SEC Takes First Significant Steps Toward Crowdfunding

Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.

Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser's accredited status. Id.

Access to Broader Audience, But Reach Still Limited

New Rule 506(c) is thus double-edged. General solicitation will allow a broader audience to be reached by issuers who otherwise have been restricted in identifying potential investors, but that base is limited to those who are accredited, the determination of which requires the issuer's somewhat subjective determination, grounded in individualized facts and circumstances rather than clear SEC guidance. Enhancing the utility of the rule change for franchisors is the opportunity to use the franchise application data of their franchisees to mine the list of franchisees for potential investors in the franchisor. Because franchise application submissions typically include exactly the right net worth verification data, or produce verification of net worth data from authorized inquiries to third parties, franchisors may now consider using the Rule 506(c) solicitation to offer their securities to accredited-investor franchisees. One wonders whether franchisors seeking equity funding may consider a “paper clip” simultaneous offering of a franchise and an equity interest in the franchisor, particularly to area developers and multi-unit franchisees. Management would need to be prepared to answer to franchisees as franchisees and as investors/equity owners.

Rule 506(c), as currently drafted, modifies only Title II of the JOBS Act, but leaves Title III of the JOBS Act, “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012″ (the CROWDFUND Act), untouched. See , Pub. L. No. 112-106, ”301-05, 126 Stat. 306, 313 (Apr. 5, 2012). Investors eager to work outside the current securities regime are hopeful that when the rules are finally promulgated under CROWDFUND, they will be permitted to sell to any investor, accredited or otherwise, albeit through the use of online funding portals. See, id. at '304. Accordingly, general solicitation and advertisement would likely be limited, i.e., issuers would not be permitted to advertise in print, through broadcast media or through social media as permitted under Rule 506(c). These unwritten regulations may be more of a boon to less-sophisticated or smaller-scale franchisors in comparison to Title II's somewhat tempered Rule 506(c).

Another challenge that may arise as a result of new Rule 506(c) is the interplay between federal securities law and state blue sky laws. Although transactions effectuated under Rule 506 preempt state law generally, state registration require- ments for broker-dealers and investment advisors is not affected by the SEC's new rule. New Rule 506(c), supra note 2. If Rule 506(c), and later CROWDFUND, open the floodgates of entrepreneurial investing, issuers should be aware that the use of an unregistered intermediary may run afoul of state law. This may be a concern for multi-state franchisors employing a broker-dealer or other intermediary to solicit franchisees and other possible investors. In particular, the engagement of independent franchise sales brokers to act as sellers of the franchisor's securities will trigger the application of securities broker-dealer laws to these brokers, a level of regulation to which they are likely not accustomed.

As things currently stand, the recent change in Rule 506(c) is a half-step, rather than a leap, forward. CROWDFUND is not fully implemented for non-accredited investors.

Positive Consequences of Rule 506(c)

In the franchise context, new Rule 506(c) may have some positive effect. One possible advantage of the JOBS Act for franchisors and franchisees is the potential use of information already encompassed in a FDD as a proxy for the issuer disclosures that may be required under the Act. See, Joel Buckberg & Nicole Jumper, “Join the Crowd ' Is Franchising Uniquely Suited for Crowdfunding?,” Hospitalitas (Spring/Summer 2012). The franchise application and qualification information solicited from franchisees may also be used to verify accredited investors, as observed above. Under the new rule, franchisors should consider the nature of the franchisee and the type of accredited investor that the franchisee claims to be; the amount and type of information that the franchisor has about the franchisee; and the nature of the offering, such as the manner in which the franchisee was solicited to participate in the offering; and the terms of the offering, such as whether it requires a minimum investment amount. See , New Rule 506(c), supra note 2. Large-capital-investment franchises such as area developer or subfranchisor may produce qualified accredited investor candidates for franchisor securities offerings.

Conclusion

The SEC's ballyhooed rulemaking giving issuers more flexibility to find qualified investors on the Internet and through general advertising isn't the implementation of the JOBS Act that many business owners and investors have been anticipating. The revisions enhance the utility of Item 20 lists of franchisees, particularly multi-unit operators, as a basis for capital-raising solicitation efforts. However, the use of franchise seller networks to sell or promote the sale of franchisor securities continues to raise regulatory compliance issues. If the implementation of the general solicitation rule under 506(c) succeeds, the SEC will be pressed to expand the scope to crowdfunding, and the JOBS Act's capital raising potential will be closer to realization.

Joel R. Buckberg and Taylor K. Wirth are with Baker Donelson Bearman Caldwell & Berkowitz, PC in Nashville, TN. They can be reached at [email protected] and [email protected], respectively.'

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Recently finalized rulemaking by the SEC to implement Section 201(a)(1) of the Jumpstart Our Business Startups Act, Pub. L. No. 112-106, '201(a), 126 Stat. 306, 313 (Apr. 5, 2012) (the JOBS Act), allows issuers of securities to engage in general solicitation and advertising to accredited investors in some private placement offerings of securities. See, “Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings,” Release No. 33-9354 (Aug. 29, 2012), [hereinafter New Rule 506(c) ]. This advertising activity was previously prohibited under the widely used private placement exemption of SEC Rule 506, enacted under Regulation D to perfect exemption from the registration requirements of the Securities Act of 1933, as amended. Although the SEC's announcement leaves several notable questions unanswered, Rule 506(c) has the potential to enhance the utility of investment programs in the franchise world.

