SEC Proposed Rule Changes for Exempt Offerings – Part 2
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 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 the second blog in the series which focuses on offering communications, the new demo day exemption, and testing the waters provisions. The first in this series centered on the offering integration concept and can be read HERE.
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.
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 background on the current exemption framework, including a chart summarizing the most often used exemptions and there requirements, see Part 1 in this blog series HERE.
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.
Offering Communications; Expansion of Test-the-Waters Communications; Addition of “Demo Days”
Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering, from the Act’s registration requirements. The Supreme Court case of SEC v. Ralston Purina Co. and its progeny Doran v. Petroleum Management Corp. and Hill York Corp. v. American Int’l Franchises, Inc. together with Securities Act Release No. 4552 set out the criteria for determining whether an offering is public or private and therefore the availability of Section 4(a)(2). In order to qualify as a private placement, the persons to whom the offer is made must be sophisticated and able to fend for themselves without the protection of the Securities Act and must be given access to the type of information normally provided in a prospectus.
All facts and circumstances must be considered including the relationship between the offerees and the issuer, and the nature, scope, size, type, and manner of the offering. Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest. Rule 506 is “safe harbor” promulgated under Section 4(a)(2). That is, if all of the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with. An issuer can rely directly on Section 4(a)(2) without regard to Rule 506; however, Section 4(a)(2) alone does not pre-empt state law and thus requires blue sky compliance.
Effective September 2013, in accordance with the JOBS Act, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rule 506 by bifurcating the rule into two separate offering exemptions. The historical Rule 506 was renumbered to Rule 506(b) new rule 506(c) was enacted. Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors – provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.
Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and this adds a burden of verifying such accredited status to the issuing company. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Accordingly, in the Rule 506 context, determining whether solicitation or advertising has been utilized is extremely important.
Likewise, other offerings allow for solicitation and advertising. In particular, Regulation A, Regulation Crowdfunding, Rule 147 and 147A, and Rule 504 all allow for solicitation and advertising. For more information on Rule 504, Rule 147 and 147A, see HERE; on Regulation A, see HERE ; and on Regulation Crowdfunding, see HERE. Part 1 of this blog series talked about issues with integration, including between offerings that allow and don’t allow solicitation, but equally important is determining what constitutes solicitation in the first place.
Generally, testing the waters through contacting potential investors in advance of an exempt offering to gauge interest in the future offering, could be deemed solicitation. In 2015 the SEC issued several C&DI to address when communications would be deemed a solicitation or advertisement, including factual business communications in advance of an offering and demo day or venture fairs.
At that time, the SEC indicated that participation in a demo day or venture fair does not automatically constitute general solicitation or advertising under Regulation D. If a company’s presentation does not involve the offer of securities at all, no solicitation is involved. If the attendees of the event are limited to persons with whom either the company or the event organizer have a pre-existing, substantive relationship, or have been contacted through a pre-screened group of accredited, sophisticated investors (such as an angel group), it will not be deemed a general solicitation. However, if invitations to the event are sent out via general solicitation to individuals and groups with no established relationship and no pre-screening as to accreditation, any presentation involving the offer of securities would be deemed to involve a general solicitation under Regulation D. For more on a pre-existing substantive relationship, see HERE.
The proposed rule would expand test-the-waters for all companies to be able to use generic solicitations of interest communications prior to determining which exempt offering they will rely upon or pursue. Also, Regulation Crowdfunding would allow for test-the-waters much the same as Regulation A. Furthermore, a new “demo day” will be allowed for all offerings which would be exempted from the definition of general solicitation or advertising.
The SEC considered but determined not to add a rule that statutorily defines a substantive pre-existing relationship or to add to or expand on the examples of solicitation and advertising currently contained in Rule 502(c). As a reminder, Rule 502(c) lists the following examples of solicitation or advertising:
- Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising; provided, however,that publication by a company of a notice in accordance with Rule 135c or filing with the SEC of a Form D shall not be deemed to constitute general solicitation or general advertising; provided further, that, if the requirements of Rule 135e are satisfied, providing any journalist with access to press conferences held outside of the U.S., to meetings with companies or selling security holder representatives conducted outside of the U.S., or to written press-related materials released outside the U.S., at or in which a present or proposed offering of securities is discussed, will not be deemed to constitute general solicitation or general advertising.
Demo Days; New Rule 148
New Rule 148 would provide that certain demo day communications would not be deemed general solicitation or advertising. Specifically, as proposed, a company would not be deemed to have engaged in general solicitation if the communications are made in connection with a seminar or meeting by a college, university, or other institution of higher education, a local government, a nonprofit organization, or an angel investor group, incubator, or accelerator sponsoring the seminar or meeting.
Sponsors of events would not be permitted to make investment recommendations or provide investment advice to attendees of the event, nor to engage in any investment negotiations between the company and investors attending the event. The sponsor would not be able to charge fees beyond a reasonable administrative fee and could not receive compensation for making introductions. Advertising for the event would also be limited such that specific offerings could not be advertised and the information about a presenting company would be limited to: (i) notice that the company is conducting or planning to conduct an offering; (ii) the type and amount of securities offered; and (iii) the intended use of proceeds.
