We considered the alternative, suggested by some commenters,1000 of requiring
submission and review of testing the waters materials before or concurrent with first use, rather than at the time the offering statement is submitted for non-public review or filed, which could aid regulators in detecting fraudulent solicitation of interest communications, potentially resulting in investor protection benefits. However, requiring initial submission and review of testing the waters materials prior to their use could dissuade issuers, particularly smaller or less experienced issuers, from engaging in testing the waters communications, thereby undermining many of the benefits of permitting such communications discussed above.
We also considered the views of other commenters who suggested we relax some of the proposed requirements for the use of testing the waters. For example, we could have treated the solicitation materials as non-public when filed with the Commission, at
999 See Massachusetts Letter 2; NASAA Letter 2; WDFI Letter.
1000 See Massachusetts Letter 2; NASAA Letter 2; WDFI Letter.
least until the offering statement is qualified,1001 or removed the requirement for public filing of solicitation materials for all Regulation A offerings or for Tier 2 offerings.1002
Issuers that have elected to use testing the waters communications have already incurred the cost of preparing the materials, so the incremental direct cost of the requirement to file the materials with the Commission will be low. We recognize that permitting issuers to file the solicitation materials non-publicly with the Commission could reduce the indirect costs of some issuers by limiting the ability of the issuer’s competitors to discover information about the issuer.
However, we note that this information may become available to competitors in any event through the solicitation process and removing the requirement to publicly file the materials may result in adverse effects on the protection of investors to the extent that it may facilitate fraudulent statements by issuers to all or a selected group of investors that may fail to compare the statements in the solicitation materials against the offering circular. On balance, we believe that the final rule’s requirements governing the use of testing the waters communications appropriately balance the goals of providing flexibility to issuers and protection to investors.
Ongoing Reporting
Currently, Regulation A issuers do not have ongoing reporting obligations. The final rules prescribe an ongoing reporting regime for issuers that conduct Tier 2 offerings that requires, in addition to annual reports on Form 1-K, semiannual reports on Form 1- SA, current event reporting on Form 1-U, and notice to the Commission of the
1001 See Heritage Letter and Ladd Letter 2.
1002 See BIO Letter and MoFo Letter.
suspension of ongoing reporting obligations on Form 1-Z.
These reporting requirements will have benefits and costs. These reporting requirements should strengthen investor protection and decrease the extent of information asymmetries between issuers and investors in the Regulation A market, relative to existing Regulation A. Requiring ongoing disclosures for Tier 2 offerings will provide investors with periodically updated information, allowing them to identify investment opportunities best suited for their level of risk tolerance and re-evaluate the issuer’s prospects through time, resulting in better informed investment decisions and improved allocative efficiency of capital. By standardizing the content, timing, and format of these disclosures, the amendments to Regulation A will make it easier for investors to compare information across issuers, both within and outside of the new Regulation A market.
The additional reporting requirements for Tier 2 offerings increase the availability of public information that can be used for valuing securities. A reduction in information risk due to improvements in disclosure can lower the issuer’s cost of capital.1003 Because there are no resale restrictions, some securities issued in amended Regulation A offerings are likely to be quoted on the OTC market, and required ongoing disclosure requirements will provide investors with updated information about their underlying value, and as a result, lower the inherent asymmetric information risks associated with trading in this market.1004 The enhanced information environment should facilitate more informationally efficient pricing and better liquidity for amended Regulation A
1003 See Diamond, D., and R. Verrecchia, 1991, Disclosure, liquidity, and the cost of capital, Journal of Finance 46(4), pp. 1325-1359; Easley, D., and M. O’Hara, 2004, Information and the cost of capital, Journal of Finance 59(4), 1553–1583; Easley, D., S. Hvidkjaer, and M. O’Hara, 2002, Is information risk a determinant of asset returns? Journal of Finance 57(5), pp. 2185–2221.
1004 See Ang, A., A. Shtauber, and P. Tetlock, 2013, Asset pricing in the dark: The cross section of OTC stocks, Review of Financial Studies 26(12), pp. 2985–3028.
securities.1005 Tier 2 ongoing disclosure requirements should also provide timely and relevant issuer information at a lower cost to broker-dealers that initiate quotations and make markets in these securities. Increased secondary market liquidity can make securities more attractive to prospective investors, which can promote capital formation. Hence, there may be significant benefits for capital formation from the ongoing reporting requirements in the final rules.
