SEC Final Rule Changes For Exempt Offerings – Part 5
On November 2, 2020, the SEC adopted final rule changes to harmonize, simplify and improve the exempt offering framework. The new rules go into effect on March 14, 2021. The 388-page rule release provides a comprehensive overhaul to the exempt offering and integration rules worthy of in-depth discussion. As such, like the proposed rules, I am breaking it down over a series of blogs with this final blog discussing the changes to Regulation Crowdfunding. The first blog in the series discussed the new integration rules (see HERE). The second blog in the series covered offering communications (see HERE). The third blog focuses on amendments to Rule 504, Rule 506(b) and 506(c) of Regulation D (see HERE). The fourth blog in the series reviews the changes to Regulation A (see HERE).
Current Exemption Framework
The Securities Act of 1933 (“Securities Act”) requires that every offer and sale of securities either be registered with the SEC or exempt from registration. Offering exemptions are found in Sections 3 and 4 of the Securities Act. Section 3 exempts certain classes of securities (for example, government-backed securities or short-term notes) and certain transactions (for example, Section 3(a)(9) exchanges of one security for another). Section 3(b) allows the SEC to exempt certain smaller offerings and is the statutory basis for Rule 504 and Regulation A. Section 4 contains all transactional exemptions, including Section 4(a)(2), which is the statutory basis for Regulation D and its Rules 506(b) and 506(c). The requirements to rely on exemptions vary from the type of company making the offering (private or public, U.S. or not, investment companies…), the offering amount, manner of offering (solicitation allowable or not), bad actor rules, type of investor (accredited) and amount and type of disclosure required. In general, the greater the ability to sell to non-accredited investors, the more offering requirements are imposed.
For a chart on the exemption framework incorporating the new rules, see Part 1 in this blog series HERE.
Regulation Crowdfunding – Background
Title III of the JOBS Act, enacted in April 2012, amended the Securities Act to add Section 4(a)(6) to provide an exemption for crowdfunding offerings. Although it took a while, Regulation Crowdfunding went into effect on May 16, 2016. The exemption allowed companies to solicit “crowds” to sell up to $1 million in securities in any 12-month period as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor could not exceed (a) the greater of $2,000 or 5% of the lower of annual income or net worth of such investor if the investor’s annual income or net worth is less than $100,000; and (b) 10% of the annual income and net worth of such investor, not to exceed a maximum of $100,000, if the investor’s annual income or net worth is more than $100,000. When determining requirements based on net worth, an individual’s primary residence must be excluded from the calculation. As written, regardless of the category, the total amount any investor could invest was limited to $100,000. For a summary of the provisions, see HERE.
In addition, all offerings must be conducted through a single offering portal and advertisements are limited to directing investors to that portal. Companies are required to provide specified information through the filing of a Form C with staggered information requirements based on the offering size. The financial statement requirements progressively increase based on increased offering size.
On March 31, 2017, the SEC made an inflationary adjustment to the $1,000,000 offering limit to raise the amount to $1,070,000 – see HERE. This was the last rule amendment related to Regulation Crowdfunding, though it has been on the Regulatory Agenda since that time.
On May 4, 2020, the SEC adopted temporary final rules under Regulation Crowdfunding for small businesses impacted by COVID-19, which include, among other things, an exemption from certain financial statement review requirements for companies offering $250,000 or less. These temporary rules were subsequently extended and apply to offerings initiated under Regulation Crowdfunding between May 4, 2020, and February 28, 2021 (see HERE).
The new rules increase the offering limits, adjusts the formula related to the maximum amount an unaccredited investor can invest, remove the investment limit for accredited investors, allow for investments through special purpose vehicles (SPVs), and align the bad actor provisions with those in Regulation A. The proposal to limit the type of securities that can be offered to align it with Regulation A was not adopted in the final rule amendments.
Increase in Offering Limit
The amendments increase the amount an issuer can raise in any 12-month period from $1,070,000 to $5 million. It is believed, and I agree, that Regulation Crowdfunding will become much more widely used with a reduced cost of capital and greater efficiency with this increase in offering limits (together with the other amendments discussed herein, including allowing the use of special purpose vehicles). In addition, the increased limit may allow a company to delay a registered offering, which is much more expensive and includes the increased burden of ongoing SEC reporting requirements.
Increase in Investment Limit
The amendment rules increase the investment limits by altering the formula to be based on the greater of, rather than the lower of, an investor’s annual income or net worth. Moreover, the investment limits no longer apply to accredited investors. In addition to the obvious benefit of increasing capital available to companies, the SEC believes that accredited investors may be incentivized to conduct more due diligence and be more active in monitoring the company and investment relative to an investor that only invests a nominal amount. A smart activist investor can add value to a growing company.
Use of Special Purpose Vehicles
The amendment rules allow for the use of special purpose vehicles, which the SEC is calling a crowdfunding vehicle, to facilitate investments into a company through a single equity holder. Such crowdfunding vehicles can be formed by or on behalf of the underlying crowdfunding issuer to serve merely as a conduit for investors to invest in the crowdfunding offering. These special purpose entities may not have a separate business purpose beyond the crowdfunding investment and must not, in fact, conduct any business beyond the investment. The crowdfunding vehicle is a co-issuer in the offering and as such, investors in the crowdfunding vehicle will have the same economic exposure, voting power, and ability to assert state and federal law rights, and receive the same disclosures under Regulation Crowdfunding, as if they had invested directly in the underlying company.
The rule benefits companies by enabling them to maintain a simplified capitalization table after a crowdfunding offering, versus having an unwieldy number of shareholders. A cleaner cap table can make companies more attractive to future VC and angel investors. Allowing a crowdfunding vehicle will also reduce the administrative complexities associated with a large and diffuse shareholder base.
Importantly, a crowdfunding vehicle will constitute a single record holder for purposes of Section 12(g), rather than treating each of the crowdfunding vehicle’s investors as record holders as would be the case if they had invested in the crowdfunding issuer directly. Although a company can always voluntarily register under Section 12(g), unless an exemption is otherwise available, it is required to register if, as of the last day of its fiscal year: (i) it has $10 million USD in assets or more; and (ii) the number of its record security holders is either 2,000 or greater worldwide, or 500 persons who are not accredited investors or greater worldwide. Such registration statement must be filed within 120 days of the last day of its fiscal year (Section 12(g) of the Exchange Act). A registration statement under Section 12(g) does not register securities for sale, but it does subject a company to ongoing SEC reporting obligations.
Miscellaneous
Regulation Crowdfunding offerings have always meant to pre-empt state law; however, the language in the prior rule was somewhat ambiguous. To avoid any doubt, the SEC has amended Regulation Crowdfunding to specifically include crowdfunding investors in the definition of a “qualified purchaser” for purposes of Section 18 of the Securities Act, which section delineates federally covered securities and transactions (for more on federal pre-emption, see HERE).
The new rules also extend certain provisions of the Covid-related temporary relief for financial statements through August 28, 2022. That is, any offering under Regulation Crowdfunding, together with other Regulation Crowdfunding offerings in the last 12 months, where the target offering amount is between $107,000 and $250,000, may provide financial statements that are certified by the principal executive officer instead of reviewed by an independent public accountant. This temporary relief will apply only if reviewed or audited financial statements of the company are not otherwise available.
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