United States: SEC Adopts Amendments To Harmonize Private Offering Exemptions

Yesterday, the SEC adopted, by a vote of three to two, amendments designed to harmonize and simplify the patchwork universe of private offering exemptions. The final amendments were informed by feedback received from the March 2020 proposal, the SEC's advisory committees and the SEC's Government-Business Forum on Small Business Capital Formation, as well as engagement with investors and companies. According to Chair Jay Clayton, the amendments "reflect a comprehensive, retrospective review of a framework that has, over time, unfortunately become difficult to navigate, for both investors and businesses, particularly smaller and medium-sized businesses.... Today's amendments would rationalize that framework, increase efficiency and facilitate capital formation, while preserving or enhancing important investor protections."  Here is the almost 400-page adopting release. The final amendments will become effective 60 days after publication in the Federal Register.

According to the press release, the amendments are intended to "reduce potential friction points to make the capital raising process more effective and efficient to meet evolving market needs." In summary, the amendments:

• "Establish more clearly, in one broadly applicable rule, the ability of issuers to move from one exemption to another;
• increase the offering limits for Regulation A, Regulation Crowdfunding, and Rule 504 offerings, and revise certain individual investment limits;
• set clear and consistent rules governing certain offering communications, including permitting certain 'test-the-waters' and 'demo day' activities; and
• harmonize certain disclosure and eligibility requirements and bad actor disqualification provisions."

At the open meeting

According to Clayton, the SEC's "exempt offering framework, which consists of no fewer than 10 different exemptions, was built over time, over fifty years," and is now plagued by a lot deferred maintenance and long due for an overhaul. As Clayton said in a 2018 speech, the current framework would not likely exist as it is if the SEC were starting with blank slate. 

In crafting the amendments, he said, the SEC had three key objectives:

1. "remaining true to proven principles for retrospective review and modernization, improving all three components of our mission: investor protection, capital formation and market integrity; 
2. addressing the substantial changes in our marketplace, including changes in communications technology and access to capital; and
3. greatly reducing costs, particularly for smaller and medium-sized business as well their investors."

Perhaps anticipating criticism of the final amendments to come from dissenting Commissioners Allison Lee and Caroline Crenshaw, in his statement, Clayton took issue with those

Clayton believes that the amendments will eliminate costs and provide

Noting that the private markets have increasingly been the source of capital for larger companies in the past 25 years, Clayton maintained that the amendments will add important efficiencies,

Many smaller and medium-sized businesses "do not have the resources, expertise and experience to effectively navigate our complex private offering rule sets.  These companies and their investors are the ones we intend to benefit from today's amendments, which aim to replace unnecessary complexity and uncertainty with a clearer, more consistent system."

Reducing costs, the third objective, will be achieved by eliminating "paperwork and lawyer hours that as a practical matter serve no mission-oriented purpose, and specifically do not enhance investor protection.  Many of these costs are the result of rules that were constructed in an age of different communications and other technologies." Although the rules should accommodate the mail, "SEC regulations should not cling to the mails and paper as the default or preferred paradigm for communications."

In her statement, Commissioner Hester Peirce ascribed the importance of the new rulemaking to the role of small business in wealth accumulation: "[s]mall businesses are engines of capital accumulation.  Unfortunately, many small businesses that could be successful struggle to find the capital they need to create wealth." In her view, the current regulatory scheme  "unnecessarily hinders capital formation and unduly restricts investors' opportunities to participate in economic growth."  She appreciated, for example, the increases in the maximum offering limitations, the new rules regarding "demo days," and the streamlining of the integration analysis into "a single rule with a clear principle, guidance on how to apply that principle, and four safe harbors..."  However, she thought the rules should go further in eliminating restrictions. For example, while she appreciated the rule change that will permit companies "to rely on a prior verification of accredited investor status at the time of a subsequent sale, so long as the investor represents in writing that she is still an accredited investor and the issuer is not aware of information to the contrary," she would rather have eliminated the "five-year time limit on the ability of issuers to rely on a prior verification." These new amendments, in her view, are a "positive step," but more work is left to do.

