SEC Proposed Rule Changes for Exempt Offerings – Part 3
On March 4, 2020, the SEC published proposed 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). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. I have been breaking the information down into a series of blogs, with this third blog focusing on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D other than integration and offering communications which affect all exempt offerings and were discussed in the first two blogs in this series. In addition, this third blog will cover amendments to the bad-actor disqualification provisions. The final two blogs in this series will discuss changes to Regulation A and Regulation Crowdfunding.
To review the first blog in this series centered on the offering integration concept, see HERE. To review the second blog in the series which focused on offering communications, the new demo day exemption, and testing the waters provisions, see HERE.
Background; 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 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). Currently, 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 background on the current exemption framework, including a chart summarizing the most often used exemptions and their requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would 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 Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; 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.
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 providing 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.
Moreover, non-exclusive methods of verification include:
- 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 issuer that have previously invested in a 506 offering with the same issuer.
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. The SEC has provided guidance regarding relying on tax returns by noting that in a case 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.
In the new proposed rule release, the SEC realizes that the non-exclusive list may create some uncertainty and lead to some companies to believe that they must rely only on the methods in the list. The SEC is proposing to add a new item to the non-exclusive list that allows for a company to accept the written representation of an investor that they are accredited if the company has previously taken steps to verify accredited status and is not aware of any new information to the contrary.
The amended rule will also reiterate the principles-based approach of the rule, including reminding companies 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
Currently Rule 506(b) has scaled disclosure requirements based on the size of the offering, where unaccredited investors are included. The proposed rules update the information requirements for investors under Rule 506(b) where any unaccredited investors are solicited. The new information requirements would 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 will be required. For offerings greater than $20 million, the same financial information that is required for Tier 2 Regulation A offerings will be required.
The effect of the rule change would be to eliminate the ability for a company that has trouble getting financial statements to be able to only provide a balance sheet. Foreign private issuers would be able to 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 would be 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 offer securities 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.
Currently Rule 504 provides an exemption for offerings up to $5 million in any twelve-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.
The proposed rule changes will increase the maximum offering under Rule 504 from $5 million to $10 million in any 12-month period.
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 differs between Regulation D and the other exemptions. The proposed rules will 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. Under Regulation A and Regulation Crowdfunding, the look-back period is measured from the time the company files an offering statement. 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 proposed rule change will add “or such sale” to any look back references in Regulation A and Regulation Crowdfunding.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
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.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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« NASDAQ Provides Additional Relief To Shareholder Approval Requirements For Companies Affected By Covid-19 Disclosures Related To Covid-19 – What Investors Want To Know »
SEC Publishes FAQ On COVID-19 Effect On S-3 Registration Statements
The SEC has issued FAQ on Covid-19 issues, including the impact on S-3 shelf registration statements. The SEC issued 4 questions and answers consisting of one question related to disclosure and three questions related to S-3 shelf registrations.
SEC FAQ
Disclosure
Confirming prior guidance, the SEC FAQ sets forth the required disclosures in the Form 8-K or 6-K filed by a company to take advantage of a Covid-19 extension for the filing of periodic reports. In particular, in the Form 8-K or Form 6-K, the company must disclose (i) that it is relying on the COVID-19 Order (for more information on the Order, see HERE); (ii) a brief description of the reasons why the company could not file the subject report, schedule or form on a timely basis; (iii) the estimated date by which the report, schedule or form is expected to be filed; and (iv) a company-specific risk factor or factors explaining the impact, if material, of COVID-19 on the company’s business. Also, if the reason the report cannot be filed timely relates to the inability of any person, other than the company, to furnish any required opinion, report or certification, the company must also attach, as an exhibit to the Form 8-K or Form 6-K, a statement signed by such person stating the specific reasons why the person is unable to furnish the required opinion, report or certification. The Form 8-K or 6-K must be filed with the SEC on or before the original due date of such report.
Furthermore, when the delayed report is filed it must contain disclosures that it was delayed based on the Covid-19 Order and reiterate the reasons it could not timely file the report.
Effect on Form S-3
S-3 eligibility and the ability to take down periodic offerings from an effective S-3 registration statement is often the lifeblood for publicly traded companies, especially during times of financial hardship. For a detailed review of S-3 eligibility, see HERE.
Generally speaking, a company must be current in its SEC reporting requirements in order to file or utilize an existing S-3 shelf. Moreover, a company must re-assess its eligibility to continue to use the shelf each time it files an update to the registration statement, which could be through a post-effective amendment or a Form 10-K which is automatically incorporated by reference and acts as a prospectus update.
The SEC has issued three question-and-answer FAQs related to the ability to use or file an S-3 shelf registration statement while relying on the Order allowing for an extension of the filing of periodic reports due to Covid-19.
The first question confirms that a company can continue to conduct takedowns using an already effective registration statement while relying on the Covid-19 Order for an extension to the filing date of a report, including a Form 10-K. However, in order to continue to use an existing S-3, the company must make a determination that the prospectus, as it exists at that time, complies with Section 10(a) of the Securities Act. This is no different than at any other time a shelf is used – that is, it is always incumbent upon a company to believe that its prospectus complies with Section 10(a). Section 10(a)(3) requires that when a prospectus is used more than nine months after the effective date of the registration statement, the information contained in the prospectus cannot be older than 16 months.
However, Section 10(a)(3) has a qualifier that information must be updated at 16 months “so far as such information is known to the user of such prospectus or can be furnished by such user without unreasonable effort or expense.” The new SEC FAQ provides that “[A]lthough Section 10(a)(3) may permit registrants relying on the COVID-19 Order to conduct a takedown using a prospectus that contains information older than sixteen months in the event that updated information cannot be furnished without unreasonable effort or expense, registrants and their legal advisers will need to determine when it is appropriate to update the prospectus. Registrants are responsible for the accuracy and completeness of their disclosure.”
In addition, shelf offerings pursuant to Rule 415 require a company to file a post-effective amendment (which could be via a Form 10-K that is forward incorporated by reference) to reflect any facts or events arising after the effective date which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. In other words, if the information in the prospectus is materially inaccurate, it cannot be used.
The second question confirms that a company must re-assess its eligibility to continue to use Form S-3 at the time of the filing of its Form 10-K. In general, each time a company files a post-effective amendment to its Form S-3, including through the filing of a Form 10-K, the company must assess its eligibility to continue to use the Form. For example, to continue to be eligible the company must have timely filed all of its periodic reports (with some limited Form 8-K exceptions) for a period of at least 12 calendar months. For a complete and detailed list of eligibility requirements, see HERE. Where the company has relied on the Covid-19 Order to extend the filing deadline for that Form 10-K, it can make its eligibility assessment at the time of filing under the new deadline.
The third question confirms that a company may file a new s-3 registration statement between the original due date of a required filing and the due date as extended by the COVID-19 Order, even if the company has not yet filed the required periodic report. The SEC will consider a company current and timely in its Exchange Act reports as long as it timely filed the Form 8-K for an extension of the deadline for a particular report such as a Form 10-Q or 10-K. However, although the company can file a new Form S-3, the SEC will not likely accelerate its effectiveness until the delayed periodic report has been filed. The company will no longer be considered current and timely, and will lose eligibility to file new registration statements on Form S-3, if it fails to file the required report by the due date as extended by the COVID-19 Order.
« SEC Enacts Temporary Expedited Crowdfunding Rules NASDAQ Provides Additional Relief To Shareholder Approval Requirements For Companies Affected By Covid-19 »
SEC Enacts Temporary Expedited Crowdfunding Rules
Following the April 2, 2020 virtual meeting of the SEC Small Business Capital Formation Advisory Committee in which the Committee urged the SEC to ease crowdfunding restrictions to allow established small businesses to quickly access potential investors (see HERE), the SEC has provided temporary, conditional expedited crowdfunding access to small businesses. The temporary rules are intended to expedite the offering process for smaller, previously established companies directly or indirectly affected by Covid-19 that are seeking to meet their funding needs through the offer and sale of securities pursuant to Regulation Crowdfunding.
