By Greg Writer
On September 23, 2013, the amendments to Rule 506 of Regulation D under the Jumpstart Our Business Startups Act (known as the “JOBS Act”) became effective following the adoption of implementing rules by the Securities and Exchange Commission (“SEC”). These amendments lift the longstanding ban on general solicitations and advertisements to accredited investors. As a result, companies can now pitch their private investment opportunities to accredited investors through newspaper, television and website advertisements, and other previously prohibited means, if they comply with certain requirements. This will significantly increase the number of potential investors for small businesses and start-up companies.
Background of Rule 506. In general, when a company raises money by offering investments in its securities, including its equity or debt, it must register the offering under federal law and any applicable state securities laws unless exemptions from registration are available. Private companies normally seek to avoid registration under the securities laws because the costs of compliance are prohibitive. They will most commonly rely on Rule 506 of Regulation D under the Securities Act of 1933, which is also known as the “private placement exemption”, as the exemption from federal registration. Under Rule 506, companies will typically issue their securities only to individuals and entities that qualify as “accredited investors”. An accredited investor is deemed, by virtue of the investor’s financial position, sophistication and/or relationship with the company, to be capable of obtaining the information necessary to evaluate the benefits and risks of the potential investment. Among others, individuals who meet specific income and asset thresholds can qualify as accredited investors.
Rule 506 is an attractive exemption for private companies issuing securities (“issuers”) because it does not mandate disclosures of financial and other information when the offerings are limited to accredited investors. Thus, it greatly reduces the costs of compliance. Rule 506 also has the advantage of preempting substantive regulation of the offering by state governments. Connecticut, for example, only requires companies to file a copy of the SEC’s Form D exemption notice with the Department of Banking and pay a small fee (currently $150) in connection with any Rule 506 offering. Prior to the amendments to Rule 506 becoming effective, its main drawback was that issuers were prohibited from generally soliciting or advertising their offerings to accredited investors. Unless small businesses hired an intermediary (such as a registered broker-dealer) to locate investors, Rule 506 effectively limited their pools of accredited investors to their preexisting contacts and / or investors who were active in their area.
Amendments to Rule 506. Rule 506 has now been amended to, among other things, add a new provision – Rule 506(c) – which allows issuers to generally solicit and advertise to accredited investors, provided that the following conditions are met:
Satisfying the first requirement will be particularly challenging for issuers. The SEC’s implementing rules provide that issuers can use one of the following procedures to verify that their purchasers are accredited investors: (1) a general principles-based approach which takes into account, among other factors, the nature of the purchaser, the type of accredited investor, the information the issuer has about the purchaser, and the nature and terms of the terms of the offering; or (2) a non-exclusive list of four methods that are each deemed to meet the verification requirement. The non-exclusive list of methods that issuers may rely on, under appropriate circumstances, are: (1) income verification (which involves reviewing IRS reporting forms such as tax returns and obtaining a purchaser’s written representation regarding current income); (2) net worth verification (which involves reviewing certain asset and liability statements and obtaining the purchaser’s written representation regarding their liabilities); (3) third party verification (by, among others, a registered broker-dealer, licensed attorney or CPA); or (4) a grandfather clause (allowing issuers to accept a certification of accredited investor status from any natural person who invested in their prior Rule 506 offering(s) prior to September 23, 2013).
Preservation of the Old Rule 506. Some companies may decide that it is not worth the additional time and expense to verify the status of accredited investors in order to comply with the new Rule 506(c). It is important to note that these companies can still utilize the exemption under the old Rule 506 – which is now codified as Rule 506(b) – when raising money in a private offering. As such, they can still offer securities to accredited investors without any mandatory disclosure requirements as long as they refrain from general solicitations and advertisements.
Potential Benefit of the Amendments. Rule 506(c) will hopefully encourage more companies and investors to engage in private offerings. Some companies have been deterred from private investment offerings in the past because they did not want to hire registered intermediaries to locate accredited investors. In addition, the SEC estimates that over 8 million households qualify as accredited investors but only a few hundred thousand of them have invested in private offerings. General solicitations and advertisements could open up the investment market to a wider range of companies and accredited investors.
Potential Causes for Concern.
The SEC has already proposed additional rules that may limit the benefits of the Rule 506(c) and increase the costs of compliance. These proposed rules would, among other things, require issuers to submit their general solicitation materials to the SEC and would require issuers Form D exemption notices both before and after the offering. In addition, the SEC adopted “bad actor rules” concurrently with its JOBS Act implementing rules. The bad actor rules prohibit convicted felons and other bad actors from participating in any Rule 506 offering. Some issuers may be under the false impression that they can now advertise or solicit accredited investors without restriction. Accordingly, attorneys should take special care to counsel their clients on the new rules before they engage in activities that could blow their Rule 506 exemption.
What does it mean to be an accredited investor?
