The SEC, Accredited Crowdfunding, And The Art Of Hair Splitting
Summary of Remarks of Joe Wallin to Section 201 of the JOBS Act Given at a Presentation to the Angel Capital Association, Northwest Regional Meeting, held in Seattle, Washington, on May 2, 2012.
Last week I spoke on a panel with Dan Rosen,Tom Alberg, William Carleton and Gary Kocher at the Northwest Regional Meeting of the Angel Capital Association.
I put together these materials as a guide to my remarks. After I prepared them, the Federal Regulation of Securities Committee of the Business Law Section of the American Bar Association (ABA) submitted its comments to the Securities and Exchange Commission (SEC) on Section 201 of the JOBS Act. I have added excerpts from the ABA Committee Letter where helpful to understanding the material.
What Section 201 requires:
The JOBS Act (the “Act’) requires the SEC, not later than 90 days after the enactment of the Act, to revise its rules under Rule 506:
- To provide that the prohibition against general solicitation or general advertising contained in Regulation D (Reg D) does not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers are accredited.
- The new rules must require the issuer to take “reasonable steps to verify” that purchasers are accredited, “using such methods as determined by” the SEC.
The law is quoted below:
Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).
- To issue the new rules, the SEC will look at the text of the JOBS Act and is likely going to look at the legislative history so that it can turn what it believes to be Congress’ intent into rules and regulations.
- Title II of the JOBS Act allowing general solicitation doesn’t say “provided that the issuer reasonably believes that all purchasers of securities are accredited investors.” It says “provided that all purchasers of securities areaccredited investors.” It is unclear if the SEC will emphasize this difference in language in its rulemaking.
- Contrast this with the existing rules under Rule 506. Those rules say: “Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories…”
- The current practice in accredited investor offerings now is to have investors certify that they are accredited, and depending who they are–have them initial or check a box next the definition that they fall within.
- The ABA Committee letter recommends that the SEC’s proposed rules or accompanying release include a reasonable belief standard.
The SEC is allowing the public to comment on how the SEC should implement the provisions of the JOBS Act before it proposes the new rules. Comments are accessible to the public.
- Professor William K. Sjostrom, a Professor of Law at the University of Arizona made the following argument, which I believe the SEC should accept:
“I believe it is critical that the Rule allow general solicitation and advertising provided that the issuer REASONABLY BELIEVES that all purchasers are accredited investors. If instead the Rule requires all purchasers to be accredited investors, I suspect that many issuers will forgo engaging in general solicitation and advertising out of concern of destroying the exempt status of their offerings by selling to an investor whom they reasonably believed was accredited but turns out not to be.” (http://sec.gov/comments/jobs-title-ii/jobstitleii-1.htm)
- Other commentators have also argued that anything more than the current practice of collecting accredited investor certifications would be too burdensome on companies. A comment from a law firm states:
“[T]he current practice to assure the securities purchasers … are accredited investors is … an investor suitability evaluation on all the subscribed investors. Only basic self-certificated information is provided in this process. We believe the current practice of providing a suitability questionnaire is sufficient to fulfill the issuer’s duty to assure the … investors are accredited. It would be rather onerous for … securities issuers to request tax returns, bank statements, and financial information to verify the self certification…” (http://sec.gov/comments/jobs-title-ii/jobstitleii-5.pdf )
- The ABA Committee Letter takes a similar tact:
”In setting forth the reasonable sets to be taken to verify that the purchasers of the securities offered by means of general solicitation or general advertisement in Rule 506 offerings are accredited investors, the proposed rules should reflect current custom and practice.”
What was the intent behind the statute?
The language requiring the SEC to pass rules requiring issuers to take steps to verify that they are selling to accredited invested was added in the mark-up session on H.R. 2490, as amendment no. 1 to that bill.
In the transcript of that committee mark-up session, the following argument was made for adding the verification language:
This amendment would clarify that the SEC shall write rules to require that the issuer of a security, using the exemption provided for under this bill shall take reasonable steps to verify their purchases of the securities are accredited investors using such methods as determined by the commission.
Mr. Chairman, I understand that lifting the ban on general solicitation and general advertising on private offerings may make sense that those offerings are only sold to accredited investors. We know that because of their wealth or their level of sophistication, accredited investors are not in need of as many investor protections as the average retail investor.
And we know that with the current prohibition on solicitation and advertising it can be tough for a company to connect with accredited investors who may be interested in investing in their company.
