September 23, 2013 marked the day when the United States
(and I emphasize just the United States) lifted its historic 80 year
old ban on issuers/entrepreneurs being permitted to generally
solicit and market their exempt or unregistered securities. This
applies to investments where only Accredited Investors ultimately
invest in the financing.
Referred to as a ‘506(c) offering under Regulation D of the
1933 Act’, Title II of the JOBS Act was passed into law with
bi-partisan support in Congress and signed into law by the
President on April 5, 2012. The SEC finalized and approved its
rules with respect to Title II on July 10, 2012 (by a strong 4-1 vote
of the SEC Commissioners) and set September 23, 2013 for the
commencement of this new era in the U.S. securities industry.
I believe that the impact and importance of 506(c) is very
significant to issuers and enhances their ability to approach
investors to raise private capital without the necessity of becoming
a public company. Going forward, in emails and social media,
at cocktail parties and pitch competitions, and in news programs
and on radio, issuers will be inundating the peace and quiet of
Americans to seek their investment.
Prior to the approval of the 506(c) exemption, issuers relied on
other available exemptions including 506(b) however this had two
significant differences: (i) issuers could only communicate their offer
of securities to investors with whom they had a “pre-existing and
substantial relationship” – meaning “No General Solicitation”; and (ii)
investors were able to “self certify” that they satisfied the statutory
requirements for being Accredited Investors without the issuer
having to take any independent steps to verify the accreditation.
The new obligation of issuers to undertake “reasonable
steps” to verify the Accredited Investor status of an investor is
fundamental to a 506(c) offering being respected by regulators
as a legitimate exempt offering - failure to take such action may
jeopardize the exemption. The SEC has published principal-based
guidelines for what constitutes “reasonable steps” which may, and
probably will, differ investor by investor and include the use of tax
returns and certifications by accountants, bankers and lawyers.
Issuers must now seriously consider with their advisors,
lawyers and bankers, whether to avail themselves of the increased
marketing flexibility afforded by 506(c) or seek to comply with the
traditional means of effecting an exempt offering under 506(b).
Although the analysis is more complicated and nuanced, the
essence of the statutory trade off is to decide whether to market
publicly under 506(c) and cast a wider net to attract as many
potential Accredited Investors as possible albeit by accepting
responsibility of verifying whether all such investors qualify
financially. Or the more traditional alternative of limiting the
offering to those investors with whom the issuer has “pre-exiting
and substantial relationship with” but be permitted to rely on their
representations that they meet the Accredited Investor standards
without having to take “reasonable steps” themselves.
Issuers using the service of registered broker dealers may
benefit from the pre-existing and substantial relationship that
these regulated entities have in place with their account holders.
I caution readers that even once they have familiarized themselves
with the rules and consulted their advisors, I believe that the
interpretation of these rules is critical to understanding how to
proceed and believe that each issuer should tailor its approach
based upon its own risk tolerance-- once size will not fit all.
While it has been argued by many institutional and angel
networks that there needs to be clearer guidance, we want to
emphasize to issuers that a “principal based analysis” is employed
by regulators specifically to allow them to apply their judgment
in hindsight to each fact pattern to determine if reasonable steps
were taken, rather than being limited to an absolute safe harbor.
I also want to point out that even for issuers and placement agents
that decide to avoid the benefits and responsibilities of general
solicitation under 506(c), market participants seeking to pursue such
traditional 506(b) exempt transactions ought to be more sensitive
to novel issues that previously might not have been considered by
regulators to be activities which violate 506(b). To wit, the use of
pitch competitions and social media contemporaneously with a
506(b) financing. Keep in mind, if it is deemed that the issuer isn’t
eligible for a 506(b) for whatever the reason, even by a regulator
after the fact, it is nearly impossible (but not actually impossible) to
demonstrate that the issuer took the necessary reasonable steps to
verify, since in all likelihood, the issuer probably only obtained self-certification from the investor as to their accreditation and will have
no third party verification to draw upon.
There is concern about the subject nature of the interpretation of
what is, and isn’t acceptable activity in and around a 506(b) offering.
That is key if you want to avoid being deemed to have generally
solicited investors and to have undertaken the reasonable steps under
506(c) to verify an Accredited Investors status. These judgments will
be in the hands of regulators, probably enforcement lawyers and not
corporate finance professionals, who will be reviewing the history
of the transaction only after investors have lost money and have
complained – and their views will vary state by state.
I have not discussed the disclosure obligations of an issuer
conducting either a 506(b) or 506(c) offering I do want to emphasize
that all offerings are subject to both Federal and State anti-fraud
laws and I recommend seeking the advice of counsel on how to
satisfy these. Like any new approach, this lifting of the marketing
ban is a substantial departure from what has been permissible in
the U.S. for decades. There are new choices now and with them
come perils which need to be fully appreciated and analyzed. In
the end there is no doubt that more entrepreneurs will have greater
access to the investing public and a higher probability of achieving
their capital raising goal.
For more information contact:
Douglas S. Ellenoff