SEC: Time to revamp securities offering exemptions

On June 18, 2019, the Securities and Exchange Commission (the "SEC" or the "Commission") issued a “Concept Release on Harmonization of Securities Offering Exemptions,” requesting public comment to assess the current available exemptions from registration under the Securities Act of 1933, as amended (the "Securities Act"), and to consider whether revisions would be required to promote capital formation while maintaining investor protection. Considering the depth and complexity of this concept release, an overhaul of the existing exempt offering framework may have a significantly greater impact than the Securities Offering Reform of 2005.

The concept release has been previewed by the SEC over the last year, including in an August 2018 speech by Chairman Clayton, during which he discussed the SEC’s objective to review the exempt offering framework “to ensure that the system as a whole, is rational, accessible, and effective.”¹ Describing the existing framework as an "elaborate patchwork,"² he emphasized the need to understand the complexity of the current framework and whether changes would be required to rationalize and streamline the framework, as well as remove any complexities created by overlapping exemptions, which may create confusion in trying to identify “the most efficient path to raise capital.”³

Specifically, the concept release raises 19 questions for comment, consolidated below in the following key thematic topics:

1. Effective Capital Raising Option? Does the current framework provide appropriate capital raising options for different types of issuers at key stages of their business cycle while addressing investor protection considerations? Is the existing exempt offering framework too complex?  Are the exemptions themselves too complex?
2. Time of Sale or Time of Offer? Should the exemptions be revised across the board to focus consistently on investor protection at the time of sale rather than at the time of offer?  Should offers be deregulated altogether?
3. How to Communicate with Investors? How have developments in technology affected an issuer’s ability to communicate with its investors? Should the SEC consider a rule change to enhance an issuer’s ability to communicate with investors throughout the exempt offering framework?
4. Exempt or Registered Offering?  Would a more streamlined exempt offering framework encourage issuers to stay private longer and forego registered offerings? What changes should be considered to encourage more issuers to enter the registered public markets?
5. Expand Definition of Accredited Investor? Should exempt offerings be accessible to more retail/unaccredited investors, by either changing the definition of accredited investor or allowing investors to opt into accredited status after receiving disclosure about the risks? Should the availability of an exemption be conditioned on the involvement of a registered intermediary when an offering is open to retail investors who are unaccredited investors?
6. How Much to Invest? With respect to exemptions imposing investment limits, should they be based on a percentage of the investor’s income or investment portfolio? Should such limits impose particular challenges in different parts of the country due to regional income differences?
7. What Should the Disclosure Requirements Be? Should the disclosure requirements of the various exemptions be harmonized? If rules are changed such that non-accredited investors can participate in exempt offerings of all types, should the Commission scale the type and amount of information that is required to be disclosed to non-accredited investors based on the characteristics of the investors or the offering?

Current Exempt Offering Framework

Exemptions from registration have evolved from Congress’s initial recognition in 1933 that in “certain situations there is no practical need for registration or the public benefits from registration are too remote.”⁴ Courts later recognized that offers of securities may be exempt from registration, but offerees must be able to fend for themselves.⁵ Recent revisions and expansions have modernized the exempt offering regime, including Regulation Crowdfunding, Regulation A, expanded options for issuing securities to employees as compensation and allowing general solicitation to accredited investors.  However, the question now being tackled is whether a full overhaul of the current system is necessary to address its complexities or whether the existing framework should be replaced with a more efficient system.  

Current Exemptions from Registration⁶

As noted in the concept release, capital raised through exempt offerings is significant and has grown in recent years, reaching $2.9 trillion in 2018. By comparison, registered offerings raised just under half that amount at approximately $1.4 trillion. Exempt offerings raised under Rule 506(b) alone raised $1.5 trillion in 2018.

Figure 1 below shows the upward trend in exempt offerings as compared to registered offerings.⁷

One important observation made by the concept release is the fact that the rise of investments in exempt offerings relative to registered offerings may leave “certain types of investors with fewer investment opportunities than might have been available to them if public markets were used more frequently.”⁸ The concept release also provides useful statistics on the overall amounts raised in the exempt markets in 2018.⁹

As the data demonstrates, while the largest amount of private capital was raised in Rule 506(b) offerings, non-accredited investors participated primarily in offerings pursuant to Regulation A, Rule 504 and Regulation Crowdfunding.¹⁰ In light of such data, SEC is seeking comments on whether it would be consistent with capital formation and investor protection to increase the range of investment opportunities available to investors considered to be non-accredited.