On the other hand, Commissioner Lee did worry that the final amendments would have a deleterious effect on the protections for retail investors.  In her view, private offerings are

But recently, she argued, "the exception (or exemptions from registration) have swallowed the rule, with statutory and regulatory changes steadily chipping away at restrictions on private offerings and exposing more and more retail investors to their risks."  The final amendments are another example of that trend, in her view. While the amendments might be presented as a way to enhance investor opportunity, "the evidence suggests that retail investors would actually do worse in the private markets. And, as with so many of our rulemakings in the last few years, investors—the supposed beneficiaries of the rule—largely oppose it." In addition, because of the dearth of data about the private markets, the amendments lack "meaningful analysis of how our policymaking has affected the dramatic shift of capital to the private market in recent years, and fails to account for how public and private markets do or should interrelate.... Thus, once again we make significant changes to a market that is already awash in capital, but into which we have little visibility."

Although Lee certainly took issue with individual changes, her primary concern was "the sweeping effect of these changes taken together and in the broader regulatory context, including the Commission's failure to address the effects of inflation on the nearly 40-year-old wealth thresholds in the accredited investor definition.... At the same time, we steadily strip away investor protections in this market, reducing disclosure requirements and relaxing accredited investor verification standards." The SEC's rulemaking, she said, takes too narrow a view of the changes made without taking into account other regulatory efforts as a whole. These changes, she contended, "are cast as mere adjustments to the framework to make it easier to navigate, but their effects on investor protection loom large." For example, she worried that the "drastic changes to the integration framework," which eliminate "any real analysis of whether separate offerings should be considered functionally the same," are poised "to effectively nullify" the integration doctrine, rendering it "hollow but for a requirement to wait 30 days between offerings."  Similarly, while it may make sense to adjust the framework for exemptions to harmonize the various rules, she observed, it's important to keep in mind that the differences in the rules may reflect the different purposes underlying those rules; it "does not make sense in all instances for their requirements to be the same."

In Lee's view, the consequence will be a continued "blurring of lines between public and private markets," including "wholesale importation of general solicitation into the private market," resulting in difficulties for regulators in policing these markets.  Instead of eroding the boundaries between the public and private markets, she urged, the SEC should be considering how to increase opportunities in the public markets, which provide better opportunities for retail investors.  

To Commissioner Crenshaw, there were tradeoffs inherent in the rulemaking, and she was critical of the failure "to engage in any substantive way with the crucial threshold question of whether those tradeoffs are—or even can be—balanced in a way that adequately protects retail investors." She was also concerned about the potential for the amendments to increase the wealth divide: "the rule fails to address the fact that in the private markets, the rich and well-connected typically have better access to the most promising companies, while retail investors get the leftovers—too often, unfortunately, the losers. Instead of providing retail investors access to that elusive high return rate, the majority's steady march of expanding the private markets will only further entrench the country's increasing and concerning economic divide." In her view, currently, "high growth companies are increasingly deciding to remain private, benefitting groups of experienced and well-funded professional investors."  But the amendments "do not fix that problem." Instead, the amendments simply permit investment in these markets by "a class of investors who do not have the capital to survive one or two failed ventures. This approach will serve only to further widen the wealth and access gaps between investors who start rich and those who don't."  

Investors such as venture capitalists have "structural advantages that have led to their success," such as trained professionals to evaluate early stage companies, diverse portfolios to absorb the inevitable losses and market power to demand detailed information—advantages not available to most retail investors. And there is a surplus of capital waiting to invest in top tier companies, but

There is no evidence to support this idea, she argues.  Rather, the little evidence that exists suggests that "these changes appear likely to offer only at best marginal benefits to the companies who need the most assistance, while increasing risks but not rewards for investors."

Interestingly, at the conclusion of the statements, there was a brief unscripted colloquy arising out of Crenshaw's statement. (Based on my notes only,) Commissioner Elad Roisman asked Crenshaw to further explain how the rulemaking would contribute to the economic divide?  After all, it would provide retail investors with more access to potentially profitable investments.  Crenshaw reiterated her argument that the amendments might provide more access, but it was likely to be access to the most risky investments (the "loser" investments) in which retail investors were more likely to lose money, not profit.  In her view, because of information and power asymmetries, private offerings did not treat all investors equally.  Peirce chimed in that companies may need non-VC funds and that we needed to careful about what constraints we put on how people can spend their own money.  

