Businessmen seeking capital investment for their business often turn to private placements as a quick and relatively uncomplicated way of raising money. One major drawback to this approach has always been that those raising money through private placements were prohibited from advertising or undertaking general solicitations to accomplish their goal. This often made private placements unworkable in many situations. The SEC recently changed all that by their revisions to Regulation D.
The SEC developed Regulation D to apply to private placement securities offerings and as a result, Regulation D has historically prohibited any form of general solicitation. The term “general solicitation” in this context means advertising, television commercials, seminars, email broadcasts, junk mail solicitation, and other means of getting your message out to a large number of people you do not know. Recently, as a result of the Jump Start Our Business Start Ups Act (the “Jobs Act”), the SEC has amended Rule 506 of Regulation D to allow general solicitations in very specific circumstances. This change will be a significant and material reversal of SEC policy that could be a tremendous boon for those planning to make use of Regulation D to raise capital.
The SEC implemented the new rule by adding Section (c) to Rule 506. In order to obtain the benefit of the new rule, an issuer must first meet all the other terms of Regulation D, the purchasers of securities sold in the offering must be all accredited investors, and the issuer must take reasonable steps to verify that the purchasers of securities are accredited investors.
The term “accredited investor” in this context refers generally to an individual with a net worth of $1,000,000 and/or income of $200,000 annually. There are other categories of investors that are defined as accredited investors, but for the purpose of this article, we will be referring to individuals who meet the criteria described above.
Under old Rule 506(b), sales to accredited investors are exempt also, but no general solicitations are allowed. However, under that rule, it is only necessary for the issuer to form a “reasonable belief” as to the status of the accredited investor. This exemption stays in place. In contrast, in order to use Rule 506(c), the issuer must “take reasonable steps to verify that all purchasers of the securities are accredited investors.”
In the release implementing the new rule, the SEC emphasized that there could be many ways of taking reasonable steps to verify that an individual was accredited. The SEC also acknowledged that in some cases many steps must be taken while in other cases fewer steps might be necessary. For example, if the offering required a minimum investment of $1,000,000, very few steps would be necessary to confirm that the investor is accredited, because by the very nature of the investment it is highly likely that the investor would be accredited.
The SEC emphasized that the “reasonable steps to verify” standard was intended to be subjective and to be based on reasonable actions in the circumstances. This is a benefit to issuers, because it allows them to take the actions they see fit. At the same time, it is a challenge to issuers, because it creates uncertainty, due to the fact that an issuer never knows for sure if its actions are sufficient to meet the reasonable steps to verify standard.
In an attempt to clarify the issue, the SEC did provide three (3) non-exclusive and non-mandatory methods of verifying that a natural person is an accredited investor. They are as follows:
1. In order to satisfy the income requirement, the SEC recommends that the issuer review IRS forms that report a purchaser’s income for the 2 most recent years and that the issuer obtain a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
2. With regard to whether an accredited investor meets the definition based on his net worth, the Commission recommends that the issuer review the investor’s bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties and with respect to liabilities a consumer report from at least one nation-wide consumer reporting agency.
3. As an alternative to the methods noted above, the SEC recommends that the issuer obtain information from a registered broker-dealer, an investment advisor, a licensed attorney, or a certified public accountant that has made a determination that the investor was accredited within the prior three (3) months, based on either the income requirement or the net worth requirement.
It is important to understand that those steps are not mandatory, but issuers should be careful to include measures that are designed around these suggested methods in order to make their determination and to assure they have taken “reasonable steps” to verify.
These new verification methods will require potential investors to share much more of their confidential financial information with the issuer and those that have worked in this field know that potential investors are generally very reluctant to divulge this kind of information just to be allowed to make an investment. This reluctance could cause a significant barrier to this new type of offering.
The SEC did not elaborate on the types of general solicitations that might be allowed under the new rule, but historically a general solicitation has been understood to mean any type of appeal to persons who are unknown to the issuer. For example, advertising in newspapers and magazines, advertising on the internet, advertising on the television or radio, conducting seminars, and advertising through the mails. Thus, issuers who comply with this rule should have a tremendous advantage over prior Regulation D offerings, because they will be free from the private placement rules that prohibited general solicitations. Of course, it will be incumbent on the issuer to make sure that they meet all the requirements that will allow them to enjoy the benefit of Rule 506(c), and I would encourage them to seek experienced securities counsel to make sure that they meet the necessary requirements. Failure to meet the standards of the rule would mean the exemption is not available and any sale of securities in that case, would be in violation of the registration requirements of the securities laws.