IN BRIEF
- The recent Dodd-Frank rollback contains certain reforms to Rule 701, the Investment Act of 1940, and Regulation A.
- These reforms will affect privately held, high-growth companies; venture capital funds; and public reporting companies.
- Practitioners should understand the key takeaways from these reforms and its impact on their clients.
On May 24, 2018, President Trump signed into law a broad rollback of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. In addition to a number of changes applicable specifically to financial institutions, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the Act) contains a number of reforms to federal securities laws and regulations that will affect privately held, high-growth companies; venture capital funds; and public reporting companies, including:
- Rule 701: Directs the U.S. Securities and Exchange Commission (SEC) to raise the threshold amount that triggers mandatory increased issuer disclosure for issuances of securities under a compensatory benefit plan in reliance on Rule 701 from $5 million to $10 million in any 12-month period.
- Investment Company Act of 1940 (1940 Act): Exempts from investment company status certain venture capital funds that have no more than 250 investors and no more than $10 million in aggregate capital contributions and uncalled committed capital.
- Regulation A: Directs the SEC to permit public reporting companies: (a) to make exempt offerings under Regulation A; and (b) to satisfy the periodic and current reporting requirements for Regulation A Tier 2 offerings by meeting the reporting requirements of section 13 of the Securities Exchange Act of 1934 (Exchange Act).
Although mandated under the law, the reforms to Rule 701 and Regulation A are not immediate. The changes are required to be made by the SEC within 60 days of adoption of the Act, and the SEC already has a substantial rulemaking docket in process. Accordingly, the revisions may not be effective for several months.
Rule 701—Increased Minimum Value to Trigger Enhanced Disclosure
The Act directs the SEC to increase the amount of securities that a private company may offer and sell under employee benefit plans before enhanced disclosure by that company is triggered. The Act increases the threshold amount for enhanced disclosure from $5 million to $10 million over a 12-month period. Rule 701 is an exemption to the registration requirements of the Securities Act of 1933 (the Securities Act) that allows private companies to issue securities under employee benefit plans, including options, restricted stock, and restricted stock units. Rule 701 has an overall limitation on use based on the value of the awards at the time of issuance in any 12-month period not exceeding the greater of: (i) $1 million; (ii) 15 percent of the issuer’s total assets; and (iii) 15 percent of the issuer’s total class of equity offered, in each case measured as of its last balance sheet date. As a result, Rule 701 generally is flexible with the size of the issuer.
In addition, Rule 701 currently includes an enhanced disclosure requirement by an issuer if, in any 12-month period, the issuer awards more than $5 million in securities in the aggregate in reliance on Rule 701. If the enhanced disclosure threshold is exceeded, issuers must provide all recipients of securities issued under Rule 701 with various and potentially onerous required disclosures, including risk factors associated with investing in the issuer’s securities and GAAP-compliant financial statements that are no more than 180 days old. The issuer must give this information to each participant (including participants who received an award before the threshold was exceeded) within a reasonable period of time before the date of sale. The date of sale in some cases may be at the time of grant (for example, RSUs and restricted stock).
The Act directs the SEC to raise the 12-month threshold for enhanced disclosure to $10 million from $5 million. In addition, it provides that the SEC must also include a provision to adjust the threshold for inflation every five years.
Key takeaways: Private companies that issue stock options and other securities to employees, consultants, directors, and other stakeholders should continue to monitor their compliance with Rule 701. As companies remain private for longer periods of time and valuations increase, they have been much more likely to reach the current $5 million disclosure threshold in a 12-month period in recent years. At the same time, the SEC’s enforcement staff recently has demonstrated an increased interest in Rule 701 and has begun imposing civil penalties for failure to comply with Rule 701’s disclosure requirements. Until the SEC rulemaking for Rule 701 is complete, issuers who are nearing the $5 million disclosure threshold should consult their attorneys to discuss strategies for managing Rule 701 securities offerings and any required disclosures. However, some issuers may want to consider delaying certain grants to later dates when the $10 million disclosure threshold becomes available (hopefully in the coming months) to avoid triggering the enhanced disclosure requirements.
1940 Act—Expanded Exemption for Venture Capital Funds
The Act also amends section 3(c)(1) of the 1940 Act to permit certain funds to accept more than the prior limit of 100 investors without being required to register as an investment company, which provides significantly more potential capital fundraising flexibility to venture capital funds that rely on section 3(c)(1). Having an applicable exemption under the 1940 Act is critical for venture fund sponsors to avoid registration requirements that would make the operation of typical venture funds financially impractical. Previously, section 3(c)(1) exempted any fund from the definition of an investment company under the 1940 Act if it was beneficially owned by no more than 100 persons and did not make a public offering of its securities. The new amendments allow a venture capital fund relying on section 3(c)(1) to accept up to 250 investors instead, so long as the fund: (i) has at all times less than $10 million in aggregate capital contributions and uncalled committed capital; and (ii) meets the definition of a “venture capital fund,” which is defined through a cross reference to Rule 203(l)-1 under the Investment Advisers Act of 1940 (the Advisers Act).[1] The $10 million limit will be adjusted every five years to account for inflation.
