ESG Investing and Ratings
As I mentioned in the last blog in this series on ESG, back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s regulatory focus.
Enter Chair Allison Herron Lee and in a slew of activity over the past few months, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and enhanced ESG disclosure regulations are most assuredly in the works.
Investors are focused now more than ever on ESG matters. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
One thing has not changed and that is that the system of “rating” or “scoring” a company based on all things ESG is extremely over-inclusive and imprecise. The Aggregate Confusion Project from Massachusetts Institute of Technology (MIT) found that “It is very likely…. that the firm that is in the top 5% for one rating agency belongs in the bottom 20% for the other. This extraordinary discrepancy is making the evaluation of social and environmental impact impossible.”
In a series of blogs I am tackling the wide and popular current ESG conversation. In the first blog, I focused on climate change initiatives (see HERE). In this second blog I am discussing ESG investing, ratings and the role of a Chief Sustainability Officer, and the third blog will be on ESG disclosures in general.
Backing up – What is “Environmental, Social and Governance” or “ESG”
It is clear that ESG matters are an important factor for analysts and investors and thus for reporting companies to consider. It is also clear that companies have increasing pressure to report ESG matters and will be judged on those reports by different groups with different criteria in a current no-win environment (pun intended).
In the broadest sense, “Environmental, Social and Governance” or “ESG” refers to categories of factors and topics that may impact a company and that investors consider when making an investment and analysts and proxy advisors consider when making recommendations about investments or voting matters for corporate America. However, from a micro perspective, ESG means different things to different constituencies and has become a sort of catch-all phrase for a spectrum of topics ranging from very real and serious societal issues to the topic de jour touted by paid special interest groups and influence peddlers.
The G (governance) in ESG is a little more concrete, including, for example, whether there are different share classes with different voting rights, the ease of proxy access, or whether the CEO and Chairman of the Board roles are held by two people. The environmental category can include, for instance, water usage, carbon footprint, emissions, what industry the company is in, and the quantity of packing materials the company uses. The social category can include how well a company treats its workers, what a company’s diversity policy looks like, its customer privacy practices, whether there is community opposition to any of its operations, and whether the company sells guns or tobacco.
However, once a topic is fitted into a category, the measurement of that category and the meaning behind the information are much more nebulous. Furthermore, ESG topics are being heralded by non-shareholder stakeholders influencing investors. A number of self-identified ESG experts have developed and many groups produce ESG ratings. The ratings are not standardized, and as such the analysis can be arbitrary as it may treat similarly situated companies differently and may even treat the same company differently over time for no clear reason.
ESG Investing and Ratings
It is clear that ESG matters carry great weight with the investment community, especially powerful investors such as hedge funds, ESOPs, pension funds, family offices, unions, and private equity groups, and as such companies cannot ignore potential ratings and analyst coverage on these matters. Investors are pouring billions into asset managers who proclaim ESG who are in turn pumping out new ESG products (I can’t help but think about the mortgage bundling and complicated hedging products created around it right before the housing bubble in 2007-2008).
However, just like with ratings organizations, ESG fund managers and ESG products are not standardized in their meaning. As Commissioner Roisman said in a recent speech:
“When an asset manager markets a fund as having an ESG strategy, it has an obligation to disclose material information about that fund to investors and potential investors. Additionally, it would make sense to me that asset managers who want to use these terms to name their funds or advertise their products should be required to explain to investors what they mean. How do the terms “ESG,” “green,” and “sustainable” relate to a fund’s objectives, constraints, strategies, and the characteristics of its holdings? Are “E,” “S,” and “G” weighted the same when selecting portfolio companies? Does the fund intend to subordinate the goal of achieving economic returns to non-pecuniary goals, and if so, to what extent?”
Also, it would not make sense for ESG to mean the same thing for different funds. That is, one investor may be much more interested in investing in a fund that is concerned with renewable resources while another wants one focused on social issues such as diversity. I note that the same issue presents itself when talking about a standardized ESG disclosure regime, which I will talk further about in another blog in this series.
Irrespective of the difficulty in defining ESG, it is clear that index funds and long-term investors are interested in long-term value for their portfolios. In order to preserve long-term value, a fund or investor must have a diverse portfolio that mitigates systematic risk including climate change risk, financial stability risk and social stability risk. This long-term portfolio management means that not every investment will be a winner and not every investment will consider ESG, but a diverse portfolio definitely involves ESG considerations.
We also now have an ESG friendly administration, meaning that ESG issues could find more support by the SEC for inclusion in a company’s annual proxy statement. Shareholder proposals such as demands for reporting of greenhouse gas emissions, gender and race issues in the workforce and of course more on climate change, have historically been blocked as involving ordinary management decisions or micromanagement of the corporate structure. Under the new administration, these proposals may survive attack and appear on proxy statements for shareholder approval.
Likewise, the new administration is likely to support regulatory changes that will either directly or indirectly impact public companies. For example, near the end of the Trump administration the Department of Labor (DOL) passed rules that would prohibit ERISA fund managers from considering factors, that were not directly cost benefit based, such as ESG, in making voting and investment decisions for retirement funds. On March 10, 2021, the DOL announced that it will not enforce these new rules. Rather the DOL recognizes the use of ESG considerations in improving investment value and long-term investment returns for retirement investors and as such fiduciaries will not be prohibited from using these factors in any voting or investment decision analysis.
Who is a Chief Sustainability Officer
The time and expense of covering ESG ratings and attracting ESG investors is substantial. Enter a Chief Sustainability Officer (CSO). A CSO is now a common position in Fortune 500 companies and growing in all sectors. In addition to fielding the numerous ratings organizations and assisting management with messaging on ESG matters, a CSO is generally responsible for reviewing and helping to formulate ESG policies. These policies include both engaging in more socially responsible activities (investments in climate change initiatives) and reducing irresponsible activities (reducing pollution from corporate plants or changing materials to make products more sustainable). A CSO will also be integral in assisting with compliance with the existing and new climate and ESG disclosures in general.
Importantly, a CSO has the potential to reduce the impact of third-party ratings organizations. Until there are standardized rating systems in place, third-party ratings remain arbitrary and capricious. A CSO can work on data and analytics that are presented to rating organizations and analysts that reduce the information gaps and analyst irregularities. A CSO can also put programs and messaging in place for direct corporate engagement with the investment community related to ESG matters.
It is now commonplace for a company to issue sustainability reports and those reports, although not generally currently filed with the SEC, are made publicly available on a company’s website. A CSO should likewise be integral in the reports contents and importantly communicating its meaning to the board of directors.
Regardless of the noise surrounding ESG, there is no doubt that ESG is an important factor in Enterprise Risk Management (ERM) and must be understood and considered by a board of directors in its duties for ERM oversight. An effective CSO must be able to help the board unpack these issues as well.
« ESG Matters – What a Difference A Year Makes ESG Disclosures – A Continued Discussion »
ESG Matters – What a Difference A Year Makes
What a difference a year makes – or should I say – what a difference an administration makes! Back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s disclosure based regulatory regime. Enter Chair Allison Herron Lee and in a slew of activity over the past few weeks, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; Corp Fin has called for public comment on ESG disclosures and suggested a framework for discussion on the matter; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and the SEC issued a statement calling for public comment on climate related disclosures including a detailed list of questions to consider.
The ESG activity coming out of the SEC is so constant, I had to go back and add to this blog three times after I thought it was finished.
It seems that the SEC must answer the call from investors for valuable ESG disclosures. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
Net zero refers to operating such that global warming is limited to below 2o Celsius with net zero greenhouse gas emissions by 2050. But like all things ESG, there is a lot of disagreement on the best path forward. On March 10, 2021, the UK’s Institutional Investors Group on Climate Change, representing $35 trillion Euro in assets under management, published a Net Zero Investment Framework 1.0 specifically discouraging the use of carbon market offsets in achieving net zero goals. The problem is that many large companies use carbon offsets as an integral part of their stated net zero plans. Disclosure of plans may satisfy the SEC, but it is no guarantee that investors or stakeholders will approve of any course of action.
Back in 2010 the SEC issued guidance to public companies regarding disclosure requirements as they apply to climate change matters. Reviewing compliance with these guidelines is top of list for both Corp Fin and the Enforcement Taskforce. The Enforcement Task Force is also focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
In a series of blogs I will discuss ESG related matters including this first blog, which is focused on the climate change initiatives, a second discussing ESG investing, ratings and the role of a Chief Sustainability Officer and a third on ESG disclosures in general.
SEC Recent Climate Related Disclosure Initiative
As indicated, in the past 6 weeks, the SEC has issued a slew of statements and started numerous initiatives related to climate disclosures and environmental matters. Climate change is a top priority for the Biden administration. On February 1, 2021, the SEC announced that Satyan Khanna was named its first ever Senior Policy Advisor for Climate and ESG. Mr. Khanna was a former agency attorney and ex-adviser to Biden.
On February 24, 2021, acting SEC Chair Allison Herren Lee directed the Division of Corporation Finance to enhance its focus on climate related disclosures in public company filings. In her announcement, Chair Lee indicated that Corp Fin will review the extent to which public companies address the topics identified in the SEC’s 2010 guidance, assess compliance with disclosure obligations under the federal securities laws, engage with public companies on these issues, and absorb critical lessons on how the market is currently managing climate-related risks. The SEC staff has been directed to also update the 2010 guidance for present day efficacy. Then on March 15, 2021 the SEC solicited public comment on climate change disclosures with specific questions to consider.
The directive is not surprising as Chair Lee has always been vocal about her desire for increased climate and environment related disclosures. Stepping up initiatives for climate disclosure regulations, in March, Chair Lee, speaking at a virtual conference, stated that the SEC wants to implement a global framework for climate disclosures working in collaboration with global stakeholders and climate authorities. Certainly our markets are global and the SEC has made other recent disclosure changes to align with global practices, such as mining disclosure requirements (see HERE. New Corp Fin Director John Coates is fully on board. He is a former Harvard Law School professor who has pushed the SEC to update is corporate disclosures requirements on climate change and ESG matters.
On March 4, 2021, the SEC announced the creation of a Division of Enforcement Climate and ESG Task Force made up of 22 members from various offices. The task force will be focused on “ESG-related misconduct” including reviewing compliance with the 2010 climate disclosure guidelines and focusing on investment advisors, investment companies and broker-dealers that tout ESG priorities to ensure that practices align with those stated priorities.
I would also think that the Task Force will spend time reviewing the numerous ESG related financial products including high-yield debt instruments that have flooded the market. As one Wachtell Lipton memo pointed out, “[M]assive inflows into ESG-oriented investment funds and seemingly insatiable demand for ESG-related issuances have led to ‘greenium’ pricing (i.e., a lower cost of capital for issuers) of many ESG-related issuances. Moreover, credit rating agencies are increasingly factoring ESG risks – including related regulatory risks – into their ratings, as are credit committees at banks into their determinations.”
Also, on March 4, SECers Hester M. Peirce and Elad L. Roisman issued a joint statement questioning the practical meaning of the SEC’s climate and ESG related activities. As noted in the statement, Corp Fin has been reviewing companies’ disclosures, assessing their compliance with disclosure requirements under the federal securities laws, and engaging with them on climate change and a variety of issues that fall under the ESG umbrella, for decades. The concern is that the new initiative should be limited to reviewing public disclosures against the existing backdrop of regulation and not suddenly holding companies to a new undisclosed standard. The commissioners also questioned the timing of the enforcement task force, pointing out that it would be more prudent to wait until Corp Fin had completed its assessment on existing rules and until the Division of Examinations has completed this examination cycle. With that said, the statement concludes with a supportive call for adequate guidelines and rules resulting from input from SEC staff, investors, issuers and practitioners.
