QUIET 506 - A Study in Irony

Joseph W. Bartlett, Special Counsel, Reitler Kailas & Rosenblatt LLC

The offering and sale of securities in non public companies in the United States requires an exemption from the registration requirements in the Securities Act of 1933, and the most common exemption is contained in '33 Act Regulation D, Rule 506, which exempts offerings and sales to accredited investors as defined in Regulation D, Rule 501(2), presuming that the offering does not involve general solicitation and general advertising, as per the ban on Rule 502(c).

In the early days of Regulation D, an inadvertent violation of Rule 502(c), at least as perceived as a violation at the time, generally required a cooling off period until the contamination of general solicitation had worn off. [1] This happened often when, for example, an officer of a company seeking capital privately … "Newco' in contemporary parlance … gave an interview to the press and mentioned, in the course of telling the reporter what Newco was all about, that Newco was raising money. Another red light in that regard was perceived as arising from a presentation by a Newco of its pitch materials, pitching for capital, at an event to which a number of people were semi-publicly invited and were sitting in attendance.

The new reality is that the scope of the general solicitation ban has become significantly narrowed. I quote from an interesting memorandum, available at SecondMarket, by SecondMarket's General Counsel, Annemarie Tierney because it describes the metrics on which practicing lawyers like myself generally rely these days.

"The process by which we allow potential buyers access to our password-protected platform is consistent with the guidance provided in the SEC's no action letter responses to IPONET, dated July 25, 1996 and of Lamp Technologies Inc., dated May 29, 1997. In these letters, the SEC staff took the position that qualification of accredited investors using the procedures specified in those letters, and offers, and sales to accredited investors on a password-protected website of securities posted after their qualification would not be viewed as a form of general solicitation or general advertising within the meaning of Rule 502(c) of the Securities Act.

"SecondMarket generally locates buyers when interested parties visit our website and complete an initial registration process to become a participant on the first tier of our two-tiered website. On Tier 1 of our website, participants have the ability to review publicly derived information regarding more than 10,000 private companies. To the extent that a potential buyer is interested in a specific company, and wants to find out whether that company's securities are for sale, they are directed to complete a market standard questionnaire designed to certify the buyer's status as an accredited investor. This form is completed and executed electronically … .

"Once we have determined that a potential buyer is an accredited investor, we complete a background check and other required broker dealer diligence on the potential buyer, a process that generally takes 24 to 48 hours. Once the process is completed, potential buyers that are determined to be accredited investors and have clear background check results are given access to the password-protected Tier 2 of SecondMarket's website … .

"Once accredited investors gain access to Tier 2 of the website, they are able to indicate interest in buying a specific company's securities and are able to determine whether securities of that specific company are available for sale through SecondMarket. To the extent that a market opens in a specific company's securities, only accredited investors that specifically indicated interest in buying shares of that company will be contacted regarding participating in the market for that company's shares."

One would think offhand, particularly someone like me who has been around from the early days of Reg. D, that posting online information "regarding more than 10,000 private companies" would represent, in each case, general solicitation because a posting on the internet is, at least technically, solicitation involving literally billions of individuals and firms. However, based on the IPONET and Lamp Technologies No Action letters, [2] we now understand that, if the issuer engages in a "Two-Step" (my slang) dance and follows the prescribed moves faithfully, pitching Newcos on the web is not offside. Once one of the viewers on line is attracted to a deal posted on the internet and reaches out for company information, then the necessary "pre-existing substantive relationship" is established through the use of a questionnaire, which includes the individual self-certifying he or she (or it) is accredited and, in the case of AngelList and others (although not all), a "background check" which comes up clean.

