On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Act”). While much of the Act was designed to provide smaller financial institutions and community banks with relief from regulations implemented under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), Title V of the Act includes provisions designed to encourage capital formation. Specifically, the Act directs the Securities and Exchange Commission (the “SEC”) to reform Rule 701 and Regulation A under the Securities Act of 1933 (the “1933 Act”). In addition, the Act expands the scope of the blue sky registration exemption by amending Section 18 of the 1933 Act. Finally, the Act expands the exception under Section 3(c)(1) of the Investment Company Act of 1940 (the “1940 Act”) for “qualifying venture capital funds,” directs the SEC to streamline the offering process for closed-end funds, and expands investor protection to mutual funds domiciled in U.S. territories. These changes are described below.
1933 Act Actions
Rule 701 provides an exemption from the registration requirements of the 1933 Act for offers and sales of securities by private companies pursuant to written compensatory benefit plans or contracts for employees, directors and consultants. Rule 701 requires issuers to deliver a copy of the compensatory benefit plan or the contract to participants before offering and selling the relevant securities. However, if the aggregate sales price during any consecutive 12-month period exceeds $5 million, Rule 701 requires issuers to provide enhanced disclosures to all participants “a reasonable period of time before the date of the sale.” The enhanced disclosures include risk factors and financial statements that are no more than 180 days old. For retirement plans under ERISA, issuers must provide participants with a copy of the summary plan description required by ERISA. For plans not subject to ERISA (e.g., typical stock incentive plans), issuers must provide participants with a summary of the material terms of the plan.
The Act directs the SEC to increase the threshold amount for enhanced disclosures from $5 million to $10 million over a 12-month period.
Regulation A provides an exemption from 1933 Act registration requirements for certain smaller public offerings. Regulation A offerings are divided into two tiers: Tier 1 offerings are limited to $20 million in sales in a 12-month period while Tier 2 offerings may not exceed $50 million in sales in a 12-month period. Tier 2 offerings are exempt from state blue sky laws, but issuers must satisfy ongoing periodic reporting obligations. For both tiers, issuers must file offering statements on Form 1-A with the SEC.
Currently, companies that have SEC reporting obligations under Sections 13 or 15(d) of the Securities Exchange Act of 1934 are prohibited from issuing securities pursuant to Regulation A. The Act directs the SEC to amend Regulation A to allow reporting companies to offer securities pursuant to Regulation A. In addition, reporting companies utilizing Tier 2 offerings will be able to satisfy Regulation A’s periodic reporting obligations by complying with their reporting obligations under Section 13 or Section 15(d).
Blue Sky Registration Exemption
Section 18 of the Securities Act exempts offerings of “covered securities” from state blue sky laws. Section 18(b)(1) provides that covered securities include securities listed or authorized for listing on the New York Stock Exchange, American Stock Exchange, or National Market System of the Nasdaq Stock Market. In addition, covered securities include securities listed or authorized for listing on a national securities exchange that has been determined by the SEC to have listing standards similar to the aforementioned exchanges.
The Act amends Section 18 to apply the exemption from state blue sky laws to offerings of securities designated as qualified for trading in the national market system that are listed, or authorized for listing, on any national securities exchange, rather than applying the exemption to the various enumerated securities exchanges.
1940 Act Actions
Expansion of the Section 3(c)(1) Private Fund Exception for Qualifying Venture Capital Funds
Certain private investment funds ¾ including venture capital funds, hedge funds, and private equity funds ¾ rely on an exception from the 1940 Act definition of “investment company” contained in Section 3(c)(1) of the 1940 Act to avoid registration with and regulation by the SEC as an investment company. Prior to enactment of the Act, Section 3(c)(1) excepted a fund from the definition of “investment company” if the fund was not engaged in a public offering and if the fund’s securities were beneficially owned by not more than 100 persons.
The Act extends the Section 3(c)(1) exception by permitting “qualifying venture capital funds” that are not engaged in a public offering to have up to 250 beneficial owners. The intent behind expanding beneficial ownership in qualifying venture capital funds is to improve access to capital for small, startup businesses in which such venture capital funds invest.
As amended by the Act, Section 3(c)(1) defines a “qualifying venture capital fund” as any venture capital fund (as currently defined in Rule 203(l)-1 under the Investment Advisers Act of 1940) with not more than $10 million in aggregate capital contributions and uncalled capital commitments. Given this size limitation, the Act’s expansion of Section 3(c)(1) can be expected to have a relatively limited effect on the overall private investment fund market.
Streamlining the Offering Process for Closed-End Funds
The Act directs the SEC to propose rules to allow registered closed-end funds that are listed on a national securities exchange or interval funds operating under Rule 23c-3 under the 1940 Act (together, “closed-end funds”) to rely on reporting procedures currently available to operating companies with well-known seasoned issuer status. In particular, the new rules will streamline the registration process for closed-end funds, allowing them to offer additional shares through a shelf registration and to deliver prospectuses electronically. In addition, closed-end funds would no longer have to file post-effective amendments to their registration statements to update their financial statements. Instead, a closed-end fund’s initial registration statement could refer to future amendments and incorporate those by reference.
Notably, the Act’s changes do not apply to so-called “tender offer funds,” which are registered closed-end funds that are not listed on an exchange and do not make use of Rule 23c-3. Instead, tender offer funds offer liquidity through periodic tender offers made pursuant to the Exchange Act’s tender offer rules. It is not clear why the Act carves tender offer funds out of its relief.
The Act directs the SEC to propose the new closed-end fund rules within one year from enactment of the Act, and such new rules should be effective by May 24, 2020.
Expanding Investor Protection to Mutual Funds Domiciled in U.S. Territories
The Act repeals Section 6(a)(1) of the 1940 Act, which provided an exemption from investment company registration and regulation for mutual funds organized in certain U.S. territories, namely Puerto Rico, the Virgin Islands, and Guam. The exemption was originally enacted in 1940 based on the belief that it would be difficult to enforce the 1940 Act in distant U.S. territories. Repeal of the exemption will have the effect of extending the investor protection provisions of the 1940 Act to shareholders of mutual funds organized in Puerto Rico, the Virgin Islands, and Guam.
Existing funds relying on Section 6(a)(1) generally will have three years from the date of enactment of the Act to come into compliance with the amendment, subject to the ability of the SEC, upon its own motion or acting upon a fund’s application, to extend the effective date for up to another three years.