The SEC has finally issued proposed rules that would eliminate the prohibition against general solicitation and advertising in Rule 506 offerings. The proposed rules are good news for startups because they offer broader access to investment capital sources, and the SEC should be applauded for its reasoned and reasonable approach in the new rules.
There was a lot of handwringing and blog ink spilled over what the SEC might do with Section 201 of the Jumpstart Our Business Startups Act (the “JOBS Act”). Recall that the JOBS Act directed the SEC to amend Rule 506 of Regulation D to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities were accredited investors. Section 201 of the JOBS Act went on to require that the SEC’s rules require the issuer to take reasonable steps to verify that the purchasers of the securities were accredited investors, using such methods as determined by the SEC.
I have highlighted some of the most significant quotes and points from SEC Release No. 33-9354 below.
The Highlights of the Proposed Rules
- You can continue to use the existing rules, so long as you don’t generally solicit or advertise an offering.
- The SEC has created a new rule: Rule 506(c).
- Offerings under the new Rule 506(c) don’t have to comply with the prohibition on general solicitation and advertising under Rule 502(c).
- Under new Rule 506(c), general solicitation and advertising are permissible as long as:
- the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors;
- all purchasers of securities must be accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes that they do, at the time of the sale of the securities; and
- all terms and conditions of Rule 501 and Rules 502(a) and 502(d) are satisfied.
- No specific method or methods of verifying accredited status are required under the proposed rules.
- There is no non-exclusive list of specific methods for satisfying the verification requirements included in the proposed rules.
- Instead, the rules will require that “[T]he issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under this Section [506(c)] are accredited investors.”
- Issuers relying on the new rules will have to check a box on the new Form D indicating that they are doing so.
- The new rules do not eliminate the reasonable belief standard. If a person who does not meet the criteria for an accredited investor invests in a generally solicited or advertised offering, the issuer does not lose the ability to rely on the 506 exemption, so long as the issuer took reasonable steps to verify that the purchaser was accredited and had a reasonable belief that such person was accredited.
The Current Rules
If you are not familiar with Rule 506, it is the most utilized securities law exemption by startups in raising capital from angels and venture capital investors. Currently, however, Rule 506 has a hitch that crimps its helpfulness to startups. As currently written, startups cannot generally solicit or advertise their securities offerings and still make use of the Rule 506 exemption. Examples of general solicitation or advertising include “advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars whose attendees have been invited by general solicitation or general advertising.” (Rule 502(c) of Regulation D). The Proposed Rules Thankfully, the SEC has issued proposed rules that will, if adopted as proposed, make it easier for issuers to raise capital. In doing so, the SEC exercised restraint, and should be applauded for doing so.
- “We have considered comment letters received to date on Section 201(a) of the JOBS Act, and we are requesting comment on various issues relating specifically to the proposed amendments described above. In this release, we are proposing only those rule and form amendments that are, in our view, necessary to implement the mandate in Section 201(a). We recognize that commentators have urged us to consider and propose other amendments to Regulation D or to Form D that they believe are appropriate in connection with implementation of the rule and form amendments proposed here. . . . We appreciate the suggestions made by these commentators; however, at this time, we are not proposing these or any other amendments to Regulation D or to Form D.”
If you comply with existing 506 rules, and don’t generally solicit or generally advertise—nothing changes. There are no additional verification requirements. As stated in the proposed rules:
- “[W]e are preserving, under existing Rule 506[(b)], the existing ability of issuers to conduct Rule 506 offerings without the use of general solicitation….In this regard, we do not believe that Section 201(a) requires the Commission to modify Rule 506 to impose any new requirements on offers and sales of securities that do not involve general solicitation. Therefore, the amendments to Rule 506 we are proposing today would not amend or modify the requirements relating to Rule 506.”
But, if you do generally solicit or advertise under the new Rule 506(c), you will have to:
- take reasonable steps to verify that all of the purchasers are accredited investors;
- reasonably believe that all of the purchasers are accredited investors; and
- check a box on the Form D indicating that you are acting pursuant to the rules which allow general solicitation.
What Are Reasonable Steps?
The SEC’s proposed rules are flexible. They don’t mandate a certain, specified list of steps to be taken to verify a person is an accredited investor. Nor do they even provide a non-exclusive list of specific methods for satisfying the verification requirement. Instead, the SEC had this to say:
- “Whether the steps taken are ‘reasonable’ [is] an objective determination, based on the particular facts and circumstances of each transaction.”
- “Issuers would consider a number of factors when determining the reasonableness of the steps to verify that a purchaser is an accredited investor.”
- Some of these example factors would include (these factors are provided by the SEC and discussed in the proposed rules):
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- the amount and type of information about the purchaser; and
- the nature and terms 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.
In sum, the SEC had this to say: “The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa.”
- “An issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer.” [This quote is from the proposed rules.]
Importantly, regarding the often used checked-box or questionnaire filled out by potential investors, the SEC had this to say:
- “In the case of [an issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation], we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.”
- “In the case of [an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer], we believe an issuer would be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification.”
The SEC agrees with commentators that the ability to make an investment of a high minimum investment amount is relevant to the issuer’s evaluation of the type of steps that would be reasonable to take in order to verify the purchaser’s status as an accredited investor.
- “The terms of the offering would also affect whether the verification methods used by the issuer are reasonable. Some commentators have expressed the view that a purchaser’s ability to meet a high minimum investment amount could be relevant to the issuer’s evaluation of the types of steps that would be reasonable to take in order to verify that purchaser’s status as an accredited investor. We believe that there is merit to this view. By way of example, the ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any other third party, could be taken into consideration in verifying accredited investor status.”
About record keeping, the SEC had this to say:
- “Regardless of the particular steps taken, it would be important for issuers to retain adequate records that document the steps taken to verify that a purchaser was an accredited investor. Any issuer claiming an exemption from the registration requirements of Section 5 has the burden of showing that it is entitled to the exemption.”
The SEC should be applauded. They maintained the integrity of existing Rule 506. They didn’t propose rules that would have made Rule 506 substantially more difficult to use. The proposed rules, if adopted after the comment process is completed, will go a long way toward opening up additional capital sources for startups.