While you were Quarantining – the Private Offering Regulatory Framework Gets a Makeover – What’s New and What you Need to Know.

Rosenberg Martin Greenberg LLP
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On March 15, 2021, at long last, the Securities and Exchange Commission (“SEC”)’s proposed amendments to the private offering rules (a process which began in June 2019 via a concept release) are anticipated to go into effect.[1] Their goal? To (i) harmonize, simplify, and improve the existing framework; (ii) promote capital formation; (iii) expand investment opportunities for entrepreneurs and emerging businesses; and (iv) promote growth for companies of all sizes.[2] The revised framework also endeavors to expand the pool of potential investors eligible to participate in private offerings while also preserving and improving investor protections.[3] In addition, effective December 8, 2020, new categories of qualifying natural persons and entities were added to the definition of “accredited investor.”[4]

The big question is, will these changes truly expand access to capital for businesses, both struggling and thriving alike, in this ongoing COVID-19 reality? The answer to that question remains to be seen but here’s what you should know going into the Spring of 2021.

Why the Changes?

All securities offerings must be registered with the SEC unless they fall within an offering exemption. It is no secret to those in the business community that raising private capital, even in the best of times, is challenging, expensive, and fraught with landmines. Issuers must determine which exemption or safe harbor is available and applicable to their offering, comply with both federal and state securities laws, and in most circumstances, obtain the guidance and expertise of counsel. The private offering legal framework designed by the SEC has long been criticized as being overly-complex, unnecessarily exclusive, and for many potential issuers, prohibitively expensive. It has been described as a “patchwork” approach to capital formation instead of a comprehensive and cohesive regulatory framework.

What’s Changed?

Some of the most material amendments in the private offering context are as follows:

  1. Integration rules were streamlined to encourage seamless movement between exemptions;
  2. Both the offering and investment limits for Regulation A, Regulation Crowdfunding, and Rule 504 offerings were increased;
  3. Consistent and clear rules were established with respect to certain offering communications from issuers to investors;
  4. Disclosure, eligibility, and bad actor disqualification provisions were harmonized;[5] and
  5. The definition of “accredited investor” was revised to add new categories of qualifying natural persons and entities.[6]

The Details

(i) Controlling for the Risk of Integration

The concept of “integration” seeks to prevent issuers from improperly evading registration with the SEC by artificially dividing a single offering into multiple offerings.[7] While it is legally permissible for an issuer to utilize various private offering exemptions either simultaneously or in close time proximity to each other, this raises the issue of whether the offerings will be considered “integrated” for compliance purposes.[8] The concern from an issuers perspective is that because different exemptions have different requirements, integrating them could result in one or more of the offerings failing to meet all the applicable requirements and conditions of the exemptions (which could result in a rescission of funds by investors). One practical example of when this may come into play would be when an issuer, conducting simultaneous private offerings, relies upon one exemption that prohibits general solicitation and another that permits it. Also, in times of economic uncertainty and downturn, many issuers who may have planned to make a public offering may opt instead to raise private capital.

The revised Securities Act of 1933 (“Securities Act”), Rule 152(a), provides that “offers and sales will not be integrated if, based on the particular facts and circumstances, 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.”[9] The amendments also include four specific safe harbors. The SEC’s goal is to provide issuers with clarity and flexibility to choose between types of offerings which may encourage issuers to raise more capital. The catchall language above makes it clear that if an issuer’s intent in conducting multiple offerings is not to evade the securities laws, the sales will not be integrated.

Particularly helpful to small issuers may be the SEC’s clarifications and guidance with respect to what constitutes “general solicitation” in connection with a private offering. Many small issuers rely on the Regulation D, Rule 506(b) offering exemption (which prohibits general solicitation and limits offerings to an unlimited number of accredited investors and 35 non-accredited investors). In determining whether such offerings prohibiting general solicitation will be integrated with other offerings (i.e., offerings permitting general solicitation), an issuer must have a reasonable belief based on the facts and circumstances that the issuer either (i) did not solicit a purchaser through general solicitation or (ii) had a “substantive relationship” with such purchaser prior to the commencement of the offering. Specific examples of prior existing substantive relationships between an issuer and investors include existing or prior investors, investors in prior deals conducted by the issuer’s management team, or friends and family members of controlling persons of the issuer.[10]

