The JOBS Act Title II and Regulation D

By Stuart Ober, CFE, AIFA^(R)

The Jumpstart Our Business Startups Act (“JOBS Act”) was signed into law on April 5, 2012, with the purpose of stimulating capital formation for small businesses by easing regulations and access to capital markets.[1] [2]  The JOBS Act has been said to be the “twenty-first century response”[3] to the Securities Act of 1933 (“Securities Act”) which was enacted 80 years earlier in the midst of the Great Depression.  Proposed after the financial crisis of 2008, the Great Recession, the JOBS Act was one of a number of solutions Congress enacted to spur the economy.

With the digital age and advent of the Internet, a more updated approach to raising capital by small companies was needed.  On September 23, 2013, the U.S. Securities and Exchange Commission (“SEC”) enacted a new rule to implement Title II of the JOBS Act requirement to lift the ban on general solicitation and general advertising for private securities offerings relying on Regulation D[4] Rule 506, provided that sales are limited to accredited investors, and that issuers[5] take reasonable steps to verify that all purchasers are accredited investors.

This allowed small businesses to find investors and raise funding for their companies publicly – using social media and the Internet, but with restrictions, according to the SEC, that “require the issuer to take reasonable steps to verity that purchasers of the securities are accredited investors.”[6]  There are no restrictions on who a company can solicit, but the company has restrictions on who is permitted to buy the securities.

Who are Individual Accredited Investors? 

An individual accredited investor is defined as:

• An individual with a net worth of at least $1 million, exclusive of the value of his or her primary residence,
• An individual with income exceeding $200,000 or joint spousal income exceeding $300,000 in the two most recent calendar years and a reasonable expectation in the current year of the same income level.[7] [8]

Prior to Title II, “going public,” or being a public company, for a company was limited to large and mature companies, primarily because going public was expensive and time-consuming.   Issuers had two options for raising capital: (1) through publicly registering their securities with the SEC or (2) through private placements, such as under SEC Regulation D, relying upon an exemption from registration for small issuers.  General solicitation and advertising were forbidden under the law for small companies who raised funds through private placements under Regulation D.

Background Regarding Private Placements

What is a private placement?

According to the SEC, a securities offering exempt from registration with the SEC is sometimes referred to as a private placement or an unregistered offering.  Under the federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available.[9]  Such an exception is found under SEC Regulation D, which, before Title II, established three exemptions from registration.

What is Regulation D?

Regulation D under the Securities Act provides a number of exemptions from the registration requirements, allowing issuers to raise capital without having to register their securities with the SEC.   Prior to Title II, Regulation D included three SEC rules—Rules 504, 505 and 506—that issuers often relied upon to sell securities in unregistered offerings. 

Rule 504

Past:  Rule 504 permitted certain issuers to offer and sell up to $1 million of securities in any 12-month period.  These securities may be sold to any number and type of investor, and the issuer is not subject to specific disclosure requirements.  Generally, securities issued under Rule 504 will be restricted securities,[10] unless the offering meets certain additional requirements.[11] 

Current:  Rule 504 has been changed and now permits the offer and sale of up to $5 million of securities. 

In general, issuers relying on Rule 504 may not use general solicitation or advertising to market the securities and purchasers will receive restricted securities. Investors in such offerings should be informed that they may not be able to sell the securities for at least a year unless the issuer registers the resale transaction with the Commission.

However, general solicitation and advertising are permitted and investors receive non-restricted securities, if the issuer offers and sells the securities as follows:

• exclusively under one or more state laws that require registration, public filing and delivery to investors of a substantive disclosure document before sale;
• in one or more states that do not have a provision requiring registration, public filing and delivery of a disclosure document before sale, so long as: the securities have been registered in at least one other state that provides for such registration, public filing and delivery before sale;  the issuer offers and sells securities in that other state under those provisions; and the issuer delivers to all purchasers in any state the disclosure documents mandated by the state in which it registered the securities; or

• exclusively in a state according to an exemption in such state that permits general solicitation and advertising, so long as sales are made only to “accredited investors.”[12]

