S. Lee Terry Jr.
Brave, new, and unregistered world

A primer for CFOs on raising equity capital now that Rule 506(c) is in place.

October 10, 2013
by S. Lee Terry Jr., J.D.

CFOs understand the basic rules about raising money by selling stock or other equity securities to fund their businesses. They can do a private offering to a limited number of select investors, and maybe someday they can register a public offering with the SEC and sell stock to thousands of investors.

All that is changing. As of Sept. 23, there are no longer only two categories of offerings, public and private; there is also an entirely new category—unregistered public offerings. As a result, by Halloween, email inboxes (or spam filters) could be flooded with solicitations to invest in all sorts of enterprises, legitimate and otherwise. Advertisements are likely to appear on TV, radio, and billboards for new investment opportunities.

The backdrop

These changes have been a long time in the making. The Jumpstart Our Business Startups (JOBS) Act, P.L. 112-106, was signed into law on April 5, 2012. The overall theme of the JOBS Act was to alter or eliminate restrictive rules on new capital formation to get out of the recession. The resulting law was an amalgamation of five different bills covering several hot buttons for liberalizing capital formation, such as “crowdfunding,” smoothing the path for IPOs, and increasing the number of shareholders that a private company can have before it is forced to start making filings with the SEC.

Surprisingly, the JOBS Act provision that is now expected to have the biggest impact on capital formation got the least attention during the bill’s consideration—the mandate to eliminate the prohibition on “general solicitation” and advertising in unregistered offerings made under Rule 506 of the SEC’s Regulation D.

Rule 506 has long been the SEC rule most commonly used to raise capital by all sorts of businesses, from hedge funds to high-tech startups. Even though the amount of capital raised by issuers under the old Rule 506 already rivaled the amount raised in SEC registered public offerings, Congress nevertheless insisted in the JOBS Act that the SEC remove the constraints on capital formation resulting from the prohibition of public solicitations of investors in Rule 506 offerings.

When the JOBS Act was passed, the SEC was still occupied with drafting dozens of rules mandated by the lengthy and complex Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203, the financial reform bill passed in the wake of the 2008 stock market crash. This regulatory burden kept the SEC from meeting the July 1, 2012, deadline explicitly provided in the JOBS Act to amend Rule 506.

After more than a year of delays and two changes in the SEC chairmanship, on July 10, 2013, the SEC adopted the rule repealing the ban on general solicitation and advertising in Rule 506 offerings that are sold only to “accredited investors.” The final SEC rule provides that Rule 506(c) is not available if any “bad actors” are involved with the offering, i.e., persons or entities with a history of securities law violations.

What it means for CFOs

So what does this mean for a CFO considering the best way to raise capital? Here is a brief primer.

First, although solicitations to invest can be advertised to the world, Rule 506(c) offerings can be made only to “accredited investors,” the CFO needs to understand which investors qualify and how that status must be verified under the new rules.

The concept of “accredited investor” has been part of Regulation D since its adoption in 1982 and has changed very little the past 31 years. While financial institutions and other large entities have always been included in the definition, the most commonly used categories have always been the “net worth” and “income” tests for individual investors. An executive officer or board member of the issuer is also an accredited investor.

In general, the income test refers to an investor who has earned $200,000 or more each of the past two years (or $300,000 together with the investor’s spouse) and who expects to earn $200,000 (or $300,000) again in the current year. The net-worth test generally refers to an investor with a net worth over $1 million excluding any positive net home equity.

The SEC announced that, as mandated by the JOBS Act, it is reviewing the definition of accredited investor as it relates to individuals, i.e., the net-worth and income tests. A rule change increasing the dollar amounts for one or both tests is considered likely.

While it has always been the issuer’s burden to determine whether investors in Regulation D offerings are accredited, the new rules for unregistered public offerings under Rule 506(c) explicitly require a higher level of diligence by the issuer in making this determination, requiring “reasonable steps to verify” accredited investor status. While the definition of “reasonable steps to verify” is left flexible by the SEC to reflect individual facts and circumstances, the rule does give several examples of steps that would be per se reasonable, such as obtaining copies of individual investors’ tax returns or W-2 wage statements.

Second, the CFO needs to appreciate that the SEC has already proposed several rules that could discourage issuers from choosing Rule 506(c) for their funding needs (for example, a proposal to require all investor solicitation documents to be filed with the SEC) and may propose others. Therefore, staying abreast of regulatory developments in this area is essential.

Finally, one of the effects of Rule 506(c) may be a tendency for companies to avoid using SEC-registered broker-dealers as investment bankers in unregistered public offerings in order to save on brokerage commissions and expenses. It remains to be seen, however, whether the use of professional brokers and investment bankers in unregistered public offerings will be a means for potential investors to differentiate legitimate offerings from insubstantial or even fraudulent solicitations.

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S. Lee Terry Jr., a former SEC staffer, practices corporate and securities law in Denver. He will be among the speakers at the AICPA CFO Conference on May 8–9, 2014, at the Gaylord National Resort & Convention Center in National Harbor, Md.