On September 23, 2013, the amendments to Rule 506 of Regulation D under the JOBS Act (Jumpstart Our Business Startups Act) became effective following the adoption of implementing rules by the Securities and Exchange Commission (SEC). These amendments lift the longstanding ban on general solicitations and advertisements to accredited investors. As a result, companies can now pitch their private investment opportunities to accredited investors through newspaper, television and website advertisements, and other previously prohibited means, if they comply with certain requirements. This change will significantly increase the number of potential investors for small businesses and start-up companies.
BACKGROUND OF RULE 506
In general, when a company raises money by offering investments in its securities, including its equity or debt, it must register the offering under federal law and any applicable state securities laws unless exemptions from registration are available. Non-public companies normally seek to avoid registration under securities laws because the costs of compliance are prohibitive. They will most commonly rely on Rule 506 of Regulation D under the Securities Act of 1933, also known as the “private placement exemption,” as the exemption from federal registration. Under Rule 506, companies will typically issue their securities only to persons and entities that qualify as “accredited investors.” An accredited investor is one who is assumed, by virtue of the investor’s financial position, sophistication and/or relationship with the company, to be capable of obtaining the information necessary to evaluate the benefits and risks of the potential investment.
Rule 506 is an attractive exemption to companies issuing securities (“issuers”) because it does not mandate disclosures of detailed financial and other information when the offerings are limited to accredited investors. Thus, it greatly reduces the costs of compliance. Rule 506 also has the advantage of preempting substantive regulation of the offering by state governments. Prior to the JOBS Act amendments, the main drawback of Rule 506 was that it banned issuers from generally soliciting or advertising their offerings to accredited investors. Unless issuers hired an intermediary (such as a registered broker-dealer) to find investors, Rule 506 effectively limited their pool of accredited investors to their preexisting contacts and /or those who were active in their local area.
AMENDMENTS TO RULE 506
Rule 506 has now been amended to add a new provision – Rule 506(c) – which allows issuers to engage in general solicitations and advertisements to accredited investors, provided that the following conditions are met: (1) the issuers take reasonable steps to verify that the purchasers of their securities (“purchasers”) are accredited investors; (2) the purchasers are, in fact, accredited investors; and (3) the terms and conditions of the other applicable rules have been satisfied.
The most challenging requirement for issuers is to ensure they are taking reasonable steps to verify their purchasers accredited investor status. Issuers can choose from a list of four specific methods established by the SEC in order to satisfy the verification requirement. Alternatively, issuers can use a general principles-based approach to fulfill the same requirement.
PRESERVATION OF THE OLD RULE 506
Certain companies may decide that it is not worth the additional time and expense to comply with the verification requirement of Rule 506(c). It is important to note that these companies can still utilize the exemption under the old Rule 506 (which is now codified as Rule 506(b)) when raising money. Under Rule 506(b), they can still offer securities to accredited investors without any mandatory disclosure requirements as long as they refrain from general solicitations and advertisements.
POTENTIAL BENEFIT OF THE AMENDMENTS
Rule 506(c) may encourage more companies and investors to become involved in private offerings. Some companies have been deterred from private investment offerings in the past because they did not want to hire registered intermediaries to locate accredited investors. In addition, the SEC estimates that over 8 million households qualify as accredited investors, but only a few hundred thousand of them have invested in private offerings. General solicitations and advertisements could open up the investment market to a wider range of companies and accredited investors.
POTENTIAL CAUSES FOR CONCERN
The SEC has already proposed additional rules that may limit the benefits of Rule 506(c) and/or increase the costs of compliance. For example, these proposed rules would require issuers to submit their general solicitation materials to the SEC and would increase the Form D exemption notice requirements. In addition, the SEC adopted “bad actor rules,” prohibiting convicted felons and other bad actors from participating in Rule 506 offerings under either the old rule or the new rule, concurrently with its rules regarding the JOBS Act amendments. To ensure that your company is complying with the requirements of Rule 506, you should consult with an attorney prior to offering any investment to prospective investors. For more information, please contact Mark W. Klein (mklein@brodywilk.com).