Investment Limitation
Regulation A currently does not place limits on the amount of securities that may be purchased by an investor. The proposed rules included a 10% investment limit for all investors in Tier 2 offerings. Several commenters recommended providing exceptions to the limit, or altering the limit, for certain types of investors, such as accredited investors,957 and for securities that will be listed on an exchange upon qualification.958
We recognize that there are potential investor protection benefits as well as costs
from imposing investment limits in Regulation A offerings. To help balance those benefits and costs, the final rules seek to focus these limits on those investors who may be less likely to be able to fend for themselves and sustain losses. Accordingly, non-
956 See Securities Act Section 3(b)(2)(D) (expressly providing for Section 12(a)(2) liability for any person offering or selling Section 3(b)(2) securities).
957 See ABA BLS Letter; Andreessen/Cowen Letter; Canaccord Letter; Cornell Clinic Letter; Fallbrook Technologies Letter; Heritage Letter; Ladd Letter 2; Leading Biosciences Letter; McCarter & English Letter; MCS Letter; Milken Institute Letter; MoFo Letter; Paul Hastings Letter; Richardson Patel Letter; SVB Letter; WR Hambrecht + Co Letter.
958 See Milken Institute Letter.
accredited investors in Tier 2 offerings will be limited to purchases of no more than 10% of the greater of annual income or net worth (for natural persons) or the greater of annual revenue or net assets (for non-natural persons), as proposed.959 In a change from the proposal, the final rules do not apply the investment limit to investors in Tier 2 offerings that are accredited investors as defined in Rule 501 of Regulation D. We believe that accredited investors, due to their level of income or net worth, are more likely to be able to withstand losses from an undiversified exposure to an individual offering.
We also recognize that there are costs associated with investment limits. In particular, the investment limitation could limit potential gains for non-accredited investors in Tier 2 offerings. The investment limitation could require some issuers to solicit a greater number of investors or to solicit additional accredited investors, which could impose additional costs on those issuers or limit capital formation if they are unable
to attract additional investors.960 Despite these costs, we believe that this limitation, as
tailored in the final rules, is an appropriate means of protecting investors while promoting efficiency, competition and capital formation.
The investment limitation could also lead to a more dispersed non-accredited investor base or a higher proportion of accredited investors in the investor base to the extent that the 10% threshold impacts investor participation. This could facilitate increased liquidity as there would be more investors with which to trade. More diffuse ownership could also exacerbate the shareholder collective action problem and weaken
959 Annual income and net worth would be calculated for individual purchasers as provided in the accredited investor definition in Rule 501 of Regulation D. See 17 CFR 230.501.
960 An issuer would, however, be able to conduct a Tier 1 offering, which does not impose investment limitations.
external monitoring by non-affiliated shareholders to the extent that coordination costs with other shareholders increase. We do not believe, however, that either of these outcomes is a likely consequence of the 10% investment limit.
In a change from the proposal, the final rules exclude sales of securities that will be listed on a national securities exchange upon qualification from Tier 2 investment limitations. This provision may provide additional investment opportunities for some investors and may enhance capital formation for some issuers. We do not anticipate that this provision will reduce investor protection since such issuers will be required to meet the listing standards of a national securities exchange and become subject to ongoing Exchange Act reporting, resulting in a high level of investor protection.
As an alternative to the final rules, we considered imposing more restrictive investment limitations, as suggested by various comments, including extending investment limitations to Tier 1 offerings,961 imposing a limit lower than 10% on “all but
the wealthiest, least risk averse” investors,962 or imposing a 10% investment limitation
across investments in all Regulation A offerings rather than applying the limitation on a per offering basis.963 Applying the investment limitation in Tier 1 offerings could marginally enhance investor protection, especially since these offerings will be subject to less extensive disclosure and transactional requirements. However, given that Tier 1 offerings will remain subject to state registration requirements, it is unclear whether
961 See CFA Institute Letter.
962 See CFA Letter.
963 See CFA Letter (not recommending this specifically, but noting this as one reason why the investment limit was not an adequate substitute for state review of Tier 2 offerings) and Cornell Clinic Letter.
investment limits would significantly enhance investor protection in these offerings.964 Moreover, adding the investment limitation in Tier 1 offerings could have an adverse effect on capital formation for the smallest Regulation A issuers, which may face greater hurdles than larger issuers in attracting a broad investor base.
