An Overlooked Class of Private Offerings: Independent Rule 506(c) Raises

A. Introduction

On Sept. 23, 2013, new rules issued by the Securities and Exchange Commission permitting the use of general solicitation in an unregistered offering of securities under Rule 506(c) of Regulation D will go into effect. ¹Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Securities Act Release No. 33-9415, 78 Fed. Reg. 44,771 (July 24, 2013). The new rules were required by Title II of the Jumpstart Our Business Startups Act of 2012. ²Jumpstart Our Business Startups Act (JOBS Act), Pub. L. No. 112-106, 126 Stat. 306 (2012). The rules have been the subject of much controversy because of their potential use by hedge funds and other private pooled investment vehicles. Investor advocates are worried that investors will be targeted with difficult-to-substantiate information about fund performance. ³Letter from Barbara Roper, Dir. of Investor Prot., Consumer Fed’n of Am., to Elizabeth Murphy, Sec’y, Sec. & Exch. Comm’n 13 (Oct. 3, 2012). Elected representatives have also sounded the alarm on hedge funds utilizing new Rule 506(c). Following the proposed rule, on Aug. 29, 2012 members of the U.S. Senate wrote to the SEC to inform the Commissioners that (despite there being no language to that effect in the text of the JOBS Act) hedge funds should not be allowed to take advantage of the new rules. ⁴It is notable that from 2009 to 2012 over 80 percent of the aggregate amount of funds raised in securities offerings relying on Rule 506 of Regulation D went to pooled investment funds. Vladimir Ivanov & Scott Bauguess, Capital Raising in the U.S.: An Analysis of Unregistered Offerings Using the Regulation D Exemption, 2009–2012 11 (July 2013).

Another area of focus is the new breed of online securities platforms that have been created over the past few years. These include entities such as CircleUp ⁵CircleUp, https://circleup.com (last visited Sept. 17, 2013). and SeedInvest, ⁶SeedInvest, http://www.seedinvest.com (last visited Sept. 17, 2013). which are either broker-dealers themselves or who partner with broker-dealers. Although currently operating in compliance with the prohibition on general solicitation on offerings made under Rule 506, ⁷General conditions to be met, 17 C.F.R. §230.502(c) (2013). after Sept. 23 many of these platforms will cease to be password-protected, and the general public will be able to see the way in which securities offerings are presented online in the 21^st century. They will see a wide range of offering materials (slide decks, videos and the like) presented in a visually appealing and interactive format. These platforms are likely to attract significant attention from the public and the press.

What has been lost in much of the public discussion of new Rule 506(c) is how the rule will be used by operating companies (that is, companies other than private investment funds) raising capital without the use of a securities intermediary, whether online or offline. For these actors, Rule 506(c) presents an attractive opportunity to reach new investors using their own efforts (and an equal opportunity to get themselves in trouble while doing so). Previously, operating companies working without an intermediary were limited to their own network of personal and professional contacts to build relationships with investors for a capital campaign. After Sept. 23, these companies will be able to openly advertise their securities offerings through “independent” (that is, non-intermediated) Rule 506 raises into channels that are most likely to attract the attention of potential investors.

The current version of Rule 506 of Regulation D is already frequently used by operating companies without a securities intermediary. A 2013 SEC study of Rule 506 of Regulation D provides insights into the use of the exemption from registration. ⁸Ivanov & Bauguess, supra note 4. Over the period 2009 to 2012, pooled investment funds were responsible for raising approximately 81 percent of the total amount raised through Rule 506 offerings. However, pooled investment funds accounted for only 24 percent of the total number of offerings that were made under Rule 506. The SEC Regulation D study goes on to report that small operating companies were the primary users of Rule 506. Of the companies that reported revenue, nearly 30 percent had revenues of $1,000,000 or less. Additionally, the average size of a Rule 506 raise was approximately $30 million, but the median size was $1.5 million. The disparity between the average and median reflects the large presence of small operating companies seeking to raise capital. One of the most interesting facts revealed by the study is that not only are the majority of Rule 506 raises conducted by individual operating companies, only 12 percent of those offerings utilized a securities intermediary. ⁹Id. at 13.

