General Solicitation and Startups, October 24, 2012

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From a presentation I gave on the proposed SEC rules implementing Section 201 of the JOBS Act on October 24, 2012.

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General Solicitation and Startups, October 24, 2012

  1. 1. GENERAL SOLICITATION AND STARTUPS ___________________STARTUPLAWBLOG.COM
  2. 2. Joe WallinDavis Wright Tremaine LLPjoewallin@dwt.comjoewallin.com(206) 757-8184 Keith Baldwin Davis Wright Tremaine LLP keithbaldwin@dwt.com (425) 646-6133 Randall Lucas Applied Dynamite (617) 905-7467 2
  3. 3. Private Company Fund Raising Suppose you are a private company and you want to raise money. How do you do it? Almost all companies use Rule 506. Rule 506 allows you to raise an unlimited amount of money from accredited investors, with no SEC or state filings prior to closing. (Forms D are due after closing, however.) As long as you take money from only accredited investors, there are no specific disclosure requirements. Provided, however, “general solicitation and general advertising” are disallowed. 3
  4. 4. Current Rules What are general solicitation and general advertising? (1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and (2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. So you can’t run an ad in the newspaper (under the current rules). You are supposed to work only through your pre- existing relationships. These rules make raising money difficult. And companies foot fault all the time. E.g., accidentally telling a reporter about a current and ongoing fundraising. 4
  5. 5. Why no advertising? Why does Rule 506 prohibit general advertising? – Because 506 is a safe harbor under the Securities Act of 1933, Section 4(2), which provides an exemption from registration for securities offering which are “not involving any public offering.” – Advertising or generally soliciting funds is considered inconsistent with a non-public offering. 5
  6. 6. Don’t Jump the Gun! These rules prohibiting general solicitation and general advertising are still the current rules. You can’t Twitter, use Facebook, etc. to raise money. Just recently, the SEC took enforcement action against two individuals who ran a social media campaign to buy a brewery. These guys never actually collected any money. They only collected commitments. They still got in trouble. The point ─ the current rules are still in effect. You cannot generally solicit or generally advertise yet. 6
  7. 7. JOBS Act changes However, the JOBS Act will change this (and the world of private company financing). Here is what the JOBS Act said: Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitations or general advertising contained in section 230.502(c) [Rule 506] of such title shall not apply to offers and sales of securities made pursuant to section 230.506 [Rule 506], provided that all purchasers of the securities are accredited investors. (cont’d on next page) 7
  8. 8. Text of Rule Does this mean you’ll be able to run ads in newspapers, announcing you’re raising money? – Yes, but you may not want to for a few different reasons. • Heightened verification requirements. – If you generally advertise or generally solicit, you have to take reasonable steps to verify that the purchasers of securities are accredited investors. • Blue Sky. – Some states want pre-filings before soliciting funds in those states. – E.g., New York. 8
  9. 9. Text of Rule cont’d However, such rules shall require the issuer to take reasonable steps to verify that purchasers of securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77(d)(2)). 9
  10. 10. The New Rules Adoption Process Are the SEC rules final yet? – No. Have draft rules been proposed? – Yes. See here: sec.gov/rules/proposed/2012/33- 9354.pdf. – The SEC has proposed a new section 506(c). Are the new rules going to work? – There was a lot of worry over what they would say. – Would they require investors give onerous disclosure? A lot of folks were really worried. 10
  11. 11. Enabling capital formation vs. protecting investors The actual rules say just this regarding the verification requirement: “The issuers shall take reasonable steps to verify that purchasers of securities sold in any offering under this section 230.506(c) are accredited investors.” A lot of people are complaining, on both sides. – Securities regulators say the rule doesn’t do what Congress instructed the SEC to do; that it doesn’t protect investors. – On the other side, people are asking for safe harbors. 11
  12. 12. SEC authority to define “reasonable steps” What the statute said: “However, such rules shall require the issuer to take reasonable steps to verify that purchasers of securities are accredited investors, using such methods as determined by the Commission.” (Emphasis supplied.) What the rules said: “The issuers shall take reasonable steps to verify that purchasers of securities sold in any offering under this section 230.506(c) are accredited investors.” 12
  13. 13. What Will Happen in the Final Rules? We don’t know for sure. Probably the final rules will look substantially similar to the proposed rules, but we won’t know until we see them. We should be happy the proposed rules weren’t ridiculously onerous. 13
