The Jumpstart our Business Startups Act (“JOBS Act”) sought to ease the regulatory burdens of capital raising for America’s small businesses and entrepreneurs. Congress passed the bipartisan JOBS Act legislation on March 27, 2012, and President Barack Obama signed it into law on April 5, 2012.
The JOBS Act contains seven titles that each relate to a different aspect of “improving access to the public capital markets for emerging growth companies.” Title II, Access to Capital for Job Creators, eliminates a long-standing ban on the use of general solicitations and general advertising in the context of some private placements. Specifically, Section 201(a) requires that the Securities and Exchange Commission (“SEC” or “Commission”) authorize the use of general solicitations under Rule 506 of Regulation D and Rule 144A of the Securities Act of 1933 so long as securities are sold only to accredited investors. Issuers are, however, required to take “reasonable steps” to ensure sales are limited to accredited investors.
Eliminating the ban on general solicitations has a number of potential advantages. The practice will allow companies engaging in Rule 506 offerings “to reach a greater number of potential investors, thus increasing their access to capital.” The provision will reduce the costs of locating accredited investors and potentially make share prices more efficient.
Nonetheless, it also poses risks for investors. “With the demise of this ban, we can expect more aggressive selling than we have had in the past, including more selling via the [I]nternet.” Moreover, the elimination of the general solicitation ban increases the likelihood of fraudulent offers. The reform may, therefore, decrease investor confidence and punish legitimate issuers by reducing the amount of available capital.
Part I of this paper reviews the traditional ban on general solicitations. Part II examines the effect of the JOBS Act, including the requirement that issuers engage in “reasonable steps” to determine accredited investor status. Part III discusses the SEC’s rulemaking efforts in this area, as well as the new rule’s impact on issuers and broker-dealers. Part IV provides a conclusion.
A. Background on Rule 506
Section 5 of the Securities Act of 1933 (“1933 Act”) requires the registration of shares with the SEC. The 1933 Act also contains a number of exemptions from the registration requirement. Specifically, Section 4(a)(2) of the 1933 Act exempts shares sold in “transactions by an issuer not involving any public offering.” Rule 506 of Regulation D provides a safe harbor for private placements. The rule allows companies to raise an unlimited amount of capital and sell to an unlimited number of accredited investors. The rule has, however, traditionally banned the sale of securities through the use of a general solicitation.
B. What is a General Solicitation?
A general solicitation includes “[a]ny advertisement, article, notice[,] or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio” and “[a]ny seminar or meeting whose attendees have been invited by any general solicitation or general advertising.” Use of the Internet can also constitute a general solicitation, as can emails.
A general solicitation does not depend only upon the number of offerees. Instead, the Commission looks to the existence of a substantial, preexisting relationship between the seller and the purchaser. This type of relationship “exists where the [issuer] has information regarding a potential offeree such that the [issuer] can evaluate the prospective offeree’s sophistication and financial circumstances.” Where such a relationship exists, the Commission has found that offerings to a large number of people will not constitute a general solicitation.
Offerings over the Internet have tested the boundaries of the prohibition on general solicitations. The Commission has indicated that these offerings could occur without violating the prohibition if limited to accredited or sophisticated investors. Issuers and broker-dealers could assure that this occurred by using password-protected websites, with investors establishing their status as sophisticated or accredited through the completion of a questionnaire.
The law surrounding general solicitations, therefore, developed in a complex fashion. Dissemination of information to an indiscriminate number of offerees likely constituted a general solicitation. An offer limited to accredited investors could avoid the prohibition but nonetheless carried risks. To the extent aimed at accredited investors, the offering could still constitute a general solicitation if made to investors who did not meet this standard. Moreover, the use of a general solicitation rendered inapplicable the private placement exemption in both Section 4(a)(2) and Rule 506. As a result, those relying on Rule 506 had an incentive to take a conservative approach toward the definition of general solicitation and avoid any marketing technique that involved a significant number of offerees. This imposed limits on the capital raising process.
