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. I have been breaking the information down into a series of blogs, with this third blog focusing on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D other than integration and offering communications which affect all exempt offerings and were discussed in the first two blogs in this series. In addition, this third blog will cover amendments to the bad-actor disqualification provisions. The final two blogs in this series will discuss changes to Regulation A and Regulation Crowdfunding.
To review the first blog in this series centered on the offering integration concept, see HERE. To review the second blog in the series which focused on offering communications, the new demo day exemption, and testing the waters provisions, see 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). Currently, 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 their 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.
Rule 506(c) allows for general solicitation and advertising; however, all sales must be made to accredited investors and the company must take reasonable steps to verify that purchasers are accredited. It is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. For more on Rules 506(b) and 506(c), see HERE.
Rule 506(c) provides for a principles-based approach to determine whether an investor is accredited as well as providing a non-exclusive list of methods to determine accreditation. After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the company would have to take to verify accredited investor status, and vice versa. Where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.
Examples of the type of information that companies can review and rely upon include: (i) publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages); (ii) third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms; and (iii) third-party accredited investor verification service providers.
Moreover, non-exclusive methods of verification include:
- Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year. If such forms and information are joint with a spouse, the written representation must be from both spouses.
- Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit reports from a nationwide agency.
- Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.
- A written certification verifying accredited investor status from existing accredited investors of the issuer that have previously invested in a 506 offering with the same issuer.
Related to jointly held property, assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the accredited investor net worth test, but only to the extent of his or her percentage ownership of the account or property. The SEC has provided guidance regarding relying on tax returns by noting that in a case where the most recent tax return is not available but the two years prior are, a company may rely on the available returns together with a written representation from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specifies the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. However, if the evidence is at all questionable, further inquiry should be made.
In the new proposed rule release, the SEC realizes that the non-exclusive list may create some uncertainty and lead to some companies to believe that they must rely only on the methods in the list. The SEC is proposing to add a new item to the non-exclusive list that allows for a company to accept the written representation of an investor that they are accredited if the company has previously taken steps to verify accredited status and is not aware of any new information to the contrary.
The amended rule will also reiterate the principles-based approach of the rule, including reminding companies to consider (i) the nature of the purchaser and the type of accredited investor that the purchaser claims to be; (ii) the amount and type of information that the company has about the purchaser; and (iii) 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.
Rule 506(b); Harmonization of Disclosure Requirements
Currently Rule 506(b) has scaled disclosure requirements based on the size of the offering, where unaccredited investors are included. The proposed rules update the information requirements for investors under Rule 506(b) where any unaccredited investors are solicited. The new information requirements would align with information required under Regulation A. For Rule 506(b) offerings up to $20 million, the same financial information that is required for Tier 1 Regulation A offerings will be required. For offerings greater than $20 million, the same financial information that is required for Tier 2 Regulation A offerings will be required.
The effect of the rule change would be to eliminate the ability for a company that has trouble getting financial statements to be able to only provide a balance sheet. Foreign private issuers would be able to provide the financial information in either U.S. GAAP or IFRS as would be permitted in a registration statement.
If the company is not subject to the Exchange Act reporting requirements, it must also furnish the non-financial statement information required by Part II of Form 1-A or Part I of a Securities Act registration statement on a form that the issuer would be eligible to use (usually Form S-1). If the company is subject to the Exchange Act reporting requirements, it must provide its definitive proxy with annual report, or its most recent Form 10-K. These information requirements only apply where non-accredited investors will be solicited to participate in the offering.
Finally, as mentioned in Part I of this blog series related to integration where an issuer 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.
On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amended Rule 147 to allow companies to continue to offer securities under Section 3(a)(11) of the Securities Act and created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. At that time, the SEC also amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. For more on the 2016 rule amendments, see HERE.
Currently Rule 504 provides an exemption for offerings up to $5 million in any twelve-month period. Rule 504 is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Rule 504 does not have any specific investor qualification or limitations. However, Rule 504 does not pre-empt state law and as such, the law of each state in which an offering will be conducted must be reviewed and complied with.
The proposed rule changes will increase the maximum offering under Rule 504 from $5 million to $10 million in any 12-month period.
Rules 504, 506(b), 506(c), Regulation A and Regulation Crowdfunding all have bad-actor disqualification provisions. While the disqualification provisions are substantially similar, the look-back period for determining whether a covered person is disqualified differs between Regulation D and the other exemptions. The proposed rules will harmonize the bad-actor provisions among Regulations D, A and Crowdfunding by adjusting the look-back requirements in Regulation A and Regulation Crowdfunding to include the time of sale in addition to the time of filing.
Under Regulation D, the disqualification event is measured as of the time of sale of the securities in the offering. Under Regulation A and Regulation Crowdfunding, the look-back period is measured from the time the company files an offering statement. However, the SEC believes that it is important to look to both the time of filing of the offering document and the time of the sale with respect to disqualifying bad actors from participating in an offering. The proposed rule change will add “or such sale” to any look back references in Regulation A and Regulation Crowdfunding…