The following article is part of an ongoing series of articles examining the JOBS Act. Previous articles in this series include:
How to Tell if Crowdfunding is Right for Your Business - June 25, 2012
New Law Gives Companies More Options for Raising Capital - April 6, 2012
(September 4, 2012) In a rare display of bipartisan support, Congress this year passed a statute – the Jumpstart Our Business Startups (JOBS) Act – that promises to noticeably reduce the regulatory hurdles small businesses face when attempting to raise capital through offerings of stock and other securities. Most JOBS Act press coverage has focused on “crowdfunding,” by which a company would annually be allowed to sell up to $1 million of securities in modest amounts per investor. Less noticed is another provision of the Act which liberalizes SEC Rule 506.
Background on Rule 506
For many years Securities and Exchange Commission Rule 506 has offered a very useful “safe harbor” exemption for private placement transactions. This Rule not only allows an issuer to avoid the delay and expense of filing a registration statement with the SEC, but also exempts the offering from potentially burdensome “blue sky” filing requirements under a dizzying array of State securities statutes. The only filing requirement imposed is a relatively simple Form D notice, which is to be filed with the SEC and relevant State securities administrators within 15 days after the initial sale. Moreover, if a Rule 506 offering is sold only to persons who meet the SEC’s definition of an “accredited investor,” then the issuer is excused from having to prepare a detailed private placement memorandum meeting specified requirements as to content. For these reasons, the “accredited-only” Rule 506 offering has become a favored route for issuers seeking to raise capital.
Rule 506 has never before allowed issuers to use advertising or other forms of generalized publicity to attract the attention of prospective investors. Instead, companies that want to rely on this Rule have largely been limited to soliciting prospects who are already known to them. These “rifle shot” restrictions have, as a practical matter, limited the potential audience to which an offering might otherwise have been addressed. But that is about to change.
Section 201(a)(1) of the JOBS Act requires the SEC to amend Rule 506 to allow advertising in accredited-only offerings. Under the statute, the rule as so revised also “shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”
The SEC’s Proposed Rule 506(c)
On August 29, 2012, the SEC published proposed rule amendments to implement Section 201(a)(1). As proposed, new Rule 506(c) would set forth conditions under which an issuer is allowed to use advertising or other forms of general solicitation in accredited-only offerings.
In its Proposing Release,1 the SEC discussed several of the public comments it had already received.2 A number of commentators (most notably State securities commissioners) had urged the commission to impose detailed regulations on how to verify a purchaser’s status as an accredited investor. The SEC declined to follow that advice. Noting that the “accredited investor” definition covers many different categories of investors, and recognizing that issuers have used Rule 506 in a wide range of different contexts, the Commission stated that verification steps that would be reasonable in one context might be either ineffective or unduly burdensome in other contexts:
We considered but have decided not to propose requiring issuers to use specified methods of verification. We believe that, at present, proposing to require issuers to use specified methods of verification would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor, as well as the potentially wide range of verification issues that may arise, depending on the nature of the purchaser and the facts and circumstances of a particular [accredited-only] offering. We are also concerned that a prescriptive rule that specifies required verification methods could be overly burdensome in some cases, by requiring issuers to follow the same steps, regardless of their particular circumstances, and ineffective in others, by requiring steps that, in the particular circumstances, would not actually verify accredited investor status.
Instead, the SEC’s proposed amendment on this point simply states: “The issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under this § 230.506(c) are accredited investors.”
The Proposing Release does offer some insight into what verification steps the SEC would consider “reasonable” under the circumstances. Most notably:
An issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer. In the case of the former, we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status. . . .
The terms of the offering would also affect whether the verification methods used by the issuer are reasonable. Some commentators have expressed the view that a purchaser’s ability to meet a high minimum investment amount could be relevant to the issuer’s evaluation of the types of steps that would be reasonable to take in order to verify that purchaser’s status as an accredited investor. We believe that there is merit to this view. By way of example, the ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any other third party, could be taken into consideration in verifying accredited investor status.