Ironically, the historic Rule 506 (now classified as 506(b) with the approach of SEC regulations under Title II of the JOBS Act) is known in trade jargon as "Quiet 506" and the platforms presenting deal flow online under Quiet 506 are expanding robustly. There are commentators who are anxiously awaiting the SEC's promulgation of the proposed Regulations which would formally lift the ban on general solicitation and general advertising for accredited investors pursuant to Title II of the JOBS Act, the suggestion being that, until those Regs are in place, the ban in Rule 502(c) on general solicitation and general advertising has some teeth in it. The fact, however, is that the ban has been, as a practical matter, history for a number of years by virtue of the Two-Step process. Quiet 506(b) is in fact a very noisy Rule 506 in the real world and platforms such as AngelList, Circle Up, and others are already taking advantage of the internet to raise capital for emerging growth companies … and have been for some time. The advent of the Title II Regs, in that sense, is anti-climactic. The online market for deals is like the Mississippi River in John McPhee's book on the forces of nature; it finds its own way regardless of the SEC or, in the Mississippi's case, the Corps of Engineers. Let me bore you not only with this piece but a link [3] to two others which supplement the underlying thesis to the effect that, if the technology and new ideas are as strong today as many (including I) think, and the regulators stay out of the way intelligently (a meaningful word, of course), we can (in fact already have) "build it and they will come." All that said, there is much to be monitored as this story play outs. A series of failures could poison the atmosphere and the process grind to a halt. However, the 800 pound gorilla (pardon the clichés) is the internet and I don't think the "Sky is Falling" prophets can hold it back. We are already in an online marketplace for early stage capital up to our earlobes, courtesy of the internet, and the trick now is to adjust to the new reality in the legal sense of the word.

The problem from this corner is not the ban on general solicitation and advertising; as I say, with the Two-Step process that has been effectively put to sleep, Title II or no Title II. The issue is how to build a platform which does not run afoul of other provisions in the securities laws which remain in playi.e., the requirement for individuals and firms in the business of effecting transactions in securities to register as broker dealers and/or to avoid the imposition of the registration requirements of the Investment Advisers Act of 1940 if and to the extent the act of selecting a company to be chaperoned across the platform is deemed to be investment advice. Indeed, the North American State Securities Administrators have gotten off the canvass and are working mightily to come back to the party by aggregating functions which would effectively neutralize the pre-emption of Blue Sky by the National Securities Markets Improvement Act of 1996.

In short, there is a new story in the making and how it will play out is by no means certain at this point. What is certain is the issues will generally arise outside of Rule 502(c)'s formal lifting of the ban on general solicitation but in other compartments of securities regulation in the United States and, indeed, around the world.

Finally, a fearless forecast on the upcoming market: Will the internet Gorilla become dominant in that segment of U.S. and world capital markets which is built on growth companies raising the equity needed to traverse the Valley of Death and complete the journey from "the embryo to the IPO" (or trade sale), thereby funding the development and exploitation of intellectual property and novel ideas currently on the shelves and loaded with promise?

For starters, see the link ( to a list of the "Crowdfunding Portals: Investment-Based" which are up online today … U.S. and worldwide. It is not complete but eye opening, nevertheless; as of the last update September 27th, there are 88 listings. There is another list I am told, which totals over 500 listings.

Second, a knowledgeable observer and I were discussing the impact of this incoming tide and I remarked that the elite investors, in their own minds, would likely find sourcing deal flow online as "undignified." He laughed and responded that 10 or so years ago, the maxim was that looking for spouses through online dating services was undignified. Now, he claims, everyone over 30 uses these platforms.

That said, as per an earlier piece by yours truly on 506 Platforms I think the prime (my word) Platforms may be the critical element of what (in yet another article, I have described as the Conveyor Belt … platforms organized to match like to like on the buy and sell side, selective both in the companies presented and the quality (smart and/or rich) of the investors invited to review the pitch. Knowledgeable investors, of course, like proprietary deal flow; participation in auctions often entails the "winner's curse" … you win and, therefore, overpay. But, as issuers and placement agents become accustomed to online presentations, why would not the good deals go there? Deals well over $2 million, you ask? We will see.

[1] See Bartlett, "If General Solicitation Compromises the Private Placement Use of §4(2); When "Cooling Off" is Not The Answer," The Journal of Private Equity, Summer 2006.

[2] There is a hint, generally ignored, in a footnote (88) to an SEC Alert, "SEC Interpretation: Use of Electronic Media," that the Lamp No Action Letters need to be construed narrowly, perhaps implying that participation in the process by firms subject to SEC jurisdiction … e.g., broker dealers or investment advisers albeit at that time exempt advisers … is a necessary element. Not the universal practice, however.

[3], Bartlett, "From the Embryo to the IPO, Courtesy of the Conveyor Belt (Plus a Tax-Efficient Alternative to the Carried Interest), Vol. 15, No. 7 The Journal of Private Equity, Winter 2011; and, "The JOBS Act - Title II: Online Solicitation of Accredited Investors The Platform as a Dating Service."

Joseph W. Bartlett, Special Counsel,