Pursuant to the mandate set out in the Jumpstart Our Business Startups Act, the U.S. Securities and Exchange Commission (the SEC) has adopted amendments to Rule 506 of Regulation D and Rule 144A, each under the Securities Act of 1933, as amended (the Securities Act). These changes essentially lift the ban on publicly advertising offers of securities and may fundamentally change the way in which small and medium sized companies raise capital.
Section 5 of the Securities Act prohibits the offer and sale of a security into the United States absent its registration with the SEC, unless both the offer and sale are made in a transaction that is exempt from, or not subject to, such registration. Relatively few small and medium sized companies attempt to register their offerings with the SEC; the preferred alternative being to utilize private placement exemptions, primarily the so-called "issuer exemptions" provided in Rule 504, Rule 505 and Rule 506 under Regulation D.
Rules 504 through 506 include a number of restrictions intended to protect investors in the United States, including the marketing restrictions. Prior to the adopted amendments, offers of securities to U.S. investors pursuant to Rules 504 through 506 were subject to a requirement that neither the seller nor anyone acting on its behalf (such as a securities broker), offers the securities by means of any form of "general solicitation" or "general advertising". These terms include a very wide range of marketing activities and would certainly include posting the offer of securities on a website which is available to the public or which does not have active screening or investor verification procedures, as discussed below.
As a result, marketing activities in the United States in relation to private placements pursuant to Rules 504 through Rule 506 typically have been directed at a restricted number of sophisticated investors.
The changes adopted by the SEC (and expected to be effective in late-September) impact the marketing of securities pursuant to Rule 506 only, through the creation of the new Rule 506(c). Therefore, while companies may publicly advertise offers of securities pursuant to Rule 506(c) publicly, Rules 504 and 505 still prohibit general solicitation.
The Differences Between Rules 504, 505, 506(b) and 506(c)
Prior to the creation of Rule 506(c), the fundamental differences between Rules 504 through 506 were the amount of money that could be raised and the type of investors that could be targeted. Rule 504 caps the total amount that can be raised at $1 million per year and does not limit the number of investors or the sophistication of those investors. On the other end of the spectrum, Rule 506(b) has no limit to the amount of money that can be raised, but requires that all but 35 investors be accredited investors.
Note that each exemption in Regulation D effectively prohibited general solicitation and general advertising. Although Rule 504 includes exceptions to this prohibition, issuers that avail themselves of these exceptions must register the securities in at least one state.
Finally, note that securities offered and sold pursuant to Rule 506 are considered to be "covered securities", while securities issued pursuant to Rules 504 and 505 are not. U.S. state securities laws (or "Blue Sky Laws") apply to the offer of sale of securities to investors in the relevant state, unless the securities are "covered securities" and therefore exempted by federal securities laws. Blue Sky Laws can be very different from state to state and compliance with these laws can be expensive and complicated.
The SEC's adopting release also contains a fair amount of market information relating to Rule 506 offerings. As noted in the release itself, the market information is limited in that it is based on the Form D filings made by companies, and the SEC acknowledges that a significant number of companies do not make such filings. Despite this, it is clear from the available information that the private placement market in the United States is very large and very active.
Ref: http://www.sec.gov/rules/final/2013/33-9415.pdf. The 2012 non-ABS Rule 144A offerings data is based on an extrapolation of currently available data through May 2012 from Sagient Research System’s Placement Tracker database.
The release explains it well:
"Offerings conducted in reliance on Rule 506 account for 99% of the capital reported as being raised under Regulation D from 2009 to 2012, and represent approximately 94% of the number of Regulation D offerings. The significance of Rule 506 offerings is underscored by the comparison to registered offerings. In 2012, the estimated amount of capital reported as being raised in Rule 506 offerings (including both equity and debt) was $898 billion, compared to $1.2 trillion raised in registered offerings. Of this $898 billion, operating companies (issuers that are not pooled investment funds) reported raising $173 billion, while pooled investment funds reported raising $725 billion. The amount reported as being raised by pooled investment funds is comparable to the amount of capital raised by registered investment funds. In 2012, registered investment funds (which include money market mutual funds, long-term mutual funds, exchange-traded funds, closed-end funds and unit investment trusts) raised approximately $727 billion.
"In 2011, the estimated amount of capital (including both equity and debt) reported as being raised in Rule 506 offerings was $849 billion compared to $985 billion raised in registered offerings. Of the $849 billion, operating companies reported raising $71 billion, while pooled investment funds reported raising $778 billion. More generally, when including offerings pursuant to other exemptions – Rule 144A, Regulation S and Section 4(a)(2) – significantly more capital appears to be raised through exempt offerings than registered offerings."
The SEC has created Rule 506(c), which allows companies to generally advertise an offering of securities in the United States, provided that all investors are "accredited investors" and the company takes reasonable steps to verify that the investors are accredited investors.
The SEC release provides that the determination of whether the steps taken to verify accredited investor status are "reasonable" is "an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction". The SEC proposed a number of factors that might be considered in this "principles-based approach":
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- the amount and type of information that the issuer has about the purchaser; and
- the nature 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.
Furthermore, the SEC recognizes that although verification of the status and sophistication of institutional investors may be relatively easy, verification may be more difficult if the investor is a natural person.