Accredited Investor Definition

The concept release states that in 2015, 13 percent of US households qualified under the current definition of an accredited investor under Rule 501(a)(6) of Regulation D. The concept release adds that the concept of accredited investor has implications outside of the existing exemptive regulatory framework and has been adopted by other rules and regulations.¹¹ Since the release of the Accredited Staff Report,¹² the Commission has received a number of recommendations regarding potential revisions to the definition of an accredited investor. The Advisory Committee on Small and Emerging Companies recommended, among other things, that the pool of accredited investors should be expanded to include individuals who have tested knowledge and understanding in the areas of securities and investing, or specific industry or issuer knowledge, cautioning meanwhile that any non-financial criteria should be ascertained with certainty as “simplicity and certainty are vital to the utility of any expanded definition of accredited investor.¹³ Recognizing the market participants’ desire to expand the accreditation process outside of the financial criteria, the SEC is seeking comment on how to expand, narrow or revise the definition of an accredited investor to also address the seeming imbalance of the current definition, which provides a natural person just above the qualification thresholds the ability to invest without limit, but fully restrict a person just below the threshold from investing at all.

While another proposed recommendation is to allow key or managerial employees affiliated with the issuer to qualify as accredited investors,¹⁴ it is not immediately apparent if such recommendation would garner support since employees can generally invest in the equity of the issuer through employee compensation plans.

Private Placement Exemption and Rule 506 of Regulation D

The concept release questions whether revising the framework may help combat investor and geographic disparity, a topic also raised by Chairman Clayton.¹⁵ With incomes and net worth measuring highest in the Northeast and the West, those regions also experience the higher concentrations of accredited investors.¹⁶ During the 37th Annual Government-Business Forum on Small Business Capital Formation, which took place in Ohio on December 12, 2018, Commissioner Peirce queried if any parts of the current regulations reinforce concentration of start-ups and capital formation in Silicon Valley instead of Ohio, Kansas and South Dakota, even though all locations have “smart [and] inventive people.”¹⁷

In addition to geographic disparity seen in current exempt offerings, the type of investor in exempt offerings also lacks diversity. Some exemptions permit non-accredited investors to invest, but require significant disclosure by the issuer. In a 506(b) offering, sales to non-accredited investors require disclosure akin to that of a Form S-1 registration statement for a registered public offering.

In seeking public comment, SEC is asking, among other things:

• whether exemptions under Rules 506(b) and 506(c) should be combined. The concept release hypothesizes that the preference of issuers to use Rule 506(b) over Rule 506(c) may be due to issuers’ preference for investors they have a preexisting relationship with, to preserve confidentiality of the offering and their business plan; concerns over the burden of verifying accredited investor status of new investors; and possible investor privacy concerns;¹⁸
• whether the information requirements of Rule 502(b) should be streamlined with those of other exemptions such as Regulation Crowdfunding or Regulation A offerings;
• whether Regulation D should be amended to clarify the meaning of general solicitation or general advertising; and
• whether the requirement to take reasonable steps to verify accredited investor status has an impact on the issuers’ willingness to use Rule 506(c) exemption.

Integration

Every time an issuer is engaging in multiple securities transactions, the integration doctrine requires that the issuer perform an analysis to determine whether those transactions should be “integrated,” or considered part of the same offering.  The integration doctrine has evolved over time with staff providing guidance as recently as 2015 and 2016 in the context of concurrent exempt offerings involving Regulation A, Regulation Crowdfunding and Rules 147 and 147A.  The concept release states that market participants have requested clarification of the relationship between exempt offerings in which general solicitation is not permitted and exempt offerings such as Rule 506(c) where general solicitation is permitted.  In light of the above, the SEC is seeking public comment, including, but not limited to:

• whether to articulate one integration doctrine that applies to all exempt offerings and whether a consistent integration doctrine would enable issuers to transition easily from one exemption to another;
• whether to replace the five factor integration analysis with the new analysis articulated in connection with Regulation A and Rules 147 and 147A;
• whether to shorten the six-month integration safe harbor in Rule 502(a) of Regulation D, and specifically revise Rule 152 to clarify that offers and sales not involving any form of general solicitation or advertising would not be integrated with subsequent offers and sales of securities making use of general solicitation; and
• whether to amend Rule 155 to define what constitutes a private offering, and expand Rule 155(c) to include abandoned offering that involved general solicitation.

