Regulation A’s Futility Before and After the J.O.B.S. Act

In April of 2012, President Obama signed into the law the J.O.B.S.  (Jumpstart Our Business Startups) Act.  The law’s intent and design was to make it easier for small businesses to raise money by easing their regulatory burdens both on raising capital and operating as publicly traded companies on an ongoing basis.  This article focuses on the J.O.B.S Act’s Title IV.  Title IV revises an exempt offering provision referred to as Regulation A. Prior to its revision, Regulation A was a seldom used offering exemption because companies felt that the steps necessary to complete a Regulation A offering far outweighed the benefits as the most an issuer could raise through Regulation A was $5 million.

After much wrangling, the Securities and Exchange Commission finalized its revised Regulation A rules on March 25, 2015.  The rules went into effect June 19, 2015.  I believe Regulation A (now informally referred to as Regulation A+) will prove to be an exempt offering provision that is still too unwieldy and cumbersome to be a viable and regularly used exempt offering provision.

As mentioned earlier, in its original form, the most an issuer could raise through Regulation A in any twelve-month period was $5 million. To complete the Regulation A offering process, the issuer has to complete a Form 1-A which is a 29-page document which requires the issuer to provide significant disclosures regarding the company’s business, management, and financial position.  The Form 1-A once completed has to be filed with the Commission and must undergo a qualification process, which involves an SEC Examiner reviewing the document to make sure the disclosures are adequate and in compliance with the Form 1-A mandates. Once the Commission is satisfied, it qualifies the offering thereby enabling the issuer to offer its securities under the Regulation A exemption. Historically, this process took 228 days on average. Additionally, Regulation A, unlike some of its more popular alternatives, has a state component which requires the issuer to register its securities in each state in which the issuer is planning on offering its securities.  This adds considerable time and expense to an already labor and time intensive process.

Given the significant amount of work involved with completing the Form 1-A, the considerable lag time between filing the Form 1-A and working through the qualification process, and the additional state filing requirements, many issuers took a pass on Regulation A.  As a former practitioner, I can say with first hand knowledge that securities law attorneys shunned Regulation A for more preferable choices that allowed for greater capital raising opportunities with much less time and effort.

Because of these dynamics, Regulation A had been all but dormant prior to its attempted revival under the J.O.B.S. Act.  In 1992 there were only 20 Regulation A filings, of which all 20 were qualified. Regulation A filings peaked around 1997 when issuers filed 116 Regulation A offering circulars.  But of the 116 filings, only 56 (roughly half) actually worked their way through the Commission’s review process and obtained qualification.  By 2011, the Regulation A filing number dwindled to nineteen with the Commission only qualifying one of those nineteen Regulation A filings.

By comparison, in 2010 there were a total of 7,517 exempt offerings completed under Regulation D’s Rule 506 and 8,194 Rule 506 offerings completed in 2011.  And the Rule 506 sample used for comparison included only those offerings that were for $5 million or less. The choice for practitioners was a simple one as Regulation D’s Rule 506 was a private offering exemption that has no Commission review process, no cap on its offering size, and is exempt from all state registration requirements. Prior to the J.O.B.S. Act revisions, Regulation D’s Rule 506 due to its much more stream-lined process was the clear choice.

Title IV in conjunction with the Commission’s final rulemaking made significant changes to Regulation A, with the most noteworthy involving raising Regulation A’s offering cap from $5 million to $50 million.   The Commission’s revised rules created a two tiered system under Regulation A.  Tier-1 consists of offerings up to $20 million.  Tier 2 is for offerings between $20 million and $50 million.  In essence, the Tier-1 offering regime is exactly the same as Regulation A’s original version but for the offering cap being raised from $5 million to $20 million. The onerous Form 1-A is still required, the qualification process is still intact, and there is no state pre-emption for Tier-1 offerings meaning the issuer still has to register its offering in each state it intends on offering its securities.

