Eversheds Sutherland (US) LLP
On June 18, 2019, the Securities and Exchange Commission (the “SEC”) issued a concept release (the “Release”) on ways to “simplify, harmonize, and improve the exempt offering framework to expand investment opportunities while maintaining appropriate investor protections and to promote capital formation.”1 The Release notes, among other things, that in light of the increased amounts of capital currently being raised through exempt offerings, the SEC is asking for comment regarding if it should consider rule changes to make exempt offerings available to a wider swath of investors. The current exempt offering framework has been developed over the years through various legislative action, including the Securities Act of 1933 (the “Securities Act”) and the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), as well as through exemptions adopted by the SEC.
The Release seeks input from issuers and investors as part of the SEC’s effort to perform what SEC Chairman Jay Clayton describes as a “comprehensive review of the design and scope of our framework for offerings that are exempt from registration” The Chairman’s goal in issuing the Release was “to ensure that our multifaceted private offering framework works for investors and entrepreneurs alike, no matter where they are located in the United States.”
The Release, while seeking public comments on a wide range of issues, specifically identifies potential changes to the existing exempt offering framework. Key topics identified throughout the 211-page release include:
- Investor limitations and the accredited investor definition;
- The existing exempt offering framework;
- The capital raising exemptions within the framework;
- Potential gaps in the framework;
- Pooled investment funds, and
- Secondary trading.
Investor Limitations and the Accredited Investor Definition
Under current law,2 an individual is an accredited investor if the individual is a natural person who either (1) has an income that exceeds $200,000 (or $300,000 in joint income with a person’s spouse) in each of the two most recent years and reasonably expects to reach the same income level in the current year, or (2) has a net worth greater than $1 million (individually or jointly with a spouse), excluding the value of their primary residence. Additionally, directors, executive officers and general partners of the issuer selling the securities are considered accredited investors with respect to that issuer. Further, certain entities with over $5 million in assets also qualify as accredited investors and other regulated companies, such as banks and registered investment companies, are also deemed to be accredited investors but are not subject to any asset tests.
The accredited investor definition seeks to capture those individuals or organization whose financial sophistication and ability to sustain the risk of loss of investment, or ability to fend for themselves, make the safeguards of the Securities Act’s registration process unnecessary.3 Accredited investors can participate in investment opportunities that are not otherwise available to non-accredited investors.4
Accredited investors make up a very substantial proportion of private business development company (“BDC”) investors.
One question posed by the SEC as part of the concept release is whether the limitations on who can invest in certain exempt offerings, or the sum they can invest, provide an appropriate level of investor protection (i.e., whether the current levels of investor protection are insufficient, appropriate, or excessive) or pose an unnecessary hindrance to capital formation or investor access to investment opportunities.5 Additionally, the SEC is also seeking comment on the criteria for persons and companies to qualify as accredited investors, including if the current financial thresholds should remain in place and if other measures of sophistication should qualify an individual as an accredited investor.
The Capital Raising Exemptions within the Framework
There are currently various capital raising exemptions from the federal securities laws including: the private placement exemption and Rule 506 of Regulation D, Regulation A, Rule 504 of Regulation D, the intrastate offering exemptions and Regulation Crowdfunding.
The Private Placement Exemption and Rule 506 of Regulation D
Rule 506 of Regulation D provides two exemptions from the registration requirement for issuers, allowing them to raise an unlimited amount of capital within the exemption. Companies can utilize one of the exemptions, the 506(b) safe harbor, if they follow certain requirements including, but not limited to, a prohibition from general solicitation, limiting the offering to accredited investors and up to 35 sophisticated non-accredited investors, and disclosure of relevant materials to all investors. Under the 506(c) exemption, a company can broadly solicit and advertise the offering and still meet the exemption’s requirements if the sale is limited to only accredited investors and the company takes “reasonable steps to verify that the investors are accredited investors.”
Rule 506(b) sales make up roughly 89% of offerings under Regulation D and also exceed the amount raised in the registered market. While some of the conditions to comply with the 506(c) safe harbor may be more relaxed, the concept release notes that the 506(b) exemptions continues to make up the bulk of the Regulation D market because issuers are oftentimes accustomed to replying on 506(b) and do not require the flexibility provided by the 506(c) safe harbor.