Operating companies selling securities without the use of a securities intermediary are exactly the type of companies that the JOBS Act was intended to benefit. However, selling securities is serious business. In particular, offering broadly to investors outside the issuer’s current circle exposes the company to potential liability if done incorrectly.

B. Rule 506 of Regulation D

1. Rule 506 As A Safe Harbor.

Rule 506 of Regulation D is a safe harbor provision that allows issuers of securities to be certain they will not be required to register an offering of securities under the Securities Act of 1933. Under section 4(a)(2) of the Securities Act, “transactions by an issuer not involving any public offering” are exempt from registration with the SEC. ¹⁰Securities Act of 1933 §4(a)(2), 15 U.S.C. §77c(a)(2) (2012). Long-time securities law practitioners will know this exemption as section 4(2). Congress redesignated section 4(2) as section 4(a)(2) in 2012. However, just what “not involving any public offering” means has been the subject of several U.S. Supreme Court decisions and debates among securities law practitioners.

Over time, the analysis with respect to “not involving any public offering” came to focus on four primary areas: the qualifications of the offeree, the scope and manner of the disclosure of information, the manner of the offering, and the absence of an immediate redistribution of securities. These factors each required an issuer to go through burdensome legal analysis to determine whether it qualified for the section 4(a)(2) exemption.

To provide some certainty to companies looking to make private placements, the Securities and Exchange Commission adopted Rule 506 of Regulation D to codify a safe harbor to section 4(a)(2) in 1982. ¹¹Rule 506 is the most widely used exemption from registration available under Regulation D, accounting for over 99 percent of the capital raised under Regulation D and over 94 percent of the offerings. Ivanov & Bauguess, Capital Raising in the U.S. 7. Regulation D is composed of additional offering exemptions (Rules 504 and 505) that rely on Securities Act section 3(b) for their authority. Regulation D also includes definitions under Rules 501 and 502 that apply to all the rules under Regulation D. The SEC took pieces of the analysis from each area to inform the rule. Under Rule 506, issuers may raise an unlimited amount of capital in a non-public securities offering so long as the issuer satisfies the following standards:

• The issuer cannot use general solicitation or advertising to market the securities;

• The company may sell its securities to an unlimited number of “accredited investors” and up to 35 non-accredited investors; ¹²Accredited investors are defined under Rule 501(a). Accredited investors include:(1) Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;(2) Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;(3) Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;(4) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;(5) Any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000. (This calculation must now exclude the investor’s primary residence.)(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;(7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in § 230.506(b)(2)(ii); and(8) Any entity in which all of the equity owners are accredited investors.

• Any non-accredited investors must be provided with disclosure documents that are generally the same as those used in registered offerings; and

• Purchasers receive restricted securities that may not be sold for at least one year without the securities being registered.

Under the rule, “general solicitation” is defined as any advertisement, articles, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television and radio. The term also encompasses any seminar or meeting whose attendees have been invited by any general solicitation. ¹³Rule 502(c)(2). Beyond the language contained in the rule, there is little guidance from the SEC as to what constitutes general solicitation. In any case, general solicitation is very broad and includes anything publically available in print, broadcasted, and posted on the internet that provides information about a securities offering.

Thirty years later, Congress enacted section 201 of the JOBS Act, directing the SEC to eliminate the prohibition on general solicitation contained in Rule 506. The theory behind this change is that permitting general solicitation will let early stage companies in need of capital access a broader range of funding sources, and likewise will give accredited investors access to a broader range of investment opportunities. Currently, only a small proportion of accredited investors actually invest in non-public offerings. ¹⁴Evidence suggests that in 2012 there were approximately 8.7 million households that qualified as accredited investors. SEC filings indicate that only about 234,000 accredited investors actually participated in non-public offerings. Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44,771, 44,793–94. If more accredited investors are aware of this class of offering, in theory they make more assets available to support the viability of early stage companies.

2. General Solicitation Under Rule 506(c).

On July 10, 2013 the SEC adopted rules permitting general solicitation in Regulation D offerings by adding a new class of offering to the exemption, Rule 506(c). Effective Sept. 23, an issuer may publically advertise a non-public offering made in reliance on Rule 506(c), provided that only accredited investors may purchase the securities offered. Advertisements may be made in any form—television, print media, webinars, social media, and the like.

