Cause for Hesitation in Solicitation
Nearly one year ago, Title II of the JOBS Act was enacted allowing companies to solicit investments from accredited investors, but some clarification is still needed.
Photo by Simon Cunningham (Flickr)
This article is the first in a three-part series on the JOBS Act.
It has been a busy year for many entrepreneurs, start-up companies, and online investment platforms hoping to capitalize on the excitement surrounding the passing of the Jumpstart Our Business Startups Act (the JOBS Act). For the first time since the enactment of the Securities Act of 1933, issuers can raise investment funding publicly using modern online resources, such as equity crowdfunding sites that democratize the investment process.
Companies seeking to raise capital by offering securities to investors must either register those securities with the Securities and Exchange Commission (SEC), or the securities offering must be exempt. One common exemption to the registration requirement is a private placement through Rule 506 (now Rule 506(b)) under Regulation D, which allows issuers of securities to raise an unlimited amount of capital from an unrestricted number of accredited investors and up to 35 non-accredited investors. The 506(b) exemption is widely relied on by companies, but there is one catch—the securities offerings cannot be advertised and investments cannot be generally solicited.
As mandated by the JOBS Act, the new rule 506(c) allows general solicitation in certain securities offerings. The alleviation of the old private placement regime’s ban on advertising has created momentous opportunities for start-ups, entrepreneurs and other private issuers by expanding the scope of private placements under Regulation D of the Securities Act.
Some issuers are using the new rule to push the boundaries of offering securities.
The new rule does not come without its burdens, however. In exchange for the ability to make general solicitations, issuers must adhere to heightened standards for the accredited investor verification process. While some issuers are using the new rule to push the boundaries of offering securities, many are still seeking guidance on how to comply with the new rule.
As part of the Rule 506(c) private placement, the issuer must take “reasonable steps” to verify that the purchasers of the securities are in fact accredited investors. An accredited investor, as defined by Rule 501 of Regulation D, is a person with a net worth in excess of $1 million, or an earned income of more than $200,000 per year (or $300,000 if a spouse’s income is included). To determine what steps are “reasonable,” the issuer should take into account all facts and circumstances surrounding the investment. Such factors include the nature of the investment and the investor, the amount of information the issuer has about the investor, the terms of the offering, and the methods used by the issuer to solicit the investment. These factors provided by the SEC are adaptable to the circumstance and are set forth as a guideline by which an objective accredited investor verification process may be conducted.
The SEC also describes a non-exclusive list of methods that may be employed to verify an investors accredited status. Such methods include reviewing copies of IRS forms reporting the investor’s income and obtaining a written representation that the purchaser will likely earn the required income in the current year; and obtaining a written confirmation from a registered broker-dealer, licensed attorney, certified public accountant, or a SEC registered investment advisor (also known as a Permitted Third Party Verifier) that reasonable steps have been taken to verify accredited status.
The ability to solicit investments has led many companies to advertise and solicit offerings online.
As more companies turn to Rule 506(c), methods of verifying accredited status have varied. This is due in part to the manner of solicitation. The ability to solicit investments has led many companies to advertise and solicit offerings online. While the new rules propose non-exclusive verification measures, issuers are still searching for concrete guidance on how to verify investors.
Companies such as Energynet, EarlyShares and MicroVentures require potential investors to answer online questionnaires verifying accredited status before they are allowed to view the offering online. These companies are in uncharted waters, and one issue that threatens to rock the boat is the lack of clarification as to what constitutes a solicitation.
For example, when the sale of a security interest actually occurs, an online platform will most likely engage in the more burdensome 506(c) verification methods to ensure that reasonable steps have been taken. However, the methods of screening potential investors before they can view the offerings may not be “reasonable” if the pre-screening itself is solicitation. The check-the-box, fill-in-the-blank approach worked for Rule 506(b), which prohibited general solicitation, but such approaches to verification are insufficient when conducting a 506(c) offering.
As more crowdfunding platforms enter the marketplace, and more investors purchase securities as a result of online solicitation, the question remains—what exactly constitutes general solicitation? Is it the link that brought the offering to the investor’s attention in the first place? Is it the detailed offering placed online viewable only after a representation by the investor that he/she is accredited? Or is the solicitation the actual transaction, after the investor has pursued the investment opportunity? This question has caused many issuers to pause before advertising a security offering, because once they do, the heightened verification standard kicks in.
Issuers that remain dubious about the efficacy of 506(c) can take solace in the fact that the old private placement rules have remained intact. Unless the issuer engaged in solicitation or advertising, the 506(c) “reasonable steps” verification process does not apply.
