Promoting Investor Protection in Small Business Capital Formation

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at a recent open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today [Dec. 18, 2013], the Commission proposes rules to implement Title IV of the JOBS Act. As mandated by that Act, the proposed rule would allow companies to issue a class of securities that are exempted from the registration and prospectus requirements of the Securities Act, provided that certain conditions are met. This is the third major rulemaking undertaken by the Commission to comply with the JOBS Act since its adoption last year.

Enhancements to Investor Protection under Regulation A-plus

The proposed rules being considered today enhance an existing exemptive regime known as Regulation A. Under the current provisions of Regulation A, companies can raise up to $5 million per year without registration, provided that they file an offering statement with the Commission containing certain required information and furnish an offering circular to purchasers, among other conditions.

Today’s proposal, often referred to as “Regulation A-plus,” would extend this exemption to issuances of up to $50 million in any 12-month period, while at the same time increasing investor protection for so-called “Tier 2” offerings in four important ways:

  • First, by enhancing disclosure requirements, and by requiring companies to include audited financial statements in their offering circulars;
  • Second, by ensuring that the Commission staff has an opportunity to review and comment on the offering circular before it becomes effective;
  • Third, by limiting the amount of securities that a potential investor may invest to 10% of the investor’s annual income or net worth, whichever is greater; and
  • Fourth, by requiring companies that issue a class of securities under Regulation A-plus to file ongoing disclosure reports, so long as the securities are held of record by at least 300 investors.

Given the $50 million limit on offerings under Regulation A-plus, the offering statement and ongoing disclosure reports required by the proposed rules are focused on the types of information that the staff’s experience suggests are relevant to smaller companies and their investors. As a result, the required disclosure, while valuable, is less extensive than the disclosure required in a registered offering. In that regard, I encourage commenters, and in particular investors with experience investing in smaller companies, to comment in detail about the specific disclosures that would be valuable to require in offering circulars and reports under revised Regulation A.

It is my hope that the final disclosure requirements will protect and inform investors, resulting in the investor confidence necessary for the success of Regulation A-plus, while at the same time providing an appropriate alternative to registered offerings for those small and emerging companies that need access to public capital to grow and create jobs.

The Role of the States

Today’s release also addresses the issue of preempting state blue sky review for Regulation A‑plus offerings, as provided for in Section 401(b) of the JOBS Act. One way the statute enables preemption is by authorizing the Commission to adopt a definition of “qualified purchaser” with respect to such offerings, as offers and sales to qualified purchasers would be exempt from state registration or qualification. To that end, today’s proposal would define “qualified purchaser” to include all offerees, and all purchasers in “Tier 2” offerings. In other words, the proposed rule defines “qualified purchaser” in a way that would preempt all Tier 2 offerings from state blue sky requirements—although state securities commissions would nevertheless retain jurisdiction to investigate and bring enforcement actions in the case of any fraud or deceit.

However, as the Commission acknowledges in the proposing release, the North American Securities Administrators Association—known as NASAA—recently proposed a coordinated process to streamline review of Regulation A offerings. This new streamlined protocol could substantially reduce state securities law compliance hurdles for Regulation A issuers by reducing the cost and time frame associated with state review. In that regard, the proposing release solicits comments on potential alternative approaches to the definition of “qualified purchaser” that would take into account possible state review.

The Commission is mindful of the important role that state securities administrators play in protecting investors and promoting capital formation, particularly with respect to smaller offerings. It has long been recognized that the states are on the “front lines” of antifraud enforcement for smaller offerings. Moreover, the states have a history of working closely with issuers and investors in their jurisdictions, and have extensive experience reviewing small offerings. This is important expertise and experience to incorporate into the process. Accordingly, I look forward to NASAA and the state regulators completing their work to implement a workable protocol for state review of offerings under Regulation A, and I urge both investors and other interested parties to comment on the pros and cons of incorporating a form of state review into the Regulation A qualification process.

Ongoing Reporting and Secondary Trading

Before concluding, it is important to note that, in accordance with the statute, securities issued pursuant to Regulation A-plus will not be restricted securities, and will thus be freely tradeable by security holders who are not affiliates of the issuer. Accordingly, the ongoing reporting requirements in the proposed rules provide an important protection for investors in securities issued pursuant to Tier 2 of Regulation A.

It cannot yet be known whether a reliable secondary market will develop for Regulation A securities. However, even with the proposed reporting requirements, the market for such securities will almost certainly be less transparent than the market for listed securities. In addition, given the smaller offering size and reduced transparency, Regulation A securities may experience wider spreads, lower liquidity, and the potential for significant volatility as compared to registered securities, in any secondary trading markets that may develop.

Although the JOBS Act is silent regarding what actions can be taken to mitigate the risks to investors that may result from such a trading environment, the Commission must be proactive in addressing foreseeable consequences.

In that regard, I expect the staff to actively monitor any secondary trading activity that develops after adoption with respect to Regulation A securities, for any possible indications of fraud, manipulation, or market failure. The rule changes we propose today will not achieve the hoped for benefits in capital formation, if the end result is that investors are left holding a portfolio of securities that cannot be valued or sold.

Notably, Regulation A-plus is just one of several initiatives under the JOBS Act that raises this issue. Other JOBS Act provisions may also increase the number of companies that are exempt from the registration and reporting requirements of the Exchange Act, but still have significant security holdings in public hands. For example, the availability of general solicitation and advertising under Regulation D allows shares to be sold to an unlimited number of accredited investors in transactions that are much more widely dispersed than the traditional private placement. Although such securities are initially restricted, they may be resold after a one-year holding period pursuant to Rule 144, provided that certain limited information about the issuer is publicly available. Similarly, as currently proposed, shares issued in crowdfunding transactions would be freely tradable after a one-year holding period.

While there may not be a single, simple solution to this developing problem, it is clear that the Commission needs to take a hard and comprehensive look at Exchange Act Rule 15c2-11, which describes the information required under Rule 144 for non-reporting companies, and provides the conditions pursuant to which broker-dealers may publish quotations in over-the-counter securities. The problems with Rule 15c2-11 have long been documented, and the likelihood of an exponential growth in companies whose securities trade in reliance on that rule is real. The Commission needs to get in front of the problem and not wait until investors are harmed. It is my hope that the staff will complete such a review, together with any recommended ameliorative steps, before the adoption of the rules implementing crowdfunding and Regulation A-plus.

As always, the Commission’s focus must be on the public interest and the interests of investors, who alone supply the capital required for capital formation.

I look forward to comments on today’s proposal and on the issues raised in the release.

Finally, I want to thank the staff for their hard work on this proposal.

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