Request for Public Input on Climate Change Disclosure
On March 15, 2021, SEC Chair Allison Herren Lee issued a statement requesting public input on climate change disclosures. On the same day Ms. Lee gave a speech to the Center of American Progress outlining the SEC’s initiative on climate change matters. The request for public comment outlined specific questions for consideration and in particular:
- How can the SEC best regulate, monitor, review, and guide climate change disclosures in order to provide more consistent, comparable, and reliable information for investors while also providing greater clarity to registrants as to what is expected of them? Where and how should such disclosures be provided? Should any such disclosures be included in annual reports, other periodic filings, or otherwise be furnished?
- What information related to climate risks can be quantified and measured? How are markets currently using quantified information? Are there specific metrics on which all companies should report (such as greenhouse gas emissions)? What quantified and measured information or metrics should be disclosed because it may be material to an investment or voting decision? Should disclosures be tiered or scaled based on the size and/or type of registrant)? Should disclosures be phased in over time? How are markets evaluating and pricing externalities of contributions to climate change? Do climate change related impacts affect the cost of capital, and if so, how and in what ways? How have registrants or investors analyzed risks and costs associated with climate change? What are registrants doing internally to evaluate or project climate scenarios, and what information from or about such internal evaluations should be disclosed to investors to inform investment and voting decisions? How does the absence or presence of robust carbon markets impact firms’ analysis of the risks and costs associated with climate change?
- What are the advantages and disadvantages of permitting investors, registrants, and other industry participants to develop disclosure standards mutually agreed by them? Should those standards satisfy minimum disclosure requirements established by the SEC? How should such a system work? What minimum disclosure requirements should the SEC establish if it were to allow industry-led disclosure standards? What level of granularity should be used to define industries (e.g., two-digit SIC, four-digit SIC, etc.)?
- What are the advantages and disadvantages of establishing different climate change reporting standards for different industries, such as the financial sector, oil and gas, transportation, etc.? How should any such industry-focused standards be developed and implemented?
- What are the advantages and disadvantages of rules that incorporate or draw on existing frameworks, such as, for example, those developed by the Task Force on Climate-Related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), and the Climate Disclosure Standards Board (CDSB)?[7] Are there any specific frameworks that the SEC should consider? If so, which frameworks and why?
- How should any disclosure requirements be updated, improved, augmented, or otherwise changed over time? Should the SEC itself carry out these tasks, or should it adopt or identify criteria for identifying other organization(s) to do so? If the latter, what organization(s) should be responsible for doing so, and what role should the SEC play in governance or funding? Should the SEC designate a climate or ESG disclosure standard setter? If so, what should the characteristics of such a standard setter be? Is there an existing climate disclosure standard setter that the SEC should consider?
- What is the best approach for requiring climate-related disclosures? For example, should any such disclosures be incorporated into existing rules such as Regulation S-K or Regulation S-X, or should a new regulation devoted entirely to climate risks, opportunities, and impacts be promulgated? Should any such disclosures be filed with or furnished to the SEC?
- How, if at all, should registrants disclose their internal governance and oversight of climate-related issues? For example, what are the advantages and disadvantages of requiring disclosure concerning the connection between executive or employee compensation and climate change risks and impacts?
- What are the advantages and disadvantages of developing a single set of global standards applicable to companies around the world, including registrants under the SEC’s rules, versus multiple standard setters and standards? If there were to be a single standard setter and set of standards, which one should it be? What are the advantages and disadvantages of establishing a minimum global set of standards as a baseline that individual jurisdictions could build on versus a comprehensive set of standards? If there are multiple standard setters, how can standards be aligned to enhance comparability and reliability? What should be the interaction between any global standard and SEC requirements? If the SEC were to endorse or incorporate a global standard, what are the advantages and disadvantages of having mandatory compliance?
- How should disclosures under any such standards be enforced or assessed? For example, what are the advantages and disadvantages of making disclosures subject to audit or another form of assurance? If there is an audit or assurance process or requirement, what organization(s) should perform such tasks? What relationship should the SEC or other existing bodies have to such tasks? What assurance framework should the SEC consider requiring or permitting?
- Should the SEC consider other measures to ensure the reliability of climate-related disclosures? Should the SEC, for example, consider whether management’s annual report on internal control over financial reporting and related requirements should be updated to ensure sufficient analysis of controls around climate reporting? Should the SEC consider requiring a certification by the CEO, CFO, or other corporate officer relating to climate disclosures?
- What are the advantages and disadvantages of a “comply or explain” framework for climate change that would permit registrants to either comply with, or if they do not comply, explain why they have not complied with the disclosure rules? How should this work? Should “comply or explain” apply to all climate change disclosures or just select ones, and why?
- How should the SEC craft rules that elicit meaningful discussion of the registrant’s views on its climate-related risks and opportunities? What are the advantages and disadvantages of requiring disclosed metrics to be accompanied with a sustainability disclosure and analysis section similar to the current Management’s Discussion and Analysis of Financial Condition and Results of Operations?
- What climate-related information is available with respect to private companies, and how should the SEC’s rules address private companies’ climate disclosures, such as through exempt offerings, or its oversight of certain investment advisers and funds?
- In addition to climate-related disclosure, the staff is evaluating a range of disclosure issues under the heading of environmental, social, and governance, or ESG, matters. Should climate-related requirements be one component of a broader ESG disclosure framework? How should the SEC craft climate-related disclosure requirements that would complement a broader ESG disclosure standard? How do climate-related disclosure issues relate to the broader spectrum of ESG disclosure issues?
SEC 2010 Climate Disclosure Guidance
In 2010 the SEC issued a 29-page document providing guidance on climate change disclosures. In 2010 and the few years prior, climate change was not only a global topic of discussion, but a regulatory hotspot as well. The EPA passed regulations requiring the reporting of and reduction of greenhouse gases by the largest pollutants; internationally the Kyoto Protocol was passed; the European Union Emissions Trading System became effective; international climate change conferences became the norm; official and un-official groups banded together on the subject; and the insurance industry revamped its actuarial and risk assessment system to account for climate change.
For some public companies, the regulatory changes could have a significant impact on operating and financial decisions including capital expenditures to reduce emissions and compliance with new laws, including those requiring reporting. Also, companies not directly impacted by the changes could be indirectly impacted by changes in costs for goods and services and impacts on their supply chain. The SEC release also notes that changes in weather patterns, increased storm intensity, sea level rise, melting of permafrost and temperature extremes at facilities could affect operations and financial disclosures. Likewise, changes in the availability or quality of water or other natural resources can have impacts on machinery, equipment and operations. Climate can also impact consumer demand such as reduced demand for heating fuels and warm clothing in warmer temperatures.
In 2010 as today, companies were and are required to report material information that can impact financial conditions and operations (see most recent amendments to MD&A disclosures HERE. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision, or put another way, if the information would alter the total mix of available information. Although some environmental disclosures are prescriptively required by Regulation S-K or S-X, climate matters would be disclosable if it fell under the general materiality bucket of information (i.e., such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading).
The 2010 release delineated areas that could require such disclosure.
Description of Business
Item 101 of Regulation S-K requires a description of the general development of the business both historically and intended (see HERE for recent amendments to Item 101 including the addition of ESG related human capital disclosures). Then and now, Item 101 requires disclosures related to the costs and effects of compliance with environmental laws. Although the specific section and language in Item 101 has changed since 2010, the general requirement that disclosures be provided related to the costs of compliance and effect of compliance with environmental regulations, including capital expenditure requirements, remains the same.
With respect to existing federal, state and local provisions which relate to greenhouse gas emissions, Item 101 requires disclosure of any material estimated capital expenditures for environmental control facilities for the remainder of a registrant’s current fiscal year and its succeeding fiscal year and for such further periods as the registrant may deem material.
Legal Proceedings
Item 103 of Regulation S-K requires a company to briefly describe any material pending legal proceeding to which it or any of its subsidiaries is a party. Like Item 101, Item 103 has recently been amended – see HERE.
Item 103 specifically applies to the disclosure of certain environmental litigation including proceedings arising under any federal, state or local provisions that have been enacted or adopted regulating the discharge of materials into the environment or primary for the purpose of protecting the environment. Disclosure is required for both private civil suits and litigation where a governmental entity is a party. In 2010 the threshold for disclosure where the government is a party was $100,000, but that threshold has since been increased to either $300,000 or a threshold determined by the company as material but in no event greater than the lesser of $1 million or 1% of the current assets of the company.
Risk Factors
Item 503 of Regulation S-K requires disclosure of the most significant factors that make an investment in the company or offering speculative or risky. Item 503 has also been amended – see HERE. Where appropriate, climate change risk factors would need to be included, such as existing or pending legislation or regulation.
Management Discussion and Analysis (MD&A)
Item 303 or Regulation S-K – MD&A- is intended to satisfy three principal objectives: (i) to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management; (ii) to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and (iii) to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance. Like the others, MD&A has been amended since 2010 – see HERE.
The 2010 guidance contains a lengthy discussion on MD&A including management’s necessity to identify and assess known material trends and uncertainties considering all available financial and non-financial information. The SEC indicates that management should address, when material, the difficulties involved in assessing the effect of the amount and timing of uncertain events and provide an indication of the time periods in which resolution of the uncertainties is anticipated.
Item 303 requires companies to assess whether any enacted climate change legislation, regulation or international accords are reasonably likely to have a material effect on the registrant’s financial condition or results of operations. This analysis would include determining the likelihood of the legislation coming to fruition as well as potential impact, both positive and negative. Items to consider include: (i) costs to purchase, or profits from sales of, allowances or credits under a “cap and trade” system; (ii) costs required to improve facilities and equipment to reduce emissions in order to comply with regulatory limits or to mitigate the financial consequences of a “cap and trade” regime; and (iii) changes to profit or loss arising from increased or decreased demand for goods and services produced by the company arising directly from legislation or regulation, and indirectly from changes in costs of goods sold.
However, despite the lengthy discussion of MD&A, the SEC guidance lacks in real-world application. I would certainly hope that the SEC’s updated forthcoming updated guidance provides a better framework with tangible information to assist management’s analysis.
Foreign Private Issuers
Foreign private issuers’ (FPI) disclosure obligations are generally delineated in Form 20-F. Although many items are similar to, they differ from those in Regulation S-K. However, an FPI is required to disclose risk factors; effects of governmental regulations; environmental issues; MD&A and legal proceedings, all of which may require climate related information.
« Finders – Part 3 ESG Investing and Ratings »
Finders – Part 3
Following the SEC’s proposed conditional exemption for finders (see HERE), I’ve been writing a series of blogs on the topic of finders. New York recently proposed, then failed to adopt a new finder’s regulatory regime. California and Texas remain the only two states with such allowing finders for intra-state offerings. Also, a question that has arisen several times recently is whether an unregistered person can assist a U.S. company in capital raising transactions outside the U.S. under Regulation S, which I addressed in the second blog in this series (see HERE). This blog will discuss the New York, California and Texas rules.
New York
On December 1, 2020, the state of New York adopted an overhaul to some of its securities laws including modernizing registration and filing requirements with the Investor Protection Bureau and the Office of the Attorney General. Although the proposed rules would have adopted a new definition of “finder” and required licensing and examinations for such activity, the final rule release dropped the proposal without explanation.
Putting aside finders, an important aspect of the new rules is that companies conducting Rule 506 offering in New York will now need to file a completed Form D through the NASAA electronic filing depository. Prior to the new rules, New York’s Martin Act was very unclear on filing requirements and as a result, most practitioners simply did not file any notice documents or pay any fees where the offering pre-empted state law under the NSMIA (see HERE). This position was supported by an interpretive opinion published by the New York State Bar Association. Under the new rules, it is clear that a Form D is required, aligning New York with federal and other state notice provisions.
