Rule 506(b) Securities Offerings: Leveraging 506(b) Placements, Comparison to Rule 506(c) Offerings

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Rule 506(b) Securities Offerings: Leveraging 506(b) Placements, Comparison to Rule 506(c) Offerings Navigating Rules for Solicitation and Accreditation Process for Non-Accredited Investors WEDNESDAY, AUGUST 24, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Matthew A. Cordell, Attorney, Ward and Smith, Raleigh, N.C. Knox Proctor, Attorney, Ward and Smith, New Bern, N.C. James F. Verdonik, Attorney, Ward and Smith, Raleigh, N.C. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 SEC RULE 506: PRIMARY CAPITAL-RAISING TOOL FACTORS TO CONSIDER WHEN CHOOSING RULE 506 (b) OR RULE 506 (c) Jim Verdonik Ward and Smith, P.A. E: P: (919) August WARD AND SMITH, P.A.

6 Summary PART I PART II PART III PART IV PART V Rule 506 Overview Summary of Rule 506 (b) and 506 (c) Similarities and Differences Accredited Investor Definition: Old and New Rule 506 (b): How Do You Avoid Making a General Solicitation? Rule 506 (c): What Are Reasonable Steps to Verify Accredited Investor Status? 6

7 PART I RULE 506 CHOICES OVERVIEW 7

8 Rule 506 The Once and Future Capital Raising Champion In the Capital Raising World, Rule 506 has Been the Workhorse. Recent Changes to Rule 506 Are Making Rule 506 an Even More Useful Capital Raising Tool Changes Offer More Choices, Which Require More Legal Analysis Cannot Sleep Walk Through Rule 506 Offerings Offerings to Non-Institutional Investors Create Biggest Challenges 8

9 Standards for 506 (b) vs 506 (c) For Rule 506 (b) avoiding a General Solicitation requires that the Issuer or the Issuer's Agent had a "Prior Substantive Relationship" with Each Offeree before the Offer. For Rule 506 (c) no "Prior Substantive Relationship" with Offerees is required, because General Solicitations are Permitted, but the Issuer must take "reasonable steps to verify" the Accredited Investor status of each Purchaser before the Closing the Sale to that Purchaser. 9

10 Primary Choice Rule 506 Offerings The Second Half of this Presentation will: Compare the "Prior Substantive Relationship" requirement of Rule 506 (b) to the "Reasonable Steps to Verify" requirement of Rule 506 (c). Discuss How Continuing Past Practices in Rule 506 (b) Offerings may result in Issuers Conducting General Solicitations that deprive the Issuer of the Exemption from Registration. 10

11 PART II SUMMARY OF RULE 506 (b) AND 506 (c) SIMILARITIES AND E. Knox Proctor Ward and Smith, P.A. E: P: (252) August DIFFERENCES 2016 WARD AND SMITH, P.A.

12 Understanding Rule 506 Requires Understanding Prior Problems Regulation D Was Designed to Solve Section 4 (a) (2) "transactions by an issuer not involving any public offering." Because of Section 4 (a) (2)'s Lack of Detail, Lawyers were Reluctant to Render Legal Opinions that Offerings Qualified for the Exemption as Offering Issues Became More Complex due to: - National Capital Raising System began to Replace Local Capital Raising Systems - Entrepreneurial Economy Relying Less on Commercial Bank Loans and More Reliant on Selling Debt and Equity Securities Regulation D tried to Answer Section 4 (a) (2)'s Unanswered Questions: - How many investors? - How know Investors? - What types investors? - When does one offering end and a new offering begin? - Do all investors require the same disclosures? 12

13 Different Statutory Authority for Different Parts of Regulation D Section 3(b) authorizes SEC to create Exemptions up to $5 Million. Rule 504 has $1 Million Annual Maximum (Proposed to increase to $5 Million). (Proposed to increase to $5 Million). Rule 505 has $5 Million Annual Maximum. Because Rule 506 has no Annual Maximum, Rule 506 was issued under Section 4 (a) (2). 13

