SEC adopts amendments to harmonize private offering exemptions

Yesterday, the SEC adopted, by a vote of three to two, amendments designed to harmonize and simplify the patchwork universe of private offering exemptions. The final amendments were informed by feedback received from the March 2020 proposal, the SEC’s advisory committees and the SEC’s Government-Business Forum on Small Business Capital Formation, as well as engagement with investors and companies. According to Chair Jay Clayton, the amendments “reflect a comprehensive, retrospective review of a framework that has, over time, unfortunately become difficult to navigate, for both investors and businesses, particularly smaller and medium-sized businesses…. Today’s amendments would rationalize that framework, increase efficiency and facilitate capital formation, while preserving or enhancing important investor protections.”  Here is the almost 400-page adopting release. The final amendments will become effective March 15, 2021.

According to the press release, the amendments are intended to “reduce potential friction points to make the capital raising process more effective and efficient to meet evolving market needs.” In summary, the amendments:

At the open meeting

According to Clayton, the SEC’s “exempt offering framework, which consists of no fewer than 10 different exemptions, was built over time, over fifty years,” and is now plagued by a lot deferred maintenance and long due for an overhaul. As Clayton said in a 2018 speech, the current framework would not likely exist as it is if the SEC were starting with blank slate. 

In crafting the amendments, he said, the SEC had three key objectives:

Perhaps anticipating criticism of the final amendments to come from dissenting Commissioners Allison Lee and Caroline Crenshaw, in his statement, Clayton took issue with those

“who express the view that there is an inevitable trade-off among these objectives—for example, a trade-off between facilitating capital formation and enhancing investor protection.  This zero-sum perspective is inconsistent with the Commission’s demonstrated history, Congressional action, market performance, investor returns and investor protection [and] can impede much-needed progress on a range of emerging issues important to investors, our agency and the economy more generally.”

Clayton believes that the amendments will eliminate costs and provide

“access, including in areas where individual investors can be more likely to sit side by side with professional investors.  Harmonizing requirements across exemptions allows issuers to more easily navigate our framework—and ensure they are complying with our rules, including the important investor protections embedded in each.  At the same time, investors benefit from a more harmonized framework through more consistent protections generated by efficiencies….” 

Noting that the private markets have increasingly been the source of capital for larger companies in the past 25 years, Clayton maintained that the amendments will add important efficiencies,

“but I believe they will not, I repeat will not, materially alter the choice of whether to access the public markets or the private markets for larger companies.  Today’s amendments eliminate frictions and uncertainties that in various cases would be material to smaller and medium-sized companies, but they will not move the needle for large companies choosing between public and private offerings, whether for large debt or equity offerings… Also, speaking about this dynamic more generally, you don’t make the public company framework more attractive to large companies by making the private market alternatives less so.” 

Many smaller and medium-sized businesses “do not have the resources, expertise and experience to effectively navigate our complex private offering rule sets.  These companies and their investors are the ones we intend to benefit from today’s amendments, which aim to replace unnecessary complexity and uncertainty with a clearer, more consistent system.”

Reducing costs, the third objective, will be achieved by eliminating “paperwork and lawyer hours that as a practical matter serve no mission-oriented purpose, and specifically do not enhance investor protection.  Many of these costs are the result of rules that were constructed in an age of different communications and other technologies.” Although the rules should accommodate the mail, “SEC regulations should not cling to the mails and paper as the default or preferred paradigm for communications.”

In her statement, Commissioner Hester Peirce ascribed the importance of the new rulemaking to the role of small business in wealth accumulation: “[s]mall businesses are engines of capital accumulation.  Unfortunately, many small businesses that could be successful struggle to find the capital they need to create wealth.” In her view, the current regulatory scheme  “unnecessarily hinders capital formation and unduly restricts investors’ opportunities to participate in economic growth.”  She appreciated, for example, the increases in the maximum offering limitations, the new rules regarding “demo days,” and the streamlining of the integration analysis into “a single rule with a clear principle, guidance on how to apply that principle, and four safe harbors…”  However, she thought the rules should go further in eliminating restrictions. For example, while she appreciated the rule change that will permit companies “to rely on a prior verification of accredited investor status at the time of a subsequent sale, so long as the investor represents in writing that she is still an accredited investor and the issuer is not aware of information to the contrary,” she would rather have eliminated the “five-year time limit on the ability of issuers to rely on a prior verification.” These new amendments, in her view, are a “positive step,” but more work is left to do.

On the other hand, Commissioner Lee did worry that the final amendments would have a deleterious effect on the protections for retail investors.  In her view, private offerings are

“the exception to the rule in our securities regime. The registration and reporting provisions in the federal securities laws are designed to level the playing field by requiring issuers to provide all investors with reliable, timely, and material information about investments….It is well understood that retail investors operate at a severe disadvantage in the private market because of information asymmetries and other power imbalances. Historically, the primary protection against this power imbalance was to limit private companies to capital raised from investors that are large or sophisticated enough to compete, or wealthy enough to bear the cost if they lose out.” 

But recently, she argued, “the exception (or exemptions from registration) have swallowed the rule, with statutory and regulatory changes steadily chipping away at restrictions on private offerings and exposing more and more retail investors to their risks.”  The final amendments are another example of that trend, in her view. While the amendments might be presented as a way to enhance investor opportunity, “the evidence suggests that retail investors would actually do worse in the private markets. And, as with so many of our rulemakings in the last few years, investors—the supposed beneficiaries of the rule—largely oppose it.” In addition, because of the dearth of data about the private markets, the amendments lack “meaningful analysis of how our policymaking has affected the dramatic shift of capital to the private market in recent years, and fails to account for how public and private markets do or should interrelate…. Thus, once again we make significant changes to a market that is already awash in capital, but into which we have little visibility.”

