Tag: Rule 506(c)

Report on Access to Capital and Market Liquidity

Many people seem to think that the new commissioner of the Securities and Exchange Commission, Jay Clayton, is likely to focus more on capital formation issues than the previous commissioner. The recent report on Access to Capital and Market Liquidity from the SEC’s Division of Economic and Risk Analysis caught my attention.

From the signing of Dodd-Frank in 2010 through the end of 2016, the DERA notes $20.20 trillion in capital formation, of which $8.8 trillion was raised through registered offerings, and $11.38 trillion was raised through unregistered offerings. More money is being raised through private placements, than through public offerings. From 2012 to 2016 the amount raised was 26% greater. From 2009 through 2011 it was only 21.6% greater.

That data should be a caution to regulators who want to make changes to Regulation D and the “accredited investor” standard.

“When combined, the capital raised through Regulation D and Rule 144A offerings in a year is consistently larger than the total capital raised via registered equity and debt offerings. Most Regulation D offerings (over 66%) include equity securities; by contrast, in the Rule 144A market, the vast majority of issuers are financial institutions and over 99% of securities are debt securities.”

The report also looks at the new public private-placement offerings under 506(c). Only 3% of the capital raised under Regulation D since rule 506(c) went into effect has been through issuances claiming the 506(c) exemption. The report also noted that the average amount raised in a 506(c) offering is only half of that raised in Rule 506(b) offering, $13 million to $26 million. “Overall, it is not clear whether offerings under Rule 506(c) are indicative of new capital formation or a reallocation from other offering types.”

What is one of the reasons for a private placement over a public offering? It seems cheaper.

“Nonfinancial issuers paid on average about 6% in total fees for Regulation D offerings in 2009-2016. In comparison, a company going public pays an average gross spread of 7% to its IPO underwriters, while a reporting company raising equity through a follow-on (seasoned) equity offering pays an average gross spread of about 5.4%.”

There is a lot more detail in the report. More than I’m ready to digest (or want to digest).

Sources:

506(c) Enforcement Actions

Although I had a lot of hope that the changing of private placement advertising restrictions by the Securities and Exchange Commission would remove potential foot-faults from the fundraising process, the end result proved challenging. Now it appears that the SEC is on the brink of challenging firms that took at advantage of the loosened restrictions.

private placement

Given the enormous restrictions on being a company with publicly listed securities, private placements have been a vibrant form of raising capital. Although deemed more “risky”, to me that is a poor label without a further discussion of risk. The risk is liquidity, not risk of loss. A huge portion of the private placement market is by firms that provide no more risk than a publicly listed company. There is also capital being raised by start-ups and riskier companies. The common factor is not the risk of loss. The common factor is the investor’s limited ability to sell the security. If the investor needs liquidity, the investor will have limited options.

The main concern of the SEC in passing Rule 506(c) was be the increase in fraud. So far, we have not seen the enforcement actions to back up that fear.

However, the use of advertising under 506(c) for a private placement has been limited. From 2013, when 506(c) became effective, through 2015, there were $2,800 billion in offerings under 506(b) and only $71 billion in offerings for 506(c).

It seems like enforcement proceedings are in process for some firms that abused Rule 506(c). SEC Chair Mary Jo White stated that the SEC has some open investigations. Over the next few months perhaps those become public.

The failure of Rule 506(c) is that it was coupled with a proposed rulemaking that would dramatically change the landscape of private placements. We have not heard anything more on that rulemaking. It’s specter still haunts Rule 506(c) offerings.

I think Rule 506(c) is more than what most fund managers wanted for changes in advertising. Fund managers wanted some safe harbors for advertising to avoid foot-faults. Fund managers want to able to participate in league tables, talk to the press and talk at conferences without the fear that an inadvertent slip of the tongue would wreck havoc on a fundraising. I encountered no fund managers who were interested in media campaigns as part of a fundraising.

It looks like we may get more insight into the SEC’s view of Rule 506(c) when the enforcement actions are announced.

