How the SEC Should Harmonize Private Securities Offering Exemptions

The Securities and Exchange Commission requested public comment on ways to simplify, improve, or harmonize exemptions from the requirement to register securities offerings.  The SEC acknowledged that the current array of exempt offerings is complex and might be difficult for issuers to navigate.  See Concept Release on Harmonization of Securities Offering Exemptions, 84 Fed. Reg. 30,460 (June 26, 2019).

My comment proposed a new exemption from the registration requirements to replace several of the current exemptions and simplify access to capital for startup companies and small to mid-sized companies.  It would combine features from Rules 506(b) and (c) of Regulation D and eliminate costly and cumbersome limitations and restrictions that are part of current exemptions for smaller companies, particularly Regulation A, Regulation CF, and Rule 504 of Regulation D.  The approach also would broaden the base for sources of capital by eliminating the accredited investor restriction in Rule 506, but it would preserve fundamental investor protection by requiring a set of mandatory disclosures in each sale.

The reasons for proposing a new exemption are these:

  • The most favored form of exempt transaction is a Rule 506(b) offering sold only to accredited investors and not to any nonaccredited investors. Firms have shown a decided preference for Rule 506 transactions over Rule 504, Regulation A, or Regulation CF transactions.  In 2018, the amount raised using Rule 506(b) was $1.5 trillion.  The amount from using Rule 506(c) was $211 billion.  The amount raised using Rule 504 was $2 billion, the amount from Regulation A was $736 million, and the amount from Regulation CF was $55 million.  Together, Rule 504, Regulation A, and Regulation CF offerings raised approximately 0.16 percent of the amount raised through Rule 506.
  • Rule 506 transactions frequently have not included nonaccredited investors.
  • The definition of “accredited investor” was originally developed to implement the private offering exemption in section 4(a)(2) of the Securities Act, but over time the definition has strayed far from its roots. Information and disclosure have been the foundations for the section 4(a)(2) exemption.  The exemption applied when offerees had knowledge of or access to the information that would be in a registration statement.  It was not to create special opportunities for the wealthy or financially sophisticated.
  • The definition of an accredited investor has expanded and changed and now is not closely correlated with a person who has knowledge of the information that would be in a registration statement or access to that information. A natural person is an accredited investor based on net worth or net income.  Under Rule 506, an issuer does not need to make any disclosure at all when selling solely to accredited investors, although, in practice, issuers usually do provide some disclosures to accredited investors.
  • The accredited investor category has come under attack. Income and wealth do not provide a rational connection to an investor’s knowledge of information that would be in a registration statement or to an ability to ask for and obtain the information felt necessary to making an informed investment decision.  The criteria are not even effective ways of identifying the persons who understand the risks of buying securities.  Another objection, advanced by the chairman of the SEC and others, is that the accredited investor concept limits the ability of the bulk of retail investors to invest in startups during their high-growth phase.  It divides the universe of investors into favored and disfavored classes.

The solution is not to amend the definition of accredited investors.  The solution is to require delivery of a solid disclosure document in a private offering and eliminate the category of accredited investors.  That is the central element of the proposed exemption, but an important qualification is that the disclosures must not be as extensive as those mandated by Regulation S-K, Form S-1, Rule 506(b) for nonaccredited investors, or Regulation A.  The disclosure obligations of the new exemption should provide essential company and security information to buyers but avoid the high costs associated with longer disclosures.  The test should be the basic information that any investor would require before investing.

Requiring a disclosure document would allow any investor to buy under the new exemption but would impose a compliance cost.  Three factors justify the cost.  First, disclosure is the essence of the approach of the federal securities laws, and Rule 506 has strayed too far from that core value.  Second, the proposed disclosures would be significantly reduced from the disclosures required for a registered offer or other exemptions.  The cost of preparing the envisioned disclosure document is meant to be manageable for startup and small companies.  Third, under current practice, some form of disclosure document is usually part of a Rule 506 offering to accredited investors.

The proposed exemption has many more details.  In general, the exemption would have very few restrictions and limitations.  The intent would be to offer a simple, streamlined, and flexible method of raising capital to a broad range of issuers and all potential investors based on delivery of a reasonable but not unduly costly set of disclosures.

This post comes to us from Andrew Vollmer, a senior affiliated scholar at the Mercatus Center at George Mason University, a former professor at the University of Virginia School of Law, and a former deputy general counsel of the Securities and Exchange Commission.  The complete version of his submission to the SEC is available here.