By James Johnson & David Pricco
Introduction
Somewhere between the use of donation or pre-sale based crowdfunding and the expense of a full-fledged IPO, has been an underused method of raising money by utilizing “Regulation A”, a securities law that allows companies to directly raise money from private investors.
Originally adopted in 1936 as an addition to the securities act of 1933, the Regulation A securities exemption was created to help make it easier for smaller companies to raise money without going through the lengthy, complex, and expensive process of an IPO. It allows companies to raise money from investors without preparing audited financial statements or the filing of a form S1.
Unfortunately, very few companies actually raise money using the original Regulation A rules. For example, only 8 companies used Reg A to raise money in 2012. But that’s about to change, because Regulation A finally just got a much needed make-over for the age of online crowdfunding. Meet the new and improved Regulation A”+”.
On March 25, 2015, the U.S. Securities and Exchange Commission held an open meeting in which it issued the long awaited final rules for the implementation of Title IV of the JOBS Act, which creates an exemption to the registration requirement for securities; this exemption is commonly referred to as Regulation A+. The new rules are scheduled to become effective 60 days after their publication in the Federal Register.
A Look at the Existing Regulation A vs. the New “Regulation A+”
Regulation A+ is intended by the SEC to be an update and expansion of the existing Regulation A exemption. The existing Reg A was designed to be a small IPO-like offering, and was limited to offerings of $5 million and under during any 12-month period; including up to $1.5 million in resale of affiliate-held securities . Regulation A was limited to U.S. and Canadian companies (excluding shell companies), and had reduced disclosure requirements when compared to an IPO registration. An issuer that wanted to make a Reg A offering could issue a question-and-answer or narrative format disclosure statement as opposed to the extremely complicated, structured format of a S-1 disclosure statement. There was also no requirement to have financial statements audited, nor was there any ongoing reporting requirement. However, issuers utilizing Reg A had to comply with the securities laws in every state in which they intend to sell securities. For a significant multi-state or nationwide offering, this proved to be a time-consuming and expensive proposition that limited the attractiveness of Reg A to most issuers.
Under Title IV of the JOBS Act, Congress directed the SEC to reform Reg A, including raising the limit to $50 million, reviewed every two years, and eliminate state securities law compliance (although states would still retain an enforcement role) if sales were only made to “qualified investors” — the SEC would be free to define “qualified investors”. However, the SEC could compensate this loss of consumer protection by requiring audited financials and ongoing reporting.
The final Reg A+ rules going into effect in two months creates two tiers of offerings. Tier 1 consists of securities offerings of up to $20 million in any 12-month period, with not more than $6 million of that consisting of resale offers by security-holders that are affiliates of the issuer; Tier 2 consists of offerings of up to $50 million in any 12-month period, with not more than $15 million of that consisting of resale offers by affiliated security-holders. For both tiers, all selling security-holders are limited to no more than 30% of the aggregate of an initial offering or subsequent offerings for the first 12 months after the initial offering. Sold securities will be unrestricted as to resale, subject to any contractual restrictions imposed by the issuer.
Most companies are permitted to utilize Reg A+. The requirements are that issuers must have their principal place of business in the U.S. or Canada. Furthermore, issuers cannot be SEC reporting companies or certain types of investment companies, or seek to offer or sell asset-backed securities or fractional interests in mineral rights. Issuers must have a specific business plan or purpose, and that plan or purpose must not be to engage in a merger or acquisition with an unidentified company. Finally, issuers must not have been subject to any SEC order under Exchange Act §12(j) within the past 5 years, must have timely filed required ongoing reports for the last 2 years, and are not disqualified under the “bad actor” disqualification rules under Rule 506.
Issuers conducting offerings of up to $20 million can elect whether to proceed under Tier 1 or 2. Both tiers are also subject to issuer eligibility, disclosure, and other requirements contained in the provisions of Regulation A. Companies under both tiers can also submit draft offering statements to the SEC for non-public review before filing, can continue to use solicitation materials before and after the filing of the offering statement (the practice know as “testing the waters”), and are required to electronically file offering materials in alignment with current practice for registered offerings.
