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.

In a massive 585 page release, the Securities Exchange Commission on October 23 issued its long overdue proposed rules on equity crowdfunding to implement the statutory equity crowdfunding exemption set forth in Title III of the JOBS Act.  As proposed, Regulation Crowdfunding implements and further clarifies the statutory requirements for equity crowdfunding, and in some instances imposes conditions that exceed those in the JOBS Act.  The process is far from over. Given the sheer volume of issues over which the SEC is seeking comment — the release identifies 295 separate issues over which it is inviting specific comment — it’s hard to imagine that final rules will be enacted before the middle of 2014.  Equity crowdfunding has the potential to create meaningful new capital raising opportunities for startups and early stage companies, but that potential may be undercut, however, by the disproportionate disclosure and other burdens imposed in the proposed rules on issuers and intermediaries relative to other private offering exemptions.

Background

Crowdfunding is a relatively new and evolving fund raising method used by artists, musicians and not-for-profits who leverage social media, websites and the internet to raise funds from large numbers of individuals.  Crowdfunding has even been used successfully by for-profit ventures who often entice contributions by offering some token object of value such as tee shirts, early versions of a product, invites to a screening or back stage passes, in exchange for contributions.

These forms of crowdfunding have not implicated the securities rules and are perfectly legal because there is no expectation of sharing in profits, i.e., the contributors are not issued securities.  Any fund raising campaign in which contributors are offered some share of profits would either need to be registered or qualify for an exemption.  Registration would be disproportionately expensive and burdensome for the relatively small amounts raised in crowdfunding transactions.  On the other hand, limitations under existing exemptions, including restrictions on general solicitation and general advertising and purchaser qualification requirements, have made private placement exemptions generally unavailable for crowdfunding. Moreover, funding portals would, under existing regulations, be required to register with the SEC as broker-dealers which would also be impractical in a crowdfunding context.

Title III of the JOBS Act, enacted in April 2012, fashioned a new exemption in the form of Section 4(a)(6) of the Securities Act for offerings of securities through a funding portal with limits on amounts raised ($1 million during any twelve month period) and invested, and instructed the SEC to promulgate rules to implement the new exemption.  The new Section 4(a)(6) exemption will not be available until the SEC approves final rules. Our original post summarizes the JOBS Act, including Title III on crowdfunding.

Limits on Amounts Raised and Invested

As proposed, issuers and investors would be limited by caps on dollars raised and invested in Section 4(a)(6) offerings, as follows:

  • An issuer could raise a maximum aggregate amount of $1 million through Section 4(a)(6) offerings in any rolling 12-month period
  • Investors, over the course of a 12-month period, would be permitted to invest up to:
    • $2,000 or 5% of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000
    • 10% of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or greater than $100,000.  Investors would not be able to purchase more than $100,000 of crowdfunding securities during any 12-month period

SEC Seeking Comment: Should the $1 million issuer limit be net of fees charged by the intermediary?  Should issuers be allowed to exclude any other fees when calculating the amount raised?

Non-Financial Disclosure Requirements

Consistent with Title III of the JOBS Act, the proposed rules would require companies to file certain information with the SEC and provide it to shareholders, the funding portal intermediary and potential investors.

The offering document, Form C, would be required to disclose:

  • description of the business and business plan
  • price of securities offered, target offering amount, deadline to reach target, and whether company will accept investments in excess of target
  • names of 20% or larger shareholders
  • information about officers and directors
  • related-party transactions
  • commitments cancelled if target not met

Companies would be required to amend Form C to disclose material changes (Form C-A) and provide updates on progress toward reaching the target offering amount (Form C-U).  Following the offering, crowdfunding issuers would be required to file an annual report with the SEC and provide it to investors.

SEC Seeking Comment:  The proposed rules don’t specify the specific disclosures that an issuer must include in the description of the business and the business plan, recognizing that crowdfunding issuers will be at various stages of development.  Should there be specific disclosure requirements about the business and the anticipated business plan?

Financial Statement Requirements

Issuers would be required to provide the following financial statements in the offering document, depending on the aggregate amount they offer and sell under Section 4(a)(6) in any rolling 12-month period:

  • Offerings of $100,000 or less: U.S. GAAP financial statements for the two most recently completed fiscal years or shorter period during which the issuer has been operating, and income tax return for the most recently completed fiscal year, if any, in both cases certified as true and complete by the issuer’s principal executive officer.
  • Offerings of $100,000 – $500,000: U.S. GAAP financial statements reviewed (in accordance with AICPA standards) by a public accountant independent of the issuer and accompanied by the accountant’s review report.
  • Offerings above $500,000. U.S. GAAP financial statements audited by an independent auditor, accompanied by the audit report.

SEC Seeking Comment:  Should the SEC exempt from the financial statement requirement issuers with no operating history and/or issuers that have been in existence for fewer than 12 months?

