SEC and States Square Off Over Reg. A Securities Offerings

Regulation A has long been the neglected child of securities registration exemptions, since issuers could only raise up to $5 million and then still had to jump through hoops created by state compliance reviews.

“It scares people off knowing they have to deal with securities regulators, possibly in all 50 states, if they want to do a nationwide offering,” says Kendall Almerico, a lawyer and CEO of FundHub, a firm that advises start-up companies on compliance issues.

That could soon change. A proposed rule by the Securities and Exchange Commission ups the threshold companies can raise under Reg. A without triggering extensive reporting requirements to $50 million and preempts state blue sky laws. The proposal keeps the exemption's simplified filing process and lowered audit requirements in place.

State regulators, though, unhappy with being cut out of the equation, are fighting back. On March 7, the North American Securities Administrators Association (NASAA), a coalition of state-level securities regulators that is the nation's oldest investor protection organization, voted to approve a new, streamlined review protocol as part of its battle to maintain state oversight.

“We are dismayed and shocked,” Massachusetts Secretary of State William Galvin wrote in a comment letter to the SEC. “The states have tackled preemption battles on many fronts, but never before have we found ourselves battling our federal counterpart. Shame on the SEC for this anti-investor proposal. This is a step that puts small retail investors unacceptably at risk.”

When the JOBS Act required the SEC to revisit the current Regulation A registration exemption for smaller offerings, it not only raised the fundraising limit, it also allowed issuers to market to unaccredited investors and purchasers. When the SEC proposed the rules to carry out the law, and eliminated the requirement for state-level reviews, it responded to a steadily decreasing number of issuers using the exemption.

That trend was documented in a 2012 report by the Government Accountability Office.  The number of those offerings filed and qualified (that is, cleared) by the SEC declined significantly after peaking in 1997. Offerings filed fell from 116 in 1997 to 19 in 2011, while the number of qualified offerings dropped from 57 in 1998 to just one in 2011.

Among the factors cited by securities attorneys the GAO interviewed were “the increased attractiveness” of Regulation D offerings, which are also exempt from SEC registration, but aren't subject to state securities laws and don't have to go through a federal filing and review process, as Reg. A offerings do.

Complicating matters is that states' methods for registering and reviewing securities can vary substantially. A “registration by qualification,” similar to registering securities with the SEC, requires issuers to submit documentation about the offering for review and approval. Most states also conduct a merit review—an analysis of the fairness of the offering to investors. Some use stricter standards in these reviews than others.

NASAA officials have long encouraged states to streamline their requirements and make them more uniform, including adopting a standard form for registering securities.

Still, the organization says it didn't expect the SEC to completely preempt state reviews. “Congress decided to vote a preemption provision down, so, we were surprised to see a proposal like that from the SEC,” says Andrea Seidt, NASAA president and commissioner for Ohio's Division of Securities. “Preserving state review was a decision Congress made, and regulators need to respect their authority,” says Seidt. NASAA will meet with SEC Chairman Mary Jo White in April to discuss these concerns.

Needed Improvements?

Others, however, see preemption as a move the SEC needed to make if it wanted to save Reg. A. “The relative offering or transaction costs generated by state registration rules simply overwhelm any benefit businesses may gain by using Regulation A,” wrote Rutheford Campbell, professor of law at the University of Kentucky, in a March 5 comment letter.

According to FundHub's Almerico, the SEC “did the two things that needed to be done to make it work.” Not only did it preempt blue sky laws, it redefined the qualified investor requirement to encompass anyone who wants to invest, as opposed to just accredited investors.

“Shame on the SEC for this anti-investor proposal. This is a step that puts small retail investors unacceptably at risk.”

—William Galvin,

Secretary of State,

Massachusetts

“The cost of doing a Regulation A $50 million raise is almost going to be the same as doing a $1 million raise under the equity crowdfunding rule. It may actually be less,” says Almerico. “This is going to be so much more of a game-changer, unless the blue sky laws come back into play—then it is going to die on the vine.”

Gregory Fryer, a partner with the law firm Verrill Dana, also applauds the SEC's removal of overlapping state regulatory regimes. One offering he worked on was delayed for more than 190 days due to the state review process. He was shocked to discover that wasn't unusual. The SEC's proposing release notes that from 2002 to 2012 the average time to qualify a Reg. A offering ranged from 167 to 301 days.

“Regulation A has multiple flaws, but much of what is wrong with it can be traced to neglect,” Fryer says. Among his suggestions for the SEC to also consider: provide staff reviewers with Reg. A-specific training and the discretion to make judgments about materiality; setting internal standards for faster turnaround of comments; and allowing the informal exchange of drafts between reviewers and counsel.

“It's a politically sensitive issue,” Fryer says on preemption state review. “The state regulators have a good working relationship with the SEC in many ways, but Regulation A is not one of them.”

Fryer suggests that, if there is ultimately no state preemption, the SEC should choose to defer to only one state reviewer, perhaps the home state of the issuer.

New State Review Standards

Inspired by the GAO report and fast-tracked by the SEC's proposed rule, NASAA members approved a new state review protocol last week. The coordinated review program, developed in conjunction with the American Bar Association, creates one-stop filing for all states in which registration is required, using an Electronic Filing Depository system currently in development.

The program administrator would select a lead merit examiner and a lead disclosure examiner from among the states in which registration is sought. The lead examiners would be responsible for drafting and circulating a comment letter to the participating jurisdictions. Each state in which registration is sought would have 10 business days to review an application for registration and submit comments or concerns to the lead examiners. Once a lead examiner clears the application, the decision is binding on all other states.

STREAMLING STATE REGULATION

Below is an illustrated guide to the North American Securities Administrators Association's proposed coordinated review program.

Source: NASAA.

As with existing coordinated review programs for registered public offerings, the issuer would have the option of withdrawing from select states or from coordinated review altogether. “What happens when you take state regulatory review out of the mix? One of the areas where that has already happened, and we know what the consequences are, is Regulation D,” Seidt says. Those private deals are sold without substantive SEC review and the states are preempted from conducting a regulatory review similar to what is proposed with Reg. A.

“The consequence is that we see a significant amount of fraud in those offerings,” she says. “For the fourth consecutive year, Regulation D deals ranked number one as the single most frequent investment scam.”

There are also concerns that issuers will no longer get the state guidance that helps them avoid litigation later on. “They may be selling these deals without making proper disclosure and down the road have civil liability from investors,” Seidt says.

Seidt concedes that streamlining the state compliance process is long-overdue, and she hopes the newly approved protocol will also be applied to other areas of overlapping review. “There really should be consistency for the filer,” she says. “I don't like the idea of 50 separate packages going out to all the state regulators. We need to create a centralized electronic system to handle multi-state offerings, and we are going to do that no matter what happens.”