On June 18, 2019, the U.S. Securities and Exchange Commission (the “SEC”) published a 211-page Concept Release on Harmonization of Securities Offering Exemptions (the “Release”), seeking comments related to the exempt offering framework for securities (and, as you might have guessed from the title, the harmonization of the various exemptions).
The Current Capital-Raising Landscape
The SEC notes, on page 16 of the Release, that exempt offerings now represent the significant majority of capital-raising transactions (specifically, exempt offerings accounted for $2.9 trillion – over twice(!!!) the $1.4 trillion attributable to registered offerings). Here it is for you directly from the SEC Release:
As the regulatory and operational framework for exempt offerings has evolved, the amount raised in exempt markets has increased both absolutely and relative to the public registered markets. In 2018, registered offerings accounted for $1.4 trillion of new capital compared to approximately $2.9 trillion that we estimate was raised through exempt offering channels. [emphasis added]
That’s over twice as much capital raised in private, exempt offerings than public, registered offerings! In response to this trend toward exempt offerings over registered offerings, the SEC is undertaking a review of available offering exemptions and some related rules and regulations.
Some of the most common offering exemptions (most of which require any securities restricted to be restricted securities) include:
- Section 4(a)(2) – transactions by an issuer “not involving any public offering”
- Rule 506(b) and 506(d) of Regulation D – a Form D safe harbor for private offerings that requires compliance with various restrictions including accredited investor restrictions (and other requirements not listed)
- Rule 504 of Regulation D – a Form D safe harbor for offerings of under $5 million/year (and other requirements not listed)
- Regulation A – a two-tier offering exemption with offering limits, including limits on issuer affiliates and requiring the filing of a Form 1-A with the SEC (and other requirements not listed)
- Instrastate Offering exemptions Section 3(a)(11), Rule 147, and Rule 147A – an exemption for in-state sales and offerings in compliance with the applicable state securities laws and regulations (and other requirements not listed)
- Regulation Crowdfunding Section 4(a)(6) – A Form C exemption for private offerings of less than $1.07 million (and other requirements not listed)
One of the most famous and influential decisions in the arena of securities law is SEC v. Ralston Purina 346 U.S. 119 (1953) in which the Supreme Court outlined that the Section 4(a)(2) [at the time Section 4(2)] exemption “should turn on whether the particular class of persons affected needs the protection of the  Act. An offering to those who are shown the be able to fend for themselves is a transaction ‘not involving any public offering’.”
As the SEC outlined in its Release:
The emphasis [in Ralston Purina] on the characteristics of the investors extends throughout the current exempt offering framework, in which the fewest conditions apply to an offering under an exemption where sales are restricted to accredited investors, while offerings that permit less wealthy or sophisticated investors to participate are subject to an assortment of disclosure requirements, offering and investment limits, and other conditions meant to mitigate the risk of not having the traditional protections of registration under the Securities Act.
One of the fundamental tension that the SEC is grappling with in this Release seems to be the clear market trend toward exempt offerings (and various recommendations for harmonization by other parties, such as the 2012 Small Business Forum and 2018 Small Business Forum), as compared to the “can they fend for themselves” framework of Ralston Purina which one implictly tends to consider as a small minority of investments, not a 2/3+ slice of the pie.
Comments Sought on Current Exemption Framework
The bulk of the Release is dedicated to a discussion of, and a request for comments on, various elements of the current exemption landscape, including:
- The Definition of Accredited Investor: a test of individual income, joint income, and/or net worth meant to be an approximation of the sophisticated investor who can “fend for themselves” as outlined by Ralston Purina above. According to the SEC’s math, an aggregate of approximately 13.0% of US Households qualify as Accredited Investors. In 2017, the US Department of the Treasury prepared a report that included recommendations to, among other things, revise the definition of Accredited Investor with the goal of expanding the pool of eligible sophisticated investors (for example, including an investor who is advised by a registered investment advisor or financial professional).
- Rule 506 of Regulation D: among other observations, the SEC notes that 89% of Rule 506 offerings take advantage of 506(b), as opposed to only 11% under 506(c); a comparison of the aggregate value raised thereunder is even more lopsided – $7.3 trillion (or 94%) under 506(b) compared to $466 billion (or 6%) under 506(c). The Release further notes that: “while offerings under Rule 506(b) can have up to 35 non-accredited but sophisticated investors, non-accredited investors were reported as participating in only approximately 6% of Rule 506(b) offerings in each of 2015, 2016, 2017, and 2018…. Accordingly, it appears that the vast majority of issuers either are able to meet their capital needs through offerings to accredited investors only or, alternatively, may be limiting their Rule 506(b) offerings to accredited investors to avoid these disclosure requirements, which are generally similar to the non-financial disclosure requirements of a Regulation A offering and the financial statement requirements of a Form S-1 registration statement with reduced audit requirements.”
