by Chris Maxwell and Romeen Sheth

1. What are the two new rules the SEC adopted last week?

On July 10, 2013 the SEC (1) eliminated the prohibition on general solicitation and advertisement for securities offerings in which an issuer may privately raise an unlimited amount of capital from an unlimited number of accredited investors and up to 35 non-accredited investors and (2) adopted a rule to disqualify felons and other “bad actors” from participating in such securities offerings.

The elimination of the general ban on solicitation and advertisement fundamentally changes the way private offerings have been conducted to date and the broader investment landscape. New avenues for raising capital will increase individuals’ access to capital markets and increase interaction between entrepreneurs and investors.

2. When do the new rules go into effect?

The new SEC rules will go into effect 60 days after their publication in the Federal Registrar. This date is currently estimated to be sometime in September 2013.

3. Who is an accredited investor?

Under SEC rules, an accredited investor is an individual who has either an individual net worth or joint net worth with a spouse that exceeds $1 million at the time of the purchase of the security, excluding the value (and any related indebtedness) of a primary residence; or an individual with annual income that exceeded $200,000 in each of the two most recent years or a joint annual income with his or her spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year.

4. What does eliminating the prohibition on general solicitation and advertisement entail?

The new SEC rule permits issuers to use general solicitation and general advertisement to offer their private securities provided that all purchasers of the securities are accredited investors under current SEC rules or the issuer reasonably believes that the investor will be an accredited investor at the time of the sale of the securities.

The final rule also mandates that issuers check a separate box on the already existing notice they file with the SEC claiming they used general solicitation or general advertisement to sell the securities.

5. What reasonable steps do issuers who use general solicitation and advertisements need to take to verify the investor is accredited?

The SEC states, broadly, that an issuer is required to consider the facts and circumstances of each purchaser and transaction. The rule provides a non-exclusive and non-mandatory list of suggestions that issuers may use to satisfy the verification requirement. Other methods to satisfy the verification requirement are also permitted; whether or not they are satisfactory are judged on a case by case basis. Example verification methods described in the rule include:

• Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.
• Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser’s accredited status.

6. What new steps do issuers need to take if they are conducting offerings without the use of general solicitation or advertisement?

Offerings that do not use general solicitation or general advertisement are not affected by the new rule. Issuers raising capital without the use of general solicitation or general advertisement can continue to conduct securities offerings in the same manner – by relying on purchaser self-verification – and are not subject to the new verification rule.

7. Who are the “bad actors” and felons disqualified from participating in these securities offerings?

Under the new rule, any “covered” person who had significant disciplinary events – such as criminal convictions, court injunctions, restraining orders, certain types of suspensions and bars from securities self-regulatory organizations, certain SEC disciplinary and cease-and-desist orders – cannot avail themselves of securities offerings in which an issuer privately raises capital.
Examples of covered persons include:

• The issuer, including any predecessor of the issuer and any affiliated issuer;
• Directors, executive officers, other officers participating in the offering, general partners or managing members of the issuer;
• Any director, executive officer or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of any such investment manager or solicitor.

The disqualification provisions will apply only to events that occur after the new rule is adopted. If a disqualification provision occurred prior to the new rule’s adoption, only a disclosure is required.

8. What are the potential advantages of the elimination of the general solicitation and advertisement ban?

Proponents of the elimination of the solicitation and advertising ban point to the potential to broaden the investor community and increase capital activity as the primary benefit of the new rule. The belief is that startups, entrepreneurs, and investors will now have access to one another like they have never had before and that the playing field for entrepreneurs that do not have extensive relationships with angel investors and VC firms could be leveled.

9. What are the potential disadvantages of the elimination of the general solicitation and advertisement ban?

The general fear behind the elimination of the solicitation and advertising ban is that it will lead to an increase in fraud in connection with such offerings. In his vote against the rule, one SEC Commissioner noted his concern in reduced transparency and investor protection. His belief is that easing disclosure requirements and capital markets regulations will impede capital formation, as individuals will be more reluctant to invest their money out of fear of fraud.

Further, the Angel Capital Association (ACA) – the leading professional and trade association for angel investors supporting high-growth early stage ventures – believes the new requirement for investors to disclose personal information in order to meet the new accredited investor verification standards could face serious resistance in the angel community due to the privacy concerns of investors not wanting to share sensitive financial information with multiple companies in which they invest. The ACA notes that the violation of privacy angels would feel from this heightened threshold could lead to diminished angel involvement in high-growth early stage ventures.

10. What is on the horizon?

Whether the new rules will be beneficial to investors, entrepreneurs, and the economy at large will ultimately depend on the balance between multiple factors including, but not limited to, (1) how many new offerings will result because of the elimination of the general solicitation and advertising ban, (2) how much more fraud will occur because of the new rules, and (3) what will the scope (in $ amount) of such fraud be.

In tandem with the adoption of the two new rules, the SEC issued a proposal detailing several measures that will track the effect of the elimination of prohibition on general solicitation and advertisement on the market. This proposal has just entered a 60 day comment period.

This information is presented for educational purposes and is not intended to constitute legal advice; see disclaimer here. Contact Chris Maxwell for more information at cmaxwell@mmmlaw.com.