The U.S. Securities and Exchange Commission published a concept release on June 18, 2019 (Release), seeking public comment “on ways to simplify, harmonize, and improve” the framework for exemptions from registration under the Securities Act of 1933, in order to promote capital formation while protecting investors.¹ Comments are due by September 24, 2019.

According to the Release, Congressional acts² and SEC rules have altered the exempt offering framework over time, causing “gaps and complexities” as well as confusion, and the SEC believes this framework could benefit from a comprehensive review. The Release discusses the exemptions’ legal framework and related “broad topics,” including: the “accredited investor” definition; application of an integration analysis to exempt offerings; ability of pooled investment funds to participate in exempt offerings; and regulation of the secondary trading market in exempt offerings. The Release will be of interest to issuers, investors and market participants, and is divided into self-contained sections that each explain the current laws and rules and then request comments thereon.

The Release indicates that private offerings are significant because the amount “raised in exempt offerings is always larger than the amount raised in registered offerings,” based on SEC staff (Staff) calculations of data collected from 2009-2018 regulatory filings. Given the relative importance of exempt offerings, the Release focuses on the structure of the primary market for exempt offerings, and includes consideration of whether a correct balance has been reached between the ability to raise capital and provide access to investors on the one hand, and investor protection on the other. The Release also notes that secondary markets for private resales are widely available to facilitate the exchange of information and securities at a low cost, and improving liquidity in such markets could enhance investment opportunities for more investors.

Background

The Securities Act requires that every offer and sale of securities must be registered with the SEC unless an exemption from registration is available.³ Registration is intended to facilitate the disclosure of material information to investors. However, when there is no need for such disclosure or only a remote public benefit, Congress has recognized exemptions to the registration requirements and authorizes the SEC to adopt additional exemptions.⁴ Certain classes of securities, as well as types of transactions, are exempted from the Securities Act registration requirements, pursuant to Sections 3 and 4, respectively. However, the exempt offering also must comply with certain requirements, protections and other conditions in accordance with the statutory exemption or SEC rules, including (among other matters): the amount raised in the offering; manner of solicitation and advertising; permitted purchasers and limits on the amounts they may invest; and disclosures to be filed with the SEC or otherwise provided to investors.

Concept Release

The Release provides an overview of the exempt offering framework, and considers whether limiting investors (or the amounts they can invest) provides appropriate protection while allowing access to such exempt offerings. The Release also discusses when exempt offerings should be integrated with each other (or with registered offerings), as well as whether and how issuers can transition between exempt offerings or from an exempt offering to a public offering. Further, the Release considers whether it would be appropriate to “expand issuers’ ability to raise capital through pooled investment funds,” as well as any resulting impact on retail investors. The Release concludes with an overview of secondary trading of securities that were initially issued in exempt offerings, and considers whether revisions to the resale exemptions would improve liquidity in the secondary market.

Current Exempt Offerings Framework

The Release notes that the exempt offerings “were not adopted as part of one cohesive regulatory scheme.” However, a focus on the nature of the investor “extends throughout the current exempt offering framework.” This investor-centric regime creates a scale where sales to accredited investors have the fewest conditions applied to an offering, while “an assortment of disclosure requirements, offering and investment limits, and other conditions meant to mitigate the risk of not having the traditional protections of registration under the Securities Act” apply to offerings where investors do not meet such wealth and sophistication thresholds. While the market for exempt offerings has grown, the Release concludes it is not surprising that non-accredited investors have “limited access to unregistered offerings.”

