September was when the public was allowed to comment on proposed SEC rules amendments that will permit unbridled use of general advertising in “private placements,” provided all purchasers are “accredited.”
The SEC’s proposed rule was issued pursuant to the JOBS Act, passed in April of this year, which required enactment of an SEC rule within 90 days.
Is this a case of “better never than late?”
For decades, private placements of securities were effected primarily pursuant to Section 4(2) (now 4(a)(2)) of the ’33 Act, as transactions not involving a public offering.
Over time, a “lore” developed around what did not constitute “public,” and companies and lawyers were frustrated (and often at odds) over whether a particular offering was exempt from registration.
If you sold securities to a small number of wealthy and sophisticated businesspeople, with the kind of disclosure that a registration statement might provide, and if you legended the stock against transfer and instituted a stop transfer instruction on the shares, and if you got an investment letter, and if your investor held the stock for some undefined substantial period, you had a good private placement.
The practice arose to limit the number of offerees to 25, although this was arbitrary as a matter of federal law and was derived from some blue sky regulation.
Then the 25-person standard slipped to 25 purchasers, provided all offerees were rich and sophisticated.
Then it was noted that if you were dealing with informed and rich and sophisticated investors, their number really didn’t matter; it was sometimes said glibly that you could “sell to a thousand Rockefellers but not one poor widow or orphan.”
Then there was the question of what sort of disclosure had to be given, and what it meant to offer disclosure that was “of the type” that would be given in a registration statement. Very few private placement memoranda went into that level of detail.
A subtext developed for the most sophisticated investors. If a venture fund did its own diligence and had the power to “access” all information, why was it necessary to provide any written information whatsoever?
In the face of a call for clarity, the SEC promulgated Regulation D in 1982. As often amended, the regulation now allows sales of unlimited securities to an unlimited number of “accredited” investors, as well as up to 35 non-accrediteds if certain conditions are met, including investor retention of stock for various, increasingly shortened, time periods. Such sales also are exempt from state regulation.
But no general advertising was allowed.
While Reg D contains no requirement to provide information of any nature or in any form to accredited investors, who could be thought to fend for themselves, disclosure of the kind that might be provided in a registration statement is required for non-accredited investors.
A combination of factors has resulted in the practice of drafting private placement memoranda in many cases. Companies wanted to offer to non-accrediteds; investors wanted facts; the lawyers wanted a record of what the investors were told; anti-fraud provisions of Rule 10b-5 continued to apply.
Congress enacted a panoply of provisions under the JOBS Act that reduced the scope of federal regulation, under the rationale that restrictions on investment impaired job growth.
Our focus here is on one of these new provisions: permitting private placements using general advertising if made only to investors believed to be accredited. (Accrediteds include certain institutions, and individuals with $1 million of net worth exclusive of principal residence, or with annual earnings over $200,000, or $300,000 for couples.)
In August, the SEC proposed implementing this new exemption (Release 33-9354) by establishing an exempt offering to accredited purchasers (or purchasers reasonably believed to be accredited) under new Rule 506(c).
The SEC solicited comments for a 30-day period prior to finalization. (The final rule may not apply universally. Among other things, the SEC has sought comment on whether certain issuers should be barred from 506(c) transactions, such as “blank check” or “penny stock” companies.)
Key open issue
The key question is: “How does an issuer know that its purchasers are in fact accredited?”
The SEC response is to talk around the matter. (We might pause to note that issuers today have the same problem; they must verify accredited status so as to not exceed the 35-person cap on non-accrediteds under current Reg D.)
In 17 pages, the SEC refuses to establish either a safe harbor to establish a belief that all investors are accredited, or a list of weighted or exclusive factors, noting that there are so many types of accredited investors and offerings that any guidance might prove limiting.
This approach misses one volatile point: helping define the individual accredited investor.
There is discussion in the release of things to think about, to be sure:
• nature of purchaser (a circular exercise);
• amount of information known about purchaser (an obvious point);
• manner in which purchase was solicited (which ought to be irrelevant);
• minimum amount of investment, with larger amounts being more indicative of being accredited (a dangerous suggestion).