Although Lee certainly took issue with individual changes, her primary concern was “the sweeping effect of these changes taken together and in the broader regulatory context, including the Commission’s failure to address the effects of inflation on the nearly 40-year-old wealth thresholds in the accredited investor definition…. At the same time, we steadily strip away investor protections in this market, reducing disclosure requirements and relaxing accredited investor verification standards.” The SEC’s rulemaking, she said, takes too narrow a view of the changes made without taking into account other regulatory efforts as a whole. These changes, she contended, “are cast as mere adjustments to the framework to make it easier to navigate, but their effects on investor protection loom large.” For example, she worried that the “drastic changes to the integration framework,” which eliminate “any real analysis of whether separate offerings should be considered functionally the same,” are poised “to effectively nullify” the integration doctrine, rendering it “hollow but for a requirement to wait 30 days between offerings.”  Similarly, while it may make sense to adjust the framework for exemptions to harmonize the various rules, she observed, it’s important to keep in mind that the differences in the rules may reflect the different purposes underlying those rules; it “does not make sense in all instances for their requirements to be the same.”

In Lee’s view, the consequence will be a continued “blurring of lines between public and private markets,” including “wholesale importation of general solicitation into the private market,” resulting in difficulties for regulators in policing these markets.  Instead of eroding the boundaries between the public and private markets, she urged, the SEC should be considering how to increase opportunities in the public markets, which provide better opportunities for retail investors.  

To Commissioner Crenshaw, there were tradeoffs inherent in the rulemaking, and she was critical of the failure “to engage in any substantive way with the crucial threshold question of whether those tradeoffs are—or even can be—balanced in a way that adequately protects retail investors.” She was also concerned about the potential for the amendments to increase the wealth divide: “the rule fails to address the fact that in the private markets, the rich and well-connected typically have better access to the most promising companies, while retail investors get the leftovers—too often, unfortunately, the losers. Instead of providing retail investors access to that elusive high return rate, the majority’s steady march of expanding the private markets will only further entrench the country’s increasing and concerning economic divide.” In her view, currently, “high growth companies are increasingly deciding to remain private, benefitting groups of experienced and well-funded professional investors.”  But the amendments “do not fix that problem.” Instead, the amendments simply permit investment in these markets by “a class of investors who do not have the capital to survive one or two failed ventures. This approach will serve only to further widen the wealth and access gaps between investors who start rich and those who don’t.”  

Investors such as venture capitalists have “structural advantages that have led to their success,” such as trained professionals to evaluate early stage companies, diverse portfolios to absorb the inevitable losses and market power to demand detailed information—advantages not available to most retail investors. And there is a surplus of capital waiting to invest in top tier companies, but

“not all viable companies readily attract this funding, even despite the surplus of capital clamoring to be invested. The solutions this rule presents are to allow private companies to raise capital by selling more risky offerings, in greater dollar amounts, with less information, and fewer rights, to unprepared and unprotected investors. Nowhere does the release examine whether this is a good idea…. At the core of this rule is the assumption that retail investors will successfully buy offerings that professional investors reject. We apparently believe that retail investors can better assess the risk adjusted returns and find value that venture capital overlooks. This is unlikely to be true.”

There is no evidence to support this idea, she argues.  Rather, the little evidence that exists suggests that “these changes appear likely to offer only at best marginal benefits to the companies who need the most assistance, while increasing risks but not rewards for investors.”

Interestingly, at the conclusion of the statements, there was a brief unscripted colloquy arising out of Crenshaw’s statement. (Based on my notes only,) Commissioner Elad Roisman asked Crenshaw to further explain how the rulemaking would contribute to the economic divide?  After all, it would provide retail investors with more access to potentially profitable investments.  Crenshaw reiterated her argument that the amendments might provide more access, but it was likely to be access to the most risky investments (the “loser” investments) in which retail investors were more likely to lose money, not profit.  In her view, because of information and power asymmetries, private offerings did not treat all investors equally.  Peirce chimed in that companies may need non-VC funds and that we needed to careful about what constraints we put on how people can spend their own money.  

The final amendments

Below are the highlights of the final amendments as set forth in the press release:

Integration.  When companies engage in multiple offerings near in time, it is often necessary to analyze whether the offerings are “integrated”—essentially a single offering—for purposes of analyzing compliance. The amendments “establish a new integration framework that provides a general principle that looks to the particular facts and circumstances of two or more offerings, and focuses the analysis on whether the issuer can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering.”

The amendments provide four non-exclusive safe harbors from integration:

Offering and investment limits. The amendments raise the offering limits under and make other changes to various exemptions as follows:

Regulation Crowdfunding and Regulation A Eligibility.  To facilitate investing in Regulation Crowdfunding issuers, the amendments permit the use of certain special purpose vehicles as a conduit for investors. In addition, the amendments impose eligibility restrictions on the use of Regulation A by issuers that are delinquent in their Exchange Act reporting obligations.

 “Test-the-Waters” and “Demo Day” Communications.  The amendments make the following changes related to offering communications rules, by:

Other Improvements to Specific Exemptions.  The amendments also:

Copied below is the SEC’s table providing an overview of the changes to the exemptions:

Today’s the day—if you haven’t already—Vote! Vote! Vote!