On June 6, OTC Markets filed a petition for rulemaking with the SEC requesting that the SEC amend Regulation A to expand the eligibility criteria to include all small issuers, including those that are subject to the Securities Exchange Act of 1934 (“Exchange Act”) reporting requirements and to allow “at-the-market offerings.”
On March 25, 2015, the SEC released final rules amending Regulation A. The new Regulation A creates two tiers of offerings. Tier I of Regulation A, which does not preempt state law, allows offerings of up to $20 million in a twelve-month period. Due to difficult blue sky compliance, Tier 1 is rarely used. Tier 2, which does preempt state law, allows a raise of up to $50 million. Issuers may elect to proceed under either Tier I or Tier 2 for offerings up to $20 million. The new rules went into effect on June 19, 2015 and have been gaining traction ever since. Since that time, the SEC Division of Corporation Finance has issued periodic Compliance and Disclosure Interpretations (C&DI) to provide guidance related to Regulation A. I have previously written several articles on Regulation A and the C&DI. For a good review and summary, please see my blog HERE.
From inception, a Regulation A company could apply for a listing on the OTC Markets OTCQX Tier assuming it meets the qualifications. Elio Motors trades on the OTCQX. For a review of such qualifications, see my blog HERE. Unlike the OTCQX, generally a company that is not subject to the Exchange Act reporting requirements did not qualify for the OTCQB; however, effective July 10, the OTCQB has amended their rules to allow a Tier 2 reporting entity to qualify to apply for and trade on the OTCQB. My blog on the OTCQB rules related to Regulation A can be read HERE.
Whether trading on the OTCQX or OTCQB, keep in mind that unless the issuer has filed a Form 8-A or Form 10, they will not be considered “subject to the Exchange Act reporting requirements” for purposes of benefiting from the shorter 6-month Rule 144 holding period. For a short overview of Rule 144, see HERE.
Regulation A Eligibility – Reporting Issuers
As enacted, Regulation A is available to companies organized and operating in the United States and Canada. The following issuers are not eligible for a Regulation A+ offering:
- Companies currently subject to the reporting requirements of the Exchange Act;
- Investment companies registered or required to be registered under the Investment Company Act of 1940, including BDC’s;
- Blank check companies, which are companies that have no specific business plan or purpose or whose business plan and purpose is to engage in a merger or acquisition with an unidentified target; however, shell companies are not prohibited, unless such shell company is also a blank check company. A shell company is a company that has no or nominal operations; and either no or nominal assets, assets consisting of cash and cash equivalents, or assets consisting of any amount of cash and cash equivalents and nominal other assets. Accordingly, a start-up business or minimally operating business may utilize Regulation A+;
- Issuers seeking to offer and sell asset-backed securities or fractional undivided interests in oil, gas or other mineral rights;
- Issuers that have been subject to any order of the SEC under Exchange Act Section 12(j) denying, suspending or revoking registration, entered within the past five years;
- Issuers that became subject to Exchange Act reporting requirements, such as through a Tier 2 offering, and did not file required ongoing reports during the preceding two years; and
- Issuers that are disqualified under the “bad actor” rules and, in particular, Rule 262 of Regulation A+.
Although companies subject to the reporting requirement have been disqualified from day one, the SEC quickly issued guidance clarifying that Regulation A may be used by many existing “reporting entities” either because they voluntarily report (generally because they never filed a Form 8-A or Form 10 after an S-1 registration statement and the initial required reporting period has passed) or through a wholly owned subsidiary resulting in a complete or partial spin-off.
The SEC specifically provided that a company that was once subject to the Exchange Act reporting obligations but suspended such reporting obligations by filing a Form 15 is eligible to utilize Regulation A. The determination of eligibility is made at the time of the offering. Moreover, a company that voluntarily files reports under the Exchange Act is not “subject to the Exchange Act reporting requirements” and therefore is eligible to rely on Regulation A. In addition, a wholly owned subsidiary of an Exchange Act reporting company parent is eligible to complete a Regulation A+ offering as long as the parent reporting company is not a guarantor or co-issuer of the securities being issued.
Related to small business issuers, the current rules create an unfair distinction. A company trading on the OTC Markets that voluntarily reports to the SEC would be eligible, whereas a company that may be substantially similar but is required to file reports would be ineligible to utilize Regulation A+.