Historically, the Martin Act has not required the registration of securities, other than securities sold in real estate offerings, theatrical syndications or intra-state offerings. Instead, it requires that issuers register as dealers. In particular, the Martin Act requires that any person “engaged in the business of buying and selling securities from or to the public” register as a broker-dealer. New York exempted issuers from registering as dealers when they complete a firm commitment underwritten offering but not in other circumstances, including a best efforts underwritten offering or where no underwriter or placement agent is utilized.
The amended rules maintain this regulatory framework while expanding the definition of dealer and attempting to align, at least somewhat, the Martin Act with the federal framework involving covered securities. In particular, the new rules separate out dealers, and thus the forms necessary to file, into (i) Federal Regulation D Covered Securities Dealers; (ii) Federal Tier 2 Dealers; (iii) Federal Covered Investment Company Dealers; (iv) real estate dealers; and (v) all others.
In essence, the amended rules separate “dealers” that participate in federally covered transactions from those that do not. A Federal Regulation D Covered Securities Dealers must file a Form D. The new rules specify that the information in the Form D is all the information necessary to be filed by this category of dealer. A Federal Tier 2 Dealer must file a Uniform Notice Filing of Regulation A – Tier 2 Offering Form, which contains all the necessary information for that category of dealer. Finally, a Federal Covered Investment Company Dealer must file a Form N.
The New York rules did not proceed to provide a definition for “finders” but still require that “broker-dealers” that are not associated with a broker-dealer registered with the SEC or a member of FINRA be registered in New York to engage in broker-dealer activity. Of course, it still leaves the gaping question as to whether finder activity is broker-dealer activity requiring registration.
California
California Corporation’s Code Section 25206.1 permits the payment of a fee to finders for transactions involving intra-state offerings with California issuers subject to numerous conditions. In particular, a finder may be paid direct or indirect compensation if:
- The finder is a natural person;
- The finder only introduces accredited investors as defined by Rule 501 of the Securities Act (see HERE);
- The issuer and the transaction are in California exclusively (if an issuer is relying on a federal exemption other than one that nods to state law such as intra-state offering, the federal law would conflict);
- The securities purchase price cannot exceed $15,000,000 in the aggregate;
- The finder cannot participate in negotiating any of the terms of the offer or sale of securities;
- The finder cannot advise any party to the transaction regarding the value of the securities or the advisability of investing in, purchasing, or selling the securities;
- The finder cannot conduct any due diligence on the part of any party to the transaction;
- The finder cannot offer for sale any securities in which they own, directly or indirectly;
- The finder cannot receive, directly or indirectly, possession or custody of any funds;
- The securities transaction must be qualified or exempt from qualification under California law;
- The finder can only disclose (a) the name, address and contact information of the issuer; (b) the name, type, price, and aggregate amount of any securities being offered; and (c) the issuer’s industry, location and years in business;
- The finder must file in advance of taking any finder’s fees, a statement of information with the finder’s name and address, together with a $300 filing fee, with the California Bureau of Business Oversight, and thereafter file annual renewal statements with a $275 filing fee and representations that the finder has complied with the exemption conditions;
- Concurrently with each introduction, the finder shall obtain the informed, written consent of each person introduced or referred by the finder to an issuer, in a written agreement signed by the finder, the issuer, and the person introduced or referred, disclosing the following: (a) the type and amount of compensation that has been or will be paid to the finder; (b) the finder is not providing advice to the issuer or any person introduced or referred by the finder as to the value of the securities or as to the advisability of investing in, purchasing, or selling the securities; (c) whether the finder is also an owner, directly or indirectly, of the securities being offered or sold; (d) any actual or potential conflict of interest; (e) that the parties to the agreement have the right to pursue any available remedies for breach of the agreement; and (f) a representation that the person being introduced is accredited; and
- The finder must keep all records related to the transaction for five years.
Texas
Texas has a state finder’s registration process which is less onerous than full broker-dealer registration. A finder registers in Texas by filing a Form BD and Form U-4 with the state. A finder must be a natural person and cannot have agents working on their behalf.
Like California, even if registered, a finder’s activities are limited are subject to numerous conditions. Texas finders are strictly limited to dealing with accredited investors. Further, like California, a Texas finder would only be able to be compensated or operate in regard to Texas-based intra-state offerings or the activity would run afoul of federal securities laws.
Rule 115 of the Texas State Securities Board defines a “finder” as “[A]n individual who receives compensation for introducing an accredited investor to an issuer or an issuer to an accredited investor solely for the purpose of a potential investment in the securities of the issuer, but does not participate in negotiating any of the terms of an investment and does not give advice to any such parties regarding the advantages or disadvantages of entering into an investment, and conducts this activity in accordance with §115.11 of this title (relating to Finder Registration and Activities). Note that an individual registered as a finder is not permitted to register in any other capacity; however, a registered general dealer is allowed to engage in finder activity without separate registration as a finder.”
in turn prohibits a finder from: (i) participating in negotiating any terms of an investment; (ii) giving advice to an accredited investor or an issuer regarding the advantages or disadvantages of entering into an investment; (iii) conducting due diligence on behalf of a potential issuer or investor; (iv) providing a valuation or other analysis to an issuer or investor; (v) advertising to seek investors or issuers; (vi) having custody of an investor’s funds or securities; (vii) serving as escrow agent for the parties; or (viii) disclosing information to an investor or issuer other than as specified in parts (b) and (c) of the rule.
Rule 115.11(b) in turn requires that a finder disclose the following to each accredited investor: (i) that compensation will be paid to the finder; (ii) that the finder can neither recommend nor advise the investor with respect to the offering; and (iii) any potential conflict of interest in connection with the finder’s activity.
Rule 115.11(c) enumerates permitted finders’ disclosures, including: (i) the name, address and telephone number of the issuer; (ii) the name and a brief description of the security to be issued; (iii) the price of the security; (iv) a brief description of the business of the issuer in 25 words or less; (v) the type, number and aggregate amount of securities being offered; and (vi) the name, address, and telephone number of the person to contact for additional information.
Rule 115.11(d) contains specific detailed record-keeping requirements for finders. Records are required to be kept for five years and must be segregated from any other records the finder may maintain.
« SEC Final Rule Changes For Exempt Offerings – Part 5 ESG Matters – What a Difference A Year Makes »
SEC Final Rule Changes For Exempt Offerings – Part 5
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this final blog discussing the changes to Regulation Crowdfunding. The first blog in the series discussed the new integration rules (see HERE). The second blog in the series covered offering communications (see HERE). The third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (see HERE). The fourth blog in the series reviews the changes to Regulation A (see HERE).
Current Exemption Framework
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A. Section 4 contains all transactional exemptions, including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Regulation Crowdfunding – Background
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Although it took a while, Regulation Crowdfunding went into effect on May 16, 2016. The exemption allowed companies to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor could not exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. As written, regardless of the category, the total amount any investor could invest was limited to $100,000. For a summary of the provisions, see HERE.
In addition, all offerings must be conducted through a single offering portal and advertisements are limited to directing investors to that portal. Companies are required to provide specified information through the filing of a Form C with staggered information requirements based on the offering size. The financial statement requirements progressively increase based on increased offering size.
On March 31, 2017, the SEC made an inflationary adjustment to the $1,000,000 offering limit to raise the amount to $1,070,000 – see HERE. This was the last rule amendment related to Regulation Crowdfunding, though it has been on the Regulatory Agenda since that time.
On May 4, 2020, the SEC adopted temporary final rules under Regulation Crowdfunding for small businesses impacted by COVID-19, which include, among other things, an exemption from certain financial statement review requirements for companies offering $250,000 or less. These temporary rules were subsequently extended and apply to offerings initiated under Regulation Crowdfunding between May 4, 2020, and February 28, 2021 (see HERE).
The new rules increase the offering limits, adjusts the formula related to the maximum amount an unaccredited investor can invest, remove the investment limit for accredited investors, allow for investments through special purpose vehicles (SPVs), and align the bad actor provisions with those in Regulation A. The proposal to limit the type of securities that can be offered to align it with Regulation A was not adopted in the final rule amendments.
Increase in Offering Limit
The amendments increase the amount an issuer can raise in any 12-month period from $1,070,000 to $5 million. It is believed, and I agree, that Regulation Crowdfunding will become much more widely used with a reduced cost of capital and greater efficiency with this increase in offering limits (together with the other amendments discussed herein, including allowing the use of special purpose vehicles). In addition, the increased limit may allow a company to delay a registered offering, which is much more expensive and includes the increased burden of ongoing SEC reporting requirements.
Increase in Investment Limit
The amendment rules increase the investment limits by altering the formula to be based on the greater of, rather than the lower of, an investor’s annual income or net worth. Moreover, the investment limits no longer apply to accredited investors. In addition to the obvious benefit of increasing capital available to companies, the SEC believes that accredited investors may be incentivized to conduct more due diligence and be more active in monitoring the company and investment relative to an investor that only invests a nominal amount. A smart activist investor can add value to a growing company.
Use of Special Purpose Vehicles
The amendment rules allow for the use of special purpose vehicles, which the SEC is calling a crowdfunding vehicle, to facilitate investments into a company through a single equity holder. Such crowdfunding vehicles can be formed by or on behalf of the underlying crowdfunding issuer to serve merely as a conduit for investors to invest in the crowdfunding offering. These special purpose entities may not have a separate business purpose beyond the crowdfunding investment and must not, in fact, conduct any business beyond the investment. The crowdfunding vehicle is a co-issuer in the offering and as such, investors in the crowdfunding vehicle will have the same economic exposure, voting power, and ability to assert state and federal law rights, and receive the same disclosures under Regulation Crowdfunding, as if they had invested directly in the underlying company.
The rule benefits companies by enabling them to maintain a simplified capitalization table after a crowdfunding offering, versus having an unwieldy number of shareholders. A cleaner cap table can make companies more attractive to future VC and angel investors. Allowing a crowdfunding vehicle will also reduce the administrative complexities associated with a large and diffuse shareholder base.
Importantly, a crowdfunding vehicle will constitute a single record holder for purposes of Section 12(g), rather than treating each of the crowdfunding vehicle’s investors as record holders as would be the case if they had invested in the crowdfunding issuer directly. Although a company can always voluntarily register under Section 12(g), unless an exemption is otherwise available, it is required to register if, as of the last day of its fiscal year: (i) it has $10 million USD in assets or more; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year (Section 12(g) of the Exchange Act). A registration statement under Section 12(g) does not register securities for sale, but it does subject a company to ongoing SEC reporting obligations.
Miscellaneous
Regulation Crowdfunding offerings have always meant to pre-empt state law; however, the language in the prior rule was somewhat ambiguous. To avoid any doubt, the SEC has amended Regulation Crowdfunding to specifically include crowdfunding investors in the definition of a “qualified purchaser” for purposes of Section 18 of the Securities Act, which section delineates federally covered securities and transactions (for more on federal pre-emption, see HERE).
The new rules also extend certain provisions of the Covid-related temporary relief for financial statements through August 28, 2022. That is, any offering under Regulation Crowdfunding, together with other Regulation Crowdfunding offerings in the last 12 months, where the target offering amount is between $107,000 and $250,000, may provide financial statements that are certified by the principal executive officer instead of reviewed by an independent public accountant. This temporary relief will apply only if reviewed or audited financial statements of the company are not otherwise available.
« Caremark Eroded – Director Liability In Delaware Finders – Part 3 »
Caremark Eroded – Director Liability In Delaware
This year has marked a string of cases eroding the long history of Delaware’s board of director protections from breach of fiduciary duty claims. In Re Caremark International Inc. Derivative Litigation was a civil action in the Delaware Court of Chancery in 1996 which drilled down on a director’s duty of care in the oversight context. Caremark found that generally directors do not need to approve or exercise oversight over most company decisions, other than mergers (see HERE), changes in capital structure and fundamental changes in business.
