Representative Kevin McCarthy (R-CA and House Majority
Whip) recently introduced the Access
to Capital for Job Creators Act (H.R. 2940), which would remove the ban on
general solicitation for securities offering conducted under Rule 506 of
Regulation D. Rule 506 is a safe harbor regulation which sets forth some
conditions that if met, will assure an issuer that its securities offering is
exempt from registration under Section 4(2) of the Securities Act of 1933.
The rule permits the sale of securities to up to 35 non-accredited but
sophisticated investors and an unlimited number of accredited investors.
However, the issuer must also avoid engaging in a "general solicitation,"
which prohibits the issuer from conducting any public advertising of the
offering. Rep. McCarthy's bill would remove this prohibition on any
offering conducted exclusively to accredited investors.
Rep. McCarthy has advocated for the bill by arguing that
it will increase access to capital for small businesses. This is
certainly true. Under current law, issuers of securities may only offer
their private placements to pre-existing contacts, which significantly limits a
small business's pool of potential investors. However, while it may be
true that lifting the ban on general solicitation will help many small issuers
get a wider audience for their investment pitches, regulators have concerns
that removing this requirement will increase the likelihood of fraud. The
North American Securities Administrators Association (NASAA) articulated these
concerns in testimony before the House Capital Markets Subcommittee.
NASAA's testimony, Heath Abshure, Chairman of the NASAA's Corporation
Finance Section Committee, expressed concern that Rule 506 offerings are often
used to defraud investors. Since an offering conducted under Rule 506 is
considered a "federally covered security," states are preempted from regulated
them in any meaningful way (apart from prohibiting outright fraud). As a
result, state securities regulators have become increasingly alarmed at the
widespead use of this exemption, which they believe has led to increased
incidents of securities fraud. If this exemption permitted publicly
advertised offerings, they argue that these instances of fraud would become
even more prevalent.
The outlook on this legislation is mixed. The state
regulators' concerns are certainly valid, though the reality is that most
perpetrators of securities fraud routinely violate the registration
requirements anyway. Perhaps increased enforcement of anti-fraud
provisions is the answer to dealing with fraud rather than retaining the
general solicitation ban. That said, I don't think Rep. McCarthy's bill
is particularly well thought-out. He simply eliminates the ban on general
solicitation without considering the effects on other parts of Rule 506.
With no ban on general solicitation, Rule 506 would allow a company to
raise unlimited amounts of money from an unlimited amount of investors using
public advertising. This would pretty much be a public offering and
allowing it to qualify as an exempt unregistered offering would essentially
negate the registration requirements of the Securities Act and of the
securities laws of all of the states. As a result, the only real limit
placed on a company that does not register its securities would be that all of
the investors must be accredited. But even that would not be much of a
limitation, since an investor's status as an accredited investor is determined
by a questionnaire. Investors can and frequently do misrepresent
themselves on investor questionnaires, especially if they are convinced that
they are being given access to a great "investment opportunity."
I do agree that the ban on general solicitation is an
outdated idea. However, simply removing it from Rule 506 without
considering the impact on the rest of the Securities regulatory system is
probably not the answer. In it's testimony, the NASAA itself advocated
for the adoption of a different exemption called the Model Accredited Investor
Exemption (which I'll explore in a future post), so the NASAA is not completely
unsympathetic to business owners. Overall though, I'm pleased that
legislators and regulators are now beginning to look to find ways to update
securities laws for the 21st century.
See also: Doug Cornelius-Lifting
the Ban on General Solicitation
Read more articles by Alexander Davie at Strictly Business, a
business law blog for entrepreneurs, emerging companies, and the investment
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