On August 29, 2012, the Securities and Exchange Commission (SEC) published proposed rules (available here) to eliminate the ban on general solicitation and advertising for securities offerings made to qualifying investors pursuant to SEC Rule 506 under the Securities Act of 1933. The proposed rules were required by the Jumpstart Our Business Startups Act (JOBS Act), signed into law in April 2012. The congressional concern underlying the JOBS Act is that issuers face significant hurdles in reaching accredited investors who stand ready to provide needed capital.
Rule 506 Offering Restrictions and the JOBS Act
Rule 506, which is part of Regulation D under the Securities Act of 1933, provides a non-exclusive “safe harbor” exemption from federal registration requirements for private securities offerings in an unlimited dollar amount to an unlimited number of “accredited” investors, as well as up to 35 non-accredited investors, provided certain conditions are satisfied. Rule 506 plays a major role in capital formation in the United States. The SEC estimates that in 2011 the amount of capital raised in Rule 506 offerings was $895 billion. The availability of the Rule 506 safe harbor is subject to several requirements, currently including a “manner of offering” restriction prohibiting the issuer of the securities, and any person acting on its behalf, from offering or selling the securities by any form of general solicitation or general advertising. The prohibition applies without regard to the accredited status of investors.
General solicitation and general advertising are not defined terms in Regulation D, but the prohibition has been broadly interpreted by the SEC to bar, for example, the use of publicly available media, such as unrestricted websites. The restriction has proven to be a significant challenge with the advent of online platforms of matching services designed to bring together accredited investors with entrepreneurs in need of capital. The restriction also applied to any seminar or meeting when the attendees are invited by any general solicitation or advertising.
Proposed Rule 506 Revisions
Under the proposed rules, companies issuing securities would be permitted to use general solicitation and general advertising to offer securities provided that:
The issuer takes reasonable steps to verify that all of the purchasers of the securities are accredited investors.
All purchasers of securities are accredited investors, because either:
They fall under one of the categories of persons who are defined as accredited investors under existing Rule 501; or
The issuer reasonably believes that they meet one of the requirements at the time of the sale of the securities.
Under Rule 501, a natural person qualifies as an accredited investor if he or she has; (a) individual net worth, or joint net worth with a spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person, or; (b) income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
In determining the reasonableness of the steps that an issuer has taken to verify that a purchaser is an accredited investor, the proposing release explains that issuers are to consider the facts and circumstances of the transaction. This includes, among other things, the following factors:
The type of purchaser and the type of accredited investor that the purchaser claims to be.
The amount and type of information that the issuer has about the purchaser.
The nature of the offering, meaning:
The manner in which the purchaser was solicited to participate in the offering.
The terms of the offering, such as a minimum investment amount.
Proposing release notes that impose specific verification methods on an issuer “would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor. We are also concerned that a prescriptive rule that specifies required verification methods could be overly burdensome in some cases, by requiring issuers to follow the same steps, regardless of their particular circumstances, and ineffective in others, by requiring steps that, in the particular circumstances, would not actually verify accredited investor status.”
The proposed rules would preserve the existing portions of Rule 506 as a separate exemption so that companies conducting Rule 506 offerings without the use of general solicitation and general advertising would not be subject to the new verification rule.
The proposed rules would also amend Form D, which issuers must file with the SEC when they sell securities under Regulation D. The revised form would add a separate box for issuers to check if they are claiming the new Rule 506 exemption that would permit general solicitation and general advertising.
The proposed rules are subject to public comment until early October. We anticipate that the rules will become effective before the end of the year. Cautionary Note: Until the new rules are effective, issuers should not change the manner in which offerings are solicited.