The Securities and Exchange Commission (the "SEC") published a rule proposal to eliminate the ban on general solicitation and general advertising as part of an unregistered offering of securities made in reliance on the non-exclusive safe harbor set forth in Rule 506 of Regulation D of the Securities Act of 1933. The change is required by Section 201(a) of the Jumpstart Our Business Startups Act of 2012 (the "JOBS Act"). While the SEC issued a proposed rule permitting general solicitations for Regulation 144A offerings, this alert focuses only on Rule 506. Should the rules be adopted as proposed, they will change the way issuers can raise capital through the sale of unregistered securities.
Rule 506 offerings are a primary means by which companies raise capital through the sale of securities. Under Rule 506, companies whose securities are not registered with the SEC for sale to the public can sell their securities to investors who meet certain net worth, income, or other requirements so that they are considered "accredited investors." Currently, an individual is an accredited investor if he or she either meets the income test by having an annual income for the past two years exceeding $200,000, or $300,000 with his or her spouse, each year, with a reasonable expectation of earning that amount this year, or meets the net worth test by having a net worth or joint net worth with his or her spouse exceeding $1,000,000, excluding the value of his or her primary residence and certain other debt. Entities can also be accredited investors based on their net worth, the accredited investor status of their owners, or if they are a bank, savings and loan, broker-dealer, insurance company, registered investment company, business development company, licensed small business investment company, or certain employee benefit plans.
THE JOBS ACT AND THE PROPOSED RULE
The SEC's leeway in this rulemaking process was constrained by clear guidance from Congress. Title II of the JOBS Act requires that:
Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise [Rule 506] to provide that the prohibition against general solicitation or general advertising . . . shall not apply to offers and sales of securities made pursuant to [Rule 506] provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.
The proposed rule is meant to satisfy the Congressional directive, albeit on an extended timeline. It does so through a number of changes to Rule 506 to allow offers through general solicitations, with two key revisions. First, the proposed rule maintains the existing Rule 506(b), but adds language specifying that these existing conditions apply only to offerings not involving general solicitation or general advertising. Second, the proposed rule adds a new subsection (c) to Rule 506 that provides conditions to be met for offerings using general solicitation or general advertising. These new conditions include compliance with the terms of Rule 501 (definitions), 502(a) (integration) and 502(d) (limitations on resale). The new conditions also include a requirement that all purchasers of securities sold in a Rule 506(c) offering are accredited investors, and that the issuer must "take reasonable steps" to verify that all purchasers in the offering are accredited investors.
The SEC declined to identify the specific methods that an issuer must employ to satisfy the "reasonable steps" requirement under Section 201(a)(1) of the JOBS Act. Under the proposed rule, certain issuers will benefit because they will not be required to go through a set of steps which may be unnecessary or inapplicable with respect to their particular offering. Yet the lack of specified methods is problematic as well, since the proposed rule provides no clear path for issuers to follow to ensure that their accredited investor verification steps were reasonable.
RULE 506(c) ONLY APPLIES TO ISSUERS ENGAGING IN GENERAL SOLICITATION
While all purchasers in a Rule 506(c) offering that relies on general solicitation must be accredited investors under the proposed rule, the SEC notes that the new guidelines only apply in the circumstances of a general solicitation. Issuers will still be able to sell securities under Rule 506(b) in offerings that do not involve general solicitation in which they may sell to non-accredited investors (with certain additional disclosure) and may also follow past guidance from the SEC regarding the method of verification of accredited investor status. It appears the SEC will continue to allow issuers to use an accredited investor questionnaire in these offerings, rather than the heightened requirements contemplated by the proposed rule for sales of securities involving general solicitation. Issuers should be able to continue to rely on previous SEC guidance, such as the Lamp Technologies and IPONET no-action letters, which set forth many of the rules issuers follow to keep Rule 506(b) offerings that use websites from being considered general solicitations. However, despite assurances in the proposed rule that the SEC is not imposing new conditions on offers and sales that do not involve general solicitation, it is possible that, over time, the SEC will require the heightened accredited investor verification process for all Rule 506 offerings.
THE PROPOSED RULE FOCUSES ON THE REASONABLE STEPS AN ISSUER MUST USE TO VERIFY THE ACCREDITED INVESTOR STATUS OF PURCHASERS
As the scope of the rulemaking was constrained by the JOBS Act, the main focus of the analysis in the proposed rule focuses on what measures constitute "reasonable steps" to verify accredited investor status. The SEC made it clear that the current method used by most issuers, under which the investor makes a representation, usually by checking a box in a questionnaire as to the type of accredited investor he or she is, will not be sufficient for a Rule 506(c) offering that uses general solicitation.
According to the SEC, "whether the steps taken are 'reasonable' would be an objective determination, based on the particular facts and circumstances of the transaction." The SEC cited three examples of factors an issuer should consider:
- the nature of the purchaser and type of accredited investor the purchaser claims to be;
- the amount and type of information 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 the minimum investment amount.
We anticipate issuers using general solicitation to conduct a Rule 506(c) offering may find it difficult to verify the accredited investor status of natural persons. There is little public information available on personal finances of individuals, and there are privacy concerns related to the collection of that information. The most practical method suggested by the SEC entails a review of the potential investor's W-2 to confirm his or her income for the past two years. However, even this method could be troublesome as investors may be reluctant to provide this detailed personal information to issuers, and investors seeking to evade accredited investor requirements could potentially forge a W-2. For issuers relying on investor tax forms to certify accredited status, we recommend also having the investor represent that he or she will make at least as much income in the present year as is reported in the W-2.
