The rules proposed recently by the SEC are quietly astonishing.
Going into last week, one big concern had been whether a new, invasive regime of verification might chill angel investing, which would have been especially hard to bear when issuers chose not avail themselves of the new permissiveness. But last week's release goes out of the SEC's way to be reassuring about preservation of (to borrow Joe Bartlett's phrase) the "quiet" 506:
"While we are proposing Rule 506(c) to allow for Rule 506 offerings that use general solicitation, we are preserving, under existing Rule 506(b), the existing ability of issuers to conduct Rule 506 offerings without the use of general solicitation. We recognize that offerings under existing Rule 506 represent an important source of capital for issuers of all sizes and believe that the continued availability of existing Rule 506 will be important for those issuers that either do not wish to engage in general solicitation in their Rule 506 offerings (and become subject to the new requirement to take reasonable steps to verify the accredited investor status of purchasers) or wish to sell privately to non-accredited investors who meet Rule 506(b)’s sophistication requirements. Retaining the safe harbor under existing Rule 506 may also be beneficial to investors with whom an issuer has a pre-existing substantive relationship. In this regard, we do not believe that Section 201(a) requires the Commission to modify Rule 506 to impose any new requirements on offers and sales of securities that do not involve general solicitation. Therefore, the amendments to Rule 506 we are proposing today would not amend or modify the requirements relating to existing Rule 506."
This is a good thing and should make it easier for the startup ecosystem to transition, over time, to something other than the paradigms that are normative today.
Curiously, however, the release does not go on to propose a prescriptive set of verification methods for the fork of 506 involving general solicitation or general advertising.
The guts of the SEC's proposed, new, "noisy" 506(c) read as follows: "The issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under this Section 203.506(c) are accredited investors."
What are "reasonable steps?" The release says that the answer to that question will be "based on the particular facts and circumstances of each transaction."
The release does discuss a variety of verification strategies proposed in public comment letters to date, including the idea - advocated by the ACA, SecondMarket, and others - that a proposed investment over a certain size should be indicative, in and of itself, that the investor likely has the net worth to be accredited. Third party verification is also discussed, though the release declines to say that such third parties must be broker dealers or must satisfy any criteria.
And the release has implicit warnings, too. I'd still like to see answers to the questions I put to FundersClub in GeekWire recently, but the discussion below, from the release, raises yet more:
"An issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer. In the case of the former, we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status. In the case of the latter, we believe an issuer would be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification."
Many lawyers, I suspect, will feel that the lack of clearer guidance on verification methods will make the "noisy" 506(c) less usable. But I think many entrepreneurs are going to use the new rule.
I will say the release is curious in this regard: when you consider how important it seemed to the Commission to nail down how to calculate the exclusion of the principal residence from the accredited investor net worth test - even to the point of overriding state law about mortgage deficiencies - it's odd to see it being so hands off on something so much more fundamental to private financing.