But I am concerned about the process in which accredited investors verify that they are in fact accredited. As I understand it, it is currently a self-certification process. This obviously leaves room for fraud.
In testimony from the North American Securities Administration Association the state securities commissioner from Arkansas notes it is going to be impossible to limit the sale to only accredited investors when issuers advertise to everyone. Indeed, there will be no reason to believe that any investor seduced by public advertising will hesitate to be dishonest with completing the investor suitability questionnaire.
That is why I have offered this amendment. My amendment would require the SEC when issuing a rule to provide for the exemption under Representative McCarthy’s bill to include a provision mandating that issuers take reasonable steps to verify investor status as an accredited investor.
If we are rolling back protections for our targeted audience of sophisticated individuals, we must take steps to ensure that those folks are in fact sophisticated.
If this argument is going to inform the SEC’s rulemaking on this subject, and if the SEC believes that this is what the legislative history indicates should inform the rulemaking, then it is unlikely we are going to see a continuation or retention of a check-the-box or questionnaire regime for advertised offerings. However, for non-advertised offerings, perhaps the old regime can continue. And in fact, the argument can be made that it should continue because if there is no advertising then the heightened risk which prompted these verification processes be added won’t exist. Of course, it remains to be seen whether the SEC will require verification in just offerings in which there is general solicitation, or all offerings.
The ABA Committee letter makes a good argument–that the purpose of the JOBS Act is to encourage and support capital formation, and “any requirement that imposes additional burdens on issuers or on purchasers would contravene the fundamental impetus for the JOBS Act.”
What are the stakes?
- The standard that issuers will need to meet to engage in an exempt offering is important because presumably under the new JOBS Act scheme, if you advertise your offering and then inadvertently accept a non-accredited investor, then you will not be able to fall back on Section 4(2) to avoid registration because you will have engaged in a public offering. This raises the stakes considerably on the determination of whether an investor is accredited or not.
- The new rules regarding “reasonable steps to verify” have the potential of being very onerous on companies trying to raise capital. This has arguably been the trend in SEC rulemaking. For example, the SEC’s recent rules on the bad actor disqualification are lengthy and complex and impose onerous due diligence burdens on issuers.
- Lily Brown, Senior Special Counsel to the Director from the SEC’s Division of Corporation Finance, said in a recent web conference that issuers will likely have to do more than have investors check the box or fill out a questionnaire. We won’t know what this means until rules are issued.
- Presumably this means that issuers are going to have to request documentation from investors demonstrating their incomes or net worth, such as tax returns, net worth statements prepared by third party accountants, bank statements, brokerage account statements, etc.
- We also won’t know whether issuers will be able to rely on the old rules as long as they don’t advertise, or if the new SEC rules will apply whether issuers advertise or not.
- For now, the current rules are still in effect. Meaning, you can’t advertise or Twitter or LinkedIn your offerings yet.
If you want to write a comment to the SEC on these rules, I’d suggest the following comments:
- The new rules should make clear that the issuer only has to “reasonably believe” that all purchasers are accredited investors.
- The current practice of having an investor certify in a questionnaire that they are accredited, after having been given the definitions of accredited investor, is sufficient to fulfill the issuer’s duty to assure that investors are accredited.
- If the SEC is going to require documentation from investors to show that they meet the net worth or income tests, tax returns from the last 2 years should be sufficient to prove the income tests are met. Similarly, a net worth statement prepared by a third party accountant should be sufficient to demonstrate the net worth test has been met.
- If the SEC is going to require documentation from investors to show that they are accredited, the SEC should not require this in offerings in which there is not advertising.
- The new rules should make clear that, if an issuer obtains evidence that an investor is accredited, the issuer can rely on that for a reasonable period of time (e.g., a year or two).
- If a company raises money in a convertible debt offering from investors who provided sufficient information that they are accredited at the time that they invested, the company should not have to obtain updated information from the investor on conversion of the note into stock.
- In general, the SEC should create a safe harbor to the effect that an issuer can rely on the information provided by investors and, if company acts reasonably, the exemption is in place.
For More Information:
- DESPITE THE JOBS ACT, THE OLD RULES STILL APPLY FOR NOW
- MY FAVORITE PART OF THE JOBS ACT
- THE PRESIDENT FAVORS CROWDFUNDING, BUT IS IT GOOD ENOUGH?