Sources:

Narrowing the Safe Harbors

narrow safe harbor compliance

The Securities and Exchange Commission rolled out the accredited investor verification requirement and made it principle-based for purposes of Rule 506(c). You have to take reasonable steps to verify that an investor meets the accredited investor standard. In the same release it created four non-exclusive safe harbors that would deemed to be taking “reasonable steps.”  The SEC recently released six new Compliance and Disclosure Interpretations on the verification of prospective investors as accredited investors.

One safe-harbor method is to review the IRS filings for the two most recent years. That seems straightforward. Just deliver me the two latest tax filings. But the SEC has made that safe harbor nearly  impossible to navigate during the first part of a calendar year. In Question 260.35, the SEC takes a very strict view of the safe harbor. The filings must be for the two most recent years. So if you were to use that safe harbor in 2014, the issuer must get the 2013 and 2012 tax filings.

For most potential investors this safe harbor is inaccessible in January and may extend further into the year depending on when the investor files his or her tax return. I’ve filed an extension for the past few years and don’t get my taxes done until August. I couldn’t prove myself to be an accredited investor using the safe harbor until that point in the calendar year.

The SEC’s solution is to switch to the principles-based approach by reviewing the two most recent available years and getting written representations from the potential investor that:

(i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available,
(ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and
(iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.

The SEC is clearly making it hard to navigate the investor verification requirement. It seems to laying mines around the entrances to the safe harbor.

Sources:

Image is US Navy 060628-N-4776G-144 The Nimitz-class aircraft carrier USS Ronald Reagan (CVN 76) navigates its way through the narrow strait that make up the inlet to Pearl Harbor for a port visit.jpg

 

Guidance on Accredited Investor Verification

The Securities and Exchange Commission revised the private placement rules last year to permit public private-placements. Of course it took some prodding from Congress in the JOBS Act to get that change. The law and the new regulation require the issuer to take “reasonable steps” to determine that the investor is an “accredited investor.”

The SEC rule has four non-exclusive safe harbor methods which meet the verification requirement. One of those methods is to rely on the written confirmation of accredited investor status issued by a registered broker-dealer or investment adviser. The Securities Industry and Financial Markets Association has put together guidance on that verification method.

For individuals, SIFMA recommends that the investor have been a client for at least six months so the firm has sufficient knowledge. Second, SIFMA recommends that the broker or adviser obtain a representation from the investor that he or she is not borrowing money to make the investment.

To make the determination, SIFMA has two methods. In the account balance method, the investor must have at least $2 million with the broker or adviser. This assumes $1 million liabilities. If the investor discloses debt greater than this, obviously the account balance threshold will increase.

The second method is the investment amount method. In this situation, the investor must commit at least $250,000 to the investment and represent that it is less than 25% of the investor’s net worth.

I’m not sure the guidance breaks new ground, but its good to see some filling in the holes. The SEC safe harbor also permits CPAs and lawyers to issue the accredited investor verification. It will be interesting to see if the bar association and PCAOB offers any guidance to its members.

Sources:

Accredited Investor Verification

rich accredited investor

When Congress imposed a lifting of the ban on advertisements for private placements, it also imposed a mandate that the fundraiser “take reasonable steps to verify that purchasers of the securities are accredited investors.” The methods for verification were to be determined by the Securities and Exchange Commission.

The SEC, to its credit, did not impose impose strict methods for verification. It largely decided to allow fundraisers to use a principles-based approach. The SEC did include four non-exclusive safe harbors for verification.

Congress thought that lifting the ban would invigorate fundraising. But funds and companies have been reluctant to use it. According to a speech by Keith Higgins, only 10% of private placements have used the Rule 506(c) methods. Since September 2013, there were 900 offerings that raised $10 billion under Rule 506(c). But there were over 9,200 offerings that raised $233 billion under the old Rule 506(b) regime.

With the verification requirement, the outcome and backlash has been that fundraisers should only use one of the four methods. That of course, is silly. It’s safe, but overly cautious. The SEC did specifically state that reliance on an investor’s self-answered questionnaire alone is not taking reasonable steps. You will need to look at your potential investor and find out some additional information.