14 Advantages of Rule 506 over Rules 504 and 506 Rule 506 has Three Primary Advantages over Rule 504 and Rule 505 Unlimited $$$$ Amount Federal Preemption of State Registration Laws Greater Liability Protection The Private Funds Industry can use Rule 506, but not Rules 504 or

15 More Changes in Practice than in Theory In Theory Rule 506 (b) is just old Rule 506 with the following Changes: Bad Actor Restrictions Checking the Box in Form D Greater Emphasis on Timely Filing Form D In Practice Rule 506 (b) is likely to Evolve on a Different Course than Old Rule 506 because: As Business People see others using Websites and Social Media to sell securities, they may forget the Solicitation Restrictions of Rule 506 (b) With Many Exemptions Permitting General Solicitations, the SEC is Likely to More Closely Scrutinize Compliance with the No General Solicitation Requirements of Rule 506 (b) The Accredited Investor Verification Practices of Rule 506 (c) Offerings may Change Industry Practices in Rule 506 (b) Offerings 15

16 Primary Issues That Differ in Rules 506 (b) and 506 (c) Rule 506 (b) Does Not Permit General Solicitation (PART IV) Rule 506 (b) Permits 35 Non-Accredited Investors, But Different Disclosure Rules Apply to Non-Accredited Investors Rule 506 (c) Requires Issuer to take Reasonable Steps to Verify Accredited Investor Status (PART V) 16

17 Divisions Within Rule 506 (b) and Within Rule 506 (c) Because the SEC Distrusts Internet Offerings, Different Standards are evolving For: Rule 506 (b) Offerings Conducted on the Internet vs 506 (b) Offerings Not Conducted on the Internet 506 (c) Offerings Conducted on the Internet vs 506 (c) Offerings Not Conducted on the Internet Because Rule 506 itself does not distinguish between Internet offerings and other types of offerings, the different standards are based on the different mechanics of the each type of offering, but absent future guidance the basic principles likely apply to all types of offerings. 17

18 Primary Issues That Apply to Both Rules 506 (b) and 506 (c) Same Issuers Can Use the Exemption Both Require Filing Form D Bad Actor Prohibition of Rule 506 (d) State Registration Laws Are Preempted Same Liability Criteria and Defenses Same Issuers Can Use the Exemption Affiliates and Other Re-Sellers Cannot Use the Exemption Investors Receive Restricted Securities for Re-sale Purposes No Special Exemption from Section 12 (g) Registration Rules Accredited Investor Definitions Are the Same 18

19 Same Issuers Can Use Both Exemptions The Nature of the Issuer Often Determines the Exemption You Choose In Internet Based Rule 506 Offerings Platforms and Lead Investors Often Organize Exempt Investment Companies to Sell Securities and Reinvest in a Single Issuer Public Companies Most Exempt Investment Companies Registered Investment Companies Rule 506 Rules 504 and 505 Section 4 (a) (6) Regulation Crowdfunding Regulation A State Crowdfundin g Yes No No No No in many States Yes No No, but No No in many change is likely States (Fix Crowdfunding Act) Yes No No No No in many States 19

20 Private Funds Industry The "Private Funds" Industry uses Exceptions from the Definition of "Investment Company" - Section 3 (c) (1) for funds with 99 or Fewer Owners - Section 3 c) (7) for funds whose investors are all "Qualified Purchasers" Neither of these exceptions apply if the Private Fund is making an Exempt Public Offering (504 and 505),but do Apply to Rule 506 Offerings 20

21 SEC Form D Must Check Box to Indicate Whether Offering Uses Rule 506 (b) or Rule 506 (c) Cannot Check Both Integration Issues Must Identify Intermediaries Who Compensate in Offering - Unregistered Brokers Issues - Bad Actor Issues 21

22 Bad Actor Issues Rule 506 (d) Prohibits Use of Rule 506 if Identified Classes of People have Committed Bad Acts Two General Classes: - People and Entities Associated with Issuers, including Promoters and 20% Shareholders - Intermediaries and their Personnel Defense of the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed. Can Obtain Exemption from SEC Staff 22