The temporary rules will provide eligible companies with relief from certain rules with respect to the timing of a company’s offering and the financial statements required. To take advantage of the temporary rules, a company must meet enhanced eligibility requirements and provide clear, prominent disclosure to investors about its reliance on the relief. The relief will apply to offerings launched between May 4, 2020 and August 31, 2020.
TEMPORARY RULES
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. Regulation Crowdfunding went into effect on May 16, 2016. The exemption allows issuers to solicit “crowds” to sell up to $1,070,000 (as adjusted for inflation in 2017) 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 cannot 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. Regardless of the category, the total amount any investor can invest is limited to $100,000. For a summary of the provisions, see HERE.
In March 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework including Regulation Crowdfunding. The proposed rules would increase the offering limit to $5 million; increase the investment limit by altering the formula to be based on the greater of, rather than lower of, an investor’s annual income or net worth; remove investment limits on accredited investors; allow the use of special purpose vehicles and reduce the types of securities that can be sold in a Regulation Crowdfunding offering. However, the timing for implementation of the proposed rules, either as proposed or with changes, is uncertain.
As noted, the temporary rules are intended to provide existing eligible smaller businesses with quick access to capital by reaching out to the “crowd” which may include local investors, customers, vendors, etc., that are willing to support small businesses. This table, which was included in the SEC press release announcing the temporary rules, and to which I have provided explanatory and further detailed information, is a very good summary of the temporary rules.
| Requirement | Existing Regulation Crowdfunding | Temporary Amendment |
| Eligibility | The exemption is not available to:
|
To rely on the temporary rules, issuers must meet the existing eligibility criteria PLUS:
|
| Offers permitted | After filing of offering statement (including financial statements) | After filing of offering statement, but financial statements may be initially omitted (if not otherwise available) |
| Investment commitments accepted | After filing of offering statement on Form C (including financial statements) | After filing of offering statement on Form C that includes financial statements or amended offering statement that includes financial statements.That is, the temporary rule allows a test-the-waters period by allowing the company to file a Form C and post offering information on a funding platform, gathering indications of interest, prior to filing financial statements. If the offering does not garner interest, the company may determine to abandon or delay the offering and would not have occurred the expense of financial statement preparation.
Certain disclosures will need to be added if no financial statements are included and no investment commitments can be accepted until the financial statements have been provided. |
| Financial statements required when issuer is offering more than $107,000 and not more than $250,000 in a 12-month period | Financial statements of the issuer reviewed by a public accountant that is independent of the issuer | Financial statements of the issuer and certain information from the issuer’s federal income tax returns, both certified by the principal executive officer.Must also provide a statement that financial information certified by the principal executive officer has been provided instead of financial statements reviewed by an independent public accountant. |
| Sales permitted | After the information in an offering statement is publicly available for at least 21 days | As soon as an issuer has received binding investment commitments covering the target offering amount (note: commitments are not binding until 48 hours after they are given) |
| Early closing permitted | Once target amount is reached if:
|
As soon as binding commitments are received reaching target amount if:
|
| Cancellations of investment commitments permitted | For any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. Thereafter, an investor is not able to cancel any investment commitments made within the final 48 hours of the offering (except in the event of a material change to the offering). | For any reason for 48 hours from the time of the investor’s investment commitment (or such later period as the issuer may designate). After such 48-hour period, an investment commitment may not be cancelled unless there is a material change to the offering. |
e Crowdfunding Professional Association (C
« SEC Proposed Rule Changes for Exempt Offerings – Part 2 SEC Publishes FAQ On COVID-19 Effect On S-3 Registration Statements »
SEC Proposed Rule Changes for Exempt Offerings – Part 2
On March 4, 2020, the SEC published proposed 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). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, I will break it down over a series of blogs, with the second blog in the series which focuses on offering communications, the new demo day exemption, and testing the waters provisions. The first in this series centered on the offering integration concept and can be read HERE.
Background; 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 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.
For more background on the current exemption framework, including a chart summarizing the most often used exemptions and there requirements, see Part 1 in this blog series HERE.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would 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 Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; 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.
Offering Communications; Expansion of Test-the-Waters Communications; Addition of “Demo Days”
Section 4(a)(2) of the Securities Act exempts transactions by an issuer not involving a public offering, from the Act’s registration requirements. The Supreme Court case of SEC v. Ralston Purina Co. and its progeny Doran v. Petroleum Management Corp. and Hill York Corp. v. American Int’l Franchises, Inc. together with Securities Act Release No. 4552 set out the criteria for determining whether an offering is public or private and therefore the availability of Section 4(a)(2). In order to qualify as a private placement, the persons to whom the offer is made must be sophisticated and able to fend for themselves without the protection of the Securities Act and must be given access to the type of information normally provided in a prospectus.
All facts and circumstances must be considered including the relationship between the offerees and the issuer, and the nature, scope, size, type, and manner of the offering. 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). That is, if all of the requirements of Rule 506 are complied with, then the exemption under Section 4(a)(2) would likewise be complied with. An issuer can rely directly on Section 4(a)(2) without regard to Rule 506; however, Section 4(a)(2) alone does not pre-empt state law and thus requires blue sky compliance.
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) 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, are 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 this adds a burden of verifying such accredited status to the issuing company. 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.
Likewise, other offerings 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.
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 day 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 proposed rule would expand test-the-waters for all companies to be able to use generic solicitations of interest communications prior to determining which exempt offering they will rely upon or pursue. Also, Regulation Crowdfunding would allow for test-the-waters much the same as Regulation A. Furthermore, a new “demo day” will be allowed for all offerings which would be exempted from the definition of general solicitation or advertising.
The SEC considered but determined not to add a rule that statutorily defines a substantive pre-existing relationship or to add to or expand on the examples of solicitation and advertising currently contained in Rule 502(c). As a reminder, 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; 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.
Demo Days; New Rule 148
New Rule 148 would provide that certain demo day communications would not be deemed general solicitation or advertising. Specifically, as proposed, a company would not be deemed to have engaged in general solicitation if the communications are made in connection with a seminar or meeting by a college, university, or other institution of higher education, a local government, a nonprofit organization, or an angel investor group, incubator, or accelerator sponsoring the seminar or meeting.
Sponsors of events would not be permitted to make investment recommendations or provide investment advice to attendees of the event, nor to engage in any investment negotiations between the company and investors attending the event. The sponsor would not be able to charge fees beyond a reasonable administrative fee and could not receive compensation for making introductions. Advertising for the event would also be limited such that specific offerings could not be advertised and the information about a presenting company would be limited to: (i) notice that the company is conducting or planning to conduct an offering; (ii) the type and amount of securities offered; and (iii) the intended use of proceeds.
The new rule is similar to the broker-dealer exemption included in Securities Act Section 4(b) for online portals hosting offerings that allow for general solicitation and advertising such as Rule 506(c), Regulation A and Rule 147 and 147A intrastate offerings. For more on Section 4(b), see HERE.
Solicitations of Interest
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. In the current rule release, the SEC notes that “[W]e believe that the existing testing the-waters provisions allow issuers to consult effectively with investors as they evaluate market interest in a contemplated registered or Regulation A securities offering before incurring the costs associated with such an offering, while preserving investor protections.”
The SEC is proposing a new rule to allow 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 general solicitation or advertising. Likewise, the SEC is proposing to allow test-the-waters communications for Regulation Crowdfunding and to align the provisions such that a company could ultimately choose either a Regulation A or Regulation Crowdfunding offering.
The pre-offering determination generic solicitations, set forth in new Rule 241, would be similar to existing Rule 255 of Regulation A. Rule 241 would 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. The solicitations would be subject to the antifraud provisions of the federal securities laws.
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 would 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 then 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 filed in a Regulation A offering and proposed 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 after 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 would 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.
As an aside, the SEC has also expanded the ability for companies to test the waters in association with registered offerings – see HERE – but I believe those provisions should be expanded to be more analogous to Regulation A.
