Jonathan Nzali Tips
The last previous two dealt with the status and regulatory compliance for foreign issuers hoping to raise capital within the US. Depending on your status and particular circumstances you are expected to deal with only some individuals who could afford better than others the risks involved with foreign divestitures of their investment portfolio. This last part here provides clarification on the applicable regulatory guidelines.
Verification of Investor Status under Rule 506(c)
Rule 506(c) allows a company to generally advertise an offering of securities in the United States (including on the internet), provided that all investors are “accredited investors” and the company takes reasonable steps to verify that the investors are accredited investors.
The SEC release provides that the determination of whether the steps taken to verify accredited investor status are “reasonable” is “an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction”. The SEC proposed a number of factors that might be considered in this “principles-based approach”:
· the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
· the amount and type of information that the issuer has about the purchaser; and
· the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
The SEC also stated that “[t]hese factors would be interconnected, and the information gained by looking at these factors would help an issuer assess the reasonable likelihood that a potential purchaser is an accredited investor, which would, in turn, affect the types of steps that would be reasonable to take to verify a purchaser’s accredited investor status.”
Furthermore, the SEC recognizes that although verification of the status and sophistication of institutional investors may be relatively easy, verification may be more difficult if the investor is a natural person.
Rule 506(c) therefore also sets out a non-exclusive list of methods that companies (or third parties) may use to satisfy the verification requirement for investors who are natural persons:
· receipt of certain documentation of levels of income or net worth of the purchaser (such as tax returns, bank statements, and credit reports);
· verification of accredited investor status from certain third-parties, such as a registered broker-dealer, a registered investment adviser, a licensed attorney, or a certified public accountant; or
· for an existing shareholder which previously purchased in a Rule 506 offering by the company, the receipt of a certification from the purchaser that it still meets the definition of an accredited investor
If the investor’s status is to be established by verification of his or her net worth as per the first method above, the release states that the verification requirement will be met if the noted documentation is reviewed and the investor provides “a written representation that all liabilities necessary to make a determination of net worth have been disclosed”.
Note that the requirement to take reasonable steps to verify that all purchasers are accredited investors is independent of the requirement that sales be made solely to accredited investors, and must be satisfied even if all purchasers happen to be accredited investors. The release states that it will be important for issuers (and any third party verification service providers) “to retain records regarding the steps taken to verify that a purchaser was an accredited investor”.
The SEC has left the previous formulation of Rule 506 unchanged in the form of Rule 506(b). Although issuers must still reasonably believe that investors are accredited investors, issuers will not be subject to the verification or related record retention requirements if they do not employ general solicitation or general advertising in reliance upon Rule 506(c). Note also that issuers conducting offerings pursuant to Rule 506(b) may still offer and sell securities to no more than 35 sophisticated non-accredited investors, which is not the case for issuers pursuing Rule 506(c) offerings.
Impact of Rule 506(c) on the private placement market for U.S. issuers and FPIs.
So what does the creation of Rule 506(c) mean for companies (both U.S. issuers and FPIs) looking to raise cash? The short answer is that these changes will likely have a major impact on the way that companies raise money from sophisticated investors in what now seems to be ‘semi-private’ offerings. True equity “crowdfunding” is not impacted by these new rules. The rules governing that market are yet to come.
It is likely that we will continue to see more angel networks, venture capital groups and securities brokers bring companies and accredited investors together online. These offerings and platforms will likely have some or all of the following characteristics:
· access to the site may be available to accredited and non-accredited investors (though issuers may be able to pursue Rule 506(b) if only accredited investors were given access to the site);
· the ability to invest will be granted to accredited investors only;
· verification of the investor’s status will be completed by a variety of methods, including representations from the investor and the provision of certain information to the company (or platform, broker, etc) by the investor that proves the investor’s status;
· verification may be completed by third party service providers;
· records will be kept by the party that verifies the investor’s status; and
· Form D will be filed by the company, the broker or perhaps through the platform.
“Global” Fundraisings
So what are the options for FPIs?
