Oct. 03, 2019 - Chapter 8 of Davies Governance Insights 2019
SEC Proposes New Capital Raising Framework for Small Businesses Under JOBS Act
On December 18, 2013, the SEC proposed rules to amend Regulation A under the U.S. Securities Act of 1933 (the 1933 Act) to modernize and expand the framework for capital raising by smaller companies, as mandated under Title IV of the Jumpstart Our Business Startups Act (the JOBS Act). Currently, Regulation A enables eligible U.S. and Canadian issuers that are not SEC reporting companies to raise up to $5 million in any 12-month period in one or more offerings exempt from registration under the 1933 Act.1 Regulation A has been used infrequently in recent years principally due to the low offering threshold and the absence of state securities or “blue sky” law exemptions for Regulation A offerings.2 Title IV of The JOBS Act, entitled “Small Company Capital Formation,” directed the SEC to add a new exemption from registration under the 1933 Act for offerings of securities up to $50 million in any 12-month period. The proposed rules, known as Regulation A+, would expand Regulation A into two tiers:
- Tier 1, an exemption from registration for securities offerings of up to $5 million in any 12-month period, including up to $1.5 million for the account of selling securityholders (to preserve the existing exemption in Regulation A in substantially its current form), and
- Tier 2, an exemption from registration for securities offerings of up to $50 million in any 12-month period, including up to $15 million for the account of selling securityholders (to create the new exemption mandated under the JOBS Act).
The proposed rules seek to modernize the Regulation A offering framework by including a number of proposals that resemble regulatory developments in the registered offering process under Section 5 of 1933 Act. Rules regarding issuer eligibility (including “bad actor” disqualification provisions), communications, qualification and offering process (including “testing the waters” provisions), offering statement disclosure and certain other matters would apply equally to both Tier 1 and Tier 2 offerings. Tier 2 offerings would be subject to additional requirements, such as investor purchase limits, the provision of audited financial statements in the offering statement and the issuer becoming subject to ongoing reporting requirements. In light of the additional requirements proposed for Tier 2 offerings, securities offered and sold in a Tier 2 offering would be exempt from registration and qualification under state securities laws.3
Eligible Issuers and Securities
Regulation A is currently available to any U.S. or Canadian entity that has its principal place of business in the United States or Canada and is not subject to SEC reporting obligations under the U.S. Securities Exchange Act of 1934 (the “1934 Act”).4 Certain types of issuers, such as certain investment companies and “blank check companies,” are not eligible to offer or sell securities under Regulation A. Under the proposed rules, Regulation A would also not be available to issuers that are delinquent in Regulation A filings in the two years preceding the filing of the offering statement or are subject to certain SEC orders entered in the five years preceding the filing of the offering statement. The proposed rules would also amend the existing “bad actor” disqualification rules in Regulation A to conform them to the recent “bad actor” rule amendments adopted for Rule 506 offerings.
The types of securities that may be offered under the proposed rules would be limited to equity securities, debt securities and debt securities convertible into or exchangeable into equity securities, including any guarantees of such securities. Asset-backed securities are excluded.
Communications, Qualification and Offering Process
An issuer that seeks to conduct a Regulation A offering must prepare, file and qualify an offering statement on Form 1-A before any sales of securities can be completed. The core of the offering statement is the offering circular, a disclosure document much like an abbreviated version of the prospectus in a registered offering. The proposed rules seek to modernize the Regulation A offering process in a manner consistent with regulatory developments in the registered offering process, including:
- The offering statement and all other documents required to be submitted or filed with the SEC under Regulation A, such as ongoing reports, will have to be submitted or filed electronically on EDGAR.
- An issuer that has not previously sold securities pursuant to Regulation A or under an effective registration statement would be permitted to make a confidential submission of the offering statement. All confidential submissions (including subsequent amendments and SEC correspondence regarding these submissions) would be required to be publicly filed as exhibits to the offering statement not less than 21 days before qualification of the offering statement.
- When a preliminary offering circular is used during the prequalification period to offer securities to potential investors, issuers (or broker-dealers participating in the offering) would be required to deliver a preliminary offering circular to potential investors at least 48 hours in advance of the sale.5 Where the sale was made in reliance on the delivery of a preliminary offering circular, a final offering circular would have to be delivered within two business days after the sale but (under the “access equals delivery approach” used in registered offerings) issuers and intermediaries would be permitted to satisfy their delivery requirements by filing the final offering circular on EDGAR.
- Issuers would be permitted to “test the waters” by publicly soliciting indications of interest from any potential investor both before and after the filing of the offering statement. Solicitation materials would have to include certain disclaimers and satisfy certain other requirements. Issuers would be required to file all solicitation materials when the offering statement is either submitted for non-public review or filed with the SEC. Any solicitation materials used after the public filing of an offering statement would need to be preceded or accompanied by a preliminary offering circular or contain a notice informing potential investors where and how to obtain the most current preliminary offering circular. This requirement could be satisfied by providing the URL link to the preliminary offering circular or offering statement on EDGAR.