However, Tier 2 has additional reporting requirements and investor limitations over Tier 1. Tier 2 issuers are required to provide audited financial statements, and are required to file annual, semiannual, and current event reports, which will include ongoing audited financials; non-accredited investors are limited to investing in a Tier 2 offering no more than the greater of 10% of the investor’s annual income or net worth. Tier 2 issuers are also exempt from the mandatory registration requirements under Exchange Act §12(g) if it meets all four of the following conditions: (1) the issuer engages services from a transfer agent registered with the SEC; (2) the issuer remains subject to a Tier 2 reporting obligation; (3) the issuer is current with its annual and semiannual reporting requirements at year’s end; and (4) the issuer has a public float of less than $75 million as of the last business day of its most recent semiannual period, or if it has no float, annual revenues of less than $50 million in its last completed fiscal year. Any issuer that exceeds these thresholds has a two-year transition period before it must register its securities.
Tier 2 offers have a significant benefit over Tier 1 offerings to compensate for these additional requirements, in that state securities law registration and qualification requirements are preempted for securities offered or sold to any person under a Tier 2 offering. Tier 1 offerings will still be subject to state registration and qualification requirements, although issuers who elect Tier 1 can utilize the new coordinated review program developed by the North American Securities Administrators Association. However, it remains to be seen whether the cost of multi-state review under the coordinated review program becomes a cheaper option that the additional disclosure and ongoing reporting requirements under Tier 2.
Finally, Reg A+ provides several safe harbors from integrating other securities offerings — no integration with any previously closed offerings, with any subsequent crowdfunding offering, or whether the issuer complies with the terms of another exemption for another offering independently such that a simultaneous Rule 506(c) offering can also be conducted.
Summarizing the New Reg A+ Rules
Tier 1:
-Can raise up to $20 million in Reg A offerings in any 12-month period (no more than $6 million in resales by affiliates; no more than 30% of the aggregate of the initial offerings and subsequent offerings for first 12 months may be affiliate resales)
-Sold securities are unrestricted (subject to Rule 144)
-Subject to basic eligibility and disclosure requirements under previous Reg A
-Must file Form 1-A offering statement
-May submit draft offering statements to SEC for non-public review
-May generally solicit
-May “test the waters” and use sales literature before and after filing of Form 1-A as well as after qualification
-Subject to state registration/qualification requirements (but may use Coordinated Review Program)
Pros and Cons of Tier 1
Pros:
-Not subject to additional financial disclosure requirements (with limited exception)
-Not subject to ongoing reporting requirements at federal level (with exception of termination report at close of offering)
-No investment limit on investors
Cons:
-Lower cap on total offering
-Subject to state registration/qualification
Tier 2:
-Can raise up to $50 million in Reg A offerings in any 12-month period (no more than $15 million in resales by affiliates; no more than 30% of the aggregate of the initial offerings and subsequent offerings for first 12 months may be affiliate resales)
-Sold securities are unrestricted (subject to Rule 144)
-Subject to basic eligibility and disclosure requirements under previous Reg A
-Must file Form 1-A offering statement
-May submit draft offering statements to SEC for non-public review
-May generally solicit
-May “test the waters” and use sales literature before and after filing of Form 1-A as well as after qualification
-Additional audited financial statement requirements
-Required to file annual and semiannual reports, and “current event” reports when necessary
-State registration/qualification preempted (though states may require filing of all offering materials and still have anti-fraud enforcement authority)
-Non-accredited investors limited to purchases of no more than the greater of 10% of investor’s annual income or net worth (unless securities are listed on national exchange)
-Exempt from Exchange Act §12(g) mandatory registration requirement, for two-year transition period, if issuer meets all of the following qualifications:
-Engages services of SEC-registered transfer agent
-Remains subject to Tier 2 reporting obligation
-Current in annual and semiannual reporting requirements
-Has public float of less than $75 million as of last business day of semiannual reporting period; or, in absence of public float, less than $50 million in annual revenues as of last completed fiscal year
Pros and Cons of Tier 2:
Pros:
-Higher cap on total offerings
-Preemption of state registration/qualification
-Able to be exempt from Exchange Act §12(g) mandatory registration requirement and have two-year transition period instead
-Easier process to register securities on national exchange
Cons:
-Additional financial disclosure and ongoing reporting requirements
-May also be required to submit “current event” reports on quarterly basis in order to satisfy Rule 144 and Rule 144A
-Potential investment limit for non-accredited investors
The Reg A+ Process
Although the exact details of the process by which a company will undergo a Reg A+ offering will be determined in the coming months and years as issuers and accounting and legal advisors begin to develop standards and the SEC issues guidance memoranda clarifying grey areas of the process, the general outline of the Reg A+ offering process can be gleaned from the final rules promulgated.
