This article was originally posted on the “State Bar of Wisconsin’s Business Law Section Blog,” and was written by Attorney Lindsay M. Fedler.

Many people believe most capital is raised by companies (“Issuers”) making initial public offerings or trading on major exchanges such as the NYSE or NASDAQ. Notable 2017 examples include Snap! (parent company for social media app Snapchat) and real estate site Redfin. Generally, issuers must register publicly offered securities with the Securities and Exchange Commission (“SEC”) – a process involving extensive information reporting and expense.
However, most companies opt to raise capital from the private markets through private offerings exempt from registration if certain conditions are met, which reduces their regulatory burden, costs, and time required to raise new capital. Private offerings have increased substantially since the beginning of the Great Recession.[1] A large portion is raised through Regulation D, which is comprised of three rules: Rule 504, Rule 506(b) and Rule 506(c). Between 2009 and 2014, ten times as many private Regulation D offers were made (about 163,000) as there were public offerings (about 15,500).[2]
Today, over 90 % of issuers engaging in private offerings use the exemptions available under Rule 506. Two key terms applying to Rule 506 exemptions are “accredited investor” and “bad actor”.
An accredited investor[3] can be:
• Institutional, such as a bank, private business development company, or certain types of charitable organizations and trusts;
• A person associated with the issuer, such as a director, executive officer, or general partner;
• Individual investors meeting net worth or income requirements:
o Income: Individual or joint income must have exceeded $200,000 or $300,000 respectively in the previous two years (with no reasonable expectations of a change in the current year);
o Net Worth: the investor’s individual or joint net worth must exceed $1 million dollars (excluding the value of the investor’s primary residence); or
• An entity in which all equity owners are accredited investors.
If certain persons or entities involved in the offer and sale of the issuer’s securities engage in conduct which constitutes a disqualifying event under the definition of a “bad actor,” the issuer cannot use Regulation D exemptions.[4] “Covered persons” include:
• The issuer, its predecessors and affiliated issuers;
• The issuer’s directors, executive officers, general partners, managing members, and any other participating officers;
• Beneficial owners of 20% or more of the issuer’s voting securities;
• Promoters;
• Investment managers (if the issuer is a pooled investment fund); and
• Any person compensated for soliciting investors.
Disqualifying events[5] include:
• Criminal convictions, court injunctions and restraining orders involving the purchase or sale of securities, falsified SEC filings, or other securities related business.
• Final orders of certain state and federal regulators, certain SEC orders, and US Postal Service false representation orders.
• Suspensions or expulsions from memberships in a self-regulatory organization (SRO) such as FINRA, or from association with an SRO member.
Only events occurring after September 23, 2013 are disqualifying.[6] Disqualifying events occurring before September 23, 2013 must still disclosed to prospective investors.[7] A “look back” period of five to ten years may apply, measured from the date of the disqualifying event. For example, the date of the final order issued by a state securities regulator triggers the look-back period – not the date(s) of the underlying conduct.
There are some exceptions to bad actor disqualification. The issuer will not be disqualified if it shows it did not know and could not have reasonably known that a disqualified person participated in the offering, or the court or regulatory authority entering the relevant order, judgment, or decree advises in writing that disqualification under the rule should not result as a consequence.[8]
Rule 506(b) and (c)
In 2012, Title II of the JOBS Act amended Rule 506, directing the SEC to permit general solicitation and advertising in some Rule 506 offerings. As a result, the Rule 506(c) exemption allowing for general solicitation and advertising so long as all investors are accredited became effective on September 23, 2013. Rule 506(b) preserves Rule 506 as it existed before the adoption of Rule 506(c).
The exemptions under Rules 506(b) and (c) share several characteristics. Under both:
• Issuers may raise an unlimited amount of funds through the offer and sale of its securities to unlimited accredited investors;
• Prior to the sale of securities, issuers must decide what information should be provided to accredited investors, and ensure that it does not violate antifraud provisions of the securities laws; and
• The securities are not subject to the specific registration requirements of states where they are offered and sold, in contrast to Rule 504. While issuers must still file a notice form and pay a fee to the state(s) where the securities will be offered, there are no additional requirements above what is needed to complete Form D. Some states mandate electronic filing of Rule 506 document through the Electronic Filing Depository (“EFD”). For information on electronic filing procedures, check out https://efdnasaa.org, containing contact information for actual human regulators in each state to answer all questions related to Regulation D filings.
506(b)
In addition to raising unlimited funds from accredited investors, an issuer may sell its securities to up to 35 non-accredited investors under the 506(b) exemption. The issuer must reasonably believe each non-accredited investor has enough knowledge and experience in financial and business matters to properly evaluate the investment, otherwise known as the “sophistication” requirement, which is somewhat open to interpretation. Frequently, an issuer requires the prospective investor to complete a questionnaire certifying the investor as accredited or non-accredited, and if not, whether the investor has sufficient knowledge or experience in financial and business matters to make an informed decision about the investment.
Issuers must provide non-accredited investors with disclosure documents about the issuer and its securities depending on the offering size, and any information distributed to accredited investors.[9]
Advertising in connection with the offer or sale of 506(b) exempt securities is strictly prohibited. Issuers may approach investors if a substantive, pre-existing relationship exists.
506(c)
Unlike 506(b), under 506(c) an issuer may advertise the offer and sale of its securities under 506(c), through social media, email, and more traditional media (print and radio). No substantive pre-existing relationship with the prospective investor is required.
However, an issuer relying on 506(c) may only sell to accredited investors, with more stringent requirements for verifying the investor’s accredited than under 506(b).
Self-verification by a prospective investor of accredited status is insufficient – the onus is on the issuer to verify accredited status under 506(c). The SEC suggested several non-exhaustive ways to meet the verification requirement for accredited investors under 506(c)(2)(ii)(A)-(D):
• Income verification. Review investor’s two most recent years’ tax returns and obtain the investor’s written representation of a reasonable expectation of reaching the necessary income level in the current year.
• Net worth verification. Review bank and/or brokerage statements, tax assessments, or independent appraisal reports within the prior three months plus the investor’s written representation that all liabilities necessary for determining net worth were disclosed.
• Third party verification. Confirmation from a broker, investment adviser, attorney, or CPA verifying the investor met the accredited investor requirements in the past three months.
• Prior investor self-verification. If the investor purchased the same issuer’s securities as an accredited investor in a Rule 506(b) offering prior to September 23, 2013 and continues to hold the securities, the issuer can obtain the investor’s certification at the time of the sale of securities under Rule 506(c) that he or she qualifies as an accredited investor.
An accredited investor qualifying based on joint annual income or net worth requires the issuer to review documentation for and obtain a written representation from both spouses.
The stricter verification requirements result from the possibility that participation of non-accredited investors in a 506(c) offering using advertising makes the issuer ineligible under both 506(b) and (c). If an issuer using 506(c) does not advertise but inadvertently sells to a non-accredited investor, the filing can effectively be revised to a 506(b) exemption. However, once advertising is introduced, the offering will forever be a 506(c) offering and cannot be converted to a 506(b) offering allowing for sophisticated non-accredited investors.
Rule 506(c)’s Impact on Issuers
One big advantage of raising capital under Rule 506(c) is the ability to advertise to a far larger market than under Rule 506(b). However, issuers have been slow to embrace Rule 506(c), with the vast majority of Regulation D filings continuing to be made under Rule 506(b). Perhaps the field of private offerings has prohibited advertising for so long that issuers are wary of using it without more regulatory guidance, or maybe it’s the more stringent verification requirements for ensuring all investors are accredited, especially where advertising is used pursuant to Rule 506(c).
Some third party platforms are attempting to bridge the gap as a middleman for accredited investors and issuers. These platforms verify investors’ accredited status for the issuers advertised through the platform, in exchange for compensation or some portion of the proceeds raised. The platform also accepts some responsibility for “drawing the line” for advertising content of the issuer.
While Congress intended Rule 506(c) to expand investment opportunities and access to capital, time will tell if issuers take advantage.

