In July 2013, the SEC adopted some of its long-awaited rules required under the 2012 Jumpstart Our Business Startups (JOBS) Act. The new rules permit general solicitations in certain private placements, such as so-called “Rule 506 offerings.”
Under revised Rule 506, issuers can now use public web pages, advertisements and broad solicitations to market private placements and attract investors, as long as they only sell to qualified investors. The change may be particularly useful for early stage companies that need to cast a broader net to find funding.
Many companies will welcome the new rules and the ability to identify a broader base of investors. But issuers should also consider the additional compliance concerns that come with the new rules. Here are some examples.
Quality of Content
Permission to make a general solicitation is not a license for issuers to say anything they want. A company making a general solicitation should carefully screen the content of its communications to make sure it is not saying anything that could result in a securities fraud lawsuit. It should also ensure that its placement agent is making statements that are consistent with Financial Industry Regulatory Authority (FINRA) rules about communications with investors.
In the case of Rule 506 offerings, the issuer or its placement agent must use reasonable means to determine whether its potential investors are accredited. The SEC has provided a set of principles issuers can use to determine what constitute “reasonable means,” including the nature of the purchasers, the amount of information that the company or agent has about the investor and the nature of the offering. For example, an offering made as a general solicitation over the Internet would require more diligence to determine that the investors are in fact accredited.
In adopting the new rules, the SEC provides some helpful examples of “reasonable means.” However, there could be situations in which it is unclear what is reasonable. For instance, an issuer may try to verify an investor based on net worth but discover that the investor owns assets that are difficult to value, such as illiquid securities. Companies are also allowed to pay a third party to verify their investors. If they do, they should assess whether that third party satisfies the SEC’s criteria and is capable of properly handling investor information.
Companies that don’t get this right could face risks down the line. A completed private placement could be challenged by the SEC or by investors seeking a refund of their purchase price long after the completion of the offering. The required SEC filing, the “Form D,” will require issuers to “check a box” if they have made a general solicitation. Checking that box will make it easier for regulators and plaintiff law firms to determine which offerings might be easiest to challenge.
“Bad Actor” Rules
Under amended Rule 506, the private placement exemption won’t be available if the issuer, the agent or certain personnel have been disqualified. The persons covered by the rule include directors and officers of the issuer or the agent participating in the offering process, as well as any 20% shareholders of the issuer. A wide variety of events can disqualify a person, such as criminal convictions and SEC cease and desist orders.
Accordingly, issuers will need to be more selective about choosing a dealer and doing due diligence to make sure they, their personnel and their dealer are not disqualified. On an ongoing basis, they will need to carefully monitor the legal proceedings that could disqualify them. For public companies, the annual “D&O questionnaires” furnished to senior management by a company’s securities counsel may become even longer and more challenging for officers and directors as new questions are added to attempt to ferret out any relevant events.
Many believe that the SEC is concerned about general solicitations and the possibility that unqualified investors may end up participating in private offerings. The commission has proposed additional rules that may make offerings involving general solicitations even more challenging. For example, under the proposal, issuers would need to include more information in reports about private placements and file those documents earlier. In light of these additional challenges, many issuers may be reluctant to utilize general solicitation.
Lloyd Harmetz is a Capital Markets Partner at Morrison & Foerster LLP.