Regulation Crowdfunding
Currently a company may not solicit potential investors until their Form C is filed with the SEC. The proposed new rule will allow both oral and written test-the-waters communications prior to the filing of a Form C much the same as Regulation A. The new Regulation Crowdfunding test-the-waters provisions are proposed in new Rule 206.
Under proposed Rule 206, companies would be permitted to test the waters with all potential investors. The testing-the-waters materials would be considered offers that are subject to the antifraud provisions of the federal securities laws. Like Regulation A, any test the waters communications would 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.
As discussed above, Rule 206 is separate from the proposed new Rule 241. Rule 241 requires an integration analysis. Accordingly, if Rule 241 test-the-waters materials were used within 30 days of the commencement of a Regulation Crowdfunding offering, they would need to be filed with the SEC with the Form C together with any subsequent Rule 206 materials.
« NYSE, Nasdaq And OTC Markets Offer Relief For Listed Companies Due To COVID-19 SEC Enacts Temporary Expedited Crowdfunding Rules »
NYSE, Nasdaq And OTC Markets Offer Relief For Listed Companies Due To COVID-19
In addition to the SEC, the various trading markets, including the Nasdaq, NYSE and OTC Markets are providing relief to trading companies that are facing unprecedented challenges as a result of the worldwide COVID-19 crisis.
NYSE
The NYSE has taken a more formal approach to relief for listed companies. On March 20, 2020 and again on April 6, 2020 the NYSE filed a notice and immediate effectiveness of proposed rule changes to provide relief from the continued listing market cap requirements and certain shareholder approval requirements.
Recognizing the extremely high level of market volatility as a result of the COVID-19 crisis, the NYSE has temporarily suspended until June 30, 2020 its continued listing requirement that companies must maintain an average global market capitalization over a consecutive 30-trading-day period of at least $15 million. Likewise, the NYSE is suspending the requirement that a listed company maintain a minimum trading price of $1.00 or more over a consecutive 30-trading-day period, through June 30, 2020.
The NYSE intends to waive certain shareholder approval requirements for continued listing on the NYSE through June 30, 2020. In particular, in light of the fact that many listed companies will have urgent liquidity needs in the coming months due to lost revenues and maturing debt obligations, the NYSE is proposing to ease shareholder approval requirements to allow capital raises. The big board amendments align the requirements more closely with the NYSE American requirements.
The NYSE big board rules prohibit issuances to related parties if the number of shares of common stock to be issued, or if the number of shares of common stock into which the securities may be convertible or exercisable, exceeds either 1% of the number of shares of common stock or 1% of the voting power outstanding before the issuance subject to a limited exception if the issuances are above a minimum price and no more than 5% of the outstanding common stock. For a review of the NYSE American rule for affiliate issuances, see HERE. The NYSE also requires shareholder approval for private issuances below the minimum price for any transactions relating to 20% or more the outstanding common stock or voting power. For a review of the 20% rule for the NYSE American, see HERE.
Realizing that existing large shareholders and affiliates are often the only willing providers of capital when a company is undergoing difficult times, the rule change allows for the issuance of securities to affiliates that exceed the 1% or 5% limits if completed prior to June 30, 3030 where the securities are sold for cash that meets the minimum price and if the transaction is reviewed and approved by the company’s audit committee or a comparable committee comprised solely of independent directors. The waiver cannot be relied upon if the proceeds would be used for an acquisition of stock or assets of another company in which the affiliate has a direct or indirect interest. Furthermore, the waiver does not extend to shareholder approval requirements triggered by the transaction under other rules such as the equity compensation rule or change of control rule. The substantially similar NYSE American rules can be reviewed HERE – equity compensation, and HERE – change of control.
The NYSE has also waived the 20% rule for private placements completed through and including June 30, 2020 where a bona fide financing is made to a single purchaser for cash meeting the minimum price requirement. Again, the waiver does not extend to shareholder approval requirements triggered by the transaction under other rules such as the equity compensation rule or change of control rule.
Nasdaq
The Nasdaq has taken a less formal approach on some of its requirements and a formal rule amendment on others. Although Nasdaq has not suspended its listing requirements, it will give due weight to the realities surrounding the worldwide crisis in both considering listing standards compliance and requests for financial viability waivers, such as under Rule 5635.
Generally, companies newly deficient with the bid price, market value of listed securities, or market value of public float requirements have at least 180 days to regain compliance and may be eligible for additional time. Nasdaq has enacted a temporary rule change such that companies that fall out of compliance with these listing standards related to price through and including June 30, 2020 will have additional time to regain compliance. That is, the non-compliance period will be tolled through June 30, 2020 and not counted in the 180 day period. Companies will still receive notification of non-compliance and will still need to file the appropriate Form 8-K. Companies that no longer satisfy the applicable equity requirement can submit a plan to Nasdaq Listing Qualifications describing how they intend to regain compliance and, under the Listing Rules, Listing Qualifications’ staff can allow them up to six months plus the tolling period, to come back into compliance with the requirement.
The information memorandum confirms that listed companies that avail themselves of the 45-day extension for Exchange Act filings (see HERE) will not be considered deficient under Nasdaq Rule 5250(c) which requires all listed companies to timely file all required SEC periodic financial reports. Companies that are unable to file a periodic report by the relevant due date, but that are not eligible for the relief granted by the SEC, can submit a plan to Nasdaq Listing Qualifications describing how they intend to regain compliance and, under the Listing Rules, Listing Qualifications’ staff can allow them up to six months to file.
As discussed in my blog related to SEC COVID-19 relief (see HERE), the SEC has granted relief where a company is required to comply with Exchange Act Sections 14(a) or 14(c) requiring the furnishing of proxy or information statements to shareholders, and mail delivery is not possible due to the coronavirus and the company has made a good-faith effort to deliver such materials. Nasdaq likewise will not consider a company in non-compliance with Rule 5250(d) requiring companies to make available their annual, quarterly and interim reports to shareholders or Rule 5620(b) requiring companies to solicit proxies and provide proxy statements for all meetings of shareholders when relying on the SEC relief. Nasdaq confirms that it permits virtual shareholder meetings as long as it is permissible under the relevant state law and shareholders have the opportunity to ask questions of management.
The Nasdaq shareholder approval rules generally require companies to obtain approval from shareholders prior to issuing securities in connection with: (i) certain acquisitions of the stock or assets of another company (see HERE); (ii) equity-based compensation of officers, directors, employees or consultants (see HERE); (iii) a change of control (see HERE); and (iv) certain private placements at a price less than the minimum price as defined in Listing Rule 5635(d) (see HERE.
An exception is available for companies in financial distress where the delay in securing stockholder approval would seriously jeopardize the financial viability of the company. To request a financial viability exception, the company must complete a written request including a letter addressing how a delay resulting from seeking shareholder approval would seriously jeopardize its financial viability and how the proposed transaction would benefit the company. The standard is usually difficult to meet; however, Nasdaq has indicated that it will consider the consider the impact of disruptions caused by COVID-19 in its review of any pending or new requests for a financial viability exception. In addition, reliance by the company on a financial viability exception must expressly be approved by the company’s audit committee and the company must obtain Nasdaq’s approval to rely upon the financial viability exception prior to proceeding with the transaction. Under the rule, companies must also provide notice to shareholders at least ten days prior to issuing securities in the exempted transaction.
OTC Markets
OTC Markets Group has provided blanket relief for OTCQB and OTCQX companies with certain deficiencies until June 30, 2020. Until that date, no new compliance deficiency notices will be sent related to bid price, market cap, or market value of public float. Also, any OTCQX or OTCQB company that has already received a compliance notice related to bid price, market cap, or market value of public float with a cure period expiring between March and June will automatically receive an extension until June 30, 2020 to cure their deficiency.
OTC Markets has also extended the implementation date for compliance with the OTCQB rules requiring at least 50 beneficial shareholders and minimum float of 10% or $2 million in market value of public float, respectively, until June 30, 2020. The extension applies only to companies already traded on OTCQB as of May 20, 2018. All other companies were subject to these requirements effective May 20, 2018.