Caremark claims, which allege failures of board oversight, have long been regarded by Delaware courts as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” To plead and prove a Caremark claim, a stockholder plaintiff must show that the board either (i) “utterly failed to implement any reporting information restrictions or controls”; or (ii) having implemented them, “consciously failed to monitor or oversee their operations, thus disabling themselves from being informed of risks or problems requiring their attention.” In other words – bad faith. Not surprisingly, these claims routinely fail at the pleading stage.
However, following Marchand v. Barnhill and In re Clovis Oncology Derivative Litigation which upheld claims against a board under Caremark last year, this year the Delaware Chancery Court also upheld claims in Hughes v. Hu and Teamsters Local 443 Health Services & Insurance Plan v. Chou. Whether these cases are actually a change in the law or just examples of how boards are utterly failing at their duties remains to be seen. Also, since these cases are all relatively new, we have yet to see whether Board of Director defendants will actually face personal liability.
Either way, they certainly act as a reminder of the importance of active, engaged board oversight of material risk and compliance issues. Clearly boards should take proactive steps to ensure that directors do not face personal liability for a failure of oversight. Part of those proactive steps include making a good faith effort to implement an oversight system and then actually monitoring it. Protocols need to be in place so that issues are brought to the board or relevant board committee promptly.
Likewise, boards should regularly review what key or mission critical risks exist (or potentially exist) for oversight. The board also needs to properly respond to risks or issues in a timely fashion and follow up with management. Board minutes should include notes on all actions taken.
Marchand v. Barnhill
In Marchand v. Barnhill the Delaware Supreme Court overruled the Chancery Court’s order granting a motion to dismiss on Caremark claims. Following the Caremark decision in 1996, almost all attempted negligent supervision causes of action were dismissed at the pleading stage. Marchand, which resulted from a listeria outbreak at Blue Bell Creameries, marked the first in what is now a series of cases that survived a motion to dismiss and continue to be litigated. In addition to being implicated in the deaths of three people, the outbreak resulted in a recall of all of the company’s products, a complete production shutdown, and a layoff involving 1/3rd of its workforce.
In determining that the Plaintiff had properly pled a case under Caremark, the Supreme Court noted that bad faith can be established by showing that no good faith efforts had been made. In this case no board committee had considered food safety protocols; no procedures were in place that required management to inform the board of food safety compliance practices, risks or reports; there was no schedule for the board to consider food safety on any sort of regular basis (even annually); prior to the outbreak red flags were presented to management who did not disclose these matters to the board; and board minutes showed a complete lack of discussion related to food safety. The Court noted that government inspectors found food safety problems at the company’s plants that were so systemic that any reasonable monitoring system would have resulted in them being reported to the board.
In other words, even though management did not disclose issues to the board, the board’s lack of inquiry or development of a plan to learn about food safety issues, in a food production company, rose to the level of bad faith supporting a complaint for lack of oversight. The Marchand parties agreed to a $60 million settlement, ten days before trial was set to commence.
In re Clovis Oncology Derivative Litigation
In re Clovis Oncology Derivative Litigation the court found that the plaintiffs had adequately pled that the board breached its fiduciary duties by failing to oversee a clinical trial for the company’s experimental lung cancer drug and then allowing the company to mislead the market regarding the drug’s efficacy. Clovis eventually disclosed these failures, resulting in a $1 billion drop in market value, a federal securities action, an SEC complaint, and the Delaware derivative action. Here the judge stated that Delaware courts are more likely to find liability under Caremark for oversight failures involving compliance obligations under regulatory mandates than for those involving oversight of ordinary business risks.
The court indicated that Caremark rests on the presumption that corporate fiduciaries are afforded “great discretion to design context and industry-specific approaches tailored to their companies’ businesses and resources.” Indeed, “[b]usiness decision-makers must operate in the real world, with imperfect information, limited resources, and uncertain future. To impose liability on directors for making a ‘wrong’ business decision would cripple their ability to earn returns for investors by taking business risks.” But, as fiduciaries, corporate managers must be informed of, and oversee compliance with, the regulatory environments in which their businesses operate. In this regard, as relates to Caremark liability, it is appropriate to distinguish the board’s oversight of the company’s management of business risk that is inherent in its business plan from the board’s oversight of the company’s compliance with positive law—including regulatory mandates.
Caremark requires a plaintiff to establish that the board either “completely fail[ed] to implement any reporting or information system or controls” or failed to adequately monitor that system by ignoring “red flags” of non-compliance. Here the board’s governance committee was responsible for overseeing compliance with regulatory requirements applicable to the clinical trial, the judge held that the plaintiff adequately pled that it knowingly ignored red flags indicating that the company was not complying with those requirements. Accordingly, he declined to dismiss the case. The case remains pending.
Hughes v. Hu
In Hughes v. Hu the Chancery Court held that the plaintiff adequately pled that the director defendants, who served on the company’s audit committee, breached their fiduciary duties by failing to oversee the company’s financial statements and related party transactions. The audit committee only met when they needed to discuss its annual 10-K and the meeting was brief and perfunctory. The plaintiff alleged that the directors made a conscious choice to avoid their duties and followed management blindly even after being presented with evidence of improper financial reporting and a failure to adequately disclose related party transactions.
In 2014 the public company even disclosed material weaknesses in its internal controls and a lack of oversight by the audit committee as financial controls and related party transactions. In 2017 the company had not fixed any of its problems and had to restate three years of financial statements. Although the case survived the motion to dismiss, it is still ongoing and none of the defendants have been found liable as of yet.
Teamsters Local 443 Health Services & Insurance Plan v. Chou
In Teamsters Local 443 Health Services & Insurance Plan v. Chou the court found that the defendants ignored red flags of illegal activity. The illegal activity involved a subsidiary of AmerisourceBergen Corporation (ABC) that was pooling excess overfill medication from cancer vials into additional syringes, which led to contamination. ABC, through a subsidiary, is in the business of buying single-dose vials of oncology drugs from manufactures, putting the drugs in syringes and selling the syringes for use by cancer patients. The vials included an overfill amount to account for human error in filling syringes and to avoid air bubbles. The overfill amount is supposed to be discarded. Instead, the subsidiary was pooling the drugs and filling additional syringes.
The company faced corporate criminal and civil penalties and stockholders brought a Caremark case against the directors. In refusing to dismiss the case, the Court found that the directors ignored three red flags including: (i) a report from an outside law firm that the subsidiary was not integrated into ABC’s compliance and reporting function (and thus that compliance had substantial gaps); (ii) a former executive filed a lawsuit until seal in federal court alleging illegal activity and although the lawsuit was disclosed in the 10-K’s signed by the directors, they did not take any remedial action; and (iii) the subsidiary received a subpoena from federal prosecutors related to illegal activity and the board still did not take action.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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« SEC Final Rule Changes For Exempt Offerings – Part 4 SEC Final Rule Changes For Exempt Offerings – Part 5 »
SEC Final Rule Changes For Exempt Offerings – Part 4
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this fourth blog discussing the changes to Regulation A. The first blog in the series discussed the new integration rules (see HERE). The second blog in the series covered offering communications (see HERE). The third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (see HERE.
Background; Current Exemption Framework
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A. Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Regulation A
The current two-tier Regulation A offering process went into effect on June 19, 2015, as part of the JOBS Act. Since its inception there has been one rule modification opening up the offering to SEC reporting companies (see HERE) and multiple SEC guidance publications including through C&DI on the Regulation A process. For a recent summary of Regulation A, see HERE. In reviewing the rules, the SEC found a few areas where compliance with Regulation A is more complex or difficult than for registered offerings, including the rules regarding the redaction of confidential information in material contracts, making draft offering statements public on EDGAR, incorporation by reference, and the abandonment of a post-qualification amendment. The new rules address these points.
The SEC has simplified the requirements for Regulation A and established greater consistency between Regulation A and registered offerings by permitting Regulation A issuers to: (i) file certain redacted exhibits using the process previously adopted for registered offerings (see HERE); (ii) make draft offering statements and related correspondence available to the public via EDGAR to comply with the requirements of Securities Act Rule 252(d), rather than requiring them to be filed as exhibits to qualified offering statements (see HERE); (iii) incorporate financial statement information by reference to other documents filed on EDGAR and generally allow incorporation by reference to the same degree as a registered offering (see HERE); and (iv) to have post-qualification amendments declared abandoned.
In addition, as has been discussed for several years now, the new rules increase the Tier 2 offering limit. Moreover, the new rules add an eligibility standard such that an Exchange Act reporting company which is delinquent in such reports, will not qualify to rely on Regulation A.
Increase in Offering Limit
The new rules increase the maximum Regulation A Tier 2 offering from $50 Million to $75 million in any 12-month period. As such, the 30% offering limit for secondary sales has increased from $15 million to $22.5 million. Tier 1 offering limits remain unchanged.
Redaction of Confidential Information in Certain Exhibits
In March 2019, the SEC amended parts of Regulation S-K to allow companies to mark their exhibit index to indicate that portions of the exhibit or exhibits have been omitted. Under the rules, a company must include a prominent statement on the first page of the redacted exhibit stating that certain identified information has been excluded from the exhibit because it is both not material and would be competitively harmful if publicly disclosed. A company must also indicate with brackets where the information has been omitted from the filed version of the exhibit. At the time the Regulation A rules were not changed such that Regulation A filers were still compelled to submit an application for confidential treatment in order to redact immaterial confidential information from material contracts and plans of acquisition, reorganization, arrangement, liquidation, or succession.
The new rules have aligned the Regulation A requirements with those for registered offerings. The SEC has added a new instruction to the Form 1-A that allows companies to redact exhibits using the same procedure as for registered offerings. SEC staff will continue to review Forms 1-A filed in connection with Regulation A offerings and selectively assess whether redactions from exhibits appear to be limited to information that meets the appropriate standard. Upon request, companies are expected to promptly provide supplemental materials to the SEC similar to those currently required by Exchange Act reporting companies. The information that the SEC could request includes an unredacted copy of the exhibit and an analysis of why the redacted information is both not material and the type of information that the company customarily and actually treats as private and confidential. The new rules follow the updated definition of “confidential” which does not include the “competitive harm” factor in the analysis. See HERE.
Regulation A Companies are also still able to request confidentiality under Rule 83. For more on confidential treatment in SEC filings, see HERE.
Confidential Offering Statement
Companies that are conducting Regulation A offerings are permitted to submit non-public draft offering statements and amendments for review by the SEC if they have not previously sold securities pursuant to (i) a qualified offering statement under Regulation A or (ii) an effective Securities Act registration statement. Prior to the rule amendments, confidential submittals had to be filed as an exhibit to a public filing at least 21 days prior to the qualification of the offering statement, which adds time and expense to the process. Aligning with confidential treatment for registered offerings, the SEC has amended the rules to allow a company to make draft offering statements and related correspondence available to the public via EDGAR by changing the previous submission selection from “confidential” to “public.”
Incorporation by Reference
The ability to incorporate financial statements by reference to Exchange Act reports filed before the effective date of a registration statement is permitted on Form S-1, subject to certain conditions. Aligning Regulation A with the S-1 provisions, the new rules will allow previously filed financial statements to be incorporated by reference into a Regulation A offering circular. To avail itself of the ability to incorporate by reference companies that have a reporting obligation under Rule 257, or the Exchange Act must be current in their reporting obligations. In addition, companies must make incorporated financial statements readily available and accessible on a website maintained by or for the company and disclose in the offering statement that such financial statements will be provided upon request. Companies conducting ongoing offerings still need to file an annual post-qualification amendment with updated financial statements.
Abandonment of an Offering
Prior to the rule amendment, Regulation A permitted the SEC to declare an offering statement abandoned but did not provide the same authority for post-qualification amendments. The new rules now specifically allow for the SEC to declare a post-qualification filing abandoned.
