Lifting the Ban on General Solicitation in Rule 506(c) Securities Offerings
In a long awaited and widely sought change, the SEC has recently announced a final rule (the “final rule”) lifting the ban on general solicitation or general advertising (collectively, “general solicitation”) in certain private offerings of securities, as required by the JOBS Act. The final rule represents a compromise of many different interests: businesses seeking to raise funds will have additional means at their disposal but will also have specific compliance requirements to satisfy; investors will have greater access to information about private investment opportunities; government officials may have more difficulty enforcing key provisions of federal and state securities laws; and consumer advocates will have added concerns about securities fraud and the erosion of consumer protections. This article focuses on how the final rule impacts the requirements that apply to businesses seeking investment.
The final rule creates a new provision in Regulation D, Rule 506(c), which allows businesses issuing securities in a private offering to use general solicitation. The final rule does not apply to all private securities offerings, or even all private securities offerings relying on the current exemption in Rule 506 (now known as Rule 506(b)). In order to take advantage of this substantial change in securities laws, businesses will have to meet a number of requirements. Specifically, any business hoping to take advantage of Rule 506(c) will have to: wait to use general solicitation until after September 23, 2013, the final rule’s effective date; follow the other terms and conditions of a Rule 506 securities offering; sell only to accredited investors; and take reasonable steps to verify that each purchaser is an accredited investor.
First, the use of general solicitation is only permitted in certain securities offerings, those under the new Rule 506(c), after the effective date of the final rule creating this provision. The SEC’s final rule only becomes effective on September 23, 2013, so the use of general solicitation prior to that date in any securities offering under Regulation D (including private offerings under Rules 504, 505, and 506) is a violation of securities laws.
General 506 Requirements
Second, the fact that the prior ban on general solicitation is lifted with respect to certain securities offerings does not change the fact that most of the terms and conditions for Rule 506 offerings remain unchanged. Among other things, this means that the definition of accredited investors remains the same, Regulation D offerings have to be separated in time or risk being integrated, and any securities sold are restricted securities. The final rule only impacts the previous ban on general solicitation in Rule 506(c) offerings; however, the ban continues in offerings under Rules 504, 505, and 506(b).
Accredited Investor Requirement
Third, all the purchasers under a new Rule 506(c) offering must be accredited investors. As noted above, the definition of accredited investors remains unchanged, so for a natural person to qualify as an accredited investor, she must have had individual income in excess of $200,000 per year (or $300,000 per year for couples) for the last two years and have a reasonable expectation of reaching that same income level for the current year, or she must have a net worth in excess of $1,000,000 (excluding her primary residence). This requirement that all purchasers be accredited investors contrasts with the “old” Rule 506 offering, which is still allowed by Rule 506(b), in which up to 35 purchasers can be non-accredited investors if they are capable of evaluating the merits and risks of the potential investment. Businesses selling securities going forward will have to make a trade-off between being able to use general solicitation (but being limited to only selling to accredited investors) and being able to sell to up to 35 sophisticated non-accredited investors (but being limited to private offerings that do not involve general solicitation).
Fourth, in a new Rule 506(c) offering, the business issuing the securities (the “issuer”) must take reasonable steps to verify that each purchaser is an accredited investor. The SEC has announced four non-exclusive safe harbors that are sufficient, but not necessary, for the issuer to show compliance with the verification requirement. The SEC has also announced a general principles-based framework in order to determine whether, under the particular facts and circumstances of each case, an issuer has taken reasonable steps to verify investor status. Any issuer that fails to meet one of the four non-exclusive safe harbors will still be able to rely on a facts and circumstances analysis of the reasonableness of the steps it took to verify accredited status under the general principles-framework, but it will take time for this body of law to develop.