Pooled Investment Funds

The concept release states that retail investors may have better access to investment opportunities in growth-stage issuers when investing through a pooled investment fund. The concept release defines pooled investment funds as investment companies (mutual funds or exchange-traded funds (“ETFs”)) registered under the Investment Company Act, or a private fund that operates pursuant to an exemption from registration. However, the concept release acknowledges that those opportunities may be limited. Open-end funds, while providing investors with the ability to redeem their interests on a daily basis, present liquidity restrictions, and due to valuation requirements, prove difficult to holding significant amounts of securities issued in exempt offerings. Another category of registered investment companies, such as closed-end funds, are highlighted in the concept release as better suited for holding less liquid securities obtained in exempt offerings since they are not subject to the same rules on liquidity risk management as open-end funds, due to their not-redeemable feature. The release lists interval and tender offer funds, as well as private funds as examples of close-end funds. The concept release goes on to provide an extensive background of pooled investment options, and the concept of pooled investment funds as accredited investors. The concept release is asking market participants to explain the extent to which issuers view pooled investment funds as an important source of capital for exempt offerings, and whether certain funds facilitate capital formation more efficiently than others. The SEC is seeking also input from small issuers looking to raise capital in micro-offerings whether they depend on angel funds as an important source of capital. The SEC is also trying to understand the current market trends of retail investors’ access to growth-stage issuers and whether the existing regulations make investor access to these issuers through a pooled investment vehicle difficult.

Secondary Trading of Certain Securities

The concept release acknowledges that secondary market liquidity for investors in small and medium-sized issuers is integral to capital formation in the primary offering market.  Limited secondary market liquidity can impact issuers’ ability to attract investors and incur a higher cost of capital, while also impairing an investor’s ability to diversify its portfolio over time.  The SEC has received comments suggesting that the safe harbor provided by Rule 144 be revised as the current holding periods are burdensome given the trend for companies to remain private for longer.  Furthermore, certain security holders who are unable to meet the conditions of current Rule 144, end up incurring significant transaction expenses to sell outside of the Rule 144 safe harbor.¹⁹ In addition, exemptions by states for secondary sales are not uniform, and market participants reported to the SEC that this inhibits efficiency in secondary sale markets.²⁰ In light of the above, the SEC is seeking feedback on how to revise restrictions on secondary sales to facilitate capital formation and promote investor protection, including, but not limited to:

• whether temporary or permanent relief from Section 12(g) registration requirement would have an impact on an issuer’s access to capital or secondary market liquidity;
• whether Rule 144 should be revised to reduce the applicable holding periods;
• whether the safe harbor for secondary sales under Section 4(a)(1) of the Securities Act should be expanded for security holders that are unable to rely on Rule 144;
• if the population of investors who qualify as accredited investors is expanded, whether the SEC should impose issuer disclosure requirements in connection with resales, similar to Section 4(a)(7) requirements; and
• whether federal preemption should be expanded to secondary sales of securities.

The concept release does not discuss direct changes to Rule 144A itself. However, some of the proposals would indirectly impact Rule 144A offerings, as such as reducing the holding period under Rule 144. Such a reduction might help enhance secondary trading liquidity after Rule 144A offerings, particularly when the securities are 144A-for-life (i.e., without registration rights). The release also requests comment as to whether there should be additional resale exemptions.

Other Exemptions

The concept release requests public comments on a number of other exemptions available under the Securities Act and promulgated rules, including Regulation A, Regulation Crowdfunding and Rule 504. The public comment period will remain open for 90 days following publication in the Federal Register.

¹ See SEC Chairman Clayton’s “Remarks on Capital Formation at the Nashville 36/86 Entrepreneurship Festival” (Aug. 29, 2018), available here.
² Id.
³ See Concept Release at page 7.  The Concept Release is available here.
⁴ H.R. Rep. No. 73-85, at 5 (1933). 
⁵ See SEC v. Ralston Purina Co., 346 U.S. 119 (1953).
⁶ Summary of standards and restrictions only, see individual rules and regulations for complete details.
⁷ See Concept Release at page 18.
⁸ Id. at page 22.
⁹ Id. at page 19.
¹⁰ Id. at page 22.
¹¹ Id. at page 38.
¹² Report on the Review of the Definition of “Accredited Investor” is available here.
¹³ See Concept Release at page 43.
¹⁴ Id. at page 44.
¹⁵ See SEC Chairman Clayton’s “Remarks on Capital Formation at the Nashville 36/86 Entrepreneurship Festival” (Aug. 29, 2018), available here.
¹⁶ See Concept Release at page 82.
¹⁷ See SEC Commissioner Peirce’s Remarks at the SEC Business-Government Forum on Small Business Capital Formation (Dec. 12, 2018), available here.
¹⁸ See Concept Release at page 80-81; See also Manning G. Warren (2017) The Regulatory Vortex for Private Placements, Securities Regulation Law Journal, Vol. 45, Issue 9, available ssrn.com/abstract=3037492. 
¹⁹ 17 CFR 230.144(d)(1); see also Advisory Committee on Small and Emerging Companies: Recommendations Regarding the “4(1½) Exemption” (June 11, 2015) available here; Final Reports for 2013-2018 of the SEC Government-Business Forum on Small Business Capital Formation available here. 
²⁰ See Concept Release at page 204.

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