Ineligibility for Delinquent Exchange Act Reporting Companies
Regulation A includes an eligibility requirement that company conducting a Regulation A offering must have filed all reports, with the SEC, required to be filed, if any, pursuant to Rule 257 during the two years before the filing of the offering statement (or for such shorter period that the issuer was required to file such reports). When the SEC amended Regulation A to allow Exchange Act reporting companies to rely on the rule, it did not amend the provision related to delinquent filings. Accordingly, since Exchange Act companies are not required to file reports pursuant to Rule 257, a company could technically be delinquent and eligible to use Regulation A. In actuality, the SEC generally commented and pushed back on such companies, but the new rules close this loophole. In particular, companies that do not file all the reports required to have been filed by Sections 13 or 15(d) of the Exchange Act in the two-year period preceding the filing of an offering statement are ineligible to conduct a Regulation A offering.
« SEC Final Rule Changes For Exempt Offerings – Part 3 Caremark Eroded – Director Liability In Delaware »
SEC Final Rule Changes For Exempt Offerings – Part 3
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this second blog discussing offering communications including new rules related to demo days and generic testing the waters. The first blog in the series discussed the new integration rules (see HERE). The second blog in the series covered offering communications (see HERE). This third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D.
Background
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A. Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering from the Act’s registration requirements. Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest. Rule 506 is “safe harbor” promulgated under Section 4(a)(2). If all the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with.
Rule 506 is bifurcated into two separate offering exemptions. Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors – provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, must be provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and the company has an additional burden of verifying such accredited status. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Rule 506(c) Verification Requirements
Rule 506(c) allows for general solicitation and advertising; however, all sales must be made to accredited investors and the company must take reasonable steps to verify that purchasers are accredited. It is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. For more on Rules 506(b) and 506(c), see HERE.
Rule 506(c) provides for a principles-based approach to determine whether an investor is accredited as well as setting forth a non-exclusive list of methods to determine accreditation. After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the company would have to take to verify accredited investor status, and vice versa. Where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.
Examples of the type of information that companies can review and rely upon include: (i) publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages); (ii) third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms; and (iii) third-party accredited investor verification service providers.
The SEC has added a new item to the non-exclusive methods of verification. In particular, where the company has previously gone through the steps to verify accredited status for an existing investor, it can rely on the written representation that the investor continues to qualify as an accredited investor as long as the company is not aware of information to the contrary. With the rule change, the entire non-exclusive methods of verification included in the rule are:
- Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year. If such forms and information are joint with a spouse, the written representation must be from both spouses.
- Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit reports from a nationwide agency.
- Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.
- A written certification verifying accredited investor status from existing accredited investors of the company that have previously invested in a 506(b) offering with the same issuer prior to the enactment of 506(c); and
- A written representation from a person at the time of sale that he or she qualifies as an accredited investor where the company previously took reasonable steps to verify such person as an accredited investor in accordance with the rules, and so long as the company is not aware of information to the contrary. A written representation under this method of verification will satisfy the issuer’s obligation to verify the person’s accredited investor status for a period of five years from the date the person was previously verified as an accredited investor.
The SEC has provided guidance on the application of some of the non-exclusive methods of verifying accredited status. To wit: related to jointly held property, assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the accredited investor net worth test, but only to the extent of his or her percentage ownership of the account or property. Where the most recent tax return is not available but the two years prior are, a company may rely on the available returns together with a written representation from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specifies the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. However, if the evidence is at all questionable, further inquiry should be made.
The new rule release reaffirms that the rule is meant to be principles-based and that by offering suggested methods of verification, the SEC is not discouraging any reasonable methods a company may deem appropriate. Companies are encouraged to consider (i) the nature of the purchaser and the type of accredited investor that the purchaser claims to be; (ii) the amount and type of information that the company has about the purchaser; and (iii) the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
Rule 506(b); Harmonization of Disclosure Requirements
Rule 506(b) has scaled disclosure requirements based on the size of the offering, where unaccredited investors are included. Prior to the amendments, the scaled requirements were broken into 4 categories. The amended rules update the information requirements for investors under Rule 506(b) where any unaccredited investors are solicited to align with information required under Regulation A. For Rule 506(b) offerings up to $20 million, the same financial information that is required for Tier 1 Regulation A offerings, is now required. For offerings greater than $20 million, the same financial information that is required for Tier 2 Regulation A offerings is now required.
In standardizing the 506(b) and Regulation A disclosures, the SEC has eliminated the ability to only provide a balance sheet where a company has trouble getting financial statements when conducting a Rule 506(b) offering. Foreign private issuers may provide the financial information in either U.S. GAAP or IFRS as would be permitted in a registration statement.
If the company is not subject to the Exchange Act reporting requirements, it must also furnish the non-financial statement information required by Part II of Form 1-A or Part I of a Securities Act registration statement on a form that the issuer would be eligible to use (usually Form S-1). If the company is subject to the Exchange Act reporting requirements, it must provide its definitive proxy with annual report, or its most recent Form 10-K. These information requirements only apply where non-accredited investors will be solicited to participate in the offering.
Finally, as mentioned in Part I of this blog series related to integration where an issuer conducts more than one offering under Rule 506(b), the number of non-accredited investors purchasing in all such offerings within 90 calendar days of each other is limited to 35.
Rule 504
On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amended Rule 147 to allow companies to continue to conduct intrastate offerings under Section 3(a)(11) of the Securities Act and created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. At that time, the SEC also amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. For more on the 2016 rule amendments, see HERE.
Even with the increased offering limits, as of today only approximately 2% of all Regulation D offerings under $5 million, rely on Rule 504. The amended rules hope to encourage the use of Rule 504 by raising the offering limits to $10 million in any 12-month period.
Rule 504 is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Rule 504 does not have any specific investor qualification or limitations. However, Rule 504 does not pre-empt state law and as such, the law of each state in which an offering will be conducted must be reviewed and complied with.
Bad-Actor Provisions
Rules 504, 506(b), 506(c), Regulation A and Regulation Crowdfunding all have bad-actor disqualification provisions. While the disqualification provisions are substantially similar, the look-back period for determining whether a covered person is disqualified differed between Regulation D and the other exemptions. The amended rules harmonize the bad-actor provisions among Regulations D, A and Crowdfunding by adjusting the look-back requirements in Regulation A and Regulation Crowdfunding to include the time of sale in addition to the time of filing.
Under Regulation D, the disqualification event is measured as of the time of sale of the securities in the offering. Prior to the amendment, the look-back period was measured from the time the company files an offering statement for both Regulation A and Regulation Crowdfunding. However, the SEC believes that it is important to look to both the time of filing of the offering document and the time of the sale with respect to disqualifying bad actors from participating in an offering. The amended rules add “or such sale” to any look back references in Regulation A and Regulation Crowdfunding.
As a refresher, the bad actor rules relate to certain activities or events involving covered persons. Covered persons include:
- The issuer and any predecessor of the issuer or affiliated issuer;
- Any director, general partner or managing member of the issuer and executive officers (i.e., those officers that participate in policymaking functions) and officers who participate in the offering (participation is a question of fact and includes activities such as involvement in due diligence, communications with prospective investors, document preparation and control, etc.);
- Any beneficial owner of 20% or more of the outstanding equity securities of the issuer calculated on the basis of voting power (voting power is undefined and meant to encompass the ability to control or significantly influence management or policies; accordingly, the right to elect or remove directors or veto or approve transactions would be considered voting (for SEC guidance on voting control, see HERE;
- Investment managers of issuers that are pooled investment funds; the directors, executive officers, and other officers participating in the offering; general partners and managing members of such investment managers; the directors and executive officers of such general partners; and managing members and their other officers participating in the offering (i.e., the hedge fund coverage; the term “investment manager” is meant to encompass both registered and exempt investment advisers and other investment managers);
- Any promoter connected with the issuer in any capacity at the time of the sale (a promoter is defined in Rule 405 as “any person, individual or legal entity, that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities other than securities received solely as underwriting commissions or solely in exchange for property”);
- Any person who has been or will be paid, either directly or indirectly, remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
- Any director, officer, general partner, or managing member of any such compensated solicitor.
Disqualifying events include:
- Criminal convictions (felony or misdemeanor) within the last five years in the case of issuers, their predecessors and affiliated issuers, and ten years in the case of other covered persons, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
- Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
- Final orders issued by a state securities commission (or any agency of a state performing like functions), a state authority that supervises or examines banks, savings and associations, or credit unions, state insurance regulators, federal banking regulators, the CFTC, or the National Credit Union Administration that, at the time of the sale, bars the person from association with any entity regulated by the regulator issuing the order or from engaging in the business of securities, insurance or banking or engaging in savings association or credit union activities; or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last ten years before the sale;
- Any order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or section 203(e) or (f) of the Investment Advisors Act that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment advisor; places limitations on the activities, functions or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock;
- Is subject to any order of the SEC entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation of future violation of any scienter-based anti-fraud provision of federal securities laws (including, without limitation, Section 17(a)(10) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Advisor Act, or any other rule or regulation thereunder) or Section 5 of the Securities Act;
- Suspension or expulsion from membership in, or suspension or bar from association with, a member of an SRO, i.e., a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
- Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; and
- U.S. Postal Service false representation orders, including temporary or preliminary orders entered within the last five years.
For further reading on SEC guidance on the bad actor provisions, see HERE.
« SEC Final Rule Changes For Exempt Offerings – Part 2 SEC Final Rule Changes For Exempt Offerings – Part 4 »
SEC Final Rule Changes For Exempt Offerings – Part 2
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this second blog discussing offering communications including new rules related to demo days and generic testing the waters. The first blog in the series discussed the new integration rules (see HERE).
Background
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they are able to make their own informed investment and voting decisions.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering from the Act’s registration requirements. Section 4(a)(2) does not limit the amount a company can raise or the amount any investor can invest. Rule 506 is “safe harbor” promulgated under Section 4(a)(2). If all the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with.
Effective September 2013, in accordance with the JOBS Act, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rule 506 by bifurcating the rule into two separate offering exemptions. The historical Rule 506 was renumbered to Rule 506(b) and new rule 506(c) was enacted. Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors – provided, however, that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, must be provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering.
Rule 506(c) allows for general solicitation and advertising; however, all sales must be strictly made to accredited investors and the company has an additional burden of verifying such accredited status. In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited, as it is with a 506(b) offering. Accordingly, in the Rule 506 context, determining whether solicitation or advertising has been utilized is extremely important.
Other private offerings also allow for solicitation and advertising. In particular, Regulation A, Regulation Crowdfunding, Rule 147 and 147A, and Rule 504 all allow for solicitation and advertising. For more information on Rule 504, Rule 147 and 147A, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. Part 1 of this blog series talked about issues with integration, including between offerings that allow and don’t allow solicitation, but equally important is determining what constitutes solicitation in the first place.
Prior to the JOBS Act, general solicitation and advertising was prohibited in most exempt offerings and “testing the waters” was not yet a mainstream term of art in the capital markets. Following the JOBS Act creation of Rule 506(c), Regulation Crowdfunding and the new Regulation A/A+ structure, offering solicitation and pre-offering testing the waters became the norm. Recognizing the benefits of additional offering communications, and testing the waters prior to launching an offering, the SEC has included expanded offering communications and testing the waters provision in its modernized exempt offering rules.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Offering Communications; Expansion of Test-the-Waters Communications; Addition of “Demo Days”
The Securities Act defines the term “offer” very broadly and includes any publication of information or communication in advance of a financing that would have the effect of arousing interest in the securities being offered. Likewise, general solicitation and advertising have been interpreted very broadly. Although Rule 502(c) lists some examples, the SEC has expanded upon those examples over the years, including information posted on an unrestricted website as a general solicitation.
