This month has been full of big news. Yes, there was the election, of course. But there was other important news for those interested in community capital. On Monday November 2, 2020 – the day before the election – the Securities and Exchange Commission issued final rules as part of a broad initiative to harmonize the regulatory framework for exempt offerings, i.e. securities offerings that don’t need to be registered with the SEC.
There are a host of exemptions from SEC registration, each for an offering of a particular type, and several of which are discussed in more detail on our Cutting Edge Capital website. The rules for these various offerings evolved in somewhat disjointed ways and had come to look like an uncoordinated patchwork quilt, with significant barriers making those exemptions more difficult to use than they needed to be.
But the SEC’s new rules lower those barriers and will not only make it easier for companies to use some of these exemption strategies, but may also open up avenues for raising capital that might not have been previously available.
The issuing release from the SEC is a rather daunting 388 pages long. The SEC has prepared this fact sheet summarizing the changes. Here are some of the highlights that we think will be most relevant to our clients:
Though the term sounds technical, integration has been an important concept in securities law for generations. It arises from the fact that each exemption strategy works within a fairly narrow set of circumstances. But what if you want to use two different strategies to reach two different groups of investors? The idea of integration is that two different offerings using two different strategies might be integrated, such that they are treated as one single offering that doesn’t meet the requirements of either intended strategy.
Here’s just one example of the way the integration doctrine worked: A company wants to raise capital under the Rule 506(b) private offering exemption from accredited investors that they personally know in several states, and then conduct an intrastate direct public offering to investors in just one state. If these two offerings are considered to be integrated – as they likely would – the combined offering would’t meet the requirements of either strategy. It wouldn’t meet the requirements of the private offering because the DPO is offered to the public; and it wouldn’t meet the requirements of the intrastate DPO because some of the investments are from other states, and because some of the investors came in before the company got the required regulatory approval for the DPO.
Over the years, courts have developed a five-prong test for when there will be integration, and they seem to always find integration where there are any similarities between the offerings. But going forward, we won’t need to dig into those factors, because here’s the good news: The new rules almost completely eliminate the integration doctrine.
Under the new rules, the focus will simply be on whether the requirements of each strategy have been satisfied. If so, there will be no integration. So, in our example above, if the company is meeting all the requirements for the Rule 506(b) private offering (for example, with no general solicitation), it won’t matter that immediately after that offering is completed the company then launches a direct public offering, with a press release, advertising, and other types of general solicitation.
But lest there be ambiguity about whether there is or isn’t integration in particular situations, the SEC has crafted two important “safe harbors” that can give confidence that two offerings won’t be integrated.
First, a private offering will not be integrated with a subsequent public offering of any kind, as long as they do not overlap in time.
Second, any two offerings that are separated by at least 30 days won’t be integrated, as long as:
- Investors in a private offering that follows a public offering were not reached through general solicitation; or
- The company had a substantive relationship with investors prior to commencement of a subsequent private offering.
Our Take: We often work with our clients on strategies involving multiple offerings, such as a private offering followed by a public offering; these new rules will open up more possible combinations of those offerings. It may also allow for two offerings concurrent with each other. For example, under the new rules, it appears that a small charitable loan fund could conduct a public offering under the federal charitable exemption in those states that also have a charitable exemption, while simultaneously conducting a Rule 506(c) offering (allowing general solicitation of a private offering) in those states that don’t have a charitable exemption. This would allow the fund to raise capital from every state in the country at a minimum compliance cost.
Several changes were made to the rules for Regulation Crowdfunding (also known as Reg CF) offerings:
- The maximum size of offerings has been increased from $1.07 million to $5 million.
- There is no longer a limit on how much an accredited investor can invest in a Reg CF offering.
- For non-accredited investors, the per-investor cap is now calculated on the greater of either their annual income or their net worth. (Previously it was based on the lesser of the two.)
- The SEC has extended for an additional 18 months a special temporary rule that allows for offerings of up to $250,000 without CPA-reviewed financial statements. (Previously, that cap was $100,000.)
- A special purpose vehicle may now be used as a conduit for investors in a Reg CF offering to simplify the company’s cap table.
Our Take: Taken together, these changes will make it easier for many companies to raise capital under Reg CF, and we expect to see more of these offerings. Whether the increased cap of $5 million will make a difference remains to be seen. Already, most Reg CF offerings do not raise the full $1.07 million they are allowed to raise, so increasing the cap may not help much. However, if these changes lead to greater acceptance of Reg CF within the investing community at large, including institutional investors that have largely stayed on the sidelines so far, we may well see more success with bigger offerings.
Other Offering Limits
The new rules increase the amount that may be raised in two other types of offerings, in addition to Reg CF:
- Reg A Tier 2: The cap is now $75 million, up from $50 million. (The cap for Tier 1 offerings, which are far less useful because they still require state registration, remains at $20 million.)
