The New Rule Now Permits General Solicitation and Advertising When Raising Capital

On July 10, 2013, the Securities and Exchange Commission (the “SEC”) adopted a new rule that implements a part of the JOBS Act. This rule lifts the ban on general solicitation and advertising with respect to certain types of securities offerings.

The new rule 506(c) goes into effect today, Monday, September 23rd. Here is what you need to know about it, if you would like to adverse your offering to the general public and through the means of general solicitation.

1. All investors must be accredited. Unlike Rule 506(b), this new Rule only allows accredited investors to participate in the offering. Who are accredited investors? These are individuals who have earned income over $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence). A bank, partnership, corporation, a nonprofit, an LLC or a trust can also be accredited investors as long as they satisfy certain tests. The full definition of accredited investor is available here.

2. Take “reasonable” steps to verify the accredited status of your investors. Under the new Rule, it is no longer enough to have the investors fill out an eligibility questionnaire. What steps are “reasonable”? This is determined in the context of each offering, looking at the particular facts and circumstances of each prospective purchaser and transaction. Rule 506(c) provides a non-exclusive list of verification methods that companies can use when looking to verify the individual investors’ accredited status, including:

• Verification based on income: by reviewing IRS forms that report income, such as Form W-2, Form 1099, Schedule K-1 of Form 1065, and Form 1040 for the two most recent years and obtaining a written representation that investors have a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;

• Verification based on net worth: by reviewing specific types of documentation dated within the prior three months, such as bank statements, brokerage statements, certificates of deposit, tax assessments, appraisal reports by independent third parties, and obtaining a written representation from the investors that they disclosed all liabilities necessary to make a determination of net worth, and/or obtaining a credit report from at least one of the nationwide consumer reporting agencies to verify the liabilities;

• A written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant stating that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the last three months and has determined that such purchaser is an accredited investor; and

• For accredited investors who purchased your securities before September 23, 2013 and who want to participate in your 506(c) offering, - a certification by such person that at the time of sale he or she qualifies as an accredited investor. 

You should keep very good records that can provide that you have taken reasonable steps to verify the accredited status of your investors.

3. Check a new box that was added to Form D. It is important to remember that if a Rule 506(c) fails, the company cannot simply switch to using Rule 506(b) or Section 4(2) private placement because Rule 506(b) or Section 4(2) do not permit general solicitation or advertising.

4. Make sure that the offering is not disqualified under the new bad actor disqualification provisions in Rule 506(d). Note the list of persons covered by these provisions is very broad and includes:

• the issuer, any predecessor of the issuer, and any affiliates of the issuer;
• any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
• any beneficial owner of 20% or more of the issuerʼs outstanding voting equity securities;
• any promoter connected with the issuer at the time of the sale;
• any investment manager of an issuer that is a pooled investment fund;
• any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in the offering;
• any general partner or managing member of any such investment manager or solicitor; or
• any director, executive officer or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.

Under the final rule, a “disqualifying event” includes any of the following:

Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries;

• Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries;
• Certain final orders from the CFTC, federal banking agencies, the National Credit Unit Administration, or state regulators of securities, insurance, banking, savings associations or credit unions;
• Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons;
• SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws;
• SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities;
• Suspension or expulsion from membership in a self-regulatory organization (SRO) or from association with an SRO member; and
• U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

There is an exception from disqualification where an issuer can show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering, so due diligence with respect to all covered persons participating in a Rule 506 offering is necessary. Such due diligence may include questionnaires and representations from certain participants, and may also include background checks.

Disqualification under Rule 506(d) only applies to disqualifying events occurring after September 23, 2013. Disqualifying events that occurred before the effective date of the rule must be disclosed to investors.

In conclusion, remember that if you are not yet ready to conduct an offering under the new Rule 506(c), you can always conduct a private placement under the old Rule 506(b) that remains unchanged. Although that Rule does not allow general solicitation or advertising, it is not limited to accredited investors only (up to 35 sophisticated purchasers can participate) and the issuer does not have to take “reasonable” steps to ensure the accredited status of its investors. Also, keep in mind that the new Rule may still change. The SEC has proposed more rules (the comment period on those expires on September 23rd) that may add complexity to Rule 506(c), such as advance Form D filings, legends, filings of offering materials with the SEC, among others.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.