This is our second post examining some of the comment letters the SEC has received in response to proposed Rule 506(c) – we reviewed the SEC’s Investment Advisory Committee recommendations here.
This post provides an overview of comment letters submitted by the North American Securities Administrators Association (NASAA) dated October 3, 2012, the Consumer Federation of America dated October 3, 2012, and the American Federation of Labor and Congress of Industrial Organizations / Americans for Financial Reform (AFL-CIO/AFR) dated October 5, 2012.
From the NASAA Comment Letter:
- “In 2011, fraudulent Rule 506 offerings were ranked as the most common product or scheme leading to enforcement actions by state securities regulators” and are among the most common traps for investors.
- State securities regulators are the primary enforcers of anti-fraud provisions, even in regards to Rule 506 offerings: the SEC initiated 124 total “securities offerings” enforcement actions in 2011, while state regulators took more than 200 enforcement actions relating to Rule 506 offerings alone.
- “As of the date of the Report, the Commission had never brought a single action against a company for violating Rule 503 by failing to file the required Form D, and we are unaware of any subsequent enforcement actions to enforce the filing requirements. However, state regulators routinely review Form D to ensure that the offerings actually qualify for an exemption under Rule 506 and to look for “red flags” that may indicate a fraudulent offering.”
- A Form D filing should be required prior to public advertising in order to put state securities regulators on notice that a general solicitation offering will be taking place (otherwise a state regulator who sees a public advertisement will have no way of knowing if it is part of a Rule 506 compliant offering or is a part of an unregistered offering, non-exempt public offering).
- Even though the JOBS Act directed the SEC to “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as are determined by the Commission,” the SEC has utterly failed to fulfill the second part of this mandate – determining appropriate methods. Since the SEC has only parroted the “reasonable steps” language from the JOBS Act, state regulators will be stuck making case by case judgment calls, resulting in inconsistent interpretations, state to state, and in increased litigation.
- The SEC should adopt non-exclusive safe harbors for verification of accredited investor status in order to provide regulators and market participants with some certainty. The NASAA provides several proposals for safe harbors, including reliance on broker-dealers for verification.
- The NASAA is dismayed by the SEC’s willingness to implement the provisions of the JOBS Act allowing the use of general solicitation without also fulfilling the requirement of the JOBS Act that the SEC adopt rules to disqualify bad actors from using general solicitation in private offerings.
- The SEC should place reasonable restrictions on the content of the advertising that can be used, similar to the restrictions described in CF Disclosure Guidance: Topic No. 3 (released in December 2011) – for example, requiring a balanced presentation of risks and rewards of the potential investment, and requiring that any statements contained in the advertising be consistent with offering documents. One concern is that “puffing” type claims that are permissible in the advertising world generally could result in securities law liability for unwary issuers. With respect to private funds, there should be a separate set of rules comparable to restrictions that apply to mutual funds, similar in content to Rule 482, the standard from Rule 156, and Rule 206-4(8).
From the AFL-CIO / AFR Comment Letter, in addition to several of the same points raised by the NASAA letter:
- The SEC should update the accredited investor definition as a basic safeguard, and should consider restricting Rule 506 offerings that use general solicitation to a new defined subset of accredited investors, called “Large Accredited Investors” that would satisfy higher threshold amounts, such as a net worth of $2.5 million or income of at least $400,000.
- The SEC should prohibit private funds relying on the exemptions in Sections 3(c)(1) and (7) of the Investment Company Act – the entities that use Rule 506 offerings the most often – from using general solicitation, because the congressional intent for the lift of the ban on general solicitation was clearly aimed at small businesses rather than hedge funds and private equity funds.
- The SEC should require that any advertising materials an issue intends to use in connection with an offering be pre-filed with the SEC (similar to FINRA’s requirement that broker-dealers pre-file similar materials) and create and/or enhance record keeping requirements with respect to matters such as investor qualifications and advertisements actually used in the offering.
From the Consumer Federation of America Comment Letter, in addition to points already discussed:
- The SEC has unnecessarily restricted the scope of its proposed rule and its request for comments: “Unaccountably, the Commission only requests comment on its proposed approach to verification of accredited investor status and its proposed addition of a checkbox to Form D, dismissing without justification other issues and alternative regulatory approaches that have been brought to its attention.”
- The SEC already fails to devote sufficient resources to oversight of Rule 506 offerings, and has repeatedly failed to take action in the face of rule violations, as noted in a 2009 Inspector General’s report. The “reasonable steps” standard proposed by the SEC will be difficult to enforce and will further overwhelm the SEC’s enforcement resources.
- If an issuer relies on a third party to verify that an investor is an accredited investor, the third party should be under obligations to maintain the accuracy of its information and safeguard investor data, at a minimum.
- The accredited investor definition should be broadened to require financial sophistication, not just a relatively high income or net worth, which are not reliable indicators of investment experience and have not been appropriately adjusted in the three decades since they were originally proposed.
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