  14. 14. Newly Proposed Rules The new rules require issuers to take reasonable steps. What are reasonable steps? – Objective determination, based on particular facts and circumstances of each transaction. – Example factors: • 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. • The nature of the offering, such as the manner in which the purchaser was solicited in the offering, and the terms of the offering, such as the minimum investment amount. 14
  15. 15. SEC Words – “The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa.” – “Third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories.” – For example: • The purchaser is a natural person and provides copies of Forms W-2. • Verification of a person’s status as an accredited investor by a third party, such as a broker-dealer, attorney or accountant, provided that the issuer has a reasonable basis to rely on such third party verification. 15
  16. 16. SEC Words (cont’d) “The nature of the offering – such as the means through which the issuer publicly solicits investors – may be relevant in determining the reasonableness of the steps taken to verify accredited investor status.” “An issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer.” 16
  17. 17. SEC Words (cont’d) “In the case of the former, we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status. In the case of the latter, we believe an issuer would be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification.” 17
  18. 18. SEC Words (cont’d) “By way of example, the ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any other third party, could be taken into consideration in verifying accredited investor status.” “[I]f an issuer knows little about the potential purchaser who seeks to qualify under the natural person tests for accredited investor status, but by the terms of the offering require a high minimum investment amount, then it may be reasonable for the issuer to take no steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by the issuer or by a third party, absent any facts that may indicate that the purchaser is not an accredited investor.” 18
  19. 19. SEC Words (cont’d) “Regardless of the particular steps taken, it would be important for issuers to retain adequate records that document the steps taken to verify that a purchaser was an accredited investor.” “Any issuer claiming an exemption from the registration requirements of Section 5 has the burden of showing that it is entitled to that exemption." 19
  20. 20. “Reasonable belief” standard Proposed rules do not require issuer to follow uniform or specified verification methods. The SEC did not propose a non-exclusive list of specified methods of satisfying the verification requirement. The reasonable belief standard remains: “If a person who does not meet the criteria for any category of investor purchases securities in a Rule 506(c) offering, we believe that the issuer would not lose the ability to rely on proposed Rule 506(c) exception, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.” 20
  21. 21. Summary – No specific method or methods of verifying accredited status are required under the proposed rules. • There is no non-exclusive list of specific methods for satisfying the verification requirements included in the proposed rules. • Instead, the rules will require that “[T]he issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under this Section [506(c)] are accredited investors.” – Issuers relying on the new rules will have to check a box on the new Form D indicating that they are doing so. – The new rules do not eliminate the reasonable belief standard. If a person who does not meet the criteria for an accredited investor invests in a generally solicited or advertised offering, the issuer does not lose the ability to rely on the 506 exemption, so long as the issuer took reasonable steps to verify that the purchaser was accredited and had a reasonable belief that such person was accredited. 21
  22. 22. Summary You can continue to use the existing rules, so long as you don’t generally solicit or advertise an offering. The SEC has created a new rule: Rule 506(c). – Offerings under the new Rule 506(c) don’t have to comply with the prohibition on general solicitation and advertising under Rule 502(c). – Under new Rule 506(c), general solicitation and advertising are permissible as long as: • the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors; • all purchasers of securities must be accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes that they do, at the time of the sale of the securities; and • all terms and conditions of Rule 501 and Rules 502(a) and 502(d) are satisfied. 22
  23. 23. The Push and Pull of the Law Dodd-Frank made it harder on private companies to raise money. – Made it harder to be an accredited investor. – Imposed bad actor rules. JOBS Act tries to make it easier to raise money. – General solicitation in 506 offerings. – Crowdfunding. 23
  24. 24.  Questions? 24

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