With the Tier-2 offerings, raising the cap has come with a corresponding increase in disclosure and compliance requirements.  With a Tier-2 offering, issuers must now include audited financial statements with its Form 1-A.  Additionally, issuers will have to file annual audited financial statements with the Commission.  Also, unaccredited investors will be limited in the amount they can invest; the greater of 10% of their income or 10% of their net worth. Regulation A places no limits on accredited investors participating in a Tier 2 offering.  Finally and significantly, Tier-2 offerings are exempt from all state registration requirements.

The pressing question and the one interested parties are anxious to see is whether the “new and improved Regulation A” will result in an uptick in Regulation A’s use.  Though it will be some time before this question can be answered with certainty.  I believe that Regulation A will remain a least preferred offering exemption for some very fundamental reasons.

First off, Congress approached revising Regulation A from the flawed premise that “if we make it bigger, it will be better.” But the offering size wasn’t really the problem with Regulation A.  The fundamental problem with Regulation A is that Regulation A’s distinguishing characteristics aren’t compelling enough to cause an issuer to choose Regulation A over other options.

The more pointed approach should have been to address the matter from the issuer’s perspective. Approaching Regulation A from the issuer’s perspective would have forced the question.  “What advantage does a Regulation A exemption provide that other choices do not?” And the only reason that a thoughtful issuer would select Regulation A over some other alternative would be if Regulation A allows for options that other exemptions do not.  Regulation A does have some distinguishing characteristics, but at the end of the day those characteristics are not compelling enough to outweigh the cumbersome Regulation A aspects that have pushed it to the back of the private offering exemption line.

First off, Regulation A, unlike Regulation D’s Rule 506 has no investor qualification requirements.  Rule 506 investors must either be accredited or financially savvy. In contrast, anyone can invest in a Regulation A offering regardless of investor qualification. In some narrow contexts, this can be advantageous. But generally speaking investors who are neither financially savvy nor have significant disposable income set aside for investing will be unable to write the kinds of checks private companies are looking for when raising capital, particularly given the 2,000 investor threshold to public disclosure.

Investors who lack both financial sophistication and sufficient disposable income aren’t in a position to invest or lose significant amounts of money.  Investors in this demographic will be a cumbersome lot for any issuer to manage.  They may not understand the speculative nature of investing in general, and will likely be investing money that they can ill afford to lose.  If any issuer finds itself in a position where their decision to use Regulation A is necessitated by the fact that their potential investor base consists primarily of non-accredited, non-financially savvy investors, then the issuer may want to consider the long-term viability of doing an offering under these circumstances.  The fact that Regulation A opens its doors to all potential investors upon closer examination can be more of a minus than a plus.

Second, shares sold in a Regulation A offering are not restricted, meaning that the initial investor can re-sell his shares without having to register them.  Again this apparent advantage in most Regulation A offerings rarely comes into play.  With most closely held companies, the shares will remain illiquid and in the hands of its initial investors until the company goes public at some point.  Private companies cannot afford to lose control of their cap table as transfers can lead to a crossing of the 2,000 investor threshold under Section 12(g) of the Exchange Act.  Outside of these two distinguishing characteristics, other exemptions provide for the same options that Regulation A provides without all the cumbersome registration and disclosure requirements.

Historically, Regulation A has been a seldom used offering exemption for the reasons previously discussed.  Regulation A should have been left on its downward trajectory towards dormancy.  The attempt to revive it under the J.O.B.S Act was a misdirected attempt that may have delayed its extinction somewhat.  But in the end, issuers will come to this conclusion.  Sometimes the most appropriate thing to do is let sleeping regulations lie which is what should have happened here with Regulation A.

The preceding post comes to us from Neal Newman, Professor of Law at Texas A&M University School of Law.  The post is based on his recent paper, which is entitled “Let Sleeping Regs Lie: A Diatribe on Regulation A’s Futility Before and After the J.O.B.S. Act” forthcoming in the UPenn Journal of Business Law and available here.