Let the Fundraising Begin: SEC Harmonizes and Improves its Exempt Offering Framework

On November 2, 2020, the Securities and Exchange Commission (“SEC”) voted to amend and simplify its rules governing private-offering exemptions under the Securities Act of 1933 (the “Securities Act”) to promote capital formation (the “Amendments”).[1]  The SEC release included discussion of their intent to remain true to the key components of their mission, namely investor protection, capital formation and market integrity, while modernizing rules to adapt to developments in technology, marketplaces and access to capital.

The Amendments allow issuers to move from reliance on one private offering exemption to another, increase offering limits for investments covered under certain exemptions, harmonize disclosure and eligibility requirements while reducing offering costs and concerns over integration with other exemptions.  The substantial majority of the amendments take effect 60 days after publication in the Federal Register; the extension of the temporary Regulation Crowdfunding provisions take effect upon publication in the Federal Register.[2]

Changes to Private Offering Exemptions and Investment Limits

1. Regulation A Amendments.  The Amendments increase the maximum offering amount under Tier 2 of Regulation A (colloquially known as Reg A+) from $50 million to $75 million and raise the maximum offering amount for secondary sales under Tier 2 of Regulation A from $15 million to $22.5 million.  According to an SEC report, the amount of capital raised, and the number of issuances and amounts sought in Tier 1 and Tier 2 offerings, reported, as of December 31, 2019:

a. $2.446 billion raised by 183 issuers in ongoing and closed offerings (averaging $13.4 million), including $230 million in Tier 1 and $2.216 billion in Tier 2 offerings;

b. $9.095 billion sought across 382 qualified offerings (average of $23.8 million), including $759 million sought across 105 qualified Tier 1 offerings and $8.336 billion sought across 277 qualified Tier 2 offerings (excluding withdrawn offerings).[3]

2. Regulation Crowdfunding Amendments.  Once effective, the Amendments increase the offering limit in Regulation Crowdfunding from $1.07 million to $5 million, which is substantial and perhaps long overdue for this exemption that permits non-accredited investors.  According to a 2019 SEC report, between May 16, 2016 and December 31, 2018, approximately 1,351 Regulation Crowdfunding offerings occurred seeking between $94.3 million and $775.9 million.[4]  The SEC estimates that 29 offerings reported raising at least $1.07 million from May 16, 2016 through December 31, 2018.  The increased minimum amount may generate more interest in Regulation Crowdfunding.

The Amendments remove the investment limits for accredited investors, which will make this private offering exemption more consistent with other exemptions under Regulation D of the Securities Act.  Regarding non-accredited investors, the Amendments use the greater of an investor’s annual income or net worth when calculating the investment limits, which strikes a better balance between protecting these investors but allowing them greater freedom to invest.  The Amendments extend for 18 months the existing temporary relief that exempts issuers from financial statement review requirements for offering $250,000 or less of securities in reliance on the exemption within a 12-month period.

The Amendments also clarify that securities offered and sold under Regulation Crowdfunding will constitute “covered securities” so that state securities law registration and qualification requirements do not apply.

3. Rule 504 of Regulation D Amendments.  The Amendments raise the maximum offering amount from $5 million to $10 million for private offerings under Rule 504 of Regulation D of the Securities Act.  Recall that in October 2016, the SEC adopted amendments to Rule 504 to increase the aggregate amount of securities that may be offered and sold from $1 million to $5 million and apply bad actor disqualifications to Rule 504 offerings.  The main benefit of this new increase is that more small businesses will be able to rely on Rule 504, as it will now be in the consideration set for certain companies seeking funding of up to $10 million if Rule 504 makes sense for them.

