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Did the JOBS Act unintentionally change the statutory private offering exemption?

Posted in Capital Raising

General Solicitation and Stock SalesFor 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.

  • http://wac6.com/ William Carleton

    Interesting argument!

    Given the way Section 201(a) of the JOBS Act is worded (text below), could it not also be argued that Congress did not intend to itself change the 506 safe harbor under 4(2)(excuse me, 4(a)(2)!), but understood and intended that rulemaking would first have to occur?

    “Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).”

    • http://twitter.com/gustav316 Gustav Schmidt

      Thanks for the comment! I agree that Congress did not itself change or intend to change Rule 506 directly but instead directed the SEC to adopt rules permitting issuers to utilize the 4(a)(2) exemption via Rule 506 even if the issuer engaged in general solicitation where all the purchasers were accredited. My point was that in doing so, Congress expressly recognized that there is at least one set of circumstances in which an issuer can engage in general solicitation and still have the offering deemed to be an offering “not involving any public offering.” Maybe there are others and maybe those other situations would be available to issuers right now (without having to wait for the final SEC rules). In the end, this is probably a purely academic arguemnt with no real practical application because of the risks invovled. No reasonable issuer would proceed with an offering on this basis. They’d wait a few months for the new SEC rules to be finalized. However, if I were a defendant in a lawsuit alleging a violation of Section 5 because I engaged in general solicitation in connection with a private offering, this arguement would not be as far fetched as it would have been before the passage of the JOBS Act.

  • joewallin

    Gustav, what do you make of the SEC’s inability to get the rules done? Do you think it is related to your argument here? That everything changes very dramatically once this is done…and that is why Mary Schapiro didn’t want it happening on her watch?

    • http://twitter.com/gustav316 Gustav Schmidt

      Joe, thanks for reading and for the comment. Obviously the SEC has been stretched thin by Congress starting with all of the Dodd-Frank rulemaking that was mandated and continuing with the additional mandates under the JOBS Act. Making matters worse is the extensive cost-benefit analysis required under the Administrative Procedures Act which, in the wake of the proxy access case, makes it even more difficult for the SEC to timely promulgate new rules. That said, I think that the lack of expediency in the rule making process is related to my arguement in that I think there may be a colorable arguement that issuers could go ahead with a 4(a)(2) offering that involves general solicitation without waiting for the final rules to be adopted by the SEC to expressly permit this under the 506 safe harbor. Would any reasonable person actually do this? Probably not, but its an interesting idea nonetheless. I don’t really know what to make of the Mary Schapiro thing. I assume that, like most things in modern media, it is probably overblown.

      • joewallin

        Thanks Gustav. Yeah, who knows..but, the old rules and the old are definitely in-congruent!

  • Kevin Frei

    Gustav, I think the ban on advertising might be the only thing that makes the accredited investor exemption sustainable. When the ban is lifted, businesses will naturally advertise their offers as “opportunities.” Has anyone stopped to consider how the general public might react when they realize that these opportunities are foreclosed to them? I for one think the current regime is terribly unjust, and I think the SEC will be blind-sided when the 98% reject the “investor protection” argument and demand to participate. But of course if the public could participate in private securities, there would no longer be any meaningful distinction between public and private offers and I don’t see how the SEC could possibly rectify the situation.

    I think the SEC is one of the biggest mistakes to come out of the New Deal. It’s mandate is to focus on investor protection, which is exactly the wrong target. If you design your net to keep out losers, you will necessary catch some winners too. The only way to get the balance right is to focus on the ratio of wins to losses, which is directly quantifiable in the securities market as profits. Optimizing the net (the regulations) to improve that ratio and increase the total volume of investments is the way to maximize social gain, which should be our goal. So to my mind the only way to do that is to bring market forces to the regulations themselves through a competitive system of independent regulatory regimes – run by the exchanges and brokerages – that focuses on the average rate of return over time of a given portfolio of stocks. I think the SEC’s monopoly on the regulations will always be a distant second-best approach, and I sure hope that the JOBS Act will precipitate a crisis at the SEC that will force us to reconsider whether the SEC is just or even rational. But I haven’t seen anyone else writing online from that perspective, so please let me know if it’s crazy lol.