The JOBS Act and the Capital Raising Process (General Solicitations, Rule 506, and the Missed Opportunity)

The JOBS Act also required that the Commission amend Regulation D (specifically Rule 502(c)) to provide that the prohibition on general solicitations will not apply to offerings under Rule 506 "provided that all purchasers of the securities are accredited investors."  The exemption shall, however, "require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors."

Of all of the provisions in the JOBS Act designed to promote capital raising, this one has the most potential for success.  Allowing companies to broadly advertise private placements may help locate a larger class of potential investors.  Yet the provision as drafted will be likely not be effective in that regard.

First, the provision oddly is keyed to Rule 506, rather than the statute.  Rule 506 is a safe harbor under Section 4(2), the private placement exemption.  Section 4(2) is used in cases where companies sell to a small number of sophisticated investors or as a backup in case the requirements of Rule 506 are not met.  By allowing general solicitations only for offerings under Rule 506, the exemption in Section 4(2) will become less appealing.  In effect, the cost of obtaining a pass on general solicitations will be the need to adhere to a a higher cost regulatory environment (Rule 506).  So the net result may be more rather than less regulation of a private placement offering.   

Second, the risk of liability associated with the use of the exemption is significantly greater than many other exemptions.  The ability to use a general solicitation is determined not at the time of the solicitation, but at the time the purchases are made.  To the extent a company engages in a general solicitation but sells to unaccredited investors, the exemption under 506 will be unavailable.  Because the fallback, Section 4(2) does not permit a general solicitation, the inapplicability of the exemption will result in a violation of Section 5.   

Third, the JOBS Act also requires companies to "take reasonable steps to verify that purchasers of the securities are accredited investors."  This imposes affirmative obligations on the part of the company using the exemption to ensure the accredited status of the investors.  Moreover, the statute does not state that companies taking these "reasonable steps" will be free from liability should an unaccredited investor actually purchase shares.  In other words, as currently phrased, the requirement that companies take "reasonable steps" is simply another requirement of the statute that, if not done, can result in the unavailability of the exemption.  In those circumstances, the sale to a single unaccredited investor may still result in the unavailability of the exemption.   

Its possible (although the statute does not say it) that Congress intended to allow the use of the exemption where unaccredited investors purchases shares so long as the company took the requisite reasonable steps.  Nonetheless, there will likely be instances where the purchase by an unaccredited investor was deemed "unreasonable" and, as a result of this single investor, the exemption will not be available. 

Fourth, general solicitations may not result in a violation of Section 5 but they can still result in a violation of the antifraud provisions.  Trying to attract investors with a positive message may subsequently be viewed as materially incomplete.  Moreover, to the extent the company is public, the general solicitation will likely be information ultimately conveyed to the market.  The action for fraud would be brought on behalf of all shareholders, not just those who purchased in the private placement. 

It is likely, therefore, that most legitimate issuers will not use the general solicitation authority included in the JOBS Act.  Those promoting fraudulent deals will, however, have no such hesitancy.  Pump-and-dumps and other fraudulent transactions require general solicitations as a mechanism for encouraging investor demand.  Once demand increases, promoters typically sell large blocks of stock into the market.  Eventually, the price collapses but the perpetrator of the fraud has cashed in.  These often occur through spam email. See Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions

Until the JOBS Act, only those purporting to rely on Rule 504 could use general solicitations (the "seed capital" rule permits general solicitations in some circumstances).  The rule had a cap of $1 million and was limited to non-reporting companies.  See Rule 504(a) of Regulation D.  With the JOBS Act, general solicitations relying on Rule 506 can be for unlimited amounts and be used by reporting companies.  Since the validity of a general solicitation under this Rule is determined not at the time of the solicitation, but at the time the shares are purchases, the SEC will have less room to close down a fraudulent deal.  Said another way, the SEC will have to wait until investors have actually been injured before being able to intervene. 

One way to reduce this possibility is to ban recidivists from using Rule 506.  Proposals to do so (as mandated by Dodd Frank) are in the works.  See Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.  Yet the current proposals do not cover all of the participants involved in schemes designed to circumvent the registration requirements. 

Another possibility would have been to allow for certain types of general solicitations.  Prohibiting the use of spam email, for example, would not be likely to harm legitimate businesses, but would probably make it harder for those committing fraud.  Nonetheless, such a refinement does not appear in the JOBS Act.  

J Robert Brown Jr.