Wednesday, September 16, 2015

General Solicitation Restrictions for Private Placement Issuers

On August 6, 2015, the Securities and Exchange Commission (the "SEC") issued a number of Compliance and Disclosure Interpretations ("CDIs") related to the issue of “general solicitation” (or “general advertising”) as it pertains to issuers seeking to raise capital in private placements in a Rule 506 transaction. As this blog has discussed elsewhere, Rule 506 under the Securities Act of 1933 allows companies to raise unlimited amounts of capital without having to register the securities with the SEC. Under Rule 506(b), these securities may only be sold to “accredited investors” (a category generally restricted to high net worth individuals and large institutional investors such as investment banks, pension funds, insurance companies, etc.) and to a limited number (no more than 35) “sophisticated” non-accredited investors. Traditionally, this limit on investor participation has been bolstered by a complete ban on the use of “general solicitation” by issuers (or their agents, such as registered BDs acting as placement agent) offering Rule 506 securities to investors. This restriction on general solicitation is found in Rule 502(c) (To avoid any confusion, Rule 502(c) will henceforth be referred to simply as Rule 502 to differentiate it from Rule 506(c)). The rule does not define the term “general solicitation” or “general advertising”, though it does offer a non-exhaustive list of what would be considered to be so, including the use of “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio.”

The JOBS (Jumpstart Our Business Startups) Act amended Rule 506 by adding a new Section 506(c), which did away with this restriction on general advertising for issuers relying on this new Section 506(c), while also imposing more stringent requirements on who could actually invest (i.e. all of the actual purchasers must be accredited investors; even the most sophisticated non-accredited investors are barred from participation) as well as the steps an issuer or its agent had to take to ensure that such investors are, in fact, accredited. One reason for this amendment was that the prior complete ban on general solicitation for all Rule 506 private placements was seen as a barrier to the ability of some companies, particularly startups and smaller companies, to raise the capital they needed.

This amendment has, therefore, largely been welcomed. At the same time, however, there has been some concern that, given that companies now could engage in general solicitation (so long as they complied with the other requirements of Rule 506(c)), the SEC would begin to take a stricter enforcement approach regarding what they would consider to be general solicitation for companies choosing to raise capital under the “old” Rule 506(b). (Note that “old” here is merely used to differentiate Rule 506(b) from Rule 506(c); the availability of Rule 506(b) has not been eliminated by the new amendment.) The eleven CDIs issued by the SEC on August 6th were, in part, an effort to respond to these concerns. This blog post will discuss and analyze each of these eleven CDIs in turn. (On the SEC website, these appear in the Securities Act Rules and Interpretations Section as Questions 256.23 through 256.33, and will be numbered accordingly here).

Question 256.23

Here, the SEC states explicitly that the use of an unrestricted, publicly accessible website to offer or sell securities would constitute general solicitation or advertising. Therefore, a company relying on the “old” Rule 506(b) to offer securities would be barred from doing so on a publicly accessible website. This is hardly surprising, though it is nice to have it stated so explicitly.

Question 256.24

Here, the SEC addresses what kinds of information a company can widely disseminate without violating the Rule 502 ban on general solicitation. This can be an issue because the SEC takes a very broad view of what constitutes an “offer” to sell securities. Information which is designed or which can have the effect of arousing investor interest in a company, even if no actual mention of any securities being offered or sold is included, may in some instances be considered to be “general solicitation or advertising.” An example might be a press release that includes rosy projections about future potential growth or future earnings. The idea is that, if the company is considering raising capital in the near term, widely distributed communications that have (or appear to have) the intent of ginning up interest may be deemed to be “general solicitation,” which again would preclude the company from relying on the registration exemption under Rule 506(b). As the SEC puts it, information which “condition[s] the public mind or arouse[s] public interest” in a securities offering (even where the offering is not mentioned or alluded to) would result in a violation of the general solicitation ban. Conversely, information that does not condition or arouse the public’s interest would be acceptable. Thus, disseminating purely factual business information about the company would not violate the restriction on general solicitation.

Question 256.25

This brings us directly to the next question, which asks: What is factual business information?

