On November 2, 2020, the U.S. Securities and Exchange Commission (“SEC” or “Commission”) voted to amend its rules to harmonize, simplify, and improve the exempt offering framework. These amendments will, in general, be effective 60 days after publication in the Federal Register.
Bigger is Better
An item of great import for companies looking to effect meaningful capital raises, the offering limit in Regulation Crowdfunding (“Reg CF”) was raised from $1.07 million to $5 million along with adjustments of individual investment limits. This increase in the amount that a company can raise via a Reg CF Offering will likely make it a popular alternative to capital formation under Regulation D. It also democratizes the ability of people to invest in start-ups because of the lower financial eligibility requirements for investors in Reg CF Offerings compared to Reg D offerings. Specifically, the Commission amended the investment limits for investors in Reg CF offerings by: (a) removing investment limits for accredited investors; and (b) using the greater of their annual income or net worth when calculating the investment limits for non-accredited investors.
Demo Days Are Here Again
In addition, the Commission has clarified its requirements for so-called “demo days” communications for Reg CF purposes under Rule 148. These amendments provide a non-revenue opportunity for Accelerators and Angel Investors to run “demo days” for their portfolio companies. “As adopted, an issuer will not be deemed to have engaged in general solicitation if the communications are made in connection with a seminar or meeting sponsored by a college, university, or other institution of higher education, a State or local government or instrumentality of a State or local government, a nonprofit organization, or an angel investor group, incubator, or accelerator.” In order to avoid misuse of the rule to make such a demo day a pitch for one particular issuer, the Commission also added a requirement that more than one issuer participate in the seminar or meeting. Under the final rule “the sponsor will not be permitted to:
- Make investment recommendations or provide investment advice to attendees of the event;
- Engage in any investment negotiations between the issuer and investors attending the event;
- Charge attendees of the event any fees, other than reasonable administrative fees;
- Receive any compensation for making introductions between event attendees and issuers, or for investment negotiations between the parties; or
- Receive any compensation with respect to the event that would require it to register as a broker or dealer under the Exchange Act, or as an investment adviser under the Advisers Act.
In addition, as proposed, the advertising for the event may not reference any specific offering of securities by the issuer.”
The Commission adopted limitations on the information conveyed at the event regarding the offering of securities by or on behalf of the issuer. As adopted the issuer is allowed to convey only:
- Notification that the issuer is in the process of offering or planning to offer securities;
- The type and amount of securities being offered;
- The intended use of the proceeds of the offering; and
- The unsubscribed amount in an offering.
Moreover, the Commission allowed for communications to not be subject to the constraints of Rule 148 by stating that “issuers may continue to rely on our previously issued guidance, and not be subject to the conditions of Rule 148, including the limit on communications if the organizer of the event has limited participation in the event to individuals or groups of individuals with whom the issuer or the organizer has a pre-existing substantive relationship or that have been contacted through an informal, personal network of experienced, financially sophisticated individuals.”
While clarifying the requirements of Rule 148 for in-person gatherings (that are limited by, for example, physical restraints of venue size and the like), with regards to “virtual” or “on-line” demo day presentations the SEC narrowed the scope of the exemption so that online participation in the event is limited to: (a) individuals who are members of, or otherwise associated with the sponsor organization (for example, members of an angel investor group or students, faculty, or alumni of a college or university); (b) individuals that the sponsor reasonably believes are accredited investors; or (c) individuals who have been invited to the event by the sponsor based on industry or investment-related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event. These amendments are directionally correct and the Commission and its staff should be lauded for adopting them.
Back to the Future
While these recent developments are very helpful improvements, it also makes sense to take a step back and go to the 2015 Reg CF Adopting Release and recap how a Reg CF offering is to be conducted. For starters, a company that wishes to do a Reg CF fundraise is subject to some basic requirements:
- has to use the services of a single broker-dealer or funding platform.
- that funding platform has to be registered as such with the SEC and FINRA.
- the transaction must be conducted exclusively through the intermediary’s platform
While the transaction has to take place on a single platform, that intermediary “may engage in back office or other administrative functions other than on the intermediary’s platform.” This last sentence is key because it allows for the funding portal to outsource many of its functions to a third party service provider seamlessly via API.
Moreover, Rule 301(a), as adopted, requires that an intermediary have a reasonable basis for believing that an issuer seeking to offer and sell securities in reliance on Section 4(a)(6) through the intermediary’s platform complies with the requirements in Securities Act Section 4A(b) and the related requirements in Reg CF. Rule 301(b) explains how an intermediary can comply with this jumble of words: an intermediary will be deemed to have satisfied this requirement if the issuer has engaged the services of a transfer agent that is registered under Section 17A of the Exchange Act. So, the easiest way for a funding platform to comply with the rule and provide easy to use services to issuers and investors is for it to leverage a transfer agency service that connects seamlessly via API. The Adopting Release was quite clear on this point by stating “[a]t the same time, mindful of the role that may be played by registered transfer agents in maintaining accurate shareholder records, we are providing a safe harbor for compliance with Rule 301(b) for those issuers that use a registered transfer agent.”
Last, but certainly not least, using an SEC-registered transfer agent also helps an issuer manage its obligations under Section 12(g) of the Exchange Act which establishes the investor and other thresholds at which an issuer is required to register a class of securities with the SEC (i.e. if the issuer has 2000 or more equity investors and 500 or more of them are not accredited investors).
Registration of a class of securities is a costly and legally burdensome exercise for a Reg CF Issuer and more suited for much larger companies. Thankfully the SEC added a footnote 665 in the Adopting Release that states: “We also note that an issuer’s exemption from Section 12(g) is conditioned on, among other things, that issuer engaging a registered transfer agent.” Put differently, an issuer that utilizes a transfer agent and complies with the other requirements of Rule 12g-6 does not have to include the purchasers of its Reg CF securities in its record holder count under Section 12(g) and can avoid the expense and effort of being deemed an Exchange Act reporting company.
According to the Q3 2020 Venture Monitor published by PitchBook and NVCA, over 6000 companies in the U.S. raised less than $5million (many presumably under Reg D). Companies like these are ideal candidates to use Reg CF going forward and may not need VCs to do so. The further development of the Reg CF market in the U.S. will be driven in part by the Commission’s thoughtful and forward-looking amendments. We trust other nations will follow the lead for capital formation for small to medium-size enterprises. We look forward to working cost-effectively and transparently with issuers, investors, broker-dealers and funding platforms.
Gautam Gujral is co-founder & General Counsel of Vertalo a Fintech providing a solution for digital asset lifecycle management. Previously, Gujral was a Managing Director at Credit Suisse in the Prime Services department within the Investment Banking division, based in New York. At CS, he was the architect of the “Prime Solutions” business that solved non-traditional financing and other issues for hedge funds, and helped CS differentiate itself and leapfrog others in the market. Prior to joining Credit Suisse First Boston in 1997, Gautam worked for the United States’ Securities and Exchange Commission where he received the prestigious SEC Capital Market Award for his groundbreaking work on Regulation of Exchanges and Alternative Trading Systems. He is also the recipient of the SEC Chairman’s Award for Excellence for the SEC’s Municipal Securities Disclosure Initiative which for the first time required ongoing disclosure by issuers and creation of repositories for such disclosure. He is admitted to the Bar in New York, Maryland and Washington, D.C. He also holds FINRA Series 7, 24 and 63 licenses. He is fluent in English, German and Hindi.