- Rule 504: Often used for multi-state direct public offerings, the cap has been increased from $5 million to $10 million. (And interestingly, it had been increased from $1 million to $5 million just four years ago.)
Some of the new rules will make it easier for companies to communicate with potential investors, even when conducting or contemplating a private offering that does not allow for general solicitation.
The SEC will now allow companies looking to raise capital to make a presentation at “demo days” following these rules (which will comprise a new Rule 148):
- The sponsor of the demo day must be a state or local government body, school, angel investor group, incubator, or accelerator. (But note that the list of potential sponsors does not include fund sponsors, venture capital associations, or professional organizations.)
- The sponsor doesn’t make investment recommendations, get involved in investment negotiations, charge fees for making introductions, or charge attendees anything more than administrative fees.
- There must be at least two companies presenting at the event.
- Advertising for the event may not reference any specific offering by companies that will be presenting at the event.
- At the event itself, the presenting companies can provide only certain basic information about their particular securities offerings.
Significantly, it is not necessary that attendees of an in-person demo day either be accredited or have any pre-existing relationship with either the sponsor or with any of the companies making a presentation; there is no limit on how many may attend in person. However, if the demo day event allows for online participation, it must be limited to online participants who are either:
- members of the sponsoring organization;
- individuals that the sponsor believes to be accredited investors; or
- individuals who were invited to the event because of their experience, as described in any advertising for the event.
Our Take: While demo day and pitch events have become quite common in recent years, we have generally advised our clients to be careful, because many of those events flaunt the securities laws and put the presenting companies at risk. This new rule will give presenting companies confidence that they can make these presentations without worrying about violating securities laws. We expect these demo days to become much more common.
Testing the Waters
One of the challenges many companies face when deciding among different offering strategies is that they have no way of knowing which offering strategy is most likely to succeed, i.e. which target group of investors will most likely invest. And while the rules for Reg A Tier 2 offerings expressly allowed for “testing the waters,” or soliciting interest in an offering, before doing all the legal and other work that Reg A requires, other exemption strategies did not have that option.
The new rules will change all that and will allow a company that has not yet decided on a particular offering strategy to do a generic solicitation of interest – either publicly or privately – from potential investors to help it decide. Here are some guidelines under this new Rule 241:
- The company must keep copies of the testing-the-waters materials; and if they end up doing a Reg A or Reg CF offering they must file those materials with the SEC.
- No money can be solicited or accepted while testing the waters.
- Specific disclosures must be included in the testing-the-waters materials (for example, a statement that indications of interest are non-binding).
This is a limited exemption that only applies to the testing-the-waters. A subsequent offering must still comply with all of the requirements for the chosen strategy. This means that if a company does a public testing-the-waters (i.e. with general solicitation or advertising) and then choses to do a private offering, the company will need to follow the new integration rules described above and ensure that the private offering does not involve general solicitation.
Our Take: This is a big step forward for companies that are weighing different offering strategies. However, the new rules on testing-the-waters expressly do not preempt state laws. This means that – for now at least – state laws may still prohibit testing-the-waters, even if allowed under federal laws. This will require careful analysis of the interplay of state and federal laws.
Rule 506(c) Accredited Investor Verification
Rule 506(c), which arose out of the JOBS Act of 2012, is a variation on the private offering exemption. It allows for general solicitation and advertising; but in exchange, it requires that every investor in the offering be an accredited investors, and it further requires that the company take steps to independently verify the accredited status of every investor.
But what happens if the same investor in a Rule 506(c) offering invests twice, or more often? Does the company need to go through the investor verification process every time the same investor invests? We now have an answer to that question. Under the new rules, once the company does its verification of an investor’s accredited status, it may rely on that verification for up to five years, as long as the company is not aware of any facts suggesting the investor is no longer accredited.
Our Take: Several of our clients have been in this situation, since it is not uncommon for an investor to make multiple investments in the same company, and this additional clarity will be helpful. It will both reduce compliance costs and increase confidence for companies using the Rule 506(c) strategy.
We welcome these changes in the federal securities rules, which will not only lower some of the barriers to using the existing exemptions, but also make some of those exemptions more useful and, hence, more likely to be used.
There are a number of other changes in the new Rules that are probably of less importance to our clients, such as financial disclosure requirements for Rule 506(b) offerings with non-accredited investors; and restrictions on the use of Reg A by companies delinquent in their reporting obligations. Note, too, that the new rules described here will be effective sixty days after they have been published in the Federal Register (which probably means some date in January 2021).
Naturally, this summary of the new rules is offered for informational purposes only and should not be taken as legal or investment advice. For more information about Cutting Edge Counsel (including our capital-raising practice group known as Cutting Edge Capital), visit www.cuttingedgecapital.com or email us at email@example.com.