The Offering Statement and Other Considerations
Under the proposed rules, Regulation A offering statements would continue to be filed on Form 1-A. The proposal would eliminate the Model A “question and answer” disclosure format and update the disclosure requirements in the current Model B narrative option, including, for example, requiring more detailed disclosure in the MD&A regarding the issuer’s results of operations and liquidity and capital resources.6
The proposed rules require all issuers to include two years of financial statements in the offering statement. Financial statements for U.S. issuers would continue to be required to be prepared in accordance with U.S. GAAP, but Canadian issuers could prepare financial statements in accordance with either U.S. GAAP or International Financial Reporting Standards as issued by the International Accounting Standards Board. For Tier 1 offerings, audited financial statements would be required to the extent the issuer obtained an audit for other purposes, the audit was performed in accordance with U.S. generally accepted auditing standards or the auditing standards of the PCAOB and the auditor was independent under Rule 2-01 of Regulation S-X, although the auditor need not be registered with the PCAOB. For Tier 2 offerings, the financial statements included in the offering statement must be audited in accordance with PCAOB standards.7
As noted in the proposed rule, the provisions of Section 11 of the 1933 Act would not apply to Regulation A offerings. However, other anti-fraud and civil liability provisions of the securities laws do, and would continue to, apply to Regulation A offerings, including the liability provisions of Sections 12(a)(2) and 17 of the 1933 Act and Rule 10b-5 under the 1934 Act.
Qualification of a Regulation A offering statement would not by itself result in the issuer becoming subject to the reporting requirements of the 1934 Act. Section 12(g) of the 1934 Act, however, requires issuers with total assets exceeding $10 million to register under the 1934 Act any class of equity securities held of record by either 2,000 persons or 500 persons who are not accredited investors.8 The proposed rules would not exempt securities sold pursuant to Regulation A from the Section 12(g) registration thresholds. Accordingly, an issuer conducting a Regulation A offering would be advised to closely monitor the number of record holders for 1934 Act purposes, especially because securities sold pursuant to Regulation A are not considered “restricted securities” and may be transferred without restriction.
Additional Requirements for Tier 2 Offerings
Under the proposed rules, Tier 2 offerings would be subject to the following additional requirements, which are intended to address certain investor protection concerns. First, as indicated above, financial statements included in the offering statement for a Tier 2 offering would be required to be audited in accordance with PCAOB standards. Second, Tier 2 offerings would be subject to investment limits – an investor would not be permitted to invest more than 10% of the greater of the investor’s annual income and net worth in any one Tier 2 offering.9
Third, issuers in Tier 2 Offering would be subject to an ongoing reporting regime that is analogous to the regime for U.S. domestic reporting companies under the 1934 Act, but with reduced disclosure requirements. Tier 2 issuers would be required to file annual reports on Form 1-K, semi-annual reports on Form 1-SA, current reports on Form 1-U and special financial reports on Form 1-K and Form 1-SA. Annual reports on proposed new Form 1-K would include disclosures relating to the issuer’s business and operations for the preceding three years (or ince inception if in existence for less than three years); related party transactions; beneficial ownership; executive officers and directors; executive compensation; MD&A; and two years of audited financial statements. Semi-annual reports on proposed new Form 1-SA would require disclosures similar to quarterly reports on Form 10-Q, but without information about market risk, risk factors, disclosure controls and procedures and internal controls.10 Current reports on proposed new Form 1-U would require disclosure within four business days of certain material events, including fundamental changes in the business, bankruptcy, changes in control, changes in the certifying accountant, and departure of officers.
A Tier 2 issuer may suspend its reporting obligations by filing a Form 1-Z at any time after completing its reporting for the fiscal year in which the offering statement was qualified, provided that: (i) the issuer has filed all required ongoing reports for the shorter of the period since the issuer became subject to such reporting obligations or its most recent three fiscal years and the portion of the current year preceding the date of filing the Form 1-Z; (ii) the securities of each class to which the offering statement relates are held of record by fewer than 300 persons; and (iii) offers or sales made in reliance on a qualified offering statement are not ongoing. Regulation A reporting requirements would be automatically suspended if the issuer registers a class of securities under Section 12 of the 1934 Act.
Can Regulation A be the “Game Changer” for Smaller Growing Companies?
Until about a decade ago, IPOs of up to $50 million were common in the United States. However, for a variety of reasons (including significant regulatory changes, expanded disclosure requirements, lengthy SEC review process, stock exchange governance listing requirements, etc.), the traditional IPO process has become substantially more time consuming and expensive. Additionally, the uncertainty about being able to complete the lengthy registration process and launch an IPO in favorable market conditions has often discouraged smaller companies from embarking on this path. Despite the accommodations for emerging growth companies provided by the JOBS Act, a traditional IPO may not be a realistic capital raising alternative for smaller companies in the United States.