That investigation adds time and and energy. For private equity funds, it’s probably a step that should be taken anyhow. Investor defaults on capital calls is a bad thing. You want to make sure that your potential investor will be able to make the contributions over course of the expected timeline of capital calls. That’s a bit different than a one time contribution to a hedge fund or private company investment.

Minimum investment goes a long way to meeting the reasonable steps. If an investor is making a $1 million investment then presumably the investor has the $1 million new worth which is the accredited investor baseline test. The SEC did not specifically endorse this standard. The concern is that the investor may have borrowed the money to make the investment. The SEC is clearly worried about shady operators getting little old ladies to mortgage their homes to make risky investments.

For me, the biggest concern is the overhang of the proposed changes to Regulation D that were put up for comment at the same time the SEC lifted the ban. That injects too much uncertainty into the fundraising process. The SEC stated that there will likely be a grace period and some transitional relief. But its hard to plan a fundraising that could take 12 months with that kind of uncertainty.

I was interested in using Rule 506(c) because of the uncertainties around the definition of general solicitation and advertising. It would be great to eliminate potential foot-faults. I could sleep better at night, not worrying about whether an employee would mention fundraising at an industry event. The company could respond to media requests and could correct misinformation in the media about the fundraising.

But the SEC has left too much uncertainty in the process to fully embrace a Rule 506(c) offering.

References:

Filing Form D and General Solicitation

soap box

One of the current issues around a fund manager or company from using advertising as part of its private placement fundraising is the proposed changes to filing requirements for Form D.

Few people I have spoken with actually want to use general solicitation like bulk emails, newspaper ads, or web ads. But they do want to be able to mention fundraising at industry events, advertise the fund manager as a brand, and talk to the media. All of those could be considered general advertising and solicitation or could come close to the line. The SEC has not created a bright line test for when an announcement becomes general and endangers a private placement.

Many people embraced the lifting of the ban on general solicitation and advertising because the fund manager or company could avoid the advertising foot fault of private placement.

The requirement that a firm take reasonable steps to determine if potential investor is accredited is one impediment. For funds with large minimum investment requirements and mostly institutional investors, it’s probably less of an impediment.

The foot-faults under the proposed rule are even greater.

For instance, the proposed rule would require filing of Form D before a general advertisement or solicitation begins. That’s a problem when it’s not clear whether an activity falls under those terms. It’s also a problem if the terms of the offering change over the course of the pre-sale marketing period. Often, a private fund’s terms are not complete during the initial marketing phase.

Even worse, the proposed rule imposes a draconian ban on the use of private placements if you failed to file the Form D before the activity that would be considered general advertising and solicitation.

I agree that not requiring the filing until 15 days after the first sale is not the best method to provide information to investors or regulators. I think the better position is to require the filing 15 days before the first sale.

The proposed rule 510T would also require filing the materials used in general solicitation and advertisements with the SEC. Again, with those terms not well defined it’s hard to know if you have violated the rule. If the materials escape and get published in the media, you’ve potentially blown the private placement and the filing requirement with no ability to cure.

According to Jim Hamilton’s World of Securities Regulation, seven Senators have urged the SEC to adopt the proposed rules to help state securities regulators. Broc Romanek in theCorporateCounsel.net notes that SEC Commissioner Aguilar has weighed in supporting the proposed rules as necessary for investor protection.

Fund managers may be intrigued by the lifting of advertising requirements, they are more likely to cause a foot-fault than staying under the existing private placement regime.

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You Got Questions About 506(c) – The SEC Has Answers

sec-seal

The new Rule 506(c) is a big substantive change on how private placements can be run. That leaves many, including me, with a lot of questions. The Securities and Exchange Commission just posted a series of new questions and answers on the new rule. Most of the answers are expected confirmations, but there are a few surprises.

Question 260.05 If you switch a pre-rule offering to new Rule 506(c) offering, do you need to file an amendment to From D. YES.

