Securities Law and Other Resources for Growing Companies
On Wednesday FINRA issued a regulatory notice informing members that new FINRA Rule 5123 – Private Placements of Securities will take effect on December 3, 2012, and will apply prospectively to private placements that begin selling efforts on or after that date.
In an open meeting last Wednesday the Securities and Exchange Commission voted to propose rules and amendments to implement Section 201(a) of the JOBS Act, which is responsible for eliminating the prohibition on general solicitation and general advertising in private offerings conducted pursuant to Rule 506 of Regulation D and private resales conducted pursuant to Rule 144A of the Securities Act of 1933; provided that, in the case of Rule 506, all purchasers are accredited investors and reasonable steps have been take to verify their status as such, and, in the case of Rule 144A, all purchasers are qualified institutional buyers.
In 2011 issuer’s raised an estimated $895 billion in offerings using Rule 506 and an estimated $168 billion in offerings using Rule 144A. In 2010 those numbers were even higher, with an estimated $902 billion raised in offerings using Rule 506 and an estimated $233 billion raised in offerings using Rule 144A. In reality the Rule 506 numbers may be higher still, as even the Commission acknowledges that not everyone who uses the exemption files a Form D (which is a requirement, but not a condition to the availability, of the exemption).
Offers and Sales that Involve General Solicitation and General Advertising Under Rule 506
Under the proposed rules and amendments a new subsection (c) would be added to Rule 506 which would permit general solicitation and general advertising in offers and sales of securities provided that:
Note: offers and sales of securities made pursuant new Rule 506(c) would not be subject to the information disclosure requirements of Rule 502(b), because all of the purchasers in such an offering would be accredited investors.
Reasonable Steps to Verify Accredited Investor Status
In an effort to provide flexibility to accommodate the various types of issuers, investors and methods of verification, the Commission declined to define what constitutes taking “reasonable steps to verify” that a purchaser is an accredited investor. Instead the proposing release indicates that reasonableness should be an objective determination, based on the facts and circumstances surrounding a given transaction. The proposing release also goes on to discuss in some detail three factors that an issuer might consider, among others, when assessing the reasonable likelihood that a purchaser is an accredited investor and the reasonable steps that would be necessary to verify a purchaser’s status as such.
The Nature of the Purchaser
The first factor to consider is the nature of the purchaser and the type of accredited investor that the purchaser claims to be. For example, verifying that a broker-dealer is an accredited investor by virtue of being registered under Section 15 of the Securities Exchange Act of 1934, can be accomplished by simply conducting a FINRA BrokerCheck search. Whereas verifying that an individual purchaser is an accredited investor under the annual income or net worth standards may require several steps and raise additional issues, such as privacy concerns regarding the type of personal financial information that a purchaser may need to provide to verify their status as an accredited investor.
Information About the Purchaser
The second factor to consider is the amount and type of information that an issuer has about a purchaser. For example, certain verifying information may already be in the public domain, such as information about a purchaser’s annual income garnered from a proxy statement or information found in a Form 990 about a non-profit organization’s total assets. Other third-party information that is not available publicly may also provide reasonably reliable evidence of a purchaser’s accredited investor status, such as copies of an individual’s Forms W-2 or 1099 to verify annual income. Additionally, a purchaser’s status as an accredited investor might be verified by a third-party service provider, such as a broker-dealer, attorney, accountant or other reasonably reliable third-party that offers verification services.
The Nature and the Terms of the Offering
The third factor to consider is really twofold: the nature of the offering and the terms of the offering. For example, the manner in which a purchaser is solicited, such as through a website accessible to the general public, a widely disseminated email or by social media, as compared to from a database of pre-screened accredited investors maintained by a reasonably reliable third-party, will require a greater or lesser number of steps to verify that the purchaser is an accredited investor. Likewise, the terms of the offering itself may bear on the number of steps required to verify that a purchaser is an accredited investor. For example, in the release the Commission notes that it tends to agree with the view that a purchaser’s ability to meet a high minimum investment amount could be relevant to an issuer’s evaluation of the steps necessary to verify the purchaser’s status as an accredited investor.
