On Aug. 29, 2012, the SEC will consider rules to permit advertising in certain private offerings. These changes are mandated by the JOBS Act and impact SEC Rule 506.
The SEC has a site on its web page where interested persons can submit comments on these changes in Rule 506 before the amendments are proposed. This article summarizes the comments that have been submitted. Review of this summary should help you understand the issues raised by these changes, and the anticipated changes by the SEC on Aug. 29. For more information on the JOBS Act, please see our previous articles on this topic, “Impact of the JOBS Act on Private Fund Managers” and “JOBS Act Has Potential to Attract New Players to the Public Capital Markets.”
Will the SEC Adopt a Temporary Rule?
Action on these items was originally scheduled for August 22, 2012. There were press reports that the SEC might adopt an interim rule permitting advertising, in addition to proposing final rules, at the Aug. 22, 2012 meeting. Several comment letters opposing this idea have been posted very recently on the SEC’s website. Opponents of an interim rule include the CFA Institute, comment letter dated Aug. 16, 2012; Mercer E. Bullard and others, comment letter dated Aug. 16, 2012; Fund Democracy Inc. and others, comment letter dated Aug. 15, 2012; and the North American Securities Administrators Association Inc. (NASAA), comment letter dated Aug. 15, 2012.
Press reports on Aug. 21, 2012 indicate that the SEC will not adopt a temporary rule, but will propose amendments to Rule 506. In addition, on Aug. 21, 2012 the SEC indicated that vote on the Rule 506 changes would be on Aug. 29, 2012 rather than Aug. 22, 2012. The notice for the Aug. 29, 2012 SEC meeting makes clear that the SEC will consider proposed rules.
(Rep. Patrick McHenry, R-N.C., a member of the House Committee on Oversight and Government Reform, has sent a letter to the SEC criticizing the decision not to adopt a temporary rule, and requiring that the SEC produce documents to his SubCommittee concerning the process for implementing the Rule 506 changes.)
Comments to Rule 506
As of Aug. 16, 2012, 57 comment letters had been posted on the SEC site relating to Rule 506. The comment letters range from simple statements on the SEC’s comment form to detailed discussions of the legal and practical issues presented by these changes in Rule 506. There is even one handwritten comment letter, one anonymous comment letter and one letter from three members of the U.S. Senate.
As of the same date, the website indicates that the SEC staff has had six meetings with external commenters: the Massachusetts Securities Division, the National Small Business Association, FINRA, the Angel Capital Association, the Managed Funds Association and the Real Estate Investment Securities Association.
The comment letters address the following issues, which are summarized below.
- Strict liability versus reasonable belief: will the new Rule 506 exemption be lost if there are nonaccredited investors, even if the issuer has taken steps to verify accredited status?
- Steps required to verify accredited investor status?
- Continue the existing subscription document procedure
- Self-certification under penalty of perjury
- Nonexclusive safe harbor
- Size of investment
- Third-party verification
- Accredited verification provider
- Certification through testing
- Regulation of advertising content
- Integration issues
- Regulation S
- Increase in accredited investor tests
- Changes in Form D
Strict Liability?
This issue involves whether the new private placement exemption will be lost if “any investor” is not accredited, or will be available as long as the issuer reasonably believes that all investors are accredited. Put another way, will the new exemption be available if there are nonaccredited investors but the issuer has taken steps to verify, and reasonably believes, that all investors are accredited?
The JOBS Act requires that all investors be accredited if advertising is used. Several comment letters have advocated the position that the failure to meet this requirement should result in the loss of the exemption. Comment letters advocating this position include those of the NASAA, dated July 3, 2012; the Ohio Division of Securities, dated July 3, 2012; and the Commonwealth of Massachusetts, dated July 2, 2012. This position, in large part, is based on the fact that the JOBS Act, in this section, does not specifically refer to a “reasonable belief” standard. These regulators also believe that a “strict liability” standard will provide a strong incentive for issuers to take the “verify” requirement seriously. It is not an accident that regulators are advocating this position.
(The Commonwealth of Massachusetts also recommended that an issuer be required to appoint a “key person” similar to a chief compliance officer, who is trained to determine accredited investor status, and who has the responsibility for verifying accredited investor status. This suggestion is designed to identify a person to hold liable if nonaccredited investors are included in an advertised 506 offering.)
