© 2013 The Texas Lawbook.
By Alex Arellano
Special Contributing Writer to The Texas Lawbook
The days of hedge funds and start-ups buying advertising time during your favorite football game half time show may be upon us. Entrepreneurs will now be able to reach a large audience in their search to obtain investment dollars for their businesses.
There are, however, strings attached and additional diligence requirements to follow.
The Securities and Exchange Commission (“SEC”) has lifted the long standing ban that prohibited companies claiming an exemption from registration for a private offering of securities under Rule 506 of the Securities Act of 1933 (the “Securities Act”), from advertising or marketing securities to the general public. As required by the Jumpstart Our Business Startups Act (“JOBS Act”), Rule 144A under the Securities Act has also been amended to allow persons reselling securities to use general advertising only if the securities are sold exclusively to qualified institutional buyers.
These SEC rule changes could significantly impact companies’ compliance and marketing functions, as well as the capacity of start-ups to expand the reach of their fund raising efforts through general solicitation. It remains to be seen, however, how many companies will take advantage of this new regime, given the additional regulatory hurdles imposed, or whether the change will ultimately increase the amount of capital raised by start-ups.
Companies offering securities in an effort to raise funds must either register the securities with the SEC or rely on an exemption from registration. One of the most commonly claimed registration exemptions today is Rule 506 of Regulation D, promulgated under the Securities Act.
In order to qualify for a Rule 506 exemption today, an entity is permitted to raise funds from up to 35 non-accredited, sophisticated investors, as well as from an unlimited number of “accredited investors.” Generally, investors must meet certain asset or income thresholds to qualify as “accredited investors.” In particular, for an individual to be considered an “accredited investor” as defined by Rule 501 of Regulation D, such individual must have:
• A net worth exceeding $1 million (excluding the value of the individual’s primary residence) or;
• Have an annual income of $200,000 (or joint income with that person’s spouse of $300,000) in each of the two most recent years; and
• Have the expectation to reach the same income level in the current year.
Companies are required to have a reasonable belief that an investor is accredited, which is usually satisfied by representations and other documents in the subscription packet.
An estimated 7 percent of households in the United States currently qualify as accredited investors. Traditionally, the Rule 506 exemption was not available to a company that advertised to or solicited an investment from the general public; however, the changes in the JOBS Act have now removed this barrier to fundraising.
As of Sept. 23, 2013, the SEC will end the ban on general advertising and solicitation pursuant to the rules adopted under the JOBS Act. In an attempt to aid capital raising efforts, the new SEC rules allow issuers offering unregistered securities under Rule 506 to advertise such securities to the general public and still maintain their Rule 506 exemption. Companies seeking to solicit investment from the general public must take affirmative steps to verify the accredited status of each of their investors.
Under the new rules, companies must take “reasonable steps to verify that purchasers are accredited investors.” What steps are reasonable to verify the status of an investor will depend on the facts and circumstances of each situation, but the new rules do provide a list of four non-exclusive methods that issuers may employ in order to satisfy the verification requirement for investors who are natural persons. The four methods of verification include:
1. Verification based on a review of forms reporting income to the IRS including forms W-2 and 1099 for the two most recent years;
2. Verification through review of recent bank statements (3 months), brokerage statements and appraisal reports;
3. Written verification from a broker-dealer, attorney, CPA, or SEC registered investment adviser, that has taken reasonable steps to verify accredited investor status; or
4. Previous investors who have qualified as accredited for prior offerings and continue to be qualified as such.
These rule changes, which become effective Sept. 23 of this year, may have a significant impact on the ability of companies to raise funds. Many start-ups will likely seek funding through general solicitation, but certain companies may not be interested in using general solicitation since they often want to know their investors and have a traditional network of funding sources.
Even after the rule changes, companies wishing not to engage in general advertising can conduct offerings according to the traditional Rule 506 procedures and rules.
There is some speculation and concern that the rule changes will open the door to more cases of fraud. The rule changes will certainly increase the regulatory burden on start-ups and may also increase uncertainty since the rules do not specify the types of general solicitation permitted. It will be interesting to see the true impact of these rule changes as they come into effect.
Alex Arellano is a member of Winstead’s corporate practice group in Dallas. He counsels private and public companies on general corporate matters as well as mergers and acquisitions. He can be reached at aarellano@winstead.com.
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