By now many readers have heard about the new "Rule 506(c)" promulgated by the SEC as a result of the JOBS act. The buzz in the blogosphere is that Rule 506(c) allows anybody to conduct a private placement offering on the internet. Web sites like AngelFund, Fundable, and CircleUp have been launched, promising to provide a crowd-sourcing clearinghouse where entrepreneurs or real estate developers seeking equity can post their private placement offerings, and investors seeking opportunities can find them. Once again we see the power of the internet working at the speed of light to create a frictionless market that promises to expose all potential willing buyers to all potential willing sellers.
Or do we? Keep in mind that any time one seeks investor money for a business, one is selling securities. Theraison d'etre of the SEC is to create rules and enforcement mechanisms to ensure some level of integrity in this process.
It was for this reason that the SEC created restrictions on the ability to raise money via private placement offerings. Prior to Rule 506(c), raising money from strangers usually fell into the realm of public offerings. Private placement offerings were traditionally driven by the rolodex on the desk of the entrepreneur or developer seeking investors. The process worked because there was typically a pre-existing relationship nexus between the "issuer" (the entrepreneur or developer seeking funds) and the investor.
Rule 506(c) offerings are not based on a preexisting relationship nexus. It enables anybody to raise money from strangers. In this way, 506(c) offerings walk and talk a lot like public offerings, but without the procedural framework that provides protection for investors. For this reason, the SEC has imposed additional mandates on issuers to make sure the investors are truly accredited. Issuers can no longer rely on the prior form of self-certification commonly used in private placement offerings. Instead, issuers must undertake a whole new level of verification of accredited investor status for 506(c) offerings.
SEC enforcement test cases will likely be emerging over the next year. In the meantime, issuers wanting to engage in general solicitation and general advertising to reach new investors should proceed with the meticulous, cautious attention to the process of verifying the accredited status of potential investors. It is likely that the SEC will be scrutinizing 506(c) offerings carefully and enforcing rule violations vigorously. Similarly, we have not yet seen litigation by disgruntled investors against issuers arising from 506(c) offerings. Again, we would not be surprised to see an environment in which this kind of litigation produces harsh results for issuers.
As noted, the most important feature of 506(c) offerings is that the issuer (the developer or entrepreneur seeking the funds) has an affirmative obligation to verify that each investor qualifies as an accredited investor. This is a significant departure from 506(b) private placements, where issuers typically had investors complete a questionnaire and could self-certify that they were accredited. The duty under 506(c) extends well beyond simply requiring a questionnaire. At the very least the issuer (either in-house or through a third party) will have to review significant personal financial information of potential investors to verify the accreditation status of each.
Keep in mind that this is an affirmative obligation of the issuer. The penalty for getting it wrong falls on the issuer, and that penalty is potentially harsh. In the case of any enforcement activity or litigation against the issuer, the extent of the issuer's due diligence in investigating whether the affected investor qualified as an accredited investor will be examined in the harsh light of a courtroom.
This brings us back to the web sites promising to create a frictionless crowd-sourcing environment. Even if these sites claim to admit only "accredited investors", it does not appear that the sites assume responsibility and liability for the process of verifying accredited status. Further, even if they did accept responsibility, we are not aware of a bonding or insurance product that provides net worth to satisfy liabilities that could arise as a result.
What this means as a practical matter is that issuers--that is, developers or entrepreneurs seeking money--must be scrupulously careful about engaging in general solicitation and advertising on their private placement offerings. This type of web-based market for private equity may be useful for the purpose of introducing possible investors to the issuer, but, once the introduction is made, the additional requirements pertaining to verification of investor suitability should be meticulously satisfied to minimize the possibility of future liability.
By the way, the new rule 506(c) does not apply to existing crowdsourcing (or "crowdfunding") mechanisms such as Kickstarter. Kickstarter and similar sites have to date attempted (not always successfully) to sidestep significant SEC activity by creating a structure under which entrepreneurs seeking funds do not offer equity in their businesses in exchange for the money. Instead, they offer some lagniappe in case the business is successful, such as a free copy of a CD from a musician raising money to produce a CD, or a free meal from a chef raising money to open a restaurant. However, it appears that the SEC is working toward a set of rules that will govern crowdsourcing under the Kickstarter model. Watch future editions of Lindquist Gets Real for updates.