General Solicitation under Rule 506

[written before Reg D 506(c) adopted]

The small business raises all the capital it can from friends, relatives, and everyone it knows who has money. In order to expand its fundraising to new potential investors, it hires a securities lawyer. Then the small business learns the bad news: It cannot raise money from anyone with whom it does not have a substantial pre-existing relationship. Otherwise it will violate the prohibition against general solicitation.

History of the Rule

Section 4(2) of the Securities Act of 1933, as amended (“1933 Act”) exempts from registration transactions by an issuer not involving a “public offering.” In 1935, (Securities Act Release No. 33-285), the SEC defined no public offerings in terms of an offering to a defined group of offerees. The number of the offerees and their relationship to each other and the issuer. It held “an offering to a given number of persons chosen from the general public on the ground that they are possible purchasers may be a public offering even though an offering to a larger number of persons who are all members of a particular class, membership in which may be determined by the application of some preexisting standard, would be a non-public offering.” Several courts adopted the language of this Release to define the Section 4(2) exemption.

In Securities and Exchange Commission v. Sunbeam Gold Mines Co., 95 F.2d 699, 701 (9th Cir. 1938), the court stated:

[A]n offering of securities to all residents of Chicago or San Francisco, to all existing stockholders of the General Motors Corporation or the American Telephone & Telegraph Company, is no less “public,” in every realistic sense of the word, than an unrestricted offering to the world at large. Such an offering, though not open to everyone who may choose to apply, is nonetheless ‘public’ in character, for the means used to select the particular individuals to whom the offering is to be made bear no sensible relation to the purposes for which the selection is made.

As a result of this thinking, the SEC emphasized the number of offerees setting the arbitrary figure of 25 as a test of whether an offer was public. This numerical limit prevented general solicitation. In Securities and Exchange Commission v. Ralston, Purina Co., 346 U.S. 119 (1953), the Supreme Court explicitly rejected the SEC’s claim that a numerical test of 25 offerees should govern and rejected the SEC’s contention that the number of offerees was the critical factor. The Court held:

We are advised that “whatever the special circumstances, the Commission has consistently interpreted the exemption as being inapplicable when a large number of offerees is involved.” But the statute would seem to apply to a “public offering,” whether to few or many. It may well be that offerings to a substantial number of persons would rarely be exempt. Indeed, nothing prevents the Commission, in enforcing the statute, from using some kind of numerical test in deciding when to investigate particular exemption claims. But there is no warrant for superimposing a quantity limit on private offerings as a matter of statutory interpretation . . . .

“No particular numbers are prescribed. Anything from two to infinity may serve: perhaps even one . . . .”1Id. at 125 and n.11

Instead of relying on the number of individuals involved, the Court stated that application of the exemption “should turn on whether the particular class of persons affected needs the protection of the Act” or whether such persons are able “to fend for themselves.”2Id. at 124-25 The chief problem with general solicitation is that it may in fact reach some persons who do need the protection of the 1933 Act because they lack access to the kind of information registration ordinarily provides.

In 1974, the SEC adopted Rule 146 as a nonexclusive means of establishing compliance with Section 4(2). The rule limited offerees to 35. General solicitation and general advertising were prohibited and issuers were required to pre-screen offerees and evaluate their financial condition and “sophistication.”

In 1980, the ground work for Regulation D was raised by the Small Business Development Act which authorized the SEC to exempt from registration offerings up to $5 million. In 1982, Rule 146 was superseded by Regulation D. “General solicitation” and “general advertising” continued to be bared without a least an underlying state registration.

General Solicitation under Rule 506 Defined

“General solicitation” or “general advertising” are undefined in the statutes or rules. Instead, the Securities and Exchange Commission (SEC) takes a case by case approach. Rule 502(c) prohibits:

  1. any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television and radio; and
  2. any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”

In no action letters, the SEC has stressed the importance of the existence and substance of a “pre-existing relationship” with potential investors as a key indicator of determining if a communication is a “general solicitation” or constitutes “general advertising.” According to the SEC, the presence of a pre-existing relationship between an issuer and a potential investor is strong evidence that general solicitation or general advertisement has not occurred. The SEC declined to take enforcement action against issuers for any of the following actions:

  1. Submitting a generic questionnaire to investors during the fundraising period, provided that the questionnaire did not specify or promote a particular investment, but simply questioned the suitability of potential investors. These investors cannot participate in any pending offering.
  2. Providing password protected information on the Internet to potential investors who had already been determined by the issuer to qualify as accredited or sophisticated investors.
  3. Speaking (including an interview to the media about a company so long as the discussion is generic in nature and does not reference any investment currently offered or contemplated.
  4. Discussing a company or new product as long as no current funding initiatives or historical investment results are mentioned.

On the other hand, the SEC has indicated that it believes that the following actions violate Rule 502(c):

  1. Mass mailings
  2. Speaking to the media about a solicitation when funding or investment matters are discussed, whether such speech is directed at current fundraising efforts or deemed to be an attempt to “condition the market” by making reference to the success or attractive return of previous investments.
  3. Print, radio and television advertisements or solicitations regarding funding or investment matters
  4. Tombstone advertising (an ad which does no more than give the barest of information) is held by SEC staff to “condition the market” for the securities and therefore constituted an offer even though the tombstone did not specifically mention the transaction in question.

Is a mass mailing to venture capitalists general advertising or solicitation? The SEC has not ruled.

