On March 4, 2020, the Securities and Exchange Commission (“SEC”) issued proposed amendments (the “Proposals”) in Release No. 33-10763, “Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets ” (the “Release”) affecting certain exempt offering rules to reduce impediments to fundraising under the Securities and Exchange Act of 1933 (“Securities Act”). The Proposals would reduce certain incompatibilities among the most frequently relied upon private offering exemptions to facilitate fundraising.
Background. Countless private companies and investment funds raise funds in reliance on the private offering exemptions found in the Securities Act. As more and more companies continue to defer IPOs or to deregister under the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”), this reliance has increased. According to the SEC, in 2019 approximately $2.7 trillion (69.2 percent) was raised through exempt offerings in contrast to registered offerings that accounted for $1.2 trillion (30.8 percent).
Of the approximately $2.7 trillion raised in exempt offerings, approximately 55 percent was raised in reliance on Rule 506(b) of Regulation D with a smaller fraction raised under Rule 506(c) of Regulation D, Regulation A or under Regulation Crowdfunding (Regulation CF).
Unlike Rule 506(c) offerings, which are the second most popular exemption, there is no verification of accredited status in a Rule 506(b) offering and no SEC review or ongoing reporting requirements unlike Regulation A+ and public offerings. Capital raised through Regulation D remains to be associated with strong public market performance in that the strength of the unregistered market is correlated with the economy. To promote this continued unity and the effectiveness of a few other offering exemptions than Rule 506(b), in June 2019, the SEC issued a concept release seeking to simplify the exempt offering framework under the Securities Act and to receive public comment. The Proposals in the Release are an outgrowth of last year’s concept release.
Overview of the Proposals. The Proposals are intended to meet evolving market needs by increasing the efficiency of the capital raising process among three particular registration exemptions under the Securities Act: Rule 504 of Regulation D, Regulation CF and Regulation A. The Proposals would foster integration by focusing on the facts and circumstances of the particular offering to determine whether the issuer has complied with the Securities Act’s private offering exemptions or the registration requirements.
Offering and Investment Limits. The Proposals contain changes to offering and investment limits including:
Regulation A: Raise (i) the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million; and (ii) the maximum offering amount for secondary sales under Tier 2 of Regulation A from $15 million to $22.5 million.
Regulation CF: Increase (i) the offering limit in Regulation CF from $1.07 million to $5.0 million; and (ii) the investment limits applicable non-accredited investors to allow them to rely on the greater of their annual income or net worth when calculating the annual investor limits (and exclude limits for “accredited investors”). This increase has tremendous appeal as it would provide a needed boost to entrepreneurs seeking capital throughout the United States.
Rule 504 of Regulation D: Increase the maximum offering amount under Rule 504 from $5.0 million to $10 million in a twelve-month period.
Integration Framework: The concept of “integration” in connection with securities offerings concerns the process for determining whether securities transactions should be considered part of the same offering when analyzing whether registration of the securities is required or if a private offering exemption is available. The Proposals would establish a new Rule 152 of the Securities Act that would replace current Rules 152 and 155 to determine whether multiple securities offerings should be integrated and considered part of the same offering for exemption purposes. New Rule 152 would replace a five-factor test with a facts and circumstances analysis applying four new specific safe harbors:
· Safe Harbor No. 1: Any offering made more than 30 calendar days before the commencement of another offering, or more than 30 calendar days after the termination or completion of another offering, would not be integrated with another offering; provided that, for an exempt offering for which general solicitation is not permitted, the purchasers either were (i) not solicited by means of general solicitation or (ii) derived from an established substantive relationship prior to the commencement of the offering for which general solicitation is not permitted.
· Safe Harbor No. 2: Offers and sales of securities made in compliance with Rule 701, pursuant to an employee benefit plan, or in compliance with Regulation S would not be integrated with other offerings.
· Safe Harbor No. 3: A registered offering would not be integrated with a subsequent offering if made following a terminated or completed offering (i) for which general solicitation is not permitted; (ii) a for which general solicitation is permitted but made only to qualified institutional buyers and institutional accredited investors; or (iii) that terminated or was completed more than 30 calendar days before commencement of the registered offering.
· Safe Harbor No. 4: Offers and sales made in reliance on an exemption for which general solicitation is permitted would not be integrated with earlier terminated or completed offering.
General Solicitation and Offering Communications.
1. “Test-the-Waters” and “Demo Day” Communications. The Proposals include amendments to offering communications, including:
Allowing an issuer to use generic solicitation of interest materials to “test-the-waters” for an exempt offer of securities before determining on which exemption it will rely to sell the securities;
Allowing issuers using Regulation CF to “test-the-waters” before filing an offering document with the SEC in a manner similar to Regulation A offerings; and
Finding that certain “demo day” communications would not be deemed general solicitation or general advertising. A “demo day” refers to a seminar or meeting by a college, university, or other institution of higher education, a local government, a nonprofit organization, or an angel investor group, incubator, or accelerator.
Through proposed Rule 206, issuers may test-the-waters with all potential investors provided the issuers include certain legends in the testing-the-waters materials. In addition, proposed amendments to Rule 204, oral communications with prospective investors would be permitted once the Form C is filed.