Companies are invited by the release to gather information from public sources (e.g., if the investor is CEO of a large public company), from the investor (“please forward me your W-2”), or from a reliable third party such as a registered broker or other professional.
Two SEC suggestions bear closer attention.
First, why does a high minimum investment prove accredited status? A person in receipt of general advertising might take 100 percent of family savings, clean out his IRA, and take a second mortgage to achieve a large enough investment, creating the worst scenario of meeting the minimum by an uninformed investor going “all in.”
While at least one commentator on the proposed rule endorsed the minimum investment approach as a basis for establishing a reasonable belief of accredited status, utilizing an analogy to the Adviser’s Act that defines a “qualified investor” as having at least $1 million under management, the risks are very different. A “qualified investor” can be charged a performance fee by a registered adviser, while under the proposed rule we are talking about someone who may be permitted to commit virtually all his assets into a widely advertised but risky enterprise.
Second, what third party will want to certify that someone is accredited, and what is their liability if they are wrong? Does a broker really know a person’s balance sheet? Perhaps as part of its customer intake, but will a broker want to convey that information? Perhaps an investment adviser? Will a CPA or lawyer tackle this? A bank?
The September public comments to the SEC run the gamut. Some comments simply say that the rule should permit an issuer to just accept a signed investor statement as dispositive. The Angel Capital Association warned that the lack of a safe harbor will chill angel investment, contrary to congressional intent, noting that the vast majority of prior Form D filings show that only accrediteds participate and that no particular regulatory problems have been noted.
The release made clear that other registration exemptions were being preserved. Thus, the existing regime under Rule 506 will be placed into new Rule 506(b), allowing issuers to conduct 506 offerings with up to 35 non-accredited purchasers, under the current rules which prohibit general solicitation.
Further, the practice of permitting parallel private placements in the United States under Reg D and offshore under Regulation S (offshore transactions with no directed selling efforts in the United States) will continue to be available with respect to 506(c) offerings.
Conforming amendments are also proposed for Rule 144A, which permits the resale of privately placed securities by one institutional investor to other institutional investors. Although the exemption does not cover an initial sale by the issuer, it creates liquidity for such original purchaser and thus facilitates capital formation.
As with Rule 506 practice, the SEC proposal (as directed by the JOBS Act) will permit reselling institutional purchasers under Rule 144A to utilize general solicitation, provided the actual purchasers qualify as institutions under Rule 144A (or are reasonably believed by the seller to so qualify).
It is fun to speculate about the future, the pop-up ads on your computer, the invitation to invest offered by a 30-second ad during “Real Housewives of Beverly Hills.” What else can we expect?
Third-party service providers will get into the specialized business of verifying accrediteds, and issuers will purchase such services.
Unregistered finders who bring investors to private companies may find themselves somewhat superseded.
The allure of broad advertising will attract many issuers who, having unsuccessfully undertaken a 506(c) offering, will find themselves with little ability to retreat to another exemption (all other parts of Reg D and Section 4(a)(2) having been compromised by the advertising).
Unscrupulous promoters of smaller public companies, not subject to ’34 Act reporting under the vastly expanded relief from that burden pursuant to another section of the JOBS Act, will launch a purported 506(c) offering as a way to hype their stock price.
Oh, yes. Just maybe the flow of capital will be facilitated, although one commentator cynically noted that issuers already have unfettered access to all the accrediteds they need.
Finally, the SEC proposal does require disclosure on Form D, required in all Reg D offerings, of specific reliance on 506(c). The release states that the SEC will thus be able to “look into the practices that were developed to satisfy the verification requirement” for accredited investors and consequentially fine tune its rule.
Shortly we will have a final Rule 506(c) allowing advertising in private placements, upsetting 80 years of theory and practice. The congressional rationale is job creation.
I await with concern the actual impact of this development on the jobs market and the cost of its unintended consequences.
Stephen M. Honig practices at Duane Morris in Boston.