Previously, we discussed a startup’s most important tool for selling debt or equity securities in compliance with the Securities Act of 1933, as amended: Rule 506(b) of Regulation D. This rule is critically important to startups because it acts as a safe harbor for compliance with the exemption from registration contained in the Securities Act (Section 4(a)(2)). However, it presupposes that the startup already has access to ready and willing investors and has a preexisting relationship with them. After all, Regulation D makes it clear that Rule 506(b) offerings may not use “any form of general solicitation or general advertising.” The situation changed somewhat when in 2012, Congress enacted the Jumpstart Our Business Startups (JOBS) Act.
The JOBS Act directed that Rule 506 should include a safe harbor permitting general solicitation so long as all the investors are “accredited investors.” This new exemption is found in Rule 506(c).
Below is a walkthrough of many of the key issues of a Rule 506(c) offering, including comparisons with Rule 506(b) offerings as appropriate.
What is the key difference between 506(b) and 506(c)? The key difference is that 506(c) allows a startup to offer securities through general solicitation (within the bounds of the rule).
The tradeoff for this is that the company must “verify” that all purchasers are accredited investors, and this rule doesn’t allow any sales to non-accredited investors (we discussed the criteria for accredited investors in the prior post). This is a key difference – with 506(b) offerings, the rules only require that the startup reasonably believe an investor to be accredited and allows up to 35 non-accredited investors (subject to special disclosure requirements for the non-accreds).
What steps do you have to take to verify that the purchasers are accredited investors? If you’re relying on Rule 506(c), an issuer has an affirmative obligation to take “reasonable steps” to verify that each and every investor is an accredited investor.
As Rule 506(c) is still in its early days, the question of what constitutes “reasonable steps” to verify a potential investor’s status as an accredited investor is still being developed. The determination of whether the issuer has taken “reasonable steps” to verify the status of its potential investors depends on the particular facts and circumstances of each purchaser and transaction. Guidance from the Securities and Exchange Commission (SEC) and Rule 506(c) itself provide a flexible principles-based verification method, as well as a non-exclusive list of verification procedures that an issuer may use.
Factors that the issuer should consider under the flexible principles-based verification method include:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- The amount and type of information that the issuer has about the purchaser; and
- The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
The non-excusive list of verification procedures set forth in Rule 506(c) includes:
- Verification based on income, by reviewing copies of tax forms that report income;
- Verification based on net worth, by reviewing specific types of documentation dated within the prior three months, such as bank statements, brokerage statements, certificates of deposit, tax assessments and a credit report from at least one of the nationwide consumer reporting agencies, and obtaining a written representation from the investor;
- A written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant stating that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the last three months and has determined that such purchaser is an accredited investor; and
- A method for verifying the accredited investor status of persons who had invested in the issuer’s Rule 506(b) offering as an accredited investor before September 23, 2013 and who remain investors of the issuer.
It is important to note that merely relying on a questionnaire and asking investors to self-certify that they are accredited investors (which is a fairly typical practice for Rule 506(b) offerings) generally will not suffice as “reasonable steps” under Rule 506(c).
Who can use Rule 506(c)? Only the startup itself. Section 4(a)(2) and Rule 506(c) exempt “private placements” by an “issuer.” The issuer is the entity actually selling the securities in question. Because of this, the exemption does not apply to securities being sold by founders or other stockholders. This is identical to the scope of reliance on Rule 506(b).
Are securities sold under Rule 506(c) permanently exempt from registration? No. This exemption is a “transactional” exemption; a particular offer or sale of securities by the issuer is exempt from registration, but the exemption does not stick to or run with the securities after that transaction is concluded. Securities sold under the Section 4(a)(2) exemption are, therefore, “restricted securities,” having restrictions on further transfers or resale. Again, this is identical to securities sold under Rule 506(b).
Is there a dollar limit on the size of a Rule 506(c) offering? No. Similar to Rule 506(b), as long as the startup complies with the requirements of Rule 506(c), there is no limit to the amount of capital that can be raised.