« Disclosures Related To COVID-19 SEC Proposed Rule Changes for Exempt Offerings – Part 2 »
Disclosures Related To COVID-19
The SEC has been reiterating the need for robust disclosures related to the impact of COVID-19 on publicly reporting companies. In the last few weeks I have written about some of the guidance issued by the SEC including Disclosure Guidance Topic No. 9. Since that time the SEC has continued to issue guidance in the form of public statements. This blog will summarize the SEC guidance and statements on disclosures up to date, and include a sample risk factor for inclusion in SEC reports.
Public Statement by Chair Jay Clayton and Director of the Division of Corporation Finance, William Hinman
On April 8, 2020, SEC Chairman Jay Clayton and William Hinman, the Director of the Division of Corporation Finance, issued a joint public statement on the importance of disclosure during the COVID-19 crisis.
Before I get into summarizing the statement, my personal thought is that although there are many reasons why disclosure is important, including the basic premise that the securities laws are founded on that very concept, it is especially important now to support investor confidence, activity in our markets and capital raising efforts. If investors are kept informed of the impact of COVID-19 on companies, see that these companies are continuing on and meeting their requirements and that the markets haven’t just fallen into Neverland, they will continue to invest through the trading of securities, and direct investments through PIPE transactions. Without adequate information, not only will investors not likely invest directly in companies, but a company may be prohibited from accepting funds even if they want to if there is a concern of trading on material non-public information.
In my view the best way to protect the capital markets is to encourage confidence and investments. I’ve seen a noticeable uptick in liquidity in the small-cap space. My belief is that many people who are staying at home, are not just watching Netflix, but rather are actively trading the markets, making both short-term and long-term plays, following the markets very closely, reviewing companies for undervalued opportunities and spending more time researching than ever before. My advice to all my clients, and readers, is to make sure that information is being disseminated as quickly as available and as often as possible.
Further on the broader economic level, transparency and information will bolster confidence on a B2B level such as between suppliers, manufacturers and retailers, allow for the extension of credit and support the general continued flow of business operations.
Reporting Earnings and Financial Results
Both Topic No. 9 and the Public Statement encourage companies to proactively address financial reporting matters earlier than usual. Many companies will rely on the available 45-day extension and will be grappling with the accounting complexities of the COVID-19 impact including short-term dramatic changes in expenses and revenues. The SEC suggests engaging needed experts and beginning an analysis of the potential impacts as quickly as possible to be prepared to meet filing deadlines, even with the extensions.
Many companies, although not obligated, choose to issue earnings releases and conduct investor and analyst calls (for more on earnings releases, see HERE. In their Public Statement, Chair Clayton and Director Hinman urged companies to provide as much information as practicable regarding their current and future financial and operating status. Disclosures should include any information on the impact of COVID-19 as it stands today, how the company is responding to COVID-19 including how it is protecting the health and well-being of its workers and customers, and how operations and financial condition may change in the future as a result of the virus. The SEC advises against boilerplate information, but rather companies should make a concerted effort to provide meaningful information on key operational and financial considerations and challenges.
The SEC notes that historical information is relatively less significant at this time, making forward-looking information all the more important. Investors and analysts are extremely interested to know where companies stand today and, importantly, how they have adjusted, and expect to adjust in the future, their operational and financial affairs to most effectively work through the COVID-19 health crisis. Detailed discussions of current liquidity positions and expected financial resource needs is particularly helpful to investors and markets. Where material, a company should disclose any CARES Act or similar federal or state assistance that has been applied for and/or received, including the nature, amount and effects of such assistance.
With that said, to the extent that a company had previously issued 2020 guidance which remains in place, it is important to address the degree to which the company believes it can continue to meet those previous projections and any changes to that prior guidance. Obviously, all companies should be reviewing prior guidance to determine if it should be withdrawn.
Forward-looking information will be protected under either Sections 27A and 21E of the Private Securities Litigation Reform Act of 1995 (PSLRA) or the common law bespeaks caution doctrine as long as proper disclaimers are included (for more information, see HERE.
In addition to other considerations, the SEC reminds companies of their obligations under Item 10 of Regulation S-K and Regulation G related to the presentation of non-GAAP financial measures. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information. For more on Item 10 and Regulation G, see HERE.
Topic No. 9 specifically acknowledges that there may be instances where a GAAP financial measure is not available at the time of the earnings release because the measure may be impacted by a COVID-19 related adjustment that may require additional information and analysis to complete. In these situations, the SEC would not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate, or a range of reasonably estimable GAAP results. For example, if a company intends to disclose EBITDA on an earnings call, it could reconcile that measure to either its GAAP earnings, a reasonable estimate of its GAAP earnings that includes a provisional amount, or its reasonable estimate of a range of GAAP earnings. In filings where GAAP financial statements are required, such as on Form 10-K or 10-Q, companies should reconcile to GAAP results and not include provisional amounts or a range of estimated results.
The SEC also cautions companies against using the Topic No. 9 guidance and current SEC flexibility to present non-GAAP financial measures or metrics for the sole purpose of presenting a more favorable view of the company.
General Disclosure Guidance – Topic No. 9
The SEC Division of Corporation Finance has issued Disclosure Guidance Topic No. 9 regarding the SEC’s current views on disclosures and the obligations that companies should consider with respect to COVID-19. The overarching messaging is that a company must consider its COVID-19 impact in its disclosure documents and make necessary material disclosures using a principles-based strategy.
Certainly the actual impact and risks are difficult to ascertain and may be unknown or dependent on third parties, but the SEC encourages material disclosure on what management expects the virus’ future impact will be, how management is responding to evolving events, and how it is planning for COVID-19-related uncertainties. Examples of areas of reports that may be impacted and thus require disclosure include management’s discussion and analysis, the business section, risk factors, legal proceedings, disclosure controls and procedures, internal control over financial reporting, and the financial statements.
Topic No. 9 suggests that management consider the following non-exclusive list in considering COVID-19 related disclosures:
- How has COVID-19 impacted the financial condition and results of operations? How do you expect COVID-19 to impact your future operating results and near-and-long-term financial condition? Do you expect that COVID-19 will impact future operations differently than how it affected the current period?
- How has COVID-19 impacted your capital and financial resources, including your overall liquidity position and outlook? Consider if the cost of or access to capital and funding sources has changed and whether it is likely to change or continue to change. Have sources and uses of cash been materially impacted? Has the ability to continue to meet ongoing credit agreements changed or is it materially likely it will change? Disclosure should also be made as to the course of action a company has taken or proposes to take in light of the material impact on its financial resources.
- How do you expect COVID-19 to affect assets on your balance sheet and your ability to timely account for those assets? For example, will there be significant changes in judgments in determining the fair-value of assets measured in accordance with U.S GAAP or IFRS?
- Do you anticipate any material impairments (e.g., with respect to goodwill, intangible assets, long-lived assets, right of use assets, investment securities), increases in allowances for credit losses, restructuring charges, other expenses, or changes in accounting judgments that have had or are reasonably likely to have a material impact on your financial statements?
- Have COVID-19-related circumstances such as remote work arrangements adversely affected your ability to maintain operations, including financial reporting systems, internal control over financial reporting and disclosure controls and procedures? If so, what changes in your controls have occurred during the current period that materially affect or are reasonably likely to materially affect your internal control over financial reporting? What challenges do you anticipate in your ability to maintain these systems and controls?
- Have you experienced challenges in implementing your business continuity plans or do you foresee requiring material expenditures to do so?
- Do you expect COVID-19 to materially affect the demand for your products or services?
- Do you anticipate a material adverse impact of COVID-19 on your supply chain or the methods used to distribute your products or services?
- Will your operations be materially impacted by any constraints or other impacts on your human capital resources and productivity?
- Are travel restrictions and border closures expected to have a material impact on your ability to operate and achieve your business goals?