The SEC has long operated under the principle that accredited investors do not need the same types of protections as the general public. They are assumed to have the sophistication to understand the terms of a securities offering and the ability to sustain a complete loss of the investment. To ensure that only accredited investors participate in offerings under Rule 506(c), issuers are required to take reasonable steps to verify the accreditation status of every investor that subscribes to the offering.

The SEC established a principles-based approach to the “reasonable steps” requirement. Under the rule, issuers are expected to take into consideration, among other things:

• The nature of the purchaser and type of accredited investor the purchaser claims to be;

• The amount and type of information the issuer has about the purchaser; and

• The nature of the offering, including the manner in which the purchaser was solicited to participate and the terms of the offering, such as the minimum investment amount. ¹⁵Id. at 44,778.

The SEC makes clear that the issuer should look to the facts and circumstances surrounding the offer and the issuer’s relationship with the investor. As such, reasonable steps will change based on the circumstances. For example, offerings with high minimum cash investments might require less additional investigation than offerings with lower minimums, provided there are no facts to indicate that a third party is financing the purchase.

In its initial proposal the SEC declined to specify even a non-exclusive list of methods that constitute “reasonable steps to verify.” However, in the final rule the SEC gave more guidance and set out a non-exclusive list of methods the issuer could use to verify that a natural person meets the accredited investor requirements of Rule 506(c). These methods are:

• If verifying whether a purchaser qualifies on the basis of income, the issuer may use Internal Revenue Service records that report income for the purchaser for the two most recent years, along with written representation from the purchaser that they have a reasonable expectation that will met the income requirement this year as well.

• If verifying whether a purchaser qualified on the basis of net worth, the issuer may use bank statements, brokerage statements, other statements of security holdings, certificates of deposit, tax assessments and appraisals provided by independent third parties, provided the records are no more than three months old. The issuer must also use a credit report to assess the purchaser’s liabilities. The issuer must also get written representation from the purchaser that all liabilities necessary to make a net worth determination have been disclosed.

• The issuer may rely on written confirmation from a third party that the third party has taken reasonable steps to verify the purchaser’s accredited status. The SEC specifically named broker-dealers, certified public accountants, attorneys, and SEC-registered investment advisers as acceptable third parties, but also stipulated that other third parties could be acceptable provided they take reasonable steps to verify that purchasers are accredited and the issuer has a reasonable basis to rely on that verification.

• Finally, a purchaser who invested in the issuer in a previous Rule 506(b) offering as an accredited investor and remains an investor in the issuer’s Rule 506(c) raise is deemed to satisfy the verification requirements if the issuer obtains certification from the purchaser that he or she qualifies as an accredited investor at the time of sale. ¹⁶Id. at 44,780–81.

3. Traditional Rule 506 Transactions Still Permitted.

While Rule 506(c) of Regulation D allows for offerings to be made utilizing general solicitation, the SEC preserved the traditional form of Rule 506 as Rule 506(b). Many companies that are able to rely on their professional and personal networks will continue to utilize traditional, independent Rule 506 offerings without the presence of a securities intermediary.

There are advantages to traditional Rule 506(b) offerings for many early stage companies. Such companies frequently have issues with their corporate governance. These may include company actions not correctly approved by the board of directors, the issuance of stock that is not authorized by their incorporating documents, failure to recognize preemptive rights, and so on. A traditional Rule 506 offering, made away from the glare of public scrutiny, allows companies to fix errors as the offering proceeds. Angel investors or institutional investors can work with those companies as the corporate governance is straightened out to protect their investment. This can only be done when prior relationships exist or the meetings are occurring on a face-to-face basis. Prior relationship or face-to-face meetings allow for the parties to establish trust that the company’s oversights are not indicative of an inability to execute the business model.

Additionally, in a Rule 506(b) raise, issuers may continue to utilize and rely solely on investor representations about accredited investor status. They will not be required to take the reasonable steps to verify accredited status required by Rule 506(c) offerings.

