[author: David Jenson]
Section 201(a) of the JOBS Act directed the SEC to amend Rule 506 of Regulation D in order to allow for the use of general advertising and general solicitation in Rule 506 offerings in which all of the purchasers were accredited investors.
On August 29th, the SEC proposed amendments to Rule 506 to carry out the direction of the JOBS Act through new Rule 506(c). Rule 506 offerings are a central component of equity financing in the U.S. Rule 506 offerings accounted for an estimated $895 billion in capital raised in the U.S. in 2011, compared with $984 billion raised through registered offerings. The 2010 estimates are $902 billion from Rule 506 offerings and $1.07 trillion from registered offerings. And the estimates of the amount of capital raised in Rule 506 offerings are most certainly low, since they were compiled based on a review of Form D filings, which in some cases need not be amended to report additional sales. For more on the importance of private offerings in the U.S., take a look at some of our previous coverage. Whereas in the past, an issuer conducting a Rule 506 offering was prohibited from using any means of general solicitation or advertising to attract purchasers (such as open invitation seminars or publicly distributed advertisements), after the implementation of proposed Rule 506(c), you may see advertisements for private investment opportunities in magazines and newspapers, all over the internet, or on billboards.
With the importance of Rule 506 and the magnitude of this proposed change in perspective, here are some of the take-aways from the SEC’s proposing release (if you want a little more background on Rule 506 and accredited investors, scroll down first).
Proposed Rule 506(c)
Proposed Rule 506(c) provides that, in order for an offering that makes use of general solicitation or general advertising to qualify for exemption from registration under Rule 506 of Regulation D, all of the purchasers must be accredited investors, and the issuer must “take reasonable steps to verify that purchasers of securities . . . are accredited investors.” The additional requirements in Rule 506(c) apply only to those offerings that make use of general solicitation or advertising, and they do not affect an issuer’s ability to conduct Rule 506 offerings without the use of general advertising or solicitation, just as before.
Reasonable Belief in Accredited Investor Status
Rule 501(a) defines an accredited investor, in part, as a person “who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories” (my emphasis). Section 201(a)(2) of the JOBS Act, which directed the SEC to adopt an amendment to Rule 144 under the Securities Act, specifically made reference to a “reasonable belief” standard for determining whether a purchaser is a qualified institutional buyer, yet Section 201(a)(1) of the JOBS Act, relating to Rule 506, did not expressly use the term “reasonable belief.” This led some to wonder whether the “reasonable belief” portion of the accredited investor definition was being eliminated. The SEC answers in the proposing release that the reasonable belief component to the accredited investor definition is not, in fact, being eliminated:
“In our view, the difference in the language between Section 201(a)(1) and Section 201(a)(2) reflects only the differing manner in which the reasonable belief standard was included in the respective rules at the time they were adopted, and does not represent a Congressional intent to eliminate the existing reasonable belief standard in Rule 501(a) or for Rule 506 offerings.”
Reasonable Steps to Verify Accredited Investor Status
While the SEC’s proposing release does not provide a clear definition or standard for how an issuer can demonstrate that it has taken “reasonable steps” to verify that all of the purchasers in a Rule 506(c) offering are accredited investors, the release does provide some helpful insight into how the SEC will likely interpret this flexible standard:
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There is no set definition or objective test for what steps would constitute “reasonable steps” in any given transaction or situation. The SEC describes it as a flexible test that depends on the facts and circumstances of each transaction.
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The SEC envisions that a number of factors would be taken into consideration in determining whether the steps taken by the issuer were “reasonable” under the circumstances, including:
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the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
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the amount and type of information that the issuer has about the purchaser; and
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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.
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Steps that might be reasonable in one situation would not necessarily be reasonable in another.
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The SEC seems to be indicating that verification from a third party source – such as a broker dealer or accountant who the issuer has a reasonable basis for believing – or through the production of documents – like W-2s or public securities filings or FINRA BrockerCheck – are preferred over representations directly from the purchaser. Without more, a purchaser’s representation of accredit investor status would be insufficient to meet the “reasonable steps” standard.
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The proposing release makes reference to the probable rise of offering portals in footnote 53: “For example, in the future, services may develop that verify a person’s accredited investor status for purposes of proposed Rule 506(c) and permit issuers to check the accredited investor status of possible investors, particularly for web-based Rule 506 offering portals that include offerings for multiple issuers.”
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In footnote 51, the SEC explains that in some cases, an issuer may be able to satisfy Rule 506(c) without taking any steps; in other words, in some cases, “reasonable steps” may consist of not taking any steps: “If an issuer has actual knowledge that the purchaser is an accredited investor, then the issuer would not have to take any steps at all.”
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The fact that a purchaser is able to meet a high minimum investment amount without third party financing is a factor that could be used to reasonably verify accredited investor status, and in appropriate cases could, taken alone, be sufficient to demonstrate that the issuer took reasonable steps to verify accredited investor status.
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An issuer should retain “adequate records that document the steps taken” to verify accredited investor status, since the issuer has the burden of proving that it is entitled to the Rule 506(c) exemption.
Additional Background on Regulation D and Accredited Investors
Generally, sales of securities must be registered under the Securities Act, unless an exemption from registration applies. Section 4(a)(2) of the Securities Act contains an exemption for transactions “not involving any public offering.” Rules 501 through 508 under the Securities Act, which are known as Regulation D, provide a safe harbor in connection with a use of the private offering exemption. While complying with the requirements of Regulation D are not the only way to take advantage of the private offering exemption, Regulation D provides certainty to issuers that if they meet its requirements, the offering is exempt as a private offering. There are actually several different ways in which offerings can qualify for the Regulation D safe harbor. One way is through Rule 506, which allows an issuer to sell an unlimited amount of securities to an unlimited number of purchasers who are accredited investors, and up to 35 purchasers who are not accredited investors but who meet a certain threshold of investment sophistication, provided that the terms and conditions of Rules 501 and 502 are also satisfied.
An “accredited investor” is an investor that falls into 1 of 8 categories set forth in Rule 501(a), including a bank, a private business development company under the Investment Advisers Act of 1940, a tax exempt organization with at least $5 million in assets, and certain natural persons who have a net worth of at least $1 million, or who had an annual income of at least $200,000 individually, or at least $300,000 together with a spouse, in each of the last two years. In the past, a person could count the value of a primary residence towards the $1 million net worth threshold. However, Section 413(a) of the Dodd-Frank Act provided that the value of a person’s primary residence could no longer be counted for purposes of the net worth calculation.
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