By Brad H. Hamilton and Marika Rietsema Ball.
On November 2, 2020 the Securities and Exchange Commission (the “SEC”) made several helpful changes to its securities private placement and “Reg A” regulatory scheme that will assist start-ups, and small and growing businesses in offering securities and raising money from investors. The SEC also made practical changes to a few rules that were confusing and poorly understood. Except for financial statement relief for Crowdfund offerings, which is effective immediately, these changes become effective 60-days after published in the Federal Register. Notably, the SEC did not make any changes to the “issuer exemption” for private placements under the Securities Exchange Act of 1934 (the “’34 Act”), which we discuss at the end of this article.
The new rules address, among other things:
We have written before about the relative uselessness of the SEC’s Crowdfunding rule; the very low limit (originally $1 million; now $1.07 million) and the high cost of compliance made this offering impractical for all but small, local businesses that would benefit from local ownership by their customer base. For example, the SEC reported that in 2019 Crowdfunding offerings raised $62 million, compared to $1,492 billion raised in traditional private placements under Rule 506(b).
As a reminder, a Crowdfunding offering is one that can only be conducted through an online ‘intermediary’ (a third-party internet portal service), and severely restricts the maximum dollar amount an investor can spend per year on Crowdfunding investments (currently the greater of $2,200 or a percentage (5% or 10%) of the lesser of the investor’s net worth or annual income). The SEC’s recent changes have the potential to make the Crowdfunding exemption useful as a potential funding mechanism.
First, Regulation Crowdfunding (new Rule 206) now lets companies “test-the-waters” with potential investors through oral or written communications and materials designed to gauge investor interest, before starting the Crowdfund offering. The “test-the-waters” materials must say:
WARNING: These “testing-the-waters” communications and materials will still be considered an offering for purposes of the antifraud provisions of the securities laws – Sections 12(2) and 17(a) of the Securities Act of 1933 (the “Securities Act”), and Section 10(b) and Rule 10b-5 under the ‘34 Act. That means, if your “testing-the-waters” materials include any untrue statement of a material fact, or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading, than the issuer can be liable for securities fraud under both state and federal law, when the issuer later conducts its Crowdfunding offering. The solicitation of interest materials also must be filed with the SEC when the issuer files its Form C to commence the Crowdfunding offering.
This raises substantial risk for issuers who may be complacently thinking that “I’m only testing-the-waters for investor interest and since this isn’t an offering document, a little exaggeration can’t hurt.” Fraud, for securities law purposes, is much broader than one would ordinarily believe. It includes omissions (sometimes even unintentional ones) rather than just deliberate misrepresentations. Therefore, regardless of whether you intend to defraud an investor, if you fail to disclose a material fact, you may be liable. The liability can be personal as to corporate officers, directors, principal shareholders, and promoters. Moreover, securities fraud claims are often brought under state law statutes that provide for an award of attorneys’ fees to the successful claimant.
Consequently, “testing-the-waters” communications should be carefully drafted with assistance of your securities lawyer and should feature the same “bespeaks caution” legends as all private placement offering materials.
Calls with Prospective Investors
The SEC has amended its rule on investor communications during a Crowdfunding offering (Rule 402) to allow the issuer to engage in oral conversations with prospective investors, but those communications must be limited to the following statements:
The issuer’s representative should heed the warning above; if any of these conversations with potential investors veer off into a sales pitch (and what entrepreneur isn’t adept at sales?), the anti-fraud rules apply to oral communications as well as written documents.
Increases to Crowdfunding Limits
Reduced Financial Statement Requirements
In addition to the original low limits on amounts offered and amounts invested, the SEC’s requirement that issuers provide audited or reviewed financial statements for Crowdfunded offerings prohibited most business from using Crowdfunding. In May, 2020 the SEC provided some relief to the financial statement requirements for small offerings and now extends that relief as follows:
This is a temporary rule that is effective immediately but expires on August 28, 2020.
To eliminate an ongoing debate about whether Crowdfunding offerings are “covered securities” under federal law and therefore exempt from state “blue sky” regulations, the SEC also amended the definition of a “qualified purchaser” to include any person to whom securities are offered or sold pursuant to a Regulation Crowdfunding offering. Since securities offered and sold to a qualified purchaser are “covered securities,” this change eliminates any doubt that Crowdfunding offerings are exempt from state blue sky laws.
