Effective September 23, 2013, the Securities and Exchange Commission (“SEC”) lifted the ban on general solicitation and advertising in connection with certain fundraising activities. This rule change was required by the Jumpstart Our Business Startups Act (the “JOBS Act”). We have seen a considerable amount of confusion in the media about what this rule change means for private companies and funds. Of particular note, the rule change does not put into effect the so-called “crowdfunding” exemption called for by the JOBS Act, which contemplates the ability of private companies to raise up to $1 million annually from lower net worth investors. The SEC is expected to propose rules related to crowdfunding this fall. Even under the new rules, there are significant restrictions on the ability to raise capital. This advisory highlights key aspects of the SEC’s rule change concerning general solicitation, as well as other actions taken by the SEC.
- General Solicitation and Advertising Allowed. Private companies that need to raise capital often rely on Rule 506 of Regulation D, a “private offering” exemption from the requirement to register securities offerings with the SEC and state securities agencies. An issuer may raise an unlimited amount of capital in a Rule 506 private offering. Under new Rule 506(c), any issuer may engage in general solicitation and advertising with respect to the securities being offered (including via the Internet, social media, seminars and radio or television broadcast), without registering the offering with any agency, provided that all purchasers in the offering are “accredited investors” and the issuer has taken reasonable steps to verify such status.
- Accredited Investors Defined. An individual is an accredited investor only if such person (1) had income in excess of $200,000 (or $300,000 with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or (2) has a net worth over $1 million, either alone or with a spouse, excluding the value of the person’s primary residence and any loan secured by the residence (up to the value of the residence). Other categories of accredited investors exist, primarily for certain types of entities.
- Verification of Accredited Investors. To utilize new Rule 506(c), the issuer of the securities must take reasonable steps to verify the accredited investor status of each purchaser. This may include reviewing W-2s, tax returns, bank and brokerage statements, credit reports and similar documentation, as well as obtaining third party verification by a registered broker-dealer or investment adviser or by a licensed attorney or certified public accountant. The SEC does not require any specific verification method or process – only that “reasonable steps” must be taken. This is an objective standard that depends on the facts and circumstances of each purchaser and the particular offering, but in most cases relying only on an investor questionnaire completed by the investor will not be sufficient. Importantly, the existing provisions of Rule 506 as a separate exemption are not affected by new Rule 506(c) and, accordingly, issuers conducting private offerings under Rule 506 without the use of general solicitation or advertising may continue to do so in the same manner without being subject to the new verification requirement.
- Beware of Integration. An issuer may not use any form of general solicitation or advertising under new Rule 506(c) if even one of its purchasers is unaccredited. As a result, it is not permissible for an issuer to conduct contemporaneous Rule 506 private offerings, one of which is open to unaccredited investors and one of which utilizes general solicitation or advertising. Even if not contemporaneous, Rule 506 private offerings taking place in close proximity to one another risk being “integrated” (or combined from a regulatory standpoint). If integrated, the exemption from the registration requirements utilized by the issuer may no longer be available, in which case securities laws may be violated. A safe harbor from integration exists for Rule 506 private offerings made six months before or six months after another offering. Issuers relying on new Rule 506(c) need to plan carefully as engaging in a general solicitation may limit an issuer’s ability to complete the current and future offerings.
- Disqualification from Rule 506. Effective September 23, 2013, the SEC also adopted a disqualification rule that was required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under this rule, an issuer cannot rely on Rule 506 for a private offering if the issuer or any other person covered by the rule had a “disqualifying event,” which includes certain types of criminal convictions, court injunctions and orders, and regulatory orders, suspensions or expulsions. Persons covered by the rule include the issuer, its predecessors and affiliates, as well as its directors and certain officers, general partners and managing members, 20% beneficial owners, promoters of the offering, investment managers, and persons compensated for soliciting investors. However, if the issuer can show that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering, then the issuer is not disqualified from relying on Rule 506. Disqualification applies only for disqualifying events that occur after September 23, 2013, but any preexisting disqualifying event must be disclosed to investors.
- Proposed Amendments to Private Offering Rules. Lastly, in connection with the above actions, the SEC released a proposal which, according to the SEC, is “intended to enhance the SEC’s ability to assess developments in the private placement market now that the rule to lift the ban on general solicitation has been adopted.” If adopted as proposed, private offerings under Rule 506 would become subject to a number of new requirements, including:
- Issuers that intend to engage in general solicitation or advertising under new Rule 506(c) would, in addition to the current requirements regarding Form D, be required to (1) file a Form D at least 15 days before engaging in general solicitation or advertising for the offering and (2) update the information contained in the Form D and indicate that the offering has ended within 30 days of completing or abandoning such an offering. Currently, an issuer engaged in a private offering under Rule 506 is only required to file a Form D no later than 15 days after the first sale of securities in such an offering.
- Issuers would be required to provide additional information on Form D, including (1) identification of the issuer’s website, (2) expanded information on the issuer itself, (3) the securities being offered, (4) the types of investors in the offering, (5) the use of proceeds from the offering, (6) information on the types of general solicitation used, if any, and (6) the methods used to verify the accredited investor status of investors, if applicable.
- Issuers would be banned from relying on Rule 506 for private offerings for one year if the issuer or its affiliates did not comply with the Form D filing requirements, subject to a cure period for certain late Form D filings. Such disqualification does not exist currently.
- Issuers would be required to include certain legends or cautionary statements in any written general solicitation materials used under new Rule 506(c).
- Issuers would be required to submit copies of general solicitation materials to the SEC through an intake page on the SEC website (such materials would not be available to the general public, although it’s unclear whether state securities agencies would have access).
This proposal has been controversial and is viewed by some as discouraging issuers from relying on new Rule 506(c), at least until it has been acted on by the SEC, due to the uncertainty it creates for issuers and offering participants. The 60-day comment period closed on September 23, 2013, although this period can be extended at the SEC’s discretion. Over 300 comment letters have been submitted. Given the level of interest in this proposal, as well as the status of the SEC’s other rulemaking obligations (such as rules related to the “crowdfunding” exemption called for by the JOBS Act, as mentioned above), it remains to be seen when, and on what terms, the SEC will take action on it.
Contact your Varnum attorney for more information on these matters or the JOBS Act generally.