July 10, 2019
By: Allan Grauberd
The SEC is undertaking a systematic reexamination of private offering exemptions from federal securities law registration in an effort to improve private capital formation. In issuing its concept release (the “Concept Release” or “CR”) on June 18th, 2019, the chairman of the SEC, Jay Clayton, stated that:
“We are taking a critical look at our exemptions from registration to ensure that our multifaceted private offering framework works for investors and entrepreneurs alike, no matter where they are located in the United States,” said SEC Chairman Jay Clayton. “Input from startups, entrepreneurs and investors who have first-hand experience with our framework will be key to our efforts to analyze and improve the complex system we have today.”
The Concept Release offers a broad overview of the various securities registration exemptions that are the product of more than eight decades of evolving exemption legislation and rulemaking. The SEC explains and suggests a reexamination of, among other things, the Section 4(a)(2) private placement exemption, the Regulation D safe harbor and, specifically, Rules 504, 506(b) and 506(c), Regulation A, intrastate exemptions, Regulation Crowdfunding, resale exemptions, and various regulations with respect to pooled investment funds. And it offers a variety of possible amendments for public comment.
The Concept Release (helpfully) provides statistical analysis of the frequency of each exemption’s use and includes an interesting chart on page 18 comparing the amounts raised in various types of exempt private offerings in the past decade, which shows an aggregate exceeding the amount raised in all registered offerings!
What follows are highlights of the Concept Release and some of the more interesting possibilities suggested for possible amendment1.
Regulation D and Rules 506(b), 506(c) and 504
A key element of the private offering framework is the Regulation D safe harbor and, specifically, Rule 506(b). One of the themes of the Concept Release, which comes up prominently in the discussion of Regulation D and Rule 506(b), is enhancing the ability of non-accredited investors to invest in a broader range of offerings (CR at p. 23).
Rule 506(b), which permits offerings of an unlimited amount to an unlimited number of accredited investors (and up to 35 non-accredited investors with requisite sophistication levels), remains by far the most popular exemption, with $1.5 trillion raised in 2018 (CR at p. 19). Despite allowing non-accredited investors meeting sophistication standards to participate, most Rule 506(b) offerings have been sold solely to accredited investors with only 6 percent of Rule 506(b) offerings including non-accredited investors (CR at p. 79).
The reason for the disparity, the SEC suggests (CR at p. 79), is that the presence of any non-accredited investor (regardless of sophistication) triggers the information requirements of Rule 502(b), which compels a significant information burden on a private offering analogous to that of a registered offering. The author’s experience as a practitioner is that this information burden, indeed, is a significant reason why non-accredited investors have been excluded from most private offerings involving issuers not already subject to the periodic reporting requirements of the Securities Exchange Act of 1934. The SEC poses possible alternatives to the information requirements to permit more participation by non-accredited investors, such as if they are advised by a financial professional or invest a limited amount or if they invest alongside a lead accredited investor on the same terms (CR at p 83-84, question 36, 38).
In 2013, the SEC added a new exemption under Rule 506(c), which permits an offering made solely to accredited investors to be publicly advertised, so long as the issuer verifies independently the accredited status of the investors2. The SEC notes, however, that Rule 506(c) has not caught on as originally expected, with Rule 506(b) representing 89% of Rule 506 offerings as compared to 11% for Rule 506(c), and 94% of amounts raised vs 6% for Rule 506(c). (CR at 79). Rule 506(c), according to practitioners, has not functioned well because (i) issuers have familiarity with their investor networks and don’t need to advertise for “accredited strangers”, (ii) investors are reluctant to share their personal financial information as needed for the Rule 506(c) verification process and (iii) issuers are reluctant to disclose their offering and business information to potential competitors and regulators (CR at p. 80).
The SEC poses questions on how to improve the utilization of Rule 506(c), such as providing less burdensome accreditation verification requirements or expanding the criteria to qualify as an accredited investor (see further below). From the author’s experience, the main reason for the under-utilization of Rule 506(c) is that attracting investors is still primarily a relationship based game, with public advertising having limited utility in bringing in the type of investors who are likely to have a level of trust required to make a significant investment in a private company. With the added burden of verification and risks of publicity of an issuer’s financing requirements and business plans, most issuers and securities practitioners remain comfortable with the old fashioned private placement model of Rule 506(b).
