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:
- the issuers take reasonable steps to verify that the purchasers of their securities (“purchasers”) are accredited investors;
- the purchasers are, in fact, accredited investors; and
- the terms and conditions of the other applicable rules have been satisfied.
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.