C. The Impact of Changes to Rule 506

1. Changes to Rule 506 May Drive More Interest and Investment in Early Stage Companies.

For issuers, the changes to Rule 506 present an opportunity to utilize any and all means of communication to attract those non-investing accredited investors. The SEC states that in 2010 approximately 8.7 million U.S. households, or 7.4 percent of all U.S. households, qualified as accredited investors based on the net worth standard in the definition of accredited investor. ¹⁷Id. at 44,793. Nevertheless, data from Form D filings in 2012 suggest that approximately 153,000 investors (including natural persons and organizations) participated in unregistered securities offerings by operating companies, and only 234,000 investors participated in all unregistered offerings. ¹⁸Id. at 44,792. Other numbers indicate the SEC is omitting or undercounting many angel investors. The University of New Hampshire Center for Venture Research reports that there were approximately 268,160 active angel investors in the U.S. ¹⁹Jeffrey Sohl, The Angel Investor Market in 2012: A Moderating Recovery Continues, Center for Venture Research, April 25, 2013, http://paulcollege.unh.edu/sites/default/files/2012_analysis_report.pdf. With either set of numbers, it is clear that the majority of accredited investors do not invest in early stage companies. The use of general solicitation to target offerings to currently non-investing accredited investors could dramatically increase the funds available to early stage operating companies.

According to a recent Accredited Investor Survey conducted by the online social networking platform iCrowd, 71 percent of accredited investors that responded to the survey did not know they were considered accredited investors or that they were eligible to invest in private securities offerings by early stage operating companies. ²⁰Charles Luzar, iCrowd Report: Young Accredited Investors Drawn to Alternative Assets, Aug. 21, 2013, http://www.crowdfundinsider.com/2013/08/21167-icrowd-young-accredited-investors-alternative-assets/. This figure suggests a substantial knowledge barrier that limits the amount of investment capital available from accredited investors. General solicitation has the ability to reduce this barrier by changing the process for generating investor interest. Rather than the investor acting first with the knowledge that he or she is accredited, the investor will first be engaged and attracted to the investment opportunity through the general solicitation.

The possible forum for general solicitation is beneficial to attracting more investors as well. Under Rule 506(c), issuers are able to reach their target investors through all manner of communications. Whether the company wants to use television commercials, sponsored content on Facebook, Twitter, or LinkedIn, skywriting, or a well-produced video on its own website, an issuer is free to utilize any public forum for marketing its securities under Rule 506(c). While there are no actual numbers on how many investors would invest in early stage companies, it stands to reason that if a small share of the 71 percent of accredited investors that did not know they were accredited investors were aware of securities offerings in early stage companies of interest, at least some would invest—dramatically increasing the amount of capital available in the marketplace.

The iCrowd Accredited Investor Survey also indicates that younger accredited investors are more interested in investing in securities offered pursuant to Rule 506 than older investors. While the actual motivations vary by individual, common themes appear to be a lack of trust in Wall Street and the desire to invest in causes they identify with. When taken together, a receptive audience targeted by appropriate communications channels means that lifting the prohibition on general solicitation under Rule 506(c) has great potential to substantially increase the amount of capital supplied by accredited investors to early stage operating companies.

2. General Solicitation Allows for Additional Benefits to Issuers.

Increased access and amount of capital available under Rule 506(c) is the principal benefit for issuers. Additional benefits from general solicitation may come from being able to incorporate the securities offering into its general marketing plan and receiving feedback on the business concept. Current practices from portal based early stage investing in the U.K. and rewards based crowdfunding in the U.S. offer insights into how issuers may take advantage of the additional benefits provided by Rule 506(c).

Acquiring investors is a very similar activity to acquiring customers. The company must generate name recognition and demonstrate why the product is more valuable to the individual than the actual price paid. In the U.K., companies are currently using funding platforms to gain the interest of both investors and customers. Storemates is a recently funded company on the U.K. platform Seedrs. ²¹Seedrs.com, Seedrs Case Study: Storemates (Jan. 5, 2013), http://blog.seedrs.com/2013/01/05/seedrs-case-study-storemates/. The company matches people who have spare storage space in their homes with people looking for more storage. The business relies on consumer uptake in order to have any storage space available for people looking to store stuff. By placing its securities offering with Seedrs, the company was able to make dual use of the fees paid to the platform—professional services for the offering, and generating name recognition. While the offering was ongoing, the company was able to issue press releases about the status of the raise, post YouTube videos, and allow the platform to do its own marketing for the company.

