Proposed Rules Eliminating the Prohibition Against General Solicitation and Advertising in Rule 506 Offerings Meet With Opposition by NASAA
As required by Title II of the JOBS Act, on August 29, 2012, the SEC has published proposed rules eliminating the prohibition against general solicitation and advertising in Rules 506. I previously wrote blogs outlining the content of the proposed rules. The rules are currently in the public comment period.
As I previously noted, the SEC proposed simple modifications to Regulation D mirroring the JOBS Act requirement stating that it is “proposing only those rule and form amendments that are, in our view, necessary to implement the mandate” in the JOBS Act. The entire text of the rule release is available on the SEC website.
Title II of the JOBS Act, requires the SEC to amend Rule 506 of Regulation D to permit general solicitation and advertising in offerings under Rule 506, provided that all purchasers of the securities are accredited investors. The JOBS Act requires that the rules require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors using such methods as determined by the SEC.
Rule 506 is a safe harbor promulgated under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act of 1933, exempting transactions by an issuer not involving a public offering. In a Rule 506 offering an issuer can sell an unlimited amount of securities to accredited investors and up to 35 unaccredited sophisticated investors. The standard to determine whether an investor is accredited is the reasonable belief of the issuer. Currently, Rule 506 offerings, must abide by certain general conditions set forth in Rule 502, including Rule 502(c) which prohibits general solicitation and advertising.
The Amendment to Rule 506
The SEC proposed a new Rule 506(c) which would permit the use of general solicitation and advertising to offer and sell securities under Rule 506 provided that the following conditions are met:
1. the issuer takes reasonable steps to verify that the purchasers are accredited;
2. all purchasers of securities must be accredited investors, either because they come within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and
3. all terms and conditions of Rule 501 and Rules 502(a) and (d) are satisfied.
The current Rule 506 will also remain in place. Accordingly, an issuer that does not wish to engage in general solicitation and advertising could rely on the old Rule 506 and offer and sell to up to 35 unaccredited sophisticated investors, as long as the disclosure and other requirements of current Rule 506 are met. An issuer opting to rely on the old Rule 506 would also not have to take any additional steps to verify that a purchaser is accredited.
Reasonable Steps to Verify Accredited Investor Status
In a nutshell the SEC declines to define what actions suffice as reasonable steps to verify accredited investor status, and instead leaves the determination to the issuer. According to the SEC, “whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction.” The SEC suggests that where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification and not conduct its own additional verification process.
Although the SEC was apprehensive to list suggested methods of verification it did lay out examples of some factors to be considered, including:
a. The nature of the purchaser and type of accredited investor they claim to be. For instance, if the purchaser is claiming that they are accredited because they are a broker dealer registered with the SEC, verification could be a simple check on the FINRA website.
b. The amount and type of information that the issuer has about the purchaser.
c. Nature and terms of the offering, such as type of solicitation and minimum investment requirements. The example proffered by the SEC is an offering conducted by soliciting pre-approved accredited investor lists from a reasonably reliable third party, vs. open air solicitation via social media or television or radio advertising.
Reasonable Belief that all Purchasers are Accredited Investors
In addition to requiring that an issuer take reasonable steps to verify that accredited investor status, the new Rule 506(c) (and the current Rule 506) requires that an issuer have a reasonable belief that all purchasers are accredited investors. The reasonable belief standard ensures that the exemption will not be lost if an issuer takes reasonable steps to verify accredited status and reasonably believes that an investor is accredited, but later learns that such investor was not in fact accredited.
NASAA Calls for Withdrawal and Re-Write of Proposed Rules
The North American Securities Administrators Association (NASAA) has called upon the SEC to withdraw its proposed Rule 506(c) and start fresh. Members of NASAA are comprised of state securities regulators. In correspondence to the SEC dated October 3, 2012 and again in a teleconference with the AARP, AFL-CIO, Consumer Federation of America and Americans for Financial Reform on October 10, 2012, Heath Abshure, President of NASAA, said that the rule fails in its current form to implement any protections for investors. By releasing a proposed rule that does nothing more than recite what is already in the JOBS Act, Abshure stated, the SEC has neglected its duty to both issuers and investors.
