On October 26, 2016, the Securities and Exchange Commission adopted final rules intended to make intrastate and regional offerings more viable pathways for smaller raises. The new rules (i) amend Rule 147 to simplify the “doing business” SEC logostandard, (ii) create a new intrastate exemption, Rule 147A, which allows use of the internet and other forms of general solicitation as well as out-of-state incorporation and (iii) increase the 12-month offering cap under Rule 504 from $1 million to $5 million.  This post will address all three of these significant reforms.

Amendments to Rule 147

The statutory exemption for intrastate offerings appears in Section 3(a)(11) of the Securities Act of 1933, which exempts from registration “any security … offered and sold only to persons resident within a single State … where the issuer … [is incorporated] and doing business within … such State …”.  Rule 147 is the safe harbor for Section 3(a)(11), and has not been amended in any significant way since its adoption in 1974.

One of the primary impediments to the use of Rule 147 has been the difficult test that issuers have been required to meet in order to establish sufficient nexus with the state in which the offering is made. To satisfy the doing business test, issuers were required to derive at least 80% of their consolidated gross revenues in-state, have at least 80% of their consolidated assets in-state and use at least 80% of net proceeds from the offering in connection with the operation of an in-state business.  Requiring an issuer to derive most of its revenue, maintain a majority of its assets and invest most of the capital it raises all in one state could create inefficient constraints for many emerging companies to operate and grow.

The final rules modify the current “doing business” in-state requirements in Rule 147 by requiring issuers to satisfy only one of four specified tests. Under amended Rule 147 (and new Rule 147A), in order to be deemed to be “doing business” in a state, an issuer will have to satisfy only one of the following requirements:

  • 80% of consolidated assets located in-state;
  • 80% of consolidated gross revenues derived from operation of a business or of real property located in or from the rendering of services within such state;
  • 80% of net offering proceeds intended to be used, and are in fact used, in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services within such state; or
  • Majority of employees are in such state.

The final rules take a side-by-side approach, adopting amendments to modernize Rule 147 and also establishing a brand new intrastate offering exemption under the Securities Act, designated Rule 147A, which will be similar to amended Rule 147 but with no prohibition on offers to non-residents and allowing issuers to be incorporated out of state. Under the final rules, issuers will be able to choose between utilizing Rule 147 and Rule 147A for intrastate offerings based on their preferences for communicating with investors. The SEC elected to keep and modify Rule 147 as a safe harbor under Section 3(a)(11) to allow issuers to continue to rely on state law exemptions that are conditioned upon compliance with Section 3(a)(11) and Rule 147.

New Rule 147A

In addition to the overly restrictive doing business requirements, two other features have served to dissuade issuers from taking advantage of the intrastate exemption. The first is the requirement that issuers be incorporated in-state, which disqualifies many emerging companies all over the country that choose to incorporate in management friendly confines like Delaware (or are forced to do so by their investors).  Second is the prohibition on making offers to out-of-state residents, even if sales are made only to in-state residents, which effectively eliminates the use of the internet, social media and other methods of general solicitation in conducting the offering.

New Rule 147A corrects these shortcomings. First, there is no requirement that the issuer be incorporated in-state.  So, for example, a company incorporated in Delaware that has its principal place of business in New York may sell to New York Delawareinvestors.  Second, it permits offers to out-of-state residents so long as all sales are limited to in-state residents, and more broadly allows general solicitation and general advertising (including use of unrestricted websites).  When using space-constrained social media like Twitter to solicit, the issuer may use an active hyperlink to the offering disclosure.   Rule 147A does require, however, prominent disclosure in all offering materials that sales will be made only to residents of the same state as the issuer.

Features Common to Amended Rule 147 and New Rule 147A

Both amended Rule 147 and new Rule 147A contain the following common features:

  • Issuer “principal place of business” must be in-state, and issuer must satisfy at least one “doing business” requirement that would demonstrate in-state nature of issuer’s business;
  • New “reasonable belief” standard in determining purchaser’s residence;
  • Issuers must obtain written residency representation from each purchaser;
  • Resales limited to state residents for a six month period;
  • Integration safe harbor that would include prior offers or sales of securities by the issuer, as well as certain post-offering offers or sales; and
  • Legend requirements to offerees and purchasers about resale limits.