Let’s take a hypothetical company, Acme plc. Its shares are all owned by its founders (members of its board or employees (both current and former) that are spread out around Europe), its operations are conducted almost entirely outside of the United States (except for a small proportion of sales), its assets consist almost entirely of IP and IT held in Europe and its board of directors are all European citizens living in the United Kingdom. Therefore, subject to confirming with their lawyers, Acme plc appears to be an FPI.
Acme plc would like to raise £5 million in order to build its mobile site and increase its marketing spend. It was able to raise the first £3 million relatively easily from members of its board and other friendly investors in the United Kingdom procured by U.K. Fake Financial Capital (a financial adviser), but the last £2 million proved to be more difficult.
U.K. Fake Financial Capital has a relationship with a U.S. financial adviser (U.S. Fake Advisor) that is registered as a broker dealer with the SEC and, given Acme’s primary markets and the activity of U.S. investors in these segments, U.K. Fake Financial Capital suggests that it may be able to find investors in the United States to round out Acme’s fundraise.
U.S. Fake Advisor has recently set up a new website/platform in order to advertise and facilitate fundraisings. Although the deals on the platform can be viewed by anyone, only accredited investors (that are verified by U.S. Fake Advisor or by a third party service provider) may invest.
Acme plc contacts U.S. Fake Advisor and, after the necessary diligence and paperwork, engages U.S. Fake Advisor to assist the company in finding U.S. accredited investors for its fundraising. A few weeks after posting the details of the fundraising on the website, communicating with interested investors and responding to their questions, Acme plc has raised $3.5 million needed to close out its fundraising.
So, in this perhaps overly rosy scenario, what do we have?
Although there are many details and more than a few steps left out of the discussion above, we have the makings of an offer and sale of securities to investors in the United Kingdom pursuant to Regulation S and an offer and sale of securities to accredited investors in the United States presumably pursuant to Rule 506(c). Note that if U.S. Fake Advisor had determined that it would simply contact a few accredited investors the old-fashioned way (i.e. by telephone or even email) or by providing only verified accredited investors with access to the platform (instead of posting the offer to a platform/website that was open to the public), the offer may have been made pursuant to Rule 506(b).
Takeaways for FPIs
There are a few basic steps or principals that FPIs need to keep in mind if they are considering raising money in the United States:
- It’s possible to raise a portion of your fund outside of the United States and a portion inside the United States.
- Assessing and maintaining your status as a FPI will minimize your ongoing reporting and other requirements if you do raise money in the United States.
- Offers and sales of securities in the United States must either be registered or made pursuant to an exemption.
- Although each case is different, offers and sales to accredited investors generally carry less risk than offers and sales to non-accredited investors.
- One of the many issues that wasn’t covered in this note is that the FPI will almost certainly need the help of a U.S. registered broker dealer. The rules covering broker dealers (which can include a company selling its own shares and employees of the company doing so) are very complicated and are often a particular point of emphasis for the SEC. Beware. Talk to a lawyer and know that working with a registered broker dealer is highly likely.
Conclusion
The creation of a crowdfunding market and the liberalisation of the advertising and marketing restrictions for private offerings set out in the JOBS Act clearly represent significant changes to the U.S. capital markets. Crowdfunding may develop into yet another option for companies seeking to raise capital in the United States and the lifting of the ban on general solicitation and advertising will likely make this already enormous market more efficient and user-friendly by bringing it online.
Regardless of these changes, however, raising capital in the United States will remain a relatively complicated process that involves risk for issuers and other transaction participants. This is unavoidable as the SEC, FINRA and the courts (not to mention the lawyers) are all active watchdogs.
Unfortunately, these risks are often misunderstood, particularly by non-U.S. companies. With proper advice, thousands of non-U.S. companies tap the U.S. capital markets every year and the changes resulting from the JOBS Act that will drive the ability of U.S. companies to raise funds can do the same for non-U.S. companies.
I hope this was helpful to all my blog readers. Let me know if there are some parts you would like clarifications on. Do not forget to consult with your lawyer if you are actively seeking to raise substantial funds from members of the general public in the USA that do not have a “special relationship” with you.
Jonathan Nzali Tips 