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December 1, 2016
On October 26, 2016, the SEC adopted amendments to Rule 504 of Regulation D that facilitate smaller companies’ “capital raising efforts and provide additional investor protections.” As a result of the changes to Rule 504, the SEC will repeal seldom-used Rule 505 of Regulation D. In the Conclusion section below, we offer our view of the practical benefits of these amendments.
The SEC’s Adopting Release can be found at https://www.sec.gov/rules/final/2016/33-10238.pdf. All quoted language is from the Adopting Release. Amended Rule 504 will become effective on January 20, 2017. The repeal of Rule 505 will become effective on May 22, 2017.
Rule 504 of Regulation D
Rule 504 of Regulation D currently provides issuers with an exemption from registration for offerings whose aggregate amount offered and sold is no more than $1 million, less the aggregate offering price for all securities sold within the 12 months before the start of and during the offering of securities under Rule 504, in reliance on any exemption under section 3(b), or in violation of section 5(a) of the Securities Act of 1933. Rule 504 allows issuers to offer and sell securities to an unlimited number of purchasers. An issuer relying on Rule 504 cannot be an investment company, a blank check company, or subject to SEC reporting requirements.
Except as described below, issuers may not use general advertising or solicitation in a Rule 504 offering, and securities offered and sold under Rule 504 are restricted securities, which means that the issuer must make disclosures to purchasers regarding limitations on reselling the securities. These conditions do not apply, however, if the offering is:
(a) exclusively in one or more states that require registration of the securities and distribution of state-approved disclosure documents;
(b) in one or more states that do not require registration of the securities, if the issuer registers the securities in at least one other state that requires registration and distribution of state-approved disclosure documents, and those documents have been delivered to all purchasers, including those purchasers in the state or states that do not require registration; or
(c) issued exclusively according to state law exemptions from registration of the securities that permit general advertising and solicitation so long as sales are made only to “accredited investors.”
Almost all states have adopted a uniform registration form for offerings relying on Rule 504 called SCOR (The Small Corporate Offering Registration).
Amendments to Rule 504 and Repeal of Rule 505 of Regulation D
Amended Rule 504 increases the aggregate amount permitted to be offered and sold from $1 million to $5 million, less the aggregate offering price for all securities sold within the 12 months before the start of and during the offering of securities under Rule 504, in violation of section 5(a) of the Securities Act. The SEC hopes that this increase will “bolster efforts among the states to enter into, or revise existing, regional coordinated review programs that are designed to increase efficiencies associated with the registration of securities offerings in multiple jurisdictions without increasing risks to investors.” It also gives states the flexibility to set their own limits on the offering amount.
Similar to Rule 506 of Regulation D, no exemption under amended Rule 504 will be available for the offering of securities of any issuer if that issuer would be subject to disqualification under Rule 506(d). This provision means that “bad actors” will be disqualified from participating in offerings that are exempt under Rule 504. The SEC believes the application of the “bad actor” disqualification provisions to Rule 504 will provide added investor protections and “create a more consistent regulatory regime across Regulation D.”
In approving amended Rule 504, the SEC noted that the amendments to Rule 504 make the Rule substantially similar to Rule 505 of Regulation D and that Rule 505 is rarely used when compared to Rule 504 and Rule 506. For these reasons, the SEC has decided to repeal Rule 505, effective on May 22, 2017.
If the states revise their existing regional coordinated review programs as the SEC hopes, and if those revisions produce a registration process that is cost-effective in light of the size of the offering, we believe that these changes will result in an increased number of Rule 504 offerings that are registered with one or more states.
Further, we foresee a broader use of Rule 504 for offerings that are designed to raise more than $1 million while relying on state blue sky exemptions for offerings made to a small number of persons (such as 10, 15, or 25 persons, depending on the state). This strategy could be useful for issuers that desire to raise more than $1 million from one or a few accredited investors but that also want to offer the securities to friends, family members, and employees who are not accredited investors. Rule 506(b) does allow an issuer to offer and sell securities to up to 35 unaccredited investors. When there is even one unaccredited purchaser, however, the issuer must provide to that investor (and as a practical matter to all investors) line item disclosures under Rule 502(b) that are typically much more extensive than those that issuers provide in a small offering under Rule 506(b) made only to accredited investors. The practical costs—in time and money—of preparing these enhanced disclosures means that securities are rarely offered and sold to unaccredited investors in offerings made under Rule 506(b). Amended Rule 504’s increased offering amount may, in the circumstances described above, permit an issuer to include investors who otherwise would not be allowed to participate in the offering.
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