The Uncharted Waters of General Solicitation

The Uncharted Waters of General Solicitation Darryl Steinhause and Amy Giannamore * Although many had hoped that the Jumpstart Our Business Startups Act would allow issuers to make private o erings in an unfettered manner, upon closer examination there are still pitfalls of which issuers (and in particular their principals and employees) must be aware. The Jumpstart Our Business Startups Act (the JOBS Act) directed the Securities and Exchange Commission (the SEC) to enact an amendment to Regulation D promulgated under the Securities Act of 1933 (Regulation D) which would permit general solicitation advertising in o erings made under Rule 506 of Regulation D. On September 23, 2013, new Rule 506(c) of Regulation D which permits general solicitation for private o erings if certain requirements are met became e ective. 1 In addition, the JOBS Act mandated a change to the Securities Act of 1933, as amended (the Securities Act) which provided an exemption from registration as a broker or a dealer under the Securities and Exchange Act of 1934, as amended (the Exchange Act) for persons that maintained a platform for solicitation of investors in a Rule 506 o ering (the JOBS Act Exemption). While many had hoped that these changes would allow issuers to make private o erings in an unfettered manner, upon closer examination there are still pitfalls of which issuers (and in particular their principals and employees) and broker-dealers must be aware. The Requirements of Rule 506(c) Rule 506 provides a safe harbor from registration of securities issued pursuant to Section 4(a)(2) of the Securities Act. New Rule 506(c) expands this safe harbor to permit issuers to engage in general solicitation when o ering and selling securities in a private o ering, provided that: (1) All purchasers are accredited investors (or investors that the issuer reasonably believes are accredited at the time of the sale); (2) the issuer takes reasonable steps to verify the accredited investor status of each purchaser; and (3) the issuer complies with other applicable provisions of Regulation D. Purchasers Must Be Accredited Although the general solicitation is permitted to be sent to persons who are not accredited, the securities may only be purchased by persons who are accredited investors or investors that the issuer reason- * Darryl Steinhause is a partner at DLA Piper LLP (US) and can be reached at darryl.steinhause@dlapiper.com. Amy Giannamore is of counsel at DLA Piper LLP (US) and can be reached at amy.giannamore@dlapiper.com. 45

The Real Estate Finance Journal ably believes are accredited at the time of the sale. Reasonable Steps to Verify Accredited Investor Status New Rule 506(c) requires the issuer to take reasonable steps to verify that the purchasers of the securities are accredited investors. O erings conducted under Rule 506 typically have relied on a check the box subscription agreement where the investor indicates that they are (or are not) accredited. This method of accreditation con rmation is not likely to satisfy the requirements of Rule 506(c). Rule 506(c) provides several non-exclusive methods which would satisfy the issuer's reasonable requirement to verify including: (1) reviewing two years of tax returns and obtaining a certi cate from the purchaser that such purchaser has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor in the current year; (2) reviewing bank, brokerage or other statements with respect to assets, and a consumer report from at least one of the nationwide consumer reporting agencies dated within 3 months with respect to liabilities, and obtaining a certi cate from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed; or (3) obtaining written con rmation from a registered broker-dealer, registered investment advisor, licensed attorney or certi ed public accountant that such person has taken reasonable steps to verify the purchaser's accredited investor status. As a result of the above requirements, investors in Rule 506(c) o erings are required to provide signi cantly more information to the issuer. Some investors may feel uncomfortable with providing this information or may question why it is necessary. However, the information being provided is similar to what the investors have traditionally provided to their broker-dealers. Regulation D Compliance Requirements New Rule 506(c) requires that the issuers comply with the other requirements of Regulation D. In a separate release, 2 the SEC has proposed that issuers that want to conduct an o ering pursuant to Rule 506(c) must also le an Advance Form D at least 15 days prior to the o ering being made. The Advance Form D would include basic information about the o ering. Issuers would still be required to amend the Form D within 15 days after the rst sale of the securities to provide all required information. These are currently proposed rules and have not been adopted as of the date of this article. In addition, the SEC has adopted new rules with respect to the disquali cation of persons from all Rule 506 o erings which are e ective as of September 23, 2013. 3 The socalled bad actor disquali cation provisions eliminate the ability of persons (including of- cers, directors, principals and owners of more than 20% of an issuer or sponsor) to conduct a Rule 506 o ering, including those who are subject to certain orders of federal or state agencies or have been found liable for things such as fraud. The disquali cation provisions require that the trigger event occur after the e ective date of the new provisions. Events that occurred prior to such date which would have been a disquali cation event if they occurred after the e ective date have become mandatory disclosure events for the issuer. 46

