On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The June concept release sought public comments on: (i) whether the exemptive framework as a whole is effective for both companies and investors; (ii) ways to improve, harmonize and streamline the exemptions; (iii) whether there are gaps in the regulations making it difficult for smaller companies to raise capital; (iv) whether the limitations on who can invest and amounts that can be invested (i.e., accredited investor status) pose enough investor protection and conversely create undue obstacles to capital formation; (v) integration and transitioning from one offering exemption to another; (vi) the use of pooled investment funds as a source of private capital and access to those funds by retail investors; and (vii) secondary trading and re-sale exemptions.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, I will break it down over a series of blogs, with this first blog focusing on integration.
Background; Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
In recent years the scope of exemptions has evolved stemming from the JOBS Act in 2012, which broke up Rule 506 into two exemptions, 506(b) and 506(c), and created the current Regulation A/A+ and Regulation Crowdfunding. The FAST Act, signed into law in December 2015, added Rule 4(a)(7) for re-sales to accredited investors and the Economic Growth Act of 2018 mandated certain changes to Regulation A, including allowing its use by SEC reporting companies, and Rule 701 for employee stock option plans for private companies. Also relatively recently, the SEC eliminated the never-used Rule 505, expanded the offering limits for Rule 504 and modified the intrastate offering structure.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For more information on Rule 504 and intrastate offerings, see HERE; on rule 506, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. The disparate requirements can be tricky to navigate and where a company completes two offerings with conflicting requirements (such as the ability to solicit), integration rules can result in both offerings failing the exemption requirements.
The chart at the end of this blog contains an overview of the current most often used offering exemptions.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
The current Securities Act integration framework for registered and exempt offerings consists of a mixture of rules and SEC guidance for determining whether two or more securities transactions should be considered part of the same offering. In general, the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. That is, where two or more offerings are integrated, there is a danger that the exemptions for both offerings will be lost, such as when one offering prohibits general solicitation and another one allows it.
The current integration rule (Securities Act Rule 502(a)) provides for a six-month safe harbor from integration with an alternative five-factor test including: (i) whether the offerings are part of a single plan of financing; (ii) whether the offerings involve the same class of security; (iii) whether the offerings are made at or around the same time; (iv) whether the same type of consideration will be received; and (v) whether the offerings are made for the same general purpose. For SEC guidance on integration between a 506(c) and 506(b) offering, see HERE). Although technically Rule 502(a) only applies to Regulation D (Rule 504 and 506 offerings), the SEC and practitioners often use the same test in other exempt offering integration analysis.
A different analysis is used when considering the integration between an exempt and registered offering and in particular, whether the exempt offering investors learned of the exempt offering through general solicitation, including the registration statement itself. Furthermore, yet a different analysis is used when considering Regulation A, Regulation Crowdfunding, Rule 147 and Rule 147A offerings although each of those has a similar six-month test.
The amended rules would completely overhaul the integration concept such that each offering would be viewed as discrete regardless of whether it was completed close in time to a second offering. Under the new rules, where a regulatory safe harbor exists such safe harbor could be relied upon. For all other offerings, the new integration rules would look to the particular facts and circumstances of the offering, and focus the analysis on whether the company can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering. Of course, where exempt offerings allow general solicitation, they must include the regulatory legends required for such offering.
In making the analysis as to whether an offering complies with an exemption, where solicitation is not allowed, the company must have a reasonable belief that the investors were either not solicited or that such investor had a substantive relationship with the company prior to commencement of the offering. Generally a substantive relationship is one in which the company, or someone acting on the company’s behalf such as a broker-dealer, has sufficient information to evaluate, and in fact does evaluate, such prospective investors’ financial circumstances and sophistication and established accreditation. That is, a substantive relationship is determined by the quality of the relationship and information known about an investor as opposed to the length of a relationship. For more on substantive pre-existing relationships, including a summary of the SEC’s no action letter in Citizen VD, Inc., see HERE.
Moreover, the SEC is proposing four new non-exclusive safe harbors from integration, including: (i) any offering made more than 30 calendar days before the commencement or after the termination of a completed offering will not be integrated – provided, however, that where one of the offerings involved general solicitation, the purchasers in an offering that does not allow for solicitation, did not learn of the offering through solicitation (this 30-day test would replace the six-month test across the board); (ii) offerings under Rule 701, under an employee benefit plan or under Regulation S will not integrate with other offerings; (iii) a registered offering will not integrate with another offering as long as it is subsequent to (a) a terminated or completed offering for which general solicitation is not permitted; (b) a terminated or completed offering for which general solicitation was permitted but that was made only to qualified institutional buyers (QIBs) or institutional accredited investors (IAIs); or (c) an offering that terminated more than 30 days before the registration statement was filed; and (iv) offerings that allow for general solicitation will not integrate with a prior completed or terminated offering.
The determination of whether an offering has been terminated or completed will vary depending on the type of offering. A Section 4(a)(2), Regulation D, Rule 147 or Rule 147A offering will be terminated or completed on the later of the date the company has a binding commitment to see all the securities offered or the company and its agents have ceased all efforts to sell more securities. As to Regulation A offerings, such will be terminated or completed when the offering statement is withdrawn, a Form 1-Z has been filed, a declaration of abandonment is made by the SEC or the third anniversary after qualification of the offering. Offerings under Regulation Crowdfunding will be terminated or completed upon the deadline of the offering set forth in the offering materials.
Registered offerings will be terminated or completed upon the (i) withdrawal of the registration statement; (ii) filing of an amendment or supplement indicating the offering is completed and withdrawing any unsold securities; (iii) entry of an order by the SEC; or (iv) three years after the filing of an S-3. Although the same termination and completion analysis for each offering would be preferred, the differing natures of the offering mechanics do not make that feasible.
To avoid an abuse of the 35 unaccredited limitation under Rule 506(b), where a company conducts more than one offering under Rule 506(b), the number of non-accredited investors purchasing in all such offerings within 90 calendar days of each other would be limited to 35.
To avoid abuse involving Regulation S offerings, where there is a concurrent Rule 506(c) offering, the company will need to prohibit resales to U.S. persons for a period of six months except for QIBs or IAIs.
The new integration principles and safe-harbors would be aggregated in Securities Act Rule 152. Moreover, Rules 502(a), 251(c) (i.e., Regulation A integration provision), 147(g) and 147A(g) (both intrastate offering provisions) will be amended to cross reference the new amended rule 152. Other rules (Rules 255(e), 147(h) and 147A(h)) will be eliminated as the provisions will be covered in Rule 152…