As we mark the one-year anniversary of the adoption of Rule 506(c) and the elimination of the ban on general solicitation and general advertising, I filter through the discussions taking place among crowdfunding professionals, potential issuers, and lawyers, and it is apparent that the marketplace remains somewhat confused about the state of regulations that apply to online securities sales platforms. The key to this puzzle is understanding that there are choices in how to operate a website that provides a platform for offering securities to the public, because alternative – meaning mutually exclusive – sets of regulations may apply. Let’s work through this systematically:
No Action letter / Rule 506(b) track:
The first websites that existed years before the JOBS Act was a twinkle in anyone’s eye, were structured so that the private placements being offering by the website met the conditions of Regulation D Rule 506 (which has since been renumbered Rule 506(b)) that prohibited engaging in general solicitation or general advertising (GSGA). In order for a broker or dealer to be able to reach out to a potential investor about an offering and have such communication not be deemed GSGA there had to have been a pre-existing, substantive relationship between the issuer or such broker-dealer, and the offeree. The same principal has been applied to websites hosting offerings, as set forth in a series of SEC NO-action letters. Additionally, the exemption required that offers and sales only be made to accredited investors (AIs).
A series of SEC No Action letters created a framework where the involved parties could bootstrap the creation of this required, pre-existing relationship between investor and broker or issuer in order to meet the requirements of then-Rule 506 (now Rule 506(b)). SEC Staff took the position that the qualification of accredited investors for website access using the procedures specified in those letters, which involved a pass-word protected website that prevented users/investors from accessing company/issuer information or information about a securities offering until after the investor had registered on the site and gone through an AI certification process, would create a factual situation such that offers and sales to such accredited investors of securities that were posted after the investor’s qualification as an AI, would not be viewed as a form of general solicitation or general advertising within the meaning of Rule 502(c). In other words, soliciting accredited investors does not necessarily involve the solicitation of a securities offering. The procedures set forth in those letters were two-tier:
Tier 1: The investor had to register to view public information that was available about the company. If the investor wanted to know if the securities of an issuer are for sale then the investor has to fill out the AI questionnaire, and if such investor met the AI tests then a background check was conducted, and if the result of the background check was satisfactory then the investor was issued a password for access to Tier 2. In one case the Tier 1 process also involved the investor opening an account with the registered broker dealer that was affiliated with the site. One letter also noted favorably the existence of a kind of cooling-off period between when an investor registered on the site and when she invested, arguably helping to create the indicia of a pre-existing business relationship that would negate a subsequent communication about the sale of a security to being deemed GSGA. Some of these platforms have an actual rep call and speak with the investor as part of the registration process.
Tier 2: Access to the password protected part of the website was given to vetted accredited investors. With this access an investor was able to indicate interest in buying securities, and only buyers who indicated interest in a company would receive information about securities if they go on sale – in other words, at no time in this process was an investor made aware of information about securities being offered before the investor asked for it, the investor had to reach out to the site to indicate interest in investing in a company if that company was raising money, and the investor would receive information about offerings posted after her registration, not those offers pre-existing when she first signed up.
This process was referred to as “Quiet 506”.
[As an aside, the question of whether the website needs to register as a broker-dealer or be supervised by one is also an issue, but separate from the topic of this post.]
Rule 506(c) track.
Now let’s consider how the adoption of Rule 506(c), and the elimination on the ban on GSGA, affects this analysis:
Rule 506(c), that permits offers to be made using GSGA without registering securities with the SEC, is a completely different track (unavailable at the time of those no-action letters). Under 506(c), websites can now be freer about the information they make available to the public at large, including that the issuer is raising money and what securities it is offering, but if they do so then the issuer’s heightened responsibility (under 506(c)) to verify a purchaser’s actual AI status, is triggered because only AIs can purchase under 506(c). I refer to offers of this type as “accredited investor crowdfunding”, because it is a type of crowdfunding since the offer is made openly to the public as is the premise of crowdfunding, but only AIs can buy.
The adoption of Rule 506(c) did not change any aspects of offers and sales under old 506 /renumbered 506(b) first discussed above. Consequently, despite the existence of 506(c) allowing GSGA, and despite the pending adoption of Regulation Crowdfunding for retail crowdfunding under Title III of the JOBS Act, discussed below, if a website platform wants to structure itself to host offerings along the lines of a traditional Reg D Rule 506 (now Rule 506(b)) private placement, thus foregoing GSGA and avoiding the added layer of purchaser AI verification, then the approach developed pre-506(c), from the no-action letters, remains the operative guidance.
One should be very careful in thinking that Rule 506(c) could be relied upon as a fallback exemption for a website that may be found to engage in GSGA, the reason being that the Rule 506(c) requirement that the issuer take reasonable steps to verify the AI status of each purchaser will likely not be met if an offering starts out being structured as a 506(b) offering, because market practice for offers under 506(b) allows for purchaser self-certification of AI status which is not adequate to meet the purchaser verification requirement under 506(c). Moreover, the statutory Section 4(a)(2) exemption for offerings “not involving a public offering” is not available as a fallback for a 506(c) offering that does not meet all the criteria of that rule, because the 4(a)(2) exemption is premised on an issuernot engaging in GSGA, so engaging in GSGA under Rule 506(c) offering is in direct opposition to this; however, the Section 4(a)(2) exemption remains available as a fallback for offerings that do not meet all the criteria of Rule 506(b) (depending on facts and circumstances, of course).
Regulation Crowdfunding track.
Proposed Regulation Crowdfunding, which will relate to retail crowdfunding activities as contemplated by Title III of the JOBS Act, covers offers and sales of securities over the Internet to the public at large (no AI requirement) using methods that would otherwise be deemed GSGA, and is the subject of rules proposed by the SEC last October. (see my prior memo for a summary of the proposed rules). This will allow for the use of GSGA and sales to anyone, but has many layers of regulation, primarily set forth in great detail in the JOBS Act itself, over how much an issuer can raise, how much a purchaser can buy, how the offering is conducted, investor’s rights, and how the website/portal is operated. Those final regulations, yet to be adopted by the SEC, will provide a third track for structuring sales over the Internet, and will not affect the No Action letter/506(b) track or the 506(c) track described above.
Websites must be designed carefully to comply with the chosen exemption, and issuer’s need to evaluate and understand whether the website they contemplate using is structured to meet the Rule 506(b) exemption, or the Rule 506(c) exemption which places a burden on the issuer to take reasonable steps to verify AI status of each purchaser. Some websites are providing tools for issuers or are integrated with third party providers, to help an issuer fulfill its verification duty.