Rarely Used Rule May Expand Small Companies’ Access to Capital

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SEC proposal would exempt small businesses from federal and state security registration.

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Smaller companies hoping to secure capital may soon have a new avenue available, thanks to a new Securities and Exchange Commission (SEC) proposal nearing the end of its comment period.

Amid a flurry of other proposed and final rules mandated by the Jumpstart Our Business Startups (JOBS) Act, the new SEC proposal would exempt small businesses from federal and state registration to secure capital up to $50 million in securities within a year.  Currently, small businesses must register with the SEC if they want to raise any capital greater than $5 million.

The SEC’s proposal would amend Regulation A, which currently imposes the $5 million cap on registration-free capital accumulation.  The SEC’s recent proposal – widely labeled as Regulation A-Plus – is an effort by the Commission to increase the use of Regulation A, which recorded only one qualified offering in 2011.

The current Regulation A framework permits companies to offer up to $5 million in unregistered securities in a 12-month period.  Of the $5 million, security holders of the company may only offer $1.5 million in securities under current rules.  Filing securities registrations with the SEC is required under the 1933 Securities Act, but it can be costly and time-consumer for small businesses.  Under Regulation A, companies need not complete the full registration but only are required to file offering statements and annual financial audits with the SEC. These reduced standards make relatively small securities offerings less expensive and time-consuming than full SEC registration.

According to a 2012  Government Accountability Office (GAO) report, businesses have relied on Regulation A less and less in recent years. In 1997, businesses filed 116 unregistered securities offerings using the exemption in Regulation A, compared to only 19 in 2011.  Only one such offering in 2011 qualified for exemption under Regulation A.

The GAO report noted that the precipitous decrease in the use of the Regulation A exemption was likely due to the attractiveness of other available options for smaller businesses.  After the passage of the National Securities Markets Improvement Act, Regulation D has exempted qualifying companies from SEC registration requirements without any limit on the maximum offering amount.  Regulation D offerings are not only exempt from registration but are also not subject to costly and time-consuming state blue sky laws.  Blue sky laws are individual state registration and qualification requirements for offering securities.

Regulation A’s major advantage over Regulation D is that issuers are able to sell securities to an unlimited number of unaccredited investors.  Under Regulation D, issuers are limited to raising up to $5 million through a combination of unlimited accredited investors and up to 35 unaccredited investors.  Regulation A lacks this unaccredited investor cap.

Without a statutory preemption of state laws, however, Regulation A offerings have still been disfavored.  According to SEC data, in 2010 and 2011 there were over 15,500 Regulation D filings for up to $5 million, the targeted range for Regulation A.  During this same period, there were only eight qualified Regulation A offerings

In the hopes of encouraging smaller companies seeking capital from unaccredited investors to rely on Regulation A more frequently, the proposed rule would give issuers two options to offer securities under the Regulation: Tier one, which would be exactly the same as the current Regulation A, and Tier 2.  This second option would permit an exemption for unregistered public offerings up to $50 million, a ten-fold increase from the current limit. It would also increase the amount security-holders of the company could sell from $5 million to $15 million.

Regulation A-Plus would allow small business stock issuers more flexibility in communicating with potential investors before and after filing their securities offerings with regulators.  This change would assist issuers in determining if adequate interest in the securities exists before going through the expense of the offering process.  Regulation D does not provide similar “testing the waters” provisions, but it also does not require the additional information that would be required under Regulation A-Plus.

The SEC also directly addressed the GAO report’s concerns that other available options were preferred because of state blue sky law preemption.  Companies opting for the proposed Tier 2 of Regulation A would be exempt from seeking state approval for their offerings.  Instead, Tier 2 offerings would be subject to additional public reporting requirements.  The SEC would require companies to file audits of financial statements included in the offering circular and regular ongoing reports similar to those required for public company offerings.  Investments would also be limited to the greater of 10 percent of the investor’s annual income or net worth.

State regulators have not welcomed the SEC’s proposal to expand opportunities for businesses to be exempted from their securities regulations.  The North American Securities Administrators Association (NASAA), which represents securities regulators, has urged SEC commissioners not to expand Regulation A’s preemption of state regulatory power.  Andrea Seidt, President of the NASAA and the Ohio Securities Commissioner, stressed the inherent high risk of Regulation A offerings and the necessary role state review plays in discouraging securities fraud.

Another state regulator, William F. Galvin, Secretary of the Commonwealth of Massachusetts, submitted to the SEC an equally strong rebuke of Regulation A-Plus.  “The states have tackled preemption battles on many fronts, but never before have we found ourselves battling our federal counterpart,” Galvin wrote.  “Shame on the S.E.C. for this anti-investor proposal . . . that puts small retail investors unacceptably at risk,” he continued.

Interested members of the public may comment on the SEC’s proposed rule until March 24, 2014.