Amendment to Rule 504

Rule 504 of Regulation D exempts from registration offers and sales of up to $1,000,000 of securities in any rolling 12-month period. Two of Rule 504’s general requirements, the prohibition on general solicitation and securities sold being deemed “restricted” securities, do not apply if the offer and sale are made:

  • exclusively in one or more states that provide for the registration of the securities, and require the public filing and delivery to investors of a disclosure document before sale;
  • in one or more states that require no registration, filing or delivery of a disclosure document before sale, if the securities have been registered in at least one state that provides for such registration, filing and delivery; or
  • exclusively according to state law exemptions that permit general solicitation so long as sales are made only to “accredited investors”.

Several states have instituted coordinated review programs to streamline the state registration process for issuers seeking to undertake multi-state registrations in reliance upon Rule 504. Because these offerings are typically limited to a few states, review of these offerings is undertaken on a regional basis. These programs establish uniform review standards and are designed to expedite the registration process, thereby potentially saving issuers time and money.

The new rules amend Rule 504 to increase the aggregate amount of securities that may be offered and sold from $1 million to $5 million. The SEC is hoping that the higher offering cap will promote capital formation by increasing the flexibility of state securities regulators to implement coordinated review programs to facilitate regional offerings.

The final rules repeal Rule 505 of Regulation D, which exempts offers and sales of up to $5 million and is now rendered obsolete by amended Rule 504. The rules also apply bad actor disqualifications to Rule 504 offerings, consistent with other rules in Regulation D.

Effective Dates

The foregoing reforms have the following effective dates:

  • Amended Rule  147: 150 days after publication in the Federal Register
  • New Rule 147A:  150 days after publication in the Federal Register
  • Amended Rule 504:  60 days after publication in the Federal Register
  • Repeal of Rule 505:  180 days after publication in the Federal Register

The SEC yesterday issued its highly anticipated final rules amending Regulation A to allow issuers u-s-secto raise up to $50 million in any 12 month period through public offering techniques but without registration with the SEC or state blue sky authorities.  The 453 page rules release features a scaled disclosure regime to provide issuers with increased flexibility with regard to offering size and should lower the burden of fixed costs associated with conducting Reg A offerings as a percentage of proceeds. The new rules go into effect 60 days after they are published in the Federal Register.

Reg A has been one of the most rarely used exemptions for securities offerings because it’s been perceived as cost ineffective: the $5 million maximum is just not worth the burdens associated with blue sky registration and qualification requirements in each state where the securities are offered.  JOBS act 2Fixed costs such as legal and accounting fees have served as a disincentive to use the exemption for lower offering amounts. Congress addressed the problem in 2012 through Title IV of the JOBS Act, which required the SEC to amend Reg A by exempting from Securities Act registration certain securities offerings of up to $50 million in any 12 month period. The anticipated amendment to Reg A has been referred to affectionately by securities lawyers as Reg A+, since it’s intended to be a more useful version of the old Reg A.

Old Reg A

Old Reg A provides an exemption from Securities Act registration for offerings of up to $5 million in any 12-month period, including no more than $1.5 million in resales by selling stockholders.  Reg A transactions have been referred to as mini public offerings because they permit general solicitation and advertising (prohibited in private offerings other than accredited investor-only offerings under Rule 506(c) passed in September 2013) and require a mini-registration statement to be filed and reviewed by the SEC containing the offering statement to be delivered to offerees.  Most importantly, shares sold in old Reg A offerings are not “covered securities” under the National Securities Markets Improvement Act, meaning that issuers  must comply with the registration and qualification requirements of the blue sky laws of each state where the offering is made.  A Reg A issuer was allowed to “test the waters,” or communicate with potential investors to see if they might be interested in the offering, before it made the filing with the SEC (Form 1-A).  Finally, securities sold in Reg A offerings are not restricted securities, meaning they can be freely resold by non-affiliates of the issuer.