The Release seeks comments on questions as broad as whether the SEC should consider any changes to Rule 506(b) or 506(c) and whether the requirements of Rules 506(b) and 506(c) appropriately address capital formation and investor protection considerations.6 However, it also seeks comments on more narrow issues such as: if the 506(b) limits for non-accredited investors are necessary; if non-accredited investors should be permitted to partake in 506(b) offerings at all; if information disclosure requirements need to be increased or lessened; are issuers hesitant to rely on 506(c) (and if so, why); and many more.
Regulation A provides another exemption from registration, focusing on public offerings that are split into two tiers. Tier 1 is for offerings of up to $20 million in a 12-month period and Tier 2 is for offerings of up to $50 million in a 12-month period. Certain basic requirements – such as company eligibility criteria, bad actor disqualification provisions, disclosure, and other matters – apply to both tiers. Currently, Regulation A is not available to investment companies registered or required to be registered under the Investment Company Act of 1940, as amended (the “1940 Act”) or to BDCs.
The request for comments touching on Regulation A includes general questions about the status of the $20 and $50 million tiers and the qualifying requirements for issuers. However, it also considers if the eligibility to rely on Regulation A should be expanded to additional categories of issuers, such as BDCs.
Rule 504 of Regulation D
Rule 504 of Regulation D provides an exemption from registration under the Securities Act for some companies when they offer and sell up to $5 million of securities in a 12-month period. In most circumstances, purchasers of Rule 504 securities receive “restricted” securities which cannot be sold for at least six months to a year without being registered and issuers are prohibited from soliciting or advertising the securities.
While issuers conducting offerings under Rule 504 are not required to register their offering with the SEC, they do have to file a notice (known as Form D) with the SEC after the first sale of the securities in the offering.
Currently, a number of issuers are not eligible to use the Rule 504 exemption, including issuers that must file reports under Exchange Act Section 13(a) or 15(d), investment companies, blank check companies, and issuers that are disqualified under Rule 504’s “bad actor” disqualification provisions.
Rule 504 makes up a small segment of the capital raised in Regulation D offerings, totaling just two percent from 2009-2018 (in comparison with 98 percent coming from Rule 506).
In the concept release, the SEC seeks comments regarding the structure and restrictions of Rule 504, asking among other things if any changes need to be made to the exemption, if they should increase the $5 million offering limit, and if they should extend eligibility to Exchange Act reporting companies or investment companies.
Section 3(a)(11) of the Securities Act, known as the “intrastate offering exemption,” is yet another exemption from registration. To qualify for this exemption, an issuer must (1) be organized in the state where it is selling the securities, (2) conduct a substantial amount of its business in that state, and (3) make offers and sales only to residents of that state. In requesting feedback on the intrastate offering exemption, the SEC is asking, among other things, to what extent the exemptions are being used and if the current requirements adequately capture “intrastate” issuers and investors.
Regulation Crowdfunding allows eligible companies to offer and sell securities via crowdfunding without registering the sale with the SEC. This exemption was added to the Securities Act with the passage of Title III of the JOBS Act in 2012. To qualify for this exemption, transactions must meet several requirements, including limits on the total sum that can be raised (a maximum aggregate amount of $1.07 million in a 12-month period), restrictions on the amount an individual may invest, and a mandate that transaction be conducted through an SEC-registered intermediary (such as a broker-dealer or a funding portal).
In the Release, the SEC asks, among other things, if the costs associated with conducting a Regulation Crowdfunding offering discourage issuers from utilizing the exemption and how the SEC can lessen the burdens or minimize the costs for issuers while still retaining suitable investor protection. Additionally, the SEC asks if it should adjust the eligibility criteria for issuers or securities offered under this exemption.
Potential Gaps in the Framework
Within the concept release, the SEC notes that smaller issuers often face difficulties accessing capital. To address this, the SEC seeks comment on the feasibility of micro-offerings to provide a more realistic and cost-effective option for smaller issuers.