According to the NASAA, Rule 506 offerings result in the highest number of state led securities enforcement proceedings. I note that this is likely because Rule 506 is the most widely used offering exemption by all issuers and although Rule 506 preempts state law regarding registration requirements, it does not prohibit states from investigating and bringing enforcement actions related to fraud, which they do on a regular basis.
In NASAA’S view, the SEC should establish specific steps and non exclusive safe harbors for an issuer to verify that an investor is accredited. NASAA’s argument is that a state has the authority to determine whether an offering actually complies with Rule 506 (and thus preempts state registration requirements) and that it will therefore be left to state regulators to decide if an issuer has taken reasonable steps to verify if an investor is accredited and thus complied with Rule 506. This could lead to inconsistent results and precedence among the states.
For example, one state judge could determine that a particular method of verification was sufficient, that the Issuer therefore complied with Rule 506 and the state could not claim a violation of its registration requirements and a different state judge could reach the opposite conclusion based on the exact same facts. I have no counter argument, and in fact, foresee the same problem.
NASAA suggest the SEC require the filing of a Form D in advance of any public advertising and place reasonable restrictions on the advertisements. The reasoning in the October 3 letter is that this would give NASAA members a chance to review Form D’s for red flags and to monitor for issuers, officers, directors and placement agents with negative regulatory history. I do not agree with the validity of this argument. I do not think that either NASAA or state regulatory bodies have the manpower to monitor all Form D filings with the SEC and conduct an initial review. Moreover, the state’s only have authority to pursue enforcement proceedings for fraud conducted in their particular state.
Reviewing pre-sale Form D filings will not provide any information regarding the ultimate state of offers and sales and thus the ultimate state with jurisdictional authority involving a particular issue. Moreover, many advertisements will be via the internet and social networking, targeting potential investors nationwide, in a non-specific manner. For example, I doubt Michigan has the budget or manpower to monitor a Nevada Issuer which has filed a Form D and advertises via social media and thus technically to Michigan residents, but ultimately does not have sales in Michigan.
NASAA suggests that the pre-filing of the Form D would put a state regulator in a better position to respond to an inquiry by a potential investor that views an advertisement. However, I disagree with that argument as well. A Form D contains very limited information regarding an Issuer. Under the new Rule 506(c) after seeing an advertisement, prior to making an investment decision, an investor would need to provide information to an Issuer regarding their status as an accredited investor and receive disclosure documents from the Issuer regarding the offering. Rather than try and monitor all offerings nationwide and answer questions from investors based on seeing an advertisement, state regulators and NASAA would be better advised to create a system that allows them to speak with and respond to potential investors, within their state, once that investor has received information from an Issuer, beyond the general advertisement. In this way both the state regulator and the potential investor can make a better decision as to the next course of action.
NASAA also suggested, prior to the August 29 rule publication, and again in the October 3 letter, that the SEC punish Issuers for the failure to file the Form D with a loss of the exemption. The SEC did not address the NASAA request in either its rule making or newest request for comments and certainly did not implement the request. The SEC gave the appropriate attention to this suggestion.
NASAA suggests that Rule 506(c) contain bad actor disqualifications consistent with requirements set forth in the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Finally NASAA requests that the SEC provide rules and guidelines as to the content of advertisements. NASAA discusses the perils of overly optimistic issuers and the failure to disclose material information. This seems redundant with the existing fraud and misrepresentation laws that apply and will continue to apply to all offerings, both public and private.
The correspondence to the SEC dated October 3, 2012 reflects an overall harshly negative view of Title II of the JOBS Act and the proposed implementing rule.
Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions
Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public companies as well as private companies intending to go public on the over-the-counter market, including the OTCBB and OTCQB. For nearly two decades, Ms. Anthony has dedicated her securities law practice to being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.
Ms. Anthony’s focus includes, but is not limited to, crowdfunding, registration statements, PIPE transactions, private placements, reverse mergers, and compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, as well as the proxy requirements of Section 14. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for corporate changes such as name changes, reverse and forward splits and change of domicile.
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