2. Solicitation of Interests & New Rule 241. The Proposals would permit issuers to gauge market interest in a registered offering through discussions with qualified institutional buyers and institutional accredited investors before or after the issuer files a registration statement with the SEC. Through proposed Rule 241, issuers could solicit indications of interest in an exempt offering orally or in writing before determining on which exemption it would rely in the offering.
Eligibility to Rely on Regulation A and Regulation C:
Both Regulation CF and Regulation A permit the sale of securities to the public without meeting the requirements of a registered offering. Regulation CF (also known as regulated crowdfunding) is geared toward smaller companies seeking lower capital amounts which can be raised from non-accredited as well as accredited investors. Regulation CF, in turn, requires more disclosure documentation than offerings under Rule 506(b) and Rule 506(c) and includes per investor limits. Regulation A is geared toward small- to medium-sized companies and requires significant documentation and disclosure, as well as SEC staff review and offering circular review.
Regulation A limits the securities offered to equity securities (i.e., warrants, debt securities convertible into equity interests including guarantees of such securities) and limits eligibility to non-SEC reporting company or non-blank check companies. While Regulation A has opened up the public markets to some smaller companies and become the most popular option for public sales of digital assets and security tokens in the United States, Regulation A offerings have not been very popular because of the offering costs, the burden of an SEC review and blue sky compliance in each state in which the offering is conducted.
Likewise, Regulation CF is little-used because of its very low offering limit, making it a very expensive means of raising capital and the vast majority of offerings by these companies have been through the traditional Regulation D private placement.
The Proposals seeks to increase the use of these two exemptions by increasing the offering and investment limits within each Regulation. The Proposals would raise the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million and increase the maximum offering amount for secondary sales under the same Tier of Regulation A from $15 million to $22.5 million. The Proposals would increase the Regulation CF annual offering limit from $1.07 million to $5 million and increase the investment limits of non-accredited investors and eliminate the limits on accredited investors, which should make Regulation CF more attractive.
The Proposals would permit the use of certain special purpose vehicles to facilitate investing in Regulation CF issuers and would limit the types of securities that may be offered and sold in reliance on Regulation CF.
Presently, Regulation CF contains no restriction on the types of securities offered under that exemption while Regulation A permits only equity securities, debt securities, and securities convertible or exchangeable to equity interests. The Proposals would integrate Regulation A and Regulation CF by restricting Regulation CF to the same eligible securities as Regulation A. Rule 506(c) Accredited Investor Verification: Rule 506(c) permits general solicitation and general advertising in a private offering since its 2013 enactment by the SEC, as directed by the JOBS Act, thus changing nearly eight decades of securities rules prohibitions. The Proposals would allow an issuer to establish that an investor, for whom the issuer previously took reasonable steps to verify as an accredited investor, remains an accredited investor as of the time of a subsequent sale if the investor provides a written representation to that effect and the issuer is not aware of information to the contrary.
The Proposals also includes the statement that “in some circumstances, the reasonable steps determination may not be substantially different from an issuer’s development of a ‘reasonable belief’ for Rule 506(b) purposes.” This language suggests that “reasonable steps” for Rule 506(c), may require no more than the “reasonable belief” standard. The Proposals contain a footnote stating that reasonable steps would require more than to have an investor to check a box or sign a form to satisfy the verification requirement.
Harmonize Financial Disclosure Requirements: The Proposals would change the financial information required to be provided to non-accredited investors in Rule 506(b) private placements to align with the financial information that issuers must provide to investors in Regulation A offerings. For Rule 506(b) offerings of up to $20 million in securities, issuers would no longer be required to provide audited financial statements and would instead be required to comply with the requirements which apply to Tier 1 Regulation A offerings. Regarding Rule 506(b) offerings in an amount greater than $20 million, issuers would be required to provide audited financial statements and comply with requirements similar to Tier 2 Regulation A offerings.
Harmonize “Bad Actor” Disqualification Provisions: The Proposals would harmonize the “bad actor” disqualification rules of Regulation D, Regulation A and Regulation CF by adjusting the look-back requirements in Regulation A and Regulation Crowdfunding to also refer to the time of sale, as opposed to only referencing the time the issuer files an offering statement.
Regulation A Offerings: The SEC has proposed various amendments intended to simplify certain requirements for Regulation A offerings and establish greater consistency between Regulation A and registered offerings – such as, to file certain redacted exhibits to offering documents using the simplified process previously adopted for registered offerings and Securities Exchange Act of 1934 filings and allow issuers to incorporate financial statement information by reference to other documents filed on EDGAR.
The Proposals are subject to a 60-day public comment period following publication in the Federal Register and include more than 80 items on which to comment. The Proposals represents the most significant amendment to the United States’ securities laws since the JOBS Act in 2012. The increase to $5 million of the annual cap for issuers relying on Regulation CF is especially beneficial to smaller companies as is the potential for a test-the-waters opportunity to allow issuers to exercise this test before investing the time and money in the offering.
These Proposals would provide a well-needed stimulus following the outbreak of COVID-19 which has halted most private equity deals for assorted reasons including some unexpected ones. Many deal sponsors have pivoted for a better investment or at least better deal terms. Deals that appeared attractive at a 15 percent internal rate of return (“IRR”) have been bypassed for higher returns bearing 25+ IRR, which means a great reliance by private companies on these private offering exemptions.