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Proposed Rules Eliminating the Prohibition Against General Solicitation and Advertising in Rules 506 and 144A Offerings – Part I

As required by Title II of the JOBS Act, the SEC has published proposed rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings.  In a move that is widely supported by legal practitioners, including the Federal Regulation of Securities Committee of the Business Law Section of the American Bar Association, the SEC has proposed simple modifications to Regulation D and Rule 144A mirroring the JOBS Act requirement.  In fact, in the rule release the SEC states 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.

This Part I discussed the proposed amendments to Rule 506, Regulation D offerings.


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 calls for the same amendment to Rule 144A provided all purchasers are qualified institutional buyers (QIB).  In both cases, the JOBS Act requires that the rules require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors or QIB’s as the case may be, using such methods as determined by the SEC.  Most of the pre-rulemaking comments and commentary by the public and advocacy groups, centered on what steps and methods would be required by the SEC to verify purchaser qualification.

Rule 506 is a safe harbor promulgated under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act of 1933, exempting transaction 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.

Presently, Rule 144A does not explicitly prohibit general solicitation and advertising but it does limit all offers of securities to QIB’s, which has the same practical effect.  Section 5 of the Securities Act of 1933 (the registration requirement) as well as most of the exemptions and safe harbor exemptions regulate both the offers and sales of securities.    As further brief background on Rule 144A, it is noted that technically Rule 144A is not an Issuer’s exemption, but rather is a safe harbor for the resale of restricted securities to QIB’s, much as Rule 144 is a safe harbor for the resale of restricted securities generally.  However, since its passage in 1990, market participants have used Rule 144A as a means of raising capital for issuers by engaging in a Regulation S offering followed by the immediate re-sale of such securities to QIB’s in reliance on Rule 144A.  This method of capital raise has become widely known as a Rule 144A Offering.

The Amendment to Rule 506

The SEC is proposing to add 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.  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.   However, overall, the SEC was apprehensive to even list suggested methods of verification in case the industry perceived these listed methods as de facto requirements or de facto sufficient steps in all cases.

The SEC did lay out example of overall factors to be considered:

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.  Of course, the hardest status to verify will be natural persons claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements, however, the SEC offers no particular guidance on this point.

b.         The amount and type of information that the issuer has about the purchaser.  Clearly, the more information the better.  The SEC lists the obvious (W-2; tax returns; letters from a bank or broker dealer).  Moreover, although not required it is assumed that an issuer should at least conduct a check of publicly available information.

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.  The latter, of course, requiring greater verification than the former.  The SEC highlights the obvious, such as that the higher the minimum investment required the fewer steps an issuer would need to take to verify accreditation.

Regardless of the methods an issuer uses to verify accredited status, they should keep adequate and complete records.  If the exemption is challenged, the burden is on the issuer to prove that under the facts and circumstances of their particular offering, they took reasonable steps to verify and they reasonably believed that an investor was accredited at the time of the sale.  However, although the rules do not address the issue, the SEC is cognizant of the privacy concerns raised by having issuers obtain and maintain personal financial records from investors.

In reviewing the rule release, I believe the SEC took the right approach.  As they state “a method that is reasonable under one set of circumstances may not be reasonable under a different set of circumstances.”

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) requires that an issuer have a reasonable belief that all purchasers are accredited investors.   Current Rule 506 requires that the issuer has a reasonable belief that investors are accredited and the SEC desires to continue this standard with the new Rule 506(c).  In particular, 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.

Request for Comment

As part of its Rule release the SEC requests comments on specific questions related to the proposed rule.  In particular, the SEC is asking the public to opine on whether the proposed rule will be effective in limiting sales to accredited investors or whether specific methods of verification should be adopted.  The SEC asks commentators to suggest methods that issuers could use to verify accredited investor status, and the merits of each method.  Moreover, the SEC asks for comments addressing privacy concerns for investors who are supplying financial and personal information to issuers.  The SEC also asks for comments as to whether additional rules or restrictions should be imposed on certain types of issuers such as shell companies, penny stock issuers, or blank check companies.

The Author

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 almost two decades Ms. Anthony has dedicated her securities law practice towards 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 and the proxy requirements of Section 14. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including 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 SRO’s such as FINRA and DTC for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.

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© Legal & Compliance, LLC 2012

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