Friday, June 19, 2015

New Regulation A: Will It Get an A+ From the StartUp Community?

On March 25, 2015, the Securities and Exchange Commission (the “SEC”) announced that it was adopting final rules amending and updating Regulation A.  These new rules, which become effective on June 19, 2015, have been informally dubbed “Regulation A+.” (Please note that all references to Regulation A going forward refer to the new rules unless otherwise specified.) These Regulation A amendments implement Section 401 of the JOBS Act, which added Section 3(b)(2) to the Securities Act of 1933 directing the SEC to adopt rules exempting from the registration requirements offerings of up to $50 million. By far the biggest change is in the amount that a company may raise under the new rules (up to $50 million in any 12-month period) versus $5 million under the original rules. The new Regulation A+ breaks offerings into two tiers depending on the offering’s size, and imposes different disclosure, reporting, and investor qualification requirements for each tier. This blog discusses the changes made to Regulation A, as well as the different requirements under Tier 1 and Tier 2 offerings, in an attempt to figure out how useful will this new Regulation A+ be for startups raising capital.

Regulation A+: What’s Changed?

As mentioned above, the most important change in the new Regulation A+ is the maximum offering amount ($50 million over any 12-month period). The new rules break Reg. A+ offerings into two tiers. Under Tier 1, a company (the “issuer”) may raise up to $20 million. Of that amount, no more than $6 million may be offered by the company's affiliates (i.e., those who can exercise significant control over the company, such as large shareholders). Under Tier 2, the issuer may raise up to $50 million, with no more than $15 million of that offered by its affiliates.  Securities sold in an offering under either Tier 1 or Tier 2 are “unrestricted” securities, meaning that investors who purchase them (other than affiliates of the issuer) can immediately resell them to others (that is, the securities have greater “liquidity”, or ability to be bought and sold), which (at least theoretically) should increase their value to (and price that can be asked of) investors. However, given the relatively rare use of Regulation A in the past, it remains an open question as to whether a truly liquid secondary (investor to investor) market will develop.

Although the initial disclosure and filing requirements for both Tier 1 and Tier 2 offerings are similar, Tier 2 offerings (as would be expected given the larger amounts of money that can be raised) are subject to significantly more extensive disclosure, filing, and investor qualification requirements, which are discussed in more depth below.

Who Can Use Regulation A+?

Before delving into that, let’s first examine who is eligible to use Regulation A+. Under the new rules, the Regulation A+ will not be available to the following categories of issuers:

  • companies subject to the ongoing reporting requirements of Section 13 or 15(d) of the Exchange Act;
  • companies registered or required to be registered under the Investment Company Act of 1940 and business development companies;
  • blank check companies;
  • issuers of fractional undivided interests in oil or gas rights, or similar interests in other mineral rights;
  • issuers that are required to, but that have not, filed with the SEC the ongoing reports required by the rules under Regulation A during the two years immediately prior to the filing of a new offering statement (that applies to companies that have conducted a Reg A offering in the past)
  • issuers that are or have been subject to an order by the SEC denying, suspending or revoking the registration of a class of securities pursuant to Section 12(j) of the Exchange Act that was entered within five years before the filing of the offering statement;
  • issuers subject to "bad actor" disqualification under Rule 262 (Note that these are similar to, but not precisely the same as, the “bad actor” provisions of Regulation D).

Note that the SEC included two new categories of ineligible issuers, but the rule is still available to shell companies, issuers of penny stock or other types of investment vehicles.

Disclosure, Reporting, and Investor Qualification Requirements

At this point, because the disclosure and other requirements under the new Regulation A primarily depend on whether the offering is a Tier 1 or Tier 2 offering, let's separately discuss the requirements under each tier, starting with Tier 1.

