The next few years may be the largest watershed event in opening up private equity capital since the 1980s when Regulation D was first published by the Securities and Exchange Commission (“SEC”). By allowing general solicitation and general advertising in private offerings the SEC has now opened a new and potentially revolutionary method for raising private capital.
The SEC adopted final rules to implement the requirements of the Jumpstart Our Business Startups Act (the JOBS Act) in 2013. The new rules create a new category of private offering exemption under Regulation D (the private offering safe harbor provisions) by amending Rule 506 to add a new category of exemption — Rule 506 (c). The new Rule 506 (c) permits a business enterprise (“Issuer”) offering its own securities, or others acting on behalf of an Issuer, to engage in general solicitation or general advertising in offering and selling securities, provided that all purchasers of the securities are “Accredited Investors” and the Issuer takes reasonable steps to verify that the purchasers are Accredited Investors.
Regulation D private placements, other than those conducted under 506 (c) and some qualified exceptions under Rule 504, continue to be subject to a prohibition whereby neither the Issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising as defined under Rule 502 (c). This rule provides certain examples of the meaning of general solicitation:
“(1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
(2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising…”
These examples are not much help but they do provide a starting point. Trying to prove that a securities offering does not include general solicitation has been the task of many Issuers and their counsel and, in each case, through the imprecise standard of the “facts and circumstances” surrounding each offering. Under a number of SEC no-action letters, the presence or absence of a preexisting, substantive relationship between the issuer or its agents and the offeree is a key indicator for determining whether a communication constitutes general solicitation or not.
The new 506 (c) exemption combines most of the advantages of the traditional private offering exemption under existing Rule 506 (b) with the marketing reach of public advertising, which vastly expands the number of potential investors, provided those investors are Accredited Investors. Rule 506 exemptions are, by far, the most widely and consistently utilized private offering mechanism used to raise capital. This 506 (b) safe harbor accounts for 99% of amounts sold through Regulation D and 90% of all exempt offerings in the United States.
There are good reasons for the popularity of the Rule 506 offerings. The traditional Rule 506 (b) offerings under Reg. D require only notice filings with the SEC and the states. There are no required filings or reviews of the offering documents at either the federal or state level. If the 506 (b) offering is limited to Accredited Investors there are no specific required disclosures that must be included in the offering. The Issuer determines what disclosures are appropriate to provide full disclosure and to avoid fraud, misrepresentations and material omissions. There are such requirements, however, if non-accredited investors are included, thirty five (35) of which are permitted using a Reg. D 506 (b) exemption. Under a Rule 506 (b) offering there is no minimum or maximum amount of money that can be raised. There are no annual disclosure requirements or other ongoing oversight of the Issuer resulting from the exempt offering. Given the high costs and liability risks of operating as a public reporting company, there are great advantages of being a Rule 506 Issuer especially if the offering is limited to Accredited Investors.
The new Rule 506 (c) requires that all investors be Accredited Investors and issuers are required to take reasonable steps to verify the accredited investor status of the purchasers. Much of the SEC final rules for 506 (c) provide guidance on the factors that the Issuer or its representative should consider when taking the steps to confirm Accredited Investor Status. According to the SEC final rules, whether the steps taken are “reasonable” will be 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. So the emphasis has turned. Under a 506 (b) the Issuer is attempting to show, under the facts and circumstances of the offering, that there was no general solicitation and now the emphasis in a Rule 506 (c) is attempting to show, under the facts and circumstances of the offering, that all of the purchasers are Accredited Investors so that the Issuer can use general solicitation.
The JOBS Act and the new rule 506 (c) combine the existing features of Rule 506 with the ability of Issuers to reach vast new markets for their securities and to open new possibilities for capital raising. It doesn’t take much imagination to consider what possibilities for capital raising this new safe harbor under Regulation D will open up.
- Internet postings and online data portals or platforms are already in use for private placement transactions; for example venovate.com or www.wealthforge.com
- Advertisements on late-night cable television;
- Posts as advertisements on Facebook and Twitter;
- Offers to magazine subscribers;
- Offers to a business’ customers on the company’s data base;
- Offers to individuals and firms found anonymously on the internet using demographic profiling.
This trend means that the capital raising landscape is turning toward the anonymity of the investor with the only criteria for contact being that they are Accredited. This broad opening of a market has its own risks, however. For the small to mid-sized Issuer it is unlikely that there will be a personal connection between the Issuer and its owners using 506 (c) capital raising as there has been with previous Regulation D offerings. Lost too is the trust that comes with that personal connection. Some commentators have identified this new class of entities raising capital through general solicitation as “public private companies.” These entities should form and grow on a broad and anonymous base of investors thus opening more available capital than the traditional “friends and family” rounds for emerging firms but without the connection and trust of the prior personal relationships with the investors through the traditional Regulation D private placement exemptions.
If you have questions about the regulations, our Business Transactions Team attorneys would be glad to speak with you.