Can SEC “integration” analysis impact a Rule 506(c) offering? It depends. Rule 502(a) of Regulation D provides for “integrating” multiple offerings to see if they were really part of the same plan or scheme of financing. The concern here is that a supposed Rule 506(b) offering that includes non-accredited investors could be integrated by the SEC with a supposed Rule 506(c) offering that included general solicitation of investors. However, many practitioners believe that a Rule 506(c) offering should be treated as a “public” offering for the purposes of Rule 502(a). This approach makes Rule 502(a) simply “aggregate” the offerings instead of “integrating” them. The argument here is that, under Securities Act Rule 152 and the SEC’s guidance, consistent with the treatment of a private offering followed by a public registered offering, a completed Rule 506(b) offering should not be integrated with a later-begun Rule 506(c) offering.
The situation is more precarious when a Rule 506(c) offering is conducted before a Rule 506(b) offering; it may be difficult to show that a non-accredited investor in the Rule 506(b) offering was not attracted by the solicitation used for the earlier Rule 506(c) offering. It would be even more difficult to conduct simultaneous Rule 506(b) and Rule 506(c) offerings for the same reason. Integration analysis could presumably impact the offerings in these situations. Until the SEC or a court evaluates these situations and provides definitive guidance, startups and other issuers should be careful when relying on Rule 506(c) to ensure that they could not possibly be considered to be part of another financing that includes non-accredited investors.
If a startup accidently fails to comply with Rule 506(c), can it still rely on the Section 4(a)(2) exemption? Only if it did not engage in any general solicitation. The JOBS Act and subsequent SEC guidance make clear that the 2013 amendments to Regulation D and Rule 506, permitting general solicitation, apply only to “a subset of Rule 506 offerings” and “general solicitation continues to be incompatible with a claim of exemption under Section 4(a)(2).” Therefore, care must be taken when relying on Rule 506(c); if an issuer violates the requirements of Rule 506(c) after general solicitation of investors has begun, it is possible that no exemption would be available for the offering.
What information must an issuer provide to investors? Because a Rule 506(c) offering does not include any non-accredited investors, there are no particular information requirements. An issuer must always be mindful of the anti-fraud rules, particularly Rule 10b-5 promulgated under the Securities Exchange Act of 1934, as amended, so some form of disclosure to potential investors is generally a good idea.
Could anything make Rule 506(c) unavailable for use by a startup? Yes, there are certain “bad actor” provisions that could disqualify an issuer from relying on Rule 506(c) for an offering of its securities. These bad actor provisions are identical for Rule 506(b) offerings. The bad actor provisions apply to the issuer and its predecessors, directors, executive officers, general partners or managing members, and equity holders holding 20 percent or more of its voting securities. If any of these parties has been convicted of certain crimes involving securities or is subject to SEC or court orders regarding certain securities matters, then the entire company is barred from relying on Rule 506(c). It is common for issuers of all size to have its officers and directors complete a questionnaire on an annual basis to confirm that none of these disqualifying events exist. Startups must obviously be sensitive to this issue and be certain not to engage any “bad actors” as it seeks to grow.
What filings are required in a Rule 506(c) offering? A Form D must be filed with the SEC within 15 days of the first sale of securities. This requirement is identical to Rule 506(b) offerings, although the Form D must specifically state that the issuer is relying on Rule 506(c). A Form D is a fairly simple notice filing filed electronically with the SEC. It contains some general information about the issuer and the offering and is publicly available on the SEC’s website.
What state securities or “Blue Sky” law issues are there? Just like with Rule 506(b) offerings, another advantage of Rule 506(c) offerings is that, if the startup complies with the federal regulations, state laws requiring registration or qualification do not apply. Generally, a state in which an investor in the startup resides can require filing a copy the Form D and paying a fee. Some states have additional requirements, such as the filing of a consent to service of process or annual updates on the offerings.