New Reg A

The final rules expand Reg A into two tiers: Tier 1 for securities offerings of up to $20 million; and Tier 2 for offerings of up to $50 million.  The new rules preserve, with some modifications, existing provisions regarding issuer eligibility, offering circular content, testing the waters and “bad actor” disqualification.  Tier 2 issuers are required to include audited financial statements in their offering documents and to file annual, semiannual, and current reports with the SEC.  Except when buying securities listed on a national securities exchange, purchasers in Tier 2 offerings must either be accredited investors or be subject to certain limitations on their investment.

The key provisions of the final rules are as follows:

Offering Limitations and Secondary Sales

The final rules establish two tiers of offerings:

  • Tier 1: annual offering limit of $20 million, including no more than $6 million on behalf of selling stockholders that are affiliates of the issuer.
  • Tier 2: annual offering limit of $50 million, including no more than $15 million on behalf of selling stockholders that are affiliates of the issuer.

Investment Limitation

The SEC’s objective with the tiered approach is to scale regulatory requirements based on offering size, to give issuers more flexibility in raising capital under Reg A and to provide appropriately tailored protections for investors in each tier. The rules impose additional disclosure requirements and investor protection provisions in Tier 2 offerings. Issuers seeking a smaller amount of capital (i.e., no more than $20 million) benefit from scaled disclosure. Although Tier 2 offerings will require enhanced disclosure, it’s possible that the reduction in information assymetry will lead to higher valuations. Thankfully, the final rules raised the Tier 1 offering cap to $20 million from the proposed $5 million. The increase in maximum offering size could also contribute to the development of intermediation services, such as market making, as well as analyst coverage, which could have a positive impact on investor participation and aftermarket liquidity of Reg A shares.

In addition, selling stockholders are limited to no more than 30% of the aggregate offering price in an issuer’s initial Reg A offering and any subsequently qualified Reg A offering within the first 12-month period following the date of qualification of the initial Reg A offering.

As mentioned above, the new rules contain certain investor protections in Tier 2 offerings. The proposed rules included a 10% investment limit for all investors in Tier 2 offerings.  The final rules limit non-accredited investors in Tier 2 offerings to purchases of no more than 10% of the greater of annual income or net worth (for natural persons) or the greater of annual revenue or net assets (for non-natural persons), as proposed.  In response to commentator concerns, the Tier 2 investment limit does not apply to accredited investors or to securities that will be listed on a national securities exchange.  This is a sensible approach, inasmuch as accredited investors, due to their level of income or net worth, are more likely to be able to withstand losses from undiversified exposure to an individual offering, and there’s a higher level of investor protection with issuers required to meet the listing standards of a national securities exchange and become subject to ongoing Exchange Act reporting.

Treatment under Section 12(g)

Section 12(g) of the Exchange Act requires that an issuer with total assets exceeding $10 million and a class of equity securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, register such class of securities with the SEC. In its proposal release, the SEC did not propose to exempt Reg A securities from mandatory registration under Section 12(g), but solicited comment on the issue.  Some commentators questioned the extent to which Reg A securities would be held in street name through brokers, which the proposal mentioned as a factor that could potentially limit the impact of not proposing an exemption from Section 12(g).

The final rules conditionally exempt Tier 2 securities from the provisions of Section 12(g) provided the issuer (i) remains subject to, and is current in (as of fiscal year end), its Reg A periodic reporting obligations, (ii) engages the services of a transfer agent registered with the SEC under the Exchange Act, and (iii) meets requirements similar to those for “smaller reporting companies” (public float of less than $75 million or, in the absence of a public float, annual revenues of less than $50 million).  The transfer agent condition will provide added comfort that stockholder records and secondary trades will be handled accurately.

Offering Statement

The final rules require issuers to file offering statements with the SEC electronically on EDGAR, but permit non-public submission of offering statements and amendments for review by SEC staff before filing so long as all such documents are publicly filed not later than 21 days before qualification.  The new rules eliminate the Model A (Question-and-Answer) disclosure format under Part II of Form 1-A.

Testing the Waters

The new rules permit issuers to “test the waters” with, or solicit interest in a potential offering testing the watersfrom, the general public either before or after the filing of the offering statement, so long as any solicitation materials used after publicly filing the offering statement are preceded or accompanied by a preliminary offering circular or contain a notice informing potential investors where and how the most current preliminary offering circular can be obtained. Solicitation materials remain subject to the antifraud and other civil liability provisions of the federal securities laws.