Sample Risk Factor
Although COVID-19 risk factors have taken many forms, it is important to try and be specific as to a particular business impact. An outline of a risk factor that can be amended to address particular business situations is:
Public health epidemics or outbreaks, such as COVID-19, could materially and adversely impact our business.
In December 2019, a novel strain of coronavirus (COVID-19) emerged in Wuhan, Hubei Province, China. While initially the outbreak was largely concentrated in China and caused significant disruptions to its economy, it has now spread to several other countries and infections have been reported globally.
Because COVID-19 infections have been reported throughout the United States, certain federal, state and local governmental authorities have issued stay-at-home orders, proclamations and/or directives aimed at minimizing the spread of COVID-19. Additional, more restrictive proclamations and/or directives may be issued in the future. As a result, all of our [describe business locations] have been closed effective April 1, 2020. [Describe risk of loss of franchise fees, rents, consumer/customer payments].
The ultimate impact of the COVID-19 pandemic on the Company’s operations is unknown and will depend on future developments, which are highly uncertain and cannot be predicted with confidence, including the duration of the COVID-19 outbreak, new information which may emerge concerning the severity of the COVID-19 pandemic, and any additional preventative and protective actions that governments, or the Company, may direct, which may result in an extended period of continued business disruption, reduced customer traffic and reduced operations. Any resulting financial impact cannot be reasonably estimated at this time but is anticipated to have a material adverse impact on our business, financial condition and results of operations.
The measures taken to date will impact the Company’s business for the fiscal fourth quarter and potentially beyond. Management expects that all of its business segments, across all of its geographies, will be impacted to some degree, but the significance of the impact of the COVID-19 outbreak on the Company’s business and the duration for which it may have an impact cannot be determined at this time.
« Small Business Advocate Urges Capital Raising Relief NYSE, Nasdaq And OTC Markets Offer Relief For Listed Companies Due To COVID-19 »
Small Business Advocate Urges Capital Raising Relief
On March 4, 2020, the SEC published proposed rule changes to harmonize, simplify and improve the exempt offering framework. The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
I’ve written a five-part series detailing the rule changes, the first of which can be read HERE. My plan to publish the five parts in five consecutive weeks was derailed by the coronavirus and more time-sensitive articles on relief for SEC filers and disclosure guidance, but will resume in weeks that do not have more pressing Covid-19 topics.
On April 2, 2020, the SEC Small Business Capital Formation Advisory Committee held a special meeting (remotely) to discuss the potentially severe and immediate impact of Covid-19 on small businesses. Although the Committee did not make specific rule-change recommendations, it did urge the SEC to take immediate action to ease online private capital raising rules to assist businesses in accessing capital quicker and from a larger body of investors.
Committee members argued for an ease in crowdfunding restrictions to allow small businesses to quickly access potential investors. Commissioner Peirce agreed with the approach, noting that allowing companies to raise funds over the internet is in line with current social distancing initiatives. Pierce suggested allowing a new micro-offering exemption for quick access to capital with few restrictions.
SEC Chair Jay Clayton gave opening remarks, stressing the unprecedented challenges faced by small businesses. Although he also offered no specific solutions, he did stress the importance of preserving the flows of credit and capital in our economy to better fight and ultimately recover from Covid-19.
Although no one brought it up, I think that quick rules which allow the payment of finder’s fees to unregistered individuals and entities would be extremely beneficial, and could be accomplished while maintaining investor protections. Many small business owners (or even larger business owners) simply do not even know where to begin when it comes to capital raising, and many are uncomfortable asking for money.
I would advocate for rules that include (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions.
I would even advocate for a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements. For example, FINRA, together with the SEC Division of Trading and Markets, could fashion an exam similar to the FINRA Securities Industry Essentials Exam for finders that are otherwise exempt from the full broker-dealer registration requirements.
New C&DI on Filing Deadlines
As I wrote about in my last two blogs, the SEC has provided relief such that periodic filings that would have been due from between March 1 and July 1, 2020 can avail themselves of a 45-day extension (see HERE). In order to qualify for the extension, a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed. In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business. The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.
On April 6, 2020, the SEC issued a new C&DI explaining how the extension impacts a company that excludes particular information in its Form 10-K intending to incorporate that information in its subsequently filed proxy or information statement. In particular, a Form 10-K allows a company to include Part III information in its subsequently filed proxy or information statement for its annual meeting as long as the proxy or information statement is filed within 120 days of the end of the fiscal year. In the event that a proxy or information statement containing the Part III information is not filed by the 120th-day deadline, then an amended Form 10-K must be filed by that date with the omitted information.
The SEC confirms that if a company is unable to file the Part III information by the 120th-day deadline, it may avail itself of the 45-day extension for companies affected by the Covid-19 crisis as long as the deadline is within the relief period (March 1 through July 1, 2020).
A company that timely filed its annual report on Form 10-K without relying on the Covid-19 Order should furnish a Form 8-K with the disclosures required in the Order by the 120-day deadline. The company would then need to provide the Part III information within 45 days of the 120-day deadline by including it in a Form 10-K/A or definitive proxy or information statement.
A company may invoke the Covid-19 Order with respect to both the Form 10-K and the Part III information by furnishing a single Form 8-K by the original deadline for the Form 10-K that provides the disclosures required by the Order, indicates that the company will incorporate the Part III information by reference, and provides the estimated date by which the Part III information will be filed. The Part III information must then be filed no later than 45 days following the 120-day deadline.
A company that properly invoked the Covid-19 Order with respect to its Form 10-K by furnishing a Form 8-K but was silent on its ability to timely file Part III information may (1) include the Part III information in its Form 10-K filed within 45 days of the original Form 10-K deadline, or (2) furnish a second Form 8-K with the disclosures required in the Order by the original 120-day deadline and then file the Part III information no later than 45 days following the 120-day deadline by including it in a Form 10-K/A or definitive proxy or information statement.
« Relief For Persons Affected By The Coronavirus Disclosures Related To COVID-19 »
Relief For Persons Affected By The Coronavirus
Last week I published a blog summarizing the relief granted by the SEC for public companies and capital markets participants impacted by the coronavirus (Covid-19) (see HERE). Just as Covid-19 rapidly evolves, so have the regulators response. The SEC has now expanded the relief and issued guidance on public company disclosures related to Covid-19.
While we work to complete the usual filings while in quarantine, a new conversation is starting to develop at a rapid pace. That is, the conversation of opportunity and the accelerating of a more technologically driven economy than ever before. Businesses and service providers must stay nimble and ready to serve the ever changing needs of entrepreneurs and the capital markets – I know we are!
Extension in SEC Reporting Filing Deadlines
On March 25, 2020, the SEC extended its prior conditional relief order such that periodic filings that would have been due from between March 1 and July 1, 2020 can avail themselves of a 45 day extension. The prior order only offered an extension for filings due between March 1 and April 30, 2020.
The extension is only available under certain conditions. In order to qualify for the extension a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed. In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business. The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.
Although the SEC will likely give significant leeway to companies, the general fact that the coronavirus has an impact on the world is not enough. In order to qualify for the relief a company must be directly impacted in their ability to complete and file disclosure reports on a timely basis. For instance, disruptions to transportation, and limited access to facilities, support staff and advisors could all impact the ability of a company to meet its filing deadlines
The current report disclosing the need for the extension must also provide investors and the market place with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. In other words, if a company is so impacted by the coronavirus that they must seek an extension to its filing obligation, it must also inform investors, to the best of its knowledge and ability, what that impact is and how it is being addressed.
If the reason the report cannot be timely filed relates to a third parties inability to furnish an opinion, report or certification, the Form 8-K or 6-K should attach an exhibit statement signed by such third party specifying the reason they cannot provide the opinion, report or certification.
For purposes of eligibility to use Form S-3, a company relying on the exemptive order will be considered current and timely in its Exchange Act filing requirements if it was current and timely as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report. For more on S-3 eligibility, see HERE.
Likewise, for purposes of the Form S-8 eligibility requirements and the current public information eligibility requirements of Rule 144, a company relying on the exemptive order will be considered current in its Exchange Act filing requirements if it was current as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report.