Disqualification

The following issuers would not be eligible for equity crowdfunding under Section 4(a)(6):

  • foreign issuers, SEC reporting companies and investment companies
  • issuers that failed to make any required Form C filings in the two years before a crowdfunding offering
  • issuers with no business plan or with only a plan to merge with an unidentified operating company

Further, an issuer would be ineligible if any of the following “covered persons” was involved in a “disqualifying event”:

  • the issuer, its predecessors and certain affiliates
  • the issuer’s directors, officers, general partners or managing members
  • 20% beneficial owners of the issuer (calculated by voting power)
  • compensated solicitors for the offering
  • any director, officer, general partner or managing member of a compensated solicitor for the offering

The “disqualifying events” would include certain securities-law related injunctions and restraining orders entered in the last five years and certain regulatory orders entered in the last ten years, with exceptions for events the issuer did not know of and, in the exercise of reasonable care, could not have known of. This would require the issuer to make a factual inquiry into whether any disqualifications existed, the nature and scope of which would vary based on the circumstances of the issuer and the other offering participants.

SEC Seeking Comment:  Should the SEC include additional guidance on what types of factual inquiries should be undertaken under the reasonable care standard and should there be a cut-off date?

Resale Restrictions

Securities acquired in a crowdfunding transaction would not be allowed to be resold for a period of one year, unless they are sold to a member of the family of the purchaser, to a trust controlled by the purchaser, to a trust created for the benefit of a member of the family of the purchaser or in connection with the death or divorce of the purchaser.

Exemption from Section 12(g) Cap

Section 12(g) of the Securities Exchange Act of 1934 now requires that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons or 500 persons who are not accredited investors register that class of securities with the SEC and subject itself to the SEC’s periodic reporting regime.

The proposed rules provide that securities issued in a crowdfunding transaction under Section 4(a)(6) would be permanently exempted from the record holder tabulation under Section 12(g). An issuer seeking to exclude a person from the record holder tabulation for Section 12(g) purposes would have the responsibility for demonstrating that the securities held by the person were initially issued in a Section 4(a)(6) offering.

SEC Seeking Comment:  Should the Section 12(g) exemption for securities issued in a Section 4(a)(6) offering be permanent or only when held of record by the original purchaser, an affiliate of the original purchaser, a member of the original purchaser’s family or a trust for the benefit of the original purchaser or the original purchaser’s family?

Crowdfunding Intermediaries

The proposal requires that equity crowdfunding offerings be conducted only through a broker or funding portal (and only one), in each case that complies with Section 4A(a) of the Securities Act.  The SEC believes that this facilitates the ability of members of the crowd to share information and evaluate the idea or business. Section 4A(a) places certain requirements on these crowdfunding intermediaries, including that they:

  • be registered with the SEC either as a broker or as a funding portal by filing Form Funding Portal, as well as other substantive requirements such as the requirement to have a fidelity bond in place
  • prohibit their directors, officers and partners from having any financial interest in an issuer using their services
  • provide investors with educational materials
  • have a reasonable basis to believe the issuer is in compliance with regulations and has set up a means to keep accurate records of its shareholders, and must deny access to any issuer the intermediary believes presents a potential risk of fraud by conducting certain background checks.
  • make available information about the issuer and the offering no later than 21 days before the first day securities are sold to any investor.
  • ensure no investor exceeds the investment limits (intermediary allowed to rely on an investor’s representations about its income and net worth and total crowdfunding investments made in the last 12 months)
  • Allow investors to cancel their investment commitments until 48 hours before the deadline identified in the issuer’s offering materials

Concluding Thoughts

Equity crowdfunding has the potential to create new capital raising opportunities for many startups and early stage companies by removing antiquated regulatory barriers and allowing companies to leverage the internet and social media to reach prospective investors.  The federal securities laws were written 80 years ago when investors had no access to information about issuers.  In the internet age, prospective investors have many sources of information at their fingertips and the “wisdom of the crowd” can both steer dollars to the most promising ideas and ensure that ample information is spread to interested parties.

But the preoccupation of the SEC with investor protection has created a disconnect between the potential of equity crowdfunding and its reality in the form of the proposed crowdfunding rules.  To be fair, the framework for most of the rules was predetermined by what Congress enacted in Title III of the JOBS Act.  Nevertheless, I fear that the burden and expense associated with many of the proposed rules will, if passed substantially unchanged from its current form, prove to be far less attractive to most companies than traditional private placements.  For example, the requirement to produce audited financial statements for offerings above $500,000 will seem prohibitively expensive when compared with accredited investor-only Rule 506 offerings where no financials are mandated at all.  It’s also unclear how the burdensome rules proposed to govern intermediaries will attract established investment banks, or even boutiques, and will likely leave the field open primarily to persons with scant resources and experience.  Lastly, even in the context of a successful crowdfunded offering, companies will also need to consider carefully the negative consequences associated with a shareholder base consisting of potentially thousands of individual investors.  Those consequences include the expense associated with keeping them informed, the difficulties of securing quorums and votes and the inevitable misgivings VCs will have of investing in a crowdfunded startup.

Comment Process

The SEC is seeking comment generally on its proposed rules during a 90-day comment period, and the release identifies 295 separate issues over which it is inviting specific comment.  The deadline for comments is February 3, 2014 and could be submitted here.