Special Purpose Vehicle for Crowdfunding Investment
One of the problems with Crowdfund offerings is that the issuer ends up with a high number of small investors. If the company grows successfully and is ready for its “A” round equity offering to angel or investment fund investors, they are not interested. A high number of small shareholders is unattractive to institutional or fund investors and increases the risk and hassle-factor for these investors. For some funds, prior participation in a Crowdfund offering is a disqualifying event. The SEC will now allow formation of a special purpose vehicle (SPV) to hold the shares sold in the Crowdfunding offer for the investors. The SEC has exempted this SPV from the definition of an Investment Company so it will not be covered by investment company regulations and registration requirements and will not have to be managed by a Registered Investment Adviser. The rules and requirements for implementing an SPV are detailed and beyond the scope of this article.
Traditional private placements conducted under Rule 506 (now Rule 506(b)) of the Securities Act allow the issuer to raise an unlimited amount of money from an unlimited number of accredited investors but can only include up to 35 sophisticated non-accredited investors. However, if non-accredited investors are included, the issuer must provide those non-accredited investors with specific financial and company information, which increased based on the size of the offering. As a result, it has become common practice over the years to simply eliminate the participation of any non-accredited investors in traditional private placements, depriving them of the opportunities of these investments.
To encourage issuers to allow non-accredited investors to participate in traditional private placements, the SEC has amended Rule 502(b) to require the issuer to provide non-accredited investors the same financial reporting as required under Regulation A offerings. That is:
In addition to the preliminary communications/test-the-waters rules discussed above for Crowdfunding offerings, the SEC has adopted a new rule (Rule 241) to allow for “test-the-waters” preliminary communications for all private placements in addition to its Reg A offering rules. However, as lawyers like to say, this is a “trap for the unwary,” at least in the context of the traditional private placement under Rule 506(b).
The new Rule 241 is an offering exemption – a “generic solicitation of interest” to gauge market interest for an investment in the issuer, before the issuer has decided which private placement exemption it is going to use, will not be an offer for the sale of securities:
“Under new Rule 241, an issuer or any person authorized to act on behalf of an issuer may communicate orally or in writing to determine whether there is any interest in a contemplated offering of securities exempt from registration under the Securities Act.”
The generic solicitation of interest must include the following statements:
Importantly, these testing-the-waters communications are NOT exempt from the antifraud rules discussed above in the Crowdfunding section under the heading “WARNING,” which applies to all testing-the-waters communications. Moreover, if the issuer conducts its private placement within 30 days after the generic solicitation of interest, the issuer must provide copies of its testing-the-waters communications to each non-accredited investor.
Finally, the “trap-for-the-unwary” – as a practical matter, “testing-the-waters” communications are not recommended for a traditional Rule 506(b) private placement, which prohibits general solicitation (advertising), unless the issuers lets a substantial amount of time pass before commencing that offering. Specifically, the SEC stated:
“If the generic solicitation is done in a manner that would constitute general solicitation, and the issuer ultimately decides to conduct [a traditional private placement under Rule 506(b)], the issuer will need to analyze whether that solicitation and the subsequent private offering will be integrated, thereby making unavailable an exemption that does not permit general solicitation. Under the new integration rules adopted in this release, an issuer will not be able to follow a generic solicitation of interest that constituted a general solicitation with an offering pursuant to an exemption that does not permit general solicitation, such as Rule 506(b), unless the issuer has a reasonable belief, based on the facts and circumstances, with respect to each purchaser in the exempt offering prohibiting general solicitation, that the issuer (or any person acting on the issuer’s behalf) either did not solicit such purchaser through the use of general solicitation or established a substantive relationship with such purchaser prior to the commencement of the exempt offering prohibiting general solicitation.”
In other words, if you test-the-waters, and an investor saw your generic solicitation of interest, that investor cannot invest in your Rule 506(b) private placement (unless you already knew that investor)!
For years start-ups and entrepreneurs have been presenting their businesses, business plans or ideas at events organized by incubators, accelerators, angel investor groups, universities, and state or local government departments of economic development, ignorantly unaware or blithely ignoring restrictions on general solicitations in connection with private placements.
Technically, if the issuer was not issuing, that is not offering securities or soliciting investors and just talking about the company, the technology, the business, the market, and growth opportunities, it did not involve securities laws. In reality, the purpose of these meetings is to interest investors, and the SEC has taken a practical approach to taming this practice by adopting new Rule 148.
