Tuesday, May 12, 2015

State Securities Law Issues in Regulation A+ Offerings

By: Jim Verdonik
I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals, have authored multiple books and teach an eLearning course for entrepreneurs.  You can reach me at JFV@WardandSmith.com or you can check out my newspaper articles at http://www.bizjournals.com/triangle/search/results/_author/Jim+Verdonik?market=triangle&_author=Jim+Verdonik&title=

The most controversial issues related to new Regulation A+ relate to state securities laws.

Issuers, their legal counsel and investment bankers wanted all Regulation A+ offerings to be exempt from state registration.

State securities administrators wanted all Regulation A+ offerings to be subject to state registration.

The SEC compromised by exempting Tier 2 Regulation A+ offerings from state registration laws, but the SEC did not extend the same protection to Tier 1 Regulation A+ offerings.

There are two likely results of this compromise:

·         Many issuers who raise less than $20 million (and so could choose to be governed by the Tier 1 rules) will choose to be governed by the Tier 2 rules.

·         Other issuers will continue to do Rule 506 offerings, which are except from state registration laws.

Let's explore why people are likely to make these choices.

Regulation A+ offerings involve conducting a general solicitation.  General solicitations (a/k/a public offerings) are regulated by both state and Federal securities laws. 

Compliance with Federal law doesn't always constitute compliance with state law.  Compliance with the laws of one state doesn't always mean you comply with the laws of all states.

How do state laws apply to Regulation A+ offerings?

  • Regulation A+ gives you an exemption from registration of the offering at the Federal level like in a Rule 506 offering or a Federal registered offering of securities by an issuer listed on a national securities exchange.
  • The Tier 2 of Regulation A+ pre-empts state registration laws. 
  • The Tier 2 pre-emption of state registration does not apply to state anti-fraud rules or to certain post-closing notices and filing fees many states require.
  • Tier 1 of Regulation A+ does not preempt state registration laws.
  • Regulation A+ does not preempt state broker-dealer, salesmen or investment adviser laws that may adversely impact issuers who use unregistered intermediaries.
  • More than one state law may apply.  Generally, the laws of the issuer's home state and every state where offers or sales are made applies to securities offerings.

History of State Preemption

State pre-emption was immediately popular when it was introduced several decades ago.  Most people simply decided that dealing with more 50 different securities administrators who apply different state statutes or may interpret the same words in a uniform statute differently than other state administrators was an insane process.

Because both Rule 506 and public offerings made by listed public companies preempt state registrations, more than 99% of capital-raising transactions operate under this preemption, but state securities registration requirements still exist for a small minority of offerings.

Tier 1 Regulation A+ Offerings and State Registration Requirements

If more than 99% of capital-raising transactions take advantage of Federal preemptions from state securities registration laws, why would you consider doing a Tier 1 Regulation A+ offering which requires you to comply with state securities registration laws or find exemptions from state registrations requirements?

  • You might want to avoid the post-offering periodic reporting requirements imposed on issuers who conduct Tier 2 Regulation A+ offerings.
  • Not all SEC registered public offerings are exempt from state registration requirements.  If you are conducting a small public offering and will not be listed on a national securities exchange or NASDAQ national market, you would be required to register with the states.  In fact, exemption from state registration requirements is one of the primary advantages Tier 2 Regulation A+ offerings have over many small registered public offerings.
  • You might decide that Regulation A+ is a better capital raising path than Rule 506 given the specific business objectives you have that we discussed elsewhere.
  • You might decide to offer and sell securities in one or a few states, which makes compliance with state laws less difficult and less expensive.
  • You might decide to offer and sell securities only in states that use the same review standards the SEC uses, which makes state law compliance less difficult and less expensive.
Primary State Issues Affecting Issuer Decisions

Let's discuss the primary issues that issuers should consider when deciding whether to choose to do a Tier 1 offering which is registered with the states:

  • Efficiency and Expenses
  • Merit Review: Cheap Stock, Insider Loans and Other and Insider Transactions
  • Affiliate Re-sales of Securities
  • Audited Financial Statements
Efficiency and Expenses

Over time, most states have learned that issuers will usually choose to preempt their registration laws, unless the states make compliance quicker and less expensive and the states stop imposing onerous conditions on registrations.  States are trying to do what businesses do when they lose customers:  recover their customers be being more user-friendly.

There are two general types of state securities registration approaches:

  • Disclosure Review.
  • Merit Review
To address issuer concerns about state registration laws, the North American Securities Administrators Association (NASAA) has developed an enhanced plan of "coordinated review" to make state "blue sky" review less burdensome.  Most, but not all states participate. 

Additional information about the NASAA's coordinated review program for Regulation A+ offerings can be found at" http://www.nasaa.org/industry-resources/corporation-finance/coordinated-review/regulation-a-offerings/

For each offering the NASAA appoints:

·         One lead disclosure reviewer.

·         And one lead merit reviewer, if the issuer is trying to register the offering in one or more states that apply merit review standards.

Dealing with one or two reviewers is certainly more efficient than dealing with fifty reviewers.

Let's discuss disclosure review and merit review.

Disclosure Review

Most states use some kind of disclosure review, which is the same standard the SEC uses when the SEC reviews an issuer's securities disclosure documents. 

Disclosure review includes two basis standards:

·         Do the disclosure documents comply with the specific requirements of whatever registration statement the issuer is using?

·         Fraud, which usually means the disclosures do not include any misstatements of material facts or failure to disclose material facts necessary to make the statements made not misleading.

