Over the last several months, Congress and the U.S. Securities and Exchange Commission have created or expanded several exemptions from federal registrations of securities offerings and have proposed several additional expansions of existing exemptions. These changes provide new opportunities for capital raising for private equity funds and their portfolio companies, without the expense of federal, and in some cases state, registration of securities offerings. This article summarizes, and later details, a number of the new and expanded exemptions and the pending proposals.
Some of the new or expanded exemptions discussed in this article may make it easier for private equity funds to raise new capital and to sell-down the securities of their portfolio companies to post-closing co-investors. Others may make it easier for portfolio companies to complete follow-on offerings. And, finally, although well-intentioned, others may be too limited in scope to be of practical use to private equity funds or their portfolio companies.
Summary of Recent Developments
- Regulation A+ exempts from registration a securities offering of as much as $50 million to a broad base of accredited and unaccredited investors alike, expanding the former Regulation A exemption that was limited to an aggregate offering of $5 million.
- The FAST Act has codified, to some degree, the current practice of private re-sales by affiliates of issuers without registration, thereby giving greater certainty of exemption to certain sellers.
- Crowdfunding rules adopted pursuant to the JOBS Act permit limited offerings of up to $1 million via Internet advertising. Disclosure requirements, including in some cases delivery of audited financial statements, may make this exemption for small offerings too burdensome to use in practice.
- Rule 506(c) under Regulation D now permits general solicitations, so long as sales are made solely to accredited investors.
- A proposal to alter Rule 147, permitting certain intrastate offerings, has been made. If adopted, issuers might be permitted to avail themselves of this exemption, which is currently of limited use to non-retail businesses located solely in one state.
- A proposal to alter Rule 504 to increase the exempt offering size from $1 million to $5 million has been made.
- Venture capital funds may be able to capitalize on the HALOS Act, which, if signed into law, will provide that presentations to angel investors will not be deemed general solicitations.
New and Expanded Exemptions in Detail
Regulation A under the Securities Act of 1933 is technically an exemption from registration that functions as a short form registration on Form 1-A, allowing a public offering of securities without full registration and without resale restrictions on purchasers. Until the SEC adopted final rules mandated by the JOBS Act in March 2014, Regulation A offerings were limited to a maximum aggregate offering price of $5 million. As revised, “Regulation A+” (technically, still Regulation A) expands the exemption to offerings up to $50 million.
Regulation A+ provides for two tiers of offerings: Tier 1 for offerings up to $20 million and Tier 2 for offerings up to $50 million. If an offering is for less than $20 million, the issuer may decide whether to comply with Tier 1 or Tier 2 offerings. Tier 1 offerings are not subject to any ongoing reporting requirements, while Tier 2 offerings must file periodic reports with the SEC after the commencement of the offering. Tier 2 offerings must comply with certain investor suitability standards and limitations not applicable to Tier 1.
Controversially, Regulation A+ purports to preempt the application of state securities registration requirements from Tier 2 offerings, without explicit Congressional authorization. At least two states, Massachusetts and Montana, have sued the SEC, challenging its authority to preempt their laws without explicit Congressional authorization.
Other than the increase of the aggregate offering price to $20 million and some new disclosure requirements, the Tier 1 offering is little changed from the rarely used predecessor Regulation A. Tier 2 offerings, with additional disclosure and reporting requirements but possibly without the burden of state registration, seem most likely to be used by issuers that for their own reasons desire a broader base of offerees not limited to accredited investors and without resale restrictions.
Section 4(a)(7) of the Securities Act of 1933
For many years, practitioners, courts and the SEC have acquiesced in the private resale of restricted securities by affiliates of the issuer under a fictional exemption known as “Section 4(a)(1½).” The theory is that a private sale is not a “distribution” as the term is used in the definition of “underwriter” in the Securities Act, so the sale is exempt under Section 4(a)(1) of the Securities Act, which exempts sales not involving an issuer or an underwriter.
In December 2015, the president signed the FAST Act, which added Section 4(a)(7) to the Securities Act. Section 4(a)(7) provides a nonexclusive exemption for resales by an affiliate of the issuer. The exemption has the following conditions:
- Each purchaser must be an accredited investor.
- There may be no general solicitation of purchasers.
- Certain modest disclosures must be made.
- The seller may not be the issuer or a subsidiary of the issuer.
- Any person receiving compensation for the sale must not be a ‘bad actor” under Regulation D or disqualified from engaging in the securities industry.
- The issuer must be actively in engaged in business and not a shell company.
- The security may not be part of an unsold allotment sold to a broker or dealer.