New Rule 148 sets specific requirements for demo days. Communications in connection with a “demo day” will not be an offering of securities if the communications satisfy these specific requirements:
The SEC’s integration doctrine has long been a source of confusion and accidental non-compliance for issuers. The integration doctrine aims to prevent an issuer from avoiding registration by dividing a single non-exempt offering into multiple exempt offerings. The integration framework to determine whether multiple transactions constitute one offering has been created through a mixture of rules and SEC guidance over the years and has grown more complex over time. The SEC has adopted new Rule 152 to establish a new integration framework to reduce confusion and dramatically shorten the time periods in which separate offers can be considered ‘integrated.’
General Principle – New Rule 152(a)
The general principle of integration is set forth in new Rule 152(a) and will still be available for all offers and sales that are not covered under one of the four non-exclusive safe harbors in Rule 152(b). Under Rule 152(a), offers and sales will not be integrated so long as, based on the specific facts and circumstances, the issuer can establish that each offering either (1) complies with the registration requirement of the Securities Act, or (2) an exemption from registration is available for that particular offering. This rule replaces the previously utilized five-factor test from 1962 (1. whether the offerings are part of a single plan of financing; 2. whether the offerings involve issuance of the same class of security; 3. whether the offerings are made at or about the same time; 4. whether the same type of consideration is to be received; and 5. whether the offerings are for the same general purpose) to provide more clarity and certainty to an issuer conducting exempt and registered offerings close in time.
In Rule 152(a)(1) and Rule 152(a)(2), the SEC states specifies how an issuer will apply the general integration principle to offerings that either permit or prohibit general solicitation.
For an issuer applying the general principle to an exempt offering prohibiting general solicitation close in time to one or more other offerings, under Rule 152(a)(1), the issuer must have a reasonable belief, with respect to each purchaser in the exempt offering, that the issuer, or any person acting on their behalf:
The SEC was careful to clarify that the analysis applies only to the exempt offerings that prohibit general solicitation and not to each exempt offering. Under this new integration principle, issuers may simultaneously conduct Rule 506(c) (private placements to accredited investors that include general solicitation or advertising) and Rule 506(b) offerings (traditional private placements that prohibit general advertising), or any other combination of concurrent offerings involving offers which each permit or prohibit general solicitation. This amendment eliminates a long-standing confusion regarding whether the general solicitation communications of a 506(c) offering cause the loss of the private placement exemption for traditional Rule 506(b) private placement conducted within 6-months of one-another.
Furthermore, the SEC explained that a “pre-existing substantive relationship” is one formed with an offeree by the issuer or its agent prior to the commencement of the offering, and requires that the issuer has sufficient information to evaluate, and does in fact evaluate, the offeree’s financial circumstances and sophistication, when determining his or her status as an accredited or sophisticated investor. Relationships of this kind include the issuer’s existing or prior investors, investors in prior deals by the issuer’s management, family and friends.
Rule 152(a)(2) applies when there are two or more concurrent offerings. Under the new rule, each exempt offering permitting general solicitation must abide by the specific requirements for, and restrictions on, the Securities Act exemption it is relying on (e.g. Crowdfunding or Rule 506(c)). Otherwise, an instance where an exempt offering’s solicitation materials include information about the material terms of a concurrent offering under a different exemption could constitute an “offer” of the securities in the other offering. This would integrate the two offerings and require each offering to comply with the requirements and restrictions of the other exemption being relied on.
Non-Exclusive Safe Harbors – New Rule 152(b)
Rule 152(b) provides four non-exclusive safe harbors from integration:
This new Rule 152(b)(3) is generally in keeping with the old Rule 152, with some variance due to the SEC’s continued belief that capital raising around the time of a public offering is often crucial to ensure the issuer has sufficient funds to continue operating while the public offering is ongoing.
Commencement, Termination, and Completion of Offerings – Rule 152(c) & Rule 152(d)
The safe harbors discussed above require the issuer to determine when a separate offer and been commenced, terminated, or completed. The new Rule 152(c) states that an offering will be deemed to commence “at the time of the first offer of securities in the offering by the issuer or its agents,” and includes a non-exclusive list of factors that should be considered in determining when an offering is deemed to be commenced; these factors vary depending on which type of offering the issuer is engaged in.
New Rule 152(d) provides that an offering has been terminated or completed when the issuer and its agents cease efforts to make further offers to sell the issuer’s securities under the offering, and provides a non-exclusive list of factors to be considered, again depending upon which type of offering the issuer is engaged in. completed.