Regulation D currently requires that an issuer have a “reasonable belief” that investors are accredited. This provision is included in the definition of accredited investor in Rule 501(a). Several comment letters have said that this approach should also apply for offerings where general solicitation and/or advertising are used, notably those of BlackRock, Inc., dated May 3, 2012; the New York City Bar, dated May 4, 2012; ABA Business Law Section, dated April 30, 2012; Securities Industry and Financial Markets Association, dated April 27, 2012; William R. Sjostrom Jr., dated April 14, 2012; the National Small Business Association, dated June 12, 2012, and Aug. 2, 2012; Real Estate Investment Securities Association, dated June 5, 2012; National Investment Banking Association, dated May 30, 2012; AngelList, dated May 23, 2012; Managed Funds Association, dated May 4, 2012; and BrokerBank Securities Inc., dated July 10, 2012. In effect, these comment letters take the position that an investor should be deemed to be accredited if the issuer reasonably believes that the investor is accredited. In other words, there should be a “safe harbor” for issuers following the SEC’s procedures.
Verification of Accredited Investor Status
The JOBS Act also requires that revised Rule 506 provide that issuers who use general solicitation or advertising take “reasonable steps” designated by the SEC to verify that investors are accredited.
A key issue in this rulemaking procedure is what steps the SEC will require the issuer to use to “verify” that investors are accredited. Many comment letters have addressed this issue.
Self-Certification Should Continue
A large number of comment letters, mainly from industry participants, have taken the view that the verification process should remain essentially as it is now: self-certification through the use of a questionnaire. Comment letters on this position were received from Managed Funds Association, dated May 4, 2012; Mona Shah & Associates, dated April 12, 2012; National Small Business Association, dated June 12, 2012, and Aug. 2, 2012; the Real Estate Investment Securities Association, dated June 5, 2012; Bulldog Investors, dated June 3, 2012, and July 18, 2012; BrokerBank Securities Inc., dated July 10, 2012; Robert J. Kafarski, dated Aug. 8, 2012; Joshua Lear, dated Aug. 14, 2012; and Uglem Law P.C., dated Aug. 14, 2012.
The ABA Business Law Section, in a letter dated April 30, 2012, recommended that the SEC take into account current industry practice. This comment letter states that any requirement that imposes additional burdens on the issuer or on the purchaser would be inconsistent with the purpose of the JOBS Act.
Based on recent comment letters, including the letter dated Aug. 9, 2012, from the Small Biotechnology Business Coalition and the letter dated Aug. 2, 2012, from the National Small Business Association, it appears that the SEC staff believes that the statute requires more than self-certification.
Self-Certification Under Penalty of Perjury
One comment letter from an individual, John Nimmer, dated April 18, 2012, suggested, in effect, that current use of self-certification be continued, but that the certification be given under penalty of perjury. The National Small Business Association supported this suggestion in a letter dated Aug. 2, 2012, as did Shannon P. Uglem in a letter dated Aug. 14, 2012.
Nonexclusive Safe Harbor
Several comment letters recommend that the SEC adopt a nonexclusive safe harbor. However, the comment letters have differed in the degree to which they recommend that the SEC provide for detailed verification procedures, and in the nature of the verification procedures.
For example, the New York City Bar urged the SEC to “adopt a flexible and principles-based non-exclusive safe harbor rule” rather than “unduly detailed or prescriptive rules,” in its letter dated May 4, 2012.
On the other hand, several comment letters have suggested that the SEC should provide clear procedures for what will be considered reasonable steps to verify, a position taken by the Real Estate Investment Securities Association in its letter dated June 5, 2012; Public Citizen in its letter of June 18, 2012; and NASAA in its letter of July 3, 2012.
NASAA recommends a nonexclusive safe harbor for the verification process that specifies different types of support for different categories of investors as follows:
Persons – Verification of income can be provided through tax returns, W-2s and Form 1099.
Assets – Verification of assets can be determined with bank statements, brokerage account statements, tax assessment valuations or appraisals, together with a list of liabilities given with a sworn statement that all material liabilities are included.
Entities – Verification of eligibility can be ascertained through organizational documents and a balance sheet.
The Managed Funds Association made similar suggestions in its June 26, 2012, comment letter.
