The Securities Act of 1933 (the “Securities Act”) provides for a private offering exemption from federal securities registration which is increasingly being used by both private and public companies to raise capital during market downturns and in times of market uncertainty. While the term “private offering” leaves much to the imagination, the Securities Act provides substantial guidance about the circumstances in which an offering will be deemed private. A key component of a private placement offering is that there can be no general solicitation or advertising of the offering. The most commonly used private offering exemption is Rule 506 of Regulation D.
Rule 506 Requirements
Rule 506 of Regulation D is a “safe harbor” for private offerings of securities exempt from registration under Section 4(2) of the Securities Act. A key benefit of the exemption provided by Rule 506 is that issuers can raise an unlimited amount of funds. It can be used by public companies, or by private companies seeking to go public.
Rule 506 and the Section 4(2) exemption provide that:
♦ The issuer cannot use general solicitation or advertising to market the securities;
♦The issuer may sell its securities to an unlimited number of accredited investors and up to 35 non-accredited investors, who, alone or with a purchaser representative, have sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment;
♦ Issuers must provide non-accredited investors disclosure documents that are generally the same as those used in securities offerings registered with the SEC on Form S-1 or another SEC registration statement. If an issuer provides information to accredited investors, it must make this information available to non-accredited investors as well;
♦ The issuer must be available to answer questions by accredited and non-accredited investors; and
♦ Purchasers receive “restricted” securities, meaning that the securities cannot be sold for at least a year unless the company is fully-reporting to the SEC, in which case they are eligible for resale after six months from the time of purchase.
The JOBS Act & Rule 506 General Solicitation
Whether an offering is deemed a private offering is determined by various interpretations of the relevant SEC and case law. On August 12, 2012, the SEC proposed rules to eliminate the prohibition against general solicitation and general advertising in offerings conducted pursuant to Rule 506 of Regulation D of the Securities Act and Rule 144A of the Securities Act. The JOBS Act instructs the SEC to write implementation rules, but the SEC has not yet done so. The Act was signed into law on April 5, 2012; the SEC has already missed deadlines to implement the rules. The agency voted in August to eliminate the ban on general solicitation but still has not presented a final version of the new rules.
General Solicitation under Rule 506 & Prohibited Activities
Typically, any general notice of a securities offering directed to persons not known to the issuer or its management will be considered a general solicitation or advertising, and is prohibited. If, however, an issuer directs its notice of a securities offering to someone with whom it has a “preexisting relationship” the notice will not be deemed a general solicitation or advertising. The preexisting relationship must be sufficient to allow an issuer to be aware of the financial condition and sophistication of the solicited person. The relationship for purposes of determining whether a general solicitation has occurred can be a casual relationship and need not to be a business relationship or a formal or contractual relationship.
General Solicitation under Rule 506 & Shareholder Lists
Often issuers attempt to raise capital by contacting their own shareholders. Contacting a list of the issuer’s shareholders may involve a preexisting relationship and thus not constitute a general solicitation or advertising. Caution is advised, though: if the issuer has thousands of shareholders who are not personally known to management, it may not be possible to demonstrate knowledge of the financial condition or sophistication of the shareholders.Because the question of what constitutes a preexisting relationship is a question of fact, any issuer should avoid problems by seeking guidance from its securities counsel prior to accepting investor funds in Rule 506 offerings.
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