The JOBS Act, signed into law in April, directed the Securities and Exchange Commission (SEC) to remove the prohibition against general advertising and solicitation in private placements conducted under Rule 506 and Rule 144A under the Securities Act of 1933, provided the issuer verifies that each purchaser is an "accredited investor" (for Rule 506) or a "Qualified Institutional Buyer" (for Rule 144A). On August 29, the SEC proposed rules to implement these changes and invited public comment. Despite concerns expressed by some commentators that lifting the ban on general advertising and solicitation would lead to more fraud against unsophisticated investors, the proposed rules do not insist on rigid investor verification requirements. The more flexible approach taken by the SEC could have a significant positive effect on the ability of companies to raise capital in private offerings by making it easier for them to reach out to potential investors.
Rule 506 private placements have long been a preferred way to raise capital - accounting for approximately $895 billion raised in 2011 (more than in public offerings) - but to date the utility of Rule 506 has been limited by the prohibition against the use of general advertising or solicitation. This prohibition means a company must be able to demonstrate it had a pre-existing substantive relationship with all persons to whom it offered or sold securities and therefore limits the universe of potential investors a company may reach out to when raising capital.
The JOBS Act requires the SEC to revise Rule 506 so that the prohibition against general solicitation will not apply to offers and sales of securities pursuant to Rule 506 if all purchasers of the securities are "accredited investors," as defined in Rule 502 of the Securities Act. The JOBS Act also instructed the SEC to require that issuers "take reasonable steps" to verify each purchaser is accredited and gave the SEC discretion to determine what steps would be considered reasonable.
Under current Rule 506, an issuer may rely on the exemption so long as it reasonably believes each investor is accredited. The proposed rule, Rule 506(c), would continue this practice by allowing the issuer to rely on the exemption so long as the issuer takes reasonable steps to verify each investor's status and reasonably believes each investor is in fact accredited.
Importantly, the SEC elected not to specify any particular method to verify whether an investor is accredited. Instead, in discussing the proposed rules the SEC observes that the reasonableness of the steps taken by an issuer would be an objective determination based on the facts and circumstances of the transaction. In taking this approach, the SEC resisted calls by some commentators to implement extensive and rigid verification requirements that would significantly increase the cost of compliance and thereby discourage companies from using the new rules.
The SEC highlighted three factors that would be important in determining whether an investor is accredited:
- The nature of the purchaser and the type of accredited investor the purchaser claims to be. For instance, reasonable steps taken to verify that the net worth of an individual satisfies the accredited investor threshold would likely differ from reasonable steps taken to verify that an entity is a registered broker or dealer pursuant to Section 15 of the Securities Exchange Act of 1934. This follows from the perception that verifying income and net worth standards of individuals requires more analysis than needed for a company professionally engaged in securities transactions.
- The amount and type of information the issuer has about the purchaser. For instance, it may be reasonable for the issuer to rely on self-certification for a purchaser that is well known to the issuer, but it probably is not reasonable to do so for purchasers that have no preexisting relationship.
- The nature of the offering and the terms of the offering. For instance, verifying the status of investors solicited through a publicly accessible website, mass email or social media would necessitate greater care by the issuer than an offering made to a pre-screened pool of high-net-worth individuals. Similarly, verifying the status of investors in an offering with a small minimum investment threshold would require greater care than one in which the minimum investment amount is high enough to make it likely the investor satisfies the income or net worth standards for accredited investors.
Regardless of the factors considered, the SEC recommends the issuer retain records of the steps taken to verify each investor's status as accredited.
The proposed rule would require any issuer using general solicitation in an offering pursuant to Rule 506 to indicate as much when filing a Form D for the transaction.
The proposed revisions to Rule 144A would also permit the use of general solicitation in offerings conducted in reliance on Rule 144A. Rule 144A is often used for offerings of debt securities by listed U.S. companies or equity securities by foreign companies whose common shares are not listed on a U.S. exchange. The securities are privately sold only to Qualified Institutional Buyers (QIBs), as defined in the rule, who may subsequently resell the securities to other QIBs as permitted by Rule 144A. Rule 144A offerings are often undertaken by investment banks or broker-dealers on behalf of the issuer but cannot be publicly advertised or solicited. Under the proposed rules, the Rule 144A securities could be offered to anyone, provided that all buyers are investors whom the seller and any person acting on its behalf reasonably believes are QIBs.
The proposed rule would implement this change by simply eliminating the current references to "offer" and "offeree"; as amended, Rule 144A would require, regardless of the range of generally solicited offerings, only that the securities be actually sold to a QIB or a purchaser the seller and its agents reasonably believe is a QIB. It is worth noting that a seller of securities pursuant to Rule 144A is not required to take reasonable steps (as in Rule 506) to verify that a purchaser is a QIB to avail itself of the rule. A practical consequence of the amended Rule 144A may be to reduce the need for certain offering safeguards that are typically implemented to prevent general solicitation and that heretofore could result in loss of the registration exemption.