Changes to Disclosure Requirements for Rule 506(b) and Regulation A Offerings

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In music, tempo (the Italian word for “time”) is the speed at which music is played. Traditionally, tempo is described using Italian words, such as Largo (very slow), Adagio (slow), Andante (walking speed), Allegro (fast), and Presto (very fast). Modern composers might write similar terms in English.

Tempo also sometimes is described in beats per minute (bpm). Many consider a tempo of 60 bpm (one beat per second) usually being Adagio, 120 bpm (two beats per second) being Allegro, and 180 bpm (three beats per second) being Presto.

However, it’s difficult to maintain a steady tempo. There’s a natural tendency for musicians to slow down on difficult passages and speed up easier ones. Musicians, therefore, practice with a device called a metronome, which can be set to make clicks or beeps to match the tempo bpm. After learning a composition with a metronome, the musician usually finds it easier to keep a steady tempo.

Sometimes, pieces abruptly change tempo. Although tempo changes contribute to the music, they can be challenging for a musician using a metronome to practice because the musician has to stop and change the metronome marking.

Until now, disclosure requirements for exempt securities offerings sometimes felt as disruptive as repeated metronome changes. A small business or real estate issuer might have to develop different disclosures for their Rule 506(b) and Regulation A offerings, even if both were sold to the same investor.

On March 15, 2021, new SEC rules take effect, changing disclosure requirements to provide more consistency among different types of exempt offerings. This article focuses on changes to disclosure requirements Rule 506(b) offerings that accept unaccredited investors and Regulation A offerings. These changes streamline disclosure and make it easier for small businesses and real estate sponsors to raise funds.

Non-Accredited Investors in Rule 506(b) Offerings

In 1982, the SEC adopted Regulation D (Reg D). Rule 506(b) of Reg D establishes a safe harbor for issuers that desire to rely upon the private placement exemption in Rule 506(b). Issuers may not engage in general solicitation or general advertising to market Rule 506(b) offerings. And Rule 506(b) limits sales of securities to an unlimited number of accredited investors but no more than 35 non-accredited investors.

If the offering is sold to any non-accredited investors, there are additional requirements. Every non-accredited investor, “either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”

The issuer must give all investors accurate disclosure of material information. However, there are no specific disclosure requirements for offerings sold only to accredited investors. On the other hand, if an offering is sold to any non-accredited investors, Rule 502(b) until now has required disclosure similar to that which would be required for a public offering.

For non-reporting issuers that are not foreign private issuers, disclosure to non-accredited investors has had to include:

“(1) Offerings up to $2,000,000. The information required in Article 8 of Regulation S-X. . ., except that only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.

(2) Offerings up to $7,500,000. The financial statement information required in Form S-1 . . . for smaller reporting companies. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.

(3) Offerings over $7,500,000. The financial statement as would be required in a registration statement filed under the [Securities Act of 1033] on the form that the issuer would be entitled to use. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.

This enhanced disclosure can be costly for a small business issuer. Small businesses needing equity may find that they can’t accept investments from friends and family even though they are aware of the risk of investing in the business. And real estate funds raising equity for new acquisitions may not have access to the financial information required to sell interests to non-accredited investors.

As a result, Rule 506(b) may not work for the issuers who need them most. Those issuers frequently limit their Rule 506(b) offerings to accredited investors (no matter how sophisticated they might be), so enhanced disclosure won’t be required.

Regulation A Offering Requirements

Regulation A is another exemption small businesses use to raise funds. Regulation A is more popular with small businesses than with real estate funds. However, like sales to non-accredited investors under Rule 506(b), Regulation A requires significant financial disclosure.

The financial disclosure required by Regulation A differs from that required by Rule 502(b). Rather than incorporating requirements from Regulation S-X, Form S-1, or other registration statements, like Rule 502(b), Regulation A has tiered disclosure requirements.

For Tier 1 (up to $20 million) offerings, those requirements are in Form 1-A. Regulation A has no limit on the number of non-accredited investors. However, Regulation A limits the amount non-accredited investors may invest in Tier 2 (up to $50 million) offerings.

A Tier 1 Regulation A offering requires only consolidated balance sheets for the previous two fiscal years and consolidated statements of comprehensive income, cash flows, and stockholders’ equity for the issuer. Tier 1 financial statements need not be audited. Financial information for guarantors and affiliates is sometimes also required.

Like Rule 502(b) requirements for offerings over $7.5 million, Tier 2 offering disclosure requirements follow those in Article 8 of Regulation S-X.

How the New Rule Changes Rule 502(b) Disclosure Requirements

The new rule changes Rule 502(b) disclosure requirements to match Regulation A’s disclosure requirements. Therefore, Rule 506(b) offerings sold to non-accredited investors will need only disclose unaudited financial statements, as long as the offering amount is no more than $20 mil. Rule 506(b) offerings over $20 million will need only to make the disclosures in Article 8 of Regulation S-X instead of the disclosures required in a registration statement.

These new disclosure requirements apply only to Rule 506(b) offerings sold to non-accredited investors. Rule 506(b) offerings limited accredited investors will continue to have no specific disclosure requirements, as long as the issuer accurately disclosures all material information.

The new rules don’t affect other Rule 506(b) requirements for non-accredited investors. Therefore, non-accredited investors still will need to meet sophistication requirements.

Will Rule 506(b) and Regulation A Offerings Become More Popular?

The new rule likely will increase the number of Rule 506(b) offerings available to non-accredited investors. In particular, real estate funds usually can provide unaudited financial information, so sophisticated, non-accredited investors may gain access to those investments. So, it’s likely that the new rule will allow smaller real estate funds (under $20 million) to

Until now, Regulation A offered issuers access to non-accredited investors without the burdensome disclosures required for Rule 506(b) offerings. Plus, unlike 506(b) offerings, the issuer could advertise for investors in Regulation A offerings.

However, Regulation A offerings were unattractive because they require an initial qualification with the SEC. And Tier 1 offerings additionally require qualification under state securities laws. The time necessary to complete those qualifications has made Regulation A unattractive for many real estate sponsors. The new rule also simplifies Regulation A compliance. Those changes are beyond the scope of this article.

Although the SEC harmonized the disclosure requirements under Regulation A and Rule 506(b), Rule 506(b) offerings still may be sold to only 35 non-accredited investors. Regulation A does not contain the same limitation.

Still, it took many years before musicians arrived at the modern Western notation system. And it likely will require additional rule modifications before there is a uniform regulatory scheme.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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