On March 25, the Securities and Exchange Commission (SEC) adopted a final rule amending Regulation A that will help mid-sized companies seeking to raise capital to grow but do very little to help small entrepreneurial start-ups. This new rule is usually called Regulation A-Plus.
The securities laws require any company that issues stock to register with the SEC unless an exemption applies. The SEC estimates that registering with the SEC (called “going public”) costs an average of $2.5 million in legal, accounting, and other fees, and the annual costs for a small firm run about $1.5 million annually. This is not an option for small companies.
Regulation A implements the “small issues” exemption that has been in the law since its inception. Yet the regulatory burden is so high that virtually nobody uses the existing Regulation A exemption to raise capital. In 2011, only one company in the entire country used Regulation A to raise capital.
Congress passed the 2012 Jumpstart Our Business Startups Act (the JOBS Act) on a bipartisan basis that was intended, in part, to fix this problem. It increased the amount that can be raised using Regulation A from $5 million to $50 million and made other changes to the small issues exemption designed to help smaller firms raise the capital they need to launch and grow. In January 2014, the SEC proposed a rule implementing the JOBS Act Regulation A provisions and, on March 25, the Commission adopted a final rule.
The final rule takes two positive and important steps. First, it preempts state blue sky registration and qualification requirements for “Tier II” offerings between $20 million and $50 million that meet the demanding disclosure requirements of the new Regulation A-Plus. These offerings would remain subject to state and federal anti-fraud laws.
Having to comply with the differing demands of 51 state regulators (including Washington, DC) in connection with registration, disclosure, and qualification dramatically increases offering costs and causes very substantial delays. State regulators are the primary reason Regulation A withered and died as a practical means of raising capital. This is in no small part because about two-fifths of state regulators engage in what is called “merit review,” where the regulators decide not only if the company is being honest in its disclosures but whether the investment is a good investment. Large companies and most private offerings are exempt from these state regulatory requirements. Virtually all private capital in the U.S. is raised using Rule 506 of Regulation D, which is exempt from blue sky requirements.
The SEC should have gone further and exempted all Regulation A offerings from blue sky registration and qualification requirements. This would have helped small start-up companies. The failure to do this is by far the most important and consequential failure by the SEC. Tier I securities (those Regulation A offerings of less than $20 million) remain subject to blue sky laws and, as a result, Tier I will remain as useless to small companies as is the existing Regulation A. Congress needs to address this problem since the SEC has not.
Second, the rule lifted the Securities Act section 12(g) limit for Regulation A Tier II securities. Under section 12(g), a company has to become a registered public company if it has more than $10 million in total assets and a class of equity securities that is held of record by either (1) 2,000 or more persons or (2) 500 or more persons who are not accredited investors or it lists the securities on a national exchange. Generally, accredited investors are institutions or natural persons who have an income of more than $200,000 ($300,000 joint) or a residence exclusive net worth of $1 million or more. A company using Regulation A to raise capital from a large number of ordinary small investors would quickly run up against these limits. For example, 500 persons investing $10,000 each is only $5 million dollars. At that point, the company would be forced to stop raising capital and to spend $2.5 million on lawyers and accountants to go public.
The final rule addresses this problem by exempting Tier II Regulation A securities from the section 12(g) limits, provided the issuer meets certain conditions. First, the company must remain current on its reporting obligation. Second, it must retain the services of a registered transfer agent. Third, the exemption only applies for so long as the companies’ public float is less than $75 million. Certain other conditions apply.
Another disappointment in the final rule is its retention of the investor limitations for non-accredited investors. This limits the amount that can be invested to 10 percent of annual income or net worth. The Commission should have rejected the proposed investor limitations as inconsistent with the disclosure and fraud prevention principles of federal securities law, as having no statutory basis and being inconsistent with congressional intent.
The Commission should not get into the business of providing investment advice, it should not mandate that people maintain a particular portfolio and it should not mandate the level of risk that they may choose to undertake. It does not take too much imagination to envision a federal regulatory regime that has specified diversification or other requirements for most investors that would seriously limit investors’ options and which most entrepreneurs starting a business with their own funds would fail. Indeed, FINRA Rule 2111 relating to suitability requirements already imposes the broad outlines of such a system for transactions recommended by a broker-dealer. The Dodd–Frank mandated study of fiduciary standards by broker-dealers and the contemplated Department of Labor fiduciary standards under the Employee Retirement Income Security Act raise similar issues.