If the SEC staff thinks an offering is unfair to investors or risky, the SEC's staff will usually require the issuer to highlight disclosures about the unfair terms or the biggest risks.  But if the issuer adequately discloses all material facts related to the unfairness or risks, the SEC leaves it to investors to decide whether the offering terms are unfair or whether investing in the issuer is too risky.

Most states limit themselves to disclosure review. 

In theory, disclosure review should be the same at the Federal and state levels.  But practice is different than theory.  The SEC's staff is organized into industry sectors.  If you are a biotechnology company, your disclosure documents will be reviewed by SEC staff members who review hundreds of disclosure documents from biotechnology companies each year. Industry specialization both improves disclosures and makes the SEC's review process relatively efficient.  

Because so few state registrations occur, state securities regulators' staff usually cannot specialize by industry to the same extent the SEC's staff does.  Hopefully, NASAA's coordinated review program will take industry specialization into account when it assigns state reviewers.

The SEC also has a history of recruiting the best and the brightest regulators.  Many senior SEC staff have worked in the best accounting firms and law firms and investment banks.  Many younger SEC staff members move into these firms after being trained by the SEC.  This continuous cross-pollination between the SEC and the private sector often results in better understanding and communication during the SEC's review process than for some state securities administrators who often have less private sector experience than their SEC counterparts.

These and other factors can result in very different review comments from state and Federal securities administrators even if in theory they are applying the same disclosure review standards.  Sometimes comments from Federal and state regulators may be contradictory, which can create inefficiencies and extra expense in the review process.

Merit Review and Affiliate Re-sales: Cheap Stock, Insider Loans and Other and Insider Transactions

Merit review supplements disclosure review in certain states.

Merit review reflects a judgment by some states that certain securities offerings are inherently unfair to investors or that investing in some issuers expose investors to excessive risk.  Many merit review issues relate to how an issuer deals with its officers, directors, affiliates and promoters. 

Cheap stock issued to such insiders is a common merit review issue.  Cheap stock issues arise when the offering price is much higher than the price insiders (like officers, directors d promoters) paid for their shares.  Insider loans and interested transactions between the issuer and insiders are also common merit review issues. 

Merit review states go beyond merely requiring that cheap stock and insider transactions be clearly disclosed to investors.  Merit review states may require that cheap stock be held in escrow and cancelled, unless the issuer achieves certain performance milestones or may impose conditions on repaying insider loans. 

Re-sales of large amounts of securities by affiliates of the issuer or uses of proceeds of the offering to pay affiliates may also trigger merit review comments from state securities administrators.

Issuers that Don't Have Merit Review Issues Can Avoid Post-Closing Reporting Obligations of Tier 2 Offerings by Choosing Tier 1 of Regulation A+

Some issuers may not have cheap stock or other insider issues that are problems in merit review states. 
For problem-free issuers who are not seeking to register shares for re-sale by affiliates, the NASAA's coordinated review process may make the state review process sufficiently efficient to justify the issuer doing a Tier 1 Regulation A+ offering to raise up to $20 million. 
By choosing Tier 1, issuers would avoid the ongoing reporting requirements that Regulation A+ imposes on issuers who conduct Tier 2 offerings. 
Limiting Sales Efforts to a Limited Number of States
Issuers may be tempted to try to reduce state securities law compliance time and expenses by limiting the number of states in which they register.
But this strategy can lead to problems – especially for issuers who are conducing offerings through technology platforms rather than through a traditional underwriting syndicate. 
In an underwritten public offering, the investment banking syndicate controls where their registered representatives are offering securities.  Under the "know your customer" rule that brokers are required to comply with the sales team knows the residences of the people who have accounts with their firms and a lot more. 
Investors who invest through technology platforms often do not have as close a relationship with the technology platform operator as they have with traditional investment banks. 
Even some registered broker-dealers and investment advisers who specialize in running some technology platforms often don't have the same size compliance departments as traditional investment banks have. 
Other platforms that are not operated by registered broker-dealers or investment advisers are limited in their ability to make recommendations and collect transaction based compensation.  These limitations make them more like the classified advertising departments of newspapers.  They essentially sell advertising space and often have little knowledge about investors. 
Tracking the residences of investors and which states the offer and sales is occurring can be difficult.  This creates a risk that issuers may inadvertently make offers and/or sales in states where the issuer has not registered the offering.
State Regulation of Broker-Dealers and Investment Advisers
States may also regulate platform operators, who may have to register with states as broker dealers or as investment advisers.  Regulation A+ does not pre-empt state broker-dealer or investment adviser laws.  Consequently, if you platform operator has failed to comply with state broker-dealer or investment adviser laws, such non-compliance could adversely affect your offering. 
Don't be afraid to ask your platform operator about their compliance efforts.  As new platforms emerge to conduct securities offerings, remember that some of these platforms are themselves start-up businesses who may not have invested as much in state law compliance as they should have.

Other articles about important Regulation A+ issues include the following:

Summary of Key Provisions of New Regulation A+
Is Title III Crowdfunding Already Obsolete? Regulation A+ = Supercharged Crowdfunding
Your Goals Will Determine Whether Regulation A+ Is Right for Your Business
Which Should You Choose: Tier 1 or Tier 2 of Regulation A+?
Why Choose?  Why Not Do Both A Rule 506 Offering Followed by a Regulation A+ Offering?
Microcap Financings: Regulation A+ Offerings Join Public Shell Company Mergers and Self-Registrations to Create Small Public Companies
If you would like to learn more about learning how to grow your business or other issues important to your success, you can reach me at JFV@WardandSmith.com or  you can check out my newspaper articles at http://www.bizjournals.com/triangle/search/results/_author/Jim+Verdonik?market=triangle&_author=Jim+Verdonik&title=










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