Rule 505

Past:  Under Rule 505, issuers may offer and sell up to $5 million of their securities in any 12-month period.  There are limits on the types of investors who may purchase the securities.  The issuer may sell to an unlimited number of accredited investors, but to no more than 35 non-accredited investors, who were not required to be sophisticated.  If the issuer sells its securities to non-accredited investors, the issuer must disclose certain information about itself, including its financial statements.  If sales are made only to accredited investors, the issuer has discretion as to what to disclose to investors.  Any information provided to accredited investors must be provided to non-accredited investors.[13]

Current:  Rule 505 was repealed by the Commission on October 26, 2016, with the repeal being effective on May 22, 2017.[14]

Rule 506

Past:  There was only the Rule 506, with no general solicitation or advertising, an unlimited number of accredited investors and 35 non-accredited sophisticated investors, and restricted securities.

Current:  The JOBS Act required the SEC to adopt rules amending existing exemptions from registration under the Securities Act of 1933 and to create new exemptions that permit issuers of securities to raise capital without SEC registration.  On July 10, 2013, the SEC adopted amendments to Rule 506 of Regulation D to implement the requirements of Section 201(a) of the JOBS Act.  The amendments were effective on September 23, 2013.[15]   

Regulation D Rule 506 Becomes Two Rules:  Rule 506(b) and Rule 506(c)

As a result of the implementation of the requirements of the JOBS Act, Regulation D Rule 506 was divided into two Rules:  Rule 506(b) and 506(c). 

The SEC preserved in Rule 506(b), the existing ability of issuers to conduct Rule 506 offerings subject to the prohibition against general solicitation.[16]   Rule 506(b) retained the characteristics of Rule 506.  

An unlimited amount of money could be raised in offerings relying on either Rule 506 exemptions:  Rule 506(b) or Rule 506(c). 

Regulation D Private Placement Rule 506(b)

Regulation D Rule 506(b) remains unchanged from Rule 506 following the adoption of Rule 506(c) and continues to be available for issuers that wish to conduct a Rule 506 offering without the use of general solicitation or that do not wish to limit sales of securities in the offering to accredited investors.[17]

Rule 506(b) provides objective standards that a company can rely on to meet the requirements of the Section 4(a)(2) exemption. Companies conducting an offering under Rule 506(b) can raise an unlimited amount of money and can sell securities to an unlimited number of accredited investors. An offering under Rule 506(b), however, is subject to the following requirements:

• no general solicitation or advertising to market the securities,^[18] and
• securities may not be sold to more than 35 non-accredited investors (all non-accredited investors, either alone or with a purchaser representative,[19] must meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment, i.e., be sophisticated).

If non-accredited investors are participating in the offering, the company conducting the offering:

• must give any non-accredited investors disclosure documents that generally contain the same type of information as provided in registered offerings (the company is not required to provide specified disclosure documents to accredited investors, but, if it does provide information to accredited investors, it must also make this information available to the non-accredited investors as well);
• must give any non-accredited investors financial statement information specified in Rule 506; and
• should be available to answer questions from prospective purchasers who are non-accredited investors.

Purchasers in a Rule 506(b) offering receive “restricted securities." A company is required to file a notice with the Commission on Form D within 15 days after the first sale of securities in the offering.  Although the Securities Act provides a federal preemption from state registration and qualification under Rule 506(b), the states still have authority to require notice filings and collect state fees.

Rule 506(b) of Regulation D is considered a “safe harbor” under Section 4(a)(2), which is known as the private placement exemption.[20] [21]  Section 4(a)(2) of the Securities Act exempts from registration transactions by an issuer not involving any public offering. 

Regulation D Rule 506(c)

Section 201(a) of the JOBS Act required the SEC to eliminate the prohibition on using general solicitation under Rule 506 where all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors. The SEC adopted paragraph (c) of Rule 506 to implement Section 201(a).

