On August 29, 20121, the Securities and Exchange Commission (“SEC”) released proposed rules for eliminating the prohibition against general solicitation and general advertising in offerings of securities under Rule 5062. Congress previously required the SEC to issue these proposed rules as part of the Jumpstart Our Business Startups Act (the “JOBS Act”), which was signed into law on April 5, 20123.
The SEC’s proposed rules leave intact the existing rules for Rule 506 offerings that do not use general solicitation or advertising, and create a separate rule that allows issuers to utilize general solicitation or advertising in a Rule 506 offering as long as (1) the issuer takes reasonable steps to verify that all purchasers are accredited investors, and (2) all purchasers are (or are reasonably believed to be) accredited investors. When implemented, the proposed rules will allow solicitations and advertising for the sale of securities through direct mailers, newspaper advertisements, television or radio broadcasts, and website publications without prior review of the offering by the SEC or state securities administrators.
The SEC’s proposed rules will be subject to a 30-day open comment period, after which the SEC will vote to either adopt or reject the proposed rules.
Existing Rule 506
Rule 506 is a safe harbor rule that allows companies to sell securities such as stocks or limited partnership interests without having to incur the significant burden and expense of registering with the SEC. As a general rule, unless an exemption is met, it is unlawful to sell or offer to sell securities without first filing a registration statement with the SEC. Securities include stocks, bonds, limited partnership interests, certain limited liability company interests, options, futures, etc. The Securities Act of 1933 (the “Securities Act”) provides an exemption from the registration requirement for sales or offers to sell securities “not involving any public offering.” But, it is not entirely clear what constitutes a “public offering,” and judicial interpretations of the term have led to a standard upon which issuers are generally unwilling to rely. In recognition of this problem, the SEC adopted Regulation D, which provides certain safe harbors to issuers, including Rule 506, for complying with the private offering exemption and avoiding costly registration with the SEC.
Rule 506 allows issuers to sell an unlimited amount of securities without registering with the SEC. To comply with Rule 506 as currently adopted, issuers must satisfy the following standards:
- The issuer cannot use general solicitation or general advertising to market the securities;
- The issuer may sell its securities to an unlimited number of accredited investors and up to 35 other investors;
- All non-accredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
- Issuers must give all non-accredited investors disclosure information that is generally the same as those used in registered offerings. If an issuer provides information to non-accredited investors, it must make this information available to accredited investors as well;
- The issuer must be available to answer questions by prospective purchasers;
- The issuer must inform the investors that the issued securities will be “restricted” securities, meaning that the securities cannot be resold without either registering the securities or otherwise meeting an exemption; and
- The issuer must electronically file Form D with the SEC within 15 days after the date of first sale of securities.
In practice, because of the significant additional requirements applicable to offers to non-accredited investors, the vast majority of Rule 506 offerings are made solely to accredited investors.
Amendment Creates Separate Standards under Rule 506
The SEC’s proposed amendment to Rule 506 would create a new, separate standard for Rule 506 offerings that use general solicitation or general advertising (“New Rule 506(c)”), and would keep intact the current Rule 506 for offerings that do not use general solicitation or general advertising. Under the proposed rules, the prohibition of general solicitation or general advertising would not apply to offers and sales of securities made pursuant to New Rule 506(c), so long as all ultimate purchasers of the offered securities are (or are reasonably believed to be) “accredited investors.” Issuers who utilize New Rule 506(c) would be required to take “reasonable steps” to verify that all purchasers of the securities are accredited investors.
Under the proposed rules, issuers who do not utilize general solicitation or advertising would continue to be able to use the existing Rule 506, which allows the issuer to rely upon the affirmative representation of each investor as to their qualification as an accredited investor (and also allows up to 35 non-accredited investors to invest in the offering).
The SEC proposes to amend Form D to include a separate check box for issuers to indicate whether they are using general solicitation or general advertising in a Rule 506 offering. This requirement may signal the SEC’s intent to more closely scrutinize Rule 506 offerings that employ general solicitation and advertising.
Reasonable Steps to Verify Accredited Investor Status
The JOBS Act mandated that amendments to Rule 506 require issuers using general solicitation “to take reasonable steps to verify that purchasers of the securities are accredited investors,” and directed the SEC to create rules to determine what constitutes “reasonable steps.” Presumably, this directive was intended to require a higher standard than the current standard of reliance on investor representations. Under the SEC proposed rules, whether steps taken are “reasonable” would be an objective determination, based on the particular facts and circumstances of each transaction. In making such a determination, issuers would consider a number of factors, examples of which include:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- The amount and type of information that the issuer has about the purchaser; and,
- The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
Nature of the Purchaser. Under federal securities laws, an “accredited investor” includes natural persons and entities that fall within certain categories4. The question of what type of information would constitute reasonable verification of accredited investor status will vary based on which category the purchaser claims to fall within. For example, if an entity is an accredited investor by virtue of being a registered broker-dealer, then the issuer might check the broker-dealer’s registration at FINRA’s BrokerCheck website.
The more problematic issue, particularly with respect to natural persons, is verifying whether the net income or net worth of the prospective purchaser meets the required thresholds. Accredited investors may be particularly uninterested in disclosing financial information, particularly in a case where the accredited investor does not have a substantial, pre-existing relationship with the issuer. In this case, the issuer may be forced to rely upon third-party verification from a reputable source. The proposed rules may also lead to a rise in independent accredited investor verification services and networks and databases of pre-screened, verified accredited investors.
Information about the Purchaser. In general, the more information an issuer has about a prospective purchaser, the fewer steps the issuer would have to take to verify the prospective purchaser’s accredited investor status, and vice versa. According to the SEC, examples of the types of information that could be relied upon by an issuer include: publicly available information in regulatory filings, such as proxy statements that show the prospective purchaser’s net income, or Form 990 filings for non-profit organizations; third-party information, such as Form 1099’s or W-2s, showing annual income; or, verification from a third party such as a prospective purchaser’s broker-dealer, accountant, or attorney, provided that the issuer has a reasonable basis to rely on such third-party verification.
Nature and Terms of the Offering. The nature of the offering would also affect whether the verification methods used by the issuer are reasonable. For example, an issuer that solicits new investors through a website accessible to the general public or thorough a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer (in which case the issuer could rely on the third-party verification).
The terms of the offering may also be relevant. For instance, if the terms of the offering require a high minimum investment amount that only an accredited investor could reasonably meet, then a direct cash investment that is not financed by the issuer or by any other third party could be taken into consideration in verifying accredited investor status.
When implemented, the New Rule 506(c) will significantly change the way some companies raise capital through private placement offerings. As long as an issuing company takes reasonable steps to verify that purchasers of its securities are accredited investors and has a reasonable belief that all investors in fact meet an accredited investor standard, the company may employ any means of general solicitation and general advertising that is currently prohibited.
While giving some guidance, the proposed rules leave open many questions as to what constitutes reasonable steps to verify and reasonable belief that the purchaser is an accredited investor. Also, the New Rule 506(c) does not propose specific disclosure requirements for acceptable general solicitations or advertising. The current anti-fraud rules under both federal and state securities laws, which require that all material information regarding the investment be disclosed to the potential investor, will continue to apply to all private placement offerings.