SEC Director Keith Higgins Addresses Rule 506 (c)
On March 28, 2014, Keith Higgins, the Director of the SEC’s Division of Corporation Finance, delivered a speech at the closing session of the 2014 Angel Capital Association Summit. One focus of the speech was the elimination of the prohibition against general solicitation and investor verification procedures in Rule 506(c) offerings.
Angel Investors have historically made their investments by purchasing in private offering conducted under Section 4(a)(2) of the Securities Act or the safe harbor under Regulation D, which exempt these types of offerings from Securities Act registration. As a result of the JOBS Act, the regulatory landscape for angel investing fundamentally changed. For angel investors, the changes resulting from Rule 506(c) create new opportunities and new obligations.
Elimination of the General Solicitation Prohibition in Rule 506 Offerings
In July 2013, the SEC created a new exemption, Rule 506(c), that permits the use of general solicitation and advertising to offer securities as long as two conditions are met: the securities can be sold only to accredited investors and the issuer must take “reasonable steps to verify” the purchaser’s accredited investor status.
The Rule 506(c) exemption became available in September 2013. Since then, there have seen almost 900 new Rule 506(c) offerings that raised more than $10 billion in new capital as of March 21, 2014.
In his speech, Director Higgins addressed why some issuers are not using Rule 506(c).
“Reasonable Steps to Verify. Some believe that the reluctance of issuers to use the new Rule 506(c) exemption is because the rule requires that the issuer take “reasonable steps to verify” the accredited investor status of a purchaser. Some believe that the “reasonable steps” requirement drives away potential purchasers who are interested in making an investment but wary of turning over financially sensitive information, such as tax returns or brokerage statements, to the issuer for verification.
Given the amount of public attention that this view has received, one could almost be under the impression that the rule requires that an accredited investor produce his or her tax returns or brokerage statements in all circumstances. Of course, this is not true. It is important to recognize that, in fact, there are actually two paths for complying with the rule’s verification requirement. Issuers can rely on one of the four non-exclusive verification methods for a natural person that, if used, would be deemed to satisfy the verification requirement. To be sure, for some of these methods a prospective purchaser must provide written documentation of his or her annual income or net worth. The other method, however, is the principles-based verification method in which the issuer would look at the particular facts and circumstances to determine the steps that would be reasonable to verify that someone is indeed an accredited investor. Although the verification method must be objectively reasonable, the principles-based method is intended to provide issuers with significant flexibility in deciding the steps needed to verify a person’s accredited investor status and to avoid a “one size fits all” approach.”
According to Director Higgins, under this principles-based approach, the documentation that a person must provide, if any, will depend on the answers to questions such as:
“How much information about the prospective purchaser does the issuer already have? The more information the issuer has indicating that the person is an accredited investor, the fewer verification steps that it may have to take to comply with the rule’s requirement. A person’s investments in previous Rule 506 offerings or membership in an established angel group is also information about the person that may affect the likelihood of the person being an accredited investor and therefore may be useful in determining the steps that would be reasonable for an issuer to verify the person’s accredited investor status. The issuer would, of course, still need to consider any other relevant facts in making its final determination about the person’s accredited investor status.
How did the issuer find the prospective investor? A person that the issuer located through publicly-accessible and widely-disseminated means of solicitation may need to undergo a greater level of verification scrutiny than a person who may have been pre-screened as an accredited investor by a reasonably reliable third party.
Are the terms of the offering such that only a person who is truly an accredited investor could participate? The ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors, using their own cash, could reasonably be expected to meet it is relevant in deciding what other steps are needed to verify accredited investor status.”
Lastly, the SEC envisioned a role for third parties that may wish to enter into the business of verifying the accredited investor status of prospective investors on behalf of issuers and allowed for such third party verification under the principles-based approach as long as the issuer has a reasonable basis to rely on such third party.
These are all part of a deliberate effort by the SEC to provide issuers with an alternative to the clear but highly prescriptive list of verification methods included in Rule 506(c).
Definition of “General Solicitation
Higgins addressed another commonly-heard criticism which is that the definition of a “general solicitation” is too vague. The recent rulemaking has not changed any notions of what constitutes a general solicitation. The analysis for determining whether a specific communication or activity constitutes a general solicitation for an offer or sale of securities under Rule 506 remains the same as when the rule was first adopted in 1982, with the particular facts and circumstances surrounding the communication or activity determining the final answer.
The staff of the SEC has previously provided guidance through no-action letters on whether specific activities (such as certain venture fairs) constitute a general solicitation; perhaps the positions in these letters may warrant a fresh review and possible update. Or perhaps there is now a need to think about whether specific types of communications should not be viewed as general solicitation, such as regularly released factual business information or communications that occur at times sufficiently distant from capital raising activities and do not refer to any offering so as to negate any inference that they are solicitations. These are just some of the many ideas that have been suggested to help issuers better adjust to the new dichotomy between a “private” Rule 506 offering and a “public” Rule 506 offering.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit www.securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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