The JOBS Act – optimistically named – created a number of new ways for private companies to access capital for growth and operations. Some are more meaningful than others. This article is focused on lifting the ban against general solicitation of accredited investors in an offering that is exempt from registration with federal and state regulators. It is one of the most promising developments in recent history for companies in search of funding.
First, a little background. Whenever a company wishes to sell securities, it either must (a) register those securities with state and federal regulators; or (b) identify a specific exemption from registration. The penalties for non-compliance are very heavy. There may be SEC and state regulatory discipline, and a risk that the business and its owners become liable to investors for a return of their funds.
One such exemption that has been heavily utilized is the so-called ‘Rule 506 offering’. To avoid burdensome disclosure requirements, companies generally utilize this exemption for sales of securities only to so-called ‘accredited investors’. An ‘accredited investor’ is someone who falls into one of the following categories: (a) he has a net worth of at least $1,000,000, exclusive of his personal residence: (b) she has had an income of at least $200,000 in the trailing 2 years (or $300,000, with her spouse), and has a reasonable expectation of reaching that level in the current year; or (c) is an executive officer, general partner or director of the issuer. (Need I say that the directorship must be bona fide?) There are separate rules for entities that purchase securities.
The issuer isn’t given a green light to sell shares to anyone who claims that he is accredited. He must conduct at least some inquiry. However, compliance measures are not extensive. Commonly, the investor is simply asked to sign an accredited investor questionnaire, which summarily confirms her accreditation. The investor isn’t required to provide confirmatory evidence to back up this assertion. Furthermore, the issuer may sell shares to an unlimited number of accredited investors, plus 35 non-accredited investors.
An additional benefit to completing a fully-compliant Rule 506 offering is this: no state regulator may impose any more stringent disclosure or information requirements on the issuer. Historically, state securities regulators had taken the view that they had a separate mandate to screen offerings within their jurisdiction, which forced issuers to undergo duplicative, expensive and time-consuming compliance measures in every state in which they were selling securities. Under the so-called National Securities Markets Improvement Act, state regulators were pre-empted from piling their own disclosure requirements on an issuer that was exempt under federal Rule 506 1.
There are some downsides to the Rule 506 offering. First, a Rule 506 offering may also include non-accredited investors, but only if the issuer provides very extensive information that comes close to what would be needed in a public offering, so most private businesses shy away from is illusory.
Also, the issuer can’t conduct a ‘general solicitation’ for funds. Doing so will disqualify the offering. This prohibition extends to mailings or emails, seminars, newspaper ads and simply putting the word out through the owner’s network. This is a major limitation; the business owner may not have extensive relationships of her own with accredited investors. What does she do? Can she go to existing relationships?
It’s generally understood that the business owner may approach someone for an investment with whom she had a prior personal relationship – a college room-mate, a friend, a relative. Those approaches do not violate the ban on general solicitations. Well, any time you create an exception no larger than a mouse-hole, someone will try to drive an SUV through it. Creative minds have come up with so-called registries where the relationship consists solely of the fact that issuer and investor have registered with the same group. No-one would be surprised if the SEC (or the courts) laughed that off.
Even where solicitation is limited to relatives and friends, they may not qualify as accredited investors. In those cases, the pre-existing relationship exception doesn’t help our business owner who has no other contacts of her own and leaves him in a quandary. Often he winds up dealing with a ‘money finder’ who plugs him into his own network, putting the businessman on the edge of violating the general solicitation ban2. That may solve some short term problems, but it will rear its ugly head again at a later stage, when the business owner is ready to sell his business, or to bring in venture capital, and he is subject to searching due diligence.
The JOBS Act aimed to alleviate these problems. First, it set up elaborate and very complex rules for crowd-funding through so-called portals that aggregate the necessary information and oversee compliance by the issuer with some stringent disclosure and filing requirements. The portal is exactly that — a supervised middle-man for putting investors of all types and net worth together with companies in need of capital. Crowd-funding is not limited to accredited investors. In fact, crowd-funding was designed to offer the average citizen a chance to participate in early stage funding of companies that may at a later date blossom into the next Facebook.
In reality, crowd funding is far less attractive than it seems. The SEC was quite reluctant to see this implemented, since it requires complex oversight that stretches the SEC’s already skinny resources, and opens the door for investors who may not be able to bear the risk of loss. Consequently, at the last moment, Congressional and SEC staffers created a labyrinth of crowd-funding requirements, resulting in a structure far different from what the original sponsors envisioned.
The net result is this. A small business that looks to crowd-funding may be subjected to compliance expenses quite disproportionate with the size of the offering. If the business succeeds in crowd-funding, it may find itself with a large number of small shareholders, which increases the difficulties of conducting shareholder meetings and obtaining necessary consents or proxies. The business may also find itself dealing with investors of modest means, whose expectations may be unrealistic and who have little ability to ‘roll with the punches’ that an emerging company encounters. Most reputable lawyers recommend that clients use extreme caution in considering crowd-funding. Sometimes, what looks like gold is actually iron pyrite.
