A few months ago my colleague Aaron Thomson published a piece about the new JOBS Act aimed at making it easier for private companies to raise capital. As Aaron explained, two key aspects of the new law are the crowdfunding exemption and the elimination of the ban on “general solicitation” in connection with Rule 506 private placements involving only accredited investors. These two developments will not take effect simultaneously. The crowdfunding exemption will not take effect until the Securities and Exchange Commission (SEC) issues new rules to implement the new exemption. To underscore that fact, the SEC issued the following notice:
“On April 5, 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law. The Act requires the Commission to adopt rules to implement a new exemption that will allow crowdfunding. Until then, we are reminding issuers that any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws.”
So, for now, there is no effective crowdfunding exemption and the SEC has up to a year to issue its rules, so corporate finance strategies involving this exemption will just have to wait.
The wait will be much shorter until the removal of the ban on “general solicitations” involving “accredited investor only” private placements under Rule 506. The JOBS Act calls for the ban to disappear on July 5, 2012, and for the SEC to issue revised rules to that effect by that date. The SEC has been soliciting comments from interested parties to guide it as it develops the new rules. I’ve followed some of the comments submitted to the SEC, and they generally track the two main questions that have been swirling around in my mind since the JOBS Act was signed into law:
1. Once issuers are permitted to speak openly about pending private placements through different types of media, what restrictions will the SEC impose on the content and manner of such communications?
2. How much more will the SEC require issuers to do to verify prospective investors are in fact accredited investors?
From my discussions with friends, colleagues and business leaders, I know there is a lot of excitement about the possibility of issuers communicating more freely with prospective investors. I admit I was initially intrigued about the way open communication might help some of my clients access private capital. However, it is easy to see how unrestricted communications could readily lead to marketing and advertising strategies filled with the potential for trouble. For that reason, I expect the SEC will try to dampen the excitement by implementing additional rules to ensure that general solicitations are truthful and are free from material misstatements and omissions. No doubt unscrupulous issuers will take the lifting of the ban as license to even more freely spam the world with puffed-up information about investments that just can’t lose.
For legitimate and responsible issuers, the issue is more complex. Seemingly innocuous and even-handed descriptions of a pending private placement contained in an email, newspaper article or blog post may later be challenged as incomplete or misleading. Of course, issuers are still subject to state and federal anti-fraud laws and the elimination of the ban on general solicitation will not change that fact.
Ironically, it may turn out that by attempting a beneficial deregulation–lifting the ban on general solicitation–Congress has created an even greater regulatory monster for issuers by handing the SEC the enormous task of policing every word uttered or written by issuers and their management executives regarding private placements. I expect securities regulators will readily embrace this new task and may even request increased funding to hire the additional lawyers and staff needed to monitor and verify issuers’ statements. Private placements may be stalled while regulators work to determine the truth, accuracy and completeness of any general solicitations. Regardless of what the SEC’s rules look like, it may very well turn out that after absorbing the SEC’s new rules, legitimate and responsible issuers will choose to avoid general solicitations anyway as being too risky.
Then there is the issue of ensuring that only accredited investors participate in private placements that involve general solicitations. The JOBS Act requires the SEC publish rules requiring “the issuer to take reasonable steps to verify the purchasers of securities are accredited investors, using such methods as determined by the Commission.” What are “reasonable steps”? What “methods” will the SEC require?
I have a feeling that the SEC will require issuers to do much more than they have in the past. Today, accredited investors participating in private placements typically complete a questionnaire attesting to their status as accredited investors. And, as we explained in another recent blog post, an issuer is usually safe as long as it reasonably believes an investor is accredited, with that belief typically deriving from “accredited investor representations and warranties” the investor makes to the issuer.
As the price for the privilege of engaging in general solicitations, I think we can expect the SEC will require much more from issuers in the way of due diligence regarding an investor’s accredited status. Regulators will certainly operate from the assumption that general solicitations will attract unaccredited investors, and it will be up to issuers to perform a thorough investigation to determine who is accredited and who is not. Imagine if the SEC requires issuers to examine a prospective investor’s bank statements, tax returns, personal financial statements or W-2 statements! That could bog down the financing process and make it harder to raise capital from accredited investors who value their privacy. Facing such obstacles, issuers might choose to stay away from general solicitations altogether, which would necessarily be a strategic decision made at the outset, before the offering starts.
One of the suggestions common to many of the comments submitted to the SEC is that the current private placement structure of Rule 506 should be left intact. In other words, if an issuer chooses not to engage in general solicitations, then it should not be subject to whatever additional efforts the SEC requires to verify accredited status and, as is the case today, it would be sufficient if an issuer had a reasonable belief regarding an investor’s accredited status. If the SEC adopts such a view, we may end up with two kinds of Rule 506 offerings: those that involve general solicitations and those that do not, with different verification standards and perhaps other differences between them.
A few days from now we’ll know for sure how the SEC wants to deal with these issues. When the new rules are published, we’ll provide an update right away.