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Increase in EGCs Leads to Increased Litigation

May 31, 2016

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In the past few years, we have been seeing a definite increase in litigation and legal activity with small and micro-cap companies. As we will see, this has much to do with the increased presence of Emerging Growth Companies (EGCs) in the market. EGC activity is important to consider, because even though they are smaller, their presence will still have effects on larger companies and on the global economy as a whole.

Businesses with a total gross revenue of under $1 billion for the recently ended fiscal year can qualify to file as an emerging growth company. This category of companies was created under the JOBS Act (Jumpstart Our Business Startups Act). The JOBS Act was created with the intention of allowing smaller companies to come to market easier and to open the door to more growth opportunities.

What are EGCs?

To qualify as an EGC, the business must have their initial sale of common equity securities after December 8, 2011. Also, the calculation of their revenue must be according to GAAP or IFRS requirements. The EGC category also allows companies to utilize relaxed filing requirements. These relaxed standards allow the company to:

  • Omit financial statements from their initial filings (under certain circumstances)
  • Disclose only 2 years of audited financial statements in their IPO registration, as opposed to 3 years for non-EGCs
  • Keep draft Form S-1 confidential (with the SEC) for 15 days prior to its roadshow
  • Be exempt from requirements related to external auditor attestation of internal financial reporting controls

Companies that take advantage of these provisions have a unique chance to spend more time in actual business operations and less time on registration and other administrative processes.  While this allows younger, smaller companies to “get their feet wet” and test the market waters, it can also carry with it certain risks and concerns.

EGC Numbers and Issues

It is well established that EGCs have been dominating the IPO market in recent years. Naturally, with the increased number of EGC IPO’s, we are seeing increased numbers of IPO lawsuits as well. A thorough report by PwC breaks down these the numbers:

  • In 2015, 12% of federal securities class action filings recorded were IPO-related (23 cases). This is an increase from 11% of total cases in 2014 (19 cases)
  • 65% of the IPO related cases in 2015 involved EGCs

In addition to these IPO lawsuits, EGCs are increasingly involved in other legal issues such as:

  • Disclosure of business operations, especially those involving future prospects
  • Issues regarding inventory or supply chains
  • Failure to comply with false advertising issues
  • Weakening sales and relationships with customers.

These increases in filings may be linked to the relaxed disclosure requirements associated with the JOBS Act.

Interaction of Larger Companies with EGCs

Of course, smaller EGC’s have concerns that are distinct from larger companies. In a recent survey, data showed that smaller companies such as EGCs and privately-held companies are more concerned with business and operational risks. In comparison, larger public companies were more concerned with macroeconomic factors.

On the other hand, large companies are not immune to the problems that EGC’s face, such as accounting issues and disclosure issues. In fact, larger companies may now be facing additional challenges as they interact more and more with EGCs created by the JOBS Act.

For instance, the JOBS Act also loosened some of the provisions regarding analysts who work together with investment bankers when it comes to deals with emerging growth companies. For instance, analysts doing a stock offering for a company are allowed to upgrade shares of that company, so long as they weren’t part of pitching the deal. This exact issue came up recently in Goldman Sach’s dealings with Tesla. While not an EGC, Tesla’s concerns here still illustrates the need for continued clarity in interpreting JOBS Act provisions.

Looking Ahead

Emerging growth companies will continue to play an integral role in shaping the global economy. Since securities laws typically involve 3-year statute of limitations for IPO-related cases, we may be seeing even more shareholder actions arising over time for earlier IPOs. Special care needs to be taken as companies shed their EGC status and face increased exposure, while still having a comparatively small amount of resources.

Litigation involving EGCs can involve complex matters and new areas of law. Keeping a close watch on EGCs is an important concern for global investors moving forward. If you have any legal issues or concerns directly involving matters such as securities fraud litigation or global securities litigation, contact us at Kessler Topaz. Our team of attorneys is ready to provide assistance at every stage of a dispute, from assessing claims to trials, appeals, and settlement negotiations.