Notably, one of the safe harbors adopted by the SEC provides that an offering will not be integrated if more than thirty (30) calendar days have elapsed between the termination or completion of one offering and the commencement of another.[11] This is a significant decrease from the existing six (6) month safe harbor.[12] However, for the safe harbor to apply with respect to offerings prohibiting general solicitation, the safe harbor requires (i) that the purchasers were not solicited through the use of general solicitation or (ii) that the issuer established a substantive relationship with the purchasers prior to the commencement of the offering. In addition, with respect to multiple offerings under Rule 506(b), the safe harbor would not permit the number of non-accredited investors in any ninety (90) day calendar period to exceed 35 in the aggregate.[13]

It is the SEC’s position that the 30-day safe harbor, particularly in light of technological advances since the adoption of Regulation D by the SEC in 1982, will enhance an issuers flexibility and expand the capital raising options available to issuers under the Securities Act in order to “access capital when needed, while still providing a sufficient length of time to impede what integration seeks to prevent.”[14]

(ii) “Demo Day” Exemption

“Demo Days” generally refer to events sponsored by startup accelerators, incubators, or universities featuring startup companies that often simultaneously seek to promote an issuer generally and raise capital. The issue with demo days is that depending on how they are conducted, and the manner of information presented at such events, can trigger the general ban on solicitation under Rule 506(b) offerings. Under the amendments, an issuer will not be deemed to have engaged in general solicitation by attending one of these events so long as the event is sponsored by a college, university, or other institution of higher education, a State or local government (or instrumentality thereof), a nonprofit organization, or an angel investor group (with defined processes and procedures for the making of investment decisions), incubator, or accelerator.[15]

Under the proposed rule, sponsors will not be permitted to: (i) make investment representations or provide investment advice to attendees; (ii) engage in any investment negotiations between the issuer and investor attendees; (iii) charge attendees for the event (other than reasonable administrative fees); (iv) receive any compensation for making introductions between issuers and attendees at the event; or (v) receive any compensation from the event that would require it to register as a broker or dealer under the Exchange Act or an investment adviser under the Advisers Act.[16] In addition, any advertising for the event may not reference any specific offering of securities by the issuer.[17]

The SEC did express concerns about the reach of virtual demo day events and the provision of broad offering-related communications to non-accredited investors.[18] Accordingly, with respect to demo days that are conducted in a virtual format, the scope of the proposed exemption is narrowed so that online participation is limited to: (i) individuals who are members of or otherwise associated with the sponsor organization; (ii) individuals that the sponsor reasonably believes are accredited investors; or (iii) individuals who have been invited to the event by the sponsor based on industry or investment-related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event.[19]

In addition to restrictions and limitations on sponsors, issuers are similarly constrained under the rule and may only convey the following information at demo day events: (i) notification that the issuer is in the process of offering or planning to offer securities; (ii) the type and amount of securities being offered; (iii) the intended use of the proceeds of the offering; and (iv) the unsubscribed amount in the offering.[20] Rule 148 is thus intended to allow issuers to discuss their business plans with potential investors at demo day events and note that they are seeking capital without the uncertainty of jeopardizing their ability to rely upon certain private offering exemptions.

(iii) “Testing-the-Waters” Communications in Exempt Offerings

For many issuers it is helpful to gauge the interest in a securities offering prior to undertaking the time and expense of conducting the offering itself. Proposed Rule 241 permits issuers to use generic solicitation of interest materials for an offer of securities prior to making a determination as to the exemption under which the offering may be conducted.[21] Any such “testing-the-waters” must provide specific disclosures notifying potential investors about the limitations of the generic solicitation of interest.[22] It is important to note that such communications would be deemed to be “offers of securities” for purposes of the antifraud provisions of the Federal securities laws.[23]

In accordance with the new integration rules, an issuer will not be able to follow a generic solicitation of interest that constitutes a general solicitation with an offering pursuant to an exemption that does not permit general solicitation (such as Rule 506(b)), unless the issuer has a reasonable belief, based on the fact and circumstances, with respect to each purchaser in the exempt offering prohibiting general solicitation, that the issuer 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.[24]

Rule 241 requires that generic testing-the-waters materials include the following specific disclosures:

  1. The issuer is considering an exempt offering of securities but has not yet determined the specific exemption upon which the issuer intends to rely;
  2. No money or other consideration is being solicited, and if sent in response, will not be accepted by the issuer;
  3. No offer to buy the securities can be accepted and no part of the purchase price can be received until the issuer determines the exemption under which the offering is intended to be conducted, and, where applicable, the filing, disclosure, or qualification requirements of such exemption are met; and
  4. A person’s indication of interest involves no obligation or commitment of any kind.[25]

In connection with the above, the SEC amended Rule 502(b) to require issuers, where they sell securities in an exempt offering thereunder within thirty (30) days of making a generic solicitation of interest under Rule 241 must provide purchasers with any written generic solicitation of interest materials, regardless of whether such materials constitute a “general solicitation” subject to the integration rules in a Rule 506(b) offering. Regulation CF was similarly amended to require the distribution of generic solicitation of interest materials under Rule 241 to investors thereunder if an offering is commenced within thirty (30) days of making the solicitation. In addition, such materials must be included as an exhibit to the offering materials. In the Regulation CF context, Rule 206 provides that issuers may (i) only test the waters prior to filing a Form C and (ii) must include legends and file the solicitation materials with the Form C. Rule 204 was also amended to allow for oral communications after the filing of a Form C so long as the communications otherwise comply with Rule 204.

(iv) Rule 506(c) Verification Requirements

Rule 506(c) exempt offerings permit issuers to generally solicit and advertise an offering to accredited investors only. In contrast, Rule 506(b) does not allow for general solicitation. However, Rule 506(c) does require issuers to take reasonable steps to verify that participants in the offering are in fact accredited investors. The SEC framework currently provides a principles-based method for verification (i.e., an objective determination by the issuer as to whether the steps taken are reasonable in light of the particular facts and circumstances of the purchaser and the transaction itself) as well as a non-exhaustive list of verification methods that issuers may, but are not required to use in verifying the accredited investor status of natural person purchasers.[26]

In order to reduce the cost and burden associated with such verification, under the amendments, issuers are now permitted to establish that an investor that the issuer previously took steps to verify remains an accredited investor as of the time of a subsequent sale if the investor provides: (i) a written representation that the investor continues to qualify as an accredited investor; (ii) the issuer is not aware of information to the contrary; and (iii) the prior verification was conducted within the last five (5) years.[27]

In order to maintain issuer flexibility but also provide reassurance that reasonable verification methods will not be second-guessed by regulators, the SEC reaffirmed that the following factors should be considered when using the principles-based method of verification: (i) the nature of the purchaser and the type of accredited investor such purchaser claims to be; (ii) the amount and type of information the issuer has about the purchaser; and (iii) the nature of the offering itself, such as the manner in which the purchaser was solicited to participate in the offering and the terms of the offering (such as the minimum offering amount).[28] The SEC further acknowledged that the reasonable steps determination may be substantially similar from an issuer’s development of a “reasonable belief” of an investor’s status for Rule 506(b) purposes. The SEC continued to caution issuers that a simple “check the box” approach to verification of accredited investor status in a questionnaire, absent other information about the purchaser indicating accredited investor status will not constitute “reasonable steps.”[29]

(v) Harmonization of Disclosure Requirements

Rule 502(b) governs the information issuers are required to furnish to non-accredited investors participating in a Rule 506(b) offering. The SEC amendments align the disclosure requirements under Rule 502(b) with those under a Regulation A offering.[30] Specifically, the requirement that issuers provided audited financial statements in Rule 506(b) offerings under $20 million was removed. By aligning the non-accredited investor requirements under Rule 506(b) with Regulation A, the SEC believes that it will expand investment opportunities for those investors and address the concern of issuers that the current financial statement requirements of Rule 502(b) were overly burdensome.[31]

