Are you struggling with a capital raising plan? Whether you’re a small, large, or mid-size company, Raising Capital 101 can help you navigate the intricacies of raising capital in today’s unpredictable and often volatile business environment. From the full life-cycle of the capital raise to the obligations you’ll face after the raise concludes, each episode will feature practical and easily digestible insights, advice, and tips from the foremost experts in the industry.
Let us help you get a handle on your capital raise.
What laws and regulations do companies need to consider when raising capital through private and public offerings? This week, the KVCF team discusses the ‘33 Act, ’34 Act, and other laws and bodies that regulate securities transactions. What players are governed by which laws? What’s FINRA and how are companies affected by its authority? Do you need to comply with Blue Sky laws? These are just a few of the questions that will be discussed in today’s episode. This brief overview of the legal landscape sets the stage for Episode 5 – “What Are the Differences Between Private and Public Offerings?”
And make sure to follow the podcast on Apple and Spotify!
Episode Transcript:
Tom Voekler:
Hello, welcome to episode four of Raising Capital 101, where we learn about the ins and outs of raising capital, what to do and what not to do if you’re planning to get some investors. This is KVCF and I’m Tom Voekler, along with my colleagues, Rhys James, John Watson, and new player unlocked Mehanna Borostyan. Today we’ll discuss one of the basic laws that can impact or regulate capital raising activity. We plan to cover the ’33 Act, the ’34 Act, blue sky laws, the roles of FINRA and the exchanges. We plan to cover some additional overlaying regulations such as the Investment Company Act, the Investment Advisor Act, some ORSA, DOL impacts at a later time on another podcast so stay tuned. Let’s start with the ’33 Act. John, what is it? How’d it come about? What can you tell us?
John Watson:
The Securities Act of 1933, sometimes called the ’33 Act, sometimes called the Securities Act, was the first piece of federal securities regulation legislation in the United States. Before that, it was left to the states, handled by the blue sky laws, which we will talk about in a little bit. But the ’33 Act was passed shortly after the stock market crash of 1929 and during the Great Depression, and it was meant to combat some of the issues that led to the stock market crash of 1929. And one of the big issues was the manipulation by issuers of stock and lying about stock. So the ’33 Act sets of the basic disclosure regime that we still use today that requires issuers to disclose information to investors, and allow them to make up their mind about whether it’s a good investment for them or not.
It’s very broad in application. It applies to all offers and sales of securities. And if you want to know what a security is, you can go back to episode three and get some more background on that. But it basically requires a great deal of information be disclosed to investors, what the issuer is going to use the capital for, information about the company, issuing the security, information about the management, and attributes about security.
And an important element in addition to disclosure is the liability that it imposes on issuers for material misstatements they might make in the information they provide to investors. Not only do they need to provide the information, they also need to be truthful with that information. It basically just gives all the information to the investor. Doesn’t say whether the security is a good investment or not, that’s for the investor to decide, but it requires issuers to provide that information and for the information to be truthful.
Tom Voekler:
That’s great. So you’ve got basically public and private offerings, we’ve talked about that in the past. Like making a private offering, what options do you have?
John Watson:
Right. As much as the Securities Act is about disclosure and it requires all offers and sales to be registered with the SEC, the exemptions are just as important as the rules themselves because so much capital is raised through the exemptions. And there’s several different flavors of exemption. They vary along the amount of capital you want to raise, the amount or the types of investors you want to access, so they all have pros and cons.
A big category of private offerings is Reg D. And the offering types underneath Reg D, a couple of flavors that you usually see are 506(b) and 506(c), and they are more or less limited to accredited investors. Not completely, but that’s the main type of investor you’ll find under Reg D. And we’ll talk more about what accredited investor means.
Reg A is another type that requires some disclosure in filing with the SEC, but Reg A is capped on how much you could raise, either 20 or 75 million, depending on which tier you leverage. And there’s more options. There’s Regulation CF/Regulation Crowdfunding, which allows for raising up to 5 million online, and so forth and so on. But those are really the primary private offerings that we typically deal with.
Tom Voekler:
And what’s central tenant behind considering a private offering versus a public offering? It has changed a little bit recently, but.
John Watson:
A big difference, just zooming way out, is the amount of disclosure you have to make to the public. You’re going to have to make disclosure to your investors. But with a registered private offering, all that disclosure is going to be made public for everyone to access through the SEC’s online filing system. But with a private offering, you can keep most of that information private.
The audience you’re going to access is different. A public offering anyone can invest, but a private offering might be limited to accredited investors. There might be other limitations. The way you solicit your investors is going to be different in a private offering. Oftentimes you’re not allowed to make a general solicitation, but that’s not always the case. Sometimes you can, sometimes you can’t. It just depends on which type of offering you want to engage in.