The extension actually changes the due date for the filing of the report. Accordingly, a company would be able to file a 12b-25 on the 45th day to gain an additional 5 day extension for a Form 10-Q and 15 day extension for a Form 10-K.
Disclosures Regarding Covid-19 Impact
In an earlier press release the SEC reminded companies of the obligations to disclose information related to the impact of Covid-19 on their businesses. SEC Chair Jay Clayton had stated “[W]e also remind all companies to provide investors with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments. How companies plan and respond to the events as they unfold can be material to an investment decision, and I urge companies to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable in light of the circumstances in meeting the applicable requirements. Companies providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding coronavirus, can take steps to avail themselves of the safe harbor in Section 21E of the Exchange Act for forward-looking statements.”
The SEC Division of Corporation Finance has now issued Disclosure Guidance Topic No. 9 regarding the SEC’s current views on disclosures and the obligations that companies should consider with respect to Covid-19. The overarching messaging is that a company must consider its Covid-19 impact in its disclosure documents and make necessary material disclosures using a principal’s based strategy.
Certainly the actual impact and risks are difficult to ascertain and may be unknown or dependent on third parties, but the SEC encourages material disclosure on what management expects the virus’ future impact will be, how management is responding to evolving events, and how it is planning for COVID-19-related uncertainties. Examples of areas of reports that may be impacted and thus require disclosure include management’s discussion and analysis, the business section, risk factors, legal proceedings, disclosure controls and procedures, internal control over financial reporting, and the financial statements.
Topic No. 9 suggests that management consider the following non-exclusive list in considering Covid-19 related disclosures:
- How has Covid-19 impacted the financial condition and results of operations? How do you expect COVID-19 to impact your future operating results and near-and-long-term financial condition? Do you expect that COVID-19 will impact future operations differently than how it affected the current period?
- How has COVID-19 impacted your capital and financial resources, including your overall liquidity position and outlook? Consider if the cost of or access to capital and funding sources has changed and whether it is likely to change or continue to change. Have sources and uses of cash been materially impacted? Has the ability to continue to meet ongoing credit agreements changed or is it materially likely it will change? Disclosure should also be made as to the course of action a company has taken or proposes to take in light of the material impact on its financial resources.
- How do you expect COVID-19 to affect assets on your balance sheet and your ability to timely account for those assets? For example, will there be significant changes in judgments in determining the fair-value of assets measured in accordance with U.S GAAP or IFRS?
- Do you anticipate any material impairments (e.g., with respect to goodwill, intangible assets, long-lived assets, right of use assets, investment securities), increases in allowances for credit losses, restructuring charges, other expenses, or changes in accounting judgments that have had or are reasonably likely to have a material impact on your financial statements?
- Have COVID-19-related circumstances such as remote work arrangements adversely affected your ability to maintain operations, including financial reporting systems, internal control over financial reporting and disclosure controls and procedures? If so, what changes in your controls have occurred during the current period that materially affect or are reasonably likely to materially affect your internal control over financial reporting? What challenges do you anticipate in your ability to maintain these systems and controls?
- Have you experienced challenges in implementing your business continuity plans or do you foresee requiring material expenditures to do so?
- Do you expect COVID-19 to materially affect the demand for your products or services?
- Do you anticipate a material adverse impact of COVID-19 on your supply chain or the methods used to distribute your products or services?
- Will your operations be materially impacted by any constraints or other impacts on your human capital resources and productivity?
- Are travel restrictions and border closures expected to have a material impact on your ability to operate and achieve your business goals?
Trading on Material Non-Public Information
The combined effects of the impact of the virus and extensions in the filing of periodic reports creates an increased threat of the trading on material nonpublic information (insider trading). Like the prior issued exemptive order, Topic No. 9 reminds all companies of its obligations. If a company is aware of risk related to the coronavirus it needs to refrain from engaging in securities transactions with the public (private and public offerings, buy-backs, etc.) and prevent directors and officers, and other corporate insiders who are aware of these matters, from initiating such transactions until investors have been appropriately informed about the risk.
Companies are reminded not to make selective disclosures and to take steps to ensure that information is publicly disseminated where accidental disclosure is made. Depending on a company’s particular circumstances, it should consider whether it may need to revisit, refresh, or update previous disclosure to the extent that the information becomes materially inaccurate. Where disclosures related to the coronavirus are forward looking, a company can avail itself of either the Exchange Act Section 21E or common law safe harbors (see HERE).
Reporting Earnings and Financial Results
Topic No. 9 encourages companies to proactively address financial reporting matters earlier than usual. Many companies will rely on the available 45 day extension and will be grappling with the accounting complexities of the Covid-19 impact including short term dramatic changes in expenses and revenues. The SEC suggests engaging needed experts and beginning an analysis of the potential impacts as quickly as possible to be prepared to meet filing deadlines, even with the extensions.
Many companies, although not obligated, choose to issue earnings releases (for more on earnings releases see HERE. In addition to other considerations, the SEC reminds companies of their obligations under Item 10 of Regulation S-K and Regulation G related to the presentation of non-GAAP financial measures. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information. For more on Item 10 and Regulation G see HERE.
Topic No. 9 specifically acknowledges that there may be instances where a GAAP financial measure is not available at the time of the earnings release because the measure may be impacted by a Covid-19 related adjustment that may require additional information and analysis to complete. In these situations, the SEC would not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate, or a range of reasonably estimable GAAP results. For example, if a company intends to disclose EBITDA on an earnings call, it could reconcile that measure to either its GAAP earnings, a reasonable estimate of its GAAP earnings that includes a provisional amount, or its reasonable estimate of a range of GAAP earnings. In filings where GAAP financial statements are required, such as on Form 10-K or 10-Q, companies should reconcile to GAAP results and not include provisional amounts or a range of estimated results.
The SEC also cautions companies against using the Topic No. 9 guidance and current SEC flexibility to present non-GAAP financial measures or metrics for the sole purpose of presenting a more favorable view of the company.
Furnishing of Proxy and Information Statements
The SEC has also granted relief where a company is required to comply with Exchange Act Sections 14(a) or 14(c) requiring the furnishing of proxy or information statements to shareholders, and mail delivery is not possible. The order relieves a company of the requirement to furnish the proxy or information statement where the security holder has a mailing address located in an area where mail delivery service has been suspended due to Covid-19 and the company has made a good faith effort to furnish the materials to the shareholder.
Virtual Annual Meetings
Although the SEC regulates the proxy process for annual meetings of public companies, it does not regulate the place and format of the meeting itself, which remains subject to state law. Although Delaware provides a great deal of flexibility for companies to hold virtual meetings, many states do not. New York has historically been one of the states that does not have easy provisions for virtual meetings. Accordingly, New York Governor Andrew Cuomo has issued an executive order temporarily permitting New York corporations to hold virtual annual meetings. Although California is also not totally virtual meeting friendly, it has not yet issued exemptive relief.
Relief for Registered Transfer Agents
The SEC has issued an order providing transfer agents and certain other persons with conditional relief from certain obligations under the federal securities laws for persons affected by Covid-19 for the period from March 15, 2020 to May 30, 2020. The SEC recognizes that transfer agents may have difficultly communicated with or conducting business with shareholders and others effected by the virus.
The exemptive order would provide relief for certain activities such as processing securities transfers and updating shareholder lists. The exemptive order does not relieve the obligation to ensure that securities and funds are adequately safeguarded.
To qualify for the relief, the requesting person but make a written request to the SEC including a description of the obligation they are unable to comply with and the specific reasons for non-compliance.
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SEC Proposed Rule Changes For Exempt Offerings – Part 1
On March 4, 2020, the SEC published proposed 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). The proposed rule changes indicate that the SEC has been listening to capital markets participants and is supporting increased access to private offerings for both businesses and a larger class of investors. Together with the proposed amendments to the accredited investor definition (see HERE), the new rules could have as much of an impact on the capital markets as the JOBS Act has had since its enactment in 2012.
