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Securities Implications with Soliciting Investors

Posted by Ryan M. Newburn | Jun 15, 2022 | 0 Comments

Under US securities laws, the default rule is that every purchase or sale, or offer of a purchase or sale, of a security must be registered with the SEC, unless there is an exemption available for such purchase or sale. Going through the formal SEC registration process is expensive and time-consuming. Most private companies in the United States therefore choose not to go through the formal SEC registration process. Instead, they raise capital through what's known as an exemption.

The most commonly used exemptions are set forth in what's referred to as Regulation D. Regulation D is known as a “safe harbor” that allows companies to issue securities and raise capital without registering the securities under the Securities Act of 1933.

It is vital that you understand the exemptions and have any of your questions answered by experienced securities lawyers. Our legal team here at Newburn Law has years of experience guiding our clients. Contact us today to learn how our securities lawyers can help you.

The Most Common Exemptions

The most common exemptions issuers typically use are Rule 506(b) and Rule 506(c), and most private companies raise capital through these. For many years, the operative rule was 506(b), which prohibited companies from advertising and soliciting investors when trying to raise capital. In 2012, Congress passed the Jumpstart our Business Startups (JOBS) Act. The JOBS Act was intended to make it easier for businesses, especially smaller startups, to raise capital without having to comply with certain SEC restrictions.

As part of the JOBS Act, Congress passed new Rule 506(c). Under Rule 506(c), which became effective in September 2013, businesses may now use social and other media to advertise and solicit investors, as long as the business doesn't commit fraud in doing so and as long as the investors are considered “accredited” investors (see more on this below).

Finally, a lesser used exemption in Regulation D is the Rule 504 exemption, which prohibits solicitations (with a few exceptions), must comply with the states' different rules for securities regulations, allows non-accredited investors, and allows for investments up to $5 million within 12 months.

This article will explain the new Rule 506(c) and the general rules and prohibitions on solicitation for selling securities. Before seeking investors for any business startup, business owners should discuss their options with an experienced securities law attorney.

What Is General Solicitation and General Advertising? 

Suppose you have a startup business, and you want to raise capital for it. You want to attract money from investors. It's important to understand the rules for solicitation and advertising to raise capital because in some situations you're not allowed to do either of these to raise money.

The SEC Rules don't define the terms “general solicitation” or “general advertising.” Rule 502(c), however, offers some examples of communications that could be considered solicitation or advertising:

(1) “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio”; and

(2) “any seminar or meetings whose attendees have been invited by any general solicitation or general advertising.” Using a public website without a password is also considered a general solicitation.

When the company has a preexisting substantial relationship with a potential investor, then communicating with the person typically isn't a general solicitation. Having a preexisting substantial relationship means that the relationship was formed before the company made its securities offering, or if it was established through a registered broker-dealer or investment advisor before that person's participation in the securities offering.

Here, the rules can get a bit tricky, but an experienced securities law attorney can help you determine which potential investors qualify as having a preexisting substantial relationship with your company.

What Is an Exempt Offering?

Under Regulation D, companies can make certain offerings to investors without having to go through formally registering their offerings with the SEC. These are referred to as exempt offerings. Exemptions were created under Section 4(a)(2) of the Securities Act and are also referred to as “private placement exemptions.”

Exempt offerings provide several advantages to businesses, and that's why they're so popular. First, the process is much less expensive and time-consuming than formal SEC registration. Also, for several of the exemptions, the offeror is not required to comply with the different states' laws for registering securities, known as Blue Sky laws. For businesses that seek investors from numerous states, using one of the Regulation D exemptions is a good option.

Exempt offerings are also not subject to the voluminous disclosure requirements involved in formal SEC registration. Most exemptions require minimal disclosures, along with submission of what's referred to as Form D, which announces the company's intent to sell the securities.

As noted, the most popular exemptions are Rule 506(b) (the default exemption until 2013) and Rule 506(c).

Can You Solicit Investors? 

General solicitation of investors means to publicly advertise a private company's offerings by using mass communication. Under the new Rule 506(c), a company may solicit investors through marketing and advertising. However, the company can only sell its capital to accredited investors.

An accredited investor is:

  • An individual with an earned income over $200,000 (or $300,000 combined income with a spouse or spousal equivalent) for the two prior years, and reasonably expect to make the same income the next year; or
  • An individual with a net worth of over $1 million (not including the value of a primary residence), either alone or with a spouse or spousal equivalent; or
  • An individual who holds in good standing a Series 7, 65, or 82 license (these are professional certifications and designations for financial professionals); or
  • Other persons or entities deemed to qualify, including certain banks, partnerships, corporations, and trusts.

The idea behind only allowing investments by accredited investors is to ensure that the investors are financially sophisticated and financially well-off enough to lose money if the investment fails. The assumption is that high-income and/or high net individuals can handle an investment loss better than, for example, an elderly retired person with only $10,000 in savings.