Question 260.06 If you take reasonable steps to verify that all investors are accredited, but after the sale you find out that an investor did not meet the standard. The SEC says that’s okay as long you took reasonable steps and had a reasonable belief.

Here was a surprise.

Question 260.07 All of your investors are accredited investors, but you didn’t take reasonable steps to verify that they were accredited. The SEC says that you failed the exemption. “The verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors.”

The other item for fund managers to take a look at is Question 260.10 regarding existing investors. The SEC makes it clear that the exemption for existing investors in the non-exclusive list of verification methods only apples to the same issuer. So you can’t rely on this exemption when raising a new fund.

Another small surprise is that the SEC will allow you to retreat from a 506(c) offering back to a 506(b) offering. Question 260.11 makes it clear that as long as you did not engage in general solicitation you can amend the Form D to change the exemption. And vice-versa. Question 260.12 explicitly allows an offering to switch from 506(b) to 506(c). Many people I talked to thought you could make switch, but it’s good to hear it explicitly form the SEC.

Compliance Bricks and Mortar – Solicitation and Advertising Edition

bricks for sale

On Monday, the new SEC Rule 506(c) became effective, lifting the ban on general solicitation and advertising, creating a new era of public private-placements. These are some of the stories on the effect of the new the rule that caught my attention.

Pros and Cons of General Solicitation by Joe Wallin in Startup Law Blog

Well, ok. In the old days, you couldn’t generally solicit or generally advertise your securities offerings. You had to work pre-existing contact to pre-existing contact. You were not supposed to stand up on a stage at an industry conference and say, ‘We are raising $500,000 in Series A at $1.00 a share. Please see me and I’d love to talk to you about it.’ In fact, this was illegal. It was also illegal to blog or Tweet or use Facebook to try to raise money. Many people broke the rules. Some got in a lot of trouble.”

Angel investing: The walls come tumbling down by William Carleton in Geekwire

Some angel group leaders have been advising companies to not go there. Some angels are taking the position that they will not be investing in any deals that involve general solicitation or general advertising. The reps and warranties are already being written: “Company has not engaged in general solicitation and is not otherwise subject to Rule 506(c) . . . .” Access to many angel group meetings and demo events is being tightened up, in an effort to preserve the availability of the old rule, now known as Rule 506(b), which very much remains a viable option. (Kudos to the SEC for having the foresight to preserve the old rule in parallel with the new.)

Small Businesses Take Fundraising Public Small Businesses Take Fundraising Public by Angus Loten in the Wall Street Journal

Douglas Penman, for instance, says he is planning to make T-shirts promoting investment opportunities in his San Francisco startup, Nukotoys Inc., which makes children’s educational trading cards for mobile devices. He’s hoping to have the T-shirts worn by skyscraper window washers, to catch the eye of wealthy executives inside. The company, launched in 2010, is looking to raise $2 million to expand its user base, he says.

Online Platforms Give the First Public Look at Private Equity by Paul Spinrad in PBS’s Mediashift

A major change in federal securities regulations takes effect this week, and many people are wondering how it will turn out. It’s now legal — with the proper filings and for the first time in over 80 years — for businesses to publicly advertise for investors. Proponents hope that this change will spur entrepreneurship, job creation and innovation nationwide, particularly in areas outside of the typical startup hotspot cities. Detractors fear that the regs will provide a new mechanism for fraudsters to scam retirees and others out of their wealth. Either way, the system known as “private equity” won’t always be so private anymore — and as of Monday morning, several online platforms discussed below are giving the public its first look at the formerly secret world of startup investing.

General Solicitation Brings Startups Capital, Risks by Evelyn M. Rusli and Andrew Ackerman in WSJ.com’s Digits

“The government is doubling down on the idea that accredited investors can fend for themselves,” said William Carleton, a Seattle-based startup lawyer.

ERA’s demo day: “This is not a general solicitation” by Erin Griffith in PandoDaily

However, as I predicted, the pitches conspicuously left off a crucial piece. Up until this week, most demo day speeches end with something like “We’re raising $750,000 in seed funding and we already have a third of it committed from top-tier angel investors.”