II. Lifting the Prohibition of the Ban on General Solicitations
A. The JOBS Act’s Lifting of the General Solicitations Ban
Section 201(a)(1) of Title II of the JOBS Act seeks to lift the ban on general solicitations under Rule 506. The provision provides that issuers may engage in a general solicitation so long as all of the purchasers are accredited. The provision, however, requires issuers, as a condition of engaging in general solicitations, to take “reasonable steps” to ensure that investors are accredited. Reasonable steps entail “such methods as determined by the Commission.”
B. Legislative History Regarding the JOBS Act’s Lifting of the General Solicitations Ban
Title II of the JOBS Act started as a separate piece of legislation. Representative Kevin McCarthy, a member of the House Committee on Financial Services (the “Committee”) from California, introduced The Access to Capital for Jobs Creators Act on September 15, 2011. This legislation merely sought to remove the prohibition on general solicitations in offerings to accredited investors. As Congressman McCarthy described, the “legislation would widen the universe of potential investors for small businesses allowed under the [1933 Act] without subjecting these businesses to the onerous costs of registration with the [SEC].”
During the committee process, however, concerns were raised over the impact of the proposed reform. Representative Maxine Waters of California noted that offerings made through general solicitations could result in sales to unaccredited investors. Investors might be “seduced by public advertising” and misstate their accreditation status in order to participate. In particular, she was concerned with the prevailing practice of investors establishing accredited status through self-certification. As a result, the bill was amended to condition the general solicitation upon the need of issuers to take “reasonable steps to verify” the accredited investor status of purchasers. The bill passed the House on November 3, 2011 and was ultimately integrated into the JOBS Act as Title II.
The standard used in the legislation, however, provided considerable uncertainty. The propriety of a general solicitation could not be determined at the time it occurred. Instead, validity was determined when the securities were actually sold. Moreover, without a clear definition of “reasonable steps,” issuers would not know whether their behavior at the time of the sale in fact validated the general solicitation.
C. The SEC’s Proposed Rule and the Impact of the “Reasonable Steps” Language
Although instructed to implement the general solicitation requirement within 90 days of adoption of the JOBS Act, the SEC waited until August 29, 2012 to propose the requisite rule, more than four months after the adoption of the Act. The proposed rule did not condition the use of a general solicitation upon the sale of shares to accredited investors. Instead, issuers only needed to have a reasonable belief of accredited investor status. In addition, the proposed rule repeated the need to take reasonable steps but provided only vague guidance on the requirement.
“Reasonable steps” was intended to be an objective standard that varied with the circumstances. The circumstances included the types of accredited investors purchasing the securities, the quantity and quality of information in the possession of the issuer, and the nature of the offering, including the minimum investment amount and the method of solicitation.
The Commission indicated that “reasonable steps” would be more exacting where the solicitation occurred “through a website accessible to the general public or through a widely disseminated email or social media.” These offerings “may require greater scrutiny of purchaser status than sales to a pre-screened set of investors identified by a broker-dealer intermediary.” The SEC noted that one possibility to determine accreditation status in these circumstances would be to require investors to provide affirmative proof of their income or net worth. The release acknowledged that net worth rather than income could be more difficult to determine when assessing the accreditation status of individuals but provided no guidance on the necessary steps.
Although not ruling out the possibility of self-certification as proof of accredited investor status in all cases, the Commission indicated that the practice would not be sufficient for general solicitations made over the Internet or through other indiscriminate means. The Commission, however, limited its discussion to circumstances involving a “check-the-box” approach to certification and left unaddressed whether the standard could be met through unverified representations from investors about their net worth or income.
The release did provide that the “reasonable steps” requirement could be met through reliance on third parties. Issuers could obtain lists of prospective investors from third parties such as brokers, lawyers, or accountants who verified their accredited status. The release, however, specified that the issuer had to have “a reasonable basis to rely on such third-party verification” but did not specify the necessary standards.
Commentators complained about the uncertainty in the proposed definition of reasonable steps. As one commentator to the rule noted, “[t]he final rule should specify minimum ‘steps’ that must be taken before a general solicitation is employed.” At the same time, others argued that strict standards could add significant cost and delay to the offering process. Indeed, investor unwillingness to provide the necessary information could make it “difficult to verify the accredited investor status of natural persons,” reducing the pool of available investors.