Rule 502(c) lists the following examples of solicitation or advertising:
- Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising; provided, however,that publication by a company of a notice in accordance with Rule 135c or filing with the SEC of a Form D shall not be deemed to constitute general solicitation or general advertising; and provided further that, if the requirements of Rule 135e are satisfied, providing any journalist with access to press conferences held outside of the U.S., to meetings with companies or selling security holder representatives conducted outside of the U.S., or to written press-related materials released outside the U.S., at or in which a present or proposed offering of securities is discussed, will not be deemed to constitute general solicitation or general advertising.
Generally, testing the waters through contacting potential investors in advance of an exempt offering to gauge interest in the future offering, could be deemed solicitation. In 2015 the SEC issued several C&DI to address when communications would be deemed a solicitation or advertisement, including factual business communications in advance of an offering and demo days or venture fairs.
At that time, the SEC indicated that participation in a demo day or venture fair does not automatically constitute general solicitation or advertising under Regulation D. If a company’s presentation does not involve the offer of securities at all, no solicitation is involved. If the attendees of the event are limited to persons with whom either the company or the event organizer have a pre-existing, substantive relationship, or have been contacted through a pre-screened group of accredited, sophisticated investors (such as an angel group), it will not be deemed a general solicitation. However, if invitations to the event are sent out via general solicitation to individuals and groups with no established relationship and no pre-screening as to accreditation, any presentation involving the offer of securities would be deemed to involve a general solicitation under Regulation D. For more on a pre-existing substantive relationship, see HERE.
The amended rules specifically exempt “demo days” from the definition of general solicitation and advertising for all offerings; allow companies to use generic solicitations of interest communications prior to determining which exempt offering they will rely upon or pursue; and add test-the-waters provisions to Regulation Crowdfunding.
Demo Days; New Rule 148
“Demo days” and similar events are generally organized by a group or entity that invites issuers to present their businesses to potential investors, with the aim of securing an investment.
New Rule 148 provides that certain demo day communications will not be deemed to be a general solicitation or advertising. Specifically, a company will not be deemed to have engaged in general solicitation if the communications are made in connection with a seminar or meeting sponsored by a college, university, or other institution of higher education, a local government, a state government, instrumentalities of state and local governments, a nonprofit organization, or an angel investor group, incubator, or accelerator and in which more than one company participates. Rule 148 excludes broker-dealers and investment advisors from the scope of the exemption.
Rule 148 requires that “angel investor groups” maintain defined processes and procedures for making investment decisions, though the rule does not require that the processes be memorialized in writing.
Sponsors of events are not permitted to: (i) make investment recommendations or provide investment advice to attendees of the event; (ii) engage in any investment negotiations between the company and investors attending the event; (iii) charge attendees fees beyond a reasonable administrative fee; (iv) receive compensation for making introductions; or (v) receive any compensation with respect to the event that would require registration as a broker-dealer or investment advisor.
Advertising for the event is also limited and may not reference any specific offering of securities by a participating company. To address concerns that communications for demo day events will encompass a large number of non-accredited investors especially in light of the increase in virtual events, the new rule limits online participation for an event to: (i) individuals who are members of, or otherwise associated with the sponsor organization; (b) individuals that the sponsor reasonably believes are accredited investors; or (iii) individuals who have been invited to the event by the sponsor based on industry or investment related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event.
Rule 148 also regulates the information a presenting company can convey to: (i) notification that the company is in the process of an offering or planning an offering of securities; (ii) the type and amount of securities being offered; (iii) use of proceeds; and (iv) the remaining unsubscribed amount of an offering.
Rule 148 is a non-exclusive method of communicating with potential investors. Companies may continue to rely on previously issued guidance to attend events where the participation is limited to individuals or groups of individuals with whom the company or the organizer has a pre-existing substantive relationship or that have been contacted through an informal, personal network of experienced, financially sophisticated individuals. In those events, the information provided by the company is not limited.
Solicitations of Interest; New Rule 241
Prior to the JOBS Act, almost no exempt offerings (except intrastate offerings when allowed by the state) allowed for advertising or soliciting, including solicitations of interest or testing the waters. The JOBS Act created the current Regulation A, which allows for testing the waters subject to certain SEC filing requirements and the inclusion of specific legends on the offering materials. For a discussion on Regulation A test-the-waters provisions, see HERE.
The SEC recognizes the benefits of testing the waters prior to incurring the costs associated with an offering. As such, the SEC is adopting new Rule 241, which exempts companies from the registration requirements for generic pre-offering communications that are made in compliance with the rule. Rule 241 allows companies to solicit indications of interest in an exempt offering, either orally or in writing, prior to determining which exemption they will rely upon, even if the ultimate exemption does not allow for general solicitation or advertising. Rule 241 is an exemption from the registration requirements for “offers” but not “sales,” but since communications under the rule are considered “offers,” they are subject to the antifraud provisions under the federal securities laws.
Rule 241 is similar to existing Rule 255 of Regulation A. Rule 241 communications require a legend or disclaimer stating that: (i) the company is considering an exempt offering but has not determined the specific exemption it will rely on; (ii) no money or other consideration is being solicited, and if sent, will not be accepted; (iii) no sales will be made or commitments to purchase accepted until the company determines the exemption to be relied upon and where the exemption includes filing, disclosure, or qualification requirements, all such requirements are met; and (iv) a prospective purchaser’s indication of interest is non-binding.
Once a company determines which type of offering it intends to pursue, it would no longer be able to rely on Rule 241 but would need to comply with the rules associated with that particular offering type, including its solicitation of interest and advertising rules. Moreover, since the solicitation of interest would likely be a general solicitation, if the chosen offering does not allow general solicitation or advertising, the company would need to conduct an integration analysis to make sure that there would be no integration between the solicitation of interest and the offering. Under the new rules, that would generally require the company to wait 30 days between the solicitation of interest and the offering (see Part 1 of this blog series HERE). I say “would likely be a general solicitation” because a company may still indicate interest from persons that it has a prior business relationship with, without triggering a general solicitation, as they can now under the current rules.
If a company elects to proceed with a Regulation A or Regulation Crowdfunding offering, it will need to file the Rule 241 test-the-waters materials if the Rule 241 solicitation is within 30 days of the ultimate offering, as such solicitation of interest would integrate with the following offering. If more than 30 days pass, the Rule 241 communications would not need to be filed, but any Rule 255 communication would need to be filed in a Regulation A offering and new Rule 206 communications would need to be filed in a Regulation Crowdfunding offering.
Although new Rule 241 does not limit the type of investor that can be solicited (accredited or non-accredited), under the new rules, if a company determines to proceed with a Rule 506(b) offering within 30 days of obtaining indications of interest, it must provide the non-accredited investors, if any, with a copy of any written solicitation of interest materials that were used.
New Rule 241 does not pre-empt state securities laws. Accordingly, if a company ultimately proceeds with an offering that does not pre-empt state law, it will need to consider whether it has met the state law requirements, including whether each state allows for solicitations of interest prior to an offering. This provision will likely be a large impediment to a company that is considering an offering that does not pre-empt state law.
Regulation Crowdfunding; New Rule 206; Amended Rule 204
Prior to the amendments, a company could not solicit potential investors until their Form C is filed with the SEC. New Rule 206 will allow both oral and written test-the-waters communications prior to the filing of a Form C much the same as Regulation A. Under Rule 206, companies are permitted to test the waters with all potential investors.
The testing-the-waters materials will be considered offers that are subject to the antifraud provisions of the federal securities laws. Like Regulation A, any test-the-waters communications will need to contain a legend including: (i) no money or other consideration is being solicited, and if sent, will not be accepted; (ii) no sales will be made or commitments to purchase accepted until the Form C is filed with the SEC and only through an intermediary’s platform; and (iii) a prospective purchaser’s indication of interest is non-binding. Any test-the-waters materials will need to be filed with the SEC as an exhibit to the Form C.
Unlike Regulation A, Rule 206 only allows for testing the waters prior to the filing of a Form C with the SEC. Once the Form C is filed, any offering communications are required to comply with the terms of Regulation Crowdfunding, including the Rule 204 advertising restrictions.
However, the SEC has also amended Rule 204 to permit oral communications with prospective investors once the Form C is filed. The SEC has also expanded upon the allowed categories of advertised information that can be provided under Rule 204. Rule 204 generally allows a company to advertise a Regulation Crowdfunding offering by directing potential investors to the intermediary’s platform. Rule 204 allows such advertisements to include limited information about the offering. The SEC has added: (i) a brief description of the planned use of proceeds of the offering; and (ii) information on the company’s progress towards meeting its funding goals, to the already allowable: (a) statement that the company is conducting an offering under Regulation Crowdfunding; (b) the name of the intermediary and a link to the intermediary’s platform; (c) the terms of the offering; and (d) factual information about the legal identity and business location of the company including its full name, address, phone number, web site address, email of a representative and a brief description of the business.
The SEC has further amended Rule 204 to specify that a company may provide information about the terms of an offering under Regulation Crowdfunding in the offering materials for a concurrent offering, such as in an offering statement on Form 1-A for a concurrent Regulation A offering or a Securities Act registration statement filed with the SEC, without violating Rule 204. To do so, the information provided about the Regulation Crowdfunding offering must be in compliance with Rule 204, including the requirement to include a link directing the potential investor to the intermediary’s platform. However, since SEC rules prohibit live links to locations outside the EDGAR system, the link in such a filing could not be a live hyperlink.
Further Background Reading
Prior to the rule changes, the SEC issued a concept release and request for public comment on the subject in June 2019 (see HERE). Also, for my five-part blog series on the proposed rules, see HERE, HERE , HERE, HERE, and HERE.
« SEC Final Rule Changes For Exempt Offerings – Part 1 SEC Final Rule Changes For Exempt Offerings – Part 3 »
SEC Final Rule Changes For Exempt Offerings – Part 1
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The SEC had originally issued a concept release and request for public comment on the subject in June 2019 (see HERE). For my five-part blog series on the proposed rules, see HERE, HERE, HERE, HERE and HERE. The new rules go into effect on March 14, 2021.
The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I will break it down over a series of blogs, with this first blog focusing on integration.
Current Exemption Framework
As I’ve written about many times, the Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. The purpose of registration is to provide investors with full and fair disclosure of material information so that they can make informed investment and voting decisions.
In recent years, the scope of exemptions has evolved stemming from the JOBS Act in 2012, which broke Rule 506 into two exemptions, 506(b) and 506(c), and created the current Regulation A/A+ and Regulation Crowdfunding. The FAST Act, signed into law in December 2015, added Rule 4(a)(7) for re-sales to accredited investors. The Economic Growth Act of 2018 mandated certain changes to Regulation A, including allowing its use by SEC reporting companies, and to Rule 701 for employee stock option plans for private companies. Also relatively recently, the SEC eliminated the never-used Rule 505, expanded the offering limits for Rule 504 and modified the intrastate offering structure.
Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 4 contains all transactional exemptions including Section 4(a)(2), which is the statutory basis for Regulation D and its Section 4(a)(2) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For more information on Rule 504 and intrastate offerings, see HERE; on rule 506, see HERE; on Regulation A, see HERE; and on Regulation Crowdfunding, see HERE. The disparate requirements can be tricky to navigate and where a company completes two offerings with conflicting requirements (such as the ability to solicit), integration rules can result in both offerings failing the exemption requirements.
The chart at the end of this blog contains an overview of the offering exemptions, incorporating the new rule changes.
Rule Changes
The rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules amend the integration rules to provide certainty for companies moving from one offering to another or to a registered offering; increase the offering limits under, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; set clear and consistent rules that increase the ability to communicate during the offering process, including for offerings that historically prohibited general solicitation; and harmonize disclosure obligations and bad actor rules to decrease differences between various offering exemptions.
