Today (August 29, 2012) the Securities & Exchange Commission (SEC) released its long-awaited proposed regulations for public advertising of Rule 506 offerings. This is pursuant to the JOBS ACT that was signed this past April. It is extremely important for companies looking to raise money.
The SEC is going to have only a 30-day public comment period and then will decide whether to finally approve the regulations “shortly thereafter.” This is positive; some feared the SEC might have a much longer comment period, perhaps 90 days, and then take months after that to approve the regulations.
It seems that there are no restrictions on the type of advertising that may be done. This is also positive in that some were concerned that the SEC would limit advertising to perhaps as little as a brief “tombstone” ad. This is the very limited amount of advertising that is allowed under the Model Accredited Investors Exemption that more than 30 states adopted a number of years ago.
The SEC’s primary focus in the proposed regulations concerns instead what offering companies must do to verify that each potential investor is an “accredited investor”. (If a company chooses to use the proposed advertising approach for Rule 506 – rather than the traditional Rule 506 offering – it is limited to accredited investors only.)
Basic Approach for Verifying Accredited Investor Status
In its proposed regulations, the SEC does NOT require potential investors to provide tax returns. That was a concern, since it is likely that many accredited investors would refuse to provide their tax returns and look for other investments where that was not a requirement.
Instead the proposed regulations say the burden is on each offering company to show that it used appropriate methods to arrive at a reasonable belief that an investor is accredited. The method of doing that is dependent on the type of investor, the offering, etc. While this approach is certainly better than requiring each potential investor to provide tax returns, it also means that with an advertised Rule 506 offering there is no “safe harbor” as there is now with respect to completed investor questionnaires.
(Under the traditional Rule 506 approach, an offering company was entitled to rely on a completed investor questionnaire indicating that the investor was accredited unless the company had reason to doubt the answers. In other words, if the only information an offering company had about an investor’s qualifications were the responses to the questions, the company could rely on those even if the responses later turned out to be less than truthful.)
Unfortunately, the proposed regulations do not offer clear guidance as to what methods of verification will be adequate. The regulations state that “the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors” and must reasonably believe that those investors are accredited. (The SEC also notes that the “burden of showing” that appropriate methods were used rests on the issuer.) According to the proposed regulations, the methods will vary not only from offering to offering but from investor to investor within the same offering as well.
In part, the appropriate method depends on how much information the offeror has regarding a particular investor. The proposed regulations state that “The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa.”
The proposed regulations state that the types of information that an issuer may be able to rely on include but are not limited to “third-party information” such as:
The purchaser is a natural person and provides copies of Forms W-2; or
The purchaser works in a field where industry or trade publications disclose average annual compensation for certain levels of employees or partners, and specific information about the average compensation earned at the purchaser’s workplace by persons at the level of the purchaser’s seniority is publicly available; or
Verification of a person’s status as an accredited investor by a third party, such as a broker-dealer, attorney or accountant, provided that the issuer has a reasonable basis to rely on such third-party verification.
Effect of How the Offering Is Made
In addition, the proposed regulations state that the way the offering is made makes a difference:
An issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer. In the case of the former, we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status. [Emphasis added.]
The SEC has long stated that a form requiring an investor only to check a box saying that the investor is accredited is not sufficient. That is why current investor questionnaires ask a variety of questions. The reference to “check a box” may indicate that a traditional Rule 506 investor questionnaire may be adequate in some (but not all) cases.
High Minimum Investment Amounts
Further, the proposed regulations state that “a purchaser’s ability to meet a high minimum investment amount could be relevant to the issuer’s evaluation of the types of steps that would be reasonable to take in order to verify that purchaser’s status as an accredited investor.” That is the situation at least if the minimum is high enough that only accredited investors could reasonably be expected to meet it and there is no financing by other parties.
Not surprisingly, the proposed regulations stress that it is “important for issuers to retain adequate records that document the steps taken to verify that a purchaser was an accredited investor.”
Finally, the proposed regulations make clear that issuers may still use the traditional Rule 506 exemption instead. That will appeal to companies that do not need public advertising and prefer having the option of including non-accredited but sophisticated investors.
In any case, with respect to the public advertising approach to Rule 560 offerings, expect there to be many articles and comments – and much disagreement – about what constitutes adequate methods of verification under the particular circumstances.
Bruce E. Methven
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