The risks in mass solicitation

As of September 23, 2013 businesses and investment funds will be able to use public communication channels including the internet, social media and email to market offerings of securities for capital raises. As readers are aware, the changes stem from the Jumpstart Our Business Startups Act (JOBS Act) passed in 2012 to expand access to capital for small businesses and startups in the US

Under the new regime, issuers conducting a Rule 506(c) offering must take reasonable measures to verify that investors claiming to be accredited do, in fact, meet the definition per Rule 501 of Regulation D.  This is a substantial change from the Rule 506(b) paradigm where representations by investors in closing documents or suitability forms are commonplace for establishing the accredited status of investors. 

The ramifications of failing to satisfy the requisite reasonable measures are serious for issuers. Under federal securities laws, if an offering wasn’t properly conducted pursuant to Regulation D, including new Rule 506(c) of Regulation D, investors may have the right to undo the purchase of the securities and have their money refunded.  

Notably, a single rogue investor can potentially create the above liability in favor of all investors in an offering because selling securities to a single non-accredited investor in reliance upon Rule 506(c) is prohibited and could potentially render the exemption invalid.

So how do issuers meet the verification requirements under the new rules?  In the adopting release, the SEC provided a non-exclusive list of measures that can be taken by issuers, including relying upon:

• Financial documentation supplied by the investor 
• An SEC-registered investment adviser, certified public accountant, licensed attorney or broker-dealer that is familiar with the financial affairs of the investor
• Verification by third-parties

The SEC left open other possible alternatives that it hadn’t expressly listed that could meet the “reasonableness” test for verification. The question of whether the above enumerated verification measures rise to the level of a safe harbor – i.e., where technical compliance with the enumerated verification measures automatically satisfies the “reasonableness” test – is unclear, with some experts disagreeing on the subject. Notably, the adopting release does not use the terminology “safe harbor,” nor did the commissioners in the July 10 meeting use such terminology when the rules were adopted. If the enumerated verification measures are not a safe harbor, the reasonableness of reliance upon them could still be placed under the microscope in a court of law by an investor claiming it was irresponsible for the issuer to exclusively accept and rely upon one of the enumerated verification measures.

So far, these are the major tradeoffs for using general solicitation under Rule 506(c), as opposed to conducting a conventional private placement without public marketing of the securities under Rule 506(b). Importantly, on the same day the SEC adopted rules pertaining to Rule 506(c), it proposed more rules governing logistical aspects of such offerings. These additional requirements, if adopted, would, among other things, include a new preliminary Form D that must be filed 15 days before use of general solicitation and filing of general solicitation materials with the SEC prior to use under new Rule 510T. Issuers should closely monitor the progress of these proposed rules in the rulemaking process to know what its compliance obligations are in the coming months if planning to utilize general solicitation to market securities.
Bob Carbone is the head of compliance control provider CrowdBouncer, and a board member of the Crowdfund Intermediary Regulatory Advocates.