The JOBS Act; Rule 506 Accredited Investor Only Offerings Likely to Be Even More Popular
The Jumpstart Our Business Startups Act (JOBS Act) signed into law by President Obama on April 5, 2012, includes the removal of the general solicitation and general advertising prohibitions for securities offerings conducted under Rule 506 of Regulation D under the Securities Act of 1933 if the purchasers are limited to persons who are “accredited investors” as defined under Regulation D. This article discusses the probable impact of the prohibitions removal for such offerings.
The JOBS Act requires the SEC to amend Regulation D to remove the general solicitation and general advertising prohibitions for a Rule 506 offering limited to accredited investor purchasers within ninety (90) days of enactment of the JOBS Act (on or about July 5, 2012). The SEC is currently soliciting public input on its rulemaking mandates under the JOBS Act. With respect to the Regulation D revisions, the SEC is expected to provide guidance as to how issuers for such offerings can demonstrate their efforts to “reasonably determine” that each of the investors in the offering meets the accredited investor qualifications as prescribed under Rule 501 of Regulation D. It is questionable whether the SEC, given its already overwhelming workload, will be able to complete the revisions to Regulation D to accommodate the JOBS Act mandate within the 90-day period.
Under current law (i.e., prior to the SEC revisions to Regulation D as mandated by the JOBS Act), issuers are restricted from conducting any general solicitation or general advertising in connection with such an offering. Accordingly, issuers and other persons who are engaged by such issuer to solicit investors are restricted from soliciting prospective investors with whom they have no substantive pre-existing relationship and from advertising the offering in any media or publication available to the public. These prohibitions have acted as major obstacles for new or early-stage businesses from conducting a successful private offering under Regulation D. The dilemma for many of such issuers is that after tapping friends and family for funds, it is usually impossible to reach additional prospective investors due to the inability to get their message out.
Congress, realizing that the general solicitation and general advertising prohibitions under Rule 506 not only greatly restricted or eliminated the opportunity to conduct a successful offering for new and early-stage businesses, coupled with the widespread use of the Internet and other social media for communication with possible investors, decided that the prohibitions did not fit within the modern world of raising capital. The prohibitions caused issuers to either avoid the conduct of such offerings, downscale the possible scope of such offerings, and/or led to inadvertent violations of the prohibitions under Rule 506 leading to possible civil and administrative liabilities for the issuers and promoters of such offerings.
In response to warnings from some securities regulators that the lifting of the prohibitions would greatly diminish public investor safeguards, Congress agreed to the lifting of the prohibitions only if all investors who purchased the securities in the Rule 506 offering would qualify as an accredited investor as reasonably determined by the issuer of the securities.
The SEC, also under a previous mandate by Congress, recently set by rule, a higher bar on qualifying as an accredited investor by adjusting the $1 million net worth calculation to eliminate the investor’s equity in such person’s primary residence from the net worth calculation to reach the $1 million level. This recent change, according to the SEC, could serve to eliminate thousands of prospective investors across the country who may have qualified in the past as an accredited investor prior to the change in calculating the investor’s net worth. Separate from the $1 million net worth test, a person may also qualify as an accredited investor if the investor’s annual income for the last two years exceeded $200,000 ($300,000 when coupled with the investor’s spouse) with reasonable expectations of reaching that same income level for the current year.
The advice for issuers who would rely on Rule 506 for future offerings is to hold off for now, until the SEC completes the necessary revisions under Regulation D as mandated under the JOBS Act, or continue to abide with the general solicitation and general advertising prohibitions for Rule 506 offerings. Once the SEC completes its rulemaking, it is likely that the use of the Rule 506 exemption will be even more popular than it is now.
Even prior to enactment of the JOBS Act, Rule 506 offerings were the most popular of the three types of non-registered offerings available under Regulation D. Rule 504 has a $1 million cap on the offering amount and Rule 505, with a $5 million offering cap, also imposes under Regulation D the
so-called “bad-boy” provisions that eliminate the use of the exemption if the issuer or its promoters had been found to have violated certain federal or state securities laws. Rule 506 offerings became the securities transaction exemption of choice due to the unlimited amount of funds that could be raised for such offerings and that state securities law registration requirements are preempted by federal law for such offerings. State securities regulators, over the years, have rallied against this federal presumption of state securities registration requirements for such offerings and actively lobbied against the JOBS Act provisions that opened up this exemption way beyond what most state securities law administrators viewed as prudent. Indeed, many of the state securities law administrators view the JOBS Act change for Rule 506 offerings as anti-consumer. They agree that even more issuers will take advantage of utilizing this exemption now that it will allow general advertising and general solicitation. The state regulators apparently believe that more investors will invest who are not familiar with the issuer and its business and principals. Although issuers are still required under the state and federal securities laws to provide investors sufficient disclosure in order to avoid violations of the “anti-fraud” provisions under such laws, state securities regulators and other consumer advocates appear to find little comfort that compliance with the anti-fraud provisions and the fact that they must be accredited investors will deter investors entering into securities offerings in which they will be ill equipped to understand the risks.