In the U.S., Rule 506(c) makes it possible for independent Rule 506 raises to generate outside interest in a similar manner. While the offering is ongoing, the company may use the offering itself as an extension of its marketing in order to generate media interest about its progress. The company may also decide to direct potential investors to its offer at the same time it engages in regular marketing efforts. It is important to note that although not everyone who sees the offering material for a Rule 506(c) offering can invest, everyone can become a potential customer of the issuer’s product.

Early stage companies can also benefit from the ability to prove and amend their concepts while undertaking an offer of securities under Rule 506(c). Unlike established companies, early stage companies are still works in progress. They require feedback and assessments of their ideas. Angel and institutional investors typically provide this value to companies they invest in, but general solicitation can supply additional feedback on the business concept.

Early stage companies have started using rewards based crowdfunding to gauge interest in their products. Often, this happens through one of the major crowdfunding portals, but it can also occur independently. For example, a home security electronics company initiated its own crowdfunding program on its own website. The effort created over 1,200 backers even before the company had a product available for sale. A conspicuous “contact us” feature allows for additional feedback on what consumers are looking for in the product that the company offers.

D. The Role of Intermediaries

1. Intermediaries Provide Experience and a Platform for Early Stage Companies.

Issuers of unregistered securities face an important early decision—should the issuer use a securities intermediary or raise money independently? Intermediaries in the offer and sale of unregistered securities are typically broker-dealers, but platforms can also be organized as venture capital fund advisers if the offering structure allows investors to participate in a fund that charges “carried interest” instead of a commission, rather than directly investing in the company. ²²FundersClub Inc. & FundersClub Mgmt. LLC, SEC No-Action Letter (Mar. 26, 2013). There are many advantages to using a securities intermediary for an early stage company that come from their specialization in the investment space.

Securities intermediaries provide issuers the opportunity to list on their ready-built offering platforms. These platforms typically incorporate an attractive interface for investors. They also save the issuer the time and expense of building and maintaining an offering page on their websites or creating a separate site for the offering. Securities intermediaries are also in a better position to drive investors to their platforms. While intermediaries do have restrictions on the types and content of advertising they may do, intermediaries can promote the offering and search out accredited investors. Additionally, the promotions are not going to just any potential investor; the intermediary may have established relationships with accredited investors who regularly follow updates on the intermediary’s platform. An issuer should also not underestimate the importance of an intermediary’s reputation. Trust among investors in the reputation of the intermediary, and the reassurance provided by the fact that the intermediary is regulated by the SEC and the Financial Industry Regulatory Authority, is critically important for gaining traction in the early days of a securities offering.

Securities intermediaries also provide services to issuers in addition to merely putting them in touch with investors. The intermediary is able to offer advice and assistance throughout the process of selling securities. For an inexperienced issuer, the amount of assistance may be substantial. For example, an issuer may need professional help on how to best structure the investment in light of the company’s corporate form and ownership. Additionally, when exchanging large amounts of money for securities, the back of the house function of clearance and settlement is critically important. A securities intermediary can provide those services as well.

2. Issuers Face Challenges When Offering Securities Without an Intermediary.

Some issuers, however, will choose to go it alone rather than engaging a securities intermediary for their offers. The possible motivations to go it alone vary. These may be as simple as the issuer balking at paying commission to the intermediary and preferring to keep all of the proceeds of the offer. The issuer may believe it knows exactly who its investors will be, eliminating the need for a third party to create relationships with investors. Conversely, it may be the intermediary that determines that it will not list the issuer on its platform. If an issuer is not well managed, fails the suitability requirements for the intermediary’s customers under FINRA Rule 2111, ²³Suitability, Regulatory Notice 12-25 (May 18, 2012). or just does not fit within the platform’s criteria for issuers, it may not find a home with a reputable intermediary.

Issuers that decide to go it alone without an intermediary must be able to replicate the advantages that an intermediary provides on their own. The general solicitation provisions of Rule 506(c) can help reach that outcome. In order to attract investors, an issuer may decide to use its own website to offer securities or create a new, purpose-built site. Creative issuers may be able to drive their own traffic through flashy videos and an impressive pitch deck. For social entrepreneur types, they may be able to generate interest through a compelling story attractive to certain accredited investors.