The first big change to the Reg A offering process is that all filings to the SEC are now to be made electronically through the SEC’s online filing system, EDGAR. Previously, the Reg A offering statement was paper-filed with the SEC.
The first step an issuer must undertake is to file its Form 1-A offering statement with the SEC for qualification. The offering statement is a disclosure document that provides prospective investors with information that will help them in making their investment decision. An issuer may elect to to submit its offering statement to the SEC for confidential, non-public review; however, the issuer must publicly file the offering statement no less than 21 days before qualification of the statement.
Form 1-A is broken down into three parts. Part I contains basic details about the issuer and its offering, including information about the issuer’s eligibility, offering details, the states and other jurisdictions where the securities are to be offered, and sales of unregistered securities.
Part II is the narrative portion of the offering statement that includes disclosures about the issuer and its business, material risks, the intended use of proceeds, executives and directors of the issuer and their compensation, beneficial ownership, related party transaction, and a description of the offered securities. Part II will also contain financial disclosures about the issuer.
Both Tier 1 and Tier 2 issuers must file balance sheets of the two most recently completed fiscal years, prepared in accordance with U.S. GAAP (Canadian issuers may elect to utilize IFRS). Tier 2 issuers are also required to disclose financial statements independently audited in accordance with U.S. GAAP or PCAOB standards; if the securities are to be listed on a national exchange, the auditing firm must be PCAOB-registered and audit according to those standards. A Tier 1 issuer need not disclose financial statements; however, if a Tier 1 issuer has already obtained financial statements audited in accordance with PCAOB standards or U.S. GAAP for any other purpose, they must file those audited financial statements.
Part III of Form 1-A contains exhibits to the offering statement; however, an issuer can incorporate by reference exhibits previously filed on EDGAR.
Issuers must file all solicitation materials used in the offering, whether used before or after filing of the offering statement, or after qualification of the offering statement. Any solicitation materials used after an offering statement is filed must be accompanied by the statement itself or a link to whether the statement may be obtained.
Issuers must then also comply with state requirements. For Tier 1 offerings, issuers must comply with all state and registration requirements. For Reg A+, issuers may utilize the Coordinated Review Process that is intended to streamline the state review process; however, not all states are currently signed up to the Coordinated Review Process, so issuers will also need to ensure qualification of any offerings in those states. Finally, although state registration/qualification is preempted for Tier 2 offerings, states may still require Tier 2 issuers to file offering materials for record-keeping purposes, and also retain anti-fraud enforcement authority.
Tier 1 issuers must file a Form 1-Z exit report within 30 days of the completion or termination. States may also have additional or ongoing reporting requirements.
Tier 2 issuers have ongoing reporting requirements with the SEC, including the filing of Form 1-K annual reports within 120 days of fiscal year’s end, Form 1-SA semiannual reports within 90 days of the end of the first 6 months of the fiscal year, special financial reports on Form 1-K and Form 1-SA, and, where necessary, “current event” report on Form 1-U within 4 business days of a triggering event. Form 1-K will contain disclosures related to the preceding three fiscal years’ business and operations, beneficial ownership, related party transaction, executive compensation, and two years’ of audited financial statements. Form 1-SA is intended to be similar to a Form 10-Q, with scaled disclosure requirements appropriate to the lower disclosure burden of Reg A. Form 1-U current event reports will be used to announce fundamental changes to business, changes in control of the business, changes to key executives, bankruptcy or receivership, material modifications to the rights of security holders, changes in accountants, non-reliance on audited financial statements, and sales of at least 10% of outstanding equity in exempt offerings.
Observers noted that the final Reg A+ rules failed to designate the required Form 1-SA semiannual reports as constituting “current information” for the purposes of Rule 144 and Rule 144A; accordingly, many believe that it will become practice to issue, on a quarterly basis, Form 1-U reports in the style of Form 1-SA reports in order to comply with Rule 144 and Rule 144A.