On June 6, 2016, OTC Markets filed a petition for rulemaking with the SEC requesting that the SEC amend Regulation A+ to expand the eligibility criteria to include all small issuers, including those that are subject to the Exchange Act reporting requirements and to allow “at-the-market offerings.”
The OTC Markets petition is concise and to the point. When Congress passed the JOBS Act, it left the particulars of Regulation A+ rulemaking to the SEC with only the following mandates:
- The aggregate offering amount of all securities sold within a 12-month period shall not exceed $50,000,000;
- The securities may be offered and sold publicly;
- The securities shall not be restricted securities within the meaning of the federal securities laws;
- The civil liability provisions under Section 12(a)(2) of the Securities Act shall apply to any person offering or selling Regulation A securities;
- The issuer may solicit interest in the offering prior to filing any offering statement, on such terms and condition as the SEC may prescribe in the public interest and protecting investors;
- The SEC shall require the issuer to file annual audited financial statements; and
- Such other terms and conditions as the SEC shall determine are necessary in the public interest and protecting investors.
The JOBS Act itself did not prohibit or limit the use of Regulation A+ for reporting companies, and accordingly, that decision is within the SEC rulemaking discretion. In fact, throughout the JOBS Act and in particular in Title IV related to Regulation A+, Congress refers to expanding capital formation for “small issues” under $50 million with the goal of increasing capital to all small companies.
The SEC reasoning for excluding reporting companies in the first place is weak at best. In particular, the SEC excluded reporting issuers because the prior Regulation A rules, which were admittedly rarely used and ineffective at assisting in small business capital formation, contained the exclusion. That is, when revamping Regulation A+ as mandated by the JOBS Act, the SEC just didn’t change that provision.
The OTC Markets points out that the Regulation A+ rules as enacted offer more protections for non-accredited investors than a fully registered S-1 or S-3 offering. In particular, there are no investor limitations for unaccredited purchasers in an S-1 or S-3 offering, whereas a Regulation A+ offering limits investments by unaccredited investors to no more than 10% of the greater of the investor’s annual income or net worth. In addition, a traditional S-1 or S-3 does not have any limitations or prohibitions related to bad actor disqualifications, whereas Regulation A+ does prohibit use by “bad actors.”
The OTC Markets petition also contains a good discussion on the costs associated with an S-1 or S-3 offering, including added costs of state blue sky law compliance. State blue sky preemption is one of the cornerstones of Tier 2 Regulation A+ offerings that benefit issuers. Moreover, generally only much larger issuers are S-3 eligible and thus S-3 is not considered a “small company” capital formation tool. Similarly, private offerings under Regulation D are not registered and so do not offer the same level of investor protections. These offerings also result in restricted securities and thus less investor incentive to participate.
In addition to the obvious benefit to small and emerging company capital formation of allowing small reporting companies to utilize Regulation A+, there is also an added potential benefit to the capital markets as a whole. OTC Markets opines that the flow of freely tradable securities into the marketplace for existing public companies could have a positive uptick on the liquidity and overall growth and vitality of venture markets. Regulation A+ could have the benefit of pushing forward the much needed venture market for the secondary trading of securities of early-stage, small and emerging growth companies. OTC Markets points out that it could and should be that venture market.
The OTC Markets petition contains a pointed discussion on the market benefits, including noting that “Regulation A+ allows smaller companies, traditionally lacking the backing of bulge bracket investment banks and the large base of institutional ownership needed to fund ongoing research coverage, to reach out to a broader pool of potential investors through ‘testing the waters’ provisions and the efficient economical reach of the Internet and social media. Emerging companies can use Regulation A+ online offerings to tap into large numbers of individual investors and efficiently target smaller institutions. Allowing fully SEC reporting companies the same ability to leverage technology and transparency to reach potential investors would be expected to provide a ready source of growth capital, and, equally important, an increase in liquidity in the secondary market.”
Interestingly, OTC argues that opening up Regulation A+ to small reporting companies may reduce or minimize the use of toxic financing options which carry substantial dilution and downward pricing pressure on company stock. Moreover, allowing small reporting companies to utilize Regulation A+ may raise the interest in these offerings for investment banks.
Finally, in order to make Regulation A+ the most useful for reporting companies, OTC Markets requests that the SEC also amend the rules to allow “at-the-market” offerings. Currently all Regulation A+ offerings must be priced. In the case of a security that is already trading, the ability to price accurately is difficult and the inability to adjust such pricing in response to fluctuating market conditions can impede the success of the offering.