Issuers will also be responsible for obtaining their own support to execute the offering under Rule 506(c). In particular, an issuer may be unfamiliar with conducting the clearance and settlement of a securities transaction and may not effectively verify accredited investor status out of fear of alienating investors that have indicated interest.

E. Bulletin Boards for Independent 506 Raises

While some issuers may be successful at reaching investors while going it alone, those issuers must still concern themselves with the proper execution of a securities transaction. Issuers face many challenges when undertaking an independent offering of securities under Rule 506(c). They must put together their offering materials in a way that does not trigger liability for misleading statements or omissions, take reasonable steps to verify accredited investor status, process the payment and transfer of securities, and generate investor interest. Title II of the JOBS Act anticipated these challenges and allows securities “bulletin boards” to offer broker-dealer like services to issuers without themselves registering as broker-dealers. ²⁴JOBS Act §201(c), Pub. L. No. 112-106, 126 Stat. 306, 314–15. The exemption in Title II expands on the types of online securities bulletin boards that the SEC has determined do not require registration as a broker-dealer pursuant to a series of SEC No-Action letters. ²⁵See IPOnet, SEC No-Action Letter (July 26, 1996); Angel Capital Elec. Network, SEC No-Action Letter (Oct. 25, 1996) (hereinafter “Angel Capital”); Lamp Technologies, Inc., SEC No-Action Letter (May 29, 1997); Stock Power, Inc., SEC No-Action Letter (July 24, 1998); and Progressive Technology, Inc., SEC No-Action Letter (Oct. 11, 2000).

The bulletin board provision under Title II of the JOBS Act is narrowly constructed to protect online angel investor matching services that take part in the securities offerings hosting on the site. The SEC acknowledges this intent in its Frequently Asked Questions on Title II of the JOBS Act. ²⁶SEC, Jumpstart Our Business Startups Act Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act, Feb. 5, 2013, http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm. In particular, the SEC interprets the Title II language to prohibit any type of compensation in connection with the purchase or sale of a security, not just transaction-based compensation. As the same time, the SEC recognizes that Congress intended to allow these types of bulletin boards to co-invest in the securities offered. For instance, the online entrepreneur-angel investor matching platform AngelList relied on Title II of the JOBS Act to receive its No-Action letter from the SEC, which gave the platform assurance it was operating within the SEC’s understanding of the exemption. ²⁷AngelList LLC & AngelList Advisors LLC, SEC No-Action Letter (Mar. 28, 2013).

To maintain the exemption from broker-dealer registration under Title II, these bulletin boards may only host offerings made in reliance on Rule 506(b) and 506(c). Additionally, the Title II boards must meet certain conditions in the course of the offer and sale of securities in order to avoid broker-dealer registration. The board may not at any time handle purchaser funds or the purchased securities of the issuer, and the board may not be managed by any party that is subject to statutory disqualification from a securities self-regulatory organization under section 3(a)(39) of the 1934 Securities Exchange Act. The board may engage in ancillary services. Title II specifically highlights the provision of due diligence services (so long as the services do not include investment advice), and the provision of standardized documents to issuers and investors as acceptable ancillary services.

According to the SEC, Title II permits a narrow segment of bulletin boards to operate without broker-dealer registration. However, bulletin boards were already able to operate without registration as a securities intermediary prior to the JOBS Act, under No-Action Letter guidance from the SEC. ²⁸It is important to note that state securities commissions have their own standards for when registration as a securities intermediary is required. For example, the State of California issued to ProFounder Financial a Consent Order to Cease and Refrain from activities the state considered required registration as a broker-dealer. ProFounder Financial Inc., Consent Order to Cease and Refrain, California Department of Corporations (Aug. 2011). The clearest guidance comes from the October 1996 No-Action Letter in response to a request from the Angel Capital Electronic Network (“ACE-Net”). ²⁹Angel Capital, SEC No-Action Letter (Oct. 25, 1996). ACE-Net was a passive securities bulletin board that allowed small companies to reach accredited investors through the internet. The SEC notes that under the facts presented, ACE-Net would not be required to register as a broker-dealer so long as the bulletin board did not:

• Provide advice about the merits of particular opportunities or ventures;

• Receive compensation from issuers other than nominal, flat fees to cover administrative costs and that such fees will not be made contingent upon the outcome of any securities transaction on the bulletin board;

• Participate in any negotiations between investors and issuers;

• Directly assist investors or issuers with the completion of any transaction, such as by providing closing documentation or paid referrals to attorneys or other professionals;

• Handle funds or securities involved in completing a transaction; or

• Hold itself out as providing any securities-related service other than a passive bulletin board.

