Accredited Investors

The JOBS Act in a Nutshell – Part III General Solicitation and Private Offering Platforms

by Vanessa Schoenthaler on April 30, 2012

Jumpstart Our Business StartupsThe JOBS Act makes several significant changes to the rules surrounding private capital formation. One such change being the much-discussed elimination of the prohibition on general solicitation and general advertising in certain private securities offerings. Another being the addition of an exemption from broker-dealer registration for platforms that, to a certain extent, facilitate offers and sales of unregistered securities.

General Solicitation and General Advertising in Private Offerings

Section 201 of the JOBS Act requires that within 90 days of its enactment, or by July 4, 2012, the Securities and Exchange Commission revise Regulation D to eliminate the prohibition on general solicitation and general advertising in private offerings made in reliance on the safe harbor afforded by Rule 506, provided that only accredited investors participate in the offerings.

In its current form, Rule 506 allows an unlimited amount of capital to be raised from an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors, provided, however, that whenever non-accredited investors participate in an offering certain information disclosure requirements must be met. In its current form Rule 506 also explicitly prohibits general solicitation and general advertising, regardless of whether participating investors are accredited or non-accredited.

Section 201 of the JOBS Act also requires that the Commission, again by July 4, 2012, revise Rule 144A to provide that securities sold thereunder may be offered to persons other than qualified institutional buyers (QIBs), including by means of general solicitation or general advertising, provided that the securities are ultimately sold only to persons that the seller or anyone acting on the seller’s behalf reasonably believe to be QIBs.

Like Rule 506, Rule 144A is a safe harbor for sales of unregistered securities. Where they differ is that Rule 506 addresses sales of securities by an issuer (akin to a primary offering), whereas Rule 144A addresses resales by persons other than an issuer (akin to a secondary offering). Very generally, the safe harbor afforded by Rule 144A allows for resales of a limited category of qualifying securities to QIBs. Rule 144A resales often follow in close proximity to the private offering in which the securities being resold were originally issued.

So how are these changes going to impact the market for private securities offerings?

Insofar as Rule 506 offerings are concerned, over time we may see a shift from other types of Regulation D offerings to Rule 506 offerings, but lifting the ban on general solicitation and general advertising is not likely to have a significant impact on the type of investors participating in Rule 506 offerings.

Based on a recent report by the Commission’s Division of Risk, Strategy and Financial Innovation (FSHI), Rule 506 is already by far the most popular private offering exemption; used in over half of all the private offerings examined in FSHI’s report. And, even though Rule 506 allows for participation by up to 35 non-accredited investor, almost 90% of all Regulation D offerings (Rules 504, 505 and 506 combined) are made up entirely of accredited investors. So, while we may ultimately see even more Rule 506 offerings, there’s not much room for a shift in the ratio of non-accredited to accredited investors.

As for transactions set up to take advantage of the Rule 144A resale exemption, they only make up a small number of the private offerings conducted each year and they generally involve larger companies that already are, or immediately become, subject to the Exchange Act’s reporting requirements. Compared to Rule 506 offerings, Rule 144A transactions are fairly niche and, while I don’t have anything in the way of stats to back it up, I don’t think that we’re going to see any great shift toward Rule 144A offerings just because general solicitation and general advertising is permitted.

Where lifting the ban on general solicitation and general advertising will undoubtedly have the greatest impact is in the amount of information about private offerings that becomes publicly available. Hopefully this will result in a better understanding of how private capital formation works, as opposed to an overload of information that is of diminishing value or quality.

One other item of note here is that, despite the JOBS Act having taken effect, the current prohibition on general solicitation and general advertising remains in place until the Commission adopts amended or new implementing rules and those rules themselves take effect.

The Platform Exemption to Broker-Dealer Registration

Finally, Section 201 the JOBS Act creates an entirely new exemption from the broker-dealer registration requirements for anyone that maintains a platform or other mechanism that permits offers, sales, purchases or negotiations of securities, or permits general solicitation, general advertising or related activities by an issuer that is offering securities, regardless of whether those activities take place online, in person or by some other means.

What’s more, the exemption is available even if the person maintaining the platform invests in or provides “ancillary services” related to the securities that are made available through the platform. Ancillary services are defined to include due diligence services, provided no compensated investment advice is given, and the provision of standardized documents, provided there is no involvement in the negotiation process and the parties are free to use their own transaction documents if they choose to.

Lastly, the exemption is contingent on there being no transaction related compensation, no possession of securities or customer funds and no involvement by persons subject to statutory disqualification under Section 3(a)(39) of the Exchange Act.

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The Net Worth Standard Under the Definition of Accredited Investor Went Into Effect Today

by Vanessa Schoenthaler on February 27, 2012

The Securities and Exchange Commission’s final rules and amendments conforming the net worth standard under the definition of accredited investor to the requirements of the Dodd-Frank Act went into effect today, causing the Division of Corporation Finance to withdraw and archive C&DI Questions 179.01 and 255.47, which addressed how to determine the value of an investor’s primary residence for purposes of calculating net worth. Any such future determinations should be made in accordance with the final rules.

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The SEC’s Final Rules For Calculating Net Worth Under the Definition of Accredited Investor

by Vanessa Schoenthaler on December 22, 2011

Yesterday the Securities and Exchange Commission adopted final rules and amendments conforming the net worth standard under the definition of accredited investor to the requirements of Section 413(a) of the Dodd-Frank Act. The Commission’s rules and amendments are effective as of February 27, 2012, but the amended net worth standard has been in effect since the Dodd Frank Act was enacted on July 21, 2010.

