New Rule 506(c): SEC Opens Door to Raise Capital Through General Advertising Effective September 23, 2013 Congress loosened certain securities requirements to promote capital formation and job creation, including: Rule 506(c) (rule effective 9/23/2013) Crowdfunding (rules pending) How? Rule 506(c), allows sales to accredited investors through general solicitation to the public. States are preempted to conduct merit review of offering. States retain anti-fraud jurisdiction, and possibly over BDs or finders if compensation is tied to the transaction. Currently, three rules exempt offerings from registration requirements. Rules 504 and 505 were established to help small business raise capital with offering sizes limited to $1 - $5 Million. Rule 506 has no limit on offering size, but – unless the new 506(c) is used – an issuer can’t advertise to the general public. In 2012, private offerings under Rule 506 offerings resulted in over $173 billion of capital raised by operating companies. Median 506 offering is $1 million. Rule 506 is the most widely used registration exemption (approximately 99% of capital raised under Regulation D from 2009-2012). Current Rule 506: No limit on offering size; Sales to an unlimited number of accredited investors and up to 35 non-accredited investors who the issuer reasonably believes can evaluate the offer’s merits and risks; No general solicitation, thus registered BDs or “finders” may assist the issuer in placement efforts (i.e., locating investors). General Solicitation includes, “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio" or "any seminar or meeting whose attendees have been invited by any general solicitation.” Rule 502(a). The SEC has interpreted general solicitation to include unrestricted websites. In response to JOBS Act, on July 10, 2013, the SEC eliminated the prohibition against general solicitation in Rule 506(c) offerings. Rule 506(c) becomes effective September 23, 2013. Solicitation / advertising can be to anyone, but sale only to accredited investors. Under Rule 506(c), a company or private fund may use general solicitation in its offering, provided: 1. all sales are made to accredited investors; 2. the company takes reasonable steps to verify the purchaser is an accredited investor; and 3. Comply with Rule 501, 502(a) and 502(d) definitions, conditions, resale limitations. Another amendment disqualifies an issuer from relying Rule 506 if the issuer or certain related parties are a bad actor (discussed below). An issuer can choose which exemption it wants to use. 506(b) Remains. 506(b) allows an offering without general solicitation. Benefits of 506(b), include: No need to take reasonable steps to verify whether the purchaser is an accredited investor. Less expense than 506(c). However, if general solicitation under the “new” 506(c) is used, there is a six-month "cooling off" period before the issuer can undertake an offering to non-accredited investors under the “old” 506(b). Note: Item 6 on Form D has a box for “(c)” offerings. Issuer or private fund can’t use both (b) and (c) in one offering. New 506(c) - Form and content of an offering is relatively open, though communications are still subject to anti-fraud rules; Meaning: issuer shouldn’t make promises it can’t keep. For resale purposes, use of a general solicitation doesn’t convert privately issued securities into “public offerings”. Securities issued under Rule 506(c) are still “restricted securities”. “Accredited investor” is defined in Rule 501(a): For an individual to qualify as an accredited investor, issuer must reasonably believe that the investor: (1) has a net worth of at least $1,000,000, excluding the value of their primary residence; or (2) has income of at least $200,000 each year for the last two years (or $300,000 together with his or her spouse, if married) and have the expectation to make the same amount in the current year. Other accredited investors may based on their status: BDs, investment companies, employee benefit plans. Two ways to verify: objective standard or selecting one of four safe harbors. Objective standard is used to determine if a purchaser is an accredited investor by considering the particular facts and circumstances of each purchaser and transaction: Issuer should consider: The nature of the investor and the type of accredited investor that the investor claims to be; The amount of information the issuer has about the investor; The nature of the offering (for example: an unrestricted website offering may require additional due diligence, while a high minimum investment amount could indicate the investor’s net worth / income). Four safe harbors to verify that individuals (natural persons) are accredited, (unless issuer knows the individual is not an accredited investor): 1. Income: verifying through reliance on combination of tax reporting forms and written investor representation Tax docs showing income (W2 / 1099) and return (1040) for two most recent years and a written statement that the investor reasonably expects to meet the requisite income level for the current year. 2. Net Worth: verifying through reliance on (i) recent statements from financial institution, tax assessments, and third party appraisals or recent credit report and (ii) written statement that all liabilities have been disclosed. Cont… 3. Third party confirmation. Verification by relying on written confirmation from a registered BD, SEC registered IA, licensed attorney, or CPA, and that the third party took reasonable steps to verify the purchaser is an accredited investor within past three months and has determined that such a purchaser is an accredited investor. 4. Prior dealings. Verification based certification that the investor participated in the same issuer’s prior 506(b) offering. The means by which an offering is made is relevant in reviewing the reasonableness of the issuer’s evaluation (more steps may be required for a Facebook or Twitter solicitation that a pre-screened pool). BDs have experience screening investor suitability. Third-party online accredited investor verification services have already surfaced: www.accreditedinvestorsolutions.com www.crowdentials.com www.civalidator.com www.secondmarket.com The Securities Division does not endorse these sites. An issuer is responsible for taking reasonable steps to verify whether a purchaser is accredited investor. For issuers: High minimum investment amounts may mitigate need for additional verification. Investor questionnaires – i.e., “what is your net worth” - are not sufficient verification. Record retention is a necessity. Concerns with unregistered finders: Employees of private funds may run afoul of regulatory agencies by: Engaging in business of effecting transactions in securities for the accounts of others, especially if compensation tied to transaction. Securities issued under all 506 exemption are preempted from state securities or “blue sky” laws with respect to merits and qualification of the offering. State laws requiring BDs and IAs to be registered are not preempted. Section 201 of the JOBS Act provided a limited registration exemption for intermediaries of 506 offerings, however, their compensation cannot be transactionbased. Thus, issuers relying on the 506(c) exemption should consult with each state in which investors will be solicited to determine whether the solicitor must be registered or is exempt. Generally, IAs with assets under management below $100 Million are state regulated. Common for IA to use 506 offerings Because of 506(c) allows internet offerings, the offering may reach into other states (as compared to 506(b)). Unclear whether IAs using 506(c) will have to registered in each state and DC. Issuers / private funds should consult with each state where investors may be solicited. New Rule 506(d) prohibits issuers from relying on Rule 506 exemption if the issuer or certain related persons are bad actors: Related persons whose bad acts can disqualify an issuer include: Directors, executive officers, GP's or managing members; 20% beneficial owners Certain promoters, investment managers, placement agents and their controlling persons. Start-up companies can solicit funds on social media. Established private companies can raise capital without the assistance of an investment banker. Facilitates capital formation. Verification process may deter investors because of privacy concerns.