The Release requests comment on hundreds of questions, including the following:

• Current framework: reducing the number of exemptions (e.g., more limited in number, focus on the investor and offering size) or regulating the sale (and not the offer); and considering any impact of changes on types of issuers (e.g., certain stages of growth, industries, geographic region, minority-led) or the public markets.
• Current exemptions: introducing exemptions conditioned on “the involvement of a registered intermediary” (e.g., broker-dealer, registered funding portal) or “particular characteristics of the issuer or lead investor(s)” (e.g., holding same amount of same type of security as non-accredited investors).
• Investor eligibility and protection: increasing accessibility to non-accredited investors (e.g., expanding definition of accredited investor, new exemption for non-accredited investor participation) and scaling investor protections appropriately; assessing whether current investor limitations should be measured by alternative measures (e.g., percentage of income or portfolio) or periodically adjusted for inflation; and allowing non-accredited investors to participate in all types (or some sub-set) of exempt offerings, subject to certain conditions (e.g., size of offering, amount of investment, required disclosure) and scaling conditions (e.g., to investor or to offering).
• Required disclosure: revising rules to allow for more prompt communication to investors; and simplifying compliance through harmonizing required disclosures across the exemptions.
• Role of Congress and SEC in promulgating changes: considering if the SEC should “move one or more current exemptions into a single regulation”; assessing whether legislative change is “necessary or beneficial” to enact such changes; and assessing the metrics that measure the impact of such exemptions.

Accredited Investor Definition

The “accredited investor” standard is currently used as a proxy for financial sophistication across a number of federal and state securities laws. Private issuers (including private funds) are generally permitted to sell their unregistered securities to an unlimited number of accredited investors, on the basis that accredited investors can fend for themselves, and thus do not require the protections of certain securities laws. According to the Release, the SEC estimates that 13% of all U.S. households currently meet the accredited investor definition.⁵

The Release indicates that, in response to a December 2015 Staff report that examined the accredited investor definition, “commenters were overwhelmingly supportive of the creation of additional methods of accreditation other than financial criteria,” but differed regarding Staff suggestions as to possible revisions to the definition.⁶ In light of this Staff report and subsequent government reports on the topic, the Release is seeking further comment to potentially revise and/or expand the definition with the peripheral goal of not disproportionately complicating its application.

Specifically, the Release is seeking comment as to whether the accredited investor definition should be revised in one or more of the following ways (if at all): adjusting the current net worth thresholds (including for inflation) and/or adding a sliding scale for participation in exempt offerings for non-accredited investors (rather than the current all-or-nothing construct); introducing new financial thresholds based on the amount of investments (as opposed to, or in addition to, income and net worth tests); permitting qualification based on certain professional credentials, relevant experience in exempt offerings or passing an “accredited investor exam”; permitting knowledgeable employees of private funds to qualify as accredited investors for such funds; allowing non-accredited investors to invest in certain exempt offerings if advised by financial professionals; and changing the qualifications based on analogous rules and requirements from foreign jurisdictions.

The Release also seeks comment on the broader implications of a revised definition, including its impact on the application and enforcement of any new accredited investor criteria, as well as its impact on other regulatory regimes (e.g., ERISA, Securities Exchange Act of 1934).

Private Placement Exemption and Rule 506 of Regulation D

Section 4(a)(2) of the Securities Act exempts transactions by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act. Many U.S. private placements rely on Rule 506(b) (and to a lesser extent, Rule 506(c)) of Regulation D as a non-exclusive safe harbor from registration.⁷ According to the Release, in 2018, Rule 506(b) offerings were responsible for $1.5 trillion of raised capital and 94% of such offerings were made exclusively to accredited investors. The Release states that the “information requirement is the principal difference between a Rule 506(b) offering that includes non-accredited investors and one that is limited to accredited investors.” The Release recognizes that the increased reporting obligations for offerings to non-accredited investors (which are similar to the reporting requirements for a public offering) are a major contributing factor to the dearth of such offerings Similarly, the Release discusses the relative infrequency of Rule 506(c) offerings, citing as contributing factors the additional accredited investor verification requirements and/or inability to fall back on Section 4(a)(2) upon an inadvertent failure to meet the safe harbor.

Specifically, the Release is seeking comment on whether the requirements for Rule 506(b) and 506(c) should be revised in one or more of the following ways (if at all):

• Current framework: combining the Rule 506(b) and 506(c) safe harbors, and identifying any ripple effects of such combination on other laws, rules and regulations.
• Current exemptions: increasing the likelihood that issuers will conduct a 506(c) offering, by: clarifying the definition of “general solicitation” and/or amending the accredited investor verification requirements, including to take into account any potential changes to the accredited investor definition that could complicate the verification process; and amending the current deadline for filing Form D after an offering under Regulation D.
• Investor eligibility and protections: adjusting the extent to which non-accredited investors are permitted to invest in such offerings, including participation in a 506(c) offering on the same terms applicable to certain sophisticated, institutional accredited investors.

