Yesterday, the SEC proposed rules to implement Section 201(a) of the JOBS Act, which mandates the elimination of the prohibition against general solicitation in Rule 506 and Rule 144A offerings. The proposed rule answered the major questions securities professionals were asking about these reforms: would the new Rule 506 replace the old (no), would “reasonable steps to verify” require issuers to comply with strict guidelines (no again), and would it take the SEC over 60 pages to answer those two questions (yes!).
First, a quick review: Section 4(a)(2) of the Securities Act of 1933 exempts transactions “not involving any public offering” from the pricey and time-consuming registration requirements of Section 5 of the Securities Act. Rule 506 was (and still is) a safe harbor under Regulation D under Section 4(a)(2) of the Securities Act, meaning that if an issuer met its requirements, it could safely assume that the offering was not public.
Among other things, Rule 506 prohibited “general solicitation and general advertising” which is exactly what it sounds like. In addition, an issuer relying on Rule 506 could sell to an unlimited number of accredited investors (basically: investment companies, funds, and wealthy people) and no more than 35 “sophisticated” non-accredited investors (basically: normal people who arguably have some idea of what an investment is). A Bizarro Kanye might say, “the SEC doesn’t care about rich people” (that’s not exactly true, but remember: Bizarro isn’t that smart). After those 35, an issuer had to “reasonably believe” that the investors were accredited.
That was the old Rule 506, hereby known as Rule 506(b). The new Rule 506, or Rule 506(c), removes the ban on general solicitation, but issuers can only sell to accredited investors – no more 35 sophisticated non-accredited guys. It also requires that issuers “take reasonable steps to verify” that the investors are accredited. When the JOBS Act passed, some worried that its mandate to amend Rule 506 meant that the old version would be lost. We can all rest easy: now issuers have a choice – stick with the stricter advertising rules if you want to offer securities to non-accredited investors, or advertise like crazy and take reasonable steps to verify that everyone you sell to is accredited.
Rule 506(c) may be a huge benefit to a lot of start ups who have had trouble finding accredited investors to fund their ideas. If so, this would come at the expense of the “finders” industry, although few entrepreneurs will cry over that side effect.
The “reasonable steps to verify” also made some fear that Rule 506(c) would lead to mandatory tests or necessary documents to prove accredited-investor status. There was a concern that issuers would need to undergo much more rigorous due diligence under this new rule. (These securities professional types are real worry warts.) Relax: “we [the SEC] anticipate that many practices currently used by issuers in connection with existing Rule 506 offerings would satisfy the verification requirement proposed for offerings pursuant to Rule 506(c).” The SEC is proposing an objective standard that weighs both the type of information and the amount of information an issuer has about a possible investor. For example, if that investor claims to be a registered broker-dealer, you could just go to FINRA’s BrokerCheck website to check and be set. Or if the minimum investment was $1 Million and an investor could provide that (unfinanced) in cash, you could safely assume a personal wealth of over $1 Million (and, also, that he’s a drug kingpin). The SEC even suggested that a third party verification, such as an affidavit by an investment advisor, accountant or attorney attesting to the investor’s accredited status, would suffice. That said, the SEC made it clear that simply asking “are you accredited?” ain’t gonna cut it – some due diligence will be required.
Securities sold pursuant to Rule 506(c) offerings will remain restricted securities. None of the changes to Rule 506 are meant to imply changes to Section 4(a)(2) or the other rules under Regulation D.
The SEC is now requesting comments, and has a series of questions that it wants public feedback on. The majority focus on the verification issue, but I don’t foresee many changes. The SEC’s proposed approach offers flexibility. More flexibility also means more uncertainty, but most of that uncertainty will only happen along the margins. A company performing a decent level of due diligence should be safe. And, as before, if an investor provides falsified documents and lies convincingly, the issuer will still have reasonable belief and will have taken reasonable steps.
The SEC also proposed rules to allow general solicitation for Rule 144A re-sales of restricted securities. This is less interesting, because Rule 144A restricts sales to Qualified Institutional Buyers (QIBS), which are generally investors with over $100 million in assets. Rule 144A is usually used in initial offerings exempt from registration pursuant to Section 4(a)(2) or Regulation S (a safe harbor for the sale of securities made outside the US). I’m not sure what this change to Rule 144A is supposed to accomplish, because there isn’t exactly a large target market of QIBS. If you are planning on making a Rule 144A offering, and your investment banker says something like “well, I don’t know any QIBS, so why don’t we take out a subway ad?” you should fire him. As the SEC said, “Although Rule 144A doe not include an express prohibition against general solicitation, offers of securities under Rule 144A currently must be limited to QIBS, which has the same practical effect.” That’s diplomatic bureaucrat speak for “we have no clue why Congress made us do this.”
These are just proposed rules, meaning the public has 30 days to comment.