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By Robert L. Wernli, Jr.
On May 24, 2018, President Donald J. Trump signed into law the Economic Growth, Regulatory Relief and Consumer Protection Act which, among other things, directs the Securities and Exchange Commission (“SEC”) to make two important changes to Regulation A.
The first change is to remove the existing requirement that an issuer not be subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”) immediately prior to the offering.
The second change is to eliminate the periodic and current reporting requirements of Rule 257, otherwise required for an issuer completing a Tier 2 offering under Regulation A, for any issuer that is subject to the reporting requirements of the Exchange Act if the issuer is in compliance with its obligations thereunder.
As so amended, Regulation A could prove particularly useful to reporting companies that seek to use stock consideration ($50 million or less in a Tier 2 offering) to acquire a target company with many equity holders in a transaction that would otherwise require registration on Form S-4, or the completion of a fairness hearing under Section 3(a)(10) of the Securities Act of 1933 (the “Securities Act”), due to the unavailability of Rule 506 of Regulation D or another exemption from registration under the Securities Act.
The SEC Staff has confirmed in published guidance (Compliance & Disclosure Interpretation, Question 182.07) that Regulation A may be relied upon by an issuer for business combination transactions, such as a merger or acquisition.
As with a registered offering on Form S-4, the securities to be issued in a Regulation A offering will be unrestricted and freely tradeable under the Securities Act, though issuers and recipients of the securities will need to be mindful of transfer restrictions under Rule 144 in respect of any “control securities.”
In addition, there are several advantages to relying on Regulation A for an offering of securities related to a business combination instead of registering the offering on Form S-4:
Incorporation by reference of information with respect to the issuer . Form 1-A permits any issuer to incorporate by reference to other documents previously submitted or filed on EDGAR. Accordingly, an issuer that is an Exchange Act reporting company can satisfy the narrative disclosure contents of the offering circular by electing to provide the information required by Part I of Form S-1, the bulk of which information should be able to be incorporated by reference to the issuer’s Exchange Act filings. Alternatively, the issuer could elect to provide the information specified in Part II of Form 1-A and incorporate information by reference to its Exchange Act filings, though the issuer will need to be mindful of the differences between the information required by Part II of Form 1-A and the information required by the issuer’s Exchange Act filings and Regulation S-K, which are similar but not identical. In contrast, Form S-4 allows an issuer to incorporate by reference information from its Exchange Act filings only if the issuer is eligible to use Form S-3 and has a public float of $75 million or more. Reduced line item disclosure requirements. Unlike Form S-4, which contains a burdensome and voluminous list of detailed disclosures that must be provided in respect of the business combination transaction and the target company, the line item disclosure requirements of Form 1-A do not mandate any particular information to be disclosed about a business combination transaction or the target company, other than financial statements of the target company if the acquisition is probable (and the target company is sufficiently significant under applicable Regulation S-X tests) and related pro forma financial information, or perhaps forward-looking trend information in MD&A.
Timing and SEC Staff comments . Although the SEC Staff may take roughly the same amount of time to provide initial comments to a Form S-4 and a Form 1-A (i.e., up to 30 days after filing), our experience is that the number of comments to a Form 1-A is significantly less than the number of comments to a registration statement filed under the Securities Act. Accordingly, a Form 1-A may clear SEC Staff comments more quickly.
Additionally, under General Instruction A.2 of Form S-4, if information is incorporated by reference regarding the issuer or the target company, the prospectus (or joint prospectus/proxy statement) must be sent 20 business days prior to the date of the meeting of the target company’s security holders or, if no meeting is held, at least 20 business days prior to either (i) the date of the votes, consents or authorizations or (ii) the date the transaction is consummated or the votes, consents or authorizations may be used to affect the transaction. Form 1-A does not have a similar requirement for the offering circular.
Relaxed exhibit requirements . The exhibits required for a Form 1-A are significantly fewer than those required for a Form S-4. Importantly, there is no requirement in Form 1-A to file a tax opinion in respect of the transaction, and the SEC Staff has separately confirmed in published guidance (Compliance & Disclosure Interpretation, Question 182.18) that a tax opinion is not otherwise required for a Form 1-A.
Federal preemption of state blue sky laws. Under Section 18(b)(3) of the Securities Act, securities offered and sold to “qualified purchasers” are “covered securities” and therefore not subject to registration or qualification under state blue sky laws; and Rule 256 specifies that, for purposes of Section 18(b)(3), a “qualified purchaser” means any person to whom securities are offered and sold pursuant to a Tier 2 offering under Regulation A. Accordingly, all securities offered and sold in a Tier 2 offering under Regulation A are exempt from registration and qualification under state blue sky laws.