The SEC has increased the maximum offering amount for Tier 2 Regulation A offerings from $50 million to $75 million, and increased the maximum offering amount for secondary sales under Regulation A from $15 million to $22.5 million. The SEC took this action because, while previous amendments have stimulated the Regulation A offering market, the aggregate Regulation A financing levels remained modest relative to traditional IPOs and the Reg D market (2019 Tier 2 Regulation A offerings raised $998 million while traditional Reg D, Rule 506(b) private placements raised $1,492 billion). The amendments also clarify that Tier 2 offerings will continue to be preempted from state blue sky laws since it is the SEC’s expectation that Tier 2 offerings will continue to be more national in nature.
The SEC raised the offering limit for Rule 504 offerings from $5 million to $10 million. The Rule 504 private placement exemption under Reg D is rarely used because it does not exempt the issuer from registration under state blue sky laws, which is cumbersome and costly. The SEC hopes that raising the limit will encourage more use of Rule 504 by reducing the cost as a percentage of the funds raised. In the authors’ opinions it will not; this change will not materially increase the use of Rule 504.
Rules disqualifying “bad actors” from participating in various exempt offerings are recent, having been established by the SEC in its post-JOBS Act rule making beginning in 2012. Consequently, there are inconsistencies in the “lookback” periods as applied to various exemptions (Reg A, Reg D, and Regulation Crowdfunding). The SEC corrected this inconsistency by clarifying that a disqualifying event occurring at any time during an offering, not only before the filing (for offerings that require a filing such as Reg A and Crowdfunding), would disqualify the bad actor from further involvement in the offering – except as applied to ‘beneficial owners’ who are not directly involved in the offering. For beneficial owners the disqualification lookback period remains through the time of filing, rather than through the time of sale, because it would be too expensive and difficult for the issuer to monitor the status of uninvolved beneficial owners through the continuation of an offering.
Private placements with general solicitation (advertising) under Rule 506(c) require the issuer to take “reasonable steps” to verify that each purchaser is an accredited investor. To make this easier, the SEC amended Rule 506(c) to permit issuers to rely on their previous verification of a purchaser, by updating the verification with a written representation from the purchaser that he or she is still an accredited investor at the time of sale. Issuers may only rely on ‘self-certification’ if the issuer is not aware of any information to the contrary and may only use the re-verification for five years from the initial verification.
The Securities Act applies to what securities are issued and how they are issued. The ’34 Act applies to who can sell the issuer’s securities. Generally, a person may not offer or sell securities for another unless registered as a broker-dealer or an exemption to registration applies. The issuer itself is exempt from registering as a broker because it is not selling securities for another (it is selling its own securities), and is exempt from registering as a dealer because it is not selling securities for its own account as a regular business activity. However, an issuer cannot sell its own securities (at least until there is major progress in artificial intelligence) – only people can sell the securities for the issuer, and those people are acting as brokers because they are selling securities for the issuer. The exemption that allows directors, officers, and employees to sell the issuer’s securities in a private placement is Rule 3a4-1 under the ’34 Act.
However, Rule 3a4-1 only allows each person selling on behalf of the issuer to do so once every 12-months. If there is another offering within that 12-month period, the person can only prepare written materials and answer questions when potential investors contact the company – he or she cannot actively participate in follow-on offerings until 12-months have passed. The failure of the SEC to shorten the time periods for the broker exemption under Rule 3a4-1 seems to directly conflict with the new integration rules. The SEC has provided that offerings more than 30-days apart can be separate offerings, and private placements under various exemptions can be ongoing concurrently, but the SEC has not provide relief to allow persons to conduct those private placements.
Therefore, under the new rules the issuer’s CEO can actively participate in private placement number one, but cannot actively participate in private placement number two commencing 35 days after the completion of private placement number one, without being deemed to be a broker and unable to qualify for the exemption under Rule 3a4-1. Whether this is an intentional regulatory scheme, or an oversight by the SEC, remains to be seen. In either case, Rule 3a4-1 is no longer in line with the SEC’s new and amended private placement rules.
The November 2, 2020 SEC release, and the amendments and updates to the various private placement exemptions and offering rules, are comprehensive. This article summarizes the changes of interest to the authors and their clients and is not a comprehensive or all-inclusive explanation of those changes. Please consult with your own lawyers before taking any action based upon the information provided in this article.
Reach out to Brad Hamilton at email@example.com and Marika Rietsema Ball at firstname.lastname@example.org.
This article is provided for information purposes only and is not intended to constitute legal advice or legal opinion as to any situation. You should not take, or refrain from taking, any action based on information in this article, without seeking legal counsel from an attorney on your particular facts and circumstances. Jones & Keller would be happy to provide you with specific advice about specific situations, if desired. Do not hesitate to contact us.