Integration; new Rule 152
Current Integration Structure
Prior to the amendments, the Securities Act integration framework for registered and exempt offerings consists of a mixture of rules and SEC guidance for determining whether two or more securities transactions should be considered part of the same offering. In general, the concept of integration is whether two offerings integrate such that either offering fails to comply with the exemption or registration rules being relied upon. That is, where two or more offerings are integrated, there is a danger that the exemptions for one or both offerings will be lost, such as when one offering prohibits general solicitation and another one allows it.
Prior to the amendments, Securities Act Rule 502(a) provides for a six-month safe harbor from integration with an alternative five-factor test including: (i) whether the offerings are part of a single plan of financing; (ii) whether the offerings involve the same class of security; (iii) whether the offerings are made at or around the same time; (iv) whether the same type of consideration will be received; and (v) whether the offerings are made for the same general purpose. For SEC guidance on integration between a 506(c) and 506(b) offering, see HERE). Although technically Rule 502(a) only applies to Regulation D (Rule 504 and 506 offerings), the SEC and practitioners often use the same test in other exempt offering integration analysis. The five-factor test has been completely eliminated in the new regulatory structure.
A different analysis is used when considering the integration between an exempt and registered offering and in particular, considering whether the exempt offering investors learned of the exempt offering through general solicitation, including the registration statement itself. Yet a different analysis is used when considering Regulation A, Regulation Crowdfunding, Rule 147 and Rule 147A offerings although each of those has a similar six-month test.
New Rule 152(a) – General Integration Principal
The amended rules completely overhaul the integration concept, creating a new Rule 152(a) setting forth a general integration concept and new Rule 152(b) containing four safe harbors applicable to all securities offerings whether registered or exempt. Where a safe harbor exists under Rule 152(b), that safe harbor may be relied upon.
Where a safe harbor does not exist, offers and sales will not be integrated if, based on the particular facts and circumstances, the company can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering. Where solicitation is prohibited, the company must have a reasonable belief that each purchaser in the offering that does not allow for solicitation, was either not solicited or that such investor had a pre-existing substantive relationship with the company prior to commencement of the offering.
A “pre-existing” relationship is one that the company has formed with an offeree prior to the commencement of the offering or, that was established through another person, such as a registered broker-dealer or investment adviser, prior to that person’s participation in the offering. A substantive relationship is one in which the company, or someone acting on the company’s behalf such as a broker-dealer, has sufficient information to evaluate, and in fact does evaluate, such prospective investors’ financial circumstances and sophistication, and has established accreditation. A substantive relationship is determined by the quality of the relationship and information known about an investor as opposed to the length of a relationship. For more on substantive pre-existing relationships, including a summary of the SEC’s no action letter in Citizen VD, Inc., see HERE.
In a huge change from the prior structure, under the new integration principle in Rule 152(a), a company may conduct concurrent Rule 506(c) and Rule 506(b) offerings, or any other combination of concurrent offerings, involving an offering prohibiting general solicitation and another offering permitting general solicitation, without integration concerns, so long as the provisions of Rule 152(a)(1) and all other conditions of the applicable exemptions are satisfied. That is, if the company can establish that the purchasers in the 506(b) offering were not solicited using general solicitation or that there was a substantive relationship with that purchaser prior to the commencement of the 506(b) offering, the exemption would survive.
Rule 152(a) specifically provides that where two or more concurrent offerings are being completed which allow general solicitation, care must be given to ensuring that all offerings comply with each of the exemptions including any disclosures or regulatory legends required for such offering. For example, if a company is conducting a concurrent Rule 506(c) and Regulation A offering and discusses the terms of the Regulation A offering in its Rule 506(c) general solicitation material, all of the requirements in Regulation A must be met.
New Rule 152(a) contains introductory language that the provisions of either Rule 152(a) or (b) will not have the effect of avoiding integration for any transaction or series of transactions that, although in technical compliance with the rule, is part of a plan or scheme to evade the registration requirements of the Securities Act.
New Rule 152(b) – Statutory Safe Harbors
New Rule 152(b) sets forth four new non-exclusive safe harbors from integration, including:
(i) Any offering made more than 30 calendar days before the commencement or after the termination of a completed offering will not be integrated – provided, however, that where one of the offerings involved general solicitation, the purchasers in an offering that does not allow for solicitation, did not learn of the offering through solicitation applying the principals in Rule 152(a) (this 30-day test would replace the six-month test across the board);
(ii) Offerings under Rule 701, pursuant to an employee benefit plan, or in compliance with Regulation S will not integrate with other offerings;
(iii) A registered offering will not integrate with another offering as long as it is subsequent to (a) a terminated or completed offering for which general solicitation is not permitted; (b) a terminated or completed offering for which general solicitation was permitted but that was made only to qualified institutional buyers (QIBs) or institutional accredited investors (IAIs); or (c) an offering for which general solicitation is permitted that terminated or completed more than 30 calendar days prior to the commencement of the registered offering; and
(iv) Offers and sales that allow for general solicitation will not integrate with a prior completed or terminated offering. In particular, offerings under Regulation A, Regulation Crowdfunding, Rule 147 or 147A, Rule 504, Rule 506(b), Rule 506(c), Section 4(a)(2) and registered offerings will not integrate with a subsequent Regulation A, Regulation Crowdfunding, Rule 147 or 147A, Rule 504 or Rule 506(c) offering.
New Rules 152(c) and 152(d) – Commencement, Termination and Completion of Offerings
New Rules 152(c) and 152(d) provide a non-exclusive set of factors to consider when determining when an offer has commenced, terminated or been completed. New Rule 152(c) provides a non-exclusive list of factors to consider in determining when an offering will be deemed to be commenced. Regardless of the type of offering, it will be commenced at the time of the first offer of securities in the offering by the issuer or its agents. The Rule also includes a list of factors that should be considered in determining when an offering is commenced, including:
(i) On the date the company first makes a generic offer soliciting interest in a contemplated offering where the company has not yet determined the exemption it will rely upon (new Rule 241 covering generic solicitations of interest will be discussed in Part 2 of this blog series);
(ii) For Section 4(a)(2), Regulation D or Rule 147 or 147A, on the date the company first made an offer of its securities in reliance on these exemptions;
(iii) For Regulation A, on the earlier of the first day of testing the waters or the public filing of a Form 1-A;
(iv) For Regulation Crowdfunding, on the earlier of the first day of testing the waters or the public filing of a Form C;
(v) For registered offerings – for a continuous offering on the date of the initial filing with the SEC or for a delayed offering, on the earliest of which the company or its agents commence public efforts to offer and sell which could be evidenced by the earlier of the filing of a prospectus supplement or use of public disclosure such as a press release.
New Rule 152(d) provides a non-exclusive list of factors to consider in determining whether an offering is terminated or completed. Regardless of the type of offering, termination or completion of an offering is likely to occur when the company and its agents cease efforts to make further offers to sell the issuer’s securities under such offering. The Rule also includes a list of factors that should be considered including:
(i) For a Section 4(a)(2), Regulation D, Rule 147 or Rule 147A offering, the later of the date the company has a binding commitment to see all the securities offered or the company and its agents have ceased all efforts to sell more securities;
(ii) For a Regulation A offering, when the offering statement is withdrawn, a Form 1-Z has been filed, a declaration of abandonment is made by the SEC or the third anniversary after qualification of the offering;
(iii) For Regulation Crowdfunding, upon the deadline of the offering set forth in the offering materials or as indicated in any notice to investors by the intermediary;
(iv) For registered offerings, on the date of withdrawal of the registration statement, the filing of a prospectus supplement or amendment disclosing the offering termination, a declaration of abandonment is made by the SEC, the third anniversary after effectiveness of the initial registration statement, or any other evidence of abandonment or termination of the offering such as the filing of a Form 8-K or a press release.
An offering may also be effectively terminated. For example, if a company commences a Rule 506(b) offering and then begins to solicit under Rule 506(c) and relies exclusively on Rule 506(c) once it commences solicitation, the Rule 506(b) offering will be deemed to be terminated.
As will be discussed in this blog series, Rule 506(b) has been amended such that a company may sell to 35 unaccredited investors within any 90 calendar days. This provision alleviates concerns that a company would engage in consecutive 506(b) offerings every 30 days selling to 35 accredited investors each time.
Rules 502(a), 251(c) (i.e., Regulation A integration provision), 147(g) and 147A(g) (both intrastate offering provisions), and Rule 500(g) have been amended to cross reference the new Rule 152. Other rules including Rules 255(e), 147(h), 147A(h) and Rule 155 (related to abandoned offerings) have been eliminated as the provisions are covered in Rule 152.
Exemption Overview Chart
The following chart is includes the most commonly used offering exemptions as updated by the amended rules:
| Type of Offering | Offering Limit within 12- month Period | General Solicitation/Manner of Offering | Issuer Requirements | Offeree and Investor Requirements | SEC Filing and Information Requirements | Restrictions on Resale | Preemption of State Registration and Qualification |
| Section 4(a)(2) | None | No general solicitation. | None | Transactions by an issuer not involving any public offering. See SEC v. Ralston Purina Co.Offerees and purchasers must be sophisticated and be given access to information. | None | Yes. Restricted securities | No preemption. Must qualify in each state |
| Rule 506(b) of Regulation D | None | No general solicitation. Rule 148 “demo days” (sponsored investor event) will not be general solicitation, with attendee limits if done virtually | “Bad actor” disqualifications apply | No offeree qualifications.Unlimited accredited investors
Up to 35 sophisticated but non-accredited investors in any 90 day period but must provide certain financial and non-financial disclosures |
Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.No information requirement for accredited investor except disclosure of resale restrictions and investors must be given access to information if requested.
For any non-accredited investors: (A) if 1934 Act reporting company, certain reports or filings or (B) if non-reporting company, (1) Regulation A narrative information for eligible issuers and otherwise narrative information required by Part I of applicable registration form and (2) Regulation A financials that may be unaudited if offering $20,000,000 or less and audited if more |
Yes. Restricted securities | Exempt as “covered security,” subject to state fees and notice filings. |
| Rule 506(c) of Regulation D | None | General solicitation permitted if all purchasers are verified accredited investors. Non-exclusive safe harbors available for verification of natural persons and previous investors who self-certify within 5 years. | “Bad actor” disqualifications apply | No offeree qualifications.Unlimited accredited investors. No non-accredited investors.
Issuer must take reasonable steps to verify that all purchasers are accredited investors |
Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.No information requirement except disclosure of resale restrictions and investors must be given access to information if requested.
|
Yes. Restricted securities | Exempt as “covered security,” subject to state fees and notice filings. |
| Regulation A: Tier 1 | $20 million but no more than $6,000,000 by affiliate selling security holders subject to aggregate 30% price cap by selling security holders in first Reg A offering and any Reg A offerings in 12 months | Permitted; before qualification, testing the waters permitted before and after the offering statement is filed.
No sales or direct or indirect commitments for sales until after qualified with SEC.
General solicitation permitted after qualified with SEC. |
U.S. or Canadian issuersExcludes blank check companies, registered investment companies, business development companies, issuers of certain securities, and certain issuers subject to a Section 12(j) order; and Regulation A Exchange Act reporting companies that have failed to file certain required reports
“Bad actor” disqualifications apply No asset-backed securities. |
None | Form 1-A, including two years of unaudited financial statements.May be submitted confidentially for SEC review if publicly filed for 21 days; file sales material; file generic test the waters materials as exhibit if Regulation A used within 30 days.