So what is general solicitation and general advertising? Taken together, the no-action letters indicate a staff view that general solicitation does not occur when the solicitor and his targets have a nexus: as the SEC puts it, a “substantial preexisting” relationship. It is assumed by many that vicarious relationships qualify. Presumably, your lawyer, accountant, banker, as well as officers, directors, and management level employees can make the material available to potential purchasers with whom they are acquainted. There is so much uncertainty that no one can say for certain if the offering has qualified for an exemption.

Record Keeping

Keep careful records. The issuer has the burden of proving compliance with the exemption.

Proposals for Reform

Since the mid-1980s, there have been several solutions proposed including a finder broker-dealer, licensing investors, and permitting general solicitation of accredited investors. All have been rejected as a result of a deep-seated bias against any softening of the line between public and private offerings. The SEC staff has been generally unsympathetic to the proposals. Most are young inexperienced lawyers and accountants or hardened bureaucrats.

Several proposals are under consideration each year. Hope springs eternal.

Risks

Many entrepreneurs violate the prohibition against general solicitation (at least technically) because they do not have a substantial pre-existing relationship will all the investors in the venture. Often federal rules against commissions and finders’ fees are violated. Typically the SEC takes no enforcement action.

The primary risk is not SEC enforcement, but loss of the private placement exemption through less than strict compliance with the rules of the exemption. General Solicitation is not protected by the substantial compliance safe harbor of Regulation D.

Without an exemption, the issuer, salespeople, officers, directors, and agents may be personally liable to the investor. The investor can recover the principal, interest, and attorney fees.

The Jumpstart Our Business Startups Act or JOBS Act of April 2012 was intended to encourage funding of United States small businesses by easing various securities regulations. It passed with bipartisan support. The law provides that general solicitation does not make the offering a “public offering” under federal law. The SEC did not adopt the rule providing exceptions to the General Solicitation for Regulation D 506 (c) until July of 2013. It overturned 80 years of regulatory restriction. There are more opportunities for small business funding in the United States than ever before.

General Solicitation in Unregistered Offerings

General solicitation is allowed if all purchasers are “accredited investors” as defined in Reg D 501, and reasonable steps are taken to verify the accreditation of the investors. In addition, the Form D must be filed at least 15 days before any general solicitation.

There are no limitations on the form of the general solicitations. Any media may be used. Press releases and interviews are not limited.

Regulation D 506 offerings are “covered securities” and state law registration requirements are preempted. States may (and usually do) require filings and the payment of a fee but cannot prohibit the general solicitation of investors in their states.

Disqualifying Events

The “disqualifying events” under Rule 506(d) are:

  • Criminal convictions in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities) within ten years before the sale of securities (or five years, in the case of issuers, their predecessors and affiliated issuers);
  • Court orders, judgments or decrees (in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities) entered within five years before the sale, that, at the time of the sale, restrains or enjoins such person from engaging or continuing to engage in such conduct or practice;
  • Final orders of certain state regulators (such as state securities, banking and insurance regulators) and federal regulators, including the CFTC, (if the order is based on fraudulent, manipulative or deceptive conduct, there is a ten year look-back; if the order bars a covered person from engaging in specified activities, the order would be disqualifying for as long as the bar was in effect);
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons for so long as such orders are in effect;
  • SEC cease-and-desist orders relating to violations of certain anti-fraud provisions and registration requirements of the federal securities laws entered within five years before such sale;
  • Suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization for the duration of the suspension or expulsion;
  • SEC stop orders and orders suspending a Regulation A exemption issued within five years before such sale; and
  • U.S. Postal Service false representation orders entered within five years before such sale.

Disqualification of Bad Actors

Rule 506 (d) identifies the disqualified bad actors (“covered persons”) in the following categories:

  • The issuer and any predecessor of the issuer or affiliated issuer;
  • Any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
  • any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • Any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;
  • Any “promoter” connected with the issuer in any capacity at the time of the sale;
  • Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering (referred to as a “compensated solicitor”); and
  • Any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.

The determination of which officers participated in an offering is a question of fact but it is more than transitory or incidental involvement It could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

Reasonable Care Exemption

An issuer will not lose the Rule 506 safe harbor, despite the existence of a disqualifying event, if the issuer can show that it did not know and, in the exercise of “reasonable care,” could not have known of the disqualification. For continuous, delayed or long-lived offerings (such as those conducted by hedge funds and private equity funds), reasonable care includes updating the factual inquiry on a reasonable basis. The frequency and degree of updating will depend on the circumstances of the issuer, the offering and the participants involved, but in the absence of facts indicating that closer monitoring would be required (i.e., notice that a covered person is the subject of a judicial or regulatory proceeding), the SEC expects that periodic updating could be sufficient which could be through contractual covenants from covered persons to provide bring-down of representations, questionnaires and certifications, negative consent letters, periodic rechecking of public databases, and other steps, depending on the circumstances.

Waiver of Disqualification

The SEC’s Director of the Division of Corporation Finance may grant a waiver if he or she determines that the issuer has shown good cause that it is not necessary under the circumstances that the registration exemption be denied.

Disqualification will not arise if a state court or regulatory authority enters an order, judgment or decree; and advises in writing that disqualification under Rule 506 should not result.

 

Footnotes

1. Id. at 125 and n.11
2. Id. at 124-25

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