A Note on the Importance of Adequate Record Keeping
The proposing release also stresses the importance of an issuer retaining adequate records that document the steps taken to verify a purchaser’s status as an accredited investor because, in the event that a question should ever arise, the burden of demonstrating entitlement to an exemption from registration falls entirely on the issuer.
Offers and Sales that Do Not Involve General Solicitation and General Advertising Under Rule 506
In its current form, Rule 506 permits offers and sales of securities to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors, provided that when non-accredited investors participate in an offering the information disclosure requirements of Rule 502(b) are met. As proposed the rules and amendments would preserve Rule 506 in its existing form in amended subsection (b), maintaining the rule’s availability for those issuers who do not wish to engage in general solicitation and general advertising, and thus avoid becoming subject to the requirement that they take reasonable steps to verify purchasers’ accredited investor status, as well as those issuers who would like the option to include sophisticated non-accredited investors in their offerings.
General Solicitation and General Advertising Under Rule 144A
Under the proposed rules and amendments Rule 144A of the Securities Act would also be revised to permit offers of securities to persons other than qualified institutional buyers (QIBS), including by means of general solicitation and general advertising, provided that the securities are sold only to persons that the seller, or anyone acting on the seller’s behalf, reasonably believe to be a QIB.
Proposed Changes to Form D
Finally, the Commission is also proposing to revise Form D to add a separate box to be checked when an issuer uses general solicitation or general advertising in a Rule 506(c) offering. Such information would allow the Commission to get a general sense of the size of the market for offerings that use general solicitation and general advertising.
Comment Period
The Commission is soliciting comments on a number of aspects of the proposed rules and amendments, most notably on a variety of issues related to verification of accredited investor status. Comments are due 30 days from publication of the proposed rules and amendments in the Federal Register.
Last week the Securities and Exchange Commission approved an amended version of new FINRA Rule 5123.
The approved version of the new rule, which is considerably narrower than the original version, requires that a broker-dealer who participates in a private placement of securities file with FINRA copies of the private placement memorandum, term sheet or other offering documents, or indicate that there were no offering documents used. The filing must be made within 15 days of the date of the first sale of securities.
There are, however, a number of private placements which are exempt from new Rule 5123, for example, those involving securities sold solely to certain types of investors, such as institutional accounts, qualified purchasers within the meaning of the Investment Company Act, qualified institutional buyers (QIBs), investment companies, banks, certain employees and affiliates of an issuer, and certain accredited investors within the meaning of Rule 501(a) of Regulation D (such as banks and business development companies, but not individual investors or directors and officers). Certain types of offerings are also exempt from new Rule 5123, such as those made pursuant to Rule 144A or Regulation S.
All documents and information filed under new Rule 5123 will be afforded confidential treatment and used only to determine compliance with applicable FINRA rules and regulatory requirements.
Regulation A is a conditional securities exemption allowing for public offers and sales of up to $5 million dollars of securities in a 12-month period. To be eligible to use Regulation A a company must be organized under the laws of the United States or Canada, must not be an investment company or blank check company and must not be subject to the periodic reporting requirements of the Securities Exchange Act.
Conducting a Regulation A offering is somewhat analogous to conducting a registered offering, though much simpler in form and substance, and is often referred to as a “mini-registration”.
In a Regulation A offering a company must prepare and file an offering statement with the Securities and Exchange Commission. An offering statement requires disclosures similar to those made in a registration statement, including disclosures regarding a company’s business and financial condition, its officers, directors and principal stockholders, risk factors, a description of the use of offerings proceeds and so on. An offering statement also requires the filing of certain exhibits and the inclusion of financial statements, which can be unaudited but must be prepared in accordance with generally accepted accounting principles.
Once a company’s offering statement is on file it is reviewed and qualified by the Commission, similar to the process of a registration statement being reviewed and declared effective. After the offering statement is qualified an offering circular, which makes up part of the offering statement, must be delivered to prospective investors prior to any securities being sold.
Thereafter the company must file reports with the Commission detailing the securities sold and the use of proceeds from those sales. The reports must be filed every six months until substantially all of the proceeds from the offering have been applied.