Continuing Disclosure Obligations

Reg A currently requires issuers to file a Form 2-A with the SEC to report sales and the termination of sales made under Reg A every six months after qualification and within 30 calendar days after the termination, completion or final sale of securities in the offering. The final rules eliminate Form 2-A.  In its place, the rules require Tier 1 issuers to provide information about sales in such offerings and to update certain issuer information by electronically filing a Form 1-Z exit report with the SEC not later than 30 calendar days after termination or completion of an offering.  The rules require Tier 2 issuers to file electronically with the SEC on EDGAR annual and semiannual reports, as well as current event reports.

Application of Blue Sky Laws

The final rules preempt state registration and qualification requirements for Tier 2 offerings but preserve these requirements for Tier 1 offerings, consistent with state registration of Reg A offerings of up to $5 million under existing rules.  The SEC had originally proposed to preempt state regulation with respect to (i) all offerees in Reg A offerings and (ii) all purchasers in Tier 2 offerings.  The proposal to preempt blue sky requirements with respect to all offerees in a Reg A offering was intended to allow issuers relying on Reg A to communicate with potential investors via the internet and social media without concern that these communications might trigger registration requirements under state law.

The issue of state law preemption generated a great deal of public commentary.  To address commenter concerns and avoid potential confusion about the application of the preemption provisions in Tier 1 offerings, the final definition of “qualified purchaser” does not include offerees in Tier 1 offerings.  This is unfortunate.  In order to create an attractive alternative to IPOs, Congress mandated preemption for “qualified purchasers”, which it defined as any purchaser in a (new) Reg A offering. As made clear in the 2012 General Accounting Office Report, a primary reason Reg A has been seldom used is the delay, cost and uncertainty of divergent state review of offerings. Perhaps the SEC should have preempted state regulation of Reg A resales as well. One of the greatest benefits of a Reg A offering versus a Rule 506 offering is that the securities sold in the former will be freely tradeable immediately upon closing of the offering. Without clear federal preemption of blue-sky laws governing the resale of Reg A shares, however, investors may be concerned about their ability to resell their shares which will reduce their willingness to purchase these shares in the first place.

On December 15, 2014, the North American Securities Administrators Association launched the Electronic Filing Depository (“EFD”), an internet accessible database that allows issuers to submit Form D for Rule 506 offerings under Regulation D and pay related fees to state securities regulators.  It also allows anyone to search EFD’s Form D database.

This is a big deal.  Rule 506 of Regulation D is a “safe harbor” for the private offering exemption under Section 4(a)(2) of the Securities Act. Issuers relying on the Rule 506 exemption do not have to register their offering of securities with the SEC or state securities regulators, but they must file a Notice of Exempt Offering of Securities on Form D with the SEC and state securities regulators after they first sell their securities. The National Securities Markets Improvement Act of 1996 (“NSMIA”) was enacted to preempt state securities laws where they duplicate federal laws. As a result of NSMIA, states may not require registration under their blue sky laws of “covered securities”, which includes securities sold under Rule 506 of Regulation D, but are allowed to require issuers to make notice filings and pay filing fees when conducting offers and sales of covered securities in their state.  Most states only require that Rule 506 issuers file a copy of the Form D and pay a filing fee, but there are subtle substantive and mechanical differences among the states that make the process of complying with the blue sky requirements in multistate offerings enormously tedious and burdensome.

The launch of EFD will help alleviate these burdens.  EFD will reduce the time needed to prepare individual state paper filings as well as provide additional benefits such as a means of following the status of a state’s processing of a filing and a digitized depository of filings for public review.

Although state participation is voluntary, 38 states have already opted in.  Characteristically, New York is one of those not to have done so, which is unfortunate because New York’s filing requirements are arguably the most cumbersome, with the requirement to send blue sky filings to three different addresses in the state. 

So far, EFD only covers Form D filings and fee payment; it is not yet designed to handle any other blue sky filings required by participating states.

The NASAA hosts free training webinars on the use of EFD.  The next webinar is scheduled for February 5, 2015, with another webinar tentatively scheduled for February 23, 2015.  You can register here for the webinars.