by Robert T. Smith, Steven L. Brooks, Sean Evans and John F. Griffee On August 29, 2012, the U.S. Securities and Exchange Commission (SEC) issued its proposed rule (Proposed Rule) pursuant to the Jumpstart Our Business Startups (JOBS) Act (H.R. 3606) to implement amendments to Rule 506 of Regulation D. Rule 506 is one of the most significant and commonly relied on federal securities exemptions for companies (issuers) raising capital.1 The Proposed Rule provides that the prohibition against general solicitation and general advertising contained in Rule 502(c) of Regulation D would not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors. The Proposed Rule would also require that, in Rule 506 offerings that use general solicitation, the issuer take reasonable steps to verify that purchasers of the securities are accredited investors. This amendment to allow general solicitation will result in greater access to capital for companies considering raising capital. The following is a summary of key provisions of the Proposed Rule: Eliminating the Ban on General Solicitation Under existing Rule 506, an issuer may offer and sell securities, without any limitation on the offering amount, to an unlimited number of accredited investors, as defined in Rule 501(a) of Regulation D, and to no more than 35 non-accredited investors who meet certain sophistication requirements. The availability of the Rule 506 safe harbor is subject to a number of requirements and is currently conditioned on the issuer, or any person acting on its behalf, not offering or selling securities through any form of general solicitation. Examples of general solicitation include advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars whose attendees have been invited by general solicitation. By interpretation, the SEC has confirmed that other uses of publicly available media, such as unrestricted websites, also constitute general solicitation. The JOBS Act directs the SEC to amend Rule 506 to provide that the prohibition against general solicitation contained in Rule 502(c) shall not apply to offers and sales of securities made pursuant to Rule 506, as so amended, provided that purchasers of the securities are accredited investors. To implement the mandated rule change, the Proposed Rule creates new Rule 506(c), which would permit the use of general solicitation to offer and sell securities under Rule 506, provided that certain conditions are satisfied. These conditions are:
- the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors;
- all purchasers of securities must be accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes that they do, at the time of the sale of the securities; and
- all terms and conditions of Rule 501 and Rules 502(a) (integration) and 502(d) (limitations on resale) must be satisfied.
Offerings under proposed Rule 506(c) would not be subject to the requirement to comply with Rule 502(c), which contains the prohibition against general solicitation. Reasonable Steps to Verify Purchasers are Accredited The JOBS Act mandates that amendments to Rule 506 require issuers using general solicitation in Rule 506 offerings to take reasonable steps to verify that purchasers of the securities are accredited investors. The SEC did not propose requiring issuers to use specified methods of verification, nor did it propose a non-exclusive list of specified methods for satisfying the verification requirement. Rather, under the SECs proposed approach, issuers would consider a number of factors when determining the reasonableness of the steps to verify that a purchaser is an accredited investor. Some examples of these factors include:
- the nature of the 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; and
- 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.
The appropriate method of verification will depend on the circumstances of the offering. For example, the steps that may be reasonable to verify that a certain entity is an accredited investor necessarily differ from the steps that would be reasonable to verify whether a natural person is an accredited investor. Moreover, an issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer. Regardless of the particular steps taken, it would be important for issuers to retain adequate records that document the steps taken to verify that a purchaser was an accredited investor. Any issuer claiming an exemption under Rule 506 has the burden of showing that it is entitled to that exemption. Reasonable Belief that Purchasers are Accredited With respect to new Rule 506(c), the SEC also preserved and applied the reasonable belief standard that exists for traditional Rule 506 offerings.2 The significance of the reasonable belief standard is that an issuers determination as to whether a purchaser is an accredited investor is not subject to an absolute standard. In other words, in light of the reasonable belief standard, an issuer will not lose the Rule 506 exemption if an investor proves to be un-accredited after he/she invests (e.g., the investor provided false documentation to the issuer in order to qualify for the offering). Accordingly, as applied to new Rule 506(c), if a person who does not meet the criteria for any category of accredited investor invests in a Rule 506(c) offering, the issuer would not lose the ability to rely on the proposed Rule 506(c) exemption for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor. Traditional Rule 506 Offering Rules are Preserved Notwithstanding the new amendments under Rule 506(c), the SEC preserved the existing ability of issuers to conduct Rule 506 offerings without the use of general solicitation. The continued availability of existing Rule 506 will be important for those issuers that either do not wish to engage in general solicitation in their Rule 506 offerings (and become subject to the new requirement to take reasonable steps to verify the accredited investor status of purchasers) or wish to sell privately to non-accredited investors who meet Rule 506(b)s sophistication requirements. Retaining the safe harbor under existing Rule 506 may also be beneficial to investors with whom an issuer has a pre-existing substantive relationship. Observation The Proposed Rule bifurcates Rule 506 into two separate exemptions: (i) the tradition Rule 506 exemption (Quiet 506); and (ii) a new exemption under Rule 506(c) (Loud 506). Whether an issuer will rely on a Quiet or Loud 506 exemption will depend on the circumstances of the offering and the issuers need for widespread marketing to raise funds. By removing the ban on general solicitation in a Loud 506, the SEC significantly enhances the opportunity for raising capital. A Loud 506 allows a company to market its securities to investors throughout the country using powerful marketing tools like the internet and social media to sell securities. Offering securities under a Loud 506 and utilizing the general solicitation methods permitted thereunder, however, often will present greater risk of noncompliance in light of the enhanced, fact-sensitive verification requirement. The Proposed Rule fails to set forth a safe harbor or specific methods that will satisfy the verification requirement. The parameters of conducting a Quiet 506, on the other hand, have been well established by industry practice and SEC guidance. In light of the consequences of non-compliance with Rule 506, choosing the right path under the new Rule 506 should be considered carefully before undertaking a private securities offering. We regularly assist both financial and non-financial clients in capital raising activities, including compliance with federal and state exemption requirements. Please contact one of the attorneys listed above if you have any questions or would like to discuss any of the topics discussed in this publication. This Friday, Eldredge & Clark, LLP publication should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney on any specific legal questions you may have.
1. In 2011, the estimated amount of capital (including both equity and debt) raised in Rule 506 offerings was $895 billion. 2. Under the traditional Rule 506 approach, an issuer is entitled to rely on a completed investor questionnaire indicating that the investor is accredited unless the company has reason to doubt the answers. Download the article here