Rule 506 of SEC’s Regulation D provides a “safe harbor” for the private placement of securities. Under Rule 506, a company is able to raise an unlimited amount of money. One of the requirements of the rule is that the company cannot use general solicitation or advertising to market the securities offering. Rep. Kevin McCarthy (R-Cal.) recently introduced H. R. 2940 which, if enacted, would require the SEC to provide in Rule 506, that the prohibition against general solicitation or advertising would not apply to offers and sales, provided that all purchasers of the securities are accredited investors. Although the definition of “accredited investor” can be complex, with respect to natural persons (humans) other than company insiders, an accredited investor is one (a) with income exceeding $200,000 in each of the last two years, or joint income with a spouse exceeding $300,000 during that period, and a reasonable expectation of the same level in the current year or (b) one who has individual net worth, or joint net worth with a spouse (in each case exclusive of the value of the principal residence) that exceeds $1 Million at the time of purchase.
On the surface, eliminating the requirement of general solicitation or advertising is laudable. In these gritty times, any enhancement to capital formation is helpful. The bill, if enacted, would also provide more precision to Rule 506 compliance. I have always been concerned about what was meant by the term “general solicitation or advertising.” If the SEC were to adopt guidelines, in the rule for the term “general solicitation or advertising,” it might be helpful in constructing the “safe harbor.”
On the other hand, state securities regulators, such as Heath Absure, Arkansas Securities Commissioner, have expressed concern about the bill’s possible effect of increasing fraud under Rule 506. I think this is possible. As noted above, the test for non insider accredited investors who are natural persons is based either on income or net worth. The tests, with one recent modification, were set some time ago and are pretty low bars today. Furthermore, the tests deal with relative wealth and not with the sophistication of the investor. It is quite possible for one to be relatively rich and unsophisticated. Also, Mr. Absure observes, that many purchasers will lie about their income or net worth qualifications and purchase the securities anyway.
The prior paragraph, however, repeats criticisms of the existing regulatory scheme, which have been voiced apart from Rep. McCarthy’s bill. It is difficult to see how general solicitation or advertising (which complied with guidelines provided by the SEC) which would require each purchaser (who must be an accredited investor) to be given, prior to sale, a comprehensive private placement memorandum would significantly increase securities fraud.
The SEC had, in 2007, proposed, but did not enact, a rule that would have permitted limited solicitation or advertising in certain private placements to “large accredited investors.”