Since the newest Regulation D safe-harbor exemption went into effect in September 2013, there have been wide-ranging reports as to how the alternative investment market is responding to this new opportunity to raise capital. The alternative investment industry has spent much of 2014 comparing these conflicting reports, awaiting updates from the SEC on proposed rules that could materially impact the attractiveness of Rule 506(c), and assessing different options for complying with various requirements of the new exemption, such as the requirement to verify accredited investor status of all purchasers. Here are a few highlights:
1. Registry of Accredited Investors Report. A report released in February 2014 by the Registry of Accredited Investors estimated that over 700 issuers had raised approximately $500 million through Rule 506(c) offerings during the first 5-6 months of the rule’s adoption. A majority of these companies were in their first year of existence and trying to raise relatively small amounts of capital (40% were trying to raise less than $1.5 million). Only 25% of these companies reported selling their securities through an intermediary. Most of the issuers were concentrated in California, Texas, New York, and Florida.
2. Dealflow.com Activity Report. Dealflow.com provided a significantly different picture of Rule 506(c) during that same time period. It published data suggesting that $4.2 billion had been raised under Rule 506(c). Several explanations have been offered for the discrepancy, including that the larger number includes money raised by non-operating pooled investment vehicles while the Registry of Accredited Investors Report reflects data only for operating companies. To put these numbers in context, the SEC in recent years has estimated that companies are raising approximately $900 billion annually through Reg. D private offerings (the overwhelming majority of which is raised under Rule 506).
3. Accredited Investor Standard. There are eight different categories of accredited investor. For individual investors, the analysis typically boils down to the net worth threshold of Rule 501(a)(5) (an individual with a net worth of at least $1 million) or the annual income threshold of Rule 501(a)(6) (an individual who has earned annual income in excess of $200,000 (or $300,000 joint income with his or her spouse) during each of the last two years and has a reasonable expectation of reaching the same income level in the current year. These standards were first adopted in 1982 and remained unchanged for 30 years. The SEC proposed rules in 2007 that would have created a new category of accredited investor (creatively called a “large accredited investor”) and would have also have updated the net worth and annual income thresholds by providing for future increases that would be indexed to inflation. Those proposed rules never came to pass, but Rule 501(a)(5) was materially changed in 2010 by virtue of the Dodd-Frank Act such that the value of an individual’s primary residence is no longer included in calculating his or her net worth under Rule 501(a)(5). The Dodd-Frank Act also mandated that the GAO conduct a study regarding the accredited investor standards to better understand whether the existing criteria serves its intended purpose or if other criteria should be considered. The GAO report was released in 2013 and recommended that the SEC consider alternative criteria for accredited investor standards, including (i) a minimum amount of liquid investments and (ii) a working relationship with a registered investment adviser. The SEC is due to complete a review of the accredited investor standards this year to assess whether any adjustments are needed (Dodd-Frank requires the SEC to do this every four years).
4. Accredited Investor Verification. One of the requirements under Rule 506(c) is that an issuer take reasonable steps to verify the accredited investor status of every investor. The SEC offered no bright line rule as to how a company can definitively meet this obligation, but instead adopted a “principles-based approach” and offered four safe-harbor verification methods to offer some level of guidance. These suggested methods include: reviewing investor tax returns and other financial records (e.g., bank and brokerage statements, tax assessments, appraisal reports, and credit reports), obtaining written representations from the investor in conjunction with tax and financial document review, or obtaining written certification from certain third parties (e.g., a registered broker-dealer, attorney, SEC-registered investment adviser, or certified public accountant). If an issuer has existing relationships with accredited investors from prior Rule 506 offerings, then under certain circumstances the issuer can rely on a simple written certification from the investor. A number of third-party service companies have quickly stepped in to offer investor verification services to help issuers comply with this requirement, while other industry professionals have expressed reluctance to incur the risk and administrative burdens associated with this process.
5. NASAA Blue Sky Filing Project. NASAA is scheduled to debut its much-anticipated EFD system later this year that will provide Rule 506 issuers with a one stop shop for all of its Form D blue sky notice filings with the states. Depending on the early success of the EFD system, it might in the future be expanded beyond Rule 506 offerings to other types of programs.
6. Proposed Amendments to Regulation D. Just when the new Rule 506(c) went effective, the SEC proposed several amendments to Regulation D. These rules have not yet been finalized and the public comment period reflected the predictable mix of investor advocates calling for more regulation and greater investor protections and free enterprise proponents who argue just as passionately that less regulation is needed to facilitate capital formation and investment. One thing is certain—if the proposed amendments are adopted, Rule 506(c) will be less attractive to issuers due to the added compliance burdens, cost, restrictions, and risk. The proposed amendments would most directly affect Rule 506(c) offerings and would require, among other things, prominent legends on all advertising material, filing requirements for all advertising material, an earlier deadline for filing Form D, a new requirement to file a “final” Form D within 30 days following the termination of an offering, and certain additional disclosure items on Form D.