As required by the JOBS Act, the SEC proposed new rules to lift the ban on general solicitation and advertising in Rule 506 offerings to accredited investors. If you were hoping for clarity, you will be disappointed. The SEC tells us that issuers must take reasonable steps to verify that the purchasers of securities are accredited investors, but they don’t tell us how to accomplish this.
Accredited Investor Verification
For the past 30 years or so, securities lawyers have advised that an issuer can form a reasonable belief that an investor is accredited by means of a questionnaire. This verification process was independent of the channel by which entrepreneurs were introduced to the investor. Suddenly because Congress has legislated that companies should be able to use modern technology to find potential investors, the SEC expresses misgivings about self-certification. In the process, the SEC has thrown cold water on the only real tool we had. In its release, the SEC states: “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.”
But the SEC does not go on to discuss in any useful way what sort of other information the issuer should obtain. When the release throws in isolated examples – by suggesting that a Form W-2 might be helpful – the SEC completely misses the mark. Since the overwhelming majority of investors rely on the net worth test ($1,000,000 without counting the equity in their homes) this suggestion is nonsense. For the hand full of investors who don’t qualify under the net worth test, but do meet the income test (threshold income of $200,000 per individual or $300,000 per married couple), do we really want them to start their investing careers by by-passing the public markets and putting their money into start-ups? Is the SEC suggesting that it is safer for society if companies were to forgo organized angel groups (whose members made their fortunes in previous jobs and no longer receive W-2s) and instead focus on younger investors in high paying professions? Has the SEC thought about this at all?
Hedge Fund Advertising
One of the most startling implications of Section 201(b) of the JOBS Act is that hedge funds will be able to publicly solicit potential clients. To date, registered investment advisers who manage money through pooled funds have been unable to say anything about these products on their websites. Instead, their sites contain only contact information and a log-in link. Somehow, once the proposed rules go into effect, these sites will presumably light up and start soliciting investors. How the paradigm shift is to occur has been the subject of much discussion. In its release, the SEC simply confirmed the obvious, stating the belief that privately offered funds would be permitted to solicit and advertise under amended Rule 506 without losing their hedge fund exemptions. The North American Securities Administrators Association has been waiting for the SEC to take the lead regarding SEC registered investment advisers. NASAA doesn’t have much choice here, since Rule 506 pre-empts state regulation. But state regulators have jurisdiction over most newly formed hedge funds because they regulate investment advisers who manage up to $100 million in client funds (the larger funds fall under federal jurisdiction). Having fewer resources, the smaller and newer hedge funds are invariably going to have more issues in transition. Since the SEC totally avoided this subject in its release, perhaps the Commission is speaking to NASAA in private. I sure hope so.
On a final note, I just wanted to add that I’m not sure what to do with the word “private” going forward. Once the ban on general solicitation and advertising has been lifted, it will be difficult to call an offering under Rule 506 a “private placement.” I’m currently leaning towards “fully-compliant unregistered public offering,” but perhaps that may be a bit too cynical.
John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington. This posting does not constitute legal advice.