On Friday, March 20, 2015, the SEC announced it will vote on its proposed changes to Regulation A at an open meeting on Wednesday, March 25, 2015. These changes are generally referred to as Regulation A+ and are meant to revive an effectively defunct exemption from the registration requirements of the Securities Act. The goal of the new rules is to transform Regulation A into a workable capital-raising tool for small private companies.
In its current form, Regulation A is rarely used. As mandated by the Jumpstart Our Business Startups Act (JOBS Act), the SEC proposed significant changes to Regulation A, including increasing the amount that could be raised by an issuer from $5 million to $50 million. However, several critics believe that, in its effort to improve Regulation A’s functionality, the SEC has taken things too far. At issue is a sweeping preemption of state law contained in the proposed rules for the largest Regulation A offerings.
One of the primary reasons why Regulation A in its current form is not a viable capital-raising option for small companies is due to the lengthy and expensive review process at the state level. In its proposed rules, the SEC has eliminated state regulatory authority over many Regulation A offerings, and substituted for it other shareholder protections.
Many who view the states as the first line of defense against securities fraud argue that by eliminating this oversight, the SEC would be opening the door to increased fraud. On the other hand, supporters of the proposed rules argue that preserving the blanket state law preemption is critical to making Regulation A a workable option for smaller companies looking to raise capital.
The SEC’s Proposed Rules . On December 18, 2013, the SEC released its proposed rules in response to the JOBS Act mandate. As proposed, the new rules would create two tiers of offerings under Regulation A:
Tier 1 – an offering of up to $5 million over a rolling 12-month period, essentially like the current Regulation A exemption
Tier 2 – an offering of up to $50 million over a rolling 12-month period
As proposed, Tier 2 offerings would contain additional protections and would preempt state securities regulatory review, as explained in more detail below. These proposed investor protection provisions include a requirement for audited financial statements in the offering documents, a limitation on the amount an investor could purchase to 10 percent of the greater of the investor's annual income or net worth (calculated for individual purchasers as set out in the accredited investor definition in Rule 501 of Regulation D) and continuing reporting obligations for the issuer.
Securities sold in both tiers could be offered publicly and would not be restricted securities. Both tiers could use a “test the waters” procedure to gauge investor interest in a potential offering.
Proposed Preemption of State Review. The SEC has proposed to eliminate state securities regulatory review of Tier 2 Regulation A+ offerings.
Regulation A offerings are currently required to be registered or exempt from registration in each state where the offering is made, in addition to SEC review. Accordingly, if a Regulation A offering is made in 10 states, there would be 11 separate securities law analyses conducted, one by each state, as well as the federal securities process. Many states do not have exemptions suitable for small public offerings and would require the registration of a Regulation A offering. In addition, in many states, the securities registration review includes a “merit” review as well as a disclosure-type review. This regulatory process can be lengthy, cumbersome and expensive, factors that many believe have contributed to the infrequent use of Regulation A.
The SEC has proposed that Tier 2 Regulation A+ offerings will be reviewed by only one regulator, the SEC, which would simplify the offering process for Regulation A+ considerably. The SEC proposes to base this elimination of any state review on a determination that all purchasers in a Tier 2 Regulation A+ offering are “qualified purchasers,” under Section 18 of the Securities Act. Accordingly, the proposed rules would define “qualified purchaser” to include any offeree in a Regulation A+ offering and any purchaser in a Tier 2 offering.
A significant number of the state securities regulators have objected to the preemption aspect of the proposal.
As of May 7, 2014, the securities regulators of 26 states and Puerto Rico had objected to the SEC’s preemption proposal.
These state securities regulators have been joined by several others in opposing preemption.
In addition to opposition from various consumer and investor representatives, several members of the U.S. Congress have filed comment letters opposing preemption. In a letter dated June 3, 2014, twenty members of the U.S. House of Representatives opposed preemption and in a letter dated August 1, 2014, nine members of the U.S. Senate opposed preemption.
The North American Securities Administrators Association (NASAA) has also carried out an active campaign in opposition to preemption. In addition to hiring counsel to advise it on the preemption proposal, NASAA has adopted a “streamlined” review procedure, which could be used in place of preemption.
The NASAA Coordinated Review Program
NASAA has recently implemented a multistate review procedure for Regulation A offerings. In this program, Regulation A filings are made in one place and distributed electronically to all states. Lead examiners are appointed as the primary point of contact for a filer. One lead examiner handles disclosure issues and one examiner handles “merit” review. Only the lead examiners interact with the issuer to resolve any deficiencies, and once they determine an application should be cleared, the decision is binding on all participating states. This coordinated review procedure is designed to result in a state regulatory review procedure with a timeframe similar to the time period generally expected for federal review.
The NASAA coordinated review program is an improvement over the current review procedure for Regulation A offerings. On December 4, 2014, two members of the Committee on Financial Services of the U.S. House of Representatives submitted a comment letter urging the SEC to “closely examine NASAA’s Coordinated Review program, and not undermine crucial investor protections by preempting the states’ regulators” (see Comment Letter, Reps. Maxine Waters and Stephen F. Lynch, U.S. House of Representatives, December 4, 2014). Attached to it was a comment letter from Groundfloor Finance Inc., the first issuer to participate in the Coordinated Review program. In its comment letter Groundfloor “stongly disagree[s] with the proposal to preempt state registration” and described the coordinated review process as “communicative, user friendly, and easily manageable.” There are, however, remaining issues.
First, Regulation A+ as proposed would permit a confidential SEC review of the offering documents before filing. The NASAA coordinated review procedure would commence at the same time as the offering documents are filed with the SEC, potentially defeating the advantages of the confidential prefiling review.
Second, state securities law may not permit the “testing the waters” communications contemplated by Regulation A+. The SEC has proposed to allow “testing the waters” communications regardless of state law by treating all Regulation A+ offerees (Tier 1 and Tier 2) as qualified purchasers. Accordingly, in the absence of preemption, testing the waters communications might not be permitted in some states.
Third, depending on the states involved, state registration involves a “merit” component as well as a disclosure component. SEC review involves only a disclosure component.
And fourth, if an issuer decides to add a state after completing the NASAA coordinated review, that issuer may need to register the offering separately in that state.
Most importantly, those who support state law preemption for Regulation A+ offerings argue that NASAA’s coordinated review program, while certainly an improvement, will not eliminate the key regulatory hurdles that currently prevent issuers from utilizing Regulation A. The uncertainty and expense that comes with having multiple regulatory agencies review and approve offering materials would still exist.
On March 4, 2015, at a meeting of the SEC’s Advisory Committee on Small and Emerging Companies, most of its members agreed that state law preemption must be preserved in the final rules in order to make Regulation A+ a workable capital-raising option for small companies. They noted that NASAA has no authority to impose the coordinated review program on individual states, not all states have agreed to participate, and states are free to drop out of the program at any time. The standards applied by each state are still not uniform, and there is no process in place to resolve any conflicts that may arise during the coordinated review process. Members also pointed out that NASAA has a poor track record of implementing coordinated review procedures in the past and that one success story (Groundfloor) does not prove that this new program will work.
SEC Status .
Two of the commissioners of the SEC have expressed reservations about the preemption proposal.
Commissioner Stein has publicly opposed preemption.
Commissioner Aguilar addressed Regulation A+ and preemption in a speech delivered on April 8, 2014, entitled “NASAA and the SEC: Presenting a United Front to Protect Investors.” In this speech, Commissioner Aguilar stated that he had an “open mind” on the preemption issue. However, he also stated that he had asked the SEC's Office of General Counsel to address whether the SEC had the authority to use preemption as proposed. Several commenters have questioned the ability of the SEC to impose preemption under these circumstances. Commissioner Aguilar suggested that advice on this issue would be available to the SEC before a vote is taken on the final rule.
It is probable that this advice has been provided to the commissioners. If the General Counsel also expresses concern about the legal basis for preemption, then Regulation A+ as adopted may not contain the preemption element.
A significant question is what will happen if the SEC decides to adopt the preemption approach: Will any state regulator sue the SEC seeking to block the implementation of the preemption aspect of the proposal? Several comment letters have argued that preemption might not withstand a legal challenge, and one state has implied that it may litigate the issue. “Massachusetts must consider all our options to oppose this proposal.” (See Comment Letter, William F. Galvin, Secretary, Commonwealth of Massachusetts, March 24, 2014). In recent years, business interests have had success suing the SEC to block regulations on various theories. However, this type of litigation is expensive, and a state might have difficulty getting funding for this effort.
Many will be watching this Wednesday to see if state law preemption will survive. Either way, it is highly unlikely the debate will end.