The proposal makes the use of a general solicitation under Rule 506 a highly risky endeavor, at least in certain circumstances. This arises mostly from the uncertainty with respect to the standards for determining reasonable steps. The requirement remains undefined, is dependent upon the circumstances, and is only determined after the general solicitation has occurred. Issuers, therefore, run the risk that they will be found to have violated the requirement after having sold shares in an offering marketed through a general solicitation.
This risk has important consequences. To the extent a general solicitation occurs but the issuer does not take reasonable steps, the exemption in Rule 506 will be unavailable. Moreover, issuers will not be able to argue that the offering meets the requirements of Section 4(a)(2) of the 1933 Act, a traditional back-up argument in offerings under Rule 506. These risks will be particularly acute in the context of offerings over the Internet, social media, or through the mass distribution of emails. As the proposing release has indicated, these will be the circumstances in which the reasonable steps standard will be the most exacting and difficult to meet.
Nonetheless, the rule will likely encourage more widespread marketing of offerings intended to be made only to accredited investors. An issuer may be aware of an investor’s status through a preexisting relationship or may acquire a list from a broker or accountant. In these cases, the reasonable steps requirement is likely to be less demanding.
Importantly, however, issuers have a back-up argument in the event the reasonable steps requirement is not met. They can assert that by limiting the offering to accredited investors, there was no general solicitation. As a result, the offering would arguably qualify under Rule 506(b) and Section 4(a)(2). These subsections do not require issuers to take reasonable steps before selling securities.
Because the general solicitation portion of the JOBS Act is still a proposed rule, the potential impact is only hypothetical. The uncertainty around the meaning of “reasonable steps” suggests that the provision will not provide significant protection to issuers making offerings over the Internet, through social media, or in widely distributed emails. The JOBS Act may, however, provide sufficient protection to issuers marketing to a large number of investors they believe are accredited. This will presumably facilitate capital raising while ensuring that investors are accredited, which is the precise purpose of the JOBS Act.
*. J.D. Candidate 2013, University of Denver Sturm College of Law.
. See id. Rule 504 also permits a general solicitation, but only for offerings registered under state law and only for offerings of no more than $1,000,000. See also Revision of Rule 504 of Regulation D, the “Seed Capital” Exemption, Securities Act Release No. 33-7644, 17 Fed. Reg. 230.
. Id. The statute mandated the adoption of the rule within 90 days of enactment. The SEC, however, missed that deadline. See Commissioner Daniel M. Gallagher, U.S. Securities and Exchange Commission, Statement at SEC Open Meeting: Proposed Rules to Eliminate the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings (Aug. 29, 2012) (“. . . I am not happy to be sitting here today, almost two months after the JOBS Act deadline for a final rule, voting on a proposal.”).
. Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Release No. 33-9354, 17 Fed. Reg. 230, 239 (proposed Aug. 29, 2012), available at http://www.sec.gov/rules/proposed/2012/33-9354.pdf.
. Id. Moreover, the new rule “would likely increase the flow of information about issuers to investors that may not have been publicly available previously, thereby potentially leading to more efficient pricing for the offered securities.” Id. at 49.
. See Statement of Professor Robert B. Thompson, Peter P. Weidenbruch Jr. Professor of Business Law, Georgetown University Law Center, Hearings Before the Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs of the House Committee on Oversight and Government Reform and the Subcommittee on Capital Markets and Government Sponsored Enterprises of the House Committee on Financial Services: The JOBS Act, 5 (Sept. 13, 2012).
. Id. Testimony by Professor Thompson addressed various negative effects of the new rule. First, he noted that the requirements for a private offering of securities have been relaxed since Rule 506 was adopted in 1982, yet the “same dollar threshold” to qualify as an accredited investor remains. This is potentially problematic because “there is reason to ask if the concept of accredited investor has been stretched too far.” Another potential impact of the removal of the ban on general solicitations is the “unexpected downstream effect in facilitating a growing resale market or such securities free of any investor protections from the ’33 or ’34 Act[s].” Id. In the past, purchasers of shares sold in a private offering were required to hold them for three years. Id. at 8. Over the past fifteen years, this holding period has been reduced to one year for non-reporting companies. See id. Due to the secondary market that has developed for these shares, and the ability for companies to now advertise them to the entire population, “many more shares now change hands in a venue without mandatory disclosure or other investor protection.” Id. at 9.
