Earlier this year, President Obama signed the Jumpstart our Business Startups (JOBS) Act into law. As a previous entry to What’s the Big Deal? discussed, the JOBS Act focuses on making private capital more accessible for emerging companies as well as easing some of the administrative burdens associated with taking a company public. (See our previous blog entry here for a more in-depth description of the changes this new law brought about). After the President signed the bill into law, the SEC was on the clock to issue rules that implement many of the changes. The first proposed rule, released on August 29th, would lift the prohibition against general solicitations or general advertisements in connection with private offerings and is currently available for public comment.
Proposed Rule 506 changes
Rule 506 provides a safe harbor under Section 4(a)(2) of the Securities Act that removes the registration requirements for certain private offerings of securities. More specifically, the current rule allows an issuer to offer and sell securities to an unlimited number of “accredited investors” and up to 35 non-accredited investors who meet certain requirements. In order to qualify for this safe harbor, neither general solicitations nor general advertisements are allowed – that is until proposed Rule 506 (c) takes effect.
The proposed rule permits the use of general solicitations and advertisements to offer and sell securities under rule 506, with a few conditions. First, offerings that use these tactics may only be purchased by accredited investors. As such, the proposed rule requires that the issuer take “reasonable steps” to make sure that the investors are accredited. So what are “reasonable steps”? Good question. According to SEC, the test would be objective, based on the particular facts and circumstances of each transaction. While each situation is different, the proposed rule does outline some factors to consider:
- The nature of the purchaser and the type of accredited investor. A registered broker or a registered investment company would require fewer steps than a natural person requiring a minimum net worth or minimum annual income.
- The amount and type of information the issuer has about the purchaser. The more information an issuer has, the fewer steps it would have to take.
- The nature and terms of the offering. An offering that solicits investors through a publicly accessible website or a widely disseminated social media solicitation require greater measures than a solicitation targeted at investors included in a database of pre-screened accredited investors.
The proposed rule includes neither specified methods of verification nor a list of methods for satisfying the requirement, so issuers have the flexibility to tailor the steps to their particular circumstances. However, issuers should keep in mind that the burden of proof rests with them;
So, what if reasonable steps are taken, but a non-accredited investor slips through? According to the proposed rule, the issuer would not lose the ability to rely on the rule provided the issuer had a reasonable belief that the purchaser was an accredited investor.
These new requirements only apply to Rule 506 offerings that use general solicitations or advertisements; the requirements for those that do not remain unchanged.
So What’s the Big Deal?
The impact of the proposed rule changes and the ability for emerging companies to seek funding through general advertisements and solicitations is a significant change in the way most business raise capital. But, before the solicitations or advertisements go out, it is important to have a game plan in place to ensure you are selling to the right buyer or, at least, reasonably believe you are.
Keep in mind that this is only a proposed rule so the current ban on general solicitations and advertising for private offerings of securities remains in place until the rule is finalized.