23 Bad Actor Issues (continued) Issuer is Not Disqualified from Using Exemption If - Issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed. - Issuer must, in light of the circumstances, make factual inquiry into whether any disqualifications exist. The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and the other offering participants. SEC has indicated very low cost estimate for compliance, which drives evolving practices 23

24 Practice Points (Bad Actors) The more Control Someone Exercises the Greater the Inquiry should be. Questionnaires are used for Most People Background Check for Officers and Directors Disciplinary Check for Brokers Brokers Often Have Their Own Questionnaires Multiple Brokers and Sub-Brokers Complicate Promoters are Often Difficult to Identify 24

25 Bad Actor Issues (continued) Affects current offering, but new investors could preclude future capital raising: - Get Representations from New Investors - Get Right to Buy Back from New Investors Similar Disqualification applies to most exemptions from Registration, including Section 4 (a) (6) Regulation Crowdfunding, Regulation A and State Crowdfunding Prior Bad Acts Raise Disclosure Issues 25

26 Liability Implications of Section 4(a) (2) vs. 3(a) or 3 (b) Section 3(a) and 3(b) Rule 504 and 505 Offerings are Exempt PUBLIC Offerings. Section 4(a) (2) and Rule 506 Offerings are Exempt PRIVATE Offerings. Gustafson v Alloyd US Supreme Court (1993) - Exempt Public Offerings are Subject to Stricter Liability Rules than Private Offerings Section 302 (c) (1) (B) of JOBS Act Specifically Preserved Rule 506(c) 's Status as a "Private" Offering Despite being Able to Make A General Solicitation 26

27 Liability Issues (continued) Section 12(a)(2) of 1933 Act Creates Liability only in Exempt and Non-Exempt PUBLIC Offerings for Disclosure Violations that Involve Misstatements or Omissions that are : Intentional or Negligent Section 10 of 1934 Act Creates Liability for Section 4 (a) (2) and Rule 506 PRIVATE Offerings for Disclosure Violations that that Involve Misstatements or Omissions that are : Intentional or In Reckless Disregard of the Truth This Difference Affects the Due Diligence Defense 27

28 Federal Preemption of State Registration Laws As the National Capital-Raising System Developed, State Securities Registration Laws and Associated Exemptions Became a Much Bigger Impediment 1996 Section 18 was amended to Make all Securities Sold in Rule 506 Offerings "Covered Securities" Pre-empted State Registration Laws for all Rule 506 Offering Except Post-Closing Notice Filings and Fees Failure to Comply with Rule 506 Often Creates State Law Liabilities 28

29 Non-Accredited Investors (Sophistication) Rule 506 (b) (2) (ii) seems to require greater investigation of the Sophistication of Non- Accredited Investors General Solicitation Prohibition in Rule 502 (c) which applies to all Investors make this Distinction somewhat Illusory Avoiding General Solicitation Often Requires Issuers to Determine Investor Sophistication Before Making Offers 29

30 Disclosures to Non-Accredited Investors Rule 502 (b) Contains Specific Disclosures to Non-Accredited Investors: - Financial Statements that vary by Offering Size - Non-Financial Information Equivalent to Part II of Form 1-A if Issuer is Eligible for Regulation A Offering or Part I of Applicable Registration Statement Can make less Disclosure to the extent the Omissions are not Material to Understanding the Issuer, Its Business and the Securities Being Offered Some Financial Statement Requirements are relaxed iifthe Issuer cannot produce the Financial Statements without Unreasonable Cost 30

31 PART III ACCREDITED INVESTOR DEFINITION: OLD AND NEW Matthew Cordell Ward and Smith, P.A. E: P: (919) August WARD AND SMITH, P.A.

