Before CFOs trumpet securities offerings to scads of private investors, they may consider an additional compliance risk they’d be taking on. So say lawyers who are working to interpret a section of the Jumpstart Our Business Startups (JOBS) Act that deals with the “general solicitation and general advertising” of private placements.
U.S. companies raise billions of dollars every year through private offerings under Rule 506 of Regulation D, which gives issuers a safe harbor from Securities Act registration requirements. The method of capital raising is popular because the issuer doesn’t have to register with the Securities and Exchange Commission or abide by any ceiling on the amount raised. What’s more, the rule preempts state securities laws.
But there has been a long-time ban on “general solicitation and general advertising” of such deals. Typically, that means companies must go to existing investors to raise money or work with a broker-dealer that has preexisting ties to the sophisticated investors allowed to invest in private placements.
But the JOBS Act lifts the ban on general solicitation and advertising for Rule 506 sales. “Taken to the extreme, you could advertise a private placement under Rule 506 on the radio, on an infomercial, or on the side of a blimp flying over a stadium,” says David Lynn, a partner at Morrison Foerster. “For legal purposes, it’s still ‘private.’ But it’s not private in that you can go out and talk to investors much more freely after this rule goes into effect.”
Directed by the act, the SEC published a preliminary rule last month and is collecting comments on it until October 5.
The wrinkle in the rule is that not all the people that see an ad or listing for a deal will be able to invest: like the existing Rule 506, investors must be “accredited” — have a minimum net worth and annual income.
But there’s a new twist that presents some risk for the issuer and could increase its cost of capital: in the old way of conducting a Rule 506 deal, the issuers just had to have a “representation” from the investor certifying it was an accredited investor. If issuers use general solicitation, however, “the JOBS Act contemplates that there’s some effort required from the issuer to actually verify accredited investors,” Lynn says. While the SEC had a chance to clarify that aspect of Rule 506 in its recent proposal, “it kind of punted and said ‘we’re not going to adopt any bright-line verification,’” he adds.
In a comment letter to the SEC last July, one private investment-banking executive pointed out that requiring more than self-certification would make private placements more difficult. Michael Flannigan, an executive at BrokerBank Securities, which invests in early-stage medical companies, said many potential investors would be reluctant to go to the trouble of assembling the financial information the issuer needs, or to disclose it. “The more wealthy a person is, the more difficult this would become in many cases,” he wrote. “By the time most people accumulate a net worth of [more than] $1 million not counting their principal residence, they usually want to keep their financial information very close to the vest.”
Fortunately, while a company must take “reasonable steps” to verify an investor’s status, “it does not appear that that SEC has established a particularly high standard for what constitutes reasonable steps,” wrote attorney Alexander J. Davie on the Strictly Business law blog last month. “[The SEC] doesn’t mandate taking any particular action (such as obtaining tax returns or other financial statements) and issuers can rely on third-parties, such as accountants, lawyers, and broker-dealers, to provide verification,” he wrote.
Still, “an issuer has to be very confident in its ability to verify the accredited-investor status of participants,” Lynn says.
Companies can still conduct Rule 506 offerings the old-fashioned way. Many issuers — like a company that’s raising a series C round and just going back to its existing financial sponsors — won’t use general solicitation, says Lynn. It’s more suited to companies that don’t have access to professional private capital but have customers or individual contacts that might qualify as accredited investors. Lynn doubts the change in Rule 506 offerings will attract companies that otherwise would not do a private placement.
The SEC could still add some stipulations to the new Rule 506 that would beef up investor protections. In voting against the SEC’s preliminary rule, SEC commissioner Luis Aguilar proposed requiring that any advertising include a balanced presentation of risks and rewards, as is required with registered deals, and include warning labels “highlighting the risk of investing in unregistered securities.” Aguilar would also set a mandatory “cooling off” period, during which an investor could terminate a purchase without risk.
Regardless of whether any of Aguilar’s proposals make it into the final rule, companies will have to be careful about what they say in marketing a private placement. “Any fraud rules still apply,” notes Lynn.