Route 506: The General Solicitation Highway

People Walking

A new route to soliciting direct securities investments has opened.  For the first time in 80 years, start-ups and small businesses can broadly advertise and broadly solicit to raise money for private offerings.  Changes to SEC Rule 506, which took effect September 23, 2013, allow companies to avoid complex and costly public offerings and instead search for investors via the Internet, newspaper, social media, direct mail, and other media.  The change is the result of the JOBS Act, which required the SEC to permit general solicitation for certain private placements that are exempt from the registration requirements of Section 5 of the 1933 Act.

To travel this route, investors must be “accredited,” defined in the new rule as having a net worth of over $1,000,000 or at least $200,000 in annual income.  While the accreditation has long been required for private placements, issuers were permitted to sell to non-accredited investors who qualified as sophisticated purchasers.  Businesses who raise funds under the new rule must now take additional “reasonable steps” to ensure all investors are accredited.  Rule 506(c) provides a non-exclusive list of means to satisfy this “reasonable steps” requirement.  Issuers may use investor’s tax forms, bank statements, credit reports, and certifications from accountants, brokers, and investment advisors to ensure accreditation – assuming that investors are willing to deliver copies of such documents to issuers.  There may be other means not specified that would also be acceptable also.  Issuers will want to keep careful records about how they accredit investors, because they will bear the burden to establish their exemption from the registration provisions of the Securities Act.  If an issuer cannot do so, it may be subject to liability for general solicitation in connection with an unregistered offering in violation of the federal securities laws.

Although Rule 506 offerings are not subject to the same disclosure requirements as registered offerings, the SEC has also proposed additional rules to ensure that investors receive material information.  Under the current proposal, for which the comment period was recently extended, issuers would have to provide additional information to the SEC and the public about their Rule 506 offerings, including certain mandatory disclosures, the submission of offering materials to the SEC, and requiring issuers to file or amend their Form D with the SEC 15 days before they begin advertising.  The proposed rules have come under withering attack from some members of Congress and from many influential voices in the venture capital and angel community.

Because the regulations regarding solicitation remain complicated, and because the SEC and state regulators are keen to the potential for abuse of the new rules, publicly marketed offerings are certain to receive attention from regulators who are looking to ensure compliance and prevent fraud.

The rule change does not encompass the broad equity crowdfunding envisioned by the JOBS Act, which would allow ordinary investors to make small investments and receive equity stakes in small companies, including over the Internet.  The SEC has not yet proposed new regulations for crowdfunding, so it will likely be at least another year before that method of fundraising is available.

For further guidance on the new rules and solicitation of investment by small businesses, see the SEC’s Small Entity Compliance Guide.