[author: Richard M. Leisner
Regulation D offerings are a very important part of capital formation. In recent years, annual proceeds from Regulation D private offerings have totaled almost $1 trillion, approximately equal to the proceeds from all SEC registered offerings. These impressive results were achieved despite a regulatory scheme that prohibited the use of general solicitation or general advertising (“GS”).
Section 201(a)(1) of the JOBS Act directed the SEC to modify Rule 506 under Regulation D to remove the GS prohibition in offerings where all investors are “accredited investors.” In late August, the SEC moved closer to complying with this legislative mandate, issuing proposed rules in a 69-page explanatory memo (here
). The comment period on the proposals has closed and the issuance of final rules is widely anticipated.
Ending the GS prohibitions in Rule 506 offerings promises to be a very big deal for capital formation. It may be no exaggeration to predict that the new regulatory regime that permits GS in private offerings will foster many billions in new capital formation transactions. In these circumstances, the intense interest – and harsh criticism from disparate sources – is hardly surprising. For litigators, effective preparation for the inevitable wave of law suits that will follow adoption of final rules begins with an understanding of the proposals.
This note will briefly evaluate both the SEC’s proposals and some of the not inconsiderable criticism of the proposals in comment letters sent to the SEC (all comment letters are here
SEC Proposed New Rule 506(c)
The SEC proposes to amend Rule 506 of Regulation D by adding a new provision, Rule 506(c). The new rule is a securities registration exemption for “private offerings” that may use general solicitation or general advertising, provided:
All purchasers are “accredited investors”; and
"Reasonable steps to verify” accredited investor status are taken.
The proposals do not affect the current definition of “accredited investor,” which has always been included in Regulation D. Accredited investors comprise eight categories of individuals and entities with specified financial wherewithal or regulatory status, such as individual millionaires, individuals making more than $200,000 per year, banks, registered broker dealers and insurance companies (all definitions of accredited investors are in Rule 501(a)(1), available here
The rule proposals, however, do not include a definition of conduct that will (or will not) satisfy the “reasonable steps to verify” condition of New Rule 506(c). The proposal states “Whether steps taken are ‘reasonable,’ would be an objective determination, based on the particular facts and circumstances of each transaction.”
The release includes several pages of discussion of facts and circumstances that may bear on the determination of whether verifying steps were “reasonable.” The discussion indicates certain circumstances that would tend to require fewer – or more – verifying steps, including:
Nature of the purchaser and type of accredited investor the purchaser claims to be.
Amount and type of information the issuer has about a purchaser.
Nature of the offering, such as the manner in which the purchaser was solicited (mass media, internet or pre-screened data base of wealthy clients of broker dealer).
Terms of the offering, such as a large minimum investment amount.
Financing purchaser’s large cash investment by the issuer or a third party.
Accredited Investor Status – “Reasonable Belief” and “Reasonable Steps”
Under Regulation D an investor is treated as an accredited investor if one of two alternative conditions is satisfied: (1) the investor in fact meets the requirements of one or more of the eight categories of accredited investor specified in the definitions or (2) the issuer “reasonably believes” the investor met such requirements. The SEC has consistently taken the position that deciding if the issuer has met the “reasonable belief” requirement is to be determined upon consideration of the applicable facts and circumstances.
At first blush the concept of “reasonable belief” of accredited investor status appears to be substantively indistinguishable from the JOBS Act concept of “reasonable steps to verify” such status. In the proposing release, the SEC observed:
"[W]e anticipate that many practices currently used by issuers [to establish reasonable belief] in connection with existing Rule 506 offerings would satisfy the verification requirement proposed for offerings pursuant to [New] Rule 506(c)."
The SEC’s seemingly innocuous position contrasted with recommendations in comment letters from industry participants that the SEC specifically equate reasonable belief and reasonable steps behavior. In that case, conduct supporting “reasonable belief” in accredited investors status would also meet the “reasonable steps to verify” standard. Regulators and consumer advocates, not surprisingly, argued that verification activities should go well beyond those needed for “mere” reasonable belief. The rule proposals made numerous references to the comment letters asserting these opposing positions.
Charting a Middle Course
The SEC rule proposals chart a middle course: First, in evaluating what verifying steps will (or will not) be “reasonable,” the SEC rejected bright-line non-exclusive safe harbors, choosing instead the facts and circumstances analysis. Second, the SEC neither endorsed nor rejected equating “reasonable belief” standards with “reasonable steps” behavior, thereby effectively reiterating the facts and circumstances approach. As a result, the SEC succeeded in garnering criticism from lawmakers, regulators and industry participants.
Critics Have Their Say About Self-Certification
One high profile source of criticism was the North American State Securities Administrators (NASAA). To begin with, NASAA’s comment letter to the SEC (here
) rejected as “reasonable” verification activity the well-established industry practice of “self-certification” – relying on the investor “checking the box” on a subscription agreement representing to the issuer that the investor met one or more of the accredited investor criteria.
