’s. Exempt from principal executive officer pay ratio disclosure.	2 years of summary compensation table information, rather than 3. Limited to principal executive officer, two most highly compensated executive officers and up to two additional individuals no longer serving as executive officers at year-end.896 Not required: compensation discussion and analysis; grants of plan-based awards table; option exercises and stock vested table; change in present value of pension benefits; CEO pay ratio; compensation policies as related to risk management; or pension benefits table. Description of retirement benefit plans.

 

Scaled Disclosure Requirement	Emerging Growth Company	Smaller Reporting Company
Certain Relationships and Related Party Transactions (Item 404)	Standard disclosure requirements apply.	Lower threshold to disclose related party transactions. Not required to disclose procedures for review, approval or ratification of related party transactions. Additional requirement to disclose certain controlling entities. Required to disclose related party transactions not only since the beginning of last fiscal year but also for the preceding fiscal year.
Corporate Governance (Item 407)	Standard disclosure requirements apply.	Not required to disclose whether it has an audit committee financial expert until its second annual report following IPO. Exempt from requirements to disclose compensation committee interlocks and insider participation and to provide a compensation committee report.
Risk Factors (Item 503(c))	Standard disclosure requirements apply.	Not required in periodic reports.
Ratio of Earnings to Fixed Charges (Item 503(d))	Required for the same number of years for which it provides selected financial data disclosures.	Not required.