Commissioners’ Comments on the Final Reg A+ Rules
SEC Chair Mary Jo White declared that the final Reg A+ framework struck a balance between the demands of federal and state securities laws. Chair White noted that state review deterred issuers from using Reg A, and that because the North American Securities Administrators Association’s (the policy organization representing state securities regulators) new Coordinated Review Program, which is intended to streamline state review of multi-state securities offerings, was too new, preemption of state review of Reg A+ offerings was necessary in at least some cases until a successful track record for the CRP obviated the need for state review preemption; Chair White also emphasized that despite preemption, states retained their full anti-fraud enforcement roles.
Commissioner Aguilar noted that Reg A is one of the oldest registration exemptions, and has always been intended to provide smaller companies with a less costly way to access public capital so long as they provided the public with certain disclosures. Commissioner Aguilar further noted that the disclosure requirements under the final Reg A+ rules are less than under a registered offering, an important point of focus for the SEC in light of the risk of investment in small businesses. Finally, Commissioner Aguilar identified that the costs of both federal and state review were an impediment to use of Reg A, but that NASAA had made great strides in reducing state compliance costs by creating the CRP, so that the SEC had decided not to preempt state review for Tier 1 offerings.
Commissioner Gallagher believed that there was an urgent need for new ruled to promote small business capital formation, and that Reg A+ would give investors necessary information while avoiding considerable disclosure burdens on issuers. However, Commissioner Gallagher was disappointed that the Commission declined to adopt a higher cap for Reg A+ and instead simply relied on the statutory language, given that Congress had authorized the SEC to raise the cap and was requiring them to review it every 2 years. Commissioner Gallagher also warned that the final rule should have deemed semiannual report to be be “reasonably current” reporting, and that the failure to do so could lead to an unwritten, “backdoor” requirement that Reg A+ issuers actually engage in quarterly reporting.
Why Did Reg. A Need to Be Fixed?
Nowstreewire last year held a webinar panel discussion on the preliminary proposed Reg A+ rules entitled “Reviving Capital Formation with Regulation A Crowdfunding”, with David Feldman and Samuel Guzik, attorneys from the law firm Richarson Patel LLC, and Congressman Patrick McHenry of North Carolina, sponsor of one of the bills that was eventually folded into the JOBS Act and one of the chief proponents in Congress for crowdfunding and securities reform serving as panelists. All of the panelists pointed out that the main impetus for fixing Reg A was that nobody used it — from 2009 to the date of the panel, there had been only 19 Reg A offerings, as compared to 373 registered IPOs and over 27,000 Regulation D (Rule 504/505/506) offerings. The panelists identified several issues that dissuaded issuers from Reg A, including the $5 million limit on funds that could be raised, and the lack of preemption of state securities laws. These problems caused many issuers to instead rely on the Rule 506 exception, which has no raise limit and preempts state securities laws. Congressman McHenry noted that the key issues for him in fixing Reg A were upping the limits on the investment to make the cost of compliance worthwhile. In addition, Congressman McHenry wanted to streamline the process by preempting state securities laws so that issuers only need to communicate with the SEC.
In its meeting adopting the Reg A+ rules, SEC Commissioners Aguilar and Stein noted that the existing Reg A framework had been deemed a failure by most; the Commissioners identified the low offering cap and lack of state preemption as creating too high of a cost of capital for the money that could be raise, in addition to the introduction of Regulation D in the 1980s that facilitated much easier and cheaper capital formation through private offerings, as the causes for the lack of use of Reg A by issuers.
Regulation A+ vs. IPO
The Nowstreetwire panelists felt that Tier II of Reg A+ may become an attractive alternative to an IPO for issuers who are making offerings of less than $50 million. Tier II certainly promises to be easier, faster, and cheaper than an IPO — there are less disclosure and reporting requirements, in addition to state securities laws preemption. An issuer utilizing Tier II can “test the waters” and keep its filings confidential during its roadshow, up until 21 days before the SEC approves the filings. The panelists believed that exact cost savings will depend on the scrutiny the SEC staff gives Tier II filings, but that weeks, or even months, could be shaved off the whole offering process.
During the SEC’s issuance of the Reg A+ rules, Commissioner Stein noted his hope that Reg A+ would provide companies easier access to capital that would permit them to grow into reporting companies; indeed, all of the commissioners indicated a view of Reg A+ as a pathway for issuers to become reporting public companies.
Regulation A+ — “Crowdfunding Plus”?