Disclosure, Reporting, and Investor Qualification Requirements for Tier 1 Regulation A Offerings

As already mentioned, an issuer may raise up to $20 million over any rolling 12 month period using the new Reg A+. The primary advantage of the new rules for Tier 1 offerings is that it significantly raises the dollar amount that can be raised without significantly increasing the disclosure or other requirements. The primary disadvantage is that, as under the old Regulation A, issuers raising money in a Regulation A+ Tier 1 offering must comply with the individual “blue sky” laws of each state where they plan to sell the securities. This compliance requirement was one of the biggest reasons that the old Regulation A was not nearly as popular as Regulation D, despite the minimal federal disclosure and registration requirements, and it will be interesting to see whether the larger amounts that can be raised will be enough to offset the inconvenience of complying with individual state laws.

Aside from increasing the amount that can be raised from $5 million to $20 million, a Tier 1 offering under Regulation A+ is, with respect to filing and other requirements, largely unchanged from the original Regulation A. Although a full discussion of these requirements is beyond the scope of this post, I want to briefly touch on some of the most important points. The primary form that must be filed with the SEC is Form 1-A (“Regulation A Offering Statement”). The Form 1-A requirements include certain financial information, but for Tier 1 offerings such financial statements need not be audited, unless audited financial statements already exist. (In other words, there is no need to prepare audited financial statements specifically for a Tier 1 Regulation A+ offering.) Once the offering has been completed (or if it is terminated prior to completion), the issuer must file a Form 1-Z.  Both forms must be filed electronically on the SEC’s EDGAR system, and there is no filing fee connected with either form.  An issuer may, if he chooses, file a draft Form 1-A confidentially with the SEC (if, for example, the issuer is unsure of whether there will be enough investor interest, and so wants to, for the moment, avoid the potential embarrassment of filing it publicly only to have to later cancel or terminate the offering.)

As under the original Regulation A, a Tier 1 Regulation A+ offering is not limited to any specified number of investors, nor are there are any requirements that the investors be “accredited” or otherwise sophisticated. There is no limit (other than the overall aggregate limit of $20 million) that may be invested by any single investor.  Issuers may “test the waters” (i.e. engage in general advertising and solicitation) both before and after filing Form 1-A, but it is important to note that there are specific rules regarding certain disclaimers as well as filing requirements.  For example, any solicitation materials used before filing Form 1-A must be included when the Form is submitted, and any solicitation materials sent after it has been filed must be accompanied either by a current preliminary offering circular (Part II of Form 1-A tells you what needs to be included in an offering circular) or information indicating where the investor can obtain the offering circular him or herself.

In deciding whether to offer securities under Tier 1 of Regulation A+, there are a few questions an issuer should be asking.  First and foremost—where are the potential investors located?  Remember, Tier 1 offerings are not exempt from state blue sky laws, and so the greater number of states your potential investors are located in, the greater your compliance costs are going to be.  I would also suggest that, because the SEC imposes relatively few restrictions on the kinds of investors who can invest in such offerings and the lack of any limit on how much they can invest, state regulators are likely to give particularly close scrutiny to such offerings, particularly at the outset.  If the company thinks it may need to raise more than $20 million over the course of the year, possible integration problems may come into play.  Finally, as with any newly effective changes in the law, there is always the possibility of unforeseen issues cropping up somewhere down the road.

With all that being said, let’s move onto where the new Regulation A+ really makes its mark: Tier 2 offerings.

Disclosure, Reporting, and Investor Qualification Requirements for Regulation A Tier 2 Offerings

As mentioned above, the limit for Tier 2 offerings under Regulation A+ is $50 million, as opposed to $20 million for Tier 1 (note, however, that an issuer could, if it wanted to, engage in a Tier 2 offering of $20 million or less; in other words, an offering of $20 million or less is not automatically a Tier 1 offering.)  As would be expected, the disclosure and filing requirements for Tier 2 offerings are significantly greater than Tier 1.  Unlike Tier 1 offerings, however, Tier 2 offerings are exempt from complying with state “blue sky” laws (although states can (and generally will) still require that information provided to the SEC also be filed with the state, and that the issuer pay filing fees for the privilege.