Despite these limitations, bulletin boards may provide significant services to issuers. While the bulletin board must be a relatively passive entity in comparison to broker-dealers, they may still host a platform or mechanism that permits the general solicitation, offer, sale, and purchase of securities. The board may impose qualifying criteria on issuers wishing to post their offerings, so long as the board does not present those offerings in a form that results in recommendations. The bulletin board may also facilitate the clearance and settlement of transactions by encouraging the use of licensed providers, but may not handle funds or securities itself.

Collectively, the Title II bulletin boards and bulletin boards operating under existing SEC interpretation provide significant opportunities for issuers to use third-parties that are not securities intermediaries to help publicly advertise their securities offerings and help complete the deals. Bulletin boards provide a mechanism for the offer and sale of securities utilizing a general solicitation that the issuer would not have if it conducted its offer completely independent of any service provider. It is conceivable that regional organizations, like a chamber of commerce or business incubator, would utilize the services of a bulletin board to create a forum for their affiliated companies to advertise to accredited investors.

F. Guidelines for Issuers Making Independent 506(c) Offerings

Selling securities is a serious business that includes many legal requirements that small issuers may innocently overlook while focused on operating their business.

For an operating company, the biggest concerns when selling securities are:

• Disclosure issues;

• Ensuring compliance with the conditions of Rule 506(c), including verifying accredited investors and ensuring the absence of “bad actors”;

• Documentation; and

• The logistics of clearance and settlement.

Mistakes in any of these areas may lead to legal or regulatory proceedings. Ancillary services available through a bulletin board supporting independent Rule 506 raises can help mitigate these risks.

1. Disclosure Issues.

While there are a number of anti-fraud provisions within the securities laws, section 10(b) of the Securities Exchange Act of 1934 and its complementary Rule 10b-5 has become the standard for securities fraud liability. ³⁰Employment of manipulative and deceptive devices, 17 C.F.R. §240.10b-5 (2013). The rule states that:It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,(a) To employ any device, scheme, or artifice to defraud,(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. Under Rule 10b-5, any untrue statement of material fact or omission of a fact necessary in order to make a previous statement not misleading amount to securities fraud.

This standard for securities fraud impacts early stage companies differently than established companies. For instance, early stage companies are regularly put into situations where their optimism is critical for gaining traction with customers, media, and potential investors. However, when dealing with investors, statements regarding planned production, potential revenues, client relationships, and so on, can be hazardous to the company’s health if those statements are not supported by evidence.

By way of example, a company producing an electronics product may be in the process of negotiating a manufacturing agreement that it feels confident will be finalized. Instead, the company and the manufacturer have a number of issues to work out. If the company goes ahead and asserts the production agreement is in place and it can deliver its product on time, it will open itself up to securities fraud allegations. Asserting the production agreement is in place is a material misrepresentation that the company may be held liable for by investors or regulators.

The consequences of a finding of securities fraud are dire for an early stage company. Not only would investors have the right to sue the company, the company and its officers and directors would be considered “bad actors” and thereby prohibited from utilizing Rule 506 offerings in the future; effectively cutting off the company from access to capital in the future.

Properly performed due diligence might help identify the material assertions made by the company and determine whether there is evidence to support the statements made, and thus avoid liability. A bulletin board may require due diligence as a condition of utilizing the board.

2. Compliance With Conditions of Rule 506(c).

a. Accreditation Status of Investors.

As discussed earlier, a requirement for selling securities relying on Rule 506(c) is that the issuer must take reasonable steps to verify accredited investor status of the purchaser. If reasonable steps were not taken, the issuer cannot rely on Rule 506(c) and must instead find another exemption or face liability for violating section 5 of the Securities Act.

