Costs and Benefits of JOBS Act's Lifting of General Advertising Ban
On July 10, 2013, the Securities and Exchange Commission (SEC) swept away the 80-year-old prohibition against general solicitations and advertising for private placements of securities pursuant to Regulation D of the Securities Act of 1933, finally implementing the Congressional directive to do so under the JOBS Act of 2012.
The SEC adopted new Rule 506(c) and related regulations,1 effective on Sept. 23, 2013. Rule 506(c) allows issuers to advertise freely, to solicit, and to discuss their private placements through a broad range of avenues, from Internet and print media, to speaking engagements at conferences, to presentations made to small groups of potential investors, so long as the issuer only sells its securities to "accredited investors." At the same time, the SEC took the opportunity to propose changes to Form D filing requirements, and to propose extending Rule 156 registered investment company disclosure requirements to private investment funds.2
The lifting of the solicitation prohibition has engendered tremendous discussion in the legal and business community, as private companies and funds weigh the potential benefits and costs of these new opportunities. In a recent congressional hearing, Director of Corporation Finance Keith Higgins said that as of Oct. 30, 2013, over 200 Form D filings had been made which indicated that advertising pursuant to Rule 506(c) was planned.3 At the same time, there has yet to be any noticeable amount of advertising and solicitation by private companies, hedge funds, and the like. This article examines some of the benefits that Rule 506(c) can bring to private placement issuers, along with new requirements that also become effective.
New Rule 506(c)
Private placements under Rule 506 have long been an important and popular capital-raising mechanism with private companies, hedge funds, and private equity funds. Rule 506 allows issuers to raise funds without complying with numerous time-consuming and expensive requirements that would be mandated under other public securities offering provisions of the Securities Act. However, the relative ease with which issuers historically could raise capital under Rule 506 came with its own set of restrictions, including a prohibition on general advertising and solicitation. This restriction was interpreted broadly, and resulted in issuers taking great pains to avoid speaking about anticipated or pending private placement offerings in even informal settings. Information about private placements required confidential treatment, and solicitations needed to be primarily limited to accredited investors with whom the issuer had preexisting relationships.
New Rule 506(c) frees up issuers to solicit generally in a wide variety of mediums and forums. While the lifting of the restriction allows a private placement issuer to take advantage of traditional advertising media such as the Internet, the issuer's website, and print media, to name just a few, there is a significant and more subtle advantage in being able to "just talk" about one's offering. For instance, a hedge fund manager who offers a fund under Rule 506(c) can discuss the fund offering in a business news interview, or as a speaker (or attendee) at an industry conference. Likewise, a private equity manager that focuses on the health care sector can explore cross-marketing opportunities with an investment manager that specializes in the natural resources sector. While there has not yet been a rush to use Rule 506(c) to engage in express advertising, there is growing interest in exploring the potential for Rule 506(c) to free up private placement issuers to engage in these more informal types of marketing and solicitation.
As much as Rule 506(c) opens the door to new avenues for raising capital, the SEC included a significant gatekeeping requirement in the regulatory scheme. Under both old Rule 506—which is now Rule 506(b)—and new Rule 506(c), an issuer may sell securities only to persons who are "accredited investors" under the Securities Act of 1933. In order to meet this standard, an investor who is a natural person must have either (i) a net worth of at least $1 million, not including the value of one's primary residence, or (ii) income of at least $200,000 in each year of 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.4
Under former Rule 506 and current Rule 506(b), an issuer may rely solely on the investor's certification as to his or her status as an accredited investor. Rule 506(c), however, imposes an affirmative obligation for the issuer to take "reasonable steps" to verify that participants in private placements are accredited investors. In the adopting release, the SEC identified several nonexclusive methods for meeting the verification requirement. The simplest of these allows an issuer to continue to rely on "self-certification" by the prospective investor, if the individual is a current investor in a prior Rule 506 private placement offering by the issuer (invested before Sept. 23, 2013. Of course, this method is of limited value, as it cannot be used for new investors that the issuer would like to attract.
Two other nonexclusive methods for verification identified by the SEC are for an issuer to take "reasonable steps" to verify that an investor meets either the income and/or net worth thresholds of the accredited investor definition. These methods, however, raise challenges for issuers, as they will typically require the collection and evaluation of actual documents containing sensitive and confidential financial information from the investor, such as tax returns, credit reports, and bank and brokerage statements, as well as assessments of liabilities. Understandably, issuers may be reluctant to take on the administrative burdens of accepting custody of financially sensitive documents, given the host of issues that it raises, such as (i) who at the firm will have access to this financially sensitive information; (ii) who will be responsible for the care and custody of the documents containing the information; (iii) who will be responsible for evaluating the information and deciding whether or not the investor qualifies as an accredited investor; (iv) what procedures need to be implemented to reduce the risk of errors in this evaluation process; (v) how long will the firm need to retain investors' financial information; and (vi) what privacy considerations are raised by the acceptance of such information. Just as understandably, many investors may well be reluctant to provide personal financial information such as tax returns and credit reports to private companies, private equity firms, or hedge funds, especially where there is no prior relationship with the firm.
Perhaps in recognition of these potential obstacles, the SEC in its adopting release identified third-party verification of accredited investor status as an additional nonexclusive method available to issuers under Rule 506(c). The SEC identified four categories of professionals that can perform this function: attorneys, accountants, broker-dealers, and SEC-registered investment advisers. Third-party verification has some significant advantages: (i) it takes the administrative burden of verification off the issuer; (ii) it takes the risk of getting it wrong off the issuer; and (iii) it provides a neutral and confidential intermediary that may be more palatable to potential investors who are interested in investing but who otherwise may balk at the thought of providing documents containing their private financial information to investment managers or companies with whom they have never dealt. As of this writing, third-party verification services are just beginning to emerge.
Other Proposed Rule Changes
While the lifting of the ban on general solicitation of private placements creates significant opportunities for private issuers, the SEC has also proposed a series of rule changes that would impose new disclosure and filing requirements on issuers seeking to utilize Rule 506(c), as well as significant consequences in certain circumstances for failure to follow the proposed rules. These proposals have engendered significant criticism, and many industry participants have submitted comment letters (including Pepper Hamilton5) to the SEC urging the Commission to modify or eliminate many of these proposed rules.
One of the SEC's most significant rule changes is an effort to give teeth to the Form D filing requirements by imposing a one-year time-out from using Rule 506 if such filings are not timely made. Currently, issuers proceeding under Rule 506 must file a Form D with the SEC, disclosing certain categories of information about the issuer, the offering, and the potential investors. Under current Rule 507, a firm may be disqualified from using Regulation D if it fails to comply with Form D filing requirements, but only if a court has first entered an injunction for violating the filing requirements.
The SEC's proposed rule changes would impose a significant penalty for filing failures or missteps. The proposed rules provide that a failure to comply with Form D filing requirements at any time within a five-year period will result in an automatic one-year disqualification from using Rule 506. While issuers will be excused for a first-time violation, a subsequent failure to comply with Form D filing requirements will trigger the one-year prohibition, starting from the date when all required Form D filings were made.
The severe consequences of the SEC's proposed change to the Form D requirements may be driven in part by the fact that, historically, some issuers failed to follow Form D filing requirements without any real consequences. In a recent speech, Director of Investment Management Norm Champ noted that the proposed changes to Form D filing requirements would serve as a more effective mechanism for enforcing issuers' compliance with these requirements.6