Exit report on Form 1-Z within 30 days of offering completion. |
No | No preemption. Must qualify in each state. |
| Regulation A: Tier 2 | $75 million but no more than $22,500,000 by affiliate selling security holders subject to aggregate 30% price cap by selling security holders in first Tier 2 offering and any Reg A offerings in 12 months | Non-accredited investors are subject to investment limits of 10% of the greater of annual income and net worth, unless securities will be listed on a national securities exchange | Form 1-A, including two years of audited financial statements.May be submitted confidentially for SEC review if publicly filed for 21 days; file sales material; file generic test the waters materials as exhibit if Regulation A used within 30 days.
Annual, semi-annual, current, and exit reports |
No | Exempt as “covered security,” subject to state fees and notice filings. | ||
| Rule 504 of Regulation D | $10 million including all Section 3(b)(1) sales and sales in violation of Section 5 | No general solicitation. Rule 148 “demo days” (sponsored investor event) will not be general solicitation, with attendee limits if done virtually. Generic testing the waters permitted.General solicitation permitted if registered in state requiring use of substantive disclosure document or under exemption in state for sales to accredited investors | Excludes blank check companies, Exchange Act reporting companies, and investment companies“Bad actor” disqualifications apply | None | Form D with SEC not later than 15 days of first sale though failure to file will not destroy exemption.
Can register in a state based on state disclosure requirements for issuance of unrestricted securities. |
Yes. Restricted securities unless registered in a state requiring use of a substantive disclosure document or sold under state exemption for sale to accredited investors with general solicitation | Need to comply with state blue sky law by registration (Form U-7 may be available) or state exemption. State crowdfunding may be available |
| Intrastate: Section 3(a)(11) | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all offerees must be in- state residents making internet advertising difficult. | In-state residents “doing business” and incorporated in-state; excludes registered investment companies | Offerees and purchasers must be in-state residents | None | Securities must come to rest with in-state residents.Generally states require a one year hold. | No preemption. Must qualify in state. |
| Intrastate: Rule 147 | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all offerees must be in- state residents making internet advertising difficult.Testing the waters is permitted | In-state residents “doing business” and incorporated in-state; excludes registered investment companies | Offerees and purchasers must be in-state residents | None | Yes. Resales must be within state for six months | No preemption. Must qualify in state. |
| Intrastate: Rule 147A | No federal limit (generally, individual state limits between$1 and $5 million) | Solicitation permitted but all purchasers must be in- state residents.
Testing the waters is permitted |
In-state residents and “doing business” in-state; excludes registered investment companies | Offerees and Purchasers must be in- state residents | None | Yes. Resales must be within state for six months | No preemption. Must qualify in state. |
| Regulation Crowdfunding; Section 4(a)(6) | $5 million | Testing the waters permitted before Form C is filed.Solicitation permitted with limits on advertising after Form C is filed
Offering must be conducted on an internet platform through a registered intermediary |
Excludes non-U.S. issuers, blank check companies, Exchange Act reporting companies, and investment companies“Bad actor” disqualifications apply | No investment limits for accredited investors.Non-accredited investors investment limits in any 12-month period through crowdfunding of (i) the greater of $2,200 or 5% of the greater of annual income or net worth if either is less than $107,000, or (ii) 10% of the greater of annual income or net worth, but not more than $107,000, if both are at least $107,000. | Form C, including two years of financial statements that are certified, reviewed or audited, as required based on offering amount. Must file test the waters materials with Form C.Up to $107,000 – latest tax return and financials certified by officers; from $107,000 to $535,000 – financials reviewed by public accountant; above $535,000, audited financials but may be reviewed for first-time issuer up to $1,070,000.
Progress and annual reports |
12-month resale limitations | Exempt as “covered security,” subject to state notice filing with primary state. State antifraud rules apply. |
It is extremely difficult for small and emerging companies to raise capital, and any changes to the rules that will assist these companies is a positive step. Small businesses are job creators, generators of economic opportunity, and fundamental to the growth of the country. Small businesses account for the majority of net new jobs since the recession ended and are critical to the health and vitality of our country. In the absence of access to funding, small businesses cannot create new jobs, foster innovation, and develop into the next generation of publicly traded companies whose growth fuels capital markets investors’ retirement accounts.
I am very interested to see the new administration’s regulatory and general policies and agendas that impact small business capital raising efforts.
« Audit Committees – NYSE American SEC Final Rule Changes For Exempt Offerings – Part 2 »
Audit Committees – NYSE American
Like Nasdaq, I’ve written several times about the NYSE American listing requirements including the general listing requirements (see HERE) and annual compliance guidelines (see HERE). As an aside, although the Nasdaq recently enacted significant changes to its initial listing standards, the NYSE American has not done the same and no such changes are currently anticipated. I suspect that the NYSE American will see a large uptick in new company applicants as a result.
I recently drilled down on audit committee requirements and director independence standards for Nasdaq and in this and the next blog, I will do the same for the NYSE American. As required by SEC Rule 10A-3, all exchange listed companies are required to have an audit committee consisting of independent directors. NYSE American Company Guide Rule 803 delineates the requirements independent directors and audit committees. Rule 803 complies with SEC Rule 10A-3 related to audit committees for companies listed on a national securities exchange.
SEC Rule 10A-3
SEC Rule 10A-3 requires that each national securities exchange have initial listing and ongoing qualification rules requiring each listed company to have an audit committee comprised of independent directors. Although the NYSE American rule details its independence requirements, the SEC rule requires that at a minimum an independent director cannot directly or indirectly accept any consulting, advisory or other compensation or be affiliated with the company or any of its subsidiaries. The prohibition against compensation does not include a reasonable compensation for serving as a director.
Like the NYSE American rules, the SEC allows for different independence standards for foreign private issuers (FPI) following their home country rules and even allows for affiliation as long as the person is not an executive officer of the FPI.
The audit committee of each listed company, in its capacity as a committee of the board of directors, must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for auditing and audit-related services. Furthermore, the SEC requires that an executive officer of a listed company promptly notify the national exchange if he or she becomes aware of any material noncompliance with the audit committee requirements by that listed company.
Although charter requirements are detailed in the NYSE American rule, the SEC rule requires that the audit committee establish certain processes and procedures for handling complaints regarding accounting, internal financial controls and auditing matters, including for the confidential submission by employees. The SEC rule also requires that an audit committee be given the power, authority and funding to engage independent counsel and other advisors to carry out its tasks. Funding must also be provided to hire audit firms and pay administrative expenses.
The SEC allows for a phase-in for compliance when a company is completing an initial public offering. In particular, all but one director may be dependent for 90 days following the IPO and a minority of the audit committee may be dependent for one year from effectiveness of the registration statement. The SEC rule also contains general exemptions from the audit committee requirements including: (i) for consolidated subsidiaries that are listed on another exchange with similar audit committee requirements; (ii) FPI’s that follow home country rules and have a similar committee to an audit committee and satisfy certain additional conditions; and (iii) related to the listing of certain options, futures, asset-backed issuers, investment trusts, a passive trust or foreign governments. Specific disclosure is required when an exemption is being relied upon including an assessment of whether, and if so, how, such reliance would materially adversely affect the ability of the audit committee to act independently and to satisfy the other requirements of Rule 10A-3.
The SEC rule specifically requires that an exchange must give a listed company the opportunity to cure a defect in the audit committee requirements prior to delisting. Moreover, the SEC rule provides that if an independent director on the audit committee loses independence as a result of factors outside of their control, that person may remain on the audit committee until the next annual shareholders meeting or one year from the date of the occurrence that caused the board member to no longer be independent.
NYSE American Rule 803
Audit Committee Composition
One of the corporate-governance-related listing requirements is that a company have an audit committee consisting solely of independent directors (for more information on independence qualifications, see HERE) who also satisfy the requirements of SEC Rule 10A-3 and who can read and understand fundamental financial statements including a balance sheet, income statement and cash flow statement. One member of the audit committee must have employment experience in finance or accounting, an accounting certification or other experience that results in the individual’s financial sophistication, including but not limited to being or having been a CEO, CFO or other senior officer with financial oversight.
The audit committee must have at least three members; however, a smaller reporting company is only required to have two members on its audit committee. For the current definition of a smaller reporting company, see HERE. Nasdaq does not have this carve-out for smaller reporting companies, though it does have it for compensation committees.
None of the committee members can have participated in the preparation of the financial statements of the company or any of its current subsidiaries for the prior three years. An individual will be considered to have participated in the preparation of the company’s financial statements if the individual has played any role in compiling or reviewing those financial statements, including a supervisory role. An interim officer who signed or certified the company’s financial statements will be deemed to have participated in the preparation of the company’s financial statements and, therefore, could not serve on the audit committee for three years.
The eligibility requirements to serve on the audit committee apply to all committee members whether or not such member is afforded non-voting status or other limitations on their participation with the committee. Lawyers that work at a law firm employed by the company cannot serve on the audit committee.
The NYSE American has a limited exception to the independence requirements where a director meets the independence standards in SEC Rule 10A-3 but not the more detailed requirements of the NYSE American company guide, is not currently an executive officer, employee or family member of an executive officer and exceptional circumstances makes the appointment of the person in the best interests of the company and its shareholders. Specific disclosures are required in the company’s next proxy statement or annual 10-K when relying on this exception including the nature of the relationship that makes the person non-independent and the reasons for the board’s determination. A committee member appointed under this exception may not serve for more than two years and cannot be chair of the audit committee.
Audit Committee Charter
NYSE American Company Guide Rule 803 requires that each company must certify that it has adopted a formal written committee charter and that the audit committee will review and reassess the charter on an annual basis. The certification is submitted one time and a copy of the actual charter does not need to be provided to the NYSE American. However, Item 407(d)(1) of Regulation S-K requires that companies report whether a current copy of its audit committee charter is available on its website and provide the website address. If the charter is not on the website, companies should include the charter as an appendix to its proxy statement at least once every three years or in any year in which the charter has been materially amended.
The charter must specify: (i) the scope of the audit committee’s responsibilities and how it carries out those responsibilities including structure, processes and membership requirements; (ii) the audit committee’s responsibility to ensure that it receives written statements from the outside auditor regarding relationships between the auditor and the company and actively taking steps for ensuring the independence of the auditor; (iii) the committee’s purpose of overseeing the accounting and financial reporting processes of the company and the audits of the financial statements of the company; and (iv) the specific audit committee responsibilities and authority.
Audit Committee Responsibilities and Authority
The audit committee is responsible for items delineated in SEC Rule 10A-3 and in particular related to: (i) registered public accounting firms, (ii) complaints relating to accounting, internal accounting controls or auditing matters, (iii) authority to engage advisers, and (iv) funding as determined by the audit committee.
The audit committee is required to meet on at least a quarterly basis. Nasdaq does not specify meeting requirements.
Cure Periods
All noncompliance with audit committee requirements requires prompt notification to the NYSE American.
Consistent with SEC Rule 10A-3, if a member of the audit committee loses independent status for reasons outside the member’s reasonable control, the audit committee member may remain on the audit committee until the earlier of its next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement. A company relying on this provision must provide notice to the NYSE American immediately upon learning of the event or circumstance that caused the noncompliance.
If noncompliance is a result of a vacancy arising on the audit committee, the company will have until the earlier of the next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement – provided, however, that if the annual shareholders meeting occurs no later than 180 days following the event that caused the vacancy, the company shall instead have 180 days from such event to regain compliance. For a smaller reporting company, if the annual shareholders meeting occurs no later than 75 days following the event that caused the failure to comply with the audit composition requirement, a smaller reporting company shall instead have 75 days from such event to regain compliance. Nasdaq does not have a different compliance cure period for smaller reporting companies.
Exception
If a company has a class of equity securities listed on another exchange with SEC Rule 10A-3 audit committee requirements, they may list securities of a consolidated subsidiary on the NYSE American without having a separate audit committee for that subsidiary.
« SEC Amendments To Rules Governing Proxy Advisory Firms SEC Final Rule Changes For Exempt Offerings – Part 1 »