. Id. Because Rule 144A, unlike Rule 506, requires the use of a financial intermediary, the SEC “expect[s] that there would be fewer occurrences of general solicitation-facilitated fraud in Rule 144A offerings.” Id. at 53. In addition, conscientious investors will have to spend money when conducting due diligence to research Rule 506 offerings, as well as in litigation when seeking damages. Id. at 52.
. Id. Note that under this rule, companies and issuers can sell to an unlimited number of accredited investors, but to a maximum of only 35 unaccredited investors. Id. These unaccredited investors “must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.” Stephanie L. Chandler, A Practical Guide To Raising Capital, Jackson Walker, L.L.P., 4 (2011), http://images.jw.com/com/publications/1256.pdf.
. See Eliminating the Prohibition, supra note 6, at 19 (“An issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer.”).
In an SEC release from 2000, the Commission discussed its rationale for creating the ban on general solicitations. See Use of Electronic Media, Securities Act Release No. 7856, Exchange Act Release No. 42728, Investment Company Act Release No. 24426, 17 Fed. Reg. 231, 241, and 271, n. 69-72 (Apr. 28, 2000). At the turn of the millennium, using the Internet to conduct securities offerings became more and more popular for issuers looking to raise money. Id. The SEC was most concerned with the lack of experience and knowledge of retail investors with regard to securities in general, as well as the new online forum in which they could buy them. Id. The SEC stated that “[w]e are concerned that there may be insufficient information available to investors to enable them to understand fully the online public offering process . . . [w]e also are concerned that investors are being solicited to make hasty, and perhaps uninformed, investment decisions.” Id.
. Private Offering Do’s and Don’ts: Dealing with the Press; Avoiding a General Solicitation, Morgan Lewis 2 (2012), http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_PrivateOfferingDosAndDonts.pdf.
. See Patrick Daugherty, Rethinking the Ban on General Solicitation, 38 Emory L.J. 67, 113 (1989) (“[I]n the Staff's view, a solicitation is not ‘general,’ and thus [R]ule 502(c) is not violated, merely because a great number of prospective investors may be approached.”). See also Woodtrails-Seattle, Ltd., SEC Interpretive Letter, [1982-1983 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 77,342 (July 8, 1982). For example, the SEC issued an interpretative letter regarding a general partner of a limited partnership who wished to sell interests in the entity to over 300 limited partners. Because “each of the proposed offerees had a preexisting business relationship with the general partner,” the SEC held that this offering would not violate the federal securities laws. Id.
. See Andrew Downey Orrick, Acting Chairman, U.S. Securities and Exchange Commission, Address before the Eleventh Annual Meeting of the American Society of Corporate Secretaries: Some Observations on the Administration of the Securities Laws (June 1957) (“Even an offering to sell to the first 25 institutional investors who express an interest in buying would be public, if addressed to large groups of institutional investors without reference to their relationship to the issuer or their knowledge of the issuer.”).
. See J. Robert Brown, Jr., The JOBS Act and the Capital Raising Process (General Solicitations, Rule 506, and the Missed Opportunity), The Race to the Bottom (Apr. 5, 2012), http://www.theracetothebottom.org/home/the-jobs-act-and-the-capital-raising-process-general-solicit.html.
. See Q&A: Small Business and the SEC, supra note 16 (to comply with Section 4(a)(2), the issuer “may not use any form of public solicitation or general advertising in connection with the offering.”).
. See McCarthy Introduces the Access to Capital for Job Creators Act, Kevin McCarthy: Representing California’s 22nd District, http://kevinmccarthy.house.gov/index.php?option=com_content&task=view&id=589&Itemid=94 (last visited Nov. 26, 2012).