Key takeaways: Section 3(c)(1)’s 100-investor limit previously was the most significant regulatory factor limiting the size of venture funds that are not able to rely on section 3(c)(7)—the other 1940 Act exemption most relied upon by venture funds. Section 3(c)(7) similarly exempts funds from the definition of an investment company that do not make public offerings, and unlike section 3(c)(1), includes no limitation on the number of investors. In exchange, however, it requires that all investors be “qualified purchasers” (generally, individuals with at least $5 million in investments and entities with $25 million). Many fund managers with funds running up against the 100-investor limitation under section 3(c)(1) simultaneously form a parallel, side-by-side fund that individually relies on section 3(c)(7) to increase the amount of investor capital they can accept. For funds raising $10 million or less in capital, the new amendments may reduce the need for such side-by-side structures and/or may increase the capital raised that otherwise would be left on the table for regulatory purposes in any structure involving a fund that relies on section 3(c)(1).
Venture fund sponsors should note that there is no safe harbor or exception in the event that a venture capital fund initially intending to rely on the amended 250-investor limitation subsequently accepts more than $10 million in capital commitments if at that time the fund has more than 100 investors. In addition, based on the plain language of the amendment, fund sponsors should be aware that the standard “general partner” capital commitment may be included within this $10 million limitation. Accordingly, fund sponsors should take care and be deliberate in monitoring their fundraising activities and closings if they intend to rely on the exemption as amended.
Regulation A—Exemption for Public Reporting Companies
Finally, the Act directs the SEC to permit reporting companies to take advantage of the Regulation A exemption for securities offerings and to satisfy the periodic and current reporting requirements for Regulation A Tier 2 offerings by meeting the reporting requirements of section 13 of the Exchange Act. Often referred to as “mini-public offerings,” Regulation A offerings are exempt from securities registration requirements and can be made to the general public, but the issuer must prepare abbreviated disclosure filings that are subject to SEC review and comment. There are two tiers of Regulation A offerings. Tier 1 offerings may not raise more than $20 million in a 12-month period but require less disclosure. Tier 2 offerings may raise up to $50 million in a 12-month period but require issuers to satisfy ongoing, periodic reporting obligations. In addition, Tier 2 offerings preempt state securities registration requirements, although states may still require notice filings, consents to service of process, and filing fees.
Currently, reporting companies cannot issue securities under Regulation A. Once Regulation A is revised, reporting companies will be able to make Regulation A offerings, and reporting companies making Tier 2 offerings will be deemed to have satisfied the periodic disclosure requirements if they have satisfied their Exchange Act periodic disclosure obligations.
Key takeaways: The mandated changes to Regulation A will primarily benefit small public companies. Many small public companies that do not qualify as well-known seasoned issuers may be ineligible to take advantage of the streamlined Form S-3ASR for seasoned offerings. Although registered offerings on Form S-1 can involve a lengthy and expensive drafting and SEC comment process, the disclosures required under Regulation A can be abbreviated and less costly. In addition, reporting companies that do not trade on national exchanges must comply with state securities registration requirements. By making Tier 2 offerings, these companies will be able to avoid the complexity and cost of complying with blue sky laws for every state in which purchasers reside. However, because Tier 1 Regulation A offerings may not exceed $20 million in a 12-month period, and Tier 2 Regulation A offerings may not exceed $50 million in a 12-month period, with further restrictions for selling stockholders, it remains unclear whether this additional flexibility will be of substantial practical benefit for many companies given the alternative of Form S-3.
[1] This cross reference harmonizes the amendment with the exemption from registration under the Advisers Act that is commonly relied upon by many venture fund managers. Rule 203(l)-1 under the Advisers Act defines a “venture capital fund” to generally include private funds that meet specific conditions. These conditions include representing to investors that the private fund pursues a venture capital strategy, holding 80 percent or more of the fund’s aggregate capital contributions and uncalled committed capital in certain “qualifying investments,” conforming to specific limitations regarding the amount and types of leverage they can take on, and placing significant limitations on the ability of investors to redeem their interests. For these purposes, “qualifying investments” generally include equity securities issued by and acquired from operating companies that, among other things, are not reporting companies or foreign traded.