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 fifth and final blog focusing on amendments to 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. To review the third blog in this series which focused on Regulation D, Rule 504 and the bad actor rules, see HERE. To review the fourth blog in this series related to changes to Regulation A, 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) and Section 4(a)(6) known as Regulation Crowdfunding. 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.
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Regulation Crowdfunding went into effect on May 16, 2016. The exemption allows issuers to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor cannot exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. Regardless of the category, the total amount any investor can invest is limited to $100,000. For a summary of the provisions, see HERE.
On March 31, 2017, the SEC made an inflationary adjustment to the $1,000,000 offering limit to raise the amount to $1,070,000 – see HERE. This was the last rule amendment related to Regulation Crowdfunding, though it has been on the Regulatory Agenda since that time.
Increase in Offering Limit
The proposed amendments would increase the amount an issuer can raise in any 12-month period from $1,070,000 to $5 million. It is believed, and I agree, that Regulation Crowdfunding would become much more widely used with a reduced cost of capital and greater efficiency with this increase in offering limits (together with the other amendments discussed herein, including allowing the use of special purpose vehicles). In addition, the increased limit may allow a company to delay a registered offering, which is much more expensive and includes the increased burden of ongoing SEC reporting requirements.
Increase in Investment Limit
The proposed amendments would increase the investment limit by altering the formula to be based on the greater of, rather than the lower of, an investor’s annual income or net worth. Moreover, the investment limits would only apply to non-accredited investors whereas currently they apply to all investors. In addition to the obvious benefit of increasing capital available to companies, the SEC believes that accredited investors may be incentivized to conduct more due diligence and be more active in monitoring the company and investment relative to an investor that only invests a nominal amount. A smart activist investor can add value to a growing company.
Use of Special Purpose Vehicles
The proposed amendments would allow for the use of special purpose vehicles, which the SEC is calling a crowdfunding vehicle, to facilitate investments into a company through a single equity holder. Such crowdfunding vehicles would be formed by or on behalf of the underlying crowdfunding issuer to serve merely as a conduit for investors to invest in the crowdfunding issuer and would not have a separate business purpose. Investors in the crowdfunding vehicle would have the same economic exposure, voting power, and ability to assert state and federal law rights, and receive the same disclosures under Regulation Crowdfunding, as if they had invested directly in the underlying crowdfunding issuer in an offering made under Regulation Crowdfunding.
The proposed rule would benefit companies by enabling them to maintain a simplified capitalization table after a crowdfunding offering, versus having an unwieldy number of shareholders, which can make these companies more attractive to future VC and angel investors. Allowing a crowdfunding vehicle would also reduce the administrative complexities associated with a large and diffuse shareholder base.
Importantly, a crowdfunding vehicle may constitute a single record holder for purposes of Section 12(g), rather than treating each of the crowdfunding vehicle’s investors as record holders as would be the case if they had invested in the crowdfunding issuer directly. Although a company can always voluntarily register under Section 12(g), unless an exemption is otherwise available it is required to register, if as of the last day of its fiscal year: (i) it has $10 million USD in assets or more; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year (Section 12(g) of the Exchange Act). A registration statement under Section 12(g) does not register securities for sale, but it does subject a company to ongoing SEC reporting obligations.
The proposed amendments would narrow the types of securities eligible under Regulation Crowdfunding to debt securities, equity securities, and debt securities convertible or exchangeable into equity securities, including guarantees of such securities, to harmonize the provisions of Regulation Crowdfunding regarding eligible security types with those of Regulation A. Other types of securities would be excluded from eligibility under the proposed 260 amendments. For example, Simple Agreements for Future Equity (SAFE) securities would no longer be eligible under Regulation Crowdfunding.