The Uncharted Waters of General Solicitation General Solicitation and General Advertising Rule 506(c) allows issuers to use all means of general solicitation and general advertising to conduct Rule 506 o erings. This would include internet, social media, print media, television, radio and other forms of advertising. The SEC has indicated that it will be focused on ensuring that the materials used for any general solicitation are not fraudulent in nature. In a separate release, the SEC has proposed that all general solicitation materials be led with the SEC no later than the rst day of use. 4 Broker-Dealer Implications Under the existing Rule 506(b), which prohibits general solicitation, issuers generally rely on broker-dealers to bring clients to the issuer for the purchase of the issuer's securities. Rule 506(c) gives the issuers the ability to conduct o erings directly with the public instead of working through a selling group of broker-dealers. However, lifting the ban on general solicitation may not be the magic bullet that issuers may have been hoping for. If the o cers, directors and employees of an issuer are engaged in the marketing and sale of securities to the public, the associated persons of the issuer must comply with the broker-dealer requirements set forth in the Exchange Act or nd an exemption. De nition of a Broker and Safe Harbor Under the Exchange Act Section 3(a)(4) of the Exchange Act de nes a broker as any person engaged in the business of e ecting transactions in securities for the account of others. Section 15(a)(1) of the Exchange Act requires brokers and dealers to register as a broker or dealer. The de nition of broker has customarily been interpreted by the SEC as not requiring the issuer itself to register as a broker because the issuer is not e ecting a transaction for the account of others. 5 However, the o cers, directors and employees of an issuer do not bene t from the same interpretation. Rule 3a4-1 is a safe harbor for persons associated with an issuer (i.e., the o cers, directors and employees of the issuer) which allows them to not register under Section 15(a)(1) of the Exchange Act as a broker. Rule 3a4-1 requires that an associated person will only fall within the safe harbor if several criteria are met. In order to qualify under Rule 3a4-1, the associated person: (i) (ii) (iii) cannot be subject to a statutory disquali cation; cannot receive transaction based compensation (i.e. commissions or other compensation that is contingent upon sales) either directly or indirectly on transactions in securities; and cannot be at the time of his or her participation an associated person of a broker or dealer. In addition to complying with (i) through (iii) above, the person must also comply with one of the following: (1) the security must be sold through a registered broker-dealer (or other speci ed person); (2) the associated person (a) primarily performs, or is intended to perform at the end of the o ering, substantial duties for or on behalf of the issuer other than the sale of securities for the issuer, (b) is not, and has not for the prior 12 months, been an associated person of a broker-dealer and (c) does 47

The Real Estate Finance Journal not participate in more than one o ering every 12 months; or (3) the associated person (x) only prepares or delivers written communications through the mail or means that does not include oral solicitation, (y) only responds to inquiries initiated by potential investors which are limited to the contents of the o ering material or (z) only performs administrative work with respect to the transaction. Associated persons that work with a sponsor that conducts only one o ering every 12 months or more may be able to take advantage of Rule 3a4-1 because such persons may be able to meet the requirement set forth in (2) above. The requirements of Rule 3a4-1 will not be easy to meet for persons associated with a sponsor that conducts multiple o erings, unless the transaction is completed through a broker-dealer. In the release proposing Rule 3a4-1, the SEC stated that the safe harbor was not intended to be available to promoters of real estate syndications and other so-called tax sheltered investments that are regularly engaged in actively marketing securities. 6 As a general matter, real estate syndications and tax-shelter investments raise traditional broker-dealer regulation concerns. Even if satis ed, Rule 3a4-1 only provides a safe harbor for federal purposes. Certain states have their own requirements regarding registration as a broker-dealer. In comments to the American Bar Association, David Blass, the Chief Counsel of the SEC discussed a recent case involving the payment of transaction-based fees to a consultant who was not a registered broker or dealer. 7 The fees were paid for actively soliciting investors for private fund investments. The SEC found that the arrangement violated the registration requirements of the Exchange Act. Mr. Blass noted the following items are important in determining whether a person is required to register as a broker-dealer: E One should consider the duties and responsibilities of personnel performing solicitation and marketing e orts. Mr. Blass indicated a dedicated sales force of employees working within in a marketing department may strongly indicate that such persons are in the business of e ecting transactions, regardless of how the personnel are compensated. E One should consider whether employees who solicit investors have other responsibilities and whether the primary responsibility of the employee is to solicit investors. E One should consider how employees who solicit investors are compensated. If the employee receives bonuses or other types of compensation that is linked to successful investments it could be considered transaction-based compensation. E One should consider whether it charges a transaction fee in connection with the sale of the security. JOBS Act Exemption The JOBS Act also required the adoption of the JOBS Act Exemption for the sale of securities. The JOBS Act Exemption provides that no person is subject to registration pursuant to Section 15(a)(1) of the Exchange Act solely because: (A) that person maintains a platform or mechanism that permits the offer, sale, purchase or negotiation of or with respect to securities, or permits general 48