These factors are interconnected, and the information gained by looking at these factors would help an issuer assess the reasonable likelihood that a potential purchaser is an accredited investor, which would, in turn, affect the types of steps that would be reasonable to take to verify a purchaser’s accredited investor status. After consideration of the facts and circumstances of the purchaser and of the transaction, if it appears likely that a person qualifies as an accredited investor, the issuer would have to take fewer steps to verify accredited investor status, and vice versa. For example, if an issuer knows little about the potential purchaser who seeks to qualify under the natural person tests for accredited investor status, but the terms of the offering require a high minimum investment amount, then it may be reasonable for the issuer to take no steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by the issuer or by a third party, absent any facts that may indicate that the purchaser is not an accredited investor.3
The proposed amendments would make just one substantive change to the Form D notice itself – to add a new checkbox on the front page, showing whether the issuer intends to rely on the new Rule 506(c).
In short, the SEC chose to keep its Rule 506 amendments simple, and declined to make more sweeping changes to existing practices under that exemption. It must be noted, however, that the amendments are not final. The SEC has set a 30-day comment period, and has solicited comments on a very wide range of issues surrounding Rule 506. Thus issuers are not yet authorized to utilize advertising in Rule 506 private placements.
Potential Implications
If the SEC does indeed adopt Rule 506 changes similar to those now proposed, issuers for the first time will be allowed to advertise their securities offerings without the expense and delay of registration or qualification of the offering with federal or state securities regulators. The conditions for doing so are straightforward: aim the offering at accredited investors and take reasonable steps to verify every purchaser’s status as such. What are some of the implications to liberalizing Rule 506 in this way?
- First, issuers will have new flexibility to seek favorable media attention. It is not uncommon for issuer’s counsel to cringe at seeing a newspaper or television piece touting the company’s story at the very time when it is seeking private investment. Under Rule 506(c), however, the company is free to interact with the media, even if one motivation is to attract potential angel investors who aren’t already within its existing circle of contacts.
- Second, a company that is confident it won’t need capital from non-accredited investors is free to offer a more detailed profile of itself on its public website, and through its website can baldly solicit private inquiries from potentially interested investors. Website postings are within the issuer’s control and typically have a considerable shelf life; pains should be taken to ensure that these materials are not misleading from a securities law standpoint. An aggressively upbeat but unreliable description on a company’s website not only might require subsequent curative disclosures to investors (awkward, at best) but also might generate inquiries from wholly undesirable investors or intermediaries.
- Third, dropping the prohibitions on advertising may help draw licensed broker-dealers back into the private placement market. For any number of reasons, there has been a dwindling number of traditional broker-dealers who conduct syndicated private offerings or who recommend such offerings to their own clients. With modest investments in advertising of a high-quality Rule 506(c) offering, the sponsoring firm may be able to attract new clients who (not coincidentally) have sufficient income or net worth to meet the accredited investor standard. Moreover, the sponsoring firm is able to cast a wider net, thereby perhaps catching the eye of other broker-dealers or investment advisers whose clients might be a good fit. The resulting cooperation among investment professionals could make the private placement market more interesting and vibrant.
- Fourth, for established midsized companies that could use additional capital in the form of subordinated debt but lack the time or expertise to handle securities offerings on their own, a broker-advertised offering might now become a viable alternative to seeking institutional placements of debt securities.
- Fifth, local firms with good reputations as managers of pooled capital – such as venture capital or private equity firms – could use Rule 506(c) to expand their efforts to solicit new participants.4
Conclusion
The Rule 506 innovations sparked by Section 201(a)(1) of the JOBS Act could have many salutary effects, both direct and indirect, on the flow of capital to small business. At a time when many investors are taking a look at nontraditional asset classes, increased exposure to small business needs and opportunities could offer a welcome boost to the U.S. economy.
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1 The Proposing Release can be found at http://www.sec.gov/rules/proposed/2012/33-9354.pdf.
2 The SEC has posted these comments at http://www.sec.gov/comments/jobs-title-ii/jobs-title-ii.shtml.
3 Proposing Release at pages 19-21 (footnote omitted).
4 In the Proposing Release, the SEC confirms that Rule 506(c) offerings will not be treated as public offerings that would jeopardize the important “private fund” exemptions under Section 3(c)(1) or 3(c)(7) of the Investment Company Act. Regulation of private funds involves a complex mix of provisions under several of the federal securities laws, and under state securities laws as well, topics that are beyond the scope of this article.