The SEC suggests that issuers can also rely on third parties to verify accredited investor status. The proposed rule contemplates that an issuer could go to a broker-dealer, accountant, or attorney to provide comfort that an investor is accredited. The proposed rule suggests that issuers may be able to seek third-party verification from other types of companies as well. The rule proposal suggests that issuers may also seek third-party verification from other types of companies. Rather, all that is necessary is that the "issuer has a reasonable basis to rely on such third-party verification." It would provide comfort to both issuers and potential verification service providers if the SEC provides additional detail on this subject in the final rule. Under the proposed rule, however, it appears that intermediaries who are contemplating starting or expanding their online platforms for Rule 506(c) offerings could provide the service of third party verification to issuers as long as they have adequate due diligence procedures in place.
An additional method for verification of accredited investor status involves reliance on publicly available information. Unfortunately, this method's utility is limited since it is challenging to find reliable public income and net worth information for most individuals.
THE TYPE OF OFFER WILL DICTATE THE PROCESS AN ISSUER MUST USE TO CONFIRM AN INVESTOR'S ACCREDITED STATUS
The nature of the offering and its terms will also play a role in the level of due diligence an issuer must engage in under Rule 506(c) to confirm the accredited status of its investors. The SEC appears to be concerned with an expansive general solicitation in which the issuer reaches out to a large set of people with whom it has no relationship and about whom it has no knowledge, such as through general web advertisements or social media. The SEC noted that these broad offerings would require greater measures than an offering to a group of pre-screened investors from a database maintained by a reliable third party, such as a broker-dealer. An offering with a high minimum investment amount may also relieve some due diligence pressure on the issuer since a large cash investment is a strong indication of a high income and net worth. Additionally, when an issuer has a large amount of information on a potential purchaser, such as through a broker-dealer who has complied with know-your-customer rules, the accredited investor due diligence review need not be as extensive.
Fortunately for issuers, the SEC clarified that the determination of accredited investor status is not subject to an absolute standard. The SEC notes in the proposed rule that the ability of an issuer to maintain the exemption for a Rule 506(c) offering even if not all of the purchasers are accredited investors is consistent with its views regarding attempts by prospective investors to circumvent Regulation S requirements related to offers and sales being made only to non-U.S. persons. Following this guidance, so long as the issuer "took reasonable steps to verify that a purchaser was an accredited investor and had a reasonable belief that the purchaser was an accredited investor," the issuer would not lose its ability to rely on the new Rule 506(c) exemption for private offerings by general solicitation, unless there were indications that would put the issuer on notice that the investor is not accredited.
ISSUERS WILL NEED TO MAINTAIN RECORDS TO ESTABLISH THE REASONABLE STEPS TAKEN TO CONFIRM THE INVESTORS' STATUS
Recordkeeping regarding both the methods used and the results obtained during accredited investor due diligence will be crucial for issuers who use general solicitation to conduct a Rule 506(c) offering. The SEC stated in the proposed rule that issuers will have the burden of proving their claim to the exemption. Yet the proposed rule does not specify the means of recordkeeping that should be used. We recommend that issuers who do not retain paper copies of their records should follow the electronic recordkeeping requirements for broker-dealers in Rule 17a-4(f) under the Securities Exchange Act of 1934, which sets forth preservation, accessibility, organization, backup and other requirements to ensure that the SEC has access to usable electronic information. If an issuer must provide electronic information as part of an SEC investigation, the process would be significantly eased if it is accessible in a format with which the SEC is already familiar. Issuers would also be advised to keep the information that they receive from investors on file for as long as they control the issuing entity. At the same time, issuers will need to institute safeguards to protect personal information of the investors from exposure to third parties, particularly if the records are accessible through the Internet.
RULE 506(c) OFFERINGS USING GENERAL SOLICITATION AND FORM D
The SEC has proposed a revision to Form D to accommodate the amended Rule 506 and offerings that use general solicitation. The amended Form D would require issuers to indicate whether they are relying on Rule 506(c). Issuers that elect not to use general solicitation as part of their offering would check the box on the amended Form D that indicates that the offering is being conducted under rule 506(b). As with all offerings in reliance on Rule 506, issuers who rely on Rule 506(c) must file a Form D with the SEC within 15 days after the first sale of securities in the offering.
RULE 506(c) AND PRIVATE INVESTMENT FUNDS
The JOBS Act did not specifically address the effect of the new general solicitation rules on private investment funds, such as hedge funds, venture capital funds and private equity funds. The SEC clarifies in the proposed rule that the JOBS Act permits these private funds to make general solicitations under Rule 506(c) without losing their exclusions (either Section 3(c)(1) or 3(c)(7)) under the Investment Company Act of 1940. As long as the SEC maintains this position in the final rule, hedge funds, venture capital funds and private equity funds should be able to engage in general solicitations that comply with Rule 506(c) as soon as the final rule is effective.
OFFERINGS THAT INCLUDE GENERAL SOLICITATIONS MAY EXPOSE ISSUERS TO INCREASED RISK
The SEC's facts and circumstances approach to determining whether an issuer took reasonable steps to verify accredited investor status could expose issuers to the risk of additional litigation or enforcement proceedings. It is unclear whether the JOBS Act was meant to create a private cause of action for investors that invested in a Rule 506(c) offering that employed general solicitation if it is later determined that one or more investors were not accredited or that the issuer failed to take "reasonable steps" to evaluate the status of such investors. We also anticipate the SEC will initiate enforcement actions against issuers that may have failed to use reasonable methods to ensure all investors are accredited. The quality of an issuer's records with respect to its accredited investor due diligence will be critical in these circumstances.