As we previously blogged about, the SEC finally adopted final rules to remove the ban on general solicitation and advertising in Rule 506 offerings. The removal of the ban is a huge change in the way private offerings may be conducted and welcome relief to the thousands of issuers each year who have tapped out their “friends and family,” but yet are too small to attract private equity funds. With these new changes, however, bring challenges in making sure you conduct a “new” Rule 506 offering (a/k/a Rule 506(c) offering) correctly.
So, with the caveat that best practices are still being developed for Rule 506(c) offerings and issuers and attorneys are still parsing through the new rules, here are five potential pitfalls to avoid:
1. Being too lenient as to reasonable steps. Beginning in mid-September, Rule 506(c) offerings will allow general solicitation and advertising as long as you sell securities only to accredited investors and take reasonable steps to verify that the purchasers are accredited. Issuers are faced with the prospect of defining for themselves what “reasonable steps” are. That is good and bad. What issuers can’t do is simply take the easy way out – issuers bear the burden of proving that its offering qualifies for a registration exemption. The final rules release from the SEC gives a lot of suggestions about what reasonable steps could entail, but each case is fact and circumstance based. You should also note that the traditional method of self-certification won’t cut it for purposes of Rule 506(c). Fortunately, the SEC also provided four specific “safe harbors” that are each deemed to be reasonable steps: (i) reviewing copies of IRS forms such as a W-2 and obtaining written representations from the investor; (ii) examining bank and brokerage statements and a consumer credit report; (iii) obtaining a written confirmation from a third party such as a registered broker-dealer, SEC-registered investment advisor, a licensed attorney, or a certified public accountant; or (iv) if already an existing investor in your company, a self-certification that the investor still is accredited. While the safe harbors are not required to be followed, I believe a deviation from the safe harbors should be a very rare exception. If you can’t be sure that your past offerings qualified for an exemption from registration, then a private equity firm or underwriter may be uncomfortable with working with you in the future.
2. Deviating from the safe harbors of what is reasonable. As I mention above, deviation from the safe harbors should be a last resort. Securities offerings are fraught with risk already, why would you want more uncertainty? In fact, Rule 506 itself is a safe harbor from Section 4(a)(2) of the Securities Act. Issuers try to use Rule 506 because issuers want more certainty. When it comes to securities laws, any time you can have certainty I recommend you take it. The safe harbors are relatively easy to meet. In fact, third party verification services, like this one offered by Second Market, are already sprouting up. Even though your company may really need the investment, don’t let investors pressure you into cutting corners because it is your company that will be the one left holding the bag.
3. Verifying the accredited status of investors yourself. Don’t do it. The last thing you need is to have the private information (bank account numbers, social security numbers, etc.) of your investors stolen. Then you will be embarking on a quest to comply with the 50 state laws on data breaches. It just isn’t worth it and, as I mentioned above, third party verification services are developing. Let them handle the paperwork.
4. Accidently “integrating” two offerings. Each offering needs to meet an exemption from registration. Sometimes, however, when two or more offerings occur close in time, the securities laws “integrate” them or consider them one big offering. If multiple offerings are integrated and the combined offering doesn’t meet the registration exemption, you now have a problem. So, if you start out with a Rule 506(b) offering (the “old” Rule 506 offering, which will still exist) and you have friends and family purchase shares who are not accredited and then try to advertise a second 506(c) offering, neither offering will be exempt from registration. Make sure you plan ahead to avoid this by keeping at least six months separation between your offerings or by offering substantially different types of securities such as common stock and nonconvertible preferred stock. Oh, and another thing, those angel investor groups where you pitch your company? Yes, those pitches are general solicitation (always have been) and prevent you from qualifying for the Rule 506(b) offering exemption.
5. Not having a game plan on the general solicitation. If you decided to use general solicitation and advertising, who will be making statements? How will those statements be made? Verbally or written? What can you say in advertising and still comply with federal and state anti-fraud rules? Many of these questions don’t have definitive answers because Rule 506(c) offerings are new. I would recommend that any general solicitation be tightly controlled with only one or two executives permitted to communicate about the offering. I would also recommend that any general solicitation materials be thoroughly reviewed to ensure that the materials are consistent with the Private Placement Memorandum. Besides, as we have mentioned before, the same day that the SEC adopted the final rules to remove the ban on general solicitation, the SEC also proposed rules to help prevent fraud caused by general solicitation. My recommendation is to keep the general solicitation bland – if your securities offering is “exciting” or “unique” you are asking for trouble!