Last month, the Securities and Exchange Commission passed sweeping reforms of the rules governing exempt offerings (the “2020 Reforms”) to make it easier for issuers to move from one exemption to another, to bring clarity and consistency to the rules governing offering communications, to increase offering and investment limits and to harmonize certain disclosure requirements and bad actor disqualification provisions. I blogged about the SEC’s rules release here. I also said at the time I would blog separately about some of the particular reforms contained in the new rules. Here, then, is the first installment of a multi-part series on the new reforms, this one on the new offering and investment caps for Regulation A, Regulation Crowdfunding and Rule 504.
The SEC has estimated that approximately $2.7 trillion of new capital was raised through exempt offerings in 2019, of which only 0.05% was raised under Regulation A, Regulation Crowdfunding and Rule 504 combined. These three exemptions contain a variety of requirements and investor protections, including limits on the amount of securities that may be offered and sold under the exemptions. Regulation A and Regulation Crowdfunding also include limits on how much an individual may invest. One of the primary reasons cited for the underutilization of these exemptions is that the dollar limits have been set too low to make them useful.
Higher Caps for Tier 2 of Regulation A
SEC rules promulgated in 2015 under the JOBS Act of 2012 established two tiers of offerings under Regulation A: Tier 1 for offerings up to $20 million in a 12-month period, and Tier 2 for offerings that do not exceed $50 million in a 12-month period.
The 2020 Reforms increase the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million, and the maximum offering amount for secondary sales by existing affiliate stockholders from $15 million to $22.5 million.
Despite the increase in the offering cap to $50 million in 2015, Regulation A financing levels remained modest relative to traditional IPOs and Regulation D. A 2020 report by the SEC’s Division of Corporation Finance found that from June 2015 to December 2019, $2.4 billion was raised by 183 issuers in Regulation A offerings, $230 million in Tier 1 and $2.2 billion in Tier 2. The 2020 report noted that the weak Regulation A deal levels are likely related to a combination of factors, including the pool of issuers and investors drawn to the market under existing conditions, availability to issuers of attractive private placement alternatives without an offering limit, availability to investors of attractive investment alternatives outside of Regulation A with a more diversified pool of issuers, limited intermediary participation and a lack of traditional underwriting and a lack of secondary market liquidity.
The new $75 million cap will likely attract a more seasoned pool of investors as well as institutional investors, and improve the economics for issuers and broker dealers to participate in the Regulation A market.
Not everyone was in favor of raising the Tier 2 cap. Some opponents believe that issuers raising such large amounts of capital should be subject to the full disclosure regime of a Securities Act registration. Others worry about the negative effects of increasing the use of Regulation A for unsophisticated non-accredited retail investors given the increased risks of investor losses. The counter view, however, is that the enhanced issuer eligibility, content and filing requirements for issuers in Tier 2 offerings continue to provide appropriate protections for investors at the higher offering limit.
Higher Caps for Regulation Crowdfunding
The JOBS Act provided that the aggregate amount raised in Regulation Crowdfunding offerings during any 12-month period may not exceed $1 million, but also required the SEC to adjust the aggregate cap not less frequently than once every five years to reflect changes in the Consumer Price Index for All Urban Consumers. In 2017, the SEC raised the maximum offering limit to $1.07 million.
Regulation Crowdfunding also limits the amount individual investors are allowed to invest across all Regulation Crowdfunding offerings over the course of a 12-month period. The amount of the individual limit depends on his or her net worth and annual income, with an overall cap currently set at $107,000. The current (pre-amendment) individual investor limitations are set at:
- The greater of $2,200 or 5% of the lesser of his or her annual income or net worth, if either annual income or net worth is less than $107,000; or
- 10% of the lesser of his or her annual income or net worth, if both annual income and net worth are equal to or greater than $107,000.
The 2020 Reforms raise the Regulation Crowdfunding aggregate offering limit from $1.07 million to $5 million. The 2020 Reforms also amend the investor limit in two important ways. First, by not applying any investment limits to accredited investors; and second, by allowing non-accredited investors to rely on the greater of their annual income or net worth when calculating the limit on how much they may invest.
A 2019 SEC study found that the number of offerings and the total dollar amount of funding raised under Regulation Crowdfunding were relatively modest, with issuers raising only $108 million from May 16, 2016 through December 31, 2018. The study also found that the typical offering during the reviewed period raised less than the 12-month offering limit.
Approximately 2,000 offerings were initiated under Regulation Crowdfunding in the three and a half years from the time the exemption first became available through the end of 2019, but market participants had expressed concern that the vitality of the market and the number of offerings was being constrained by the $1.07 million offering limit.
Currently, companies seeking to raise more than $1.07 million need to spend time and expense pursuing other exempt offerings to supplement amounts raised under Regulation Crowdfunding and meet their funding needs, as the existing offering limits in Regulation Crowdfunding are insufficient to meet those needs. Permitting larger offerings under Regulation Crowdfunding should encourage more issuers to use the exemption and will lower the offering costs per dollar raised, which will make the exemption a more efficient capital raising option for smaller issuers.
The higher cap should also make Regulation Crowdfunding a more viable option for issuers looking to raise more than $1.07 million, but for which Regulation A may be cost prohibitive and for which Regulation D is too limiting in terms of the investor pool. Crowdfunding offerings permit greater participation of retail investors, in contrast to Rule 506(b) offerings under which technically up to 35 non-accredited investors may participate but as a practical matter hardly any offerings include them because of the built-in disclosure bias in favor of Rule 506(b) offerings made only to accredited investors.
As for accredited investors, the elimination of investment limits will make the treatment of accredited investors consistent across offering exemptions. Accredited investors are not subject to investment limits in Regulation D offerings. Allowing accredited investors to invest without limit in a Regulation Crowdfunding offering will obviously help issuers to meet their capital raising goals.
Higher Caps for Rule 504
In 2016, the SEC amended Rule 504 to raise the aggregate dollar amount of securities an issuer may offer and sell in any 12-month period from $1 million to $5 million. Nevertheless, Rule 504 continues to be a neglected capital raising pathway. From 2009 through 2019, only only two percent of the capital raised in sub-$5 million Regulation D offerings by issuers other than pooled investment funds was offered under Rule 504 (and under Rule 505, prior to its repeal), while 98 percent of the capital raised was offered under Rule 506.
The 2020 Reforms raise the maximum offering amount under Rule 504 of Regulation D from $5 million to $10 million.
The Rule 504 exemption has largely remained unused by issuers for several reasons, including the low $5 million offering cap. Increasing the offering amount will enable more issuers to gain access to this alternative pathway and provide more investment opportunities to investors.
But another reason for the underutilization of Rule 504 is the lack of state preemption. Securities issued in a Rule 504 offering are not deemed “covered securities”, as is the case under Rule 506(b) and (c), and as a consequence issuers in Rule 504 offerings must go through merit reviews under state blue sky laws in each state in which the offering is made. Categorizing Rule 504 securities as “covered securities” would greatly simplify the compliance requirements for issuers relying on Regulation D, and further promote access to Rule 504 for issuers that previously ignored this exemption because of the onerous requirement to comply with state blue sky laws. For the time being, the SEC has chosen not to take that step.
The foregoing offering cap changes will generally become effective 60 days after publication in the Federal Register, likely to occur sometime in February 2021.