United States: The Emerging Company Playbook: SEC Proposes Rule Amendments To Regulation A

On December 18, 2013, the Securities and Exchange Commission proposed rule amendments to Regulation A as required by Title IV of the Jumpstart Our Business Startups Act. The proposed rules provide a makeover of current Regulation A, an underutilized registration exemption limited to offerings of up to $5 million of securities in a twelve-month period, as well as create the following two-tier framework for eligible issuers to use the Regulation A exemption:

1. Tier 1 offerings of up to $5 million in a twelve-month period, including up to $1.5 million in resales on behalf of selling securityholders, and

2. Tier 2 offerings of up to $50 million in a twelve-month period, including up to $15 million in resales on behalf of selling securityholders.

Notably, the proposed rules preempt state law with respect to Tier 2 offerings, while Tier 1 offerings remain subject to state blue sky regulation. With this revised framework, emerging companies have another capital-raising option in addition to those currently available under the federal securities laws, such as Regulation D.1

Background

Regulation A offerings are mini-public offerings with no prohibitions on general solicitation and general advertising. A Regulation A issuer files an offering statement with the SEC, which is reviewed by the SEC Staff as well as by state blue sky regulators. The offering circular contained in the offering statement is delivered to investors. Regulation A securities are not "restricted securities" under the federal securities laws and are therefore freely tradable. Notwithstanding this framework, Regulation A has been a little used exemption, due, in part, to burdensome and time-consuming compliance with multiple state blue sky regimes which reduce the cost effectiveness of the exemption, as well as the availability of other more attractive exemptions to raise capital, such as Regulation D.

In April 2012, following industry calls to ease the restrictions of Regulation A to make it more attractive to emerging companies, Congress enacted Section 3(b)(2) of the Securities Act of 1933 under Title IV of theJOBS Act and gave the SEC authority to adopt rules exempting offerings of up to $50 million of securities within a twelve-month period from the registration requirements of the Securities Act. This authority included prescribing the disclosure requirements for offering documents and periodic public disclosures in these offerings. Using this authority, the SEC has proposed a revised framework for Regulation A which seeks to encourage capital formation by emerging companies, while still providing meaningful investor protections.

Overview of Section 3(b)(2) and the Proposed Rules

Eligible Issuers

Regulation A is currently limited to companies organized in or with their principal place of business in the United States and Canada, and excludes companies reporting under the Securities Exchange Act of 1934, investment companies, blank check companies, certain bad actors and issuers of fractional undivided interests in mineral rights. The proposed rules add two additional classes of issuers which would be ineligible to use Regulation A:

1. issuers that have not complied with the proposed rules' ongoing reporting requirements in the two years preceding the filing of a new Regulation A offering statement, and

2. issuers who have been subject to an SEC order denying, suspending or revoking the registration of a class of securities within five years of filing a Regulation A offering statement.2

The proposed rules also expand the "bad actor" exclusion in a manner similar to the recent amendments to the bad actor disqualifications under Regulation D.

Eligible Securities

The proposed rules limit the types of securities eligible for sale under Tier 1 or Tier 2 offerings to equity securities, debt securities and debt securities convertible into or exchangeable into equity interests, including any guarantees of such securities. Asset-backed securities are specifically excluded from the list of eligible securities.

Offering Limitations and Secondary Sales

As noted above, the proposed rules provide for a two-tier framework which includes $5 million and $50 million offering limitations in a twelve-month period. The Tier 1 offering limitation maintains the offering limitation set out in current Regulation A, while the Tier 2 offering limitation reflects Section 3(b)(2)'s increased offering limitation. Eligible issuers may elect to comply with either tier.

The proposed rules also continue to permit the ability to use Regulation A for resales by selling securityholders.3 The amount of resales in either a Tier 1 or Tier 2 offering is based on 30% of therelevant tier's offering limitation and would be aggregated with issuer sales for purposes of calculating the maximum permissible amount of securities that may be sold during any twelve-month period in such tier. The proposed rules also eliminate an existing limitation on affiliate resales unless the issuer has had net income from continuing operations in at least one of its two last fiscal years.4

Investment Limitations

Under the proposed rules, a Tier 2 offering investor would be limited to purchases of no more than 10% of the greater of an investor's annual income and net worth, with annual income and net worth determined as provided in the accredited investor definition under Rule 501 of Regulation D.5 Issuers would be required to make investors aware of the investment limitations, but could rely on investor representations without verifying compliance with the investment limitation.6

Integration

Current Regulation A provides an integration safe harbor such that offer or sales made in reliance on Regulation A will not be integrated with prior offer or sales of securities, or subsequent offer or sales of securities that are registered, made in reliance on Rule 701, made pursuant to an employee benefit plan, made in reliance on Regulation S, or made more than six months after the completion of the Regulation A offering. The proposed rules generally maintain the existing integration safe harbor while adding to the list of safe harbor provisions subsequent offer or sales made pursuant to the proposed crowdfunding rules and providing for additional guidance on the potential integration of offerings conducted concurrently with, or close in time after, a Regulation A offering.