32 Types of Accredited Investors Individuals Entities Based on Legal Status Entities Based on Assets New Rules Under Consideration 32

33 Issuer Accredited Investors Who Decides? Platform or Other Intermediary Future Investors Securities Regulators When File Form D Plaintiffs 33

34 Accredited Investors What if Are Wrong? Section 12 (a) (1) Liability for Violating Section 5 of 1933 Act because Have No Federal Exemption from Registration Cannot rely on Section 4 (a) (2) exemption if conduct a general solicitation Violate Section 12 (a) (2) of 1933 Act because fail to disclose that investors have rescission rights Violate state securities laws because state registration laws are not preempted Violate state disclosure requirements because fail to disclose rescission rights Liability is to all investors not just to the investors you fail to verify Liability for failing to disclose rescission rights from an earlier offering can cause cascading liability to investors in later offerings 34

35 Accredited Investors Individuals Net Worth Greater than $1 Million Residences Only count primary residence and mortgage in determining net worth if the home is "underwater" What is Primary Residence vs Vacation Home or r4ental Property Affects Net Worth Calculation Income - $200,000 each of past 2 years and expect $200,000 in year investment is made Spouses Can choose to include spouse in the net worth test or the income test, but the income test increases to $300,000 if include spouse's income in the income test Executive Officers, Directors and general partners are automatically accredited investors without regard to income or net worth 35

36 Accredited Investors Entities Based on Legal Status The following types of Accredited Investors can be easily verified based on their legal status: Banks S&Ls Insurance Companies Business Development Companies Registered Investment Companies SBICs ERISA Employee Benefit Plans with specified institutional trustees or $5 million of Total Assets or self-directed by an Accredited Investor 36

37 Accredited Investor Entities Based on Assets and Other Criteria The following Accredited Investors present verification issues beyond verifying their legal status: Entities not formed for the purpose of the investment and having more than $5 million of total assets: Trusts if directed by a sophisticated person 501 (c) (3) non-profits Corporations and other entities Employee benefit plans with $5 million in assets Any entity all of whose owners are Accredited Investors 37

38 December 2015 SEC Report SEC Staff Recommends Accredited Investor Changes Section 2 (a) (15) gives the SEC Wide Authority to define "Accredited Investor" to including any person who, on the basis of such factors as: Financial Sophistication Net Worth Knowledge and Experience in financial matters, Amount of assets under management 38

39 Multiple New Categories of Accredited Investors To Date All Accredited Investors have been Treated the Same Equal Treatment of All Types of Accredited Investors Is Not Required by any Statute. Proposal Would Create Categories of Accredited Investors Proposal Would Impose $$$ Limits on Investments by Some Accredited Investors This Borrows from Crowdfunding Concepts, including $$$$ Limits on what Some Accredited Investors Can Invest 39

40 New Categories of Accredited Investors (continued) New Rules Under Consideration Would: Add Categories Based on Sophistication and Experience, including Number of prior similar Investments and Affiliation with VC or similar Investor Create Higher Financial Tests for Super- Accredited Investors Who Have No $$$ Limits to How Much They Can Invest 40

41 December 2015 SEC Report re Accredited Investor Changes Recommended by SEC Staff Individuals who are Accredited Investors today would remain Accredited investors, but would be limited to investing not more than 10% of Income or 10% of Net Worth, Unless Satisfy Other Criteria. 10% Limitation Would Require More Details About both Income and Net Worth Create new Income and Net Worth Tests for investments without the 10% limitation (a) $500,000 income without spouse (b) $750,000 income with spouse (c) $2.5 Million Net Worth (without primary residence) Every four years adjust all financial thresholds for inflation going forward. 41

42 Other Proposed Changes Focus on Invested Assets Rather than New Assets Open to all Types of Entities that Meet assets Criteria (requested by Native American Tribes) Marriage Change: Permit Income and Net Worth of "spousal equivalents" to be Included 42

43 Increase in Numbers of Individual Accredited Investors Type of Individual Accredited Investor $200,000 Annual Income Test $300,000 Annual Income with Spouse $1 Million Net Worth Test if Had Adjusted 1983 Tests for CPI Measured Inflation 440,000 8 Million $490,000 Households 0.5% of All Households 1.4 Million Households 1.7% of All Households Households 6.6% of All Households 4 Million Households 3.3 % of All Households 9.2 Million Households 7.5% of All Households 2.1 Million Households 1.7% of All Households 3.8 Million Households 3.1% of All Households 43

