September 2013 marked the beginning of a new era for capital formation and entrepreneurship in the United States. Under the new Rule 506(c) of Regulation D—a product of the JOBS Act of 2012—companies have the unprecedented opportunity to raise unlimited capital through the use of general solicitation, marketing, public advertising, and social media networking. Yet, over six months later, the number of Rule 506(c) offerings to hit the street have been relatively few and far between. Since September, only one in 10 companies surveyed indicate they plan to utilize the new exemption, according to a recent report in Fortune.
The reluctance of the alternative investment community to quickly embrace this new opportunity is somewhat surprising, considering the benefits offered by the new rule. Specifically, a company can accomplish the following under a Rule 506(c) offering: (i) raise an unlimited amount of money, (ii) from an unlimited number of accredited investors, (iii) with no federal or state registration (only a notice filing on Form D), (iv) with no specific disclosure requirements (other than applicable anti-fraud rules), and (v) with the ability to freely advertise, market, and promote the offering to the public.
Why the reluctance to jump on the Rule 506(c) bandwagon? There are several plausible reasons, starting with two of the conditions to the new safe-harbor exemption. First, all purchasers in a Rule 506(c) offering must be accredited investors (or the issuer reasonably believes they are all accredited investors at the time of investment…a subtle but important point in this context). Who or what counts as an “accredited investor” is defined under Rule 501(a) of Regulation D. For some sponsors, this limitation is a non-starter. There are, after all, fewer than 10 million accredited investors in the U.S. according to published reports from the SEC and GAO, and some sponsors feel they need to reach a larger investor audience to achieve their goals.
Second, under the new Rule 506(c), an issuer must take “reasonable steps to verify” that all purchasers are accredited investors. The SEC declined to provide uniform procedures for issuers to follow to satisfy this requirement, opting for a principles-based approach. However, Rule 506(c) does list four methods that will be considered reasonable ways to verify the accredited investor status of a natural person (so long as the issuer does not have knowledge that such person is not an accredited investor). Industry groups, such as the Angel Capital Association, have quickly stepped in to publish additional guidance to help issuers better understand and comply with this new requirement.
Despite this guidance–and the practical reality that most Reg. D issuers sponsoring Rule 506, accredited-only programs have been verifying accredited investor status for years (in some form or another)–there seems to be significant confusion and discomfort with this new requirement and how to comply with it. Sponsors and registered representatives are reluctant to ask potential investors for too much personal financial information. Others are equally reluctant to incur added risk of liability by providing third-party certification of accredited investor status. For sponsors, fear of a blown exemption stemming from a non-accredited investor slipping through the cracks and being second-guessed on whether reasonable steps have been taken to verify an investor’s status as accredited appears to be a concern.
A related concern is the risk that an issuer that relies on Rule 506(c) but discovers an inadvertent violation during the course of an offering will not be able to fall back on another exemption under Regulation D or any other available exemption. Such a scenario would arguably require the issuer to stop the current offering and start from scratch at least six months later to avoid the risk of a new offering being integrated with—and tainted from—the defective Rule 506(c) offering.
A fourth reason for the tepid response to the new rule is that the primary beneficiaries of Rule 506(c) are arguably startups, new sponsors, and smaller companies that lack the resources and infrastructure to comply with it. Conversely, more experienced Reg. D sponsors already have established broker-dealer selling groups and investor databases and, therefore, do not feel they need to publicly advertise their programs to raise capital. Furthermore, sponsors may not want to risk alienating their existing selling group by marketing and selling directly to investors.
A fifth concern relates to current regulatory uncertainty. Almost as soon as the new Rule 506(c) became effective, the SEC proposed additional rules designed to better protect investors and impose more obligations on Rule 506(c) issuers, such as filing advertising materials in advance for regulatory review. If such proposed rules are adopted, Rule 506(c) will be a less attractive option. This uncertainty has caused some to adopt a “wait and see” approach to Rule 506(c).
Another concern relates to the type of investor likely to respond to a general solicitation. Sponsors desperate to raise capital might be willing to accept anyone with money to invest. An accredited investor is not necessarily a desirable investor. Qualifying potential investors who are products of a mass marketing campaign could prove to be challenging from an administrative and compliance perspective, and disastrous from a long-term strategic perspective.
Finally, there is a natural reluctance to deviate from the status quo. For all the bravado and entrepreneurship espoused throughout the industry, most are reluctant to be innovators and advocates of significant change. Kudos to The Walton Group and Nelson Brothers Professional Real Estate for being among the first to promote Rule 506(c) offerings. So long as the industry promotes greater education, awareness, and compliance with the new rule, the above-stated concerns should dissipate in the coming years as Rule 506(c) gains wider acceptance among sponsors and investors.