Raising Capital through Advertising on the Internet: Caution Advised

The SEC adopted Final Rules under the JOBS Act on July 24, 2013 to permit certain private offerings under Rule 506 of the Securities Act to to include general solicitation, or general advertising, which most notably includes Internet advertising.  However, the first thing to caution is that the rules have not yet taken effect.  The Final Rule becomes effective on September 23, 2013.  Activities before that date will need to comply with the laws and rules previously in effect.

New Rule 506

A final rule approved by the SEC makes changes to Rule 506 of Regulation D to permit issuers make unlimited use of general solicitation and general advertising to offer their securities.  Provided, however, the issuer is required to take reasonable steps to verify that the investors are accredited investors. All purchasers of the securities must meet the criteria to be accredited investors (under existing rule Rule 501 of Regulation D) or the issuer needs to reasonably believe that the purchasers meet the criteria at the time of the sale of the securities.

Under existing Rule 501, a person qualifies as an accredited investor if he or she has either:

  • An individual net worth or joint net worth with a spouse that exceeds $1 million at the time of the purchase, excluding the equity value of a primary residence; or
  • An individual annual income that exceeded $200,000 in each of the two most recent years or a joint annual income with a spouse that exceeded $300,000 for those years, and a reasonable expectation of the same income level in the current year.

Nevertheless, the final rule provides a non-exclusive list of methods that issuers may use to satisfy the accredited verification requirement for individual investors. The methods described in the final rule include the following:

  • Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.
  • Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser's accredited status.

The determination of the reasonableness of the steps taken to verify an accredited investor is an objective assessment by an issuer. An issuer is required to consider the facts and circumstances of each purchaser and the transaction.

Issuers conducting Rule 506 offerings without the use of general solicitation or general advertising can continue to conduct securities offerings in the same manner as customary and will not be subject to the new verification rule.

The Commission also approved a proposal intended to enhance the SEC's ability to assess developments in the private placement market. In particular, the proposal would improve the SEC's ability to evaluate the development of market practices in Rule 506 offerings and would address certain concerns raised by investors related to issuers engaging in general solicitation.

The proposal requires issuers intending to employ general solicitation to file an advance notice of sale 15 days before and at the conclusion of an offering. Currently, an issuer selling securities using Rule 506 is required to file a Form D no later than 15 calendar days after the first sale of securities in an offering. That Form D is a type of notice that provides information about the issuer and the securities offering. Under the proposal, issuers that intend to engage in general solicitation as part of a Rule 506 offering would, in addition to the current requirements, be required to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. Also, within 30 days of completing an offering, issuers would be required to update the information contained in the Form D and indicate that the offering has ended. The proposal requires issuers to provide additional information about the issuer and the offering. Currently, Form D requires identifying information about the company selling the securities, any related persons, the exemption the issuer is relying on to conduct the offering, and certain other factual information about the issuer and the offering. Under the proposal, issuers who intend to use general solicitation are required to provide additional information to enable the SEC to gather more information on the changes to the private offering market that could occur now that the general solicitation ban has been lifted.

The additional information would include:

  • Identification of the issuer's website.
  • Expanded information on
    • the issuer.
    • The offered securities.
    • The types of investors in the offering.
    • The use of proceeds from the offering.
    • Information on the types of general solicitation used.
    • The methods used to verify the accredited investor status of investors.

The proposal disqualifies issuers who fail to file Form D. Under the proposal, an issuer is disqualified from using the Rule 506 exemption in any new offering if the issuer or its affiliates did not comply with the Form D filing requirements in a Rule 506 offering. As proposed, the disqualification would continue for one year beginning after the required Form D filings are made. Issuers would be able to rely on a cure period for a late Form D filing and, in certain circumstances, could request a waiver from the staff. The proposal requires issuers to include legends and disclosures in written general solicitation materials Under the proposal, issuers are required to include certain legends or cautionary statements in any written general solicitation materials used in a Rule 506 offering. The legends would be intended to inform potential investors that the offering is limited to accredited investors and that certain potential risks may be associated with such offerings.

In addition, if the issuer is a private fund (a type of pooled investment vehicle) and includes information about past performance in its written general solicitation materials, it would be required to provide additional information in the materials to highlight the limitations on the usefulness of this type of information. The issuer also would need to highlight the difficulty of comparing this information with past performance information of other funds.