Rule 506(c) therefore also sets out a non-exclusive list of methods that companies (or third parties) may use to satisfy the verification requirement for investors who are natural persons:
- receipt of certain documentation of levels of income or net worth of the purchaser (such as tax returns, bank statements, and credit reports);
- verification of accredited investor status from certain third-parties, such as a registered broker-dealer, a registered investment adviser, a licensed attorney, or a certified public accountant; or
- for an existing shareholder which previously purchased in a Rule 506 offering by the company, the receipt of a certification from the purchaser that it still meets the definition of an accredited investor
Note that the requirement to take reasonable steps to verify all purchasers are accredited investors is independent of the requirement that sales be made solely to accredited investors, and must be satisfied even if all purchasers happen to be accredited investors. The release states that it will be important for issuers (and any third party verification service providers) "to retain records regarding the steps taken to verify that a purchaser was an accredited investor".
The SEC has left the previous formulation of Rule 506 unchanged in the form of Rule 506(b). Although issuers must still reasonably believe that investors are accredited investors, issuers will not be subject to the verification or related record retention requirements if they do not employ general solicitation or general advertising in reliance upon Rule 506(c). Note also that issuers conducting offerings pursuant to Rule 506(b) may still offer and sell securities to no more than 35 sophisticated non-accredited investors, which is not the case for issuers pursuing Rule 506(c) offerings.
Impact of the adopted amendments on the private placement market
So what does this all mean for companies looking to raise cash, for brokers looking to facilitate that process and for platforms that provide the technology to do so on the internet? The short answer is that these changes will likely have a major impact on the way that relatively sophisticated companies raise money from relatively sophisticated investors in semi-private offerings. True equity "crowdfunding" (i.e. Title III of the JOBS Act, i.e. raising relatively small amounts of money from a very large number of unsophisticated investors that each invest a small amount) is not impacted by these new rules. The rules governing that market are yet to come.
Once the new rules are finally implemented in the fall of 2013, it is likely that we will begin to see more angel networks, venture capital groups and securities brokers bring companies and accredited investors together online. These offerings and platforms will likely have some or all of the following characteristics:
- access to the site will be available to accredited and non-accredited investors;
- the ability to invest will be granted to accredited investors only;
- verification of the investor's status will be completed by a variety of methods, including representations from the investor and the provision of certain information to the company (or platform, broker, etc) by the investor that proves the investor's status;
- verification may be completed by third party service providers;
- records will be kept by the party that verifies the investor's status; and
- Form D will be filed by the company, the broker or perhaps through the platform.
In addition to the adopted amendments, the SEC also released a number or proposed amendments which are subject to public comment and may be adopted in some form in the future.
Proposed amendments to Regulation D and Form D
The proposed amendments to Regulation D and Form D are intended at augment the SEC’s ability to assess the use of general solicitation and general advertising in Rule 506(c) offerings and the impact that these marketing efforts have on investors and the market. The proposed rules would require the filing of an advance Form D 15 calendar days before the first use of general solicitation in a Rule 506(c) offering and the filing of a closing Form D amendment within 30 calendar days after the termination of a Rule 506 offering.
Currently, Form D requires relatively limited identifying information about the issuer, any related persons, the exemption the issuer is relying on to conduct the offering, and certain other factual information about the issuer and the offering.
Under the proposal, issuers also will be required to provide additional information to enable the SEC to gather more information on the changes to the Rule 506 market that could occur now that the general solicitation ban has been lifted.
The additional information would include:
- identification of the issuer's website;
- expanded information on the issuer;
- the offered securities;
- the types of investors in the offering;
- the use of proceeds from the offering;
- information on the types of general solicitation used; and
- the methods used to verify the accredited investor status of investors.
Proposed new Rule 510T
Under the proposed Rule 510T, issuers making offers and sales pursuant to Rule 506(c) would also be required to submit any written general solicitation materials to the SEC no later than the date of first use of these materials. These submissions would not be available to the public and Rule 510T, if adopted, would expire two years after its effective date.
Potential impact of the proposed amendments on the private placement market
With respect to the proposed amendments, the SEC acknowledged that filing Form D is not currently a condition to claiming the exemption from registration in Regulation D and indeed that many issuers in Rule 506 transactions today do not file a Form D.
Given that the proposed changes to Form D expands the information that would be required in the filing and the reluctance that many issuers have had in filing Form D to date, some commentators have questioned whether issuers will be more reluctant to pursue Rule 506 offerings. Furthermore, although the proposed new Rule 510T is intended to be temporary and the submissions will not be public, it remains to be seen whether these two changes would, if adopted, have a negative effect on the otherwise active Rule 506 private placement market.
Dan is a U.S. trained and qualified lawyer (New York) with extensive experience in capital markets and M&A transactions in the United States, Europe, Asia and Africa. This background has provided extensive exposure to rules, regulations and regulators (including the SEC and FINRA) governing many forms of capital raising in the United States. With this foundation in the traditional capital markets space, Dan is seeking to help grow the crowdfunding market in the United States in a manner that encourages capital formation, protects investors and meets the extensive requirements of the nation’s regulators.
Born and raised in Cleveland, Ohio, Dan has worked and lived throughout the United States, in London and elsewhere in Europe. In his spare time, Dan has contributed a significant amount of pro bono work to a number of organizations, including the Clinton Health Access Initiative, and enjoys suffering as he watches Cleveland’s consistently terrible sports teams lose.