The alternative of imposing a cap that is lower than 10% on “all but the wealthiest, least risk averse” investors may confer additional investor protection benefits on investors that are unable to withstand significant investment losses. However, this alternative could also limit some investors from pursuing attractive investment opportunities and limit capital formation for some issuers. Further, since risk preferences vary considerably among investors, objectively identifying “risk averse” investors in a way that is broadly applicable is a challenge. In contrast, the 10% investment limitation in the final rules that applies to all investors in a Tier 2 offering, except accredited investors, defined pursuant to Rule 501 of Regulation D, provides a standard that market participants can easily implement.
The alternative of imposing the 10% investment limitation that is aggregated across investments in all Regulation A offerings rather than applying the limitation on a per offering basis may strengthen investor protection. Because the risk profiles of different securities offerings by the same issuer are likely to be correlated, and some issuers may participate in multiple Regulation A offerings over time, such an alternative definition of the limitation may prevent a non-accredited investor from using a significant share (potentially, significantly in excess of 10%) of their net worth or income to
964 One commenter noted that the investment limitation is unnecessary with appropriate state oversight. See NASAA Letter 2.
establish a highly undiversified exposure to a single issuer. However, this alternative could also limit some investors from pursuing attractive investment opportunities and limit capital formation for issuers. Moreover, different offerings by the same issuer under Regulation A may have different risk profiles, depending on security type and class, thus for some investors, depending on their preferences, investing a larger aggregate amount in multiple offerings by the same issuer may be optimal.
Overall, while such additional restrictions may strengthen investor protection, their incremental contribution to investor protection may be small in light of other provisions of amended Regulation A. At the same time, such additional restrictions may prevent some investors from taking advantage of potentially beneficial investment opportunities and may limit the attractiveness of Regulation A to prospective issuers, reducing capital formation and competition benefits.
The final rules permit issuers to rely on an investor’s representation that the investment represents no more than 10% of the greater of the investor’s net worth and annual income, unless the issuer has knowledge that such representation is untrue. The ability to rely on investor representations should help mitigate potential costs that issuers could incur to comply with the investment limitation provisions. At the same time, we realize that investors might make inaccurate representations, whether intentionally or not, which could expose these investors to increased losses.
As an alternative to investor representations, we could have imposed additional requirements on the issuer to verify that investors in Tier 2 offerings are compliant with
the 10% investment limit, as suggested by some commenters.965 Such additional provisions could strengthen investor protections. At the same time, they would likely result in a disproportionate increase in the cost of compliance, especially for smaller issuers in Tier 2 offerings, and might deter some investors from participating in such offerings due to the potential burdens of the verification process and privacy concerns.
Integration
The final rules provide issuers with a safe harbor from integration that, with the exception of the addition of security-based crowdfunding transactions conducted pursuant to Section 4(a)(6) of the Securities Act, preserves the provisions of existing Regulation A.
We believe that the final rules provide issuers with valuable certainty as to the contours of offerings conducted before, or close in time with, Regulation A offerings. This certainty may be particularly beneficial for smaller issuers whose capital needs, and thus preferred capital raising methods, may change frequently.
As an alternative, we could have eliminated the integration safe harbor. We believe that the elimination of the safe harbor, however, would inject uncertainty into offerings conducted before, or close in time with, Regulation A offerings and would, in turn, decrease the utility of the exemption. Uncertainty as to the contours of offerings, as they relate to Regulation A, could possibly cause issuers to prefer other offering methods to Regulation A, which may have an effect on investor protection. For example, if issuers rely more on Regulation D, this alternative could result in investors receiving less
965 See Accredited Assurance Letter; CFA Letter; CFA Institute Letter; Cornell Clinic Letter; MCS Letter; WDFI Letter.
information about an issuer before making an investment, thereby reducing investor protection. Instead, if issuers rely more on registered offerings, this alternative could potentially provide investors with the more extensive disclosure required of, and liability protections associated with, such offerings, although it would cause smaller issuers to incur the higher initial and ongoing costs associated with such offerings.