4. Easing of Disclosure Under Rule 506(b) for Non-Accredited Investors.  The Amendments reduce the information requirements for non-accredited investors permitted in Rule 506(b) private offerings to align them with those for Regulation A offerings.  As such, issuers may use unaudited financial statements in offerings up to $20 million rather than audited financial statements, thus reducing costs considerably.  The SEC hopes that reducing the costs of sales and compliance costs under Rule 506(b) may expand access to capital for some issuers.  Moreover, the SEC’s data shows that a relatively small percent of investors in offerings seeking up to $20 million under Rule 506(b) are made by non-accredited investors.[5]

5. Easing of Investor Verification Under Rule 506(c).  The Amendments expand the Rule 506(c) accredited investor verification safe harbor to allow an issuer to treat an investor as accredited if (i) the issuer previously verified the investor within the last five years, (ii) the investor provides a written representation that the investor continues to qualify as an accredited investor, and (iii) the issuer is not aware of information to the contrary.  The Amendment includes reminders to issuers that these methods are from a non-exclusive list, thus they should apply the reasonableness standard directly to the specific facts and circumstances.

The SEC believes, in some circumstances, that the “reasonable steps determination” may not be substantially different from an issuer’s development of a “reasonable belief” for Rule 506(b) purposes, such as if the issuer reasonably takes into consideration a prior substantive relationship with the investor or other facts that make apparent the accredited status of the investor.  However, in contrast, such investor representation would not meet the “reasonable steps” requirement if the issuer has no other corroborating information or possess contrary information about the investor’s status an accredited investor.  The Amendments also reaffirm and update the following factors on which an issuer may rely for accredited-investor verification under Rule 506(c):

• The nature of the purchaser and the type of accredited investor that the purchaser claims to be;
• The amount and type of information that the issuer has about the purchaser; and
• The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

6. Affirmation of Regulation S Directed Selling Efforts.  The Amendments reaffirm the SEC’s position under Regulation S of the Securities Act that general solicitation by a United States issuer will not be deemed “directed selling efforts” under certain circumstances.  For example, in connection with a Regulation S offering, if the general solicitation did not occur for the purpose of conditioning the United States market then directed selling efforts as part of the Regulation S offering is permitted.  Recall that the availability of the issuer (Rule 903) and the resale (Rule 904) safe harbors under Regulations S have been contingent on the fact that (i) the offer or sale must be made in an offshore transaction; and (ii) no “directed selling efforts” may be made by the issuer, a distributor, any of their respective affiliates, or any person acting on their behalf.  This narrowing of the definition of directed selling efforts promotes international offerings, which will not be, integrated with registered domestic offerings or domestic offerings that are conducted in compliance with any exemption.

7. Adjusting Lookback Period for Bad Actor Disqualification.  The Amendments harmonize the “bad actor” disqualification provisions in Regulation D, Regulation A, and Regulation Crowdfunding by adjusting the lookback requirements in Regulation A and Regulation Crowdfunding to include the time of sale in addition to the time of filing.  The revised lookback period, which looks to both the time of filing of the offering document and the time of sale, will improve investor protections by further limiting the role of “bad actors” in exempt offerings and reducing the chance that investors may unknowingly participate in securities offerings involving offering participants who have engaged in fraudulent activities or violated securities or other laws or regulations.

Offering Day Communications Changes

The Amendments modify offering-day communications rules in the following ways:

1. First, as part of the SEC’s ongoing efforts to stimulate U.S. capital markets and boost capital formation, the Amendments permit an issuer to use generic solicitation of interest materials to “test-the-waters” for an exempt offering of securities before the issuer determines on which exemption it will rely.  This welcome change allows issuers to gauge market interest in possible private securities offerings use for the private sale of the securities, which means practically, before private offering materials are available.  The Amendments require that the legends in the testing-the-waters materials state that (a) no money or other consideration is being solicited, and if sent, will not be accepted; (b) no offer to buy the securities can be accepted and no part of the purchase price can be received until the offering statement is filed and only through an intermediary’s platform;  and (c) a prospective purchaser’s indication of interest is non-binding.

