Under present rules, entrepreneurs may not use the Internet, or even less powerful methods of mass media, to seek investors in their offerings. Under a proposal made August 29, 2012 by the Securities and Exchange Commission (the “SEC”), mass media would become available to them – with drawbacks.
In the May 2012 issue of Enterprise, we noted that the JOBS Act, among many provisions, directed the SEC to develop a rule allowing entrepreneurs to offer their securities without the present prohibition on “general solicitation.” “General solicitation” means use of mass communications, e.g., the Internet, mass mailings, telephone campaigns, newspaper advertisements, etc. The SEC on August 29, 2012 issued its proposed Rule 506(c), effectively creating a new offering method by elimination of the present ban on general solicitation.
This is only a proposal, but there will be a new rule allowing general solicitation, and past history shows that a first SEC proposal tends to be very close to, if not identical to, the rule finally adopted.
Under present exemptions from the federal requirement to register with the SEC (essentially impossible for entrepreneurs) in making offerings of their securities, even to accredited investors, companies may only contact persons with whom they have a pre-existing relationship or, according to most authorities, may contact only a small number (in the range of five to, say, 35, prospects) in one-on-one meetings or in very small private gatherings. Also, under the present most available exemption, the Rule 506 “accredited investor” exemption, the issuing company “must have reasonable grounds to believe, and believe, that the purchaser is accredited.”
The JOBS Act, and Rule 506(c) as proposed by the SEC, will allow the use of general solicitation, including offerings on the Internet. However, Congress in the JOBS Act required that the new Rule require the company “take reasonable steps to verify” that each purchaser is accredited.
Note the differing language between the present law and the JOBS Act: “having reasonable grounds to believe” a purchaser is accredited (present law) and “taking reasonable steps to verify” accredited status” (JOBS Act). Much speculation arose over whether the SEC in its rule would impose additional truly burdensome requirements on companies based upon the new word “verify.”
In its proposal of August 29, it is probable the SEC has required significantly more effort by the issuing company to “verify” the accredited status of the investor if general solicitation is to be used, than it requires for simple “reasonable grounds to believe” accredited status if the company does not propose to use general solicitation.
In their use of the presently existing exemption, that is, when not using general solicitation, most securities attorneys meet the “reasonable grounds to believe” requirement by simply having prospective investors complete “suitability questionnaires” describing their net worth and/or income, sometimes with simply a box to be checked indicating their net worth or income satisfy the requirement. Most issuers and their attorneys simply take the word of the investor, and the SEC and other regulators have generally not required further action.
The SEC’s new Rule 506(c) simply repeats the language of the JOBS Act itself, stating only “the issuer shall take reasonable steps to verify that purchasers of securities (under this new rule) are accredited investors,” without stating what actions will constitute sufficient “verification.” Its 69-page release, however, which cannot be covered in detail here, requires the company to determine what steps will constitute “verification” (and hope that juries, judges, the SEC and other regulators in future litigation will agree). The SEC release gives these companies only “factors to consider” in making that determination, which factors are (1) “the nature of the purchaser,” (2) “the amount and type of information which the company has about each purchaser,” and (3) “the nature of the offering.”
And in requiring the company to “consider” the “nature of” and “the information it has about” the purchaser, the SEC’s release implies that the company should require prospective investors to provide documents, such as net worth statements, tax returns, W-2 forms, and/or pay stubs to establish their net worth or income. The SEC makes that suggestion even though it admits “the privacy concerns” which such investors may have.
The release, in requiring consideration of “the nature and terms of the offering,” states, as an example, that a company will be required to exert more effort to “verify” the accreditation of purchasers who are solicited through ads in publicly available websites or social media than those solicited from databases of investors already pre-screened and determined to be accredited by, say, registered broker-dealers. (Of course, the latter method would probably not actually involve “general solicitation” anyway – author’s opinion.) Having investors in an Internet or social media offering just check a box would not be sufficient verification, but (by implication) it would for sales to the pre-screened investors.
These comments, and others throughout the lengthy release, indicate to this writer that the SEC intends that some discernible added effort by the company to actually verify the truth of representations made by prospective investors in offerings in which investors are individual natural persons. Probably the SEC also expects that a body of practice will develop over the first few years of implementation which will better define and quantify the appropriate requirements. The SEC’s release does not indicate how robust the SEC’s enforcement will be during the interim period.
The release also reminds entrepreneurs that, if sued by regulators or aggrieved purchasers, the entrepreneur has the burden of proof, i.e., must prove the existence of facts establishing the exemption (the claimant need only show there was no registration with the SEC – an easy showing). Therefore, the company is well advised “to retain adequate records . . . (of) the steps taken . . . .”
Another interesting question, not addressed by the SEC, or even by the numerous bloggers on this topic, is how this amended rule will be received by state securities law officials. Most states have exemptions from their own registration requirements based upon compliance by the issuing company with Rule 506. Whether and how compliance with new Rule 506(c) will comply with state law remains to be addressed.
Attorney Joseph R. Soraghan practices in legal matters pertaining to business operations and growth. He guides businesses in financing, contracts, acquisitions, mergers, and sales. Soraghan frequently resolves commercial disputes as an arbitrator or mediator, or through litigation.
Posted by permission from Missouri Venture Forum, Enterprise, October 2012