Rule 506(c) now permits securities issuers to use general advertising and solicitation, typically manifested as published advertisements, articles and notices in newspapers, magazines and other broadcast media. 17 C.F.R. 230.502(c). This will enable crowdfunding ventures and franchisors to reach a greater audience in marketing investments in their businesses. However, these issuers may sell only to accredited investors (New Rule 506(c), supra note 2), purchasers of securities who possess, or who the issuer reasonably believes immediately before the sale of securities possess, “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” 17 C.F.R. 230.501(a); 17 C.F.R. 230.506(b)(2)(ii).

New Rule 506(c) is noteworthy because sellers of securities are required to “take reasonable steps to verify that purchasers of securities ' are accredited investors.” New Rule 506(c), supra note 2. Unlike existing Rule 506 offerings, there is no 35-individuals exception for non-accredited investors under Rule 506(c). Compare 17 C.F.R. 230.506 with New Rule 506(c). Unfortunately, too, administrative guidance surrounding the new Rule somewhat muddles the verification process for accredited investors, although the SEC's release provides a non-exhaustive list for what constitutes “reasonable verification”: Id.

Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.

Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser's accredited status. Id.

Access to Broader Audience, But Reach Still Limited

New Rule 506(c) is thus double-edged. General solicitation will allow a broader audience to be reached by issuers who otherwise have been restricted in identifying potential investors, but that base is limited to those who are accredited, the determination of which requires the issuer's somewhat subjective determination, grounded in individualized facts and circumstances rather than clear SEC guidance. Enhancing the utility of the rule change for franchisors is the opportunity to use the franchise application data of their franchisees to mine the list of franchisees for potential investors in the franchisor. Because franchise application submissions typically include exactly the right net worth verification data, or produce verification of net worth data from authorized inquiries to third parties, franchisors may now consider using the Rule 506(c) solicitation to offer their securities to accredited-investor franchisees. One wonders whether franchisors seeking equity funding may consider a “paper clip” simultaneous offering of a franchise and an equity interest in the franchisor, particularly to area developers and multi-unit franchisees. Management would need to be prepared to answer to franchisees as franchisees and as investors/equity owners.

Rule 506(c), as currently drafted, modifies only Title II of the JOBS Act, but leaves Title III of the JOBS Act, “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012″ (the CROWDFUND Act), untouched. See , Pub. L. No. 112-106, ”301-05, 126 Stat. 306, 313 (Apr. 5, 2012). Investors eager to work outside the current securities regime are hopeful that when the rules are finally promulgated under CROWDFUND, they will be permitted to sell to any investor, accredited or otherwise, albeit through the use of online funding portals. See, id. at '304. Accordingly, general solicitation and advertisement would likely be limited, i.e., issuers would not be permitted to advertise in print, through broadcast media or through social media as permitted under Rule 506(c). These unwritten regulations may be more of a boon to less-sophisticated or smaller-scale franchisors in comparison to Title II's somewhat tempered Rule 506(c).

Another challenge that may arise as a result of new Rule 506(c) is the interplay between federal securities law and state blue sky laws. Although transactions effectuated under Rule 506 preempt state law generally, state registration require- ments for broker-dealers and investment advisors is not affected by the SEC's new rule. New Rule 506(c), supra note 2. If Rule 506(c), and later CROWDFUND, open the floodgates of entrepreneurial investing, issuers should be aware that the use of an unregistered intermediary may run afoul of state law. This may be a concern for multi-state franchisors employing a broker-dealer or other intermediary to solicit franchisees and other possible investors. In particular, the engagement of independent franchise sales brokers to act as sellers of the franchisor's securities will trigger the application of securities broker-dealer laws to these brokers, a level of regulation to which they are likely not accustomed.

As things currently stand, the recent change in Rule 506(c) is a half-step, rather than a leap, forward. CROWDFUND is not fully implemented for non-accredited investors.

Positive Consequences of Rule 506(c)

In the franchise context, new Rule 506(c) may have some positive effect. One possible advantage of the JOBS Act for franchisors and franchisees is the potential use of information already encompassed in a FDD as a proxy for the issuer disclosures that may be required under the Act. See, Joel Buckberg & Nicole Jumper, “Join the Crowd ' Is Franchising Uniquely Suited for Crowdfunding?,” Hospitalitas (Spring/Summer 2012). The franchise application and qualification information solicited from franchisees may also be used to verify accredited investors, as observed above. Under the new rule, franchisors should consider the nature of the franchisee and the type of accredited investor that the franchisee claims to be; the amount and type of information that the franchisor has about the franchisee; and the nature of the offering, such as the manner in which the franchisee was solicited to participate in the offering; and the terms of the offering, such as whether it requires a minimum investment amount. See , New Rule 506(c), supra note 2. Large-capital-investment franchises such as area developer or subfranchisor may produce qualified accredited investor candidates for franchisor securities offerings.

Conclusion

The SEC's ballyhooed rulemaking giving issuers more flexibility to find qualified investors on the Internet and through general advertising isn't the implementation of the JOBS Act that many business owners and investors have been anticipating. The revisions enhance the utility of Item 20 lists of franchisees, particularly multi-unit operators, as a basis for capital-raising solicitation efforts. However, the use of franchise seller networks to sell or promote the sale of franchisor securities continues to raise regulatory compliance issues. If the implementation of the general solicitation rule under 506(c) succeeds, the SEC will be pressed to expand the scope to crowdfunding, and the JOBS Act's capital raising potential will be closer to realization.

Joel R. Buckberg and Taylor K. Wirth are with Baker Donelson Bearman Caldwell & Berkowitz, PC in Nashville, TN. They can be reached at [email protected] and [email protected], respectively.'