Exchange Act Registration

Under the proposed rules, securities sold under Regulation A would not be exempt from the asset and record holder thresholds under Section 12(g) of the Exchange Act.7

Section 12(a)(2) Liability

Consistent with current Regulation A, sellers of securities under revised Regulation A would have liability to investors under Section 12(a)(2) of the Securities Act, which provides for liability in respect of any offer or sale by means of an offering circular or an oral communication that includes a materially misleading statement or omission. While Section 11 liability does not apply to these offerings, other antifraud and civil liability provisions of the federal securities laws, such as Rule 10b-5, as well as similar provisions under relevant state securities laws, would apply. Offering Statement

Regulation A issuers are required to prepare an offering statement on Form 1-A which is filed with the SEC and reviewed by the SEC Staff. Form 1-A is similar to an abbreviated registration statement and includes an offering circular which is delivered to investors.

The current version of Form 1-A has three parts:

  • Part I – Notification, which serves as a notice of certain basic information about the issuer and the offering;
  • Part II - Offering Circular, which consists of an offering circular (similar to the prospectus in a registration statement) and provides for alternative disclosure formats depending on the type of issuer (including a "question and answer" format, a specified narrative format and the narrative format of Form S-1), as well as two years of financial statements (which need not be audited except if the issuer has prepared audited financials for other purposes); and
  • Part III – Exhibits, which includes material contracts.

The proposed rules maintain the three-part structure of Form 1-A as well as propose, among other changes, the following:

  • for Part I, adding issuer eligibility, business and financial information and certain offering details;
  • for Part II, eliminating the "question and answer" format, updating the specified narrative format to include, among other things, additional guidance and disclosure requirements for "MD&A," and continuing the option to use the narrative format of Form S-1;8
  • for Tier 2 offerings, requiring audited financial statements (for Tier 1 offerings, audited financial statements would still not be required, except if already prepared for other purposes); and
  • for Tier 2 reporting companies, permitting incorporation by reference of certain items previously filed on EDGAR.

The proposed rules also modernize the filing framework by providing for electronic filing of Form 1-A on EDGAR and permitting confidential submission of a Form 1- A and related amendments, so long as all such documents are publicly filed no later than 21 calendar days before qualification of the offering statement by the SEC. The proposed rules also require delivery of a preliminary offering circular to prospective purchasers at least 48 hours in advance of sale and provide for an "access equals delivery" model for delivery of final offering circulars.

Continuous or Delayed Offerings

The proposed rules would retain the ability to make continuous or delayed offerings for, among other types of offerings, secondary offerings, securities offered and sold under dividend reinvestment plans or employee benefit plans, securities issued upon the exercise of options, warrants or rights, and certain other continuous offerings. The proposed rules also require amendments to the offering statement to be filed and requalified annually to include updated financial statements and fundamental changes to the information set forth in the offering statement.

"Testing the Waters" Communications

Regulation A currently permits an issuer to test the waters for investor interest in an offering before preparing and filing an offering statement. The "testing the waters" provisions allow companies to publish or deliver a written document to prospective purchasers or make scripted radio or television broadcasts to determine whether there is an interest in the proposed securities offering before filing the offering statement with the SEC. Regulation A issuers may approach any type of investors when testing the waters, not just qualified institutional buyers and institutional accredited investors as in an emerging growth company initial public offering. Regulation A issuers may not, however, solicit or accept money for securities offered under Regulation A until the SEC staff completes its review of the filed offering statement and the offering materials are delivered to investors. In addition, any solicitation materials must be submitted to the SEC at or before the time of first use.

The proposed rules preserve the existing "testing the waters" framework and further permit issuers to test the waters both before and after filing the offering statement, so long as any solicitation materials used after publicly filing the offering statement are preceded or accompanied by a preliminary offering circular or contain a notice as to where it may be obtained.9 The notice requirement could be satisfied by providing the uniform resource locator, also know as a "URL," to the EDGAR filing of the preliminary offering circular. The proposed rules also require that solicitation materials must be submitted or filed as an exhibit when the offering statement is either submitted for non-public review or filed, rather than at or before the time of first use.

Ongoing Reporting

Regulation A currently does not have an ongoing reporting framework other than the filing of a Form 2-A every six months to report sales under Regulation A, with a final filing due within 30 calendar days after the termination, completion or final sale of securities in the offering.