44 New Financial Thresholds for Individuals Annual Income without 10% Limit Annual Income with 10% limit Net Worth without 10% Limit CURRENT $200,000 or $300,000 with Spouse 8 Million Households RECOMMENDED BY SEC STAFF N/A 6.6% of All Households N/A $500,000 or $750,000 with Spouse Equivalent 2.1 Million Households 1.7% of All Households $1 Million 9.2 Million Households 7.5% of All Households $2.5 Million 6.4 Million Households 3.1% of All Households Net Worth with 10% limit N/A $1 Million 5.4 Million Households 4.4% of All Households 44

45 PART IV RULE 506 (b): HOW DO YOU AVOID MAKING A GENERAL SOLICITATION? Jim Verdonik Ward and Smith, P.A. E: jfv@wardandsmith.com P: (919) August WARD AND SMITH, P.A.

46 Primary General Solicitation Issues Determining whether an Offering is Exempt under Rule 506 (b) Requires Answering Two Questions: - Was an Offer Made? - Was an Offer Made to Someone the Issuer or Its Agent Did not have a Prior Substantive Relationship? Issuer must be prepared to Prove the Exemption Exists Must have the Exemption for Offers Even if No Sales Occur (Although Damages in a Civil Action Depend on Sales) 46

47 Rule 506 (b) Prohibits General Solicitations Rule 506 (b) Requires Issuers to Comply with Rule 502. Rule 502 (c) Prohibits Offering or Selling securities by using "any form of General Solicitation or General Advertising," including: - "Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio." - Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising; 47

48 Primary General Solicitation Issues Determining whether an Offering is Exempt under Rule 506 (b) Requires Answering Two Questions: - Was an Offer Made? - Was an Offer Made to Someone the Issuer or Its Agent Did not have a Prior Substantive Relationship? Issuer must be prepared to Prove the Exemption Exists Must have the Exemption for Offers Even if No Sales Occur (Although Damages in a Civil Action Depend on Sales) 48

49 Rule 502 (c)builds on Prior Section 4 (a) (2) Principles SEC v Ralston Purina 346 U. S. 119 (1953) and Subsequent Interpretations Does the Class of Persons Need to Be Protected by the Registration Provisions of the Securities Act? Issuer or Agent Must Have a Pre-Existing Relationship that Provides Sufficient Information to Determine Whether the Investors Are Able to "Fend for Themselves" 2015 No-Action Letter and CDI's Describe Information Required for Rule 506 Offerings Issuers Can Use Questionnaires to Obtain the Necessary Information Questionnaire Limited to Determining Accredited Investor Status May Not Be Sufficient, Because Ability to Fend for Self Depends on More Than Financial Resources 49

50 General Solicitation Three Categories of General Solicitation Issues for Rule 506: Internet Many SEC Concerns Requires Issuers or Platform Operators to Focus on Details both relationship Details and Timing In-Person Expect Some Greater Restrictions Other Media Expect Fewer Changes Because of Long History 50

51 General Solicitation Not Limited to Paid Advertising General Solicitation or Advertising Can Include: Press Releases Free Public Relations Articles Organized Telephone Solicitations 51

52 The Real World Still Exists Internet Competition is Decreasing the Cost of Other Media Many Investors Like to Invest Locally and Local Media is Inexpensive Person to Person is Still How Most People Conduct Business Creating a Personal Connection is Still the Best Sales Tool, But Personal Communications can be General Solicitations 52

53 General Solicitations (continued) General Solicitation includes Using Media and Word of Mouth to Drive People to Presentations Sign in Window is General Solicitation Mass Mailing to Customers is General Solicitation, But Is It an Offer? 53

54 Rule 506 (b)'s Either or Choice Is Illusory Rule 506 (b) (ii): "Each purchaser who is not an accredited investor... has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks...." Seems to give ability to sell to Accredited Investors without Regard to Ability to Fend for Themselves. 54

55 General Solicitation Depends on Factors Other Than Investor's Financial Resources CDI (2009) indicates that an offering that is restricted to Accredited Investors Can Still be a General Solicitation. Most Subscription Agreements Require All Investors to Represent they: "have such knowledge and experience in financial and business matters that [they are] capable of evaluating the merits and risks...." Issue to Avoid General Solicitation is Whether this Representation is Sufficient to Establish a Pre-Existing Substantive Relationship. Many Offerings Assume it is Sufficient, but is the Investor's Representation Really Sufficient? Problem: Ability to Fend for Self is Difficult to Determine for Many Non- Institutional Investors. 55

