As part of a series of measures aimed at improving capital-raising by smaller companies, the Securities and Exchange Commission has recently proposed rule changes that will make it easier for investors to resell restricted securities into the public market and for public companies to sell their securities in private placements. Arguing that removing obstacles to capital formation by smaller companies serves to protect investors, SEC Chairman Christopher Cox said “it’s investors who are injured and whose money is lost when the small businesses in which they invest can’t get affordable access to new capital.” Whether these proposals will have their desired effect remains to be seen. However, if adopted, these proposals may have a real impact on companies and investors participating in private placements.
Holding Period Reduced to Six Months
Under the current provisions of Rule 144 of the Securities Act of 1933, investors who purchase a company’s shares in a private placement and who are not affiliates (officers, directors and major shareholders) of the company, must hold those “restricted” shares for at least one year before being permitted to resell the shares in the public market. Even after holding the shares for one year, investors who desire to sell are subject to various restrictions, including limitations on the number of shares they can sell in any three-month period (the greater of 1% of the outstanding shares or the average weekly reported trading volume for the previous four weeks), the requirement that the shares be sold in unsolicited brokers’ transactions, the requirement that there be current public information available about the company (the issuer must have filed all SEC-mandated reports during the 12 months prior to the sale), and the requirement that the investor notify the SEC of such sales by filing a Form 144. These restrictions on resales fall away only if the investor holds the shares for at least two years and has not been an affiliate of the company for the preceding three months.
The SEC’s new proposal significantly shortens these holding periods and thereby lowers the illiquidity risk faced by investors in private placements. In the case of a public company with currently available public information, the SEC is proposing that the holding period for investors who are not affiliates of the company be reduced to six months. After this six month period, the shares may be freely sold without any volume limitations, manner of sale restrictions or Form 144 notice requirements. The proposal thus not only reduces the holding period from one year to six months, it also eliminates the restrictions that currently apply until the shares are held for two years (other than the public information requirement). As a practical matter, the removal of these restrictions after six months allows a holder to sell shares with less delay and expense, as the need for due diligence and documentation by brokers and lawyers to comply with the restrictions has been substantially eliminated. It should be noted that the proposal does have an exception that extends the six-month holding period for up to one year in the case of non-affiliates who have hedged their securities position in a reporting company by entering into certain short positions or put equivalent positions. Since Rule 144 permits investors to tack the holding period of a prior owner of the securities, the SEC has not yet addressed whether an investor is responsible to determine if the prior owner engaged in hedging transactions that would result in extending the investor’s holding period.
In the case of a non-reporting company which does not have adequate public information available, under the SEC’s proposal the current two year holding period would be reduced to one year. Thereafter, the shares could be freely sold without restriction.
In the case of resales of restricted securities by affiliates of the company, no change to the current holding periods are proposed, but the SEC is proposing to eliminate the manner of sale requirements for debt securities and to raise the share and dollar amount thresholds that trigger Form 144 filings. The SEC is also soliciting comments on whether to permit affiliates to satisfy their Form 144 filing requirements by instead filing a Form 4.
Changes to Private Placement Rules Under Regulation D
Most private placements of securities are effected by companies under Regulation D of the Securities Act which provides several exemptions from the extensive SEC registration requirements that otherwise apply to offerings of securities. The most commonly used exemption under Regulation D is Rule 506 which allows for sales to accredited investors and up to 35 non-accredited investors. “Accredited investors” include individuals (a) whose annual income for the prior two years exceeds $200,000 (or joint income with their spouse exceeds $300,000) and who have a reasonable expectation of reaching the same income level in the current year or (b) who alone or with their spouse have a net worth in excess of $1,000,000, including the value of their principal residence. No publicity, advertising or general solicitation of the offering is permitted.
The SEC has proposed revising the criteria for natural persons to be considered “accredited investors” under Regulation D by adding an alternative $750,000 “investments owned” standard to the current definition. A person with $750,000 of investments who does not meet the income or net worth tests could qualify as an accredited investor. The SEC proposal provides for ongoing adjustment of each of the dollar thresholds in the accredited investor definition to account for future inflation starting in 2012.
The SEC has also proposed a new exemption under Regulation D to be called Rule 507. This Rule will for the first time permit limited advertising, including tombstone-like ads, for Regulation D offerings. All sales under Rule 507 must be to a new class of “Rule 507 qualified purchasers” which are defined as individuals with $2.5 million of investments or annual incomes of $400,000 (or $600,000 with spouse), and institutions that have $10 million in investments or currently qualify as accredited investors without regard to the amount of their assets. The $2.5 million test for individuals mirrors the $2.5 million in investments which the SEC proposed in December 2006 as a further requirement for accredited investors who desire to invest in hedge funds and other private investment pools.
Since the current income and net worth dollar thresholds for accredited investors were adopted in 1982, the level of investor wealth and income in the US has increased substantially, due in part to inflation and increased values of personal residences. Last year the SEC staff estimated that 8.5% of US households now qualify for accredited investor status. The original theory behind setting these standards was that accredited investors are “rich” people with sufficient wealth and financial sophistication that they will be able to fend for themselves in considering potential investments and didn’t need the elaborate disclosure and other protections of registration under the Securities Act. However, given the large increase in investor wealth levels since 1982, from an investor protection perspective the SEC should consider whether the old monetary thresholds still provide reasonable assurance that those investors possess the necessary financial experience and sophistication to purchase illiquid securities in private placements. The countervailing pressure comes from small companies who desire to raise money from as broad a group of potential investors as possible. If the income and net worth requirements are raised, these companies would lose access to investment capital from a large class of individual investors who could not satisfy the higher standards.
As a further step to promote capital raising, the SEC proposed shortening the integration safe harbor under Rule 502 of Regulation D from six months to 90 days. Under the integration rule, two securities offerings for similar purposes (either consecutive private placements or a private placement followed by a public offering) that occur within six months of the other face the risk of being “integrated” under the securities laws and being deemed a single transaction required to be registered under the Securities Act. By shortening the safe harbor period to 90 days, companies will have more flexibility to engage in multiple financing transactions over a short period of time.
Adoption of Proposed Rules
The details of the proposals described above have not yet been released by the SEC. Once the text of the rules is published they will be subject to a 60-day public comment period. It is likely that some or all of these proposals will ultimately be adopted. However, it is quite possible that the specific terms of the proposals will be modified in response to public comments and further analysis by the SEC. --------------------------------------------------------------------------------