From my perspective, Regulation A has become the most popular method of fundraising and private-to-public transactions for small business issuers. Although as of the date of this blog, only one issuer, Elio Motors, Inc., has received a trading symbol and actively trades, many others are in the works and I think we will see an opening of the floodgates. As Tier 2 requires audited financial statements, the preparation process can take months and the placement of an offering can also take months.
A traditional IPO is completed using an underwriter on a “firm commitment” basis where the underwriter buys all the company’s securities on the first day of the IPO and proceeds to resell them. No Regulation A offerings have yet been completed in a firm commitment underwritten offering. To the contrary, current Regulation A offerings are either self-placed by the issuing company, or completed with the assistance of a broker-dealer placement agent on a best efforts basis. This placement process can take several months to complete. Accordingly, many issuers have not closed out their offerings as of yet and therefore have not reached the point of eligibility to apply for a trade symbol. My office alone has over half a dozen Regulation A offerings in the works.
Tier 2 offerings in particular present a much-needed opportunity for smaller companies to go public without the added time and expense of state blue sky compliance but with added investor qualifications. Tier 2 offerings preempt state blue sky laws. To compromise with opponents to the state blue sky preemption, the SEC included investor qualifications for Tier 2 offerings. In particular, Tier 2 offerings have a limitation on the amount of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth. It is the obligation of the issuer to notify investors of these limitations. Issuers may rely on the investors’ representations as to accreditation and investment limits with no added verification.
Tier 2 issuers that have used the S-1 format for their Form 1-A filing will be permitted to file a Form 8-A to register under the Exchange Act and become subject to its reporting requirements. A Form 8-A is a simple registration form used instead of a Form 10 for issuers that have already filed the substantive Form 10 information with the SEC. Upon filing a Form 8-A, the issuer will become subject to the full Exchange Act reporting obligations, and the scaled-down Regulation A+ reporting will automatically be suspended. With the filing of a Form 8-A, the issuer can apply to trade on a national exchange.
This marks a huge change and opportunity for companies that wish to go public directly and raise less than $50 million. An initial or direct public offering on Form S-1 does not preempt state law. By choosing a Tier 2 Regulation A+ offering followed by a Form 8-A, the issuer can achieve the same result – i.e., become a fully reporting trading public company, without the added time and expense of complying with state blue sky laws. The other consideration would be the added investor qualifications, but if the issuer meets the requirements for and lists on a national exchange, the added investor qualifications no longer apply.
The SEC has a well published mission of “protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation.” Regulation A+ offers significant investor protections in that a form of registration statement is filed with the SEC and subject to a review and comment process. In addition, Regulation A+ allows for pre- and post-filing marketing using the Internet, social media, presentations and the like, provided all such materials are filed with the SEC and subject to review and comment. This process provides significant investor protections, including a permanent record of disclosures made during the offering process. Regulation A+ also provides a streamlined, affordable registration process with access to an expanded pool of investors, thus facilitating capital formation.
To the contrary, private offering documents are not filed or reviewed with the SEC and the process and level of disclosure are far less regulated. Public offerings using Form S-1 limit offering communications, and those communications are not necessarily filed or reviewed by the SEC. The Form S-1 process does not allow for broad Internet, crowd or social media marketing. A Form S-1 process also does not preempt state law and accordingly has significant added costs for a company. A Form S-1 works best for larger issuers with strong underwriter and institutional support. Regulation A+ provides the best method of registered capital formation for small companies, including those that are already subject to the SEC reporting requirements.
As was understood in passing the JOBS Act in 2012, the transparent Regulation A+ process is a preferred method of capital raising for small businesses, especially companies already subject to the reporting requirements who have audited financial statements readily available and processes in place for meeting SEC reporting and review requirements.
When the SEC issued the Regulation A+ rules on March 25, 2015, it issued a press release in which SEC Chair Mary Jo White was quoted as saying, “These new rules provide an effective, workable path to raising capital that also provides strong investor protections. It is important for the Commission to continue to look for ways that our rules can facilitate capital raising by smaller companies.” Allowing small reporting companies to partake in Regulation A+ meets all the mandates of the JOBS Act while concurrently satisfying the SEC goal of providing investor protections, and I am a strong advocate in support of a rule change in that regard.