On the other hand, unless the securities offered under a Form S-4 are considered “covered securities” under Section 18(b)(1) of the Securities Act by virtue of the fact that they are listed (or authorized for listing) on a national securities exchange, the issuer will need to register or qualify the offer and sale of such securities in each applicable state unless there is an available exemption.
No strict liability under the Securities Act . Of significant importance to directors of the issuer and those signing the relevant SEC filings, there is no strict liability under Section 11 of the Securities Act for misstatements in a Form 1-A offering statement, because there is no registration under Section 5 of the Securities Act. Instead, a “seller” (including the issuer) of the Regulation A securities could potentially have negligence-based liability under Section 12(a)(2) of the Securities Act. In practice, officers and directors are rarely found to have Section 12(a)(2) liability, because such liability only attaches where the buyer purchases shares directly in the offering (i.e., not in the aftermarket) and, even then, only the person who directly sold the securities in question or who actively solicited that specific sale can be liable. Numerous courts have held that “solicitation” requires direct communication with the buyer, and directors and officers rarely engage in direct communications with the buyer. However, several decisions in the Southern District of New York hold that an officer or director’s mere signing of a registration statement may constitute sufficient solicitation to establish Section 12(a)(2) liability.
Greater flexibility to communicate with target company shareholders . Under Rule 255, at any time before the qualification of the offering statement, including before the public filing of the offering statement, the issuer or any person acting on its behalf may communicate orally or in writing to determine whether there is any interest in the Regulation A offering, provided that no solicitation or acceptance of money or other consideration, nor of any commitment, binding or otherwise, from any person is permitted until the qualification of the offering statement. This provides the issuer with significant flexibility to communicate with the target company shareholders prior to the qualification of the offering statement, so long as any written communications include the items specified in Rule 255(b) (e.g., legends and instructions on how to find the offering statement). Rule 260 also provides some relief in that “insignificant deviations” from the requirements of Regulation A will not render the exemption unavailable, which should help with any inadvertent foot faults.
In contrast, an issuer filing a Form S-4 must worry about “gun jumping” risks attendant to an offering registered under Section 5 of the Securities Act.
Integration safe harbor . Rule 251(c) expressly provides that a Regulation A offering will not be integrated with prior offers or sales of securities or subsequent offers or sales of securities that are (i) registered under the Securities Act (except as provided in Rule 255(e)), (ii) exempt from registration under Rule 701, (iii) made pursuant to an employee benefit plan, (iv) exempt from registration under Regulation S, (v) made more than six months after the completion of the Regulation A offering or (vi) exemption from registration under Section 4(a)(6) of the Securities Act (crowdfunding exemption).
On the other hand, a registered offering under Form S-4 enjoys none of the safe harbors, and the issuer must analyze under general integration principles whether the offering will integrate with another past or future offering, unless there is a safe harbor for the other offering. It may not be 100% clear that the offerings are not integrated, which could potentially call into question whether Form S-4 is available for the currently contemplated offering.
Potential greater flexibility with lock-up agreements . Entering into agreements with target company shareholders to vote in favor of a transaction or otherwise support a transaction (“lock-up agreements”) would also appear to present less of a problem under Regulation A. The SEC Staff’s policy with respect to Form S-4 registration is that an offering that has begun privately must end privately, and that registration of an offering on Form S-4 is inappropriate if lock-up agreements, which may represent offers and sales of securities, are signed in respect of the offering prior to registration, unless the lock-up agreements comply strictly with the Staff’s guidance.
Under Compliance & Disclosure Interpretation 239.13, the SEC Staff indicated that it will not object to the registration of an offering on Form S-4 where lock-up agreements, such as voting agreements and support agreements, in respect of the offering have been signed by management and principal security holders of a target company under the following circumstances (so long as such persons do not deliver written consents approving the business combination transaction alongside the lock-up agreements): (i) the lock-up agreements involve only executive officers, directors, affiliates, founders and their family members, and holders of 5% or more of the voting equity securities of the company being acquired; (ii) the persons signing the lock-up agreements collectively own less than 100% of the voting equity of the target; and (iii) votes will be solicited from shareholders of the company being acquired who have not signed the agreements and would be ineligible to purchase in a private offering.
The Staff’s policy concern does not appear to apply to a Regulation A offering, which will begin and end as an exempt transaction and will not involve registration under the Securities Act. Accordingly, issuers may have more flexibility under Regulation A to secure lock-up agreements from target company shareholders.
No filing fee . No filing fee is required for a Form 1-A. The issuer must pay a registration fee under Section 6(b) of the Securities Act in connection with the filing of a Form S-4.
Although there are a number of advantages to using Regulation A over Form S-4, there are a few disadvantages as well as some other issues to consider:
Regulation A eligibility restrictions . Not all issuers may use Regulation A. See Rule 251(b) for issuer eligibility requirements. The issuer will also need to make sure it is not disqualified from using Regulation A under Rule 262 on account of certain enumerated persons having violated “bad actor” rules. Form S-4 has no similar restrictions.