Notwithstanding the sales and use of proceeds reports, and unlike in a registered offering, once a Regulation A offering is complete there are no ongoing reporting obligations; no current, quarterly or annual reports to file (unless of course Exchange Act registration is triggered by some other means, such as by crossing the shareholder threshold required for registration). What’s more, any securities sold in a Regulation A offering are unrestricted and may be freely transferred in a secondary market transaction.
Another way in which Regulation A offerings differ from most other offerings is that Regulation A permits a company to gauge investor interest, or to ”test the waters”, by means of general solicitation or general advertising prior to the filing of an offering statement. This ability to test the waters is not without limitation however, for example any written documents or scripts of oral presentations must be filed with the Commission prior to their first use. In addition, a company must also comply with the securities laws in each state in which an offer of securities is to be made, some of which do not permit general solicitation or general advertising.
One other item of note, there are also certain instances in which Regulation A can be used for secondary offerings, allowing shareholders resell up to $1.5 million of securities in a 12-month period.
Even though Regulation A does offer a simpler alternative to a full-scale registered offering it’s hardly ever used, in part because of its $5 million dollar offering limitation. In 2010 there were 25 initial Regulation A offerings filed with the Commission, but only 7 of these offerings were qualified.
A Regulation A Redux
The JOBS Act adds a new Section 3(b) to the Securities Act which calls for the Commission to implement an exemption for the public offer and sale of up to $50 million of securities in any 12-month period. There is no required time frame for implementation of this exemption.
The requirements of the new exemption start out much like an enhanced version of Regulation A. The securities, which can be equity securities, debt securities or debt securities convertible into or exchangeable for equity securities, may be publicly offered and sold and will thereafter be freely transferable (they will not be restricted securities). Additionally, subject to any terms or conditions that the Commission may prescribe, companies that wish avail themselves of the new exemption will be permitted to “test the waters” prior to undertaking an offering.
Similar to Regulation A, the new exemption contemplates the preparation and filing of an offering statement, the form and content of which the Commission will prescribed, but which may include a description of the company’s business and financial condition, its corporate governance principles, use of proceeds and audited financial statements. In addition, the exemption requires that companies file audited financial statements with the Commission on an annual basis and provides that the Commission may also require additional periodic disclosures regarding the company’s business and financial condition, its corporate governance principles and use of the offering proceeds.
Unlike Regulation A, if the securities under the new exemption are offered and sold on a national securities exchange or to qualified purchasers then they will be “covered securities” and exempt from the state securities laws.
The Commission also has the discretion to establish disqualification provisions under which the new exemption would not be available to certain companies or their affiliates for reasons substantially similar to the bad actor disqualification provisions to be established under the Dodd-Frank Act (which are themselves based on the disqualification provisions of Regulation A).
Lastly, every two years the Commission will have to review and increase, if appropriate, the $50 million offering limitation, or, if not increased, report to Congress as to why.
The JOBS Act makes several significant changes to the rules surrounding private capital formation. One such change being the much-discussed elimination of the prohibition on general solicitation and general advertising in certain private securities offerings. Another being the addition of an exemption from broker-dealer registration for platforms that, to a certain extent, facilitate offers and sales of unregistered securities.
General Solicitation and General Advertising in Private Offerings
Section 201 of the JOBS Act requires that within 90 days of its enactment, or by July 4, 2012, the Securities and Exchange Commission revise Regulation D to eliminate the prohibition on general solicitation and general advertising in private offerings made in reliance on the safe harbor afforded by Rule 506, provided that only accredited investors participate in the offerings.
In its current form, Rule 506 allows an unlimited amount of capital to be raised from an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors, provided, however, that whenever non-accredited investors participate in an offering certain information disclosure requirements must be met. In its current form Rule 506 also explicitly prohibits general solicitation and general advertising, regardless of whether participating investors are accredited or non-accredited.
Section 201 of the JOBS Act also requires that the Commission, again by July 4, 2012, revise Rule 144A to provide that securities sold thereunder may be offered to persons other than qualified institutional buyers (QIBs), including by means of general solicitation or general advertising, provided that the securities are ultimately sold only to persons that the seller or anyone acting on the seller’s behalf reasonably believe to be QIBs.