As a result, smaller private companies have had to rely almost exclusively on exempt offerings, such as Rule 506 and 144A offerings, to raise capital in the United States. While recent changes to Rule 506 and Rule 144A have provided some more flexibility to issuers by lifting the ban on general solicitation, the attractiveness these offerings is limited due to their eligibility requirements for investors (e.g., accredited investors) and because the securities issued are subject to transfer restrictions. Investors prefer to purchase securities that are not “restricted” and may be freely traded in a secondary market (assuming there is a secondary market).11
Further, smaller companies may want (or need) to be able to approach any investors. Regulation A does not limit the number of offerees or investors that can participate in an offering, nor does it impose any requirement that investors be accredited or financially sophisticated. The proposed new Tier 2 exemption, if adopted, may finally provide smaller companies with a viable capital raising alternative that is less time consuming, less costly and more efficient than a traditional IPO and more attractive than a private placement. If successful, the proposed Tier 2 offering and the reduced ongoing reporting regime that follows an completed Tier 2 offering may possibly become the path that smaller growth companies take as a precursor to a subsequent registered IPO or listing on a national securities exchange.
1 A Regulation A offering is a public offering, with no prohibition on general solicitation and general advertising. Securities sold under Regulation A are not “restricted securities” under the 1933 Act and, therefore, are not subject to the limitations on resale that apply to securities sold in private offerings. There is currently no limit on the amount of securities that may be purchased by an investor in a Regulation A offering. However, one of the most significant concerns limiting the use of the current Regulation A exemption has been the requirement to comply with state securities or “blue sky” laws.
2 The SEC stated in the proposing release that “[i]n 2012 alone, there were eight qualified Regulation A offerings for a total offering amount of approximately $34.5 million, compared to approximately 7,700 Regulation D offerings of up to $5 million for a total offering amount of approximately $7 billion, and 52 registered offerings of up to $5 million for a total offering amount of approximately $132 million.” According to the SEC, no Canadian issuers have qualified a Regulation A offering since 2002. Rule 506 under Regulation D has become the most commonly used exemption from registration as it has no offering limit and securities issued under Rule 506 are pre-empted from registration or qualification under state securities or “blue sky” laws. (The most a state may require of an issuer in a Rule 506 offering is a notice filing and the payment of a filing fee. In Rule 506 offerings, states continue to retain jurisdiction over anti-fraud enforcement and the regulation of intermediaries such as broker-dealers.)
3 Issuers proposing to offer or sell securities in Tier 1 offerings would continue to be subject to state securities law registration and qualification requirements, unless an exemption is available under state law. The North American Securities Administrators Association has proposed a coordinated review program that would streamline the state filing and review process for Regulation A offerings, but the details have not been finalized. The SEC indicated in the proposed rules that it would monitor the development of the coordinated review program. It remains to be seen whether a coordinated state review program can be finalized, adopted and successfully implemented and, if so, whether such a program would sufficiently address current concerns about the costs of blue sky compliance.
4 Regulation A is currently not available to foreign private issuers other than Canadian issuers. The SEC has requested comment on whether to exclude all foreign private issuers (including Canadian issuers) from Regulation A, or to make Regulation A available to non-Canadian foreign private issuers.
5 A final offering circular would continue to be required to accompany or precede any written communications that constitute an offer in the post-qualification period.
6 Alternatively, issuers would still be able to satisfy the requirements of Form 1-A by providing the disclosure required by Part1 of Form S-1.
7 As with Tier 1 offerings, the auditor of financial statements being filed in a Tier 2 offering must be independent under Rule 2-01 of Regulation S-X and must comply with other requirements of Article 2 of Regulation S-X, but the auditor need not be registered with the PCAOB.
8 The JOBS Act raised the threshold number of shareholders of record for mandatory registration of a class of equity of an issuer under the 1934 Act from 500 to 2,000 (or 500 who are not accredited investors).
9 Under the proposal, issuers would be required to make investors aware of the investment limitations, but would otherwise be able to rely on an investor’s representation of compliance with the proposed investment limitation unless the issuer knew, at the time sale, that any such representation was untrue.
10 Neither the annual report nor the semi-annual report will require management certifications, management reports on internal control over financial reporting, or auditor attestation reports on the issuer’s internal control over financial reporting.
11 The proposing release notes that in order to list securities offered pursuant to Regulation A on a national securities exchange, an issuer would still be required to file a Form 10 to register the class of securities under the 1934 Act. Under the proposed rules, however, a review of the issuer’s mandatory ongoing reports would be sufficient to satisfy a broker-dealer’s obligations under 1934 Act Rule 15c2-11 to review information about the issuer in connection with publishing quotations on any facility other than a national securities exchange. Therefore, unless the issuer has taken steps to register the class of securities under the 1934 Act and list the class of securities on an exchange, as a practical matter the securities will likely trade on the OTC Markets (formerly the Pink Sheets).