One of the most significant provisions of the Jumpstart Our Business Startups Act (the “JOBS Act”), which was signed into law by President Obama on April 5, 2012, is the removal of the prohibition on general solicitation and advertising for securities offerings made pursuant to Rule 506 of Regulation D under the Securities Act of 1933 (“Rule 506 Offerings”) – so long as sales are made only to accredited investors.
This loosening of the most fundamental restriction on Rule 506 Offerings, which effectively takes the “private” out of “private placement”, is expected by many to have a much greater impact on small business capital formation than the headline-grabbing crowdfunding provisions of the JOBS Act. This is because the crowdfunding provisions only allow for relatively small offerings and impose a fairly complex and potentially burdensome regulatory scheme. The elimination of advertising prohibitions for Rule 506 Offerings, on the other hand, is a simple change with immediate impact because it will allow for Rule 506 Offerings to be broadcast to an unlimited number of investors for an unlimited amount of money so long as sales are made only to accredited investors.
Many unanswered questions remain regarding how the Securities and Exchange Commission (the “SEC”) will amend its regulations governing Rule 506 Offerings. The JOBS Act amendments to Rule 506 Offerings will not take effect until implemented by SEC rulemaking, which the statute directs the SEC to adopt within 90 days. However, the SEC staff is currently inundated with implementing regulations regarding the provisions of the JOBS Act that were effective upon its enactment. SEC action on the provisions of the JOBS Act that are only effective upon further SEC rulemaking, such as the elimination of the advertising ban on Rule 506 Offerings, are likely to be delayed. In addition, the substantial SEC rulemaking backlog resulting from the Dodd-Frank Act (not to mention the statement by SEC Chairman Schapiro prior to enactment of the JOBS Act that many of the rulemaking timelines in the JOBS Act would “not be achievable”), make it clear that the 90-day rulemaking deadlines in the JOBS Act will be extremely difficult for the SEC staff to meet.
The following are some of the Rule 506 Offering-related issues that we would like the SEC to address in its rulemaking:
Could One Non-Accredited Buyer Destroy the Exception? The statute states that all purchasers of the Rule 506 Offering must be accredited investors; but, in the next sentence, mandates that the SEC’s rules require the issuer to take “reasonable steps to verify that purchasers of the securities are accredited investors”. It is unclear whether the SEC will permit any flexibility from the literal reading of the statute that all investors must, without exception, be accredited investors. Many believe that the applicable standard for reliance upon the new Rule 506 Offering rule should be that the issuer “reasonably believes” that all investors in the offering are accredited investors, despite the fact that the plain language of the statute does not seem to provide any room for error. Unfortunately, it is not clear that the SEC has the authority to implement this view, even if it were so inclined.
What Constitutes “Reasonable Steps” to Verify that Investors are Accredited Investors? The JOBS Act requires the SEC’s amendment to Rule 506 to address what constitutes reasonable steps to verify accredited investor status. A big question is whether the SEC rules will change the existing practices of private placement issuers in determining that their purchasers are accredited investors. Private placement issuers have traditionally sought little more than a representation from the buyer that he, she or it qualifies as an accredited investor under one or more definitions, with no further information being required. In a context where potential purchasers may have been secured by broad advertisements on the internet and have no prior relationships with the issuer, the SEC may require some greater amount of information regarding a potential investor’s financial condition – but how much more, if any, information is a big unknown.
Will There be Two Types of Rule 506 Offerings? The new regime may result in two types of Rule 506 Offerings – one where general solicitation is allowed but sales can only be made to accredited investors, and another where general solicitation is prohibited but sales can be made to up to 35 non-accredited investors (the existing Rule 506). It is unclear whether the new rules will require issuers to elect between the two types of offerings in advance, or whether issuers will be allowed to take the most favorable position after the offering. This has led some to question whether the SEC may ultimately eliminate the safe harbor for Rule 506 Offerings made to non-accredited investors.
Will Rule 506 Offerings be Integrated with Crowdfunding Offerings? There is language in the crowdfunding provisions of the JOBS Act suggesting that crowdfunding offerings should not be considered as one offering, i.e., “integrated”, with Rule 506 Offerings even if they occur at the same time. But this language is far from clear, which raises a major uncertainty because the two types of offerings have inconsistent requirements. Rule 506 Offerings must be sold only to accredited investors, while a crowdfunding offering would likely sell to many (if not mostly) non-accredited investors. A crowdfunding offering must be conducted through a financial intermediary, which is not required for a Rule 506 Offering and in many cases would not be done. The result is that these two types of offerings are effectively mutually exclusive. Without clarification in the upcoming SEC rules that they are not to be integrated, issuers might have to space these types of offerings at least six months apart to take advantage of the existing integration safe harbor. This result would decrease the usefulness of the two new means of private capital raising in the JOBS Act.
Although the JOBS Act directs the SEC to amend Rule 506 within 90 days, existing rules will remain in effect until they are amended by the SEC.