New Rule 506(c): General Solicitation of Investor Capital Without SEC Registration is on the Way

As most folks are aware back in April, 2012 Congress passed and President Obama signed the “Jumpstart Our Business Startups Act” (the JOBS Act). One of the most notable and controversial sections of the JOBS Act was §201(a) wherein Congress told the Securities and Exchange Commission (the SEC) to amend Rule 506 under Regulation D to permit startup companies to use general solicitation and advertising in order to raise investment capital from the public. The only caveat being that sales could only be made to “accredited investors” (as defined in Rule 501(a) of Regulation D) whom the issuer had taken “reasonable steps to verify” were in fact accredited investors.

For those of us practicing in the securities field, this mandate by Congress represented a sea change for the SEC. Never before has an issuer been allowed to use general solicitation (ie internet, web sites, advertisements, etc.) seeking investment capital from potentially hundreds of people without first submitting a complete disclosure document (a prospectus) which was reviewed by, commented upon and (hopefully) eventually allowed (ie declared effective) by the SEC staff in the Division of Corporation Finance. Having worked for several years in this Division many (too many) years ago, I can attest to the thorough review and the many “comments” issued by the Staff requesting changes to a prospectus before it was declared effective and the not insignificant number of proposed prospectus’s that never satisfied the “full and fair” disclosure standard required by the SEC and were ultimately withdrawn. Reviewing these proposed public prospectus’s was the bread and butter of the Corp. Fin. Division and it’s what we spent the majority of our time doing. It also represented one of the most important functions performed by the SEC.

So when Congress decided to require the SEC to allow an issuer to utilize general solicitation to raise capital without preparing or filing a complete prospectus for the SEC Staff to review and clear, you can imagine the concerns and angst of the SEC Staff. This concern was justified in view of the fact that the expected (indeed targeted) primary users of this new exemption would be relatively new, startup companies in which the risks of failure are always substantial. From the beginning of the SEC back in 1934, public offerings of securities had always been filed with and reviewed and cleared by the SEC. This procedure was deemed fundamental to the SEC’s mission of protecting investors. Now I’m not criticizing the mandate from Congress to implement a new, faster and certainly less expensive way for startup and emerging companies to access investment capital which is the life-blood of any new enterprise. Infact, many of my small to medium size business clients can’t wait to give it a try. However, from the SEC’s point of view, this was unheard of before so, understandably, the SEC did not rush to implement these changes. Infact, the SEC was told by Congress to propose new rules for implementation of this new offering concept by July 5, 2012 but, not surprising, the SEC did not issue proposed rule changes until August 29, 2012. And did not adopt final rule changes, after considerable debate and controversy, until July 10, 2013. Not surprising, upon her confirmation as the new SEC Chairperson, Mary Jo White promised Congress that her first priority would be to respond to the various congressional mandates gathering dust over at the SEC.

The new provisions of Rule 506 will now go into effect on September 23, 2013. New Rule 506(c) will allow issuers to use public solicitation and advertising to raise as much capital as they want from as many investors as they want so long as all investors are accredited investors. There is no requirement for review of the offering by the SEC or any State Securities Agency. Infact, there is no disclosure/prospectus requirement at all.

However, the issuer will be required to take “reasonable steps” to verify that each purchaser in the offering is in fact accredited. This requirement now shifts the burden of determining accreditation to the issuer, not the investor. In the traditional Rule 506 private placement, an issuer could require and rely upon basic investor representations of accreditation such as whether the investor qualified by income, net worth or affiliation with the issuer and some basic representations as to the amount and source of income or net worth. Furthermore, if the representations were incomplete or false, it would be the investor’s fault.

Under the new verification requirements of Rule 506(c)(2)(ii), the “reasonable steps” will require much more such as obtaining 2 years of tax returns to substantiate an investor’s income or written confirmation from an investor’s financial advisor, attorney or CPA to substantiate his/her net worth. Furthermore, if a non-accredited investor does manage to participate in a Rule 506(c) offering, the SEC will hold the issuer responsible unless the issuer can show it met the “reasonable steps” standard of care and show that the investor (or his/her agents) knowingly submitted false or misleading information to support his/her accredited status. This is obviously a far cry from the previous reliance on simple investor representations in a subscription agreement. The SEC has stated its position that a sale to a non-accredited investor will not automatically prevent reliance on Rule 506(c) so long as the issuer took reasonable steps to verify the purchaser’s accredited status and had a reasonable belief that such purchaser was an accredited investor at the time of the sale. However, if an issuer loses its Rule 506(c) exemption for any reason, then, unlike a traditional Rule 505 or 506 private placement exemption, there are no statutory exemptions like Section 4(a)(2) of the Securities Act of 1933 (the “1933 Act”) to fall back on. Selling securities publicly without registration with the SEC or an available exemption (like Rule 506(c)) is a violation of Section 5 of the 1933 Act and a really bad way to start off an issuer’s capital raising efforts.

Perhaps the biggest concern for me is the absence of any required disclosure. I have heard commentators tout the fact that New Rule 506(c) will reduce the burden of preparing disclosure documents and the expense of hiring securities attorneys. Not surprisingly I disagree. As a securities practitioner, my role has always been twofold; first to assist my client in successfully raising capital and second to make sure my client can keep the proceeds despite how bad the business might eventually turn out to be.

A comprehensive and understandable disclosure document (let us call it a “general placement memorandum” or “GPM”) is invaluable in describing an issuer’s business, management, use of proceeds and the company’s potential for success as well as candidly describing the risks that the company’s business could face. This GPM is the backbone of any securities offering and allows the each purchaser the ability to make “an informed investment decision” which is the goal, indeed the mandate, of any successful securities offering. Without the benefit of SEC review and clearance of such disclosure document, having an experienced securities attorney assist with its preparation becomes more important than ever.

Secondly, in those cases where an issuer falls short of its performance expectations or fails altogether, unhappy investors will usually look for some basis to demand their money back, most often claiming that the issuer omitted material information in the offering disclosures or somehow mislead the investor with the information the issuer did provide. It is in these circumstances that a complete and candid (ie disclosed risk factors) GPM becomes a godsend to refute any such allegations. As I often tell clients preparing to raise investor capital, if you fail or fall short of expectations, so long as the reason is due to one of the disclosed risk factors, they may encounter many problems but a securities law violation should not be one of them. Hence the adage that a well drafted GPM is both a selling document and an insurance policy.

I would also point out two final aspects of Rule 506. First, the entire Rule 506 is now subject to a “Bad Actor” provision (new Rule 506(d); similar to Rule 262 of Regulation A) whereby any issuer having an executive officer, director of a corporate issuer or manager of an LLC issuer, or a 20% owner of the issuer, who has been convicted of certain crimes, become subject to certain judicial orders or suspended from certain securities activities will not be eligible to use the Rule 506 exemption for either a private or public placement.

Lastly, an issuer using Rule 506 will still be required to file a Form D with the SEC within 15 days after the first sale in an offering. This would include filing the Form D in each state in which sales are anticipated and the issuer is asserting reliance on federal Rule 506 for compliance with that state’s blue sky regulations.

It will be interesting to see how many issuers choose to use new Rule 506(c) and how receptive investors will be to this new public capital raising technique. As always, feel free to contact me if you would like to discuss the changes to Rule 506 further.

Article by Roger D. Linn © Barnett & Linn