But today the demos very carefully avoided that. “If you’re interested in changing the way the world books its wedding bands (or sells its used clothing, or buys its farm machinery or whatever), talk to us afterwards,” the founders declared. No fundraising, no dollar signs, no explicit asks.

How General Solicitation Will Change Private Equity And Venture Capital Forever by Ryan Caldbeck in Forbes.com

According to public filings from SEC.gov, in 2012 there were over 30,000 Reg D offerings. Collectively, they raised $1.3 trillion. About $1.1 trillion is related to financial services and pooled investment funds- i.e. hedge funds, private equity funds and similar groups raising money. The remainder spans industries from agriculture to telecom. All 30,000 of those offerings took place in a ‘silent’ offering, with no mention of the capital raise in public. The result was both inefficient, and costly for investors and the issuers.

Voluntarily Submit Your Private Placement Advertisements to the SEC

sec-seal
In a head-scratching move, the Securities and Exchange Commission has created a portal for you to voluntarily submit general solicitation materials for private placements. With Rule 506(c) now in effect, companies are free to advertise their private placements of securities, so long as the company takes reasonable steps to ensure that investors are accredited investors.

When the SEC issued Rule 506(c), it also proposed a new rule that would require a company to submit its general solicitation and advertising materials. That new rule, along with several others proposed at the same time, are controversial.

I assume that the SEC portal is set up to take submissions if required at some point at the future. I’m not sure why any company would voluntarily submit materials. I’m scratch my head even harder because there is no field to identify the issuer soliciting for investors. That would seem to limit the utility of the submission.

Perhaps the portal is intended for Whistleblowers? But there is statement and link to direct submission involving possible violations of the securities laws to the TCR portal.

Perhaps the SEC merely had its IT group put together the portal in anticipation of the proposed rule becoming effective? Perhaps.

References:

Voluntary Submission of General Solicitation Materials Used in Rule 506(c) Offerings

The New Era of Public Private-Placements

half-price advertisement

The Securities and Exchange Commission’s new Rule 506(c) goes into effect today, lifting the ban on general solicitation and advertising. Fund managers, start-ups, and established companies can make public, their private placements of securities. That is both a good thing and a bad thing.

It’s good because start-ups can now pitch their products to potential consumers and for investments by investors. Demo days are no longer operating in a shadowy area that may violate the rule on private placements. Private fund managers can now advertise their brand, much as mutual fund companies can advertise. Private fund managers can speak to the press so that their coverage is no longer incorrect.

It’s bad because once you advertise, you have to take “reasonable steps to verify” that you should have a “reasonable belief” that an investor is an accredited investor. For individuals, it may mean that an issuer would ask for tax returns or certified financial statements. I think most individuals will resist that request. So a start-up that is seeking individual investors may actually handicap its ability to attract investors by engaging in general solicitation or advertising.

It’s also bad for securities regulators. If a regulator could see information on what should be a private placement, the regulator knows its a bad private placement. By the old definition of private placement, the regulator should not be able to see the information because its private. Either the company made a bad mistake or there’s fraud involved. In the new era of public private-placements, regulators will have little insight into the nature of the private offering.

At some point the regulators will have access to the Form D filing that provides a basic set of information about the public private-placement. But that does not need to be filed until 15 days after the first sale of securities.

In an attempt to fix the loss of the red flag, the SEC proposed some additional rules to help with investor protection. I, and many others, feel the proposed rules are more likely to impede private fundraising more than protect investors.

The better solution would have been to improve the poor definition of “general solicitation and advertising.” There were many things that clearly fit into the definition and many things that clearly fell outside of the definition. If the SEC had just carved out a few more items (see the “good” above), private placements would not be in their current turmoil.

But it was not up to the SEC. It was a Congressional mandate in the JOBS Act that swept aside the ban. It was Congress who imposed the investor verification requirement.

The good news is that the old private placement regime is still in place. As long as you don’t engage in general advertisement or solicitation, in other words have a private private-placement, you don’t have to engage in the messy investor verification process.