The General Rule

To qualify as an accredited investor under the amended net worth standard, an individual investor must have a net worth, alone or jointly with their spouse, in excess of $1,000,000 excluding the estimated fair market value of their primary residence.

Subject to certain exceptions, any indebtedness secured by an investor’s primary residence, up to its estimated fair market value at the time of the sale of the securities, should be excluded from the liability side of the net worth equation. Meaning that you only need to exclude the positive equity in an investor’s primary residence when calculating their net worth.

The Commission illustrates this general rule with the example of an investor that has:

  • a net worth of $2,000,000 (calculated by using the commonly accepted definition of net worth, i.e., the difference between the value of the investor’s total assets, including their primary residence, and the value of their total liabilities, including any indebtedness secured by their primary residence);
  • a primary residence with an estimated fair market value of $1,200,000 at the time of the sale of the securities; and
  • indebtedness secured by the primary residence (a mortgage) in the amount of $800,000.

How do you calculate the investor’s net worth under the amended standard? First you have to calculate the positive equity in their primary residence:

Then you can determine their net worth under the amended standard:

The 60-Day Look-Back — The Refinancing Scenario

The liability side of the net worth equation should generally include any incremental increase in the amount of indebtedness secured by an investor’s primary residence (e.g., a refinancing, second mortgage or home equity loan, etc.) that is incurred during the 60-day period prior to the sale of the securities, even if the estimated fair market value of the investor’s primary residence exceeds the total amount of the indebtedness incurred.

The one exception to this requirement is for indebtedness incurred during the 60-day look-back period as part of an investor’s acquisition of a new primary residence. 

Negative Equity — The Underwater Mortgage Scenario

The liability side of the net worth equation should also include any excess of indebtedness secured by an investor’s primary residence over its fair market value (e.g., an underwater mortgage). Meaning that you need to reduce an investor’s net worth by the amount of any negative equity in their primary residence.

Limited Grandfathering of Certain Formerly Accredited Investors

The final rule provides for limited grandfathering under which the former accredited investor net worth standard will apply to certain purchases of securities by an investor that would not otherwise qualify under the new accredited investor net worth standard, provided that:

  • the right to purchase those securities was held on or before July 20, 2010 (the day before enactment of the Dodd-Frank Act);
  • at the time the investor acquired the right they qualified as an accredited investor under the former net worth standard; and
  • the investor held securities of the same issuer, other than the right, on July 20, 2010.

The grandfathering provision applies to the exercise of:

  • statutory rights, such as pre-emptive rights arising under state law;
  • rights derived from an issuer’s constituent documents, such as its certificate of incorporation; and
  • contractual rights, such as rights to acquire securities upon exercise of an option or warrant or conversion of a convertible instrument, rights of first offer or refusal and contractual pre-emptive rights.

Interesting Asides

Some interesting statistics from the final rule’s adopting release:

For the Commission’s fiscal year ended September 30, 2010:

  • 22,941 issuers filed a Notice of Exempt Offering of Securities on Form D;
  • 17,593 of those were initial Form D filings (filings for new offerings);
  • only 66, or 0.4%, of the initial Form D filings relied on an exemption from registration afforded by Section 4(5) (formerly Section 4(6)) of the Securities Act;
  • it’s interesting how the Commission presents this and the next data point, it might not make sense at first (the numbers don’t immediately add up), but if you think it through, it works: 16,856, or 96%, of the initial Form D filings relied on an exemption from registration afforded by one of the rules promulgated under Regulation D;
  • 834 of the initial Form D filings relied on an exemption from registration afforded by both Section 4(5) and one of the rules promulgated under Regulation D; and
  • finally, the median size of an offering relying on an exemption from registration afforded by one of the rules promulgated under Regulation D was approximately $1,000,000.

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The Proposed Amendments to the Definition of Accredited Investor and Other Odds and Ends

by Vanessa Schoenthaler on February 1, 2011

Last week the Securities and Exchange Commission issued proposed amendments to conform the definition of accredited investor to the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. As amended, the definition would read:

Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.

An interesting tidbit from the footnotes of the proposing release: in fiscal year 2010 the Commission received 17,593 initial Form D filings, of those 16,856, or 96%, claimed an exemption that relies on the definition of an accredited investor.

The Commission is soliciting comments on a number of aspects of the new definition, which are due on or before March 11, 2011. Of particular note, at the Commission’s January 25, 2011 open meeting, both Commissioners Casey and Paredes expressed interested in hearing comments on whether the amended definition should “grandfather” existing investors who were accredited at the time of their initial investment, but who may no longer be accredited under the new definition, to allow those investors to make follow-on investments.

An Extension of Comment Periods

On Friday the Commission announced that it was extending the comment period for its proposed rules on disclosures related to conflict minerals, mine safety and payments made in connection with resource extractions through March 2, 2011. The original comment period was set to expire on January 31, 2011. The extension is being issued in response to several requests for additional time to “allow for the collection of information and improve the quality of responses” by interested persons. Each of the extending releases, available here, here and here, references a representative sample of letters that have made a request for additional time.

The Cost of Implementing Dodd-Frank

Also on Friday Representatives Randy Neugebauer, Chairman of the Subcommittee on Oversight and Investigations, and Spencer Bachus, Chairman of the House Financial Services Committee, issued a joint letter to the Commission, and several other federal agencies, seeking information regarding the estimated costs associated with implementing and executing the Dodd-Frank Act. The Commission has until February 10, 2011 to respond.

(Download File)

The Commission continues to suffer from budgetary constraints and is currently operating on the basis of a continuing resolution that temporarily extends its fiscal year 2010 budget through March 4, 2011. As a result, the Commission has been forced to scale back or delay a number of Dodd-Frank initiatives, among other things.

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