SEC Proposes Light Touch To Regulating General Solicitation Under Rule 506
While the "Crowdfunding" provisions of April's JOBS Act1 have drawn all the attention, the potential game-changer in the Act may be Section 201(a)(1) which requires the SEC to amend Rule 506 of Regulation D under the Securities Act of 1933 ("Rule 506") to permit general advertising of offerings where all purchasers are "accredited investors."2
By way of background, Rule 506 is far and away the most-relied upon safe harbor for private offering under Regulation D, because offering size is unlimited and reliance upon Rule 506 eliminates a good deal of state securities regulation. Until now, however, public solicitation and advertising were prohibited, so issuers were limited in how they could draw attention to their Rule 506 offerings.
While Section 201(a)(1) opens the way to general advertising, it also requires that the issuer take reasonable steps to verify that purchasers of the securities are accredited investors "using such methods as determined by the Commission." The speculation around Section 201(a)(1) centered on what approach the SEC would take to implement Congress' "reasonable steps" mandate. If the verification methodologies chosen were too stringent, it would discourage the use of general advertising in Rule 506 offerings and defeat the purpose of the JOBS Act.
While the JOBS Act required the SEC to take action within 90 days of the April 5, 2012 enactment date, the SEC not issue proposed regulations until August 29, 2012 proposing a "light" regulatory approach to verification. In fact, the new proposed rule, Rule 506(c), simply states that "[t]he issuer shall take reasonable steps to verify that purchasers of securities "¦ are accredited investors." The proposed Rule does not mandate any specific verification methodology nor does it even suggest methodologies that would be "reasonable". If the Rule 506 regulations are enacted as proposed, we believe the ability to use general advertising in Rule 506 offerings will have positive and potentially far-reaching effects on capital formation.
In its proposing Release3 (the "Release"), the SEC explained that it did not propose specific methodologies because what steps are "reasonable" would be an objective determination based on the particular facts and circumstances of each offering. The Release goes on to discuss factors that an issuer should consider in determining reasonable steps to verify accredited investor status, such as the nature of the purchasers. When the investor is an institution or other entity, there are publicly-available means for determining their status. For example, broker dealers are listed on FINRA's Website and registered investment companies can be found on the SEC's own Website.
The Release recognizes that reasonable verification for natural persons can be more problematic, in part because individuals have legitimate privacy concerns about disclosing financial information. Moreover, where an accredited investor's status is based on net worth, it can be difficult to verify assets and liabilities. An investor can, for example, provide evidence of sufficient assets but hide certain liabilities. Accredited investor status based on income is easier to verify, since the issuer can examine W-2s or tax returns.
The Release makes one thing certain"”the SEC expects the issuer to collect sufficient information about the investor to form a reasonable belief as to accredited investor status. The SEC contrasts this with current practice, which is often limited to the investor signing a statement self-certifying as to accredited investor status.
The Release states that the terms of the offering are also relevant to verification. Offerings requiring high minimum cash investments may require a lower threshold of verification. For example, if an offering requires a $500,000 minimum cash investment, there would be a fair inference that only an accredited investor could afford to write the check, so only minimal verification may be required.
The Release states that whatever verification steps an issuer determines to take, it should retain adequate records documenting the steps taken, since the issuer has the burden of proving it is entitled to the exemption.
The SEC has set a 30-day comment period for the proposed Rule changes. Since it is already behind the schedule mandated by the JOBS Act, we expect the SEC to move to adopt final regulations before year end.
Many companies have been frustrated by their inability to reach a broader audience with their "private" securities offerings. Once adopted, Rule 506(c) will offer that opportunity, and companies will be able to apply the same methods they use to sell their products and services in offering their securities. This opportunity comes at a price, but an acceptable one. Issuers will need to work with their counsel to determine the verification methodologies that are appropriate for the facts and circumstances of a particular offering to assure that each purchaser is an accredited investor.
For more information. Please contact John P. Lowe, Jr. at (585) 295-4499 or by e-mail at jlowe@hblaw.com.
1Title III of the Jumpstart Our Business Startups Act (the "JOBS Act") relates to so-called "CrowdFunding."
2Rule 501 of Regulation D defines "accredited investor" as certain categories of institutional investors, such as banks and insurance companies, and any business entity with more than $5,000,000 in total assets. "Accredited investors" also include individuals that meet one of two tests: a net worth (not including equity in their main residence) of $1,000,000; or income in excess of $200,000 (or jointly with a spouse of $300,000) in each of the past two years and a reasonable expectation of the same level of income in the current year.
3S.E.C. Release 33-9354 (August 29, 2012)