$50 million limit . The value of the securities to be offered cannot exceed $50 million for a Tier 2 offering under Regulation A in any 12-month period. There is no limit to the amount of securities that can be registered on Form S-4.
Limitation on sales for securities not listed on a national securities exchange . Under Rule 251(d)(2)(C), in a Tier 2 offering of securities that will not be listed on a registered national securities exchange upon qualification, the value of the securities to be received by a non-accredited target company shareholder may not exceed 10 percent of the greater of such person’s annual income or net worth, if a natural person, or revenue or net assets for such person’s most recently completed fiscal year end, if a non-natural person. Compliance with this restriction could prove difficult. For example, questionnaires as to relevant facts will need to be completed by each shareholder. The restriction may create deal uncertainty if shareholders will be cashed out to the extent that they cannot receive securities in excess of the aforementioned limit and the aggregate amount of cash to be paid is not known or reasonably estimable at the time the merger agreement is signed. There is no similar limitation under Form S-4.
No relief from antifraud rules or fiduciary duty of disclosure . Although Form 1-A has significantly fewer line item disclosure requirements than Form S-4 with respect to information to be provided about the business combination transaction and the target company, the issuer may nevertheless be required to provide such information about the transaction and the target company as is necessary to meet the issuer’s general antifraud obligations under Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, as well as state antifraud rules, which are not federally preempted per Section 18(c)(1) of the Securities Act. Likewise, the issuer will need to provide sufficient disclosure of information about the transaction and the target company to satisfy the fiduciary duty of disclosure of the board of directors under applicable state law. As a result, the Form 1-A offering circular may end up having a lot of the same or similar disclosure as would be provided in a Form S-4 describing the transaction and the target company. However, in a Form 1-A, the issuer and its counsel would have the flexibility to make a reasoned determination as to what information is material and should be included, and what information is immaterial and can be left out.
No forward incorporation by reference under Form 1-A . Form 1-A does not permit forward incorporation by reference. Accordingly, an issuer will need to supplement the offering circular in accordance with Rule 253(g)(2) if there are any substantive changes or additions to the information in the offering circular filed with the SEC. Offering circular supplements may be uploaded to EDGAR under the “253G2” EDGAR tag. Under Form S-4, an issuer that is eligible to incorporate by reference may also forward incorporate by reference to future Exchange Act filings.
It is worth mentioning another important alternative to a Form S-4 registration: an exempt offering under Section 3(a)(10) of the Securities Act pursuant to a fairness hearing. A fairness hearing is generally considered to be a less burdensome process than a Form S-4 registration, and the recipients of securities in a Section 3(a)(10) transaction will also receive unrestricted securities.
Is a Regulation A offering a better alternative than an offering under Section 3(a)(10)? Perhaps. Here are a few key considerations for the issuer and counsel to consider:
The level of detail of disclosure for a Form 1-A and an application for qualification for a fairness hearing, and the related offering circulars and shareholder disclosure documents, are comparable, driven by the same antifraud and fiduciary duty of disclosure requirements. The timing of a fairness hearing, however, could be quicker than an SEC review (potentially as early as a month from submission of the application), but that is unpredictable and will depend on the applicable state authority’s process. The fairness hearing process could also last longer than a Form 1-A review process.
A favorable ruling is not guaranteed at a fairness hearing; opponents of a deal will have the opportunity to attend and advocate their positions. In contrast, the SEC Staff does not rule on the merits of the Regulation A offering; they only comment on the adequacy of the disclosure in the Form 1-A.
Lastly, securities issued pursuant to Section 3(a)(10), as such, are not covered securities and therefore do not preempt state blue sky rules, per Section 18(b)(4)(E) of the Securities Act. Accordingly, if the securities are otherwise not covered securities (e.g., because they are listed on a national securities exchange), the issuer will need to register or qualify the offering in each applicable state or confirm that there is an applicable exemption from registration or qualification.
The expansion of Regulation A to reporting companies may significantly reduce the compliance obligations under the Securities Act in respect of securities offerings made in connection with business combination transactions, particularly for small cap companies acquiring smaller companies with diverse shareholder bases that previously would have otherwise required an expensive and time-consuming registration on Form S-4. It will be interesting to see how practice develops in this area.
Robert L. Wernli, Jr. is a partner in Sheppard Mullin’s Corporate Practice Group in the firm’s Del Mar office and has a transactional practice with three main areas of focus: securities compliance and capital markets, mergers and acquisitions, and joint ventures and strategic alliances. [Note: This article assumes that the SEC, in implementing the directives under the Economic Growth, Regulatory Relief and Consumer Protection Act, makes only the changes set forth in such act, and does not make any additional changes to Regulation A.]
Copyright © 2018 The Bureau of National Affairs, Inc. All Rights Reserved.
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