2. Second, in the context of Regulation Crowdfunding in particular, issuers may “test-the-waters” before its offering document with the SEC in a manner similar to current Regulation A.  Testing of the waters may occur orally or in writing with all potential investors prior to filing a Form C with the Commission under proposed Rule 206.  Proposed amendments to Rule 204 to conditionally permit oral communications with prospective investors are permitted once the Form C is filed.  The Amendments require issuers to include legends providing that (i) no money or other consideration is being solicited, and if sent, will not be accepted; (ii) no sales will be made or commitments to purchase accepted until the Form C offering statement is filed with the Commission and only through an intermediary’s platform; and (iii) a prospective purchaser’s indications of interest are non-binding.

In addition, pursuant to proposed Rule 201(z), issuers would be required to include any solicitation materials (under Rule 206) with the Form C filing to SEC.

3. Third, the Amendments provide that certain “demo day” communications will not be deemed general solicitation or general advertising.  Demo day communications occur where issuers discuss their business plans with potential investors.  The Amendments allow issuers to disclose that they are seeking capital without uncertainty as to whether they have put at risk any reliance on a certain private offering exemption even at a seminar or meeting sponsored by a college, university or other institution of higher education, a state or local government (or instrumentality), a nonprofit organization or an “angel investor group,” incubator or accelerator, subject to certain requirements.[6]

Progressive Integration Changes 

From time-to-time, issuers use multiple private offering exemptions simultaneously or contemporaneously, which is necessitated, in part, by their differing offering limits, conditions and whether the general solicitation of investors is permitted.  Leading multiple offerings can trigger issues of integration into a single “integrated” offering, which means that the integrated offering will fail to meet all the applicable conditions and limitations.

The Amendments reduce uncertainty and legal risk associated with integrating individual private offerings.  The Amendments contain an overriding rule that no integration is necessary if each offering meets the requirements for an exemption or complies with the registration requirements based on its particular facts and circumstances.  The Amendments also furnish various safe harbors, as follows:

1. First, private offerings separated by 30 days would not be integrated if an exempt offering without general solicitation follows an offering that permits general solicitation and the issuer has a reasonable belief that each purchaser in the exempt offering without general solicitation was not solicited through general solicitation because the issuer had a preexisting substantive relationship with the purchaser.  We note that notwithstanding this flexibility, not more than 35 non-accredited investors may invest under Rule 506(b) during a 90-day period.
2. Second, a firewall will exist under the Amendments for Rule 701 and Regulation S offerings so that neither would be integrated with other offerings regardless of when the offerings occur, including offers and sales made concurrently with other offerings.
3. Third, private offerings for which a Securities Act registration statement has been filed with the SEC would not be integrated if (i) made after termination or completion of an offering for which general solicitation is not permitted, or (ii) if the terminated or completed offering permitted general solicitation, if it was made only to qualified institutional buyers or institutional accredited investors, or (iii) was terminated or completed more than 30 days before commencement of the registered offering.
4. Fourth, a new safe harbor exists for exempt offerings using permitted general solicitation made after other terminated or completed offerings for which general solicitation is not permitted will not be integrated to defeat those other offerings.  It is crucial that the issuer terminates such previous offerings that do not permit general solicitation and not reference any securities in an advertisement for the event.  Examples of these exempt offerings that permit general solicitation, that would not be integrated under the Amendment with those private offering exemptions that do not, include Regulation A, Regulation Crowdfunding, Rule 147 or 147A, Rules 504(b)(1)(i), (ii), or (iii) and Rule 506(c).

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These Amendments are expected to simplify fundraising through private offerings in particular by small and medium-size companies that cannot rely on the public market and who lack the relationships to generate venture capital and institutional financing.  The Amendments simplify issuer’s capability to promote concurrent and successive private offerings by removing doubts about how to comply with the private offering rule and embody a prominent improvement in the private offering exemptions so heavily relied upon.