Also, under Rule 506(c), the company must verify that the investor is accredited. This means that a company can't simply rely on the investor's own statement that he or she is accredited. Under Rule 506(b), by contrast, the company can simply rely on the investor's statements. So, if you were seeking investors under Rule 506(b), the investors could simply fill out a form that verified their income or net worth. You can't do this with the Rule 506(c) exemption.

So, how does a company using Rule 506(c) verify that the investors are accredited? The company must do this by looking at bank statements, tax returns, or other documents. Often, companies will hire a third party to verify that the investors are accredited.  

What Securities Law Implications Does Soliciting Investors Create?

To be allowed to solicit investors, your business must strictly comply with the new Rule 506(c), including making sure the investors are accredited and verifying them, filing the correct form with the SEC (Form D), and other requirements. Soliciting investors without also complying with other Rule 506(c) restrictions subjects a company to fines, penalties, and even sometimes the loss of a securities license.  

How to Stay Compliant with Securities Laws when Soliciting Investors  

It's important to make sure that the exemption you're suing for your securities offering allows solicitation and otherwise complies with the securities laws. For example, if you're going to solicit investors through advertising, you need to make sure you're only soliciting accredited investors and that you're verified them as such. An experienced securities law attorney can help you ensure that you remain complaint with SEC laws and regulations.

How to Avoid Being Cast As a Bad Actor

As a matter of policy, and in response to some high-profile securities fraud cases, Congress has decided that certain persons may not sell securities under the Rule 506(b) or 506(c) exemptions. In 2013, the Securities and Exchange Commission enacted certain so-called “bad actor” disqualification provisions.

These provisions, which appear as paragraphs (d) and (e) of Rule 506 of Regulation D, disqualify persons with relevant criminal convictions, regulatory or court order, or other disqualifying event that occurred on or after September 23, 2013. If the disqualifying event happened before September 23, 2013, the issuers may rely on Rule 506, but they're required to submit certain disclosures.

The bad actor provisions were adopted to implement various provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Disqualifying events include:

  • Certain criminal convictions, court injunctions, and restraining orders
  • Final orders of certain state and federal regulators
  • Certain SEC disciplinary orders and cease-and-desist orders
  • SEC stop orders and orders suspending the Regulation A exemption
  • Suspension or expulsion from membership in a self-regulatory organization such as FINRA
  • S. Postal Service false representation orders

The SEC regulations provide that persons who are subject to the bad actors are known as “covered persons” and include the following:

  • the issuer, including its predecessors and affiliated issuers
  • directors, general partners, and managing members of the issuer
  • executive officers of the issuer, and other officers of the issuers that participate in the offering
  • 20 percent beneficial owners of the issuer, calculated on the basis of total voting power
  • promoters connected to the issuer
  • for pooled investment fund issuers, the fund's investment manager and its principals
  • persons compensated for soliciting investors, including their directors, general partners and managing members

Before a company seeks to issue securities through the Rule 506 exemption, it's very important to make sure that none of the covered persons has any of the above disqualifying events in their record. Failing to identify bad actors before proceeding under Rule 506 could result in an investment being rescinded, as well as in fines and penalties.

Summarizing the Rule 506(b) Exemption 

We recognize that these rules can seem overwhelming. It is crucial to consult with an experienced securities lawyer to understand the Rule 506(b) exemption.

To quickly summarize the Rule 506(b) exemption, we've provided these bullet points below:

  • Can sell to accredited investors, plus 35 non-accredited investors
  • Must file Form D within 15 days of putting securities up for sale
  • Can rely on the investor's own statements that they're accredited
  • May not solicit investors (except on demo day)
  • Do not have to follow the formal SEC disclosure requirements
  • Exempt from the individual states' own laws for registering securities (known as Blue Sky laws)
  • Can raise an unlimited amount of capital

Summarizing the Rule 506(c) Exemption

To quickly summarize the Rule 506(c) exemption, we've provided these bullet points below:

  • Sell to accredited investors only
  • Must file Form D within 15 days of putting securities up for sale
  • Must certify that the investors are accredited
  • May use public solicitation
  • Do not have to follow the formal SEC disclosure requirements
  • Exempt from the individual states' own laws for registering securities (known as Blue Sky laws)
  • Can raise an unlimited amount of capital

Finally, if you're thinking about raising capital through a Regulation D exemption, it's very important to first contact a securities law attorney to help you navigate SEC pitfalls. While compliance is not difficult, you must understand the restrictions and limitations, particularly if you plan to solicit investors.

If you have any questions, contact our knowledgeable securities lawyers at Newburn Law. We can help answer any questions you might have through a free initial consultation.

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.


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