One comment letter, from Eric A. Brill dated June 11, 2012, recommends that as an alternative to the “verification process” an issuer should be able to accept investments from people with whom the issuer has a substantive prior relationship. Also, the comment letter from Kevin Frei dated April 23, 2012, suggested that up to 35 nonaccredited investors should be able to be included in an advertised offering so long as the issuer had a preexisting substantive relationship with those nonaccredited investors.
The Small Biotechnology Business Coalition in its letter dated Aug. 9, 2012, suggested that an investor should be considered accredited if the issuer met personally with that investor.
Size of Investment
Several comment letters have suggested that an investor should be deemed to be accredited if the amount invested exceeds a specified figure.
For example, the Managed Funds Association asserted in its June 26, 2012, letter, that this figure should be $500,000 for individuals and $2.5 million for entities.
The Small Biotechnology Business Coalition, in its letter dated Aug. 9, 2012, suggested that an investment size of more than $25,000 should result in accredited investor status.
See also SecondMarket letter dated May 25, 2012 and the Shannon P. Uglem letter dated Aug. 14, 2012.
Third-Party Verification
Several comment letters, such as the letter from the Commonwealth of Massachusetts dated July 2, 2012, have recommended that an issuer be able to use a third party to verify an accredited investor. Frank Nagy suggested in his May 26, 2012, letter that the accountant or attorney for the investor provide a letter certifying accredited status, an approach recommended by the National Small Business Association in its letter dated Aug. 8, 2012. J.C. Williams II’s May 18, 2012, letter suggested verification by an accountant, attorney, tax preparer, bank representative or other person having knowledge of the investor’s financial status. The National Investment Banking Association, in its May 30, 2012, comment letter, suggested that an issuer obtain a third-party investigative report to verify accredited investor status.
Some comment letters have recommended that issuers be able to rely on persons registered as broker-dealers (BDs) to verify accredited investor status. The NASAA in its July 3, 2012, letter as well as the Real Estate Investment Securities Association in its June 5, 2012, letter both supported this position. The National Investment Banking Association, in its May 30, 2012, letter, recommended that an issuer be able to rely on the investor verification process already used by registered BDs.
Accredited Verification Provider
Several comment letters, including those from Tom Dworzanski dated June 7, 2012, SecondMarket dated May 25, 2012, and AngelList dated May 23, 2012, have recommended that issuers be specifically permitted to use a third-party verification provider registered as a BD. This type of platform allows investors to produce documents establishing accredited investor status in a “secure confidential” context.
Some comment letters, including one written by the Sigelman Law Corporation and dated June 20, 2012, have recommended the use of an independent professional intermediary, registered with the SEC, but not necessarily a BD.
Investor Testing
One comment letter from the Cambridge Innovation Center, dated June 13, 2012, recommends that the SEC develop a standardized form that could be used to determine investor sophistication. This same comment letter suggests that the SEC develop and offer courses in investing, and that any person passing a test administered by the SEC would be considered accredited.
Content of Advertising and General Solicitation
Another important issue is whether the SEC will regulate the content of advertising materials.
Several comment letters, including those from the Ohio Division of Securities, dated July 3, 2012, and The Motley Fool, dated June 27, 2012, have suggested that the SEC adopt a uniform set of required disclosures and content restrictions for general solicitation and advertising materials.
The Ohio Division of Securities recommended, in addition, that the SEC prohibit financial projections or statements of future performance in advertising. (The Ohio Division of Securities also recommended a requirement of a disclosure document in all offerings using advertising or general solicitation, a position approved by Mercer E. Bullard and others in a letter dated Aug. 16, 2012.) The CFA Institute recommended in its Aug. 16, 2012 letter that offering materials be required to contain a special legend.
NASAA recommended in its July 3, 2012, letter that the SEC provide guidance on the permitted content of advertising materials.
The Investment Company Institute (ICI), in a letter dated May 21, 2012, recommended that the SEC adopt mutual fund type regulation on advertisements by private funds, and prohibit performance advertising until the SEC develops a uniform approach to this type of advertising. Mercer E. Bullard and several others generally supported this suggestion in a letter dated Aug. 16, 2012.
The Managed Funds Association recommended that the SEC revise its existing rules on advertising to permit greater flexibility for private funds, in its May 4, 2012, letter.
