Satisfying the JOBS Act mandate
Acting on a congressional mandate under the JOBS Act, on August 29, 2012, the SEC proposed a new Rule 506(c) under Regulation D, which for the first time would permit the use of general solicitation and advertising in private placement transactions where all purchasers are accredited investors. The proposed rules are refreshingly unvarnished and afford substantial latitude to issuers in determining an appropriate path to compliance.
Title II of the JOBS Act directed the SEC, within 90 days of enactment, to amend its Rule 506 to provide that the prohibition against general solicitation and advertising should not apply where all purchasers of the securities offered are accredited investors. SEC action has been anxiously awaited. Rule 506 is the exemption under which almost $1 trillion of securities was offered in 2011, dwarfing all other exempt offerings. More significantly perhaps, it is the first step toward a monumental change in the way private placements can be conducted, largely erasing the "private" offering element that has always been a condition to exemption from registration under Section 4(a)(2)(formerly Section 4(2)) of the Securities Act.
No change to current ban on general solicitation yet
In proposing Rule 506(c), the SEC resisted the call to adopt interim final rules that would be effective immediately, determining instead to publish it with a relatively short 30-day comment period. So until the proposed rules are final, issuers are advised to stay the course under existing Rule 506.
SEC approach is non-prescriptive
The SEC appears to have taken to heart the congressional directive and its apparent intent, and has proposed a rule that is to the point and light on prescriptive regulation. It will generally please business interests and likely be a cause for continuing concern to state regulators and investor groups concerned about fraud and overreaching sales tactics. It may challenge those charged with assuring compliance, who tend to prefer black and white to shades of gray.
What's in the proposed rule?
Specifically, new proposed Rule 506(c) imposes three conditions:
- All purchasers of securities must be accredited investors.
- The issuer must take reasonable steps to verify that purchasers are accredited investors.
- The general conditions of Rule 506 must be complied with, other than the informational requirements and the ban on general solicitation and advertising.
Regarding the first condition above, the JOBS Act could have been read to require that persons must actually be accredited investors in order comply with Rule 506(c). The SEC indicated in the proposing release that the "reasonable belief" standard that generally applies to Rule 506 compliance will also apply to Rule 506(c) determinations of accredited investor status. An issuer will not lose the 506(c) exemption so long as it took reasonable steps to verify the purchaser's accredited investor status and had a reasonable belief as to that status.
Through introduction of the second condition above, the SEC has proposed adoption of the specific language of the JOBS Act on verification and imposed on issuers a separate obligation to take reasonable steps to verify a purchaser's accredited status. Responding to many commentators' pleas, the SEC determined not to prescribe specific or uniform methods for verification given the many ways in which persons may meet accredited investor status. Rather, as the SEC said in the proposing release, "Whether the steps taken are ‘reasonable' would be an objective determination, based on particular facts and circumstances of each transaction."
The SEC refused to propose "safe harbors" that would assure an issuer that it had taken the required steps to verify accredited status in a particular 506(c) offering. But it did offer some helpful guidance on the factors that may determine the reasonableness of the verification steps taken. These include:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be. For example, what is reasonable to verify the accredited investor status of a broker-dealer is likely to be different than what is needed for a retail purchaser.
- The amount and type of information the issuer has about the purchaser. It is reasonable to expect that the more information an issuer has about a purchaser, the fewer steps it would need to take to verify accredited status, and vice versa. And if an issuer has actual knowledge that the purchaser is accredited, no steps would be required. Information could come either from publicly available sources or from third-party sources, like W-2s, that offer evidence in support of accredited investor status.
- The nature of the offering and the terms of the offering. A web-based retail offering may require greater scrutiny of purchaser status than sales to a pre-screened set of investors identified by a broker-dealer intermediary. Also, a high minimum unfinanced cash investment may be such that only an accredited investor could reasonably meet it.
Although resisting calls to bless the current self-certification approach to accredited investor status, the SEC did not rule it out in all circumstances. Given the right blend of circumstances, self-certification may be perfectly reasonable or even unnecessary. The SEC indicated in the proposing release that it anticipates that many practices currently used by issuers would satisfy the verification requirement proposed for Rule 506(c) offerings.
Rule 506 still available for offerings without general solicitation
Importantly, proposed Rule 506(c) will not be the only safe harbor under Rule 506. The SEC left unchanged the existing portions of the Rule where general solicitation is prohibited. This will facilitate offerings to non-accredited persons and permit greater flexibility if there are concerns about potential risks in the verification process or the accredited status of purchasers. It is also important to keep in mind that the JOBS Act did not change Section 4(2) of the Securities Act of 1933(now Section 4(a)(2)), so restrictions on general solicitation and advertising are still understood to apply to transactions in reliance on the statutory exemption itself.
Investment Company Act exclusions preserved
Hedge funds and other private investment firms will be pleased with the SEC's interpretive comments concerning reliance on Rule 506(c) while maintaining exemption from the Investment Company Act. In particular, the SEC advised that the effect of Section 201(b) of the JOBS Act (providing that offerings under revised Rule 506 shall not be deemed public offerings under the federal securities laws as a result of general advertising or solicitation) is to permit privately offered funds to make a general solicitation under Rule 506(c) without losing the Section 3(c)(1) and 3(c)(7) exemptions under the Investment Company Act.