In September 2013, Title II of the JOBs Act went into effect. For the first time private companies could lawfully raise investment capital from the public using Social Media to spread the word about the investment. More and more, Social Media is driving the capital raising process for small businesses across the U.S. The enactment of Title II, and the new rules implementing its provisions, have the potential to create a sea change in how private companies raise money.
Prior to enactment of Title II, companies seeking to raise capital through the sale of securities had either to register their stock offering with the Securities and Exchange Commission (“SEC”) or rely on an exemption from registration. Relying on Rule 506 of Regulation D – the most widely-used exemption in the SEC’s rulebook – a company could raise an unlimited amount of money from an unlimited number of “accredited investors” and up to 35 non-accredited investors.
It could not, however, engage in general solicitation or general advertising in offering and selling its stock to investors. The financial services industry has long felt that the ban on solicitation and advertising results in excessive concern about protecting investors who may never actually purchase securities, rather than protecting investors who actually purchase a private company’s stock.
Title II instructed the SEC to revise portions of Rule 506 to remove the prohibition on general solicitation or general advertising of securities offerings that rely on the 506 exemption. Enter Rule 506(c). While still preserving the existing Rule 506 exemption that prohibits general solicitation and advertising, the SEC created Rule 506(c), which allows general solicitation and advertising so long as (1) sales are limited to accredited investors, and (2) the company selling the securities reasonably believes, and has taken reasonable steps to verify, that all purchasers of the securities are accredited investors.
The first step is easy. Rule 501 of Regulation D has long defined an “accredited investor” as a person with: (1) a net worth or joint net worth with her spouse exceeding $1 million at the time of the purchase (excluding the value of her primary residence); or (2) annual income exceeding $200,000 in each of the two most recent years or joint annual income with her spouse exceeding $300,000 for those years (and a reasonable expectation of the same income level in the current year). Nothing has changed in this regard.
The second step is not. Determining the reasonableness of the steps taken by a company to verify whether a purchaser is an “accredited investor” is a much tougher question. It’s a new requirement with no regulatory history to fall back on and no clear safe harbor to rely on if an investor is not “accredited” and is somehow harmed by the transaction. Not surprisingly, this new requirement has left many companies seeking to raise money via Rule 506(c)’s new exemption scratching their heads wondering how to comply.
When taking steps to confirm the status of a prospective investor, according to the SEC, a company is required to consider the facts and circumstances of each purchaser and the transaction. Not exactly a picture of clarity. In fact, there has been so much confusion among the financial services industry and private company clients seeking to raise money that the SEC’s final rule included a non-exclusive list of methods that companies can use to satisfy the verification requirement for individual investors.
The methods include, among other things, (1) reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year; and (2) receiving written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that the company has taken reasonable steps to verify the purchaser’s accredited status. Other verification methods will no doubt develop overtime, but only time, and perhaps further regulation by the SEC, will determine whether the Commission staff will accept those methods as legitimate.
The existing provisions of Rule 506 – that pre-date Title II and operate as a separate exemption – are not affected by the revised final Rule 506(c). Companies that conduct Rule 506 offerings without the use of general solicitation or general advertising can continue to conduct securities offerings in the same manner they always have, and are not subject to the new verification rules.
Through March 2014, six months after the new Tile II rules were passed, the SEC reported that only 900 companies had used the new 506(c) exemption to raise $10 billion in new capital. Compare that to over 18,000 Regulation D filings in all of 2012 to raise $900 billion in new capital.
The biggest hurdle to widespread adoption of 506(c) offerings centers on the extra step that companies must take to verify the “accredited investor” status of purchasers, as well as some hesitation among startup companies and their lawyers who have not yet dealt with a 506(c) offering. In practice, however, we have seen little pushback from investors when asked to provide the necessary documentation, and the SEC presented a number guidelines that make clear investors do not have to turn over sensitive information.
Despite the fact Congress enacted the JOBS Act almost three years ago, the last word has clearly not been written about the impact of relaxing the prohibition on general solicitation and general advertising of private securities.