As with many securities-related issues, the SEC’s answer stresses that its determination of what constitutes factual business information is dependent on the specific circumstances in each instance. In general, however, “factual business information” means information about the issuer itself, its general financial condition, the products and/or services it offers, and the advertising of those products and services in the normal course of business. This definition largely tracks the definition of “factual business information” found within Rule 169, although it should be noted here that this Rule does not apply directly to Rule 506 transactions and thus should be viewed strictly as a general guideline. Where a company must be careful is when information it is providing includes what are often called “forward-looking statements,” such as projections or predictions about future performance, and in particular any forecasts or opinions about the future value of the company’s securities.

Companies which are contemplating making use of Rule 506(b) to raise capital in the near-term must be aware that the information they send out may be more closely scrutinized with respect to whether these efforts constitute “general solicitation or advertising” in connection with their intended offering. Although, as the SEC says, each situation is fact and circumstance-specific, one thing to consider is whether the company is acting in a way similar to or different from its own past practices. For example, if a company has not previously been in the habit of releasing quarterly sales results in the past, and then begins to do so shortly before attempting to raise capital in a private placement, this change in behavior may be flagged and scrutinized by the SEC. In general, companies which are considering using Rule 506(b) to raise capital should whenever possible consult with legal counsel to ensure that they do not inadvertently include information extending beyond what the SEC here refers to as “factual business information.”

Question 256.26

This question discusses one way to demonstrate the absence of general solicitation, namely where an offer to purchase securities is made to a person or persons with whom the issuer, or a person acting on its behalf (such as a registered broker-dealer acting as a placement agent) has a “pre-existing, substantive relationship.” For example, if a company is engaging in a later-stage financing round, offering securities to persons who have invested in prior rounds would generally not be considered general solicitation. Similarly, if the issuer is offering the securities through an intermediary such as a registered broker-dealer (BD), the issuer can “piggyback” onto the pre-existing, substantive relationship that the BD has with its clients, and thus the offering of securities to these persons would also not constitute general solicitation.

Question 256.27

This question asks whether there are situations where an issuer or its agent can provide information about a securities offering to persons with whom it does not have a pre-existing, substantive relationship without that information being deemed to constitute general solicitation.

The short answer is yes; the more precise answer is yes, but only in certain instances. In their answer to this question, the SEC acknowledges the “long-standing practice” where issuers or their agents are introduced to prospective investors who constitute an informal, personal network of individuals experienced with investing in private placements. The universe of early-stage investors, particularly those individuals who regularly serve as so-called “angel” investors, tends to be small and somewhat tight-knit (particularly in areas like technology). Angel investors often introduce companies they like to others in their groups. Making offers of securities to these individuals would not, per se, constitute general solicitation or advertising. In a sense, the issuer would be relying on the assumption that all of the investors in this network have the necessary financial experience and sophistication. Thus, an individual investor’s membership in this informal network serves to convey to the issuer (or its agent) the information that the issuer would normally attain by virtue of a pre-existing, substantive relationship with that investor.

Caution should be exercised before relying on this SEC guidance too heavily; as the SEC itself notes, the greater the number of people with whom an issuer does not already have a pre-existing, substantive relationship, the more likely it will be that the SEC will find that there has been general solicitation. There is, of course, no predetermined number; as with everything else, the determination will depend on the specific facts and circumstances of each case.

Question 256.28

This question asks straightforwardly whether someone other than a registered BD is able to form a pre-existing, substantive relationship with a prospective offeree (of securities), thus avoiding the general solicitation trap. According to the SEC, investment advisers who are registered with the SEC may also be able to establish such a relationship because they owe a fiduciary duty to its clients to provide only suitable investment advice (BDs owe similar duties to their clients.) The theory is that, in order to fulfill this fiduciary duty, the investment adviser would need to reasonably determine that its client is financially sophisticated and experienced enough to invest in the issuer’s securities. (Remember that a reasonable determination of an investor’s sophistication is the primary impetus behind the requirement of a pre-existing, substantive relationship in the first place.)

Question 256.29

This question asks for a definition of what “pre-existing” means in the context of a pre-existing, substantive relationship. Here, thankfully, the term is rather self-explanatory. For an issuer itself, this means that the issuer formed its relationship with the prospective offeree before the commencement of its offer to sell securities. If the relationship was formed through an intermediary such as a BD or investment adviser, this means that the relationship was formed before the BD or investment adviser became involved in the offering.