The June concept release sought public comments on: (i) whether the exemptive framework as a whole is effective for both companies and investors; (ii) ways to improve, harmonize and streamline the exemptions; (iii) whether there are gaps in the regulations making it difficult for smaller companies to raise capital; (iv) whether the limitations on who can invest and amounts that can be invested (i.e., accredited investor status) pose enough investor protection and conversely create undue obstacles to capital formation; (v) integration and transitioning from one offering exemption to another; (vi) the use of pooled investment funds as a source of private capital and access to those funds by retail investors; and (vii) secondary trading and re-sale exemptions.
The 341-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, I will break it down over a series of blogs, with this first blog focusing on integration.
Background; 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 are able to make their own informed investment and voting decisions.
In recent years the scope of exemptions has evolved stemming from the JOBS Act in 2012, which broke up 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 and the Economic Growth Act of 2018 mandated certain changes to Regulation A, including allowing its use by SEC reporting companies, and 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 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 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 current most often used offering exemptions.
Proposed Rule Changes
The proposed rule changes are meant to reduce complexities and gaps in the current exempt offering structure. As such, the rules would 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 Regulation A, Rule 504 and Regulation Crowdfunding and increase the individual investment limits for investors under each of the rules; 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
The current 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 both offerings will be lost, such as when one offering prohibits general solicitation and another one allows it.
The current integration rule (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.
A different analysis is used when considering the integration between an exempt and registered offering and in particular, whether the exempt offering investors learned of the exempt offering through general solicitation, including the registration statement itself. Furthermore, 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.
The amended rules would completely overhaul the integration concept such that each offering would be viewed as discrete regardless of whether it was completed close in time to a second offering. Under the new rules, where a regulatory safe harbor exists such safe harbor could be relied upon. For all other offerings, the new integration rules would look to the particular facts and circumstances of the offering, and focus the analysis on whether 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. Of course, where exempt offerings allow general solicitation, they must include the regulatory legends required for such offering.
In making the analysis as to whether an offering complies with an exemption, where solicitation is not allowed, the company must have a reasonable belief that the investors were either not solicited or that such investor had a substantive relationship with the company prior to commencement of the offering. Generally 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 established accreditation. That is, 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.
Moreover, the SEC is proposing 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 (this 30-day test would replace the six-month test across the board); (ii) offerings under Rule 701, under an employee benefit plan or under 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 that terminated more than 30 days before the registration statement was filed; and (iv) offerings that allow for general solicitation will not integrate with a prior completed or terminated offering.
The determination of whether an offering has been terminated or completed will vary depending on the type of offering. A Section 4(a)(2), Regulation D, Rule 147 or Rule 147A offering will be terminated or completed on 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. As to Regulation A offerings, such will be terminated or completed 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. Offerings under Regulation Crowdfunding will be terminated or completed upon the deadline of the offering set forth in the offering materials.
Registered offerings will be terminated or completed upon the (i) withdrawal of the registration statement; (ii) filing of an amendment or supplement indicating the offering is completed and withdrawing any unsold securities; (iii) entry of an order by the SEC; or (iv) three years after the filing of an S-3. Although the same termination and completion analysis for each offering would be preferred, the differing natures of the offering mechanics do not make that feasible.
To avoid an abuse of the 35 unaccredited limitation under Rule 506(b), where a company 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 would be limited to 35.
To avoid abuse involving Regulation S offerings, where there is a concurrent Rule 506(c) offering, the company will need to prohibit resales to U.S. persons for a period of six months except for QIBs or IAIs.
The new integration principles and safe-harbors would be aggregated in Securities Act Rule 152. Moreover, Rules 502(a), 251(c) (i.e., Regulation A integration provision), 147(g) and 147A(g) (both intrastate offering provisions) will be amended to cross reference the new amended rule 152. Other rules (Rules 255(e), 147(h) and 147A(h)) will be eliminated as the provisions will be covered in Rule 152.
Current Exemption Overview Chart
The SEC proposed rule release published the following chart, which was also included in the June concept release, of the most commonly used offering exemptions…
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SEC Small Business Advocate Releases First Annual Report
The SEC’s Office of Small Business Advocate launched in January 2019 after being created by Congress pursuant to the Small Business Advocate Act of 2016 (see HERE). One of the core tenants of the Office is recognizing that small businesses are job creators, generators of economic opportunity and fundamental to the growth of the country, a drum I often beat. The Office recently issued its first annual report (“Annual Report”).
The Office has the following functions: (i) assist small businesses (privately held or public with a market cap of less than $250 million) and their investors in resolving problems with the SEC or self-regulatory organizations; (ii) identify and propose regulatory changes that would benefit small businesses and their investors; (iii) identify problems small businesses have in securing capital; (iv) analyzing the potential impact of regulatory changes on small businesses and their investors; (v) conducting outreach programs; (vi) identify unique challenges for minority-owned businesses; and (vii) consult with the Investor Advocate on regulatory and legislative changes.
A highlight of the achievements of the office under the leadership of Martha Legg Miller include: (i) hosted and participated in various engagement events with entrepreneurs and investors; (ii) published its business plan; (iii) participated in National Small Business Week including the Small Business Roundtable and meeting of the Small Business Capital Formation Advisory Committee; (iv) launched explanatory videos on how to participate in and comment on rule making; and (v) hosted the annual Government-Business Forum on Small Business Capital Formation, a forum I have had the pleasure of attending in the past.
The Office’s Annual Report contains discussions on: (i) the state of small business capital formation; (ii) policy recommendations; and (iii) the Small Business Capital Formation Advisory Committee.
The State of Small Business Capital Formation
The Office reviewed data published by the SEC’s Division of Economic Risk Analysis (DERA) and supplemented the date with figures and findings from third parties. According to the Annual Report, most capital raising transactions by small businesses are completed in reliance on Rule 506(b) of Regulation D ($1.4 trillion for FYE June 30, 2019) followed by rule 506(c) ($210 billion), Rule 504 ($260 million), Regulation A ($800 million), Regulation CF Crowdfunding ($54 million), initial public offerings ($50 billion) and follow-on offerings ($1.2 trillion).
The industries raising the most capital include banking, technology, manufacturing, real estate, energy and health care. Although private capital is raised throughout the country, the East Coast states and larger states such as California, Florida and Texas are responsible for higher amounts of capital raised in aggregate.
Not surprisingly, small and emerging businesses generally raise capital through a combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors and seed rounds. Bank debt and lines of credit are generally personally guaranteed by founders and secured with company assets. Also, small and community banks are giving fewer and fewer small loans (less than $100,000) as they are higher-risk and less profitable all around.
Accordingly, angel investors are an important source of financing for small businesses. Angel investors are accredited investors that look for potential opportunities to invest in small and emerging businesses. In fact, almost all private-offering investors are accredited. The SEC recently proposed a change in the definition of accredited investor to open up investment opportunities to additional qualified investors (see HERE).
The Annual Report discusses costs for early-stage companies to raise capital, including attorneys’ fees. According to the report, attorneys’ fees are between $5,000 and $20,000 for very early-stage companies and from $20,000 to $40,000 for venture-stage entities. The Report is in line with fees in my firm.
Interestingly, the Annual Report notes a correlation between the increased availability of venture capital funding and job growth in metro areas. Generally, venture-capital or private-equity-backed companies enter the public markets – 44.8% of companies currently listed on the Nasdaq were formerly backed by a venture-capital or private-equity firm.
The Report contains information related to the much–talked-about growing delay in public offerings (see more information HERE and HERE.) According to the Annual Report, companies are going pubic later in their life cycle, which also results in less funds being raised in the public markets via follow-on offerings. The Annual Report indicates 204 IPO’s from July 1, 2018 through June 30, 2019 and 294 small public company follow-on offerings for the same period. Not surprisingly, 61% of exchange traded companies with less than a $100 million market cap have no research coverage.