In any case, the reasonable steps required where there is no previous relationship between the issuer and the investor might be quite onerous. The management of a typical issuer trying to operate a business will not be able to spend the time to verify the accredited investor status of each investor.

b. Compliance With Bad Actor Prohibitions.

At the same time the SEC adopted its final rules for Rule 506(c) of Regulation D, it adopted a standard to disqualify “bad actors” from utilizing any Rule 506 offering. ³¹Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings, Securities Act Release No. 33-9414, 78 Fed. Reg. 44,730 (July 24, 2013). The bad actor standard looks beyond civil and criminal judgments to any negative history involving fraud or regulatory action by a state or federal financial regulator. The actors that may trigger the rule include the issuing company itself, along with any executive officer, officer participating in the securities offering, director of the company, 20 percent owners, promoters of the offering, and anyone in corresponding positions in limited liability companies or partnerships.

If a disqualifying event is triggered by the company or any of the covered actors, the entire offering will lose the Rule 506 safeharbor and instead result in a violation of section 5 of the Securities Act. This in turn triggers additional penalties, including disqualification from any future use of Rule 506 for at least five years and the right of any investor to rescind the transaction. For an early stage company, this penalty is severe and could lead to business failure should the company need an additional capital infusion necessary under the business model or due to investors pulling out their investments.

After a disqualifying event is triggered, the issuer does have an opportunity to petition the SEC as to why the Rule 506 safeharbor should not be denied. Grounds for a petition includes that the issuer did not know and, in the exercise of reasonable care, could not have known that a disqualification existed. ³²To be codified at 17 C.F.R. §230.506(d)(2)(iv). While what is reasonable depends on the context of each situation, a record of the investigation is necessary is all situations.

3. Standardized Documentation Allows for Investors to Better Compare Offers.

Selling securities is a contract-heavy process. Fortunately, there are a growing number of service providers who can help companies put together their offering documents without paying law firm rates. Additionally, investors prefer standardized documentation in order to better compare the terms of each securities offering. There is a growing spectrum of products, from the pure form to full-service customization, available for issuers to create the necessary documentation for their securities offering. For example, SeriesSeed.com provides issuers with a basic set of documents they may utilize to offer preferred stock to investors. ³³Series Seed, http://www.seriesseed.com (last visited Sept. 17, 2013). The documents include an amended set of articles of incorporation that the issuer must file with the state of incorporation, a term sheet for the offering, and investor agreement in order to allow investors to actually subscribe to the offer. Some companies, like VentureDocs.com, offer issuers fully customizable legal documents for equity transactions. ³⁴VentureDocs, https://venturedocs.com (last visited Sept. 17, 2013).

For investors, these options for standardized documentation help inform their investment decisions. Rather than analyzing the value of the terms and conditions to the offer, the investor can focus on the value of the company, its business model, and chance of executing its strategy.

4. Facilitating Clearance and Settlement.

The mechanics of a securities transaction involves each party to the transaction fulfilling conditions contained in the subscription agreement. In most circumstances, the conditions of the agreement include the issuer transferring securities into an escrow account and purchaser transferring funds into an escrow account. The escrow service then executes the deal upon completion of all the conditions. The third party service is particularly beneficial for transactions over a distance, as when general solicitations are used over the internet to attract investors. While the statute prohibits the bulletin board from holding funds or securities, this service may be facilitated by a bulletin board along with the other elements of the securities transaction. Similarly, a bulletin board could arrange for custody of the securities purchased.

G. Overlooked but Critically Important for the Success of Small Operating Companies.

Independent 506 offerings have been overlooked in the public discourse surrounding use of general solicitation under Rule 506(c) of Regulation D because they are not as interesting or divisive as hedge funds nor are they the result of an organized front like securities intermediaries. Still, independent 506 raises have traditionally accounted for the largest share of Regulation D offerings and this class of offerings stands to greatly benefit from general solicitation of their securities offerings.

While independent 506 offerings will continue to use the traditional Rule 506(b) format that does not involve general solicitation (in situations in which the company already has relationships with potential investors, for example), general solicitation can open up many more opportunities to reach investors, and generate public interest in the issuing company. The advantages of general solicitation should not be closed off to companies that are unable or unwilling to offer through an established securities platform. Those companies can choose to run their own offerings, or use the bundle of services presented by a bulletin board.