Treatment under Section 12(g)
Existing rules currently do not exempt Regulation A securities from the requirements of Section 12(g), but the Proposing Release requested comment on whether we should adopt such an exemption. A number of commenters recommended exempting Regulation A securities from Section 12(g) of the Exchange Act,966 and several commenters recommended changing or delaying the application of Section 12(g).967 In a change from the proposed rules, the final rules exempt securities issued in a Tier 2 offering from the provisions of Section 12(g) for so long as the issuer remains subject to, and is current in, its periodic Regulation A reporting obligations as of its fiscal year end,968 engages the services of a transfer agent registered with the Commission pursuant to Section 17A of the Exchange Act, and had a public float of less than $75 million as of the last business day of its most recently completed semiannual period, or, in the absence of a public float, had annual revenues of less than $50 million as of its most recently
966 See B. Riley Letter; CFIRA Letter 1; CFIRA Letter 2; Fallbrook Technologies Letter; Frutkin Law Letter; Guzik Letter 1 and Letter 3; Heritage Letter; IPA Letter; Ladd Letter 2; Milken Institute Letter; MoFo Letter; SBIA Letter (recommending that the trigger be “raised or remedied,” but not explicitly calling for elimination); U.S. Chamber of Commerce Letter; WR Hambrecht + Co Letter.
967 See Heritage Letter; KVCF; McCarter & English Letter; Milken Institute Letter; MoFo Letter; Paul Hastings Letter; SBIA Letter.
968 See Rule 12g5-1(a)(7).
completed fiscal year.969
The final rules are intended to provide sufficient disclosure to help investors make informed decisions while limiting the costs imposed on issuers. We believe that the initial and ongoing disclosures required for Tier 2 offerings in the final rules accomplish this objective and that the final rules also provide an appropriate balance between providing investor protection and promoting capital formation. The size of Tier 2 offerings, combined with the investment limitation and the ability to offer Tier 2 securities to the general public, may result in the number of an issuer’s shareholders of record exceeding Section 12(g) thresholds. A conditional Section 12(g) exemption for small issuers of Tier 2 securities in such instances is expected to reduce the compliance cost for small issuers and facilitate capital formation and the creation of a broad investor base in offerings made pursuant to Regulation A by small Tier 2 issuers. This will benefit those small Regulation A issuers that are not seeking to list on a national securities exchange970 and that may find the costs of Exchange Act reporting to be too high given their size.
Regulation A offerings may be particularly attractive to small private companies whose shareholder bases are approaching the Section 12(g) registration threshold. The conditional Section 12(g) exemption may enable small private issuers of Tier 2 securities under amended Regulation A to expand their shareholder base over time, as a result of secondary market trading, to the extent that such a market develops, or through subsequent security issuances, without incurring the costs associated with reporting
969 Id.
970 Issuers seeking to list on a national securities exchange will be required to register with the Commission under Section 12(b).
company status.971
While the additional requirement to use a registered transfer agent will impose costs on issuers,972 it should provide investor protection benefits by helping to ensure that securityholder records and secondary trades will be handled accurately. As it is a conditional exemption from Section 12(g), however, issuers that are not concerned with registration under the Exchange Act, perhaps because they do not believe that Exchange Act registration will be required as a result of a Regulation A offering, would not be required to retain the services of a registered transfer agent in order to conduct a Tier 2 offering.
The final rules also include an issuer size limit in the eligibility requirements for the Section 12(g) exemption for Tier 2 offerings, consistent with providing a conditional exemption tailored to facilitate small company capital formation. The issuer size limit may make Regulation A less attractive for larger issuers and issuers anticipating growth
971 See IPO Task Force. Based on two surveys, regulatory compliance costs of IPOs average $2.5 million initially, followed by an ongoing cost of $1.5 million per year.
972 We lack the information to provide a precise quantitative estimate of transfer agent costs for Tier 2 issuers. However, we have some sources of information about transfer agent costs in analogous contexts.