Like Rule 506, Rule 144A is a safe harbor for sales of unregistered securities. Where they differ is that Rule 506 addresses sales of securities by an issuer (akin to a primary offering), whereas Rule 144A addresses resales by persons other than an issuer (akin to a secondary offering). Very generally, the safe harbor afforded by Rule 144A allows for resales of a limited category of qualifying securities to QIBs. Rule 144A resales often follow in close proximity to the private offering in which the securities being resold were originally issued.
So how are these changes going to impact the market for private securities offerings?
Insofar as Rule 506 offerings are concerned, over time we may see a shift from other types of Regulation D offerings to Rule 506 offerings, but lifting the ban on general solicitation and general advertising is not likely to have a significant impact on the type of investors participating in Rule 506 offerings.
Based on a recent report by the Commission’s Division of Risk, Strategy and Financial Innovation (FSHI), Rule 506 is already by far the most popular private offering exemption; used in over half of all the private offerings examined in FSHI’s report. And, even though Rule 506 allows for participation by up to 35 non-accredited investor, almost 90% of all Regulation D offerings (Rules 504, 505 and 506 combined) are made up entirely of accredited investors. So, while we may ultimately see even more Rule 506 offerings, there’s not much room for a shift in the ratio of non-accredited to accredited investors.
As for transactions set up to take advantage of the Rule 144A resale exemption, they only make up a small number of the private offerings conducted each year and they generally involve larger companies that already are, or immediately become, subject to the Exchange Act’s reporting requirements. Compared to Rule 506 offerings, Rule 144A transactions are fairly niche and, while I don’t have anything in the way of stats to back it up, I don’t think that we’re going to see any great shift toward Rule 144A offerings just because general solicitation and general advertising is permitted.
Where lifting the ban on general solicitation and general advertising will undoubtedly have the greatest impact is in the amount of information about private offerings that becomes publicly available. Hopefully this will result in a better understanding of how private capital formation works, as opposed to an overload of information that is of diminishing value or quality.
One other item of note here is that, despite the JOBS Act having taken effect, the current prohibition on general solicitation and general advertising remains in place until the Commission adopts amended or new implementing rules and those rules themselves take effect.
The Platform Exemption to Broker-Dealer Registration
Finally, Section 201 the JOBS Act creates an entirely new exemption from the broker-dealer registration requirements for anyone that maintains a platform or other mechanism that permits offers, sales, purchases or negotiations of securities, or permits general solicitation, general advertising or related activities by an issuer that is offering securities, regardless of whether those activities take place online, in person or by some other means.
What’s more, the exemption is available even if the person maintaining the platform invests in or provides “ancillary services” related to the securities that are made available through the platform. Ancillary services are defined to include due diligence services, provided no compensated investment advice is given, and the provision of standardized documents, provided there is no involvement in the negotiation process and the parties are free to use their own transaction documents if they choose to.
Lastly, the exemption is contingent on there being no transaction related compensation, no possession of securities or customer funds and no involvement by persons subject to statutory disqualification under Section 3(a)(39) of the Exchange Act.
Yesterday the Securities and Exchange Commission’s Division of Risk, Strategy and Financial Innovation released a report analyzing information extracted from all Form D filings made with the Commission between January 2009 and March 2011. The report, entitled Capital Raising in the US: The Significance of Unregistered Offerings Using the Regulation D Exemption, coincides with a slide presentation given before the Advisory Committee on Small and Emerging Companies in October 2011. The report looks at the amount of capital raised using the Regulation D exemptions (Rules 504, 505 and 506) as compared to the amount of capital raised using other methods, public and private, and gives us a bit of insight into common Regulation D offering characteristics and the companies that most frequently avail themselves of the Regulation D exemptions.
Common Regulation D Offering Characteristics
Using information reported in response Item 13 of Form D, the report begins by estimating the total amount of capital raised in Regulation D offerings for the 2009 and 2010 calendar years (take a look at the report’s appendix for some of its methodologies and assumptions, including the treatment of Form D amendments). Item 13 of Form D requires that a company specify:
Based on a review of these figures the report estimates that, for the 2009 and 2010 calendar years, capital raised through Regulation D offerings ranged from a minimum (calculated using Item 13(b)) of approximately $587 and $905 billion, respectively, to a maximum (calculated using Item 13(a)) of approximately $1.5 and $1.2 trillion, respectively. With the average offering size being approximately $30 million, but the median offering size only being approximately $1 million, suggesting that a large number of smaller offerings took place.