Woman are founding more start-ups than previously, do it for less money, receive fewer bank loans and VC financing but, on average, generate more revenue. On the investor side, 29.5% of angel investors are women, 11% of VCs are women, and 71% of VC firms had no female partners.
There has also been a big uptick in minority-owned businesses. Minority-owned businesses have even more difficulty accessing capital. They are three times more likely to be denied a loan, pay higher interest rates when they do get a loan, generally must start with far less capital and, as a result, are less profitable. On the investor side, only 5.3% of angel investors and 1% of VCs are minorities.
Not surprisingly, there is less start-up activity in rural areas and lower amounts of capital raised. The problem is severe. Using some of its strongest language, the Annual Report states that the decline in community banks in rural areas is crippling access to early-stage debt for small businesses. Furthermore, many angel and VC groups limit investments to a particular geographical area, hence exacerbating the issue.
Policy Recommendations
Modernize, Clarify and Harmonize Exempt Offering Framework
Following up on the SEC’s June 2019 concept release and request for public comment on ways to simplify, harmonize, and improve the exempt (private) offering framework (see HERE), the Office of Small Business Advocate recommends a simplification to the exempt offering structure. The securities laws, including exempt offering regulations, are complex and difficult to navigate. The fact is that without competent securities counsel, the chances that a capital raise will be compliant with the securities laws is nonexistent.
The Office of Small Business Advocate suggests the following guiding principles to consider in restructuring the current exempt offering framework: (i) the rules, including all guidance on compliance, should be readily accessible and written in plain English; (ii) the rules should allow a company to progressively raise money throughout its growth (meaning very easy structures for small start-up capital raises); (iii) consider the Internet and technology advancements in communication (perhaps allow more open solicitation and advertising); (iv) dollar caps should be flexible for future review and adjustment and consider factors such as industry, geography and life-cycle stage; and (v) the principles underlying the current regulatory structure for exempt offerings should be re-examined.
Investor Participation in Private Offerings (the Accredited Investor Definition)
Most offering exemptions limit participation to accredited investors or if unaccredited investors are allowed, the number of such investors may be limited (506(b)), the disclosures required much more robust, or the investment amounts limited. As a result, the question of a change to the hard-line-in–the-sand accredited investor definition has been debated for years and answering the call, in December 2019, the SEC published a proposed amendment (see HERE).
The Annual Report notes that the definition of an accredited investor is designed to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary. However, the current definition results in eliminating opportunities for retail investors to diversify their portfolios and participate in the growth of companies in the private markets. Public mutual funds rarely invest in private companies and private-equity, hedge funds and venture-capital funds raise capital using the same offering exemptions as private businesses and thus have the same accredited investor limitations. Also, as a result of poor drafting, some sophisticated entities such as American Indian tribal corporations have been left out of the definition, regardless of their asset value.
The Office believes that although investor protections are important, the current definition prioritizes risk of loss over sophistication and creates too strong a barrier to capital for small and emerging-growth companies. Furthermore, the current accredited investor definition structure (and prohibitions on advertising and solicitation) makes it difficult and time-consuming for accredited investors to source investment opportunities even when they want to.
Supporting the proposed rule changes, the Office agrees that adding financial professional licenses and education goalposts to the current accredited investor definition would be beneficial. Likewise, they would not support an increase in the current financial thresholds. Rather than add to the list of entities that could qualify, the Office suggests that any entity, regardless of corporate form, should be able to qualify if it has over $5 million in assets. The Office recommends that the changes be easy to navigate, providing simplicity and certainty in ascertaining qualification to avoid increasing transaction costs. Although not included in any current rule proposal, the Office also suggests modifying the Investment Company Act rules to allow for more public mutual funds to invest in private companies.
Finders
As all capital markets practitioners know, one of the biggest challenges to raising capital is finding and being introduced to potential investors. Although larger companies engage the services of broker-dealers, there simply aren’t many options for smaller or early-stage entities. Because of the very big need, an industry of unlicensed finders has developed. This is a topic I’ve written about many times (see HERE). Some finders operate within the parameters of the law, such as by providing a multitude of valuable services such as creating pitch materials, consulting on capital structure, helping with general business goals and objectives and marketing materials, and importantly, not collecting a success or separate fee for capital introductions. However, many violate the law, causing a host of potential issues for both the finder and the company utilizing their services. Despite pleas from industry participants, the ABA, committees within the SEC and numerous other groups, the need for a workable regulatory structure remains unanswered.
The Office calls for a clear finder’s framework. In implementing a framework for finders to support emerging businesses’ capital needs and provide clarity to investors participating in the market, it is critical that the rules be clear for marketplace participants to reduce confusion, defining in plain English the activities that do not trigger registration and delineating when the scope of activities rises to the level that registration is appropriate. The framework should make clear what offering exemptions are eligible, whether the introduced investors must be accredited, the nature of compensation the finder may receive, the types of other incidental activities that the finder may engage in on behalf of the business, and the respective roles of federal and state regulators.
As I’ve mentioned several times, I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. I would even support a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements.
Crowdfunding
Since 2012, Regulation CF has provided a method for businesses to raise a small amount of capital (capped at $1,070,000) from numerous investors over the Internet utilizing the services of a funding portal. The Annual Report suggests that crowdfunding has been a success, helping many entrepreneurs that may otherwise not have been able to access capital. However, the Annual Report points out some issues with the process including the inability to properly advertise and market and thus drive investors to the opportunity and higher-than-necessary compliance costs. The Office reports that the system overseas is better, with companies raising more capital at a lower cost.
The Office suggests: (i) increase the $1,070,000 cap (no amount is suggested); (ii) remove the investment cap for accredited investors; (iii) revise the various disclosure obligations to reduce compliance costs; (iv) enable the use of special-purpose vehicles for investment; and (v) reduce the compliance burdens for funding portals.
Disclosure Requirements for Small Public Companies
Over the years, the disclosure obligations of public companies have evolved and substantially increased in breadth. Although smaller reporting companies do benefit from some scaled disclosure requirements compared to their larger counterparts (see HERE), the costs of compliance are still high. Naturally when considering whether to go public, companies weigh the increased compliance and reporting costs versus the ability to use those funds for growth. The Office states that this could be one of the larger reasons companies are choosing to stay private longer, negatively impacting the U.S. public marketplace.
The Office notes that the SEC has been taking the initiative, via rule changes and proposals, to address these concerns. Many recent amendments to the rules emphasize a principles-based approach, reflecting the evolution of businesses and the philosophy that a one-size-fits-all approach can be both under- and over-inclusive. For my blog on recent proposed changes to the management’s discussion and analysis section of SEC reports, see HERE. That blog also contains a complete breakdown of the SEC’s ongoing disclosure effectiveness initiative. In addition to supporting the recent initiative, the Office advocates for further changes to reduce compliance costs for smaller reporting companies.
The Small Business Capital Formation Advisory Committee
The Small Business Advocate Act also created the Small Business Capital Formation Advisory Committee, which replaced the SEC’s voluntarily created Advisory Committee on Small and Emerging Companies. The new Advisory Committee is designed to provide a formal mechanism for the SEC to receive advice and recommendations on rules, regulations, and policy matters related to emerging, privately held small businesses to publicly traded companies with less than $250 million in public market capitalization; trading in securities of such companies; and public reporting and corporate governance of such companies.
The Advisory Committee has made two recommendations to the SEC. In particular, related to the recent SEC’s proposed rule changes to the reporting requirements for the acquisitions and dispositions of businesses (see HERE), the Advisory Committee suggests that the rule change provide differing treatment for Regulation A companies and make Management’s Adjustments optional or not required at all. Overall the Advisory Committee supports the rules changes but would make some tweaks.
The second recommendation relates to the SEC’s proposed amendment to the definitions of “accelerated filer” and “large accelerated filer” (see HERE ). Although the Advisory Committee supports the change, it would go further to add more companies that would qualify as a non-accelerated filers by raising the revenue threshold (currently proposed to be $100 million), increasing the time for such revenue (from the last year to three years) and considering whether all smaller reporting companies should be non-accelerated filers.
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