The National Small Business Association took the position in its June 12, 2012, letter that advertising content should not be regulated.
Integration
The use of advertising for a private offering could create difficult “integration issues.” Advertising for one offering might be considered to be solicitation for other offerings. These issues could arise when there are simultaneous private (or private and public offerings) or sequential offerings and could cause the “integrated” offerings to fail to comply with applicable provisions.
The ABA Business Law Section recommended, in its April 30, 2012, letter, that the SEC clarify the integration issues “at some point.”
The Ohio Division of Securities recommended, in its July 3, 2012, letter, that the six months integration safe harbor currently contained in Reg D be increased to nine months. It also recommended that an advertised offering not be permitted during crowdfunding.
Mercer E. Bullard and others, in a letter dated Aug. 16, 2012, recommended that an issuer be prohibited from accepting investments from nonaccredited investors in a private offering at any time after using advertising.
The comment letter from AngelList dated May 23, 2012, suggested that advertised offerings should not be integrated with offerings on AngelList or similar platforms.
The comment letter from Verrill Dana dated July 24, 2012, suggested that the Reg D six-month period be retained.
Offshore Offerings – Regulation S
A similar issue arises in the context of offshore offerings. Regulation S provides an exemption for offshore offerings that is generally lost when there are “directed selling efforts” in the United States. Because it is common to have simultaneous domestic Rule 506 and offshore Regulation S offerings, advertising for a 506 offering could be considered “directed selling efforts,” resulting in the inability to use Reg S for the offshore component.
Some comment letters recommended that general solicitation and advertising under Rule 506 should not be considered “directed selling efforts” as defined in Rule 902(c) of Regulation S in a concurrent Regulation S offering. Letters proffering that position were received from Brad Wiggins, June 26, 2012; Lee D. Neumann, June 12, 2012; and the ABA Business Law Section, April 30, 2012. The New York City Bar in its letter dated May 4, 2012, recommends that the SEC liberalize the directed selling efforts concept in order to reconcile the new 506 provisions with Reg S and permit simultaneous advertised Rule 506 and Reg S offerings.
The Securities Industry and Financial Markets Association, in its letter dated April 27, 2012, took the view that Regulation S should be revised to eliminate the prohibition on directed selling efforts.
Increase in Accredited Investor Tests
Several comment letters have recommended that the SEC raise the income and net worth tests for individual investors (natural persons), including letters from the ICI dated May 21, 2012, and The Motley Fool dated June 27, 2012.
Fund Democracy Inc. wrote in its May 24, 2012, comment letter that it believed the income test should be raised to $400,000 and the asset test should be raised to $2.5 million. It was joined by several others, including The Motley Fool and the Public Citizen in their June 18, 2012, comment letter.
The National Small Business Association opposed raising these standards in its June 12, 2012, letter.
Proposed Revisions to Form D
Several comment letters, mainly from regulators, proposed a number of changes to Form D, including
- requiring filing before the first use of advertising and before the first sale;
- requiring that advertising materials be filed;
- requiring identification of any agents used for the offering; and
- providing annual updates.
Continuation of Existing Rule if There is no Advertising
Several comment letters have suggested that the SEC make clear that the provisions of the existing rule can continue to be used if there is no advertising. See, for example, the letter from Eric A. Brill dated June 11, 2012; the letter from the Real Estate Investment Securities Association dated June 5, 2012; and the letter from SecondMarket dated May 25, 2012.
Representatives of the National Small Business Association met with representatives of the SEC on July 30, 2012, and submitted a second comment letter on Aug. 2, 2012. This second comment letter discusses a number of topics that apparently were discussed in that July 30 meeting. In the letter, the National Small Business Association encouraged the SEC not to change Rule 506 so as to apply the new verification procedures to all 506 offerings. Accordingly, the SEC may be considering this approach.
Other Issues
Several comment letters recommended that in framing the new provisions of Rule 506, the SEC take into account the possible use of social media in solicitation and advertising. See, for example, the Crowdfund Intermediary Regulatory Advocates letter dated May 15, 2012, and the New York City Bar Association letter dated May 4, 2012.
The Managed Funds Association, in its letter dated May 4, 2012, made the very good suggestion that the definition of accredited investor be changed to add “knowledgeable employee” as a new separate category of accredited investor.