Other Exemptions and Potential Gaps in the Current Exempt Offering Framework

The Release also is seeking comment on changes to less-common registration exemptions, including: Regulation A; Rule 504 of Regulation D; Section 3(a)(11) of the Securities Act (Intrastate Offering Exemption); and Section 4(a)(6) of the Securities Act (Regulation Crowdfunding). As an exempt offering may be impractical (e.g., due to expense) for small companies and those seeking to raise small amounts of capital, the Release requests comment on adding a “micro-offering” or “micro-loan” exemption, as well as related requirements, conditions and investor protections.

Integration

As all offerings are required to be registered or exempt from registration, the integration doctrine provides a framework for determining whether separate offerings that individually would be exempt from registration “should be considered part of the same offering,” thus triggering registration requirements under Section 5 of the Securities Act. Integration analysis is dependent upon the facts and circumstances of each offering,⁸ and as such analysis is determined by the issuer and can become complex, the SEC has created certain safe harbors.

The safe harbors provide objective standards (e.g., time period) where no additional analysis is necessary, so long as the exempt offerings meet applicable requirements and the transactions fall within the respective safe harbors.⁹ Some safe harbors are specific to the types of transaction,¹⁰ and some are non-exclusive, in that the transaction is assessed independently and does not affect the availability of any other exemption.¹¹

The Release requests comment on the following:

• Current framework: replacing the current framework with a single integration doctrine that would apply to all exempt offerings; replacing the five-factor test with an analysis of whether each offering complied with the requirements of its exemption (e.g., Regulations A, 147 and 147A); excepting additional types of transactions from integration (e.g., Regulation S, Rules 144A and 701); and defining “a private offering as an exempt offering that does not involve any form of general solicitation or advertising.”
• Current exemptions: specifying a safe harbor for offers and sales that occurred prior to an offering with a general solicitation or advertisement, addressing any subsequent registered public offering; and amending certain rules to assist firms in adapting to changing conditions and markets (e.g., shortening the six-month window in a Rule 502(a) offering, expanding Rule 155(c) to address an abandoned offering with a general solicitation followed by a private offering) .
• Additional actions or guidance: adding other integration safe harbors; addressing other potentially concurrent offerings; or reducing confusion through elimination of existing safe harbors, in each instance indicating the effect of such measures on capital formation and investors .

Pooled Investment Funds

The Release focuses on the potential for pooled investment funds (including registered investment companies, BDCs and private funds) as a source of capital for growth-stage issuers, as well as considering retail investors’ level of access to such vehicles.¹² The discussion in the Release illustrates that, while there are many vehicles that can invest in growth-stage issuers (typically through private offerings), these vehicles generally are not structured to permit significant investments in growth-stage issuers and/or to provide investment opportunities for retail investors.

In addition, according to the Release, although closed-end funds are not subject to the same liquidity restrictions as open-end funds, and closed-end funds are accessible to non-accredited investors, such funds make up only a small portion of registered investment companies and are not readily used to invest in growth-stage companies. Further, the Release acknowledges that the ability of a closed-end fund to make significant investments in private funds has “historically raised staff concerns under the Investment Company Act, insofar as these investors could not invest directly in private funds.”¹³

For retail investors who are accredited investors but not qualified purchasers or qualified clients, access to private funds that invest in growth-stage companies generally is limited to those private funds offered pursuant to Section 3(c)(1) of the 1940 Act (limited to 100 beneficial owners, or, if a qualifying venture capital fund, limited to 250 beneficial owners). Further, and unlike certain vehicles, private funds do not, without meeting other thresholds, qualify as accredited investors under Rule 501(a) of Regulation D. Thus, not all private funds will qualify as accredited investors, and some will not qualify unless all their owners are accredited investors, precluding such vehicles from being suitable for retail investors and/or participating in growth-stage company offerings.¹⁴

