On August 29, 2012, the Securities and Exchange Commission issued proposed rules to eliminate the ban on general solicitation and general advertising in securities offerings that rely on the “safe harbor” from registration under Rule 506 of Regulation D of the Securities Act of 1933 (“Securities Act”), provided all purchasers are accredited investors The SEC also proposed rules to permit general solicitation and advertising in securities offerings pursuant to Rule 144A as long as the securities are sold only to persons reasonably believed to be qualified institutional buyers (“QIBs”). The proposed rules (“Rules”) were mandated by Section 201(a) of the Jumpstart Our Business Startups Act (“JOBS Act”) to make it easier for small businesses and startups to raise capital by allowing them to communicate freely to attract a larger number of accredited investors, including via the internet and social media. Comments are due 30 days after publication in the Federal Register.
Highlighting the importance of private offering exemptions, including Rule 506, the SEC estimated that in 2011, the amount of capital raised in all exempt offerings was just over $1 trillion, which is comparable to the amount of capital raised in registered offerings during this same period. Not only will these Rules fundamentally change the way Rule 506 offerings are marketed to solicit investors but they also significantly impact the way issuers will be required to verify the status of accredited investors.
- Proposed Amendments to Rule 506
Changes to Eliminate the Ban on General Solicitation
The proposed Rules represent a major change in the way private offerings under Rule 506 can be conducted. Rule 506 is the most frequently relied upon “safe harbor” to offer and sell an unlimited dollar amount of securities without registration to an unlimited amount of “accredited investors” and to no more than 35 non-accredited investors who the issuer reasonably believes has the knowledge and experience to evaluate the merits and risks of the investment. Satisfying the requirements of the rule provides a “safe harbor” because it offers assurance that an issuer falls within the Section 4(a)(2) exemption from the requirement to register the offering. The availability of Rule 506 is subject to a number of requirements including that the offering must be made without any form of “general solicitation.” Mass mailings, emails, newsletters, speaking engagements at seminars or other advertising in an attempt to solicit investors are all forms of general solicitation. The existing ban on general solicitation and advertising means that currently issuers relying on Rule 506 must make sales and offerings of unregistered securities only to those investors for which the issuer or intermediary has a preexisting relationship. Under the proposed Rules, issuers will be able to solicit new investors with whom they have no prior relationship through websites, emails and social media as long as all purchasers are accredited.
The new rules preserve the existing ability to conduct offerings under Rule 506 to accredited investors and no more than 35 non-accredited investors without the use of general solicitation and advertising. Issuers who do not engage in general solicitation will not be subject to the requirement to take reasonable steps to verify the accredited investor status of purchasers.
Changes to Verify Accredited Investor Status
The other major change as a result of the proposed Rules is the new requirement that in Rule 506 offerings that use general solicitation, the issuer must take “reasonable steps to verify” that purchasers of the securities are accredited investors. The JOBS Act directed the SEC to implement this verification requirement but left it up to the SEC to determine whether the steps taken would be considered reasonable. But the proposed rules do not specify verification methods or the type of information that would be sufficient to constitute reasonable steps. Instead the SEC states that whether the steps taken are reasonable would be an objective determination, based on the particular facts and circumstances of each offering and investor. The Rules offer as guidance the following examples of factors to consider in determining the reasonableness of the steps taken to verify whether an investor is accredited:
- Nature of the purchaser
- Information about the purchaser; and
- Nature and terms of the offering.
Below is a discussion of each of these factors that are intended to help issuers assess the likelihood that a potential purchaser is an accredited investor and that will affect the types of steps that would be reasonable to take to verify accredited investor status. Regardless of the steps taken, the SEC stressed that it is important for issuers to retain adequate records that document the steps taken to verify accredited investor status.
Nature of the Purchaser
Taking reasonable steps to verify accredited investor status may vary depending on which of the eight categories of accredited investors the investor claims to be. For example, verifying whether an entity is an accredited investor by virtue of being a registered broker-dealer, such as by going to FINRA’s website, would require fewer steps than verifying whether a natural person is an accredited investor.
Information about the Purchaser
The more information an issuer has indicating that a purchaser is accredited such as by obtaining Forms W-2, through publicly available information, or by obtaining verification from a third party such as a broker dealer, attorney or accountant, the fewer steps it would have to take to verify status.
Nature and Terms of the Offering
The means through which the issuer publicly solicits purchasers will affect the reasonableness of steps to be taken. The solicitation of investors through a website accessible to the general public or through widely disseminated email or social media would require greater measures to verify status than the solicitation from a database of pre-screened accredited investors created by reliable third party such as a registered broker-dealer. In addition, the terms of the offering may affect whether the verification methods used are reasonable. For example, a purchaser’s ability to satisfy a high minimum investment amount without financing could indicate that the investor is accredited because only accredited investors would be reasonably expected to meet the high minimum investment.
The SEC confirmed that an issuer would not lose the ability to rely on Rule 506 in the event a purchaser is not an accredited investor purchases securities so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor. In addition, the SEC confirmed that privately offered funds such as hedge funds, venture capital funds and private equity funds, may make a general solicitations under Rule 506 without losing the ability to rely on the exclusions from the definition of “investment company” set forth in Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act which are unavailable if they make a public offering of securities. The SEC also confirmed that concurrent offshore offerings that are conducted in compliance with Regulation S would not be integrated with domestic offerings that are conducted in compliance with Rule 506 or Rule 144A.
The proposed Rules would also revise Form D to add a separate check the box for issuers to indicate whether they are using general solicitation or advertising in a Rule 506 offering. This revision is meant to assist the SEC in its efforts to monitor the use of general solicitation in Rule 506 offerings and to help the SEC assess the effectiveness of various practices used to verify accredited investor status.
- Proposed Amendments to Rule 144A
Rule 144A allows issuers to raise capital through a primary offering of securities by the issuer to one or more financial intermediaries – commonly known as initial purchasers – in a transaction that is exempt from registration pursuant to Section 4(a)(2) or Regulation S followed by the immediate resale of those securities to QIBs. Under the proposed Rules, resales of securities pursuant to Rule 144A could be conducted using general solicitation, so long as the securities are sold to a QIB or to a purchaser that the seller and any person acting on behalf of the seller reasonably believe is a QIB.