About me: the new kid on the block. Mysterious, exciting and risky. I could be the best thing that ever happened to you, or you may rue the day we met. I'm warning you — once I've got you in my clutches, you may have a hard time extricating yourself.
About you: You're looking for a unique opportunity and you have a net worth of more than $1 million (excluding the value of your primary residence) or an annual income exceeding $200,000 for each of the past two years — and the documents to prove it. Don't be surprised if I ask for your tax returns or brokerage statements or a letter from your investment adviser. And no, I won't take your word for it!
Now that the Securities and Exchange Commission (SEC) has lifted an 80-year-old ban on general solicitation and advertising of private securities offerings, are we going to witness the proliferation of "matchmaking" websites designed to introduce companies seeking capital to Mr./Ms. Moneybags? Will "accredited investors" be able to gorge themselves on a smorgasbord of previously inaccessible private offerings? Will startup companies be able to raise money simply by creating flashy websites and inundating potential investors with tweets? One thing is certain: The much-anticipated amendments to Rule 506 of Regulation D of the Securities Act of 1933 will fundamentally change the market for private offerings.
To understand the potential magnitude of these new rules, a little background on how private sales of securities have been conducted to date is helpful. Companies seeking to sell their securities in the United States are generally required to either register the securities with the SEC or rely on an exemption from registration. Because registration is both expensive and time-consuming, many securities offerings are structured as "private placements," which are exempted from registration. The most commonly used private placement exemption is Rule 506 of Regulation D. Before the new rules went into effect on September 23, companies seeking to employ the Rule 506 exemption were prohibited from offering or selling securities through any form of "general solicitation or general advertising." Private offerings could not be publicized through newspapers or magazine advertisements, on the television or radio, via the Internet or social media, or even at seminars or meetings whose attendees had been invited by a general solicitation or general advertising.
In order to ensure that offerings fell within the safe harbor provisions of Rule 506, companies raised money quietly, by marketing only to investors with whom the company or its representative (such as an investment bank or placement agent) had a pre-existing relationship. This practice significantly limited the pool of potential investors and made private offerings truly "private."
The prohibition on general solicitation has long been perceived as an obstacle to capital raising and in the age of the Internet seems somewhat antiquated. The SEC's new rule, 506(c), permits an issuer to engage in general solicitation or general advertising in connection with an offer and sale of securities under Rule 506 if all purchasers qualify as "accredited investors" under SEC rules. (For a definition of "accredited investor," see the description in italics above.) The issuer must take "reasonable steps to verify" that all purchasers of the offered securities are accredited investors. The rule does not specify uniform verification methods to determine whether a potential investor is an accredited investor, but the adopting release included a nonexclusive list of methods that will be deemed to constitute reasonable steps. Having an investor check a box on a questionnaire is not a sufficient verification method. Even if all purchasers are, in fact, accredited investors, if the issuer has not taken steps to verify the investors' status, the issuer cannot claim the exemption. This purchaser verification process may be difficult for certain issuers, as it requires a time-consuming and costly facts and circumstances analysis and some investors may balk at providing the types of personal financial information (IRS forms, bank statements, credit agency reports) that issuers may need to conduct the analysis.
So can we expect to see ads for private placements on late-night infomercials? Will we receive e-mails describing private investment opportunities that are the "perfect match" for us? Not so fast. We're unlikely to see a flurry of solicitations any time soon, because at the same time the SEC voted to repeal the general solicitation ban, it proposed new disclosure rules pertaining to general solicitation offerings. The proposed rules require issuers availing themselves of the general solicitation rules to file a form with the SEC (Form D) 15 days prior to the first general solicitation and to file a second Form D with the SEC within 30 days after the completion of the offering. The Form D would disclose additional information about the issuer and the offering. The proposed rules would also require issuers to include certain legends and disclosures on all written general solicitation materials and to submit copies of written general solicitation materials to the SEC for a period of two years. Failure to make a Form D filing could result in a loss of the company's ability to conduct a private placement for one year. If implemented in their proposed form, these rules would impose significant new compliance burdens on issuers and may dampen companies' enthusiasm for general solicitation.
Companies seeking capital will need to weigh the burdens of the verification requirement and the proposed rules against the advantages of accessing a larger pool of potential investors. Some issuers may decide to continue to rely on the "old" rule, which is now 506(b). Undoubtedly we'll see the development of web-based platforms that match issuers and accredited investors and provide verification of investors' accredited status. Startups will be able to tweet about investment opportunities — so long as the legends and disclosures that may be required by the SEC fit within the 140-character limit! Some entrepreneurs may decide that engaging in general solicitation will have a negative effect on their company's image or credibility and decline to take advantage of Rule 506(c). Others may determine that they can raise funds more effectively through targeting pre-existing networks of accredited investors and that competing for investor attention through a general solicitation is a waste of energy. Depending on the outcome of their individual cost-benefit analyses, different issuers will take different approaches. Accredited investors trolling for sexy startups will have more investment opportunities but will be left to wonder whether the "best" prospects are still being offered through private channels. Ultimately, it's the investor who must decide: Are general solicitation offerings lightning in a bottle or only losers desperately seeking a little love?
Eliza Sporn Fromberg, Counsel, firstname.lastname@example.org
Eliza Sporn Fromberg's practice concentrates on counseling broker-dealers, investment advisers, CFTC-regulated entities, and others in the financial services industry in connection with regulatory, compliance, enforcement, litigation and arbitration matters. She assists broker-dealers, investment advisers, and their associated persons in responding to regulatory examinations and inquiries and represents members of the financial services industry in enforcement proceedings before the SEC, Department of Justice, FINRA, and other SRO and state regulators. She also conducts internal investigations and counsels clients on the impact of the Dodd-Frank Act on derivatives and financial products.
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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Day Pitney LLP. This work reflects the law at the time of writing in December 2013.