The proposed rules eliminate Form 2-A while providing the following reporting framework for Regulation A issuers:

  • Tier 1 issuers would file a Form 1-Z upon completion or termination of the offering, which would provide sales information and updates on issuer information; and
  • Tier 2 issuers would be subject to ongoing disclosure requirements, including the filing of:
  • annual reports on new Form 1-K, with disclosures similar in certain respects to a Form 10-K, as well as two years of audited financial statements (annual reports on Form 1-K would be required to be filed within 120 calendar days after the issuer's fiscal year end);
  • semi-annual reports on new Form 1-SA, with disclosures similar in certain respects to a Form 10-Q, as well as interim financial statements which would not need to be audited or reviewed (semi-annual reports on Form 1-SA would be required to be filed within 90 calendar days after the end of the issuer's second fiscal quarter);
  • current reports on new Form 1-U, with a number of event-based reporting triggers similar to certain of the triggers in Form 8-K (current reports on Form 1-U would be required to be filed within four business days after the occurrence of any such event); and
  • special financial reports on Form 1-K and 1-SA to cover lengthy gaps in financial reporting between the financial statements included in Form 1-A and the first periodic report due after qualification of the Form 1-A.

The proposed rules also permit a Tier 2 issuer to exit the ongoing reporting regime at any time by filing a Form 1-Z exit report after completing reporting for the fiscal year in which the offering statement was qualified, so long as the securities of each class to which the offering statement relates are held of record by fewer than 300 persons and offers and sales made in reliance on a qualified Regulation A offering statement are not ongoing. An issuer's obligations to file ongoing reports in a Tier 2 offering would also be automatically suspended upon registration of a class of securities under Section 12 of the Exchange Act.

State Securities Law

Section 18 of the Securities Act generally provides an exemption to "covered securities" from the registration and qualification requirements of state law. Title IV of the JOBS Act added Section 18(b)(4)(D) to the Securities Act, which states that Section 3(b)(2) securities are covered securities for purposes of Section 18 if they are offered or sold on a national securities exchange,10 or offered or sold to a "qualified purchaser" as defined by the SEC.

Under the proposed rules, the SEC defined "qualified purchaser" as all offerees of securities in a Regulation A offering and all purchasers in a Tier 2 offering.11 Accordingly, Tier 2 issuers would have the benefit of preemption, while Tier 1 issuers would still need to comply with registration and other state securities laws where there are purchasers in an offering.12

Conclusion

Among the many changes proposed to Regulation A, the proposed rules provide for preemption of state blue sky regulation in the context of Tier 2 offerings thereby eliminating one of the significant hurdles to past use of Regulation A and making Regulation A a more attractive option for emerging companies toraise capital.13 Emerging companies will still need to consider new Regulation A among the other attractive features of the JOBS Act when choosing a capital-raising alternative, including the ability to crowdfund retail investors under Section 4(a)(6) of the Securities Act, generally solicit accredited investors in a Regulation D private placement (as well as stay private longer), and use the IPO "on-ramp" by qualifying as an emerging growth company. Further, the development of liquidity and other aftermarket support for secondary trading for Regulation A securities (possibly through venture exchanges, liquidity providers and/or analyst coverage) may have an impact on the attractiveness of revised Regulation A.

We are continuing to follow the rulemaking process for Regulation A and are available to discuss this new framework should you have any questions.

Footnote

1.The full text of the proposed rules is available at http://www.sec.gov/rules/proposed/2013/33-9497.pdf. The SEC's proposing release addresses a number of advance comments received by the SEC and recommendations of industry groups, as well as includes a number of requests by the SEC for further comments on the proposed framework. The comment period will be open for 60 days following publication of the proposed rules in the Federal Register.

2 Among other questions, the SEC is soliciting comments on whether the category of eligible issuers should be extended to foreign issuers with a U.S. nexus and business development companies (who may be a source of investment capital for emerging companies).

3 Regulation A exit rights may also become a new request in the context of negotiating registration rights for early stage private placements.

4 The SEC indicated that this restriction on affiliate resales may not be appropriate for startup and early stage companies that devote large portions of their resources to startup expenses and research and development.

5 This investor protection, or loss limitation, is similar to the provisions in the recently proposed crowdfunding rules.

6 Among other questions, the SEC is soliciting comments as to whether the investment limitations should not apply to accredited investors.

7 Section 12(g) generally requires that an issuer with assets exceeding $10 million and a class of equity securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, register such class of securities with the SEC.

8 According to the proposing release, the proposed content of the offering circular would update the disclosure requirements in some respects to more closely align the disclosure in a Regulation A offering with the smaller reporting company disclosure requirements for registered offerings, while retaining certain scaled elements exclusive to the specified narrative format of Form 1-A.

9 The SEC's proposal to extend "testing the waters" to after the filing of the offering statement is meant to address the impact on any benefits of "testing the waters" from any prolonged SEC Staff review period between filing and qualification.

10 The SEC expects that listing on a national securities exchange, as an approach to preemption, will have limited impact because many Regulation A issuers would not meet the standards to list on a national securities exchange.

11 The SEC noted the substantial investor protections under the proposed rules in justifying preemption for Tier 2 offerings.

12 Notwithstanding its proposed framework for Tier I and Tier 2 offerings, the SEC is seeking comments on a coordinated review program recently proposed by the North American Securities Administrators Association.

13 Other possible uses for Regulation A include, among others, the ability for an emerging company to create a liquid stock for purposes of future acquisitions and/or employee compensation

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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