Question 256.30

This question deals with a related follow-up: Is there a minimum waiting period required for an issuer (or its intermediary) to establish a pre-existing, substantive relationship with a potential investor before it can commence an offering of securities? In short, the answer is no; so long as the relationship was established before the offering, offering securities to that potential investor will not constitute general solicitation.  This is a departure from the previously endorsed waiting period of 30 days between the self accreditation of a prospective investor and the ability of an agent to make an offer to such person.  See Lamp Technologies No-Action Letter (May 29, 1997).

In practice, of course, it would be prudent to impose at least some nominal waiting period, but there is no technical requirement for any particular length of time to pass between the establishment of the pre-existing, substantive relationship and the offering of securities.

The SEC also mentions a specific, limited accommodation it will allow for certain private funds that offer investments on a semi-continuous (e.g. quarterly or annual) basis, but as this accommodation is not applicable to most companies raising capital, I will forego further discussion of it here.

Question 256.31

This question asks for a definition of what constitutes a “substantive” relationship for the purposes of demonstrating the absence of general solicitation. Here, the SEC is kind enough to oblige by offering an actual definition: A “substantive” relationship is “one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor.” The SEC also specifically cautions here that mere “self-certification” is insufficient, in and of itself, to establish a substantive relationship. (Note that it may be possible, however, for an issuer to rely on an intermediary’s own reasonable belief; e.g. if the investor’s BD tells you the investor is sufficiently sophisticated and informed, that may be enough to establish the issuer’s own reasonable belief.)

Question 256.32

This question asks whether anyone other than BDs and investment advisers can form a pre-existing, substantive relationship with a potential investor in order to demonstrate the absence of general solicitation. The short answer here, again, is yes. What should be kept in mind is that it is the nature of the relationship which broker-dealers and investment advisers have with their clients, rather than the mere fact of the relationship itself, which allows them to demonstrate the existence of such a relationship. Thus, as the SEC puts it, “there may be facts and circumstances in which a third party, other than a registered broker-dealer [or registered investment adviser] could establish a pre-existing, substantive relationship.”

Practically speaking, it’s possible but difficult. Unless the third party (such as the issuer itself) has either a pre-existing business relationship or some kind of recognized legal duty to its offerees, the SEC cautions that it will be more difficult to establish a pre-existing, substantive relationship. For this reason, if the issuer will not be using an intermediary such as a registered BD or investment adviser, it may wish, for pragmatic reasons, to consider offering securities under Rule 506(c), rather than Rule 506(b), thus avoiding the general solicitation issue.

Question 256.33

Finally, Question 256.33 asks whether the holding of a “demo day” or “venture fair” will necessarily constitute general solicitation. The short answer is no; whether such an event constitutes general solicitation depends, as usual, on the specific facts and circumstances. Here, the two primary considerations are 1) what is being presented; and 2) who is the audience.

First, if the presentation does not involve anything that would be considered an “offer” of securities, there is no general solicitation issue. (Keep in mind, of course, the SEC’s broad interpretation of “offer” discussed above with respect to “factual business information.”) Second, if the presentation does involve an “offer” of securities, whether the event constitutes general solicitation will depend on who is invited to the event. If the only people attending are those with whom the issuer (either itself or through its intermediary) already enjoys a pre-existing, substantial relationship (or to whom it is being introduced through the sort of informal, experienced investor networks discussed above in Question 256.27), then the event will not constitute a general solicitation. (Keep in mind, however, that if materials related to the offering are distributed at such an event, and find their way to a wider public audience later, there may be a general solicitation issue.)

Thus, if an issuer is considering holding an event such as a demo day or venture fair, and intends to rely on the “old” Rule 506(b) for its private placement, it must first determine whether its activities will be deemed by the SEC to constitute an “offer” of securities; if so, it must carefully restrict access to this event to those with whom it has a pre-existing, substantive relationship (or, again, to those who may be excepted from this general rule by virtue of their involvement in an informal investing network as discussed above.)

I have previously discussed securities law-related issues about pitches and demo days here.

In a nutshell, if your company is intending to raise capital in a Rule 506(b) private placement, it must be careful about what information it provides and who it provides that information to. As this blog post has hopefully made clear, even following this recent round of CDIs, there are few hard and fast rules or “lines in the sand” when it comes to determining what constitutes general solicitation, and it is always prudent to consult with legal counsel experienced in securities law matters.

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 corporate, securities, and intellectual property law.

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