Regulations undermine JOBS Act for startup investors

The Jumpstart Our Business Startups Act became law on April 5, 2012, intended to increase jobs by making it easier for business startups to raise money to grow and expand operations.

Title II of the Act directed the Securities and Exchange Commission to issue regulations lifting the ban on general solicitations or general advertising in private placements conducted under Rule 506 of the Commission’s Regulation D as long as all purchasers of the securities are accredited investors. The Act also directed the Commission to adopt rules that “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors …” While the Act imposes no restriction on whom an issuer may solicit to purchase securities, it does impose restrictions by requiring the issuer to take reasonable steps to verify that all purchasers are accredited investors.

The definition of an accredited investor remains unchanged. Under Regulation D, a individual is an accredited investor if: (a) the person has an individual net worth, or combined net worth with the person’s spouse, that exceeds $1 million at the time of the purchase (excluding the person’s primary residence); or (b) the person has income exceeding $200,000 in each of the two most recent years or combined income with his or her spouse exceeding $300,000 for those years and a reasonable expectation of the same level in the current year.

On July 10, 2013, the SEC adopted new rules eliminating the ban on the use of general solicitations or general advertising in private placements conducted under new paragraph (c) of Rule 506. The rule requires the issuer to take reasonable steps to verify that purchasers of its securities sold in any offering using Rule 506(c) are accredited investors and provides a non-exclusive, non-mandatory list of methods that issuers may use to satisfy the verification requirement, absent knowledge that such person is not an accredited investor.

Methods listed include: (1) to verify income, reviewing copies of any IRS form that reports the purchaser’s income and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the necessary income in the current year; (2) to verify net worth, reviewing bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties and a consumer report from at least one of the nationwide consumer reporting agencies; and (3) receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or CPA that such entity or person has taken reasonable steps to verify the accredited status.

Historically, issuers in Rule 506 offerings have verified through a questionnaire in which the investor self-certifies his or her status. The new rules do not change Rule 506 offerings conducted without general solicitation of advertising, which may continue without being subject to verification requirements.

The new rules do not change Rule 506 offerings that are conducted without general solicitation of advertising.

The rules also amend Form D by adding a separate box to check if the issuer is claiming the new Rule 506(c) permitting general solicitation or general advertising. In addition, the SEC has proposed amendments to require filing an initial Form D no later than 15 calendar days prior to the first use of general solicitation or general advertising in a Rule 506 offering (instead on the current 15 days after the first sale), require the filing of a closing Form D amendment within 30 calendar days after a termination of a Rule 506 offering, require that certain legends and other disclosures be included in written general solicitation materials used in Rule 506(c) offerings, require temporary submission of written general solicitation materials used in Rule 506(c) offerings, and disqualify an issuer from relying on Rule 506 for one year if the issuer, or any predecessor or affiliate, failed to comply, within the last five years, with Form D filing requirements.

The new verification methods for an offering using general solicitation or advertising and the proposed amendments will likely lessen the utility of this portion of the Act because many investors will be unwilling to supply personal financial information, such as tax returns, bank statements or other documents, and many issuers may not want to risk being disqualified from raising additional funds for one year under the proposed amendments due to an inadvertent violation of the new rules.

As a result, many Rule 506 offerings will likely continue until further guidance or change without general solicitation or general advertising in the same manner as before adoption of the new rule.

Gerald H. Hansen is an attorney with Stinar & Zendejas LLC, a full-service business and estate planning firm. More information at www.coloradolawgroup.com or call 719-635-4200.