According to the Securities Transfer Association (STA), the registered transfer agent industry is highly competitive and many of its members can develop business models that will suit the needs of small issuers and at the same time provide adequate protection to investors. The STA further noted that it did not anticipate most small issuers to require some of the services, such as the processing of dividends, that raise the cost of recordkeeping services. See STA letter on JOBS Act regulatory initiatives, available at: http://www.sec.gov/comments/jobs-title-i/general/general- 207.pdf. STA estimated that monthly transfer agent fees would be $75‐$300 for security-based crowdfunding issuers, which translates into annual fees of $900-$3600. See STA letter on proposed crowdfunding rules, available at: http://www.sec.gov/comments/s7-09-13/s70913- 96.pdf. In 2014, average transfer agent and registrar fees amounted to approximately $9,000 in registered IPOs with offering sizes below $50 million, based on Thomson Reuters SDC data, excluding offerings from non-Canadian foreign issuers, blank-check companies, and investment companies. Offerings with proceeds below $1,000 are excluded to minimize measurement error. While estimates for security-based crowdfunding issuers are likely to underestimate the cost for a typical Tier 2 issuer, estimates for IPOs are likely to overestimate the cost of transfer agent services for a typical Tier 2 issuer. Costs of transfer agent services for a typical Tier 2 issuer may be in the range between the two sets of estimates.
or capital appreciation that expect to reach Section 12(g) thresholds after conducting a Tier 2 offering or subsequent secondary market trading. The two-year transition period before reporting must begin may partly mitigate some of these costs to issuers. Due to the uncertainty about the future composition of the issuer and investor base in Tier 2 offerings, we cannot determine the proportion of Tier 2 issuers whose number of shareholders of record will exceed Section 12(g) thresholds or the proportion of those
issuers that will not qualify for an exemption due to their size.973
Some issuers may be able to limit the number of shareholders of record by adopting a minimum investment size requirement. This may potentially limit the breadth of investor base and the availability of investment opportunities to some investors. We are not able to determine the extent to which the issuer size limit may affect overall capital formation and whether large or growth issuers will proceed with a Tier 2 offering or pursue a registered offering, a Regulation D offering or another method of financing. In addition, the issuer size limit may place at a competitive disadvantage those potential issuers that exceed the size limit but for which the costs of registration remain high, relative to potential issuers that are close to the size limit but that qualify for the Section 12(g) conditional exemption.
We recognize that there are costs associated with the conditional exemption adopted today. Under this exemption, some issuers in Tier 2 offerings with a large
973 Based on the analysis by the staff of Division of Economic and Risk Analysis of 2013 data on registrants under Section 12(g), excluding issuers with a class of securities registered under Section 12(b), approximately three-quarters of Section 12(g) registrants would have been below the issuer size limit (defined similarly to smaller reporting company (SRC) criteria). These figures may not be representative of the proportion of issuers that would be below the issuer size limit among future Regulation A issuers that would potentially exceed Section 12(g) thresholds for the number of shareholders of record.
number of shareholders could avoid—potentially indefinitely—the comprehensive disclosure requirements of the Exchange Act, which may decrease the informational efficiency of prices and potentially result in less informed investment decisions by a larger number of investors than in the absence of a conditional Section 12(g) exemption. The issuer size limit partly mitigates this concern. For the same reasons, however, the inclusion of a conditional exemption from Section 12(g) may entice small issuers that
would have otherwise generally preferred to raise capital in private offerings to enter the public markets through a Tier 2 offering pursuant to Regulation A.974 In this regard, the conditional exemption could increase the availability of information about companies that would otherwise remain relatively obscure in the private markets. On balance, we believe that provisions such as the initial and periodic disclosure requirements and the investment limit in Tier 2 offerings appropriately balance investor protections and issuer compliance costs while facilitating the creation of a broad investor base in Tier 2 offerings for small issuers.
We have considered the alternative of providing a conditional exemption from Section 12(g) registration that does not incorporate an issuer size limitation. Such an alternative would enable a broader class of potential Tier 2 issuers to remain exempt from Exchange Act registration. Larger Regulation A issuers could generate a more vibrant OTC trading market, providing enhanced liquidity to those issuers that may not otherwise be of sufficient size to make listing on a national market exchange cost-effective.
Providing an exemption from Section 12(g) could provide incentive for these larger
974 For example, issuers may be more willing to raise capital publicly and become subject to some ongoing reporting requirements if such requirements are less costly to the issuer than the costs generally associated with the ongoing reporting requirements of the Exchange Act.
issuers to broaden their investor base while still providing the ongoing disclosure of the Tier 2 reporting regime. This could result in potentially beneficial effects on capital formation, competition, and informational efficiency of prices. However, such an alternative would potentially create a class of securities permanently exempt from Exchange Act registration regardless of issuer size and thus subject to less extensive disclosure requirements than public reporting companies, which may affect investor protection.