(vi) Regulation Crowdfunding

Regulation Crowdfunding offerings include limits on the amount of securities that may be offered and purchased in an applicable period. Specifically, the exemption (i) limits offerings in any 12-month period to an aggregate of $1.07 million and (ii) limits how much an individual can invest during the 12-month period depending on his or her net worth and annual income, and may not exceed $107,000 in such period.[32] In addition, the offering statement must include specified information that outlines the issuer’s financial condition and financial statements.[33] Now, in order to encourage issuers to use the Regulation Crowdfunding exemption, the rules have been amended to (i) raise the offering limit from $1.07 million to $5 million in any 12-month period; (ii) remove and/or increase the investment limits by no longer applying such limits to accredited investors and allowing investors to rely on the greater of their income or net worth; and (iii) the extension of temporary final rules adopted in May 2020, which include, among other things, an exemption from certain financial statement review requirements for issuers offering $250,000 or less of securities within a 12-month period.[34] The final rules will apply to offerings initiated under Regulation Crowdfunding between May 4, 2020 and August 28, 2022.[35] The rules are tailored to allow conditional relief for certain requirements relating to the timing of the offering and the availability of financial statements required as part of the offering materials while also balanced against the need to retain appropriate investor protections.[36]

The SEC also added 17 CFR 227.504 to Regulation Crowdfunding to provide that, for purposes of Section 18(b)(3) of the Securities Act, a “qualified purchaser” includes any person whom securities are offered or sold pursuant to an offering under Regulation Crowdfunding. The purpose of this change is to provide certainty that State securities law registration and qualification do not apply to securities offered and sold under Regulation Crowdfunding, as amended.[37] However, these rules do not prevent states from requiring notice filings under certain scenarios. Maryland happens to be one of these states and issuers should be vigilant when undertaking such offering to confirm (i) whether the particular investment platform hosting their offering will be making such filings on their behalf or (ii) whether they will be required to research and comply with these requirements on their own.

Notably, the SEC declined the requests of some commentators to “harmonize” the types of securities offered under Regulation Crowdfunding offerings with those permitted under Regulation A.[38] Another appeal of Regulation Crowdfunding is the availability of non-traditional securities such as Simple Agreements for Future Equity (“SAFEs”), Simple Agreements for Future Tokens, and certain revenue sharing agreements.[39] While there is an elevated risk of harm to investors who may be confused by the descriptions of such non-traditional securities on investment funding portals, issuers are responsible to ensure that they are clearly describing the terms of the offered securities, particularly with respect to non-traditional securities, such as those highlighted above.[40]

These changes are the SEC’s attempt to encourage and permit larger offerings which, in turn, may incentivize more issuers to utilize the exemption and lower offering costs overall per dollar raised.[41]

(vii) Accredited Investor Definition

Effective December 8, 2020, the SEC adopted amendments to the definition of “accredited investor” in order to add new categories of qualifying natural persons and entities (as well as to make other modifications to the definition).[42] The amendments attempt to rectify the misconception that “wealth” alone is the equivalent of financial sophistication.[43] In addition to the importance of an investor’s financial ability to participate in and access investment opportunities is an investor’s ability to “analyze the risks and rewards, the capacity to allocate investments in such a way as to mitigate or avoid risks of unsustainable loss, or the ability to gain access to information about an issuer or about an investment opportunity” and the ability to bear the risk of a financial loss.[44]

Accredited Investors now include the following categories of natural persons and entities:

i) Natural persons

    1. Individuals with professional certificates and designations and other credentials from an accredited educational institution (based upon consideration of all the facts pertaining to a particular certification, designation or credential);
    2. Knowledgeable employees of private funds, determined on a case-by-case basis (only applicable to non-executives if they actively participate in the investment activities of the fund, any other private fund, or any investment company the investment activities of which are managed by the fund’s affiliated management person); and
    3. Spousal equivalents (i.e., cohabitants occupying a relationship generally equivalent to that of a spouse thus permitting spousal equivalents to pool finances for the purposes of qualifying as an accredited investor).

ii) Entities

      1. Registered Investment Advisers (all SEC and state-registered investment advisers);
      2. Rural Business Investment Companies (defined in Section 384A of the Consolidated Farm and Rural Development Act);
      3. Limited liability companies (a codification of long-standing interpretation);
      4. Other entities meeting investments-owned test (i.e., any entity owning “investments” as that term is defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered); and
      5. Certain family offices and family clients (i.e., “family offices” are entities established by families to manage their assets, plan for their families’ financial future, and provide other services to family members).[45]

By adding these additional categories, the SEC’s goal was to update and improve the definition to identify investors that have sufficient knowledge and expertise to participate in private investment opportunities from which they would otherwise be excluded. In addition, on the issuer’s side, the SEC anticipates that these amendments will render capital raising processes in exempt offerings to be more efficient and facilitate capital formation in general by expanding the potential investor pool.