The SEC seeks comments regarding whether it should add a micro-offering or micro-loan exemption and requests specific comments on size regulations of the potential offerings and any advisable limits.
The integration doctrine provides a framework to determine if multiple securities should be considered part of the same offering and helps identify if registration under the Securities Act is necessary. Over the years, in order to simplify the question of if a particular securities offering should be integrated with another, the SEC has created safe harbors from integration. These various safe harbors provide objective standards on which an issuer can rely to avoid integration of two offerings into one.
Within the Integration discussion, the SEC has asked a range of questions including if it should articulate one integration doctrine that can apply to all exempt offerings, as well as if changes should be made to various safe harbor rules or integration analyses.
Pooled Investment Funds
For the purposes of the concept release, the SEC noted that pooled investment funds include “investment companies, such as a mutual fund or exchange-traded fund (“ETF”), registered under the Investment Company Act, a BDC, or a private fund that operates pursuant to an exemption or exclusion from the Investment Company Act.” These funds can serve as an important source of funding for issuers, especially those seeking to raise growth-stage capital. Additionally, there are various advantages for retail investors in investing through pooled investment funds, including the ability to diversify a portfolio and obtain returns that are less correlated to the public markets.
The SEC notes, however, that while retail investors who are not accredited investors have exposure to exempt offerings indirectly through investment companies registered under the Investment Company Act and BDCs, those opportunities may be limited. This is a result of the fact that open-end funds, from which investors can redeem their interest on a daily basis, have various restrictions that make it challenging to hold a large number of securities issued in exempt offerings. In contrast, closed-end funds, which are better equipped to hold less liquid securities that can be obtained in exempt offerings, are not subject to the same restrictions as open-end funds. However, because closed-end funds and BDCs retain contributed capital and profits upon a liquidity event of a portfolio company, investors do not always directly benefit from these profits.
Among pooled investment funds, registered investment companies, BDCs and SBICs are all deemed to be accredited investors without having to meet asset requirements or other qualifications. Other private funds cannot qualify as accredited investors unless they qualify under a separate provision of Rule 501(a).
In the Release, the SEC asks a number of questions that touch on BDCs. Broadly speaking, the request focuses on the extent to which issuers view pooled investment funds as an important source of capital for exempt offerings. More specifically, the concept release seeks comment regarding: whether registered investment companies and BDCs provide more capital to issuers than private equity and venture capital funds; if there are regulations that discourage, or have the effect of discouraging, participation by BDCs in exempt offerings; and, for closed-end funds and BDCs, if there are existing regulations that discourage the introduction of investment products that focus on issuers seeking capital at key stages of their growth cycle.
Additionally, the SEC seeks comments on what restrictions should exist, if any, on the ability of closed-end funds, such as BDCs, to invest in private funds and if other pooled investment funds should qualify as accredited investors in similar fashion to BDCs.
This Release presents an opportunity for companies to engage directly with the SEC on key aspects of the exemption framework. If the SEC is willing to expand the availability of exempt offerings, these changes could bring a wider variety of products and distribution channels back into the market, including for BDCs. Such expansion would increase the availability of capital and allow more flexibility for BDC fundraising activities.Recent comments made by SEC staff members make clear that comments need not always be made on a formalized basis. To the extent companies wish to weigh in on the Release, there are multiple avenues to do so.
1SEC Press Release, SEC Seeks Public Comment on Ways to Harmonize Private Securities Offering Exemptions, https://www.sec.gov/news/press-release/2019-97
217 CFR 230.501(a) (“Rule 501(a) of Regulation D”)
3See, e.g., Regulation D Revisions Proposing Release; see also Amendments for Small and Additional Issues Exemptions under the Securities Act (Regulation A), Release No. 33-9741 (March 25, 2015) [80 FR 21805 (April 20, 2015)] (“2015 Regulation A Release”) at note 146.
4Concept Release on Harmonization of Securities Offering Exemptions, Rel. Nos. 33-10649; 34-86129, at 32-33 (June 18, 2019)
6Concept Release on Harmonization of Securities Offering Exemptions, Rel. Nos. 33-10649; 34-86129, at 82 (June 18, 2019).