SEC Formally Allows General Solicitation, or Advertising, for Certain Equity Offerings But Process to Accommodate is Still a Moving Target
In the wake of Title II hitting the federal register, those active in the world of private placement securities are busy digesting the net effect of this liberating rule regarding general solicitation advertising. For the first time issuers will be able to generally solicit – advertise – their private placement offerings under a new exemption, Rule 506(c) of Regulation D.
In short, Title II is a functional nod to the importance social media and the Internet plays in our collective discovery and understanding of information. Private placement offerings under Regulation D account for as much as $1 trillion raised every year according to a recent SEC study. Title II could push this market to new heights and facilitate increased capital formation for small issuers.
Although 506(c) offerings will allow general soliciation, offerings making use of this exemption are also limited to accredited investors. A recent CrowdCheck memo explains that the SEC (PDF) was originally vague in defining a methodology for verifying accredited status…
The JOBS Act directed the SEC to lift the prohibition on general solicitation provided that all purchasers of the securities were accredited investors and the issuer took “reasonable steps to verify” that the purchasers were accredited, “using such methods as determined by the Commission.” In its initial proposal the SEC declined to specify even a non-exclusive list of such methods, on the grounds that this would inhibit flexibility in the markets. However, in the final rule the SEC provided more clarity and established a principles-based method of verification that expects issuers to look at, among other things:
- The nature of the purchaser and the type of accredited investors the purchaser claims to be;
- The amount and type of information the issuer has about the purchaser; and
- The nature of the offering, including the manner in which the purchaser was solicited toparticipate and the terms of the offering, such as the minimum investment amount.
The SEC makes clear that the issuer should look to the facts and circumstances surrounding the offer and the issuer’s relationship with the investor, and that what will be required to constitute “reasonable steps” will change based on the circumstances. For example, offerings with high minimum cash investments might require less additional investigation than offerings with lower minimums, provided there are no facts to indicate that a third party is financing the purchase.
The SEC also provided a non-exclusive list of methods the issuer could use to verify that a natural person meets the accredited investor requirements of 506(c). These methods are:
- If verifying whether a purchaser qualifies on the basis of income, the issuer may use IRS records that report income (e.g., a Form W-2, Form 1099, etc.) for the purchaser for the two most recent years, along with written representation from the purchaser that they have a reasonable expectation that they will meet the income requirement this year as well.
- If verifying whether a purchaser qualifies on the basis of net worth, the issuer may use bank statements, brokerage statements, other statements of security holdings, certificates of deposit, tax assessments and appraisals provided by independent third parties, provided the records are no more than three months old. The issuer must also use a credit report to assess the purchaser’s liabilities. The issuer must also get written representation from the purchaser that all liabilities necessary to make a net worth determination have been disclosed.
- The issuer may rely on written confirmation from a third party that the third party has taken reasonable steps to verify the purchaser’s accredited status. The SEC specifically named broker- dealers, CPAs, attorneys, and SEC-registered investment advisers as acceptable third parties, but also stipulated that other third parties could be acceptable provided they take reasonable steps to verify that purchasers are accredited and the issuer has a reasonable basis to rely on that verification.
- Finally, purchasers who invested in the issuer in a previous 506(b) offering as an accredited investor and remains an investor in the issuer’s 506(c) raise is deemed to satisfy the verification requirements if the issuer obtains certification from the purchaser that they qualify as an accredited investor at the time of sale.
In a recent discussion with Bob Carbone of CrowdBouncer, he explained how the compliance service provider will take steps to verify accredited status on behalf of potential investors.
Carbone explained that CrowdBouncer’s current process of verifying accredited status mimics the process by which mortgage companies now must verify a buyer’s ability to pay back a loan post Dodd-Frank. On portals making use of the CrowdBouncer API, a potential investor must digitally sign a consent form. Within 48 hours of that form being turned in, CrowdBouncer will make a request to the IRS database for information that can be used to verify or deny accredited status, thus meeting the mandate of taking “reasonable steps to verify.” That information is then returned to the intermediary.
That status can also be shared among platforms that integrate the CrowdBouncer API. The sharing of that status is free for those making use of CrowdBouncer’s paid service tiers. There is also a free version of the API that will allow platforms to request accreditation status for a $2.95 fee per investor.
Note that this is a means to verify accredited status via a yearly salary of at least $200,000 only. The other criteria available to investors, verifying a $1 million net worth, will require a separate process. Carbone explains that a service is in the works to verify based on this criteria.
One of the reasons we started this platform and one of our goals is to maximize automation in these types of compliance flows, because we looked at compliance under the JOBS Act and all we saw was friction. Adding friction into these offerings of securities… that is going to evaporate all of the benefits of Title II activity and crowdfunding. What our solution does is it’s really a frictionless process for verifying accredited status of an investor that maximizes investor privacy.
Investor privacy is paramount in the process as the data used to confirm or deny accreditation is sensitive. Carbone explains that the entire process is encrypted and that no human being ever actually sees this data.
In discussing risks surrounding Title II, Joy Schoffler of Leverage PR seconded comments we received from Sara Hanks in regards to how measured issuers will have to be in their solicitation materials.
“One of the really big risks here is people are going to go off the cuff, especially entrepreneurs. By nature, entrepreneurs are aggressive. That’s part of what makes them successful… They’re creative and aggressive and they want to get out there and sell their company and are passionate about it,” Schoffler told Crowdfund Insider. “But making a statement, for example, on Twitter about a potential customer you may close or saying ‘Hey, great call with you, were excited to work with you;’ That may seem like something that is very acceptable, but if you’re in the middle of a capital raise and you haven’t closed that particular client yet and they’re not contracted and you’re just making a forward looking statement, that could be seen as a misstatement and you could get in trouble for it.”
Schoffler preached conservatism on behalf of issuers, especially in advance of any no action letters or case studies on the subject. In short, she explained that it will take time for the specifics of general solicitation to shake out. Until that shake out occurs, issuers should be careful in how they advertise their offerings.
One of the really big risks here is people are going to go off the cuff, especially entrepreneurs. By nature, entrepreneurs are aggressive. That’s part of what makes them successful… They’re creative and aggressive and they want to get out there and sell their company and are passionate about it.Joy Schoffler, Leverage PR
Bob Carbone explained that the consequences of non-compliance could include a loss of the exemption under 506(c). It could also open the door for all investors participating in an offering to sue for recision rights and/or damages. In short, non-compliance could be very messy and very costly.
In light of these consequences, Carbone also explains that while issuers may be tempted to perform offerings without the help of intermediaries, they should think twice about striking out on their own. “There are significant value adds to platforms that are going to help you do things like manage your communications,” he said.