The SEC yesterday issued its highly anticipated final rules amending Regulation A to allow issuers to 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. Fixed 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.
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.
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 from, 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.