The new rule is similar to the broker-dealer exemption included in Securities Act Section 4(b) for online portals hosting offerings that allow for general solicitation and advertising such as Rule 506(c), Regulation A and Rule 147 and 147A intrastate offerings. For more on Section 4(b), see HERE.
Solicitations of Interest
Prior to the JOBS Act, almost no exempt offerings (except intrastate offerings when allowed by the state) allowed for advertising or soliciting, including solicitations of interest or testing the waters. The JOBS Act created the current Regulation A, which allows for testing the waters subject to certain SEC filing requirements and the inclusion of specific legends on the offering materials. For a discussion on Regulation A test-the-waters provisions, see HERE. In the current rule release, the SEC notes that “[W]e believe that the existing testing the-waters provisions allow issuers to consult effectively with investors as they evaluate market interest in a contemplated registered or Regulation A securities offering before incurring the costs associated with such an offering, while preserving investor protections.”
The SEC is proposing a new rule to allow companies to solicit indications of interest in an exempt offering, either orally or in writing, prior to determining which exemption they will rely upon, even if the ultimate exemption does not allow general solicitation or advertising. Likewise, the SEC is proposing to allow test-the-waters communications for Regulation Crowdfunding and to align the provisions such that a company could ultimately choose either a Regulation A or Regulation Crowdfunding offering.
The pre-offering determination generic solicitations, set forth in new Rule 241, would be similar to existing Rule 255 of Regulation A. Rule 241 would require a legend or disclaimer stating that: (i) the company is considering an exempt offering but has not determined the specific exemption it will rely on; (ii) no money or other consideration is being solicited, and if sent, will not be accepted; (iii) no sales will be made or commitments to purchase accepted until the company determines the exemption to be relied upon and where the exemption includes filing, disclosure, or qualification requirements, all such requirements are met; and (iv) a prospective purchaser’s indication of interest is non-binding. The solicitations would be subject to the antifraud provisions of the federal securities laws.
Once a company determines which type of offering it intends to pursue, it would no longer be able to rely on Rule 241 but would need to comply with the rules associated with that particular offering type, including its solicitation of interest and advertising rules. Moreover, since the solicitation of interest would likely be a general solicitation, if the chosen offering does not allow general solicitation or advertising, the company would need to conduct an integration analysis to make sure that there would be no integration between the solicitation of interest and the offering. Under the new rules, that would generally require the company to wait 30 days between the solicitation of interest and the offering (see Part 1 of this blog series HERE). I say “would likely be a general solicitation” because a company may still indicate interest from persons that it has a prior business relationship with, without triggering a general solicitation, as they can now under the current rules.
If a company elects to proceed with a Regulation A or Regulation Crowdfunding offering, it would need to file the Rule 241 test-the-waters materials if the Rule 241 solicitation is within 30 days of the ultimate offering as such solicitation of interest would then integrate with the following offering. If more than 30 days pass, the Rule 241 communications would not need to be filed, but any Rule 255 communication would need to filed in a Regulation A offering and proposed new Rule 206 communications would need to be filed in a Regulation Crowdfunding offering.
Although new Rule 241 does not limit the type of investor that can be solicited (accredited or non-accredited), under the new rules, if a company determines to proceed with a Rule 506(b) offering after obtaining indications of interest, it must provide the non-accredited investors, if any, with a copy of any written solicitation of interest materials that were used.
New Rule 241 would not pre-empt state securities laws. Accordingly, if a company ultimately proceeds with an offering that does not pre-empt state law, it will need to consider whether it has met the state law requirements, including whether each state allows for solicitations of interest prior to an offering. This provision will likely be a large impediment to a company that is considering an offering that does not pre-empt state law.
As an aside, the SEC has also expanded the ability for companies to test the waters in association with registered offerings – see HERE – but I believe those provisions should be expanded to be more analogous to Regulation A.
Currently a company may not solicit potential investors until their Form C is filed with the SEC. The proposed new rule will allow both oral and written test-the-waters communications prior to the filing of a Form C much the same as Regulation A. The new Regulation Crowdfunding test-the-waters provisions are proposed in new Rule 206.
Under proposed Rule 206, companies would be permitted to test the waters with all potential investors. The testing-the-waters materials would be considered offers that are subject to the antifraud provisions of the federal securities laws. Like Regulation A, any test the waters communications would need to contain a legend including: (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 is filed with the SEC and only through an intermediary’s platform; and (iii) a prospective purchaser’s indication of interest is non-binding. Any test-the-waters materials will need to be filed with the SEC as an exhibit to the Form C.
As discussed above, Rule 206 is separate from the proposed new Rule 241. Rule 241 requires an integration analysis. Accordingly, if Rule 241 test-the-waters materials were used within 30 days of the commencement of a Regulation Crowdfunding offering, they would need to be filed with the SEC with the Form C together with any subsequent Rule 206 materials.