. See Catherine T. Dixon, Securities Offerings, Title II of the JOBS Act: Are Reports of the Death of General Solicitations Premature?, Insights: The Corporate & Securities Law Advisor, 4-5 (June 2012), available at http://www.weil.com/files/upload/Insights_Article_June_2012.pdf.
. Id. at 5. Waters stated, “I am concerned about the process in which accredited investors verify that they are in fact accredited. As I understand it, it is currently a self-certification process. This obviously leaves room for fraud.” Id.
. See Press Release, The Committee on Financial Services, Legislative Package Combines Financial Services Committee Bills into JOBS Act (Feb. 28, 2012). The Access to Capital for Jobs Creators Act passed the House by a vote of 413 to 11. Id. Fellow Committee member and Republican Representative Stephen Fincher of Tennessee introduced H.R. 3606, which contains the same provisions for lifting the ban on general solicitations as its predecessor bill and is referred to as the JOBS Act. See id. The Committee agreed on this bill by a voice vote on February 16, 2012 by a margin of 54 to 1. Id. On March 27, 2012, after a vote of 380 to 41, the bill passed the House as amended by the Senate. Press Release, Congressman Stephen Fincher, Congressman Fincher’s JOBS Act Heads to White House for President’s Signature (Mar. 27, 2012).
. Id. at 13-14. The language in Section 201(a)(1) involving offerings under Rule 506 did not expressly reference the “reasonably believe” standard. Id. at 28. The subsection relating to Rule 144A, however, did contain the language. Id. As the SEC noted: “Both Rule 506 and Rule 144A currently provide for a reasonable belief standard regarding the eligibility of an investor to participate in an offering under the respective rules, but they reach that result in different ways.” Id. In effect, the Commission found that Congress did not intend to change the reasonable belief language contained in the definition of accredited investor. Id. at 29.
. See J. Robert Brown, Jr., The JOBS Act: General Solicitations and Rule 506, University of Denver Sturm College of Law, 13, http://www.cobar.org/repository/Inside_Bar/Business/Securities/Outline_JOBSActGS_Sept17_2012FINALEDITS.pdf (last visited Nov. 27, 2012) (“The final rule needs to make clear that the failure to take reasonable steps is a violation even if sales occur to accredited investors. Moreover, the reasonable steps must be taken before purchases occur.”). Left unanswered in the proposing release was whether the reasonable steps requirement was an independent obligation that applied even if all purchasers were, in fact, accredited investors. Id. See also Richard B. Levin and Jonathan F. Langer, SEC Issues Proposed Rule Eliminating the Ban on General Solicitation and General Advertising in Rule 506 Offerings, Baker Hostetler (Oct. 3, 2012), http://www.bakerlaw.com/alerts/sec-issues-proposed-rule-eliminating-the-ban-on-general-solicitation-and-general-advertising-in-rule-506-offerings-10-3-2012/ (“The SEC declined to identify the specific methods that an issuer must employ to satisfy the ‘reasonable steps’ requirement under Section 201(a)(1) of the JOBS Act.”).
. Id. at 14. (“Also, a high minimum unfinanced cash investment may be such that only an accredited investor could reasonably meet it.”). David B. Miller, SEC Proposes Rules for General Solicitation in Private Placements, Faegre Baker Daniels (Sept. 4, 2012), http://www.faegrebd.com/showarticle.aspx?show=18898&&Language=148.
. Eliminating the Prohibition, supra note 6, at 17 (for instance, issuers could ask investors to provide “tax returns, Form W-2, Form 1099, or other income documentation, in addition to a pay stub from the current year.”).
. Id. at 20-21 (“For example, if an issuer knows little about the potential purchaser who seeks to qualify under the natural person tests for accredited investor status, but the terms of the offering require a high minimum investment amount, then it may be reasonable for the issuer to take no steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by the issuer or by a third party, absent any facts that may indicate that the purchaser is not an accredited investor.”). See also Miller, supra note 61.
. Eliminating the Prohibition, supra note 6, at 19 (“[W]e 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.”).