Although reporting obligations for Tier 2 issuers are less extensive than for reporting companies, we recognize that they will still result in a significant direct cost of compliance. One commenter estimated the qualification and reporting costs of a Tier 2 issuer to be approximately $400,000 in the first year and $200,000 annually thereafter (per issuer).1006 For the purposes of the PRA, we estimate that compliance with the requirements of Forms 1-K, 1-SA, and 1-U for issuers with an ongoing reporting obligation under Regulation A will result in an aggregate annual burden of 115,351 hours of in-house personnel time and an aggregate annual cost of $13,450,272 for the services of outside professionals.1007
In addition to the direct costs of preparing the mandatory disclosures, issuers of securities in Tier 2 offerings will be subject to indirect disclosure costs of revealing to their competitors and other market participants information about their business not
1005 See Graham, J., C. Harvey, and S. Rajgopal, 2005, The economic implications of corporate financial reporting, Journal of Accounting and Economics 40(1–3), pp. 3–73; Durnev, A., R. Morck, and B. Yeung, 2003, Value enhancing capital budgeting and firm-specific stock return variation, Journal of Finance 59(1), pp. 65–106.
1006 See IPA Letter.
1007 See Section IV below.
previously required to be disclosed.1008 These disclosures can inform the issuer’s competitors about the issuer’s strategic decisions regarding investment, financing, management and other aspects of business. For issuers seeking to reduce such costs of disclosure, Rule 506(c) of Regulation D could be more appealing. Based on the scope of disclosures required, an issuer’s combination of direct and indirect costs of disclosure is likely to be lowest for a Regulation D Rule 506 offering, followed by a Tier 1 offering, a Tier 2 offering and, finally, a registered public offering.
We evaluate below the different provisions of the ongoing reporting requirements and the alternatives we have considered.
Periodic and Current Event Reporting Requirements
Currently, Regulation A issuers do not have ongoing reporting obligations. Tier 2 issuers in a Regulation A offering will have periodic and current event reporting obligations under the final rules. As noted above, these ongoing reporting requirements will result in both direct and indirect costs to Tier 2 issuers.
Commenters made various suggestions for expanding the ongoing disclosure requirements for Tier 2 issuers. For example, several commenters suggested we require quarterly reporting instead of semi-annual reporting.1009 Another commenter suggested we require officers, directors and controlling shareholders of issuers that offer securities under Regulation A to make ongoing disclosure of transactions in company securities, similar to reporting on Forms 3, 4 and 5 and Schedules 13D, 13G and 13F in the
1008 See Verrecchia, R., 2001, Essays on disclosure, Journal of Accounting and Economics 32, pp. 97– 180.
1009 See Massachusetts Letter 2; NASAA Letter 2; OTC Markets Letter; WDFI Letter.
registered securities context.1010 While additional requirements that would bring the Tier 2 disclosure obligations closer to the reporting company disclosure obligations are likely to have informational efficiency and investor protection benefits, they are also likely to make Regulation A more costly and less attractive to prospective issuers and may not promote capital formation as much as the final rules.
Other commenters recommended reducing the continuing disclosure burden on Tier 2 issuers1011 or making continuing disclosure requirements contingent upon factors other than offering tier, such as whether the issuer has taken steps to foster a market in its securities.1012 These alternatives would likely reduce compliance costs for Tier 2 issuers; however, they also may cause investors to have less information upon which to make investment decisions, resulting in weaker investor protections and less informationally efficient prices.
Other commenters recommended requiring ongoing disclosures for issuers in Tier 1 offerings, including disclosures at a level lower than is required for Tier 2,1013 ongoing disclosure with yearly audited financials,1014 or some unspecified continuous disclosure obligation.1015 Such alternatives, particularly if accompanied by the requirement of audited financial statements, would increase the availability and quality of financial
information provided to investors in Tier 1 offerings and strengthen investor protection
1010 See OTC Markets Letter.
1011 See Heritage Letter and IPA Letter.
1012 See Heritage Letter.
1013 See Guzik Letter 1 (suggesting that Tier 1 ongoing disclosure requirements could parallel Tier 2’s requirements, but without the requirement for semiannual reports).
1014 See Ladd Letter 2.
1015 See SVB Letter.
by enabling investors to make better informed decisions. However, due to the fixed component of disclosure costs, and the likely smaller size of Tier 1 offerings relative to Tier 2 offerings, such requirements may limit capital formation and place Tier 1 issuers at a competitive disadvantage relative to Tier 2 issuers. We note that small issuers that value informational efficiency gains from ongoing disclosures above the cost of such disclosures have the option of conducting a Tier 2 offering.