In light of these practical investing limitations for retail investors and pooled investment vehicles, the Release requests comment on the following:

• Current framework: altering the ability of pooled investment vehicles to invest in growth-stage companies by encouraging investment products in such companies; permitting additional pooled investment funds (e.g., private funds) to qualify as accredited investors; allowing additional investment in private funds by certain vehicles (e.g., closed-end funds); or allowing payment of performance-based fees in order to provide access to venture-backed strategies.
• Interval funds: modifying the characteristics and structure of interval funds to encourage investment in growth-stage issuers (e.g., varying repurchase periods or mechanism for altering the interval or repurchase amounts, allowing multiple share classes, adopting a trust and series structure, altering diversification requirements, relaxing rules related to affiliated transactions); and following such changes, considering whether the SEC could facilitate the secondary market for such funds or limit their purchase to sophisticated investor .
• Investor eligibility and protections: introducing periodic reassessments of the sophistication thresholds to the “qualified purchaser” definition; simplifying all thresholds (e.g., accredited investor, qualified client, qualified purchaser) through simultaneous reassessment of such thresholds; balancing the ability of a closed-end fund to invest in a private fund with investor protections (e.g., maximum exposure in private funds, minimum number of private fund holdings).
• Additional actions and guidance: promoting liquidity in the secondary market for certain vehicles (e.g., closed-end funds, BDCs) to assist with capital formation.

Secondary Trading of Certain Securities

The Release explains that the ability of an investor who participated in a primary offering to resell their investment could attract more initial investors to the primary offering and facilitate exit opportunities that allow reinvestment and reallocation by that investor. The Release states that an issuer can benefit from additional interest in the primary offering, and such additional interest could potentially avoid or reduce an illiquidity discount; however, the Release also recognizes that a more liquid secondary market could lead to increased turnover in an issuer’s shareholder base and more shareholders (which could trip registration requirements under Section 12(g) of the Exchange Act).

As explained in the Release, in the secondary market, the investor must either register (or have the issuer register) the transaction or have an exemption from such registration, and then may face resale restrictions (e.g., restricted securities). In considering the current resale exemptions, certain factors differentiate them, including: who can use the exemption; conditions on use of the exemption (e.g., eligible buyers, information requirements, intermediary use); and whether the security remains “restricted” following the transaction. The Release also notes that all participants, the investor and intermediary, must have an exemption from registration to engage in or facilitate such transaction. Further, all of these exemptions, especially Rule 144, are subject to conditions.

While federal securities laws preempt state securities law registration and qualification requirements for secondary offers or sales in certain instances, for other resale transactions the seller must comply with state law. As explained in the Release, states have adopted model exemption(s) under either NSMIA or its predecessor, the Uniform Securities Act of 1956, but states do not have uniform standards. The Release discusses several more common state exemptions applicable to secondary transactions. However, the Release notes“[s]tate exemptions vary substantively” and states can and do apply additional conditions on exemptions, creating confusion and additional costs for resellers.

Certain questions related to resale include whether the primary and secondary sales are part of the same distribution, as well as the impact of secondary sales on an exemption relied upon to conduct the primary sales. Additionally, the Release requests comment as to whether:

• Additional resale exemptions should be provided or existing resale restrictions should be revised.
• Altering the number of permissible record holders before an issuer becomes a reporting company under Section 12(g) of the Exchange Act would promote liquidity.
• With respect to Rule 144, the holding periods should be shortened, or additional exemptions should be provided under Section 4(a)(1) for sellers that cannot comply with Rule 144.
• Rules should be adopted to foster the development of venture exchanges as a means of improving secondary trading .

Footnotes

1) Concept Release on Harmonization of Securities Offering Exemptions, SEC Concept Rel. Nos. 33-10649, 34-86129, IA-5256, IC-33512, 84 Fed. Reg. 30460 (June 26, 2019).