The new Regulation A+ also allows securities offered under Tier 2 to be registered for sale on a national exchange (NYSE, for example) using Form 8-A (if in connection with a qualified Form 1-A), which is generally less expensive and less time-consuming to file than the traditional registration form, Form 10. (Some commentators have taken to calling this a “mini-IPO” option.)  Keep in mind, however, that if an issuer does register using this option, it becomes a “reporting company” subject to the traditional reporting requirements of the Securities Exchange Act. (Note that if the company does so, it will not also be subject to the Tier 2 reporting requirements mentioned below; the Exchange Act requirements replace them.)

Under Regulation A+ itself, an issuer which sells securities in a Tier 2 offering becomes subject to certain ongoing SEC reporting requirements. These include:

  • Annual audited financial reports using Form 1-K
  • Semi-annual reports using Form 1-SA
  • Current event reports using Form 1-U (“current events” which would require filing include, for example, a material change in shareholder rights or a fundamental change in the business)

The issuer can suspend these reporting requirements by filing Form 1-Z (an “exit report”) if certain requirements are met, including that 1) fewer than 300 persons are shareholders of record of the securities sold in the Tier 2 offering; 2) the issuer has filed all of the necessary reports over the past three fiscal years (or for as long as the issuer has been obligated to file the reports, if less than three years); 3) the relevant Tier 2 offering statement was not qualified in the same fiscal year as the filing of the Form 1-Z (in other words, the Tier 2 issuer must file reports for at least one full fiscal year before they are eligible to suspend reporting); and 4) the issuer is not currently offering the same class of securities (e.g. Series A, Series B) in another Tier 2 offering.

As is clear from just this basic introduction, an issuer should not undertake a Tier 2 offering lightly, as the ongoing reporting requirements can be complex, confusing, time-consuming, and expensive.  If the company is going to be taking advantage of the option to register the securities on an exchange, the requirements can be even more onerous.  Especially in the latter case, the company should seriously consider whether the Tier 2 offering provides any significant advantage over a traditional IPO.  If the company believes there is sufficient demand from institutional and “accredited” investors, it may make more sense to engage in the “tried and true” Rule 506 private placement, especially now that Rule 506(c) allows for general advertising and solicitation.

In addition to the increased disclosure requirements, Tier 2 imposes some restrictions on investor participation when the securities being sold are not going to be registered on a national exchange. The important term here is “accredited investor,” which has the same definition in Regulation A+ as it does in Regulation D. The term is specifically defined under Rule 501 of Regulation D, and in general includes most institutional investors (banks, investment companies, insurance companies, etc.) as well as high net worth and high-income individuals. Although Tier 2 offerings may be made to any number of both accredited and non-accredited investors, non-accredited investors are limited in how much they can invest. Specifically, non-accredited individuals cannot invest more than 10% of either their net worth or annual income (whichever is greater), and non-accredited entities cannot invest more than 10% of the greater of their revenue or net assets (again, whichever is greater) as of the last completed fiscal year. To comply with this 10% requirement, the issuer is allowed to rely on a representation of the purchaser that their investment falls within the limits, as long as the issuer “does not know at the time of sale” that the representation is false.

At this point, I’ve hopefully imparted at least a basic understanding of the changes the new Regulation A+ rules make. What remains to be seen, however, is how often, and by whom, they will be used.  From what I’ve seen, the general consensus seems to have some doubt that these new rules will boost the use of Regulation A as much as the SEC is hoping.  Particularly with regard to larger offerings using Tier 2, the enhanced reporting requirements, and the “fishbowl” effect it results in, may be too much of a negative, even with the ability to raise up to $50 million and to offer unrestricted securities.  Companies may simply continue to rely on Rule 506 private placements (which have no dollar limit), even if the securities are “restricted”, or conversely may decide to just go all the way with a “true” initial public offering.

Just as importantly, how will investors, particularly retail investors, react? Will a truly liquid secondary market for these kinds of securities develop? It’s too soon to know for sure, of course, but here as well there is ample room for doubt.

Finally, it should be pointed out that a number of state regulators are none too pleased with the SEC’s decision to preempt state “blue sky” securities laws for Tier 2 offerings, and in fact regulators from two states, Massachusetts and Montana, have both sued to prevent the rules from going into effect. Even if these challenges fail, it is clear that they will be keeping a very watchful eye on Tier 1 securities, which do remain under their purview.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.

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