Section 201(a)(1) of The Jumpstart Our Business Startups Act (“JOBS Act”) required the Securities and Exchange Commission (“SEC”) to amend Rule 506 of Regulation D under the Securities Act of 1933 (“Securities Act”) to permit general solicitation or general advertising in offerings made under Rule 506 provided that all purchasers of the offered securities are “accredited investors” as defined in Rule 501(a) of Regulation D. (In its current form, Rule 506 is a non-exclusive safe harbor provision exempting certain securities offerings from the Securities Act’s registration requirements provided that the offering meets certain requirements, one of which is that the offering is not conducted through any form of general solicitation or general advertising.)
The JOBS Act also required the SEC to adopt rules requiring the Rule 506 issuer using general solicitation and advertising “to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” At its public meeting on August 29, 2012, the Commissioners, by a 4-1 vote, approved proposed rules with respect to the manner by which issuers wishing to use general solicitation or advertising in their Rule 506 offering will be required to verify that the purchasers are accredited investors.
In short, the proposed rule requires Rule 506 issuers who wish to offer securities through a general solicitation or general advertising to “take reasonable steps to verify” that the purchasers of the offered securities are accredited investors. The SEC stated that it would use an objective standard in determining whether these steps are reasonable, based on the particular facts and circumstances of each transaction.
The Commission cited several reasons supporting the adoption of its “facts and circumstances” approach to verification and refusing to adopt a uniform verification method:
- The proposed rule gives issuers and other market participants (such as broker-dealers involved in selling the securities) the flexibility to adopt different approaches to verification based on the type of investor (e.g., individual vs. entity), the amount and type of information the issuer has about the purchaser, and the manner of offering (through a publicly-available website or social media solicitation vs. an offering to pre-screened clients of a participating broker-dealer).
- By not proposing a static uniform method for verification, issuers will have the flexibility to adapt to changing market practices and implement innovative approaches to meeting the verification requirements (e.g., using third-party accredited investor lists).
- The potentially wide range of verification issues that could arise depending on the type of purchaser and offering make the adoption of mandatory methods of verification impractical, potentially ineffective and possibly overly burdensome.
- Even if it were to designate a list of specific methods to satisfy the verification requirement as “non-exclusive”, the market could view those methods as the “required” methods and thereby eliminate the flexibility that the proposed rules are intended to provide. On the other hand, the SEC staff did provide a non-exhaustive list of factors that may be appropriate to consider as part of the verification process.
In its proposing release found at http://www.sec.gov/rules/proposed/2012/33-9354.pdf, the Commission noted steps currently being taken, and the types of information being used, by issuers to verify a purchaser’s “accredited investor” status. For instance, with respect to natural persons, the Commission noted the availability of a person’s compensation information which may be publicly available in filings with a federal, state or local regulatory body or through the inspection of a person’s W-2 or other tax return documentation. The Commission also noted that many issuers currently verify a person’s accredited investor’s status through a third party such as a broker-dealer, attorney or accountant (provided that the issuer has a reasonable basis to rely on such third-party verification.)
The Commission made it clear that it expects a higher degree of verification where the Rule 506 offering is made though a publicly-available website or through a widely-disseminated e-mail or social media solicitation rather than when the issuer is soliciting investors from a database of pre-screened accredited investors created and maintained by a reliable third party. In the former instance, the Commission specifically stated that an issuer would not have taken reasonable steps to verify accredited investor status if it required only that the person check a box in a questionnaire or sign a form absent other information about the purchaser indicating its accredited investor status.
While not including any specific methods of verification in the proposed rule, the Commission did note the merit in considering a purchaser’s ability to meet a high minimum investment amount (without borrowing funds from the issuer or a third party) in determining what additional verification steps would be required. While stopping short of making this a conclusive factor, it appears that the Commission considers this to play a significant role in deciding the scope of the required verification. In fact, the Commission has asked for comment as to whether a person’s ability to meet a specified minimum investment amount should be sufficient, in and of itself, to satisfy the issuer’s reasonable verification duty, provided the high minimum investment amount is not being financed by the issuer or any third party.
The Commission also declined to revise the filing or content requirements of Form D despite the suggestions of many commentators, except that Form D will now require issuers to check a box whether they are claiming the new Rule 506 exemption for general solicitation and advertising. The Commission refused to adopt the recommendation of the North American Securities Administrators Association, the national association of state securities regulators, to make the filing of the Form D a condition of the new Rule 506 exemption and require information to be included in the Form D.
Issuers that have used Rule 506 to issue securities to accredited investors and to a limited number of non-accredited investors, such as non-executive employees, may need to consider whether they can take advantage of the new rule and still offer securities to non-accredited investors.
The SEC stated in its proposing release that private funds complying with new Rule 506 could conduct general solicitation and advertising without losing their exclusions from the definition of “investment company” under Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940.
The proposed rules also permit securities sold pursuant to Rule 144A to be offered to persons other than “qualified institutional buyers”, including by means of general solicitation, provided that the securities are sold only to persons whom the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer.
There will be a thirty-day comment period on the proposed rules. In addition to soliciting comments on whether a sufficiently high minimum investment would alone satisfy the additional required verification steps, the Commission has asked interested parties to comment on whether it should adopt a rule which, as opposed to the currently-proposed rule, specifies the methods that must or could be used by issuers to verify accredited investor status, and whether compliance with those specific methods would constitute a form of “safe harbor” for compliance with the verification requirements.
We expect numerous commenters to call on the Commission to adopt a final rule which either provides specific verification methods for specific offering circumstances, or at a minimum, set forth a list of verification methods which the Commission considers to have merit under specific circumstances. As proposed, the Commission’s rules do not provide issuers seeking to use general advertising for Rule 506 offerings or the brokerage community and other third-party intermediaries interested in expanding into this market, with much clarity as to which verification methods will satisfy the new Rule.