Takeaway

The SEC’s harmonization efforts could present (i) issuers with greater opportunities to explore multiple simultaneous offering exemptions; (ii) investors with greater opportunities to learn about potential investment opportunities and to participate in a private market that at one time might have been inaccessible; and (iii) an overall decrease in the costs for issuers and investors alike in undergoing the private offering process. It may be years before any seismic shifts are perceptible but at least it’s a move in the right direction; provided, however, that the Biden Administration permits these changes to go into effect. On January 20, 2021, the new administration informally imposed, a regulatory freeze. Its application to the SEC in general, and the amendments specifically, remains unclear.


[1] Securities and Exchange Commission, Final Rule, Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, available at: https://www.sec.gov/rules/final/2020/33-10884.pdf; 17 C.F.R. Parts 227, 229, 230, 239, 240, 249, 270, and 274 (“SEC Final Rule, Effective March 15, 2021”); Press Release, SEC Harmonizes and Improves “Patchwork” Exempt Offering Framework, available at: https://www.sec.gov/news/press-release/2020-273; these amendments are consistent with the SEC’s June 2019 concept release (available at: https://www.sec.gov/rules/concept/2019/33-10649.pdf) and the SEC’s March 2020 release (available at: https://www.sec.gov/rules/proposed/2020/33-10763.pdf).

[2] Id.

[3] Id.

[4] https://www.sec.gov/rules/final/2020/33-10824.pdf.

[5] Press Release, SEC Harmonizes and Improves “Patchwork” Exempt Offering Framework, available at: https://www.sec.gov/news/press-release/2020-273.

[6] This change was effective as of December 8, 2020 (and adopted prior to the other amendments). See SEC Final Rule available at: https://www.sec.gov/rules/final/2020/33-10824.pdf (“SEC Final Rule re Accredited Investors”).

[7] SEC Final Rule, Effective March 15, 2021 (above).

[8] Press Release, SEC Harmonizes and Improves “Patchwork” Exempt Offering Framework, available at: https://www.sec.gov/news/press-release/2020-273.

[9] Id.

[10] SEC Final Rule, Effective March 15, 2021, at pp. 31-32.

[11] What constitutes the “commencement of an offering” and “termination or completion of an offering” are further clarified under Rule 152 as amended. https://www.sec.gov/rules/interim/2020/33-10829.pdf

[12] See Rule 502(a), 17 CFR 230.251(c), 17 CFR 230.147(g).

[13] See proposed Rule 506(b)(2)(i).

[14] SEC Final Rule, Effective March 15, 2021 at p. 41.

[15] SEC Final Rule, Effective March 15, 2021, at p. 77.

[16] Id. at pp. 77-78.

[17] Id.

[18] Id. at pp. 83-84.

[19] Id. at pp. 84-85.

[20] Id.

[21] Id. at pp. 86-87.

[22] Id.

[23] Id. at p. 87.

[24] Id. at pp. 91-92.

[25] Id. at pp. 92-93.

[26] Id. at p.104.

[27] Id. at pp. 107-108.

[28] Id. at p. 109.

[29] Id. pp. 109-110.

[30] Regulation A provides an exemption for certain public securities offerings. Such offerings are outside the scope of this article. To offer securities under Regulation A, an issuer must file an offering statement on Form 1-A with the SEC (including an offering circular for distribution to investors) and must submit the Form 1-A for SEC review and comment (a process by which the offering will achieve “qualification). Regulation A offerings are outside the scope of this article and thus, amendments by the SEC to Regulation A are not included.

[31] SEC Final Rule, Effective March 15, 2021, at pp. 116-117.

[32] Id. at pp. 140-141.

[33] Id.

[34] Our original article outlining the SEC’s enactment of the temporary Regulation Crowdfunding rule amendments is available at: https://www.rosenbergmartin.com/blog/2020/06/08/raising-capital-post-covid-19-what-now/

[35] SEC Final Rule, Effective March 15, 2021, at p. 150.

[36] Id.

[37] Id. at p. 148.

[38] Id. at p. 183.

[39] Id. at pp. 181-182.

[40] Id. at p. 183.

[41] Id. at p. 149.

[42] See SEC Final Rule re Accredited Investors.

[43] Id. at p. 4.

[44] Id. at p. 5.

[45] Id.

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