The resale of securities is going to be different. Securities can be restricted in private offerings so that the investors can’t resell them. But public offering with a listed security, the securities will be very liquid, anyone can buy them and sell them anytime they want. And then the cost, so all that relates to cost. And a public offering is going to be very expensive and require a lot of third parties to help you with that offering, where a private offering can be less expensive and can be done more quickly.
Tom Voekler:
Cool. I know we are going to do episode five where we’re going to delve a little more into the cost and the timing on each of these types, but generally, and, Rhys, jump in wherever you want here, but a Reg D is, like John said, fairly quick. If management at the issuer is ready and has all the relevant information that you think is material for an investor to make their investment decision, you can have a PPM out on the street fairly quickly, very cost effectively.
Versus even on a, if we step up to a Reg A, where now you’ve got to follow certain regimes that the SEC has laid out as far as disclosures, you’re probably multiplying your costs to four or five times to that in a Reg D. And if you go even further into a true listed public security, now you’re going to have GAAP financials, you’re going to have a lot more auditing requirements, you’re going to have a lot more legal requirements, and a lot more documentations. You’re going to have charters. It’s just going to be a lot more requirements and you’re probably about tenfold, and if not multiples of that even, for a public offering. Costs in the neighborhood of three quarters of a million dollars between accounting and legal expense. Rhys, do you have anything to add on that one?
Rhys James:
Not on the cost side. I think that that’s probably on the button, and at a minimum. And it could be significantly more, depending upon how complex your business is and how complex the security you are offering may be and the amount of time it takes you to get through the commission. For both Reg A and a fully public registered deal, you do have a prescribed form of disclosure that you must follow. In Reg A it’s the offering statement, and in a public registered offering it’s one of the several forms of registration statement prescribed by the SEC. You’ve got to give them all the information in the format required by the particular form you’re using to the SEC’s satisfaction. And they can provide comments and require you to substantively respond to those prior to permitting you to offer your securities, whether that be through Reg A or a registered deal.
That’s contrasted with a Reg D or other kind of truly private offering, where you are not making an SEC filing. For those offerings there’s no SEC filing, there’s no SEC review process, so the costs are less. But issuers should not discount their disclosure obligations in those offerings. Just because there isn’t a prescribed form and mechanic to make those disclosures to the prospective investors, the issuer still needs to make full and fair disclosure of all material information relevant to the investment decision.
Tom Voekler:
Yeah, that’s really important. I think if you were to look at the private placement memorandum that we put together here for a private offering, it’s going to follow fairly closely to what a Form S-1 or S-11 has required in the public side just because, quite frankly, that is what the SEC considers is material for an investor to make their investment decision. And that is the standard we’re going to be held to, even on a Reg D. Did we give them all material information or did we not omit any material information?
Now there are multiple items in the Form S-1 or S-11 that are not necessarily relevant in a private placement, such as public compensation and parachute arrangements and some of those Sarbanes-Oxley type disclosure. But I think what you will see is sophisticated counsel will try to mirror a private placement document as closely as possible to a public document. And similarly, our Reg A documents would be the same. It’s just the level of detail, the level of regulation of that disclosure goes up each step between a Reg A and a public document. You want to add anything?
Mehanna Borostyan:
I don’t think so. We’ll jump into this I think in one of our later podcasts, but you’re also going to see levels of control. As you reach that public stage you’re giving up some level of control because you are expected to comply with certain requirements, and you’re more closely regulated by the SEC and other regulatory bodies. So that will come in later.
Tom Voekler:
That’s great. I think we touched on what the ’33 Act was originally formulated to do and what it still does. Let’s turn to the ’34 Act. Mehanna, why don’t you give us a little bit of what that is and how did that come about as well?
Mehanna Borostyan:
Sure. The Securities and Exchange Act of 1934, it’s often referred to as the ’34 Act or the Exchange Act, came about, and not surprisingly, closely after the ’33 Act, following that stock market crash of 1929. The primary difference between the ’33 and ’34 Act is that the ’34 Act is really engaged with regulating securities transactions in the secondary market. So these would be transactions between investors or parties that are not the original issuer. These trades would be between retail investors or through brokerage companies, things like that. And goal of the ’34 Act was really two fold. It was to prevent fraud in the securities market, and it was also to increase transparency in reporting.
So a lot of what you see and what you’re interacting with in the ’34 Act is those reporting requirements, like those annual reporting, quarterly reporting, and then additional reporting when you reach certain thresholds. That’s primarily why the ’34 Act came into existence, and when you’re most interacting with it as an issuer or as another body.