- The class of securities to be sold must have been authorized, and some securities of that class must have been outstanding for at least 90 days (the actual securities being sold do not have to have been outstanding for any particular period).
Securities sold under Section 4(a)(7) are “covered securities” under the Securities Act, so the application of state registration laws is preempted. Because Section 4(a)(7) is explicitly non-exclusive, the “Section 4(a)(1½)” exemption retains its vitality, but Section 4(a)(7) will provide greater certainty to re-selling affiliates than the fictional 4(a)(1½) exemption.
In October 2015, the SEC adopted final crowdfunding rules mandated by the JOBS Act. The regulation allows Internet advertising of offerings of $1 million or less, without registration, provided the offering is made through broker-dealers or registered “funding portals.” There are both initial disclosure requirements and ongoing reporting requirements. If the offering is over $100,000, initial disclosure requirements include financial statements reviewed by an independent public accountant. If the offering is over $500,000 and is not the issuer's first crowdfunding offering, initial disclosure requirements include audited financial statements.
The burden on the issuer to provide offering materials, including financial statements, in connection with such small offerings seems likely to outweigh the advantage of reaching a much larger audience via the Internet than is possible in a private offering.
Effective September 2013, the SEC amended Regulation D to add Rule 506(c). The new rule allows “public private” offerings, eliminating Regulation D’s ban on general solicitation for offerings, provided sales are limited to accredited investors.
Rule 506(c) has not yet had the impact on capital raising that was anticipated. Approximately 97% of the funds raised in Rule 506 offerings are raised in offerings under the old rule 506, now Rule 506(b). In addition, companies using Rule 506(c) tend to be significantly smaller than the issuers relying on Rule 506(b).
The most commonly cited reason for this outcome is the 506(c) requirement that the issuer take reasonable steps to ensure all purchasers are accredited investors, which the SEC interprets as something more than the self-certification by the investor that has become the standard for Rule 506(b) offerings. The diligence necessary is perceived in some quarters as unduly burdensome in that it requires investors to part with information about their financial condition that many reasonable people are loath to reveal. Also, Rule 506’s reasonable belief standard with respect to an investor’s accredited status does not apply in Rule 506(c) offerings if the issuer has not taken sufficient steps to verify the investor’s accredited status.
Other important factors that may have impacted the trend not to rely on Rule 506(c) include the lack of a need to advertise widely (private equity funds and other serial issuers have existing relationships with many potential investors and access to placement agents with existing relationships with many clients), a preference for a small number of large, familiar investors over a larger number of strangers and a prejudice against association with the smaller, perceived riskier, issuers that tend to rely on Rule 506(c).
Other Proposed New or Expanded Exemptions in Detail
Rule 147 currently provides a safe harbor for intrastate offerings exempt from registration under Section 3(a)(11) of the Securities Act. Under Rule 147, as currently in effect, an offering is exempt if:
- The offering is only made in one state (and thus no Internet advertising of the offering is permitted).
- The issuer is organized in that state.
- Purchasers are restricted from reselling the securities outside the state for nine months.
- The issuer derives at least 80% of its revenue from sources within the state, has 80% of its assets in the state and intends to use at least 80% of the proceeds in the state.
- The issuer’s principal office is in the state.
The 80% business requirements limit the availability of the existing Rule 147 largely to retail businesses.
In October 2015, the SEC proposed to amend Rule 147 as follows:
- The requirement that the issuer be organized in the state would be eliminated, so the ubiquitous Delaware corporation would not be disqualified from using Rule 147 if its business is in another state.
- The business requirement would be met if the issuer complies with any one of four standards, any one of the three 80% standards described above or if a majority of the issuer’s employees are based in the state.
- The offering could be made anywhere, although sales could still only be made in the state, thus allowing Internet offers.
As revised, Rule 147 would be much more useful to a wide range of issuers.
In the same release as the Rule 147 proposal, the SEC proposed to amend Rule 504 of Regulation D to increase the maximum offering size from $1 million to $5 million and to impose “bad actor” restrictions on Rule 504 offerings for the first time.
The HALOS (“Helping Angels Lead Our Startups”) Act, passed by the House of Representatives on April 27, 2016, and pending in the Senate, would require the SEC to amend Rule 506 to provide that “general solicitation” does not include presentations to “angel investor groups” and certain other forums, provided certain conditions are met. Issuers would be allowed access to such groups even if the event was advertised, without engaging in general solicitation, provided that the advertising of the event does not mention a particular issuer and the sponsoring organization of the event does not make investment recommendations.