2) Examples provided in the Release include: the Jumpstart Our Business Startups Act of 2012 (JOBS Act, which directed revisions to Rule 506 to eliminate the prohibitions against general solicitation and general advertising to accredited investors, added Section 4(a)(6) and Section 4A to the Securities Act and required the SEC to issue the crowdfunding rules); the Fixing America’s Surface Transportation Act of 2015 (FAST Act, which added Section 4(a)(7) to the Securities Act related to private resales of securities); and the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (Economic Growth Act, which instructed the SEC to amend Regulation A to permit its use by issuers reporting under Section 13 or 15(d) of the Exchange Act).

3) The Release notes the distinction between an illegal offering (which fails to comply with the registration requirements of Section 5 of the Securities Act) and a fraudulent exempt offering (which violates the antifraud provisions of the federal securities law). The Release states that there is a lack of data to measure the frequency and impact of fraud in the marketplace.

4) The SEC can exempt “other persons, securities, or transactions to the extent ‘necessary or appropriate in the public interest [and] consistent with the protection of investors’” pursuant to Section 28 of the Securities Act, which was added by the National Securities Markets Improvement Act of 1996 (NSMIA). NSMIA also “preempted the state registration and review of transactions involving ‘covered securities’” and established a class of covered securities (including those offered or sold to “qualified purchasers”) by amending Section 18 of the Securities Act.

5) Release at Table 3: Households qualifying under existing accredited investor criteria (this statistic does not account for institutional accredited investors).

6) See Report on the Review of the Definition of “Accredited Investor” (Dec. 18, 2015) and related comments.

7) Rule 506(b) permits an unlimited number of accredited investors to invest, and securities may be sold to 35 non-accredited investors that are sophisticated, as long as: there is no general solicitation or advertising; and additional disclosure is provided to the non-accredited investors. Rule 506(c) permits a general solicitation and advertising, if: all purchasers are accredited investors; the issuer takes reasonable steps to verify the status of such purchasers; and certain other conditions are met. All offerings made pursuant to Rule 506: are subject to “bad actor” disqualifications; result in restricted securities that have resale limitations; and potentially require state filings by issuers.

8) For example, more recent guidance has clarified a framework to consider whether an issuer can conduct simultaneous registered and private offerings (i.e., availability of Section 4(a)(2) exemption). This guidance analyzes whether the private offer or sale was conducted through a general solicitation by means of a registration statement.

9) For example, Rule 502(a) of Regulation D provides an exemption so long as all offers and sales do not take place within either six months prior to the start, or the termination, of a Regulation D offering. Rule 152 provides that once a Section 4(a)(2) private placement has been completed, a public offering or filing of a registration statement can begin (even if the filing was contemplated while the private placement was ongoing), so long as the applicable requirements for the private placement and the public offering are met. Also, Rule 152 would need to be amended to address the questions raised by Rule 506(c) (which allows a general solicitation), if a private offering were to be followed by a registered offering.

10) For example, a non-U.S. transaction under Regulation S will not be integrated with a concurrent U.S. offering (public or private) that complies with Securities Act Rule 901. Similarly, Rule 144A provides a non-exclusive safe harbor that ensures each Rule 144A transaction is assessed independently, is not affected by other offers or sales by the issuer (or subsequent holders) and does not affect the availability of any other exemption.

11) For example, Rule 155 provides a non-exclusive safe harbor when an issuer abandons one type of offering (e.g., public) and commences another type of offering (e.g., private). Rule 144A similarly provides a non-exclusive safe harbor.

12) Registered investment companies (such as open-end funds), BDCs and SBICs are all deemed to be accredited investors without meeting minimum asset or other qualifications. But open-end funds such as ETFs have liquidity restrictions as well as valuation and daily redemption requirements, leaving only a small portion of the portfolio for less-liquid investments.

13) See Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge Funds (Sept. 2003), at pp. 80-83 (discussing concerns about the “retailization” of private funds).

14) For example, a private fund may not qualify as an accredited investor if it is a small private fund (e.g., $5 million in assets or less), unless each equity owner of the fund is an accredited investor, or if it is a private fund with “knowledgeable employee” investors or general partners that do not otherwise qualify as accredited investors.