56 Prior Substantive Relationship Avoid General Solicitation SEC CDI's in August 2015 Clarify what are Good Practices for All Offerings: Substantive: Is the Quality of the Relationship Sufficient to Determine the Investor's Ability to Fend For Self? Timing : Does the Substantive Relationship Pre-Date the Offer 56

57 Who Can Establish Prior Substantive Relationships? Angel Investor in an Angel Network Can Refer Other Investors (CDI ) Registered Broker Dealers (CDI ) Registered Investment Advisers (CDI ) Facts and Circumstances Test for Other People Website Operator Who Uses Appropriate Procedures (Citizen VC No-Action Letter 2015) Difficult for Issuers Establish Substantive Relationship During the Offering Unlike Rule 506 (c)'s Reasonable Steps to Verify Accredited Investor Status 57

58 Venture Capital Conferences (Primary SEC No-Action Letter) Michigan Growth Capital No Action Letter (1995) - Granted to the Symposium Organizer (Not ot an Issuer) - Specifically Disclaims Ability of Presenting Companies to Rely on the Letter Letter Represents: - Excludes Issuers "In Registration" - Publicized by "targeted mailings to known accredited investors, limited generic advertising in Venture Journal and by word of mouth from prior attendees." - No sales commissions - Prohibit circulation of Private Placement Memoranda - Organizer does not arrange prior contacts between presenters and attendees - Presentations do not include specific financing details 58

59 Venture Capital Conferences and Past Practices SEC Has Turned a Blind Eye to Dozens of Annual Venture Capital Conferences and Demo Days: Primarily Because the Very Sophisticated Audience Makes it Easier to Determine Ability to Fend for Self Weakest Link in Chain: Not Everyone is Equally Sophisticated Businesses Had No Other Choices to Raise Capital This SEC Policy For Rule 506 (b) Offerings May Change Now That Rule 506 (c) and Other Exemptions Permit General Solicitations and Advertising. CDI (August 2015) Recommends Considering using Rule 506 (c) where the Issuer or Persons Acting on Behalf of the Issuer Use a General Solicitation to Invite People to a Presentation where an Offer is Made. 59

60 Venture Capital Conferences Primary Issues CDI August 2015 Demo Day to VC Conference Two Issues: Does the Presentation Constitute an Offer? Is the Presentation a General Solicitation? Facts and Circumstances Test 60

61 Venture Capital Conferences And General Solicitations Whether a VC Conference Constitutes a General Solicitation Depends on: Does the Issuer or the Organizer Have a Pre- Existing Substantive Relationship with all Attendees? If Not, Were the Attendees Contacted Through an Informal Personal Network described in CDI ? 61

62 Offers Are Important for Rule 506 (b), but not Rule 506 (c) The Prohibition on General Solicitation Applies to both Offers and Sales. Section 2 (a) (3)The term offer to sell, offer for sale, or offer shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value." Therefore, Simply Omitting Price Or Other Terms Is Not Sufficient to Avoid Making an Offer. 62

63 Offers at Venture Capital Conferences Whether the Presentation is an Offer Depends on whether only general "Business Information" is Discussed Are Announcements from Stage that the Issuer Will Meet with Investors at a Specified Time and Location Where Offers are Usually Made a General Solicitation 63

64 Factual Business Information CDI August 2015 Only "Offers" Violate the General Solicitation Rule Factual Business Information is not an Offer if it "does not condition the public mind or arouse interest in the offering." See Gun Jumping Issues, where Timing, Media and Other Issues Affect the Analysis Rule 135 Can be used as a Guide 64

65 Factual Business Information (continued) Facts and Circumstances Test Designed not to Interfere with Business' Ordinary Operations. Including Product Sales OK if Limited to Information a Customer or Vendor would Want to Know: - Description of Business - Financial Condition - Products - Services Not OK if Include Information Related to Investment Decisions: - Predictions - Projections - Forecasts - Valuation Opinions 65