The Uncharted Waters of General Solicitation solicitations, general advertisements or similar or related activities by issuers of such securities, whether online, in person or through any other means; (B) that person or any person associated with that person coinvests in such securities or (C) that person or any person associated with that person provides ancillary services (generally due diligence services) with respect to such securities. On its face, it appears that this provision may eliminate the problem of registration as a broker or dealer for associated persons. However, the JOBS Act Exemption has important limitations, the most signi cant of which is that the person and each person associated with that person must not receive any compensation in connection with the purchase or sale of such securities. The SEC has indicated that the compensation limitation is to be interpreted broadly. This compensation prohibition is not limited to traditional transaction-based compensation (i.e. commissions) but includes any direct or indirect economic bene t to the person or any of its associated persons. This includes salaries paid to employees in marketing or investor relation departments or carried interests or promotes held by the issuer in a fund. The SEC indicated that it believed that the JOBS Act Exemption will have limited practical applicability and it is unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration. 8 The JOBS Act Exemption only provides an exemption from the registration requirements but not does not exempt a person from being considered a broker or dealer who would be subject to certain provisions of the Exchange Act (i.e. anti-fraud provisions, etc.). The JOBS Act Exemption will likely only apply to those persons that provide ancillary services with respect to the sale of securities and who do not get paid with respect to its services in introducing potential investors to sponsors. Recent No Action Letters Related to Broker-Dealer Status Recently, the SEC issued two no action letters that addressed the use of internet solicitation of potential investors in the venture capital context. 9 The facts of the no action letters were similar. The no action letter applicant (the Applicant) was a company that maintained a website that solicited investors to determine investor interest in funding certain venture capital opportunities that had been identi ed by the Applicant. If su cient investor interest was generated, the Applicant would form a fund that would make an investment in the target company (the Private Fund). The issuance of securities in the Private Fund would be made in reliance on Rule 506 of Regulation D. The Applicant became the advisor to the Private Fund and was registered as an investment advisor under the Investment Advisers Act of 1940. The Applicant did not receive any compensation at the time that the investment was made (other than for reimbursement of actual expenses) but received a carried interest in the Private Fund. The SEC noted that because the Applicant received the carried interest in the Private Fund, the JOBS Act Exemption was not available. Even though the JOBS Act Exemption was not available to the Applicant, the SEC found that the Applicant was not required to register as a broker or dealer. The SEC took particular note that neither the Applicant nor any of its associated persons were receiving any transaction-based compensation, the Applicant was a registered investment advisor and the Applicant would have no right to withdraw any deposited funds from the custody accounts established 49

The Real Estate Finance Journal to hold investor money. Thus, the SEC took the position that the Applicant was not a broker or dealer as de ned by the Exchange Act. What Does it All Mean? Issuers, and in particular the persons associated with issuers, must ensure that they do not have to register as a broker or dealer for purposes of the Exchange Act. As discussed above, the traditional exemption provided in Rule 3a4-1 may be di cult for many issuers (and their associated persons) to meet. The JOBS Act Exemption appears to be extremely limited in application because of the prohibition on compensation and the broad interpretation given to that prohibition by the SEC. As a result, it is not practical for issuers and their associated persons to rely on the JOBS Act Exemption. Further, the recent no action letters appear to provide a limited structure under which to sell investments. It is likely that the real estate syndication industry will adjust so that there will be two alternative structures. First, some investors may want to maintain relationships with their registered broker-dealer. As a result, some investors will still be obtained through traditional broker-dealer relationships. However, many investors may not want to incur the additional cost of engaging a broker-dealer. In that case, issuers would be able to use general solicitation and general advertising to attract investors, but the investor would be directed to purchase the investment through a broker-dealer. Assuming that the sales activities occur through the broker-dealer, the issuer and its associated persons would have an exemption from the broker-dealer registration requirements. In this type of arrangement, the registered broker-dealer will likely still need to comply with the requirements imposed by the Financial Industry Regulatory Authority (FINRA), including all of the know your client rules and suitability requirements. 10 Because the broker-dealer will not have a pre-existing relationship with the client, it may be more di cult for the broker-dealer to comply with the FINRA requirements. FINRA rule changes may be required in order for broker-dealers to operate under the new general solicitation provision. Conclusion Lifting the prohibition against general solicitation may provide issuers with direct access to investors that is not currently available. However, the issuers, and the persons associated with the issuer, must be mindful of the Exchange Act and state requirements related to registration as a broker-dealer. Most sponsors that do more than one o ering per year will still need to utilize broker-dealers. However, the roles of the registered broker-dealer, the structure of the transaction and the compensation are likely to change. NOTES: 1 Release No. 33-9415. 2 Release No. 33-9416. 3 Release No. 33-9414. 4 Release No. 33-9416. 5 Release No. 13195. 6 Release No. 34-20943. 7 In the Matter of Ranieri Partners and Donald W. Phillips, SEC Release No. 34-69091. Mr. Blass noted that the Ranieri case is of particular note because the SEC was willing to bring a broker-dealer enforcement action even when there are no allegations of fraud. 8 Jumpstart Our Business Startups Act Frequently Asked Questions About the Exemption from Broker- Dealer Registration in Title II of the JOBs Act, February 5, 2013. 9 FundersClub, Inc. and FundersClub Management 50

The Uncharted Waters of General Solicitation LLC, March 26, 2013; AngelList LLC and AngelList Advisors LC, March 28, 2013. 10 It is likely that, based on the interactions that will be required between the investor and the brokerdealer, the broker-dealer will be deemed to be engaged in more than simply order-taking. As a result, the broker-dealer will likely be deemed to be making a recommendation which requires compliance with the applicable suitability requirements. See, Regulatory Notice 12-25, Regulatory Notice 12-55 and Notice to Members 01-23. 51