For securities issuers, the most widely used exemption from registration is the private offering exemption in Section 4 of the Securities Act. Formerly referred to as the “Section 4(2)” exemption, the enactment of the JOBS Act in April of this year fixed the section numbering in Section 4 of the Securities Act which, until now, had not conformed to the alternating number-letter-number format contained in the other sections of that Act. Thus, the old 4(2) private offering exemption is now the Section 4(a)(2) exemption, although many issuers and practitioners have failed to realize this administrative change as evidenced by recent Form 8-K filings pursuant to Item 3.02 which still make reference to the “Section 4(2)” private offering exemption as the applicable exemption relied upon for their respective unregistered securities offerings.
But aside from this administrative fix, has the JOBS Act actually changed the exemption requirements itself? Arguably it has as I will hypothesize in this post.
Most securities professionals are aware that the JOBS Act requires the SEC to amend Rule 506 to permit general solicitation and advertising in connection with a private offering in which all purchasers are “accredited investors.” Many people mistakenly refer to Rule 506 as an “exemption” but it is not actually an exemption per se. Rather, the SEC adopted Rule 506 to provide a safe harbor to give definitive guidance to issuers who undertook private placements of their securities under then-Section 4(2) (now Section 4(a)(2)) as to what criteria must be satisfied to provide certainty to the issuer that their offering complied with the private offering exemption. Simply put, if you meet the requirements of Rule 506, then the offering is exempt pursuant to Section 4(a)(2).
Prior to the adoption of Rule 506 which established definitive criteria for compliance with the private offering exemption, the 4(a)(2) exemption standards were developed through case law over the years. The famous Ralston Purina case and its progeny focused on three primary factors to consider in determining whether the private offering exemption applied based on the need of the offerees for the protections afforded by registration. These factors included the manner of the offering, offeree qualifications, and restrictions on resale. A generalized restatement of the legal requirements of a Section 4(a)(2) exempt offering based on the developed body of case law is as follows:
- the offering cannot involve general solicitation or advertising;
- all offerees must be sophisticated (i.e., they must be able to “fend for themselves”) and must have meaningful access to material information or must be given full disclosure of such material information related to the making of an investment decision; and
- the issuer must take steps to ensure that the securities cannot immediately be resold such that purchasers do not become conduits in the transfer of securities to unqualified purchasers.
As with most judicially developed law, the standards may vary from circuit to circuit but these three basic principles are common to case law developed in each. The courts that collectively formulated these standards derived them primarily from SEC interpretations and guidance, the legislative history of the Securities Act, and other similar information which indicated Congress’ intent with respect to the Securities Act registration exemptions.
However, with the passing of the JOBS Act and Congress’ decision to require the SEC to amend the Rule 506 safe harbor to permit general solicitation and advertising in connection with a Section 4(a)(2) offering under certain circumstances, the argument could be made that the legislative intent in respect of the private offering exemption was changed. Thus, it is arguable that a post-JOBS Act issuer could undertake a Section 4(a)(2) exempt offering using general solicitation and advertising if the purchasers were all accredited investors. In other words, an issuer could make the argument that Congress has clearly indicated that an offering can still be exempt under the private offering exemption notwithstanding the fact that the issuer engaged in general solicitation and advertising. This is evidenced by the Congressional mandate to the SEC to change the non-exclusive Rule 506 safe harbor to permit general solicitation and advertising in a private offering under certain circumstances. Furthermore, accredited investors, for the most part, are able to fend for themselves and thus the policy argument in favor of invoking the protections of registration in such circumstances where all purchasers are accredited carries less weight. Therefore, it might now be possible for an issuer to generally solicit investors under Section 4(a)(2) exempt offerings without waiting for the final rules to be adopted by the SEC and making use of the new Rule 506 safe harbor.
Of course, there is a significant amount of risk in doing this since there is no way of knowing how this argument would be viewed by a court and, to my knowledge, no recent case has presented such an argument either successfully or unsuccessfully. If an issuer were to assume the risk and attempt to conduct a 4(a)(2) offering involving general solicitation or advertising, it should at a minimum take reasonable steps to ensure that all purchasers were, in fact, accredited investors, as the proposed SEC rules indicate will likely be the primary requirement in order to maintain the offering’s exempt status. Unfortunately, the principle-based approach for determining what constitutes “reasonable steps” does not provide definitive guidance to ensure whatever steps actually are taken are reasonable (this particular issue has been discussed at length in other blog posts on this topic).
Just to be clear, I would not recommend that any company actually undertake to do what I argue is potentially possible above because of the extreme risks and potential liability that would be involved. Furthermore, with the impending adoption of the new rules implementing the JOBS Act in the near future (at least with respect to general solicitation and advertising under Rule 506), the potential costs would likely far outweigh the benefits. It’s probably better just to wait until the new SEC rules are finalized which is expected to occur early next year. However, if a company is currently involved in litigation or litigation is threatened where a plaintiff is claiming that securities sold by the company were not exempt under Section 4(a)(2) due to activity that could be construed as general solicitation and advertising, it might be an interesting counterargument to consider making in light of the recent legislative changes.