66 Website Operator Is Making a General Solicitation Every Website Operator is Making a General Solicitation (CDI August 2017) Primary Rule 506 (b) Issue is: - Is the Purpose to Attract People to Use the Website? - Is the purpose to Sell Particular Offerings listed on the Website? 66

67 Purpose of Statements Purpose Usually Depends on Two Factors: If Information About Particular Offerings is on the Home Page or Other Open Access Part of the Website, a General Solicitation is Being made. To Avoid a General Solicitation, the Information about a Particular Offering: - Must be limited to Restricted Access Parts of the Website, - Website Operator's Procedures Ensure Access only to Investors for whom the Website Operator Has Satisfied the Pre- Existing Substantive Relationship Test. 67

68 Timing of Pre-Existing Substantive Relationship Substantive Relationship Does Not Have to Pre-Date the Investor Coming to the Website Website Procedures Can Create the Substantive Relationship Determine Whether a Substantive Relationship Is Pre-Existing Based on When the Investor First Receives Access to Information that Constitutes and Offer (CDI ) 68

69 Evolution of Website Issues Lamp Technologies Lamp Technologies (1997) no action Letter Emphasized Controlled Access to Accredited Investors and a Waiting Period Lamp was a Software Developer that Operated a Website that Listed Offerings by Private Funds Used a Generic Questionnaire to form a Reasonable Basis to Believe Subscribers Are Accredited Investors Subscriber pays Monthly Fee for Password Access to Fund Offerings Subscriber Agrees Will Not Invest for Thirty Days Subscriber Agrees Not to Disclose Offerings to Others Focused on Knowledge of Investor's Financial Resources 69

70 Evolution of Website Issues Citizen VC Citizen VC (2015) No-Action Letter Changes Emphasis Away from a Waiting Period to Relationship that Provides Relevant Information about the Investor's Experience and Goals Online Venture Capital Fund Organizes SPVs Managed by an Affiliate to Invest in Specific Businesses (Not Blind Pools) Rule 506 (b) Offerings Sell SPV Interests Conducts General Solicitation to Attract Investors to its Website Home Page Promotes the Concept on Online Venture Capital, But Does Not Promote Investment in a Specific Issuer Investor Registers as a Member of the Website by Completing a Generic Accredited Investor Questionnaire Access to Specific Offerings Is Denied Until Website Operator Completes the "Relationship Establishment" Process 70

71 Citizen VC Relationship Establishment Process After Registration and Accredited Investor Questionnaire Website Operator Contacts Investor to Discuss: - Prior Investment Experience - Sophistication - Investment Goals - Investment Strategies - Financial Suitability - Risk Awareness 71

72 Citizen VC Relationship Establishment Process (continued) Send Introductory to Investor Answer Questions About the Website, the Website Operator and Potential Investments Access a Third Party Credit Report to Confirm the Investor's identity and Credit History Encourage Ongoing Interaction between he Investor and the Website operator. Imposed a $50,000 Minimum Investment 72

73 Citizen VC (continued) Quality of the Relationship Creates a Pre-Existing Substantive Relationship that is More Important than Relationship Length: Have Sufficient Information to Evaluate and Actually Does Evaluate: - Sophistication - Financial Circumstances - Ability to Understand Risks and the Securities Being Offered 73

74 PART V RULE 506 (c): WHAT ARE REASONABLE STEPS TO VERIFY ACCREDITED INVESTOR STATUS? Jim Verdonik Ward and Smith, P.A. E: jfv@wardandsmith.com P: (919) August WARD AND SMITH, P.A.