Tom Voekler:
Yeah, so like you said, the people impacted by the ’34 Act, you’ve got the issuers, the actual stock issuer or securities issuer, but you’ve got those brokers, broker dealers. It actually regulates FINRA as an SRO, which also has then its own jurisdiction over brokers. And it created the exchanges that we’re going to talk about later, which there were a lot more back in ’34 than there are now. So if we’re talking about a private versus a public entity, what does the ’34 Act dictate a private enterprise has to issue, trick question there, versus what a public company would have to do?
Mehanna Borostyan:
Yeah. As we were discussing, those private offerings and those private companies don’t have disclosure requirements to the SEC. The public companies and those public offerings have a lot of reporting requirements. So if you meet that threshold of a reporting company, you have to be issuing things such as a Form 10-K, which is your annual reporting form, or a 10-Q or an 8-K, which is certain things that may trigger a reporting requirement that the SEC has deemed is material to investors. Your company now has to track that and report that publicly through the SEC’s filing system.
So those are the type of reporting requirements that you need to be watching closely in order to ensure that you are not only filing those in a timely manner, but also following each of those reporting requirements, forms, disclosures, so that you’re disclosing everything that the SEC deems as important to investors in those secondary markets.
Tom Voekler:
So it sounds like it’s a fairly robust amount of disclosure. And again, we’re talking about cost and compliance and timing. You spend some time doing some public company reporting, it’s a fair amount of disclosure that’s required, isn’t it?
Mehanna Borostyan:
It is. And it feels, when you’re in it, you work on one form, you’re already speaking about the next form that needs to be filed. You’re already speaking about those next disclosure requirements. You often see these big companies have just Head of SEC reporting because it’s such a task for these companies to comply with these requirements that are in depth, and work with the auditors and the management team to comply with all these requirements. So it’s definitely something that takes a lot of legwork.
Tom Voekler:
And I think that’s very important for potential raisers capital to understand when you’re doing an analysis of, “What should I be doing,” and we’re going to talk about that in the next podcast, about what would we be better, private versus public. But you need to consider that the G&A expense alone on legal and accounting can be half a million, if not, on a yearly basis for a public company. Three quarters of a million is not out of the realm, just depending on how many filings you’re doing and how complex they are. And these filings are not just legal. I mean, the accounting requirements which we tangentially get involved in to make sure that they’re met, but the accountants can be much more expensive in some of these deals that you’ve seen.
Rhys James:
And I would add to that, that in addition to the substance of doing your accounting, doing your reporting, you are also taking on a significant process burden when you become an Exchange Act reporting company because you must constantly monitor your activities for anything that may result in a report being. Form 8-K is the current reporting form under the Exchange Act, and there are a myriad of events that can cause a report to become due. And that report is due pretty quickly, typically within four business days of when something happens. And so every time your business takes some material action, you’ve got to be thinking about it from a disclosure perspective.
Also, becoming an Exchange Act reporter places some burdens on not just the business but its personnel, it’s officers and directors. Relative to making ownership filings of anything they may own in the company and will cause the company potentially to have to deal with some governance requirements under the Exchange Act as well. So it’s a very significant decision for a company to intentionally become a reporting company.
Tom Voekler:
Yeah. I mean, both ’33 and ’34 Act are very large regulations. There’s a lot of rules and regulation promulgated under them as well. Very complex things obviously that you need to hire sophisticated council for. So we’re going to talk a little bit real quick about blue sky, some of the FINRA exchanges. In addition to the federal securities laws, and every state has its own set of securities laws, many of them were originally in place before the federal regime was put in place and they were called blue sky. The story behind that is that in the early 1900s a justice in the Kansas Supreme Court said that we need to start protecting investors from speculative ventures that had no more basis than so many feet of blue sky. Basically just people were selling the sky. Kansas was actually the first then in 1919 to set up some state security laws, and that became known as blue skies laws.
These are designed mostly fraud protection, a lot of them just want a notice of what’s going on in their state so that they can potentially look at the filings. Most states now are following the model Uniform Securities Act. I think 40 or so of the states are now on the same version of Uniform Securities Act. But a lot of times these get preempted in what we do. So if you are doing a properly formulated Reg D, and again, I say properly formulated, you will be exempt of everything other than just common fraud provisions.
Similarly, you would have NSMIA, which is the National Securities Markets Improvement Act of 1996. Basically it preempted a lot of exchange listed filings. So if you are under the ’34 Act, you’re going to preempt a lot of state laws. But state laws still come into effect, and especially if you’re talking about regular fraud or anything like that, but it also comes into effect. There’s certainly filings you have to make, even in preempted transactions. But also you just have to be careful that if you fall outside of them.
So you could be a public company, but if you’re not traded on an exchange, you’re doing a non-traded REIT, which we’ve done quite a few of, you are still going to be subject to some registration requirements in each of the states. And it makes for a very convoluted process when you’re dealing with 50 states. I don’t know how much more we need to do on blue sky laws, other than to make sure that you have somebody that understands what filings need to be done and what type of offering. But, Rhys, tell us a little bit about FINRA. Everybody seems to hear what that is and have no idea what it is.