- Regulation A: Regulation A, which has typically been called a “Short Form Registration,” was updated by the Jumpstart Our Business Startups (JOBS) Act in 2015. The main takeaway of this report is that Regulation A offerings are significantly less common than Regulation D offerings. Over the June 19, 2015 – December 31, 2018 period, 132 issuers reported $1.4 billion raised under Regulation A (combined Tier 1 & Tier 2), while in comparison “36,900 issuers, other than pooled investment funds, each reported raising up to $50 million in reliance on Regulation D, totaling approximately $181 billion.”
- Rule 504 of Regulation D: the requirements of Rule 504 mostly avoid the reliance on Accredited Investors that 506 contains, but generally lacks the “backup” of a broader 4(a)(2) exemption available to Rule 506. The main problem with Rule 504, according to the SEC’s report, is similar to the problem with Regulation A: almost nobody uses it. “From 2009-2018, two percent of the capital raised in Regulation D offerings under $5 million by non-investment companies was offered under Rule 504 (and under Rule 505, prior to its repeal), and 98% of the capital raised was offered under Rule 506. … [I]n 2018, there were 85 additional new offerings that claimed a Rule 504 exemption as compared to 2017; however, the increased number of Rule 504 filings generally aligns with the decrease in the number of Rule 505 offerings over the same period (83 offerings).”
- Intrastate Offerings: With regard to this exemption, there is something of an informational barrier because “Issuers conducting an offering pursuant to Rule 147 or Rule 147A are not required to file any information with or pay any fees to the Commission. Offerings conducted pursuant to Rule 147 or Rule 147A must be registered in the state in which they are offered or sold unless an exemption to state registration is available under the state’s securities laws.” The main questions asked in the Release include: whether the introduction of Rule 147A (essentially a “loosening” of the requirements of Rule 147) has had a negative effect, what the relationship of such exemptions to regional (i.e. a small number of states, neither intrastate nor truly national in scope) ought to be, among other related questions
- Regulation Crowdfunding: One interesting note from the Release is that “Unlike issuers conducting Regulation A offerings, a minority of Regulation Crowdfunding issuers have reported conducting an offering under Regulation D in the past — about 14% undertook a Regulation D offering prior to the Regulation Crowdfunding offering — suggesting that Regulation Crowdfunding, at least based on data as of December 31, 2018, tends to bring new issuers to the exempt offering market rather than encouraging current issuers to switch between offering exemptions.” Additionally, the utilization of Regulation Crowdfunding is noted to be “geographically concentrated, with just under a third of the offerings made by issuers located in California (approximately 32%), followed by New York (approximately 11%) and Texas (approximately 7%).”
Comments Sought on Other Related Areas
The remainder of the Release discusses a few interconnected elements adjacent to the current exemption landscape. The principal areas on which the Release seeks comment include:
- Integration: Including previous guidance on integration of exempt offerings in which general solicitations are not permitted as well as those in which general solicitation is permitted, as well as harmonization of integration rules into a single doctrine and time periods and safe harbors. The integration rules have certainly “trapped” well-meaning private companies before, which was assuredly not the original intention. Simplification may help with compliance.
- Pooled Investment Funds: Specifically, comments regarding whether access to pooled investment funds should be expanded for non-accredited investors (currently, non-accredited investors seeking to invest in pooled funds have very limited options and cannot invest in private equity, venture capital, or hedge fund type pooled funds, because those funds must restrict their investor pools to preserve their own exemptions from registration and from other laws such as the Investment Company Act). Those who operate registered investment companies and business development companies (which investors generally can access as a pooled investment) should stay apprised of developments here, as should the private equity, venture capital, and hedge fund world.
- Secondary Trading: One significant disadvantage of private capital-raising is the relatively illiquid nature of the investment. Investors, accordingly, may be somewhat less willing to invest. While you might note that this supposed disadvantage has not prevented the private market from growing to twice the size of the public market in 2018, the brunt of investor hesitation is likely borne by smaller issuers (larger issuer means more investors means easier liquidity, even in private or restricted securities). The SEC is seeking comments on potential revisions to improve secondary market liquidity.
If you would like to review the full text of the Release for yourself, you may do so HERE.
If you have other questions, you can contact me here.