The final rules amend Rule 262 to include bad actor disqualification provisions in substantially the same form as adopted under Rule 506(d).1018 The final rules specify that the covered person’s status is tested at the time of filing of the offering statement.
Consistent with the disqualification provisions of Rule 506(d), the final rules add two new disqualification triggers to those in existing Regulation A: Commission cease-and- desist orders relating to violations of scienter-based anti-fraud provisions of the federal securities laws or Section 5 of the Securities Act and the final orders and bars of certain state and other federal regulators. While these provisions may impose an incremental cost on issuers and other covered persons relative to the cost imposed by the disqualification provisions of existing Regulation A, they should strengthen investor protection from potential fraud.
If one of these new triggering events occurred prior to the effective date of the
1018 See 17 CFR 230.506(d).
final rules, the event will not cause disqualification, but instead must be disclosed on a basis consistent with Rule 506(e). This approach will not preclude the participation of bad actors whose disqualifying events occurred prior to the effective date of the final rules, which could expose investors to the risks that arise when bad actors are associated with an offering. These risks to investors may be partly mitigated since investors will have access to relevant information that could inform their investment decisions.
Disclosure of triggering events may also make it more difficult for issuers to attract investors, and issuers may experience some or all of the impact of disqualification as a result. Some issuers may, accordingly, choose to exclude involvement by prior bad actors to avoid such disclosures.
We expect that the bad actor disqualification provisions in the final rules will lead most issuers to restrict bad actor participation in Regulation A offerings, which could help reduce the potential for fraud in these types of offerings and thus strengthen investor protection compared with an alternative of not including bad actor disqualification provisions. If disqualification standards lower the risk premium associated with the risk of fraud due to the presence of bad actors in securities offerings, they could also reduce the cost of capital for issuers that rely on amended Regulation A. In addition, the requirement that issuers determine whether any covered persons are subject to disqualification might reduce the need for investors to do their own investigations and could therefore increase efficiency.
The disqualification provisions also impose costs on issuers and covered persons.
Issuers that are disqualified from using amended Regulation A may experience an increased cost of capital or a reduced availability of capital, which could have negative
effects on capital formation. In addition, issuers may incur costs related to seeking disqualification waivers from the Commission and replacing personnel or avoiding the participation of covered persons who are subject to disqualifying events. Issuers also might incur costs to restructure their share ownership to avoid beneficial ownership of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power, by individuals subject to disqualifying events.
As discussed above, the final rules also provide a reasonable care exception on a basis consistent with Rule 506(d).1019 We anticipate that the reasonable care exception would result in benefits and costs, compared with an alternative of not providing a reasonable care exception. For example, a reasonable care exception could facilitate capital formation by encouraging issuers to proceed with Regulation A offerings in situations in which issuers otherwise might have been deterred from relying on Regulation A if they risked potential liability under Section 5 of the Securities Act for unknown disqualifying events. This exception also could increase the potential for fraud, compared with an alternative of not providing a reasonable care exception, by limiting
issuers’ incentives to determine whether bad actors are involved with their offerings. We also recognize that some issuers might incur costs associated with conducting and documenting their factual inquiry into possible disqualifications. The rule’s flexibility with respect to the nature and extent of the factual inquiry required could allow an issuer to tailor its factual inquiry as appropriate to its particular circumstances, thereby potentially limiting costs.
One commenter recommended revising the look-back periods for disqualifying
1019 See Proposed Rule 262(b)(4).
events to run from the time of sale rather than the time of filing of the offering statement.1020 These changes would relax the bad actor disqualification standard, by allowing bad actors to participate in Regulation A offerings during the qualification process. We believe that timing application of the bad actor disqualification rules to the time of filing of the offering statement, as opposed to the time of qualification, is therefore more appropriate under the final rules.
Relationship with State Securities Law
The final rules preempt state registration and qualification requirements for Tier 2 offerings but preserve these requirements for Tier 1 offerings, consistent with state registration of Regulation A offerings of up to $5 million under existing Regulation A.
The GAO Report found that compliance with state securities review and qualification requirements was one of the factors that appeared to have influenced the infrequent use of Regulation A by small businesses.1021 Various commenters supporting preemption of state securities laws in the final rules noted that state review of offering statements is a significant impediment to the use of Regulation A and that the process of
1020 See KVCF Letter.
1021 See GAO Report. The GAO Report also cites other factors that may have discouraged issuer use of the Regulation A exemption, including a comparatively low $5 million offering limitation, a slow and costly filing process associated with Commission qualification, and the availability of other exemptions under the federal securities laws.
A recent study performs a comparison of Rule 506 offerings with Rule 505 and Rule 504 offerings that “suggests that the Blue Sky law preemption feature unique to Rule 506 offerings has greater value to issuers than the unique features of Rule 504 or Rule 505 offerings.” See Ivanov, V., and
S. Bauguess, 2013, Capital raising in the U.S.: An analysis of unregistered offerings using the Regulation D exemption, 2009-2012, available at: http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered-offerings-reg-d.pdf.
See also Leading Biosciences Letter referencing recommendations supporting preemption from the SEC Government-Business Forum on Small Business Capital Formation in 2011 and 2012. Similar recommendations were made in the final report of the SEC Forum on Small Business Capital Formation in 2013, available at: http://www.sec.gov/info/smallbus/gbfor32.pdf.
qualification in multiple states will remain inefficient despite NASAA’s implementation of a coordinated review program.1022 More broadly, commenters as well as the GAO Report indicated that the existing regime of federal and state qualification has been a significant disincentive to the use of Regulation A for capital raising. With respect to time and compliance costs associated with state qualification, we believe preemption will likely reduce issuers’ costs, although we lack comprehensive, independent data to estimate the precise amount. Only a few commenters provided specific monetary estimates of cost components. One commenter indicated that a revenue-generating
business seeking to conduct a debt or equity offering under existing Regulation A can produce a conforming offering statement for state and federal review for approximately
$50,000.1023 According to another commenter, an issuer seeking state registration in 50
states would incur $80,000 to $100,000 in legal fees.1024