It’s the second aspect of the JOBS Act that’s most compelling. The Act allows for Rule 506 offerings that involve general solicitation. That means that the entrepreneur who has a great idea but no contacts can advertise her need for capital widely, so long as she follows certain rules, and gives her access to a pool of investor with both greater resources and greater sophistication in making investments of this sort. This is the so-called Rule 506(c) exemption, which is new. A fully compliant Rule 506(c) transaction is exempt from state registration requirements, just like its traditional cousin, the one without general solicitation, and can be completed simply by filing an executed Form D with the SEC (and in NH, filing the so-called ‘State Form D’) within 15 days from the date of first sale of securities.
The so-called ‘Rule 506(c)’ exemption – one utilizing general solicitation – comes with its own prerequisites. The company must take ‘reasonable steps’ to confirm accreditation – that is, it must apply enhanced diligence to screen investors. The accredited investor questionnaire is with one limited exception no longer a sufficient tool to confirm accredited investor status.
The SEC identified four approved processes for accomplishing this, and indicated that they were not the exclusive paths for screening accreditation. The four approved confirmation paths are as follows:
– review of the investor’s W-2, 1099 or 1040 for the last 2 years, plus affirmation that investor reasonably expects to meet those levels in the current year;
– review of bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties, to confirm the value of assets, and for liabilities, a consumer report (also known as a credit report) from at least one of the nationwide consumer reporting agencies;
– a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that the person or entity in question has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months, and has determined that that purchaser is an accredited investor; or
– a sale to a natural person who participated in a prior Rule 506 offering as an accredited investor, continues to be an investor and signs a simple certification that he remains accredited.
The SEC release states quite clearly that other paths to confirm accreditation may be acceptable, but that will depend on the particular facts and circumstances at hand. The SEC assumes that ‘screening organizations’ may emerge in the future to take on the screening role, but it’s safe to assume that these organizations will be subject to their own SEC scrutiny. Screening organizations will offer prospective benefits. The issuer who goes fishing for its own accredited investors will have to apply more scrutiny than the issuer that sells to accredited investors who have been pre-screened for accreditation by a reputable third party.
(The traditional Rule 506 offering – the one with no general solicitation – survives. The enhanced due diligence required in a Rule 506(c) transaction will not change the ground rules for the traditional Rule 506 offering, the one that prohibits general solicitation. There, a simple accredited investor questionnaire should be sufficient.)
While the tradition ‘no-solicitation’ Rule 506 offering is available as an alternative, once an issuer commences a general solicitation under Rule 506, there’s no turning back — at least for a while. The SEC generally integrates offerings that take place within 6 months of one another — that is, they treat the two offerings as one and the same, and because the issuer engaged in a general solicitation during the process, it remains disqualified from using the more traditional exemption.
Let’s say that the issuer receives tentative commitment of $1,000,000 towards a $3,000,000 offering from investors with whom it has a pre-existing relationship. It doesn’t do a great deal of investigation beyond requiring the accredited investor questionnaire. Now it advertises for investors to take the remaining $2,000,000, but receives a lukewarm level of interest. In the meanwhile, some investors from the $1,000,000 group decide they will take up the remaining $2,000,000. Can they do it as a traditional 506/limited due diligence offering? Probably not, because the general solicitation has irrevocably branded this as a Rule 506(c) offering, and enhanced due diligence of accreditation for the initial investors is required even though – absent a general solicitation – this would have been a very simple Rule 506 sale under the old rules.
There is however one additional requirement the issuer must consider: The so-called ‘bad boy’ rule that may disqualify certain issuers from all Rule 506 exemptions altogether. Henceforth all issuers who intend to rely on Rule 506 must screen the following persons:
– Directors of the issuer;
– Any executive officer of the issuer;
– Other officers of the issuer who ‘participate’ in the offering;
– Any beneficial owner of 20% or more of the issuer’s voting securities, calculated based on voting power;
– Any person paid for soliciting investors in the offering.
– Persons falling into several additional categories.
Amongst other things, persons in those categories are screened for (a) convictions of misdemeanors or felonies involving securities, or the SEC, within a specific period of time prior to the issuance; (b) for various disciplinary transgressions with securities regulatory agencies; or (c) for violation of SEC cease and desist orders. The issuer will be required to delve much more deeply into the background of persons who fall into this category to satisfy the due diligence requirements. An issuer may defend a failure to identify these concerns because it didn’t know of the problem, and couldn’t have known in the exercise of reasonable care. However, just like the due diligence required in connection with accreditation for a Rule 506(c) offering, this investigation must meet steep and as yet unspecified standards that go beyond a simple ‘yes/no’ inquiry. This is not a simple matter of disclosure; allowing persons in these categories to remain in positions that require screening is an absolute disqualifier. The screening and disqualification requirements may generate some raw nerve ends amongst folks who must be screened, but there’s no getting around it3. The standards for doing a private offering have toughened up.
So, the prospects for funding the emerging business have improved markedly. But with them come more stringent compliance requirements. Meet them, and the business owner has far greater flexibility than before in seeking out capital for her business. Flunk them, and she risks an unregistered offering of a non-exempt security, and with it the possibility that investor can sue the business owner (and not just the business) for rescission of the sale.