In 2016, the SEC adopted amendments expanding the use of Rule 504 to permit offerings up to $5 million instead of the previous limit of $1 million, while rescinding Rule 505, which was rendered obsolete by Rule 504’s increased limits3. The main advantage of Rule 504 is that it permits an unlimited number of unaccredited investors with no informational requirements. The main disadvantage is that, unlike Rule 506, it does not preempt state law and therefore a separate state exemption must be found. However, many states have some type of limited offering exemption that would permit a Rule 504 offering if there is no general solicitation (advertising), and the number of purchasers in the state is a relatively small number.
The SEC also poses questions about possible amendments to Rule 504. One helpful suggestion is increasing the Rule 504 offering limit to $10 million (CR at p. 118, question 67). In the author’s experience, the sole reason to use Rule 504 is to allow non-accredited investors to participate without subjecting the offering to Rule 502(b)’s burdensome information requirements. Another suggestion (one not mentioned in the Concept Release but consistent with Chairman Clayton’s theme of enhancing capital formation throughout the U.S.), would be for offerings complying with Rule 504 to preempt state law, but that may be a bridge too far and would likely be resisted by state regulators.
Accredited Investor Definition
Following the release of the Accredited Investor Staff Report in December 2015, which reviewed the history of the definition of “accredited investor” and suggested possible changes to it, the Concept Release solicits public comment on a number of potential amendments to the definition, including expanding the definition to include (i) use of non-financial criteria as a basis for accreditation (such as investment experience); (ii) professionals such as registered investment advisors and those possessing certain securities licenses; (iii) persons holding certain credentials such as MBA degrees; (iv) persons possessing certain professional experience such as lawyers and accountants with experience in the securities industry; and (v) knowledgeable employees of private funds (for investments in their employer’s funds). Other concepts floated in the Concept Release include accredited investor examinations, an “opt-in” to accredited investor status after receiving certain risk factor disclosure, and permitting an investor advised by a financial professional to qualify. (CR at p.57).
The SEC has also requested comment on changes to the current financial thresholds in the definition of accredited investor, including whether they should be indexed for inflation (CR at p. 55).
Prospect for Change Seems Good
It seems likely, given the overall theme of increasing access to private offerings, that some of the above changes will be adopted.
Additional Items of Note:
(i) In 2013, the SEC had proposed creating penalties for failing to file a Form D, including barring issuers from using Regulation D for a period of one year after curing a failure to file to timely file a Form D4. There is nary a word in the Concept Release that suggests this will be pursued.
(ii) There is a tantalizing footnote 55 on p 29 of the CR stating that the Division of Markets and Regulation is reviewing the status of finders. This is a significant area of concern given the issuer’s risks in using persons not registered as broker-dealers in sourcing investment. There have been many ideas raised about making it easier for finders to be involved in the private placement world (such as a more limited form of registration) but these ideas have not gone far except in the M&A world where the SEC has taken a no-action position that finders no longer need to be registered (on a federal level) for participating (and receiving commissions) in M&A transactions5. There is no indication in the footnote of the nature of the examination of this issue and what options are being considered.
(iii) The SEC touches on ways to liberalize resales of restricted securities as another possible way to foster capital formation. Of interest is the request for comment on permitting venture exchanges (CR Q 138 at p 210).
(iv) The SEC raises the possibility of altering certain facets of the integration doctrine. This doctrine calls for analyzing discrete offerings on a combined basis if they meet certain criteria, and is meant as a safeguard against evading compliance with exemptions that may be limited by time, number of investors, offering amount, or method of solicitation. In the CR, the SEC looks at ways of changing its approach to make the integration doctrine less of an obstacle to private offerings (CR Q 104-110 at p 170-172).
Allan Grauberd is the Chair of Moses & Singer’s Securities and Capital Markets Practice group.
 Our focus in this article is on private placements. There are areas of the Concept Release this article does not touch on including Regulation A, crowdfunding, intrastate exemptions and private funds.
 See our November 12, 2013 article The SEC Adopts Rules Permitting Public Advertising For "Private" Offerings Under Rule 506 Of Regulation D, Bad Actor Disqualification For Rule 506 Offerings, and Proposes Enhanced Disclosure and Amendments to Form D For Rule 506 Offerings. Click here.
 See our article referenced at footnote 2. The SEC technically has that authority in the current rules but has never utilized it. The 2013 proposals suggested that there would be an emphasis on enforcing the requirement but the proposed amendments went nowhere.