75 Rule 506 (b) Accredited Investor Requirement in Rule 501 (a): Accredited Investors do not Count toward Rule 506 (b)'s 35 Purchasers Limit Is an Accredited Investor OR Issuer has Reasonable Belief is an Accredited Investor 75

76 Rule 506 (b) Allows Self-Certification Issuer can accept self-certification of Accredited Investor status by investors, unless the issuer knows or has reason to know that self-certification is wrong. Courts often side with Issuers when Non- Accredited Investors sue alleging the issuer should have known to avoid rewarding investors who make misrepresentations 76

77 Rule 506 (c) Test For Rule 506 (c), Issuers must satisfy the Rule 506 (b) Test AND Must take "reasonable steps" to verify Accredited Investor Status. The Issuer loses the Exemption from even if the investor actually is accredited. Being lucky is not a defense. 77

78 Safe Harbor for Individual Investors Relies on Reviewing Investor's Financial Documents: Income non-exclusive list includes Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040 for two most recent years and representations about current year. Net Worth Documentation for Assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and Net Worth Documentation for Liabilities: a consumer report from at least one of the nationwide consumer reporting agencies; and Written statement from investor that all liabilities have been disclosed. 78

79 Safe Harbor for Individuals (cont.) Timing: Must be dated within three months before the investment date Named Persons can provide written statements that they have taken reasonable steps to verify Accredited Investor status within the prior three months (Note This Is Broader than Reviewing Safe Harbor Documents): A registered broker-dealer A investment adviser registered with the SEC (not states) A licensed attorney in good standing in all jurisdictions where licensed A certified public accountant registered and in good standing under the laws of their residence or principal office Must have a reasonable basis to rely on others not named in the Safe Harbor. Platforms use Sub-Contractors for Verification 79

80 "Reasonable Steps" to Verify Outside the Safe Harbor WHY? Is Most Important Question for Understanding Reasonable Steps. "An issuer that solicits new investors through a website available to the general public, through a widely disseminated or social media solicitation, or through print media, such as a newspaper, will 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 reliable third party." 506 (b) Offerings: Issuer usually has contacts and knowledge of Investors other than the selfcertification OR Registered Broker or Other Intermediary has contacts and knowledge of Investors other than the self-certification In Rule 506(c) Offerings on Internet, often no one has information about investors other than the self-certification. There is no reasonable basis for believing self-certifications by Unknown Investors 80

81 Something More than Self-Certification How much more is required is a facts and circumstances test. Examples in SEC Release No (July 10, 2013) the nature of the purchaser and the type of accredited investor that the purchaser claims to be; the amount and type of information that the issuer has about the purchaser; the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering the terms of the offering, such as a minimum investment amount. 81

82 Interpreting Facts and Circumstances "After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa." SEC Release No (July 10, 2013) High Minimum Investment Amount Publicly available information about the investor, including in government filings (E. g proxy statement information) Knowledge of Prior Investment Transactions Issuers must prove they have an exemption. Create written record of the reasonable steps taken to verify Accredited Investor status and why the steps were reasonable. 82

83 Which Is More Difficult? 506 (b) or 506 (c) Issuers Who Choose Rule 506 (b) to Avoid Taking Reasonable Steps to Verify Accredited Investor Status may have more difficulty Establishing a "Prior Substantive Relationship," because: Additional steps beyond Self-Certification by the Investor is required to avoid a general solicitation Rule 506 (b)'s test involve subjective information about Investors whereas Rule 506 (c) focuses on financial information Obtaining Information is insufficient for Rule 506 (b), because the Issuer must use the Information to appropriately evaluate the circumstances of prospective Offerees Many Issuers may be incapable of analyzing the subjective information, which is similar in some ways to a broker-dealer's suitability analysis Much of the Information required to establish a Prior Existing Relationship would be useful in taking Reasonable Steps to Verify Accredited Investor Status 83

84 Which Is More Difficult? (continued) Timing Favors Rule 506 (c) Over Rule 506 (b): - With Rule 506 (c), can take Reasonable steps to Verify After Make the Offer and Before the Sale - With Rule 506 (b), the Issuer or Agent must establish the Substantive Relationship Before the Offer (CDI and ) Numbers of Investors Favor Rule 506 (c) Over Rule 506 (b): - With Rule 506 (c), must only take reasonable steps for actual Purchasers - With Rule 506 (b), Must Have Prior Substantive Relationship with all Offerees and Purchasers 84

85 ASHEVILLE GREENVILLE NEW BERN RALEIGH WILMINGTON 2016 WARD AND SMITH, P.A.