Under the federal securities laws, a company or private fund may not offer or sell securities unless the transaction has been registered with the SEC or an exemption from registration is available. Certain securities offerings that are exempt from registration may only be offered to, or purchased by, persons who are accredited investors. One principal purpose of the accredited investor concept is to identify persons who can bear the economic risk of investing in these unregistered securities.
Unlike offerings registered with the SEC in which certain information is required to be disclosed, companies and private funds, such as a hedge fund or venture capital fund, engaging in these exempt offerings do not have to make prescribed disclosures to accredited investors. These offerings, sometimes referred to as private placements, involve unique risks and you should be aware that you could lose your entire investment.
The SEC recently adopted rules to permit general advertising for certain exempt offerings.
Are you an accredited investor?
An accredited investor, in the context of a natural person, includes anyone who:
On the income test, the person must satisfy the thresholds for the three years consistently either alone or with a spouse, and cannot, for example, satisfy one year based on individual income and the next two years based on joint income with a spouse. The only exception is if a person is married within this period, in which case the person may satisfy the threshold on the basis of joint income for the years during which the person was married and on the basis of individual income for the other years.
In addition, entities such as banks, partnerships, corporations, nonprofits and trusts may be accredited investors. Of the entities that would be considered accredited investors and depending on your circumstances, the following may be relevant to you:
In this context, a sophisticated person means the person must have, or the company or private fund offering the securities reasonably believes that this person has, sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment.
How do I calculate my net worth?
To qualify as an accredited investor under the net worth test, you must have a net worth that exceeds $1 million, either alone or with a spouse. If calculating joint net worth with a spouse, it is not necessary that property be held jointly. Calculating net worth involves adding up all your assets and subtracting all your liabilities. The resulting sum is your net worth.
The value of your primary residence is not included in your net worth calculation. In addition, any mortgage or other loan on the residence does not count as a liability up to the fair market value of the residence. If the loan is for more than the fair market value of the residence (i.e., if your mortgage is underwater), then the loan amount that is over the fair market value counts as a liability under the net worth test.
Further, any increase in the loan amount in the 60 days prior to your purchase of the securities (even if the loan amount does not exceed the value of the residence) will count as a liability as well. The reason for this is to prevent net worth from being artificially inflated through converting home equity into cash or other assets.
The following table sets forth examples of calculations under the net worth test for being an accredited investor:
What if I am no longer an accredited investor?
The rules defining accredited investor were changed with the passage of the Dodd-Frank Act to exclude a primary residence from the net worth test. This means that some investors who were accredited investors prior to July 20, 2010 are now not accredited investors. For these investors, any purchase rights, such as preemptive rights or rights of first offer, related to securities that they invested in as accredited investors prior to July 20, 2010 are grandfathered in, provided that certain conditions are met. This means that the investor can still exercise these rights even though the investor may not meet the current definition of accredited investor.
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In 1982, the SEC adopted Regulation D, which set forth objectives and quantifiable rules for exemptions from federal registration. Offerings exempt under these rules 504,505 and 506 have become the most common cost and time saving methods for small and growing businesses to raise capital from private investors.
Rule 506 : Provides an exemption for limited offers and sales without regard to the dollar amount of the offering. This exemption does not limit the number of accredited investors, but the number of nonaccredited investors may not exceed 35 investors. (An accredited investor is any one investor with a certain net worth and or experience in the purchase of stocks.) All nonaccredited purchasers, either alone or together with a designated representative must be sophisticated enough (i.e., have the knowledge and experience necessary) to evaluate the merits and risks of the investment. (An offering company typically determines the sophistication of its investors with a questionnaire subscription agreement.) Rule 506 requires detailed disclosure of relevant information to potential investors; the extent of disclosure depends on the dollar size of the offering.
Rule 505 : Offerings may not exceed $5 million, less the total dollar amount of securities sold during the preceding 12 month period under Rule 504, Rule 505 or Section 3 of the act. This exemption limits the number of nonaccredited investors to 35 but has no investor sophistication standards. Rule 505 requires disclosure similar to that required for Rule 506 offerings, under $7.5 million.
Rule 504 : Offerings allow a business to raise a maximum of $1 million, less the total dollar amount of securities sold during the preceding 12 month period, under Rule 504, Rule 505 or Section 3 of the act. However, a business can raise only $500,000 by the sale of securities to persons residing in the states of Montana and Alaska, which have no disclosure laws applicable to the offering. For the states that do have disclosure laws, which are 48 out of the 50 states, a business can raise up to $1,000,000. Rule 504 has no prescribed disclosure requirements, no limit on the number of purchasers, and no investor sophistication standards. Rule 504 is the most commonly used Regulation D exemption.
Offerings that are exempt under Rule 504 are relatively simple to prepare, which reduces cost and delay and can generally be underwritten by the offering company (the securities being sold by the company’s own officers, directors and employees).