On August 29, the SEC issued proposed amendments to Regulation D that would eliminate the prohibition against general solicitation in a Rule 506 offering, provided that all participants in the offering are accredited investors. Rule 506 is the federal securities law exemption most often relied upon by startup companies when they offer and sell securities. The proposed amendments implement Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act), which was enacted into law on April 5 of this year. Section 201(a) directed the SEC to adopt rules eliminating the general solicitation prohibition and requiring issuers utilizing general solicitation methods to "take reasonable steps to verify that purchasers … are accredited investors, using such methods as determined by the [SEC]."
Rule 506 provides an exemption from the federal registration requirement for offerings – without limitation on the offering amount – to an unlimited number of accredited investors and no more than 35 nonaccredited investors, provided the nonaccredited investors are "sophisticated" and are provided specified disclosures by the issuer. One of the current conditions for a Rule 506 offering is that the issuer not engage in any general solicitation or general advertising, which includes, as examples currently provided in Regulation D, newspaper advertisements, magazine advertisements, television and radio broadcasts, general solicitation seminars and unrestricted websites.
Proposed new Rule 506(c) is limited to the language in the JOBS Act mandate, without providing specified methods as to what actions by an issuer will constitute "reasonable steps" to verify that purchasers are accredited investors. Instead, the SEC has proposed that the new rule be flexible, with the determination of what constitutes "reasonable steps" to be based on the facts and circumstances of each case.
What is clear from the SEC’s release is that a completed investor questionnaire or other representation or warranty from a purchaser will not be sufficient in most cases. Issuers will be required to undertake at least some due diligence investigation or obtain some form of documentation of a purchaser’s status. For an individual purchaser, who must have a net worth of at least $1 million apart from his or her primary residence or income in excess of $200,000 in each of the two most recent years, or income in excess of $300,000 jointly with his or her spouse in the two most recent years, documentation of net worth or income will likely be required. This could include copies of Forms W-2 or other tax filings; disclosure of an executive’s compensation in an SEC filing; certification from the purchaser’s attorney, accountant or broker; or verification from a third-party service provider (which the SEC acknowledges does not exist today). In some cases, a purchaser’s status may be verified through the issuer’s own knowledge or through the terms of the offering itself, such as if the offering requires a minimum investment of $1 million that does not involve any issuer financing of the investment.
Because the specific methods for undertaking "reasonable efforts" to verify an investor’s accredited status have been left to issuers to decide on a case-by-case basis, issuers should be able to develop sensible and cost-effective approaches for an offering on an investor-by-investor basis.
As we discussed in our April 5 bulletin regarding the adoption of the JOBS Act, the removal of the general solicitation prohibition will likely have a significant impact on equity raises by startup companies and their placement agents. Startups will be free to approach a wider audience when seeking investors and inviting prospects to meetings and investor presentations. They will also be able to consider potential new advertising methods, such as advertisements on the internet and in newspapers, magazines and other publications.
The SEC proposal also includes an amendment to Form D, which is required to be filed with the SEC by an issuer completing an offering under Regulation D, to add a check box indicating whether an issuer relied on the proposed new Rule 506(c). This will require an issuer to decide whether to take the position that it relied on Rule 506 without engaging in any general solicitation (by checking the re-named 506(b) box) or admitting that it engaged in general solicitation activities (by checking the 506(c) box). This election could have consequences for an issuer in the event of an investigation by the SEC into whether the issuer complied with the various requirements of Regulation D.
The SEC has requested that comments on the proposed rules be submitted within 30 days of the publication of the proposing release in the Federal Register. The proposed rules will not become effective until adopted by the SEC, which will occur only after the SEC considers the comment submissions made by the public.