Non-Exclusive Safe Harbors
In an attempt to promote certainty, without sacrificing flexibility, the SEC has provided the following four non-exclusive safe harbors that issuers can rely on to satisfy the verification requirement in the new Rule 506(c):
(1) Reviewing copies of any IRS form that reports income (including forms W-2, 1099, K-1, 1065, or a filed 1040) for the two most recent years, along with obtaining a written representation from the purchaser that she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
(2) Reviewing one or more of the following types of documentation, dated within the prior 3 months, and by obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed,
a. For assets (any of the following) – bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, or tax assessments and appraisal reports issued by independent third parties,
b. For liabilities (both of the following) – a consumer report (i.e., a credit report) from at least one of the nationwide consumer reporting agencies and a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed;
(3) By obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that such professional has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that the purchaser is an accredited investor;
(4) For any natural person who invested in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c) and remains an investor of the issuer, for any offering conducted by the same issuer the issuer is deemed to satisfy the verification requirement in Rule 506(c) with respect to the purchaser by obtaining a certificate by the purchaser at the time of sale that he or she qualified as an accredited investor.
Under the general principles-based framework, whether the steps taken to verify investor status are “reasonable” is an objective determination by the issuer in light of the particular facts and circumstances of each purchaser and transaction. The factors that the issuer is to consider are: (1) The nature of the purchaser and the type of accredited investor that the purchaser claims to be; (2) The amount and type of information that the issuer has about the purchaser; and (3) The nature of the offering such as 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. Under this general principles-based framework, there is no set formula for what constitutes whether the issuer took reasonable steps to verify that a purchaser was an accredited investor. Whether the steps an issuer took are adequate to meet this test can vary, based on the factors above.
The SEC has indicated that the issuer may rely upon, in addition to other reliable sources, information obtained from publicly available filings with government regulatory bodies, third-party information that is reasonably reliable (such as pay stubs indicating a natural person’s income for the last two years), or third parties that are in a position to verify a person’s accredited status (such as accountants, securities brokers, and attorneys).
With respect to the nature of the offering and the manner in which the purchaser was solicited, the more general the solicitation, the greater the measures the issuer must take to verify accredited status. Thus, issuers soliciting on a website generally available to the public must take greater measures to verify a purchaser’s accredited status than issuers soliciting for an offering with a substantial minimum investment on a website available only to a pre-selected group of high net worth individuals.
Of particular note, the SEC has explicitly stated that in offerings involving general solicitation, the issuer will not have taken reasonable steps to verify accredited status if it required only that a person check a box in a questionnaire or a sign a form, absent other information about the purchaser indicating accredited status.
It is important to note that whether the verification requirement is met under one of the non-exclusive safe harbors or the general principles-framework, the verification requirement is separate from and independent of the requirement that sales be limited to accredited investors. Thus, the verification requirement must be satisfied even if all purchasers are in fact accredited investors.
Also, it is important for issuers to retain adequate records of the steps they took to meet the verification requirement since issuers bear the burden of proof that they met all the requirements of any rule exempting their securities from registration. This is particularly true since an issuer may still rely on Rule 506(c) even if not all of the purchasers were in fact accredited investors so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and the issuer had a reasonable belief that the purchaser was an accredited investor at the time of sale.
In addition to these changes in the final rule, the SEC has proposed an additional rule that may impact Rule 506(c) offerings in the future. The proposed rule may result in the SEC requiring issuers to file a Form D at least 15 days before engaging in general solicitation, as well as filing an update to their Form D within 30 days of completing an offering. (This is in contrast to the current filing requirement that an issuer file a Form D within 15 days after the first date of sale in Rule 506(b) offerings). The SEC also specified that it may require issuers to provide additional information in connection with their 506(c) offerings and may also require the use of specific legends or disclosures or the submission of written general solicitation materials to the SEC in connection with Rule 506 offerings. The SEC has currently proposed this rule and is accepting public comment on it, but it is unclear when or if part or all of this proposed rule will become final and effective in Rule 506 offerings.
So although the SEC has finalized some substantial changes to Rule 506 offerings to allow for the use of general solicitation pursuant to the terms and conditions of Rule 506(c), the future requirements of Rule 506 offerings are still somewhat uncertain. While the requirements of Rule 506 offerings remain in a state of change, it will be important for businesses to be aware of and to comply with the securities offering requirements applicable at the time of their offering.