Some commentators (including NASAA) have suggested that the SEC’s proposing release rejected self-certification as a “reasonable” verifying action. In my view, this overstates both the actual language and tone of the SEC release. Certainly, the SEC did not endorse self-certification as a sufficient stand-alone verifying step for most offerings. Neither did the SEC reject such self-certification. Instead the SEC asked for comments on what circumstances, if any, limiting verifying steps solely to checking-the-box would be “reasonable.” In this regard, the information that many issuers will have about a prospective investor will not be limited solely to one checked box on a subscription agreement. However, the amount of information the issuer has about an investor may be significantly limited for prospective investors attracted to an offering through the internet or other mass media and with whom the issuer had no relationship before the offering.
Non-Exclusive Safe Harbors
In addition to rejecting self-certification, NASAA recommended that the SEC adopt new non-exclusive “safe harbors” that would be deemed to be reasonable verification steps. For individuals, NASAA suggested income should be verified by investors providing tax returns, Forms W-2 or 1099 or recent pay stubs. For individual net worth, NASAA suggested bank and brokerage statements, real estate appraisals or tax assessments coupled with an investor sworn list of all liabilities. In addition to NASAA, supporters of requiring documentary evidence of financial wherewithal include the SEC’s Investor Advisory Committee (here
Underlying the suggestion to use documentary evidence of financial wherewithal may be the belief that bright-line safe harbors will reduce fraud under new Rule 506(c). There is concern that unscrupulous promoters will take advantage of GS to foist unsuitable or fraudulent investments on non-accredited investors (who may find it all too easy to lie about their financial wherewithal under the SEC’s “facts and circumstances” proposal).
The SEC’s proposing release, as well as a number of commentators, expressed concerns about the bright-line “safe harbor” approach. First, there were worries that behaviors initially adopted as non-exclusive safe harbors would rapidly morph into industry standard mandatory minimums for reasonable verification steps. Second, there were concerns that many prospective investors would refuse to provide sensitive personal information as a precondition to making an investment. In the decades that Regulation D has been used as an effective capital raising exemption, established industry custom never included investors providing tax returns, W-2s, brokerage statements or property appraisals as a pre-condition to establishing accredited investor status.
Critics of the SEC’s facts and circumstances approach warn that the absence of safe-harbor certainty about “reasonable” verification actions will lead to protracted litigation about the issuer’s conduct when disappointed investors attempt to recoup their losses in litigation. It is unlikely, according to such critics, that the facts and circumstances issues could be resolved until trial. Such critics also suggest that many issuers and their advisers concerned about the absence of safe-harbor certainty will choose not to rely on New Rule 506(c) as an effective capital raising exemption.
Should Verifying Steps be a Condition of Rule 506(c)?
Criticism has also been directed at the SEC’s facts and circumstances test by those who assert that the JOBS Act’s language concerning reasonable steps to verify accredited investor status should not be made a substantive requirement of New Rule 506(c). These critics point out that there is no reference to verifying accredited investor status in the sentence directing the SEC to remove GS prohibitions in Rule 506 offerings made solely to accredited investors. The language regarding reasonable verifying steps appears in the next sentence of the law. It directs the SEC to adopt rules requiring the issuer to take reasonable steps to verify accredited investor status. These critics point out that nothing in the language of the JOBS Act states that taking such reasonable verification steps should be a condition of the new exemption.
According to this analysis, the JOBS Act requires the SEC to adopt a rule directing issuers to use reasonable steps to verify accredited investor status, but the failure to undertake such steps should not result in a loss of the exemption. The existing provisions of Regulation D provide precedent for not losing an exemption for failure to follow rules requiring certain behavior. Rule 503 requires the filing Form D, but failure to file the form will not destroy the availability of Regulation D for a transaction that otherwise satisfies applicable requirements of Regulation D.
Other Takeaways and Open Issues
While proposing New Rule 506(c), the SEC also proposed to retain as a separate exemption the pre-JOBS Act Rule 506 exemption, renumbered as Rule 506(b) (“Old Rule 506”). Old Rule 506 would preserve the regulatory “status quo ante,” complete with GS prohibitions but free from any required reasonable steps to verify accredited investor status.
Close juxtaposition in timing between Old Rule 506(b) offerings and New Rule 506(c) offerings could pose risks to exemption compliance for both transactions if they were subject to “integration” and treated as a single offering for compliance purposes. GS in the New Rule 506(c) offering might run afoul of the GS prohibitions applicable to the Old Rule 506(b) offering. And, the reasonable belief concerning accredited investor status in the Old Rule 506(b) offering might be insufficient to satisfy the necessary verifying steps required under New Rule 506(c).
Possibly more troubling is the situation in which all investors in a New Rule 506(c) offering are accredited investors per the requirements of the Regulation D definition – but for one or two investors there were very limited or even no verifying steps taken. In these circumstances, would the exemption be lost for an entire offering?
For answers to these and other questions, we look forward to the SEC’s final rules concerning “private offerings” with general solicitation and general advertising.
An earlier article reviewing the terms of these and other provisions of the JOBS Act, including provisions for crowdfunding and emerging growth companies, is available here