The proposal requires issuers to submit written general solicitation materials to the SEC.  Under the proposal, issuers are required to submit written general solicitation materials to the Commission through an intake page on the SEC website. Materials submitted in this manner would not be available to the general public. As proposed, this requirement would be temporary, expiring after two years.

Securities Exchange Act of 1934 May Have Material Adverse Effects on Your Company

This is a note that might be helpful to a few companies.  If your company is a privately held company with more than $10 million in total assets, with no intention to immediately become a public company, that issued stock, options or other securities to a large number of investors, then this information could be relevant.  This information especially relates to companies that issued or will issue stock or securities if the number of record holders of any class of stock or other securities exceeds, or may in the future exceed, a count of 500. The Securities Exchange Act of 1934 contains burdensome and costly reporting requirements, and if the Securities Exchange Act governs your company, all of the Exchange Act reporting requirements would apply so that the company thus shall be required to file annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statements on Schedule 14A, and certain persons (directors, officers, and certain holders) would be required to report transactions on Forms 3, 4, and 5 and Schedules 13D and 13G. The Securities Exchange Act of 1934 very significantly affects a company. The obligation to comply with the burdensome, challenging and costly Exchange Act only falls upon a company with more than $10 in total assets (but this is gross assets, before subtracting liabilities).  In addition, a company must have issued securities, such as stock, options, convertible notes, warrants, or other securities, and that class of securities must be held of record by more than a threshold number of holders in order for the company to be subjected to the compliance burdens of the Exchange Act.  The threshold is found in the Securities Exchange Act in Section 12(g).  The JOBS Act changed the Exchange Act by raising the shareholder threshold.  Before the JOBS Act, the 1934 Act only affected issuers of securities of any class once they were held by 500 or more persons. The JOBS Act altered the Exchange Act so that its threshold is now exceeded only if the company has either more than 500 “unaccredited" shareholders, or more than 2,000 total shareholders, including both accredited and unaccredited shareholders. The JOBS Act changed the Securities Exchange Act in this positive and very specific way, but the costly periodic reporting requirements remain in place and compliance remains extremely burdensome if registration of the class of securities is required by Section 12(g).  Therefore, if the Exchange Act is triggered, it will continue to be necessary to hire additional management personnel and clerical and supporting personnel.  The Exchange Act registration requirement remains a lurking danger for an unprepared or unwary company. Growing to 500 shareholders can happen by virtue of transfers subsequent to the company's sale of the stock to a far smaller number of people. With every transfer by one person to more than one person, the number of shareholders can grow.  When the shareholder threshold is crossed under the Securities Exchange Act of 1934, not only are the reporting obligations triggered, the SEC also can sue owners and management for several possible reasons.  This regulatory structure costs a company large amounts of money. Registering and thereafter filing periodic and current reports, and filing ownership reports and current reports, all under the Exchange Act, are major undertakings.  If these burdens are unwanted, they would not merely be distractions, they could result in a complete change in the management team.  Those in management or upon whom management may be reliant should monitor this number of holders very carefully. An example of the inner workings of the new shareholder threshold would be a company with 500 unaccredited shareholders, which cannot add one more unaccredited shareholder but can add up to 1,500 more accredited shareholders before reaching the shareholder ceiling. A significant issue in the relationship between a company and its shareholders (or holders of any class of equity security) was introduced by this differentiation between accredited and unaccredited. If the number of holders of that class of stock or securities is or may potentially be approaching the 500 number, there will be an important distinction drawn between unaccredited shareholders and accredited shareholders.  Companies need to be prepared to deal with this distinction because they can be swept up into 1934 Act registration unless they can determine whether their shareholders are "accredited".  A company can essentially miss out on this wonderful opportunity by being oblivious to it in the early years, when planning and strategy can be 100% effective at avoiding perpetually (or as long as wanted) the burdens of the Securities Exchange Act of 1934.  Has your company adopted all of the appropriate charter provisions to assure that the company is immunized from Securities Exchange Act of 1934 registration and reporting? Subsequently, even if this problem is not recognized until the number of shareholders is approaching 500, corrective actions may be possible and must be be attempted before it is too late.  Even when the number of record shareholders is almost 500, it may not be too late.