Rhys James:
FINRA is an acronym that stands for the Financial Industry Regulatory Authority. It is a self-regulatory organization overseen by the SEC, but FINRA’s job is to regulate its member firms, which are registered brokers, registered dealers, most of them are registered as both, as well as the securities exchanges.
Harken back to the ’34 Act discussion for a moment, not only does the ’34 Act govern issuer disclosures relative to the secondary market, but it also governs the registration and operation of the exchanges that make up the secondary market. As well as the brokers and dealers who are the parties that, in the case of a broker, affects securities transactions for other people. And in the case of a dealer, someone who buys and sells securities for his own account as a business.
So if you are a broker or a dealer, you have to register with the SEC and you also must become a member of FINRA, of the Financial Industry Regulatory Authority. And then once you do that, you become subject to all of the FINRA rules of membership. From an issuer’s perspective, the FINRA rules don’t directly govern an issuer’s activities. Issuers are not members unless your issuer happens to be a registered broker or dealer, but they do have a very significant impact on offerings because of the indirect governance through the broker dealers who may be helping you raise securities.
Now, if you’re doing an offering and you’re not using a broker-dealer to raise capital for you, then you’re not going to be dealing with FINRA because, again, it has just an issue where you’re not subject to their jurisdiction. However, the vast majority of broad-based offerings, if you’re going to the public markets, if you’re going to a large private offering or a Reg A, the majority are going to go through a broker-dealer. In which case there is a line between private offerings and public offerings.
In private offerings, FINRA remembers can all participate and they are subject to certain substantive rules, including a very important one in regard to advertising. The retail communications rule that provides significant substantive requirements for any advertising communications that are sent in an offering that involves a FINRA member. And these substantive requirements are much more than you’d see from the SEC solely in regard to advertising. The SEC doesn’t get into that as much, as long as it doesn’t contain any material misstatements and doesn’t conflict with your primary offering document. FINRA gets much more into what you can and can’t say and requires balanced information. The advertising rules apply to both private and public offerings on the FINRA side.
On the other hand, the corporate financing rule from FINRA only applies to public offerings. The corporate financing rule requires FINRA to issue what’s called a No Objections letter with regard to the underwriting compensation, which is what you’re paying to your broker-dealer partners as an issuer to raise your capital. FINRA has to approve that before your offering is allowed to commence.
That’s applicable to any public offering, which includes any registered offering with the SEC, as well as any Regulation A offering. And that process can take just as long as getting qualified or registered with the SEC, or longer. There’s no requirement on FINRA to keep up with the SEC relative to where they are in getting your registration statement or offering statement effective or qualified. And if you’re doing a public deal, that is a critical component to pay attention to and make sure that it is resolved early in the process.
In addition, there are substantive limits on the compensation that is permitted in public offerings. It’s a hard cap of 10% in offerings that are in a non-traded REIT or what FINRA calls a direct participation program, which is loosely defined as a program where there are pass-through tax consequences. And otherwise it’s a sliding scale that they apply to corporate deals, but roughly it usually lands around 8%. So you get a little more leeway in a non-traded REIT or at DPP than you do in a corporate public deal. And there’s no wiggle on those though, FINRA will deny your offering if you don’t comply with their compensation requirements.
Tom Voekler:
All right, cool. We’ll talk about exchanges real quick. The exchanges are kind of marketplaces where securities and other financial instruments are traded. It’s a platform for companies, government, other groups to sell securities, either initially or on a secondary market. There’s two major exchanges now that everybody talks about, it’s the New York Stock Exchange and NASDAQ. There are submarkets of each, each has their own requirements to list on them. You’d have to actually file a listing application and be approved.
I think for issuers the most important thing of note is that in addition to the disclosure regime of the ’34 Act, the exchanges themselves have their own rules and regulations that regulate the conduct of executives, the conduct of the company, in addition to their own disclosure requirements. And so it can actually add to some of the disclosure requirements that you’re doing in your proxy or in your annual report, specifically to comply with that exchange that you are on.
I think we probably can go into greater detail on another podcast specifically about those, but that kind of gives us some really good information and a basic understanding of these major fundamental regulations that surround any type of capital raising of that. You see there’s a lot involved here, but I think too often people assume that they can just go and grab some capital from friends, family or whoever, undertake a venture and not understand that there, and we talked about this last time, well, what is the security? There are fairly strict capital raising requirements in the US and it really takes good business and legal counsel.
So I really hope if you have enjoyed this podcast. You can subscribe and hear our past and our upcoming podcasts. And I thank you all and good night.
