RALEIGH – Jim Verdonik and Benji Jones, Co-Founders of Innovate Capital Law and regular contributors to WRAL TechWire, discuss recent changes to SEC rules that give businesses new freedoms to communicate with investors and conduct multiple offerings.
JIM: In our last article, we discussed capital raising statistics for year 2019 and recent changes to the permitted size of Regulation CF [crowdfunding] offerings, but the SEC has been doing a lot more than that to improve the rules for how businesses raise capital. The new rules address how you sell your deal, which is the key to capital raising.
BENJI: Yes, simply increasing offering size was just the beginning. The SEC’s issuing release was 300+ pages long, but I don’t think people want to hear us talk about all that detail. How about starting by painting the big picture.
JIM: It’s clear that what seem like very separate reforms have a common purpose. The SEC’s rule changes recognize that capital raising has become what I call capital “grazing.” Our clients are constantly raising capital. It never stops. And, now that our clients can advertise and make general solicitations, coordinating multiple offerings has increased the need to understand how offerings conducted under different offering exemptions affect one another.
BENJI: Yes, a lot of the SEC’s rule changes deal with:
- Defining when one offering begins and another offering ends.
- How one offering affects another offering – especially how general solicitation or advertising in one offering affects other concurrent and later offerings.
JIM: That makes sense. Just changing the offering limits doesn’t help much, if the rules still make it difficult to communicate with investors. You have to be free to communicate to sell effectively. Can you give us some examples of the issues the SEC has either changed or clarified?
BENJI: Multiple rule changes relate to these offering process questions, including:
- Shortening the time period between separate offerings under SEC Integration Rules
- The effects of conducting general solicitations and advertising
- Clarifications about how to do more than one offering at the same time
- Testing the Waters to determine whether investors are interested in your offering
- What effects participating in Demo Days and Pitch Events has on your offering
- Accredited Investor Verification Relief for Rule 506(c) offerings
- Expanding the number of non-accredited investors permitted in Rule 506(b) offerings
- Permitting the use of Special Purpose Vehicles (SPVs) to aggregate many investors into one limited liability company or other entity so that the issuer has one stockholder instead of 100 stockholders
INTEGRATION CAN DESTROY OFFERING EXEMPTIONS
JIM: Let’s discuss our old nemesis – Integration – first. The old rule of no offers and no sales for six months between offerings wasn’t very practical for many businesses, because networking with potential investors never stops for many businesses. Networking isn’t regulated by the SEC, but networking often spills over into offering, which is regulated.
BENJI: New SEC integration Rule 152(b)(1) will help. It reduces the old six-month safe harbor to thirty (30) days. If there is a period of time in which the company makes no offers and no sales for thirty days, we do not need to integrate the two offerings.
JIM: So, now integration has a simple 30-day test. That time reduction is great, but it’s not that simple. Is it?
BENJI: One complication is the effect of advertising and other general solicitations. In some types of offerings, you are allowed to make general solicitations and advertise. In other offerings, general solicitations and advertising are not allowed. Part of new Rule 152 deals with how investors who became aware of an issuer’s business or the investment opportunity through a general solicitation or advertising should be treated in a later offering that does not allow general solicitation or advertising even if thirty days separate the two offerings.
JIM: So, the results of an earlier general solicitation may cause “integration” of some investors or potential investors from an earlier offering in a later offering even if more than thirty days separate the two offerings.
BENJI: Exactly. So, you have to know the rules and think about how they play out both short-term and long-term.
PRE-EXISTING SUBSTANTIVE RELATIONSHIPS ARE KEY TO AVOIDING GENERAL SOLICITATIONS
BENJI: Most people know what advertising is. Is general solicitation just another name for advertising?
JIM: No, general solicitation includes advertising, but you can make a general solicitation without “advertising” the offering.
BENJI: Wait, that makes my head spin a bit. Can you explain?
JIM: The key point for the SEC is that general solicitations occur when issuers make offers to people with whom they and people acting on their behalf don’t have “preexisting substantive relationships.” What constitutes a “pre-existing substantive relationship,” is too complex to discuss here, but note that it’s not enough to just know someone or to be introduced by someone you know. Because of this requirement, the SEC believes that a lot of offerings don’t comply with the principles around the elusive “preexisting substantive relationship,” and, therefore, many issuers may be violating securities laws.
BENJI: Before we leave “pre-existing substantive relationships” I note that selling to one person without the preexisting substantive relationship does not necessarily create a general solicitation. This is a facts and circumstances test. The more people without a preexisting substantive relationship invest in a deal, the more likely that a general solicitation exists.
JIM: Businesses raising capital in offerings that do not permit general solicitations (like Rule 506(b), Rule 504 and Section 4(a)(2)) should ask their securities lawyers to help them determine how to comply with the comply with the “pre-existing substantive relationship” requirement to avoid liability.
INTEGRATION OF TWO CONCURRENT OFFERINGS
BENJI: Obviously, the 30-day safe harbor cannot apply if the issuer is conducting two or more offerings at the same time.
JIM: Yes, many clients conduct more than one offering at the same time. Sometimes, this is intentional. Other times, they don’t know that under SEC rules more than one offering is happening. Investors on one offering need to know about the other offering.
BENJI: Yes. The other offering may n-be a material fact. To avoid committing fraud with a material omission, the terms of one offering may be required to be disclosed in the other offering. This can be a problem where one offering is being conducted under Regulation CF and the other offering uses Rule 506(c), because Regulation CF limits the amount of information businesses can disclose to investors outside the Crowdfunding Platform (while Rule 506(c) allows you to say anything that isn’t fraudulent).
JIM: How can issuers avoid SEC violations for offerings that have different rules?
BENJI: New Rule 204(d) of Regulation CF tells us that you can include the terms of the Regulation CF Crowdfunding offering in the disclosure document for another other offering without violating Regulation CF as long as the disclosure document for the other offering meets the other requirements of Rule 204. But applying new integration Rule 153(a)(2), we know that if there is a cross reference to another offering, then BOTH offerings have to comply with the rules that apply to either offering, including legend requirements and communications restrictions. So in our example, the Rule 506(c) offering disclosure document would have to include Regulation CF Crowdfunding offering legends and discussion of the Regulation CF Crowdfunding offering would need to be limited to the terms of the offering permitted under Rule 204 of Regulation Crowdfunding.
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