Among the available Regulation D exemptions, Rule 506 was by far the most popular one to be claimed during the period examined. Rule 506 allows you to raise an unlimited amount of capital from an unlimited number of accredited investors, and up to 35 non-accredited investors, provided certain information and other requirements are met.
The data also reveals that during the 2009 and 2010 calendar years the total amount of capital raised in Regulation D offerings was more than twice the total amount of capital raised in public equity offerings. There are, however, other factors that might be influencing these findings, not the least of which being the state of the capital markets during the period in question. It’ll be interesting to see if this trend continues as the environment for public equity improves.
Another interesting bit of information revealed by the data is the number and type of investors that typically participate in a Regulation D offering. Only approximately 10% of investors that participated in offerings during the period examined were non-accredited investors. With approximately 90% of offerings being made up of entirely accredited investors. In addition almost 90% of offerings involved approximately 30 investors or less.
Common Company Characteristics
The report also gives us some insight into the type of companies that most frequently avail themselves of the Regulation D offering exemptions. For example, Item 4 of Form D requires that a company identify its industry group and Item 5 asks that it disclose its revenue range (though companies have the option to “Decline to Disclose”).
Based on a review of the responses to Item 4, nearly one-third, or 29%, of the Form D filers in 2009 and 2010 identified themselves as pooled investments funds (of which approximately half, or 55%, further identified themselves as hedge funds). Of the remaining companies, approximately 15% identified themselves as being in the technology industry, approximately 10% in the health care industry and approximately 8% in the real estate industry.
While approximately half of all companies declined to disclose their revenues, of the companies that did make the disclosure nearly 20% had no revenues at all and another approximately 20% had revenues of $25 million dollars or less (the chart below accounts for a $1.00 – $5 million revenue range and a $1 million – $5 million revenue range, but Form D calls for disclosure in the $1.00 – $1 million and $1 million – $5 million revenue ranges, so it’s unclear to me as to whether there’s overlap in the chart or a typo, though I assume the latter). Finally, less than 4% of all companies raising capital in a Regulation D offering reported revenues in excess of $25 million.
Additionally, during the period examined approximately 25% of all companies that raised capital in a Regulation D offering were foreign companies.
And, of the universe of public companies, approximately 10% raised capital in a Regulation D offering, with those relying on Regulation D tending to be smaller and less profitable then their peers.
A complete copy of the report is embedded below, it’s brief and there are plenty of additional charts to flip through:
Yesterday the Securities and Exchange Commission approved additional listing requirements for companies that apply to list on the NYSE, Nasdaq or Amex following completion of a reverse merger with a shell company.
Under the new rules a reverse merger company will not be eligible for listing until it:
In addition, each of the NYSE and Amex rules reserve the discretion to impose more stringent listing requirements in the case of a particular reverse merger company based on, among other things:
Two Exceptions
There are two exceptions. A reverse merger company will not be subject to the additional listing requirements if it is applying to list its securities on NYSE, Nasdaq or Amex in connection with a firm commitment underwritten public offering where the proceeds to the company will be at least $40 million and the offering occurs subsequent to or concurrently with the reverse merger.
Alternatively, if the reverse merger company satisfies the one-year “seasoning-period” and has filed at least four annual reports containing audited financial statements, then it may apply for listing under any one of the respective exchanges’ other initial listing standards.
Yesterday the Division of Corporation Finance issued informal disclosure guidance summarizing some of the more common issues that come up in the Staff’s review of the Forms 8-K filed following a reverse merger or similar change in control transaction with a shell company. This Form 8-K is sometimes referred to informally as a “Super 8-K” because, among other things, it must contain all of the information required in an Exchange Act Form 10 filing, including audited financial statements, and must be filed within the four business day window following the close of a transaction.
Some of the issues touched on in the guidance include:
Today the Securities and Exchange Commission announced the formation of a new Advisory Committee on Small and Emerging Companies.
The Committee, made up of nineteen voting members and two observer members, will provide advice and recommendations to the Commission on issues related to emerging privately held small businesses and publicly traded companies with market caps of less than $250 million.