It remains to be seen if the lifting of the restrictions will result in the increased ability to attract public funding for issuers of such offerings. Under almost any scenario, one would have to believe it will at least improve the chances of such issuers to reach a larger audience of prospective investors. The SEC and state securities regulators will be closely observing the conduct of such offerings to make sure that all investors are, indeed, accredited investors and whether the amount of securities fraud becomes more prevalent in connection with such offerings.
For most objective observers, the lifting of the general solicitation and general advertising restrictions represents a change that should have happened years ago. Even the SEC announced almost a decade ago that it was reviewing whether the general solicitation and general advertising prohibitions for such offerings still made sense in the age of the Internet and other public instant messaging systems. Congress, to its credit, in a rare bipartisan moment and tired of waiting for the SEC to act, decided that it could wait no longer, and acted to remove the “shackles” from the Rule 506 offering in order to provide initial and early-stage issuers with a greatly improved opportunity to obtain public funding.
Legislation Introduced to Create SRO for IAs
Spencer Backus (R-AL) introduced legislation this past week to create a self-regulatory organization (SRO) for “retail” investment advisers with at least $100 million of assets under management.
The proposed legislation addresses the concern long-held by others that the SEC cannot adequately oversee the estimated 12,000 advisers currently registered with the SEC. Reportedly, only about eight percent of those advisers were examined by the SEC during 2011. Still reeling from the Madoff embarrassment, the SEC continues to be under-staffed and under-financed for the magnitude of tasks it is mandated by law to perform. The creation of an SRO would serve to relieve the SEC from the immediate regulatory responsibilities over investment advisers and free up staff time and its limited capital to address other major issues such as enforcement actions against fraudsters.
The Financial Services Institute (FSI) voiced its support for the legislation and the creation of an SRO in order to help even the playing field for many of its “retail” investment advisers who compete against independent broker-dealers who are examined routinely and closely regulated by the Financial Industry Regulatory Authority (FINRA). Although the legislation does not mention FINRA as the likely SRO for retail investment advisers, FINRA has a stable of examiners who could readily be trained to conduct examinations of investment advisers. According to the FSI, a recent poll of 2,000 financial advisors revealed that 75 percent favored the creation of an SRO to regulate retail investment advisers.
To date, the SEC has not voiced an opinion regarding the legislation, but one would have to believe that the SEC would welcome not having the burden of the direct regulatory and supervisory responsibilities over the “retail” portion of the 12,000 SEC-registered investment advisers.
Regulation A Offerings
Securities cannot be offered in an interstate offering unless the securities are registered with the SEC or an exemption from such registration is available. The SEC is authorized to exempt securities from registration where it finds that registration “is not necessary in the public interest and for the protection of investors by reason of the small amount involved or the limited character of the public offering.” The SEC has utilized this authority in creating the Regulation A exemption.
Who may conduct a Regulation A offering?
The Regulation A exemption is available only for an issuer organized under the laws of the United States or Canada, is not a reporting company under the Securities Exchange Act, and is not a “development-stage company.”
The exemption also prohibits certain issuers who have previously engaged in particular behavior from relying on the exemption, including:
What are the advantages of a Regulation A offering?
The principal advantages of a Regulation A offering are that it:
How is the offering made?
Prior to the commencement of the offering, an issuer is required to file and offering statement on Form 1-A with the SEC. An offering statement on Form 1-A comprises three documents: Part I, the Notification; Part II, the Offering Circular; and Part III, Exhibits. In addition, it includes the required signatures “and any other material information necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.” Therefore, when drafting the Offering Circular, an issuer should be mindful of the type of information that a reasonable investor is likely to consider important in making its investment decision.
The requirements for the Offering Circular are generally not as onerous as those applicable to a registered prospectus. Depending on the type of issuer, the required disclosure content must follow either a “question-and-answer” format, or a format similar to a Form S-1 registration statement.
Oral offerings and written offerings may be commenced after the offering statement on Form 1-A is filed. However, sales may not be made until the Offering Circular is qualified (becomes “effective”). Unless the issuer includes a delaying notation providing that the Offering Circular shall only be qualified by order of the SEC, an offering statement is qualified without SEC action on the twentieth calendar day after filing of the offering statement on Form 1-A.
Are you allowed to “test the waters”?
The SEC allows issuers to “test the waters” and assess market interest prior to preparing and filing the mandated offering statement on Form 1-A. The issuer may solicit indications of interests from prospective purchasers by written documents or by television or radio broadcasts with respect to a contemplated offering. No pre-clearance of the material is required, although the SEC requests that copies of such information be submitted to it.
How much may you offer in a Regulation A offering?
Regulation A provides that in any given 12 months, a total of $50 million of an issuer’s securities may be sold pursuant to Regulation A. As for integration of such an offer with another private offering or registered offering by the issuer, Regulation A provides that offers or sales made in reliance on Regulation A will not be integrated with: (1) prior offers or sales of securities; or (2) subsequent offers or sales of securities that are: (a) registered under the Securities Act (with limited exception); (b) made in reliance on Rule 701 of the Securities Act; (c) made pursuant to an employee benefit plan; (d) made in reliance on Regulation S; or (e) made more than six months after the completion of the Regulation A offering.
Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:
Terry D. Nelson
Peter D. Fetzer
A. Michael Primo