The SEC's Bluff on Lifting the Ban on General Solicitation and Advertising

In one of the first major decisions of the SEC under its new chairman, Mary Jo White, the SEC has adopted long-awaited final rules which, when they go into effect, will allow companies to raise money in a private placement through general solicitation or advertising as long as all purchasers in the offering are accredited. While on its face this is a welcome development for companies seeking greater access to capital, the SEC has taken questionable steps that have the potential to eviscerate its potential benefits.

To appreciate the significance of all of this, one has to step back and understand the landscape of raising money through the private sale of company securities.

In the U.S., a company that sells its securities, such as its stock, is generally required to either register its securities with the SEC or rely upon an exemption from registration. Due to the time consuming and cost prohibitive nature of registration, the vast majority of securities offerings are structured as private offerings under the so-called private placement exemption of Section 4(a)(2) of the Securities Act. Rule 506 is what is known as a "non-exclusive safe harbor" that sets out the requirements for complying with the private placement exemption of Section 4(a)(2).

The importance of Rule 506 to the U.S. economy cannot be overstated. The SEC estimates that approximately $900 billion was raised under Rule 506 in 2012 compared to $1.2 trillion in registered offerings in the same year, with similar amounts raised under Rule 506 in 2011 and 2010.

One of the hallmarks of Rule 506 has to date been the prohibition on general solicitation and advertising. This means that securities offerings may not be publicly advertised in mediums such as newspapers, the internet or social media platforms. The flip side to this is that securities may only be sold to persons with whom the company's representatives have a so-called "pre-existing relationship" and in practice this has limited Rule 506 offerings to friends and family of the company, hampering a company's ability to raise capital.

This is where the JOBS Act comes in. Recognizing the limitations inherent in Rule 506 especially in the age of the internet, the JOBS Act provided for the lifting of the ban on general solicitation and advertising where all purchasers in the offering are accredited. The rationale for this being that accredited investors who, by and large include high net worth or institutional grade investors, are believed to be in less need of the protection of the securities laws due to assumed sophistication.

The new rules will fundamentally change the way that private offerings have to date been conducted by opening up a new universe of potential investors from forums such as LinkedIn, Facebook and Twitter.

To ensure that unaccredited investors do not participate in these offerings, the JOBS Act mandated the SEC to amend Rule 506 to require companies to take reasonable steps to verify accredited investor status. And that is what the new SEC rules do; they provide for a flexible, three factor test in establishing accredited investor status.

Indeed, if the SEC's rules ended there, then the fanfare surrounding the lifting of the ban would be justified. But this is not what happened.

The SEC took two important additional actions which if fully implemented would at best impose additional burdens on companies conducting Rule 506 offerings and at worst deter them from conducting these offerings in the first place, completely undermining the Congressional intent of the JOBS Act.

First, in an entirely expected move, the SEC adopted the so-called "bad actor" rules -- as mandated by the Dodd-Frank Act - disqualifying the use of Rule 506 if a company or certain other "covered" persons such as its executive officers, directors or more than 20% beneficial owners have been convicted of or sanctioned for securities fraud or other certain violations of law. The rule requires companies to exercise reasonable care in ensuring the absence of "bad actors" when conducting a Rule 506 offering, incrementally adding to the compliance burden in conducting an offering.

Second and more troubling, the SEC proposed a number of additional amendments to Rule 506 to complement the "bad actor" rules. These amendments include requiring notice filings -- known as Form D -- with the SEC both in advance of and following termination of an offering; increasing significantly the information collected in the existing Form D; disqualifying use of Rule 506 for one year for failure to timely file a Form D; requiring certain additional disclosures in certain types of offerings; and requiring the filing of certain offering materials with the SEC for a "temporary" period of two years.

It is noteworthy that a number of these proposed rule amendments apply not only to Rule 506 offerings engaging in general solicitation but also to those that are not. For example, the inability to rely upon Rule 506 for one year for failure to file Form D on a timely basis applies regardless and, if implemented, would have a devastating impact on a company's future ability to raise money if it were to become subject to such disqualification.

While imposing such additional burdens on companies are all laudable goals when viewed solely from the perspective of investor protection, one cannot lose sight of the fact that the principal goal of the JOBS Act was to ease access to capital and that the proposed regulation will have a disproportionate and burdensome impact on companies attempting to comply with their regulatory obligations.

Moreover, its highly questionable whether the SEC even has a mandate to adopt such far-reaching amendments to Rule 506 given the narrow mandate given to it in the JOBS Act.

Echoing this, Daniel Gallagher, one of two dissenting SEC Commissioners, stated in no uncertain terms:

Today we are finally implementing Section 201 of the JOBS Act, which, if Congress and the President are right, will facilitate capital formulation. Unfortunately, however, the Commission is also using its discretion to pursue rules that would undermine this very bipartisan goal. It is not normal for the Commission to propose rules designed to mitigate perceived problems with Congressional mandates before those mandates have been effectuated.

It seems therefore that the SEC has overreached by giving with one hand and trying to take away with the other.

And therein lies the bluff.

The information in this article is of a general nature and should not be relied upon as legal advice.