Some of the issues the Committee will address include:
The Committee will formally be established with the filing of its charter, fifteen days after publication of the Commission’s notice in the Federal Registrar, and will operate for a period of two years unless earlier terminated or renewed.
A final copy of the charter will be available on the Commission’s website, but below is the undated copy on file in the Federal Advisory Committees Database.
The Committee currently anticipates meeting at least three times each year.
The Division of Corporation Finance added eight new Compliance and Disclosure Interpretations (C&DIs) to the Commission’s website yesterday, addressing four main areas of disclosure:
Notification of Late Filings (Question 107.02)
The first notes that if a company is filing a Notification of Late Filing on Form 12b-25, but doesn’t believe that it will be able to file the required report by the extended deadline, then it shouldn’t check the box in Part II of Form 12b-25 indicating that it will.
This seems obvious enough, but what happens if a company doesn’t check the box and somehow manages to file the required report by the extended deadline? Not to worry, if the deadline is met then the Commission will consider the report to have been timely filed, regardless of the checking of the box.
Compensation Related Disclosures (Questions 108.01, 117.07, 118.08 and 119.28)
The next three C&DIs address compensation related disclosures:
The first reiterates that Regulation G and Item 10(e) of Regulation S-K apply to any non-GAAP financial disclosures, other than target level disclosures, that are included in a company’s proxy statement. With regard to pay-related non-GAAP disclosures, the Commission notes that it will not object if a company includes the requisite GAAP reconciliations in a prominently cross-referenced annex or by incorporation by reference to the relevant pages of the company’s annual report containing the requisite GAAP reconciliations.
The second specifies that a company may omit disclosure regarding disability plans (as with group life, health, hospitalization, or medical reimbursement plans) that do not discriminate in scope, terms or operation, in favor of its executive officers or directors, and that are available generally to all of its salaried employees.
The third is a little counterintuitive (at least it was at first for me). It notes that the grant date fair value for stock and option awards that are subject to performance conditions must be reported based on the probable outcome of the performance conditions as of the grant date, even if the actual outcome is known as of the disclosure date. (For clarity’s sake you may want to take a look the fact pattern posed by question 119.28)
Disclosure Regarding Departing Directors (Question 116.10)
The next CD&I represents a change in position from question 116.08, which was withdrawn as of yesterday.
Basically it states that if a company incorporates by reference into its annual report disclosure from its proxy statement regarding the identification and business experience of its directors, and the definitive proxy statement is filed within 120 days of the company’s fiscal year-end, then the company may omit from both the proxy statement and annual report disclosure regarding any director whose term will not continue after its annual shareholder meeting.
If, however, a company directly discloses information regarding the identification and business experience of its directors in its annual report (rather than incorporating by reference), it cannot omit disclosure regarding any director whose term will not continue after the company’s annual shareholder meeting.
Disclosures Related to Say on Frequency (Questions 121A.03 and 121A.04)
The final two CD&Is address disclosures related to shareholder advisory votes on the frequency of advisory votes on executive compensation (say on frequency votes):
The first notes that, with respect to the say on frequency vote, a company is not required to disclose the number of broker non-votes; only the number of votes cast for each of the one, two and three-year frequency options and the number of abstentions.
The second notes that a company may disclose the initial voting results from its shareholder meeting in an annual or quarterly report, rather than in a Form 8-K, provided the report is filed within the requisite disclosure period. Thereafter, a company may choose to disclose its board’s decision as to how frequently it will hold the shareholder advisory vote on executive compensation in a new Form 8-K, rather than by amending the annual or quarterly report in which the initial voting results were disclosed. If, however, the initial voting results are disclosed in a Form 8-K the board’s subsequent decision as to how frequently the shareholder advisory vote on executive compensation will be held must be disclosed in an amendment to the original Form 8-K, as opposed to a new Form 8-K.
Statement on Well-Known Seasoned Issuer (WKSI) Waivers
In addition to the new C&DIs, the Division of Corporation Finance also released a statement outlining the framework that it will use when determining whether to grant an “ineligible issuer” waiver to a company that has lost its status as well-known seasoned issuer for having violated the anti-fraud provisions of the federal securities laws. The statement is very brief and if you’re a WKSI worth the quick read.
