Internet Based Offerings to Accredited Investors Will Soon Be Legal
Access to capital is one of the most challenging issues facing young companies today. In order to engage in a private placement of securities that is exempt from registration under the federal securities laws, the most popular approach has been an offering under Rule 506, under which most of the requirements that may be imposed under state law are preempted. An offering under Rule 506 permits sales of securities to an unlimited number of accredited investors, and up to 35 non-accredited investors. As described in greater detail below, accredited investors are people who meet minimum wealth or income standards, or institutional investors.
Historically, Rule 506 was available only if investors were not solicited using general solicitation. General solicitation refers to public communications of the investment opportunity, and may include postings on unrestricted websites as well as email blasts, the use of social media, advertisements published in newspapers and magazines, communications broadcast over television and radio, and other similar widespread dissemination of information relating to the offering. The problem is that most business owners don't know many wealthy people, and institutional investors are usually most interested in large, well established companies.
Under the JOBS Act, which became law in April of 2012, the SEC was required to issue new rules that would permit general solicitation of investors in Rule 506 offerings. The goal is to give entrepreneurs more tools to identify and solicit prospective investors who are accredited. In August 2012, the SEC proposed the regulations required by the JOBS Act to permit general solicitation in Rule 506 offerings. We had expected a fairly rapid turnaround in finalizing the rules. But the SEC received a very large number of comments, many of which were conflicting in their positions, and accordingly, we have been waiting for many months for the SEC to act.
On July 10, 2013, the SEC finally released the final rules that will permit general solicitation in Rule 506 offerings so long as the only purchasers are accredited investors. The rule changes will become effective 60 days after publication in the Federal Register, which should occur soon.
A new Rule 506(c) will be added to Regulation D, setting out the requirements for an offering in which general solicitation is utilized. The new rule requires that all purchasers of the securities sold in the offering must be accredited investors. As a separate element, the issuer is required to undertake reasonable steps to verify that all of the purchasers of the securities sold in the offering are accredited investors. The SEC has made it clear that if all the investors are accredited investors but the issuer fails to undertake the reasonable steps to verify the investors' status, the exemption will not be available.
The principle underlying the concept of accredited investors is that a person or entity having a certain status or financial wherewithal does not need the same level of protection under the securities laws as other purchasers of securities. Under Regulation D, there are numerous categories of investors who may qualify as accredited investors, ranging from pension plans and corporations having total assets in excess of $5 million dollars, to regulated entities such as banks and investment companies. In most cases, the accredited investor status of this type of entity is relatively easy to establish, and the SEC has chosen to rely only on the "reasonable steps" requirement.
Natural persons are accredited if they either: have a net worth or joint net worth with a spouse in excess of $1 million dollars excluding the value of the investor's primary residence; or have annual income of $200,000 or joint annual income with a spouse of $300,000 in the year of investment (expected) and each of the prior two years (actual). The difficult issue for the SEC was establishing what "reasonable steps" should be undertaken by an issuer to establish the accredited status of a natural person.
Because of the difficulty in determining what steps might be reasonable to verify that a natural person is an accredited investor, the SEC elected in the final rule to take the approach of listing several non-exclusive and non-mandatory methods of verifying that a natural person is indeed accredited. The point is to allow issuers to pursue other tactics if they are effective and can be defended as reasonable, while also providing assurance that if specific steps are followed, these steps will be considered to be reasonable. In listing these specific approaches that will be deemed to be reasonable steps to verify the accredited investor status of a natural person, the SEC has made it clear that if the issuer has knowledge that the person is not an accredited investor, following these steps will not be sufficient.
The non-exclusive and non-mandatory methods may be broken out into three categories:
- Reasonable steps to directly verify income. An issuer may verify income by reviewing any Internal Revenue Service form that reports the purchaser's income for the two most recent years and obtaining a written representation from the purchaser that the purchaser has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year. Examples of acceptable Internal Revenue Service forms include Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040.
- Reasonable steps to directly verify net worth. An issuer may rely on the following types of documentation dated within the prior three months of the purchase of the security to establish net worth, plus a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
- With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
- With respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.
- Third party verification. As an alternative to the foregoing approaches to collecting direct information from a purchaser as to income or net worth, the issuer may accept a written confirmation from one of the following persons or entities that the person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that the purchaser is an accredited investor:
- A registered broker dealer;
- An investment advisor registered with the Securities and Exchange Commission;
- A licensed attorney; or
- A certified public accountant.
If qualification of an accredited investor is based on joint income or net worth with a spouse, any certification will have to be provided both by the investor and by the spouse.
Simultaneously with the release of the rule permitting general solicitation in offerings that are limited to accredited investors under Rule 506, the SEC also adopted a rule that prohibits felons and other "bad actors" from relying on Rule 506 for an exemption from registration. While this article will not go into the details of this new rule, you must be aware that there are now very explicit limitations on which companies may rely on Rule 506 for exempt offerings, based on the prior bad acts of the company, its management team or key owners.
The opportunity to begin raising capital by soliciting accredited investors through the web, social media, email blasts and similar technology resources opens up new and interesting possibilities for companies that seek to raise capital. Time will tell whether investors are willing to provide the type of information that the SEC will consider to be reasonable verification of accredited investor status. Because of the stringent requirements imposed by the SEC, if you are devising strategies to solicit investors using these various electronic and public media, it is critical that you work with competent legal counsel to make sure that you satisfy all of the requirements. If you fail to follow all the rules, you could experience significant adverse impacts ranging from giving the investors the right to rescind the investment to possible criminal liability.
Please contact Iris Linder (517-371-8127 or by using the form below) for more information.
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