The final amendments

Below are the highlights of the final amendments as set forth in the press release:

Integration.  When companies engage in multiple offerings near in time, it is often necessary to analyze whether the offerings are "integrated"—essentially a single offering—for purposes of analyzing compliance. The amendments "establish a new integration framework that provides a general principle that looks to the particular facts and circumstances of two or more offerings, and focuses the analysis on whether the issuer 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."

The amendments provide four non-exclusive safe harbors from integration:

• "any offering made more than 30 calendar days before the commencement of any other offering, or more than 30 calendar days after the termination or completion of any other offering, will not be integrated with such other offering(s); provided that:
  • in the case where an exempt offering for which general solicitation is prohibited follows by 30 calendar days or more an offering that allows general solicitation, the issuer has a reasonable belief, based on the facts and circumstances, with respect to each purchaser in the exempt offering prohibiting general solicitation, that the issuer (or any person acting on the issuer's behalf) either did not solicit such purchaser through the use of general solicitation or established a substantive relationship with such purchaser prior to the commencement of the exempt offering prohibiting general solicitation;
• offers and sales made in compliance with Rule 701, pursuant to an employee benefit plan, or in compliance with Regulation S will not be integrated with other offerings;
• an offering for which a Securities Act registration statement has been filed will not be integrated if it is made subsequent to:
  • a terminated or completed offering for which general solicitation is not permitted,
  • a terminated or completed offering for which general solicitation is permitted that was made only to qualified institutional buyers and institutional accredited investors, or
  • an offering for which general solicitation is permitted that terminated or was completed more than 30 calendar days prior to the commencement of the registered offering; and
• offers and sales made in reliance on an exemption for which general solicitation is permitted will not be integrated if made subsequent to any terminated or completed offering."

Offering and investment limits. The amendments raise the offering limits under and make other changes to various exemptions as follows:

"For Regulation A, the amendments: 

• raise the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million; and
• raise the maximum offering amount for secondary sales under Tier 2 of Regulation A from $15 million to $22.5 million.

For Regulation Crowdfunding, the amendments: 

• raise the offering limit in Regulation Crowdfunding from $1.07 million to $5 million;
• amend the investment limits for investors in Regulation Crowdfunding offerings by:
  • removing investment limits for accredited investors; and
  • using the greater of their annual income or net worth when calculating the investment limits for non-accredited investors; and
• extend for 18 months the existing temporary relief providing an exemption from certain Regulation Crowdfunding financial statement review requirements for issuers offering $250,000 or less of securities in reliance on the exemption within a 12-month period.

For Rule 504 of Regulation D, the amendments: 

• raise the maximum offering amount from $5 million to $10 million."

Regulation Crowdfunding and Regulation A Eligibility.  To facilitate investing in Regulation Crowdfunding issuers, the amendments permit the use of certain special purpose vehicles as a conduit for investors. In addition, the amendments impose eligibility restrictions on the use of Regulation A by issuers that are delinquent in their Exchange Act reporting obligations.

 "Test-the-Waters" and "Demo Day" Communications.  The amendments make the following changes related to offering communications rules, by:

• "permitting an issuer to use generic solicitation of interest materials to 'test-the-waters' for an exempt offer of securities prior to determining which exemption it will use for the sale of the securities;
• permitting Regulation Crowdfunding issuers to 'test-the-waters' prior to filing an offering document with the Commission in a manner similar to current Regulation A; and
• providing that certain 'demo day' communications will not be deemed general solicitation or general advertising."

Other Improvements to Specific Exemptions.  The amendments also:

• "change the financial information that must be provided to non-accredited investors in Rule 506(b) private placements to align with the financial information that issuers must provide to investors in Regulation A offerings;
• add a new item to the non-exclusive list of verification methods in Rule 506(c);
• simplify certain requirements for Regulation A offerings and establish greater consistency between Regulation A and registered offerings; and
• harmonize the bad actor disqualification provisions in Regulation D, Regulation A, and Regulation Crowdfunding."

Copied below is the SEC's table providing an overview of the changes to the exemptions: