On June 18, 2019, the U.S. Securities and Exchange Commission (“SEC”) issued a concept release seeking public comment on potential improvements to the current exempt offering framework, including for early-stage issuers and potential investors. The release is timely, as exempt offerings have become an increasingly popular method of raising capital – the amount raised from exempt offerings in 2018 was double the amount raised in registered offerings. The SEC aims to simplify, harmonize and improve the exempt offering framework to promote capital formation and expand investment opportunities while maintaining appropriate investor protections. Moreover, the SEC seeks to ensure that early-stage issuers have access to capital in exempt markets and that participation by interested investors is not unnecessarily restricted. Below is a high-level summary of several points from the SEC’s concept release.
Organizing and Improving the Exempt Offering Framework
The SEC is looking to identify and fix what it believes are the gaps and pitfalls in the current exemption framework that prevent issuers, particularly early-stage and smaller issuers, from efficiently accessing capital through exempt offerings. To this end, the SEC is exploring, among other things (1) whether current exemptions allow early-stage issuers to access capital or if changes are required, (2) how to clarify the requirements for conducting a private offering, and (3) how to simplify the integration rules.
Capital Access for Early-Stage Issuers
Regulation Crowdfunding is the primary exemption that seeks to address the specific needs of very early-stage issuers and startups. The SEC seeks comments on how to improve Regulation Crowdfunding and is considering adding a new micro-offering exemption to give early-stage issuers more options to raise capital.
Regulation Crowdfunding. Adopted in 2016, this exemption allows issuers to raise up to $1.07 million from small contributions made by a large number of investors. By spreading risk across many investors, Regulation Crowdfunding allows startups and other small issuers to access capital that would otherwise be unavailable. However, only 519 issuers have raised funds under this exemption (compared with over 12,000 issuers raising similar amounts under Regulation D), and the median issuer had $30,000 in assets and no revenues. Accordingly, the SEC has posed a number of questions for public comment suggesting that it is considering revamping Regulation Crowdfunding to, among other things, ease the costs, financial disclosure and reporting requirements, and other burdens to attract more issuers to rely on the exemption and increase the amounts that can be raised under the exemption.
Micro-offerings. The SEC is also considering supplementing Regulation Crowdfunding with a micro-offering exemption targeted at issuers that are too small, or are seeking too small an amount of capital, to conduct an offering effectively under another exemption. This exemption, which could also cover micro-loans, could limit the amount issuers can raise under it to less than $250,000 or $500,000 in a 12-month period, but with significantly scaled back reporting conditions, costs and other restrictions applicable to offerings under Regulation Crowdfunding.
Conducting Private Offerings
In the concept release, the SEC examines the entire exempt offering framework, reviewing both quantitative data regarding use of the exemptions and the ways in which each of the exemptions overlap and are differentiated. In addition to seeking public comments regarding general questions – such as whether the existing exempt offering framework and any specific exemptions are too complex – the SEC focuses specifically on certain aspects of the framework and particular exemptions. For instance, the SEC is considering simplifying the exempt offering process by deregulating offers altogether and focusing on investor protections at the time of sale of securities rather than at the time of offer.
Similarly, the SEC is exploring ways to harmonize the exempt offering framework, asking for public comments on questions such as whether rule changes should be considered that would facilitate the ability of issuers to transition from using one exemption to another as their businesses develop and grow. Finally, the SEC is considering ways to address overlap, inefficiency and disuse with respect to certain specific offering exemptions. For example, the SEC asks questions exploring whether the seldom relied upon Rule 506(c) under Regulation D should be eliminated and merged into Rule 506(b) and whether the terms “general solicitation” and “general advertising” need further definition and clarification.
When multiple exempt offerings are made concurrently, the SEC generally integrates the offerings into one offering which may no longer qualify for an exemption. As a result, issuers typically must wait six months before making another exempt offering. The SEC recognizes that early-stage issuers’ capital needs can change rapidly in that time frame and that the integration rules may unnecessarily impede or delay the raising of capital. The SEC is seeking public comments on (1) whether the existing rules and guidance related to integration should be combined and distilled into a single doctrine and (2) how the integration framework should be updated to facilitate access for small and early-stage issuers to exempt markets.
Focus on Investor Participation and Protection
Another avenue the SEC is considering to ease access to capital in exempt markets is by allowing more investors to participate, which would create new opportunities for investors and increase the capital available to issuers. The SEC seeks public comment on (1) how to expand the current definition of “accredited investor,” and (2) how to limit restrictions on the secondary trading of exempt securities.
Accredited Investor Definition
The SEC seeks to expand the definition of “accredited investor” to give more investors access to exempt markets. Currently, natural persons earning $200,000 in the past two years, or who have a net worth over $1 million are considered accredited investors. Non-accredited investors cannot participate in many exempt offerings. The SEC, therefore, is considering including other factors to determine accreditation for individual investors, such as holding a minimum number of investments, professional credentials, investing experience in exempt offerings, or passing an accredited investor examination.
Secondary Trading Liquidity
The SEC acknowledges that secondary market liquidity for investors in issuers affected by its rules is integral to capital formation in the primary offering market. Generally, the current private exemption framework limits secondary trading of most exempt securities. While restricted and otherwise illiquid securities can yield a more stable shareholder base with less investor turnover, small businesses report struggling to attract capital in their primary offerings because potential investors are reluctant to invest unless they are confident there will be an exit opportunity.
The SEC wants to explore ways to encourage investors to invest in exempt offerings despite these challenges. The most obvious method to do so is to ease restrictions on secondary trading to allow more investors to participate in the exempt market. The concept release promises further attention to, among other things, (1) federal resale exemptions, including the impact of Rule 144, (2) the relationship between federal registration requirements and state laws, (3) secondary sales and institutional investor exemptions under state law, and (4) various state exemptions for transactions through broker-dealers.
Pooled Investment Funds
The SEC’s concept release also examines whether the SEC should take steps to expand issuers’ ability to raise capital through pooled investment funds, and whether retail investors should be allowed greater exposure to growth-stage issuers through pooled investment funds in light of the potential advantages of investing through such funds, including the ability to have an interest in a diversified portfolio. For purposes of its discussion, the SEC characterizes pooled investment funds to include investment companies, such as a mutual fund or exchange-traded fund (an “ETF”), registered under the Investment Company Act of 1940, as amended (the “Investment Company Act”), a business development company (a “BDC”), or a private fund that operates pursuant to an exemption or exclusion from the Investment Company Act.
The SEC recognizes the potential advantages to investing through such pooled investment funds, including, but not limited to, the idea that retail investors could garner benefits from access to exempt offerings through such funds. However, the SEC also recognizes several problems with the current market structure, including the practical difficulties retail investors face in obtaining exposure to exempt offerings through these vehicles as well as the challenges presented by the liquidity and daily valuation requirements for mutual funds and ETFs. On that basis, among others, the SEC’s concept release opens the door for a mutual exploration of the scope of investment opportunities available to retail investors through these avenues.
While it is not clear whether significant changes to the exempt offering framework will follow from the concept release, the release illustrates that the SEC is considering reforms that could significantly alter the regulatory landscape for capital formation and investment, particularly for early-stage issuers and non-accredited investors. With the public comment window open until September 24, 2019, issuers and investors have a unique opportunity to participate in the potential improvement of the exempt offering framework.