In the Nowstreetwire panel, Attorney Guzik advanced the notion that the JOBS Act created three types of investment or equity crowdfunding. The first was accredited crowdfunding, authorized by Title II of the Act and codified into SEC Rule 506(c), which authorized general solicitation of an offering, so long as sales were only made to accredited investors. The second form was Title III crowdfunding, the “everyman’s” crowdfunding that everyone has been looking forward to, and which was termed “retail crowdfunding” by Attorney Guzik. However, Attorney Guzik believes that Reg A+ may also become a form of crowdfunding, which he terms “crowdfunding plus”.
Attorney Guzik noted the cost and complexity of retail crowdfunding compared with the amount that can be raised (up to $1 million over a 12 month period). Given that up to $50 million can be raised under Tier II, Reg A+ might be a viable vehicle for crowdfunding, perhaps more viable than retail crowdfunding. Title III crowdfunding does not permit general solicitation, except to direct prospective investors to the online platform where the offering takes place; all communication and disclosures about the offering must occur through that online platform. Conversely, communication in a Reg A+ offering can be done in person or online, and can leverage social media.
Conclusion — Can Reg A+ Serve as a Form of Investment Crowdfunding?
The Nowstreewire panel correctly pointed out one of the one of the main criticisms of Title III/retail crowdfunding — compliance is too complicated and expensive for the amount of money that can be raised. In exchange for also being subject to SEC approval and ongoing reporting requirements, a company can instead opt for Reg A+ Tier II and raise up to $50 million, publicly soliciting from all types of investors. It is unlikely that either Reg A+ or Title III crowdfunding will be viable for companies looking to raise five- and six-figure sums of capital — those companies will likely stick with the Reg D exemptions, which usually have far lower regulatory compliance costs. But for the company that is looking to raise millions of dollars, and is willing to take on the expense of SEC compliance and communication with hundreds of shareholders, Reg A+ might end up being the more utilized and successful crowdfunding regime.
In the SEC’s March 25 meeting, Commissioner Gallagher noted his belief that, although Reg A+ was a good start for improving small company access to capital, it might not be helpful enough for companies looking to raise under $5 million, and recommended that the Commission and SEC staff look for other ways to structure exemptions that would not pose a cost-barrier to capital for small companies while still protecting investors.
The final Reg A+ rules can be found here: http://www.sec.gov/rules/final/2015/33-9741.pdf
Other types of Investment / Equity Crowdfunding:
Regulation D Rule 506(b) private offering
- Most commonly used form of private offering by far.
- Only accredited investors allowed to invest
- Accredited Investors are allowed to self-certify
- Does not allow “General Solicitation” open public advertising. Investors must be contacted through pre-existing relationships or via a registered broker-dealer.
- No limit to how much can be raised
- No limits on how much an investor can invest
- No specific form of disclosure – Anti-Fraud liability only
Title II – Regulation D Rule 506(c): “accredited” crowdfunding
- Enacted according the JOBS act by the SEC in September 2013
- Allows “General Solicitation” open public advertising to all investors
- Only accredited investors allowed to invest
- Higher Accredited Investor verification, requires “reasonable steps” to verify income or net worth.
- No limit to how much can be raised
- No limits on how much an investor can invest
- No specific form of disclosure – Anti-Fraud liability only
- Additional rules restricting “bad actors” from participating is issuances.
- low liquidity, few secondary markets, relies on debt or acquisition.
Title III: “retail” crowdfunding
- Not yet enacted by the SEC, final rules expected in October 2015.
- Limited to raising $1 million per year
- Offering available to general public. Unlimited number of investors.
- “Blue Sky” exemption. Issuers do not need to comply to individual state’s filing and disclosure requirements.
- All solicitation to investors must be done through portal. No use of social media.
- Investors with income or net worth above $100k (beside principal residence) can invest up to 10% of net worth and income, up to $100k. Income or net work below $100k, can invest greater of $2,000 or 5% of annual income or net worth.
- Must use online funding portal or broker dealer intermediary registered with SEC and FINRA.
- Requires self-certified GAAP financial statements for the past two years, tax returns if raising $100k or less, reviewed if raising $100k – $500k, audited above $500k. Initial and annual “Registration like” financial and non-financial disclosure.
- Not allowed to “test the waters” before filing. Disclosure documents must be prepared before talking to investors.
- Lots of liability for portals.
- Securities sold are freely tradeable after one year.
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