The SEC on July 10 finally lifted its 80-year old ban on general solicitation and general advertising in Rule 506 offerings, as Congress directed it to do last year in the JOBS Act. When the new rules go into effect in September, issuers will be able to use social media, the internet, blogs, email and other communication technologies to disseminate information on their Rule 506 private offerings and reach a potentially wider pool of otherwise qualified investors, so long as all purchasers in the offering are accredited investors and the issuer uses reasonable steps to verify their status. Issuers will need to consider verification methods on a case-by-case basis, and the traditional reliance on written investor representations may not be deemed reasonable in many cases. Issuers will also need to consider the nature and quality of any such means of solicitation in terms of potential impact on their credibility and image. The SEC’s new rules could facilitate much broader access to potential investors. But its concern over investor protection also motivated the SEC on July 10 to adopt “bad actor” disqualification rules and to propose new notice and disclosure rules that may undercut the potential benefits of general solicitation offerings.
Rule 506 offerings are the most commonly used private offering exemption and raise enormous amounts of capital, primarily because it imposes no dollar limit on the amount raised. Companies and private funds (venture capital funds, private equity funds and hedge funds) raised approximately $900 billion in Rule 506 offerings in 20121. Nevertheless, the prohibition on general solicitation and general advertising2 in these offerings has long been perceived as a major obstacle to capital raising and has generated a tremendous amount of criticism from securities law reform advocates. Lawyers routinely advise clients that the safest way to steer clear of violating the general solicitation prohibition is to restrict a private offering to only those persons with whom the issuer or its placement agent has a preexisting relationship, thus severely limiting the universe of potential investors.
Reacting to the growing chorus of criticism and calls for reforming the general solicitation prohibition, Congress last year in Section 201(a)(1) of the JOBS Act directed the SEC to revise Rule 506 to provide that the prohibition against general solicitation would not apply to offers and sales of securities under Rule 506 where all purchasers are accredited investors and the issuer takes reasonable steps to verify such accredited investor3 status, using such verification methods as determined by the SEC.
SEC’s 2012 Proposed Rules
Responding to the Congressional mandate, the SEC last August proposed the adoption of a new Rule 506(c) exemption that would permit general solicitation so long as actual sales are made only to accredited investors and issuers take reasonable steps to verify such accredited status. Although the SEC considered requiring issuers to use specified methods of verification, the August proposal opted instead for a flexible “principle based” approach in which the reasonableness of verification measures would be subject to an objective test based on the particular facts and circumstances of each offering and purchaser. During the comment period, the SEC received numerous comments seeking greater clarification on the types of verification methods that would be considered reasonable under the rule. Some asserted that the proposed rules will lead to confusion and cause lawyers to insist on complex, burdensome forms and submissions that will cause many investors to back away from private offerings. Many advocated for bright line “safe harbors” for companies and investors to be able to act with confidence, arguing that without safe harbors for 506(c) offerings, issuers won’t know when they’ve done enough to satisfy the “reasonable steps” test and that the uncertainty would hamper legitimate capital raising.
Final Rule: New Rule 506(c)
In a 4-1 vote on July 10, the SEC adopted a final rule that leaves its proposed August rule largely intact by permitting the use of general solicitation and advertising in new Rule 506(c) offerings if the issuer takes “reasonable steps to verify” that all purchasers are accredited investors and all purchasers are in fact accredited or the issuer reasonably believes that they are such at the time of the investment.
So what would constitute “reasonable steps to verify”? The SEC’s adopting release describes two alternative approaches.
First, an issuer could use a “facts and circumstances” approach in which “reasonableness” would be an objective determination based on the particular facts and circumstances of each transaction, such as:
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be. For example, more extensive verification would be required in the case of an individual investor as opposed to a registered broker-dealer;
- the amount and type of information that the issuer has about the purchaser. For example, less verification would be required if the issuer has access to publicly available information about the investor; and
- the nature of the offering (i.e., the manner in which the purchaser was solicited to participate in the offering), and the terms of the offering such as a minimum investment amount. For example, less verification would be required if an issuer’s minimum investment requirement was sufficiently high that only accredited investors could reasonably be expected to meet the requirement.
Second, as an accommodation to those that advocated for greater certainty, the final rule also allows investors to rely on a nonexclusive list of methods to satisfy the verification requirement with respect to individual investors, depending on the nature of the accredited investor, including
- inspecting income tax returns and Forms W‐2, K-1 and 1040 as to income levels;
- reviewing bank and brokerage statements as to assets, and reviewing a consumer report from a nationally recognized consumer reporting agency as to liabilities;
- obtaining written representations from broker-dealers, investment advisors, lawyers or CPAs that they have taken reasonable steps to verify that the investor is an accredited investor and have determined that the investor is accredited; and
- obtaining a bring-down certificate from the issuer’s existing shareholders who previously purchased securities as accredited investors from the issuer prior to effectiveness of new Rule 506(c).
Bad Actor Disqualification and Proposed Advance Notice and Disclosure Requirements
At the same open meeting on July 10, the SEC announced two additional actions in a Proposal Release which, if fully implemented, would impose additional burdens on issuers conducting Rule 506 offerings and may deter them from conducting these offerings in the first place.
First, as mandated by Dodd-Frank, the SEC adopted the so-called “bad actor” rules, disqualifying the use of Rule 506 if a company or certain other “covered” persons such as its executive officers, directors or 20% or greater beneficial owners have been convicted of or sanctioned for securities fraud or certain other violations of law. Currently, such information would arguably be deemed material and require disclosure, but would not disqualify an issuer from engaging in a Rule 506 offering.
Second, the SEC proposed additional amendments to Rule 506 ostensibly to improve its ability to evaluate the development of market practices in such offerings. These amendments include requiring that Form D (the notice currently required to be filed with the SEC within 15 days following the first sale in the offering) be filed with the SEC both in advance and following termination of an offering, increasing Form D’s disclosure requirements, a one year disqualification for failure to file Form D timely and a two-year offering materials filing requirement. These proposals will undergo a 60-day public comment period. Comments may be posted here.
1 Vladimir Ivanov and Scott Bauguess, Capital Raising in the U.S.: An Analysis of Unregistered Offerings Using the Regulation D Exemption, 2009-2012 (July 2013) (the “Ivanov/Bauguess Study”), available at: http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered-offerings-reg-d.pdf. These statistics are based on a review of Form D electronic filings with the SEC. Because there is no Form D closing filing requirement, the amount of capital raised through Reg D offerings may be considerably larger than the amounts disclosed.
2 Although the terms “general solicitation” and “general advertising” are not defined in Regulation D, Rule 502(c) provides examples of general solicitation and general advertising, including advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars where attendees have been invited by general solicitation or general advertising. By interpretation, the SEC has confirmed that other uses of publicly available media, such as unrestricted websites, also constitute general solicitation and general advertising.
3 Generally, “accredited investors” include:
- individuals whose net worth or joint net worth with a spouse exceeds $1 million at the time of the purchase, excluding the value (and any related indebtedness) of a primary residence;
- individuals whose annual income exceeded $200,000 in each of the two most recent years (or $300,000 jointly with the individual’s spouse), and a reasonable expectation of the same income level in the current year; and
- entities with at least $5 million in assets