Under Rule 506(c), issuers can offer securities through means of general solicitation, provided that:

• all purchasers in the offering are accredited investors, and  
• the issuer takes reasonable steps to verify their accredited investor status.[22]

The JOBS Act requires that issuers wishing to engage in general solicitation take “reasonable steps” to verify the accredited investor status of purchasers.  Rule 506(c) sets forth a principles-based method of verification which requires an objective determination by the issuer (or those acting on its behalf) as to whether the steps taken are “reasonable” in the context of the particular facts and circumstances of each purchaser and transaction.  Among the factors that an issuer should consider under this principles-based method are:

• the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
   
• the amount and type of information that the issuer has about the purchaser; and
   
• the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

In addition to this flexible, principles-based method, Rule 506(c) includes a non-exclusive list of verification methods that issuers may use, but are not required to use, when seeking greater certainty that they satisfy the verification requirement with respect to natural person purchasers.  This non-exclusive list of verification methods consists of:

• verification based on income, by reviewing copies of any Internal Revenue Service form that reports income, such as Form W-2, Form 1099, Schedule K-1 of Form 1065, and a filed Form 1040;
   
• verification on net worth, by reviewing specific types of documentation dated within the prior three months, such as bank statements, brokerage statements, certificates of deposit, tax assessments and a credit report from at least one of the nationwide consumer reporting agencies, and obtaining a written representation from the investor;
   
• a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant stating that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the last three months and has determined that such purchaser is an accredited investor; and
   
• a method for verifying the accredited investor status of persons who had invested in the issuer’s Rule 506(b) offering as an accredited investor before September 23, 2013 and remain investors of the issuer.[23]

Conditions in Regulation D That Both Rule 506(b) and Rule 506(c) Must Satisfy

Pursuant to Rule 506, purchasers of securities offered pursuant to Rule 506 receive restricted securities, meaning that the securities cannot be sold for at least six months or a year without registering them.[24]

Rule 506(b) and Rule 506(c) offerings are subject to “bad actor” disqualification provisions.^[25]  As a result of Rule 506(d) bad actor disqualification, an offering is disqualified from relying on Rule 506(b) and 506(c) of Regulation D if the issuer or any other person covered by Rule 506(d) has a relevant criminal conviction, regulatory or court order or other disqualifying event that occurred on or after September 23, 2013, the effective date of the rule amendments.  Under Rule 506(e), for disqualifying events that occurred before September 23, 2013, issuers may still rely on Rule 506, but will have to comply with the disclosure provisions of Rule 506(e).[26]

Companies that comply with the requirements of Rule 506(b) or (c) do not have to register their offering of securities with the SEC, but they must file what is known as a "Form D" electronically with the SEC within 15 days after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s promoters, executive officers and directors, and some details about the offering, but contains little other information about the company.[27]

Exemptions from Broker-Dealer Registration in Title II of the JOBS Act

Section 201(a)(1) of the JOBS Act directs the SEC to revise its rules issued in Rule 506 under the Securities Act of 1933 to provide that the prohibition against general solicitation or general advertising contained in Securities Act Rule 502(c) shall not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors. Section 201(a)(1) further states that such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. [28]

Section 201(c) of the JOBS Act adds new paragraph (b) to Section 4 of the Securities Act. Section 4(b)[29] of the Securities Act states that:

For securities sold in compliance with Rule 506 of Regulation D, no person will be subject to registration as a broker or dealer solely if that person:

(a)    Maintains a platform or mechanism that permits the offer, sale or purchase of securities and permits general solicitations and general advertising,

(b)   Co-invests in the security, or

(c)    Provides ancillary services to the offering.  Ancillary services include providing due diligence services in connection with the offering, as long as these services do not include, for separate compensation, investment advice or recommendations to the issuer or to the investors.  Ancillary services allow providing standardized documents to the issuer and to the investors, as long as the person does not negotiate the investment terms on behalf of third parties, and that the issuer is not required to use the standardized documents as a condition of this service.[30]

The exemption from broker-dealer registration is provided if the person

(a)    Receives no compensation in connection with the purchase or sale of the security;

(b)   Does not have possession of customer funds or securities in connection with the purchase or sale of the security; and

Is not subject to the statutory disqualification with respect to membership or participation in of a self-regulatory organization, or is subject to an order of the SEC, another appropriate regulatory agency, or foreign financial regulatory authority.[31]

Stuart Ober, CFE, AIFA,^(R)  is President of Securities Investigations, Inc., a Woodstock, New York-based expert witness and consulting firm.