[1] S. Bauguess et al., Securities and Exchange Commission, Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009-2014, 10 (2015). (https://www.sec.gov/dera/staff-papers/white-papers/30oct15_white_unregistered_offering.html)
[2] Id. at 7.
[3] 17 C.F.R. § 230.501(a)(1)-(8).
[4] 17 C.F.R. § 230.506(d)
[5] 17 C.F.R. §§ 230.506(d)(1)(i)-(viii)
[6] 17 C.F.R. § 230.506(d)(2)
[7] 17 C.F.R. § 230.506 (e)
[8] 17 C.F.R. § 230.506(d)(2)
[9] 17 C.F.R. § 230.502(b)(2)


Lindsay Fedler, University of Wisconsin Law School 2013, is an attorney with the Wisconsin Department of Financial Institutions in Madison, Wisconsin where she specializes in the areas of securities and franchise laws and regulations at the state and federal level, and prosecutes enforcement actions on behalf of the Division of Securities. She may be reached at lindsay.fedler@wisconsin.gov . The Department of Financial Institution’s website is www.wdfi.org .

“Crowdfunding” is a relatively new word. You may have heard of the concept, but may not yet know the word. Crowdfunding is a method by which money is raised to put capital into a business. Usually, this is done through an internet site, such as Indiegogo, Razoo, Upstart or a host of others. I am not linking to any of these, because I personally don’t know the operators of any such sites and cannot vouch for them. What happens is this:  an entrepreneur sets up an arrangement with such a website to raise small amounts of money from a very large number of prospective investors. If the offering is successful, the entrepreneur gets the capital he or she needs for the business, and the investors get a small stake in the venture.

I am concerned about such funding. When America suffered the Great Crash of the markets in 1929, it was determined that we needed significant regulation to be sure investors were protected. The result was the Security Acts of 1933 and 1934, both of which put into place many of the basic regulations we still live with today. What has happened in the past 80 years? America has become the largest, most successful economy in the world. Why change something that is working?

Crowdfunding didn’t start in Wisconsin. It started on the internet. The federal government responded in 2012 with the JOBS Act, which allowed certain websites to sell certain securities to certain investors, if they met certain requirements. Those requirements seem to fit into 3 categories: 1. how the investor is categorized; 2. what information is disclosed; and 3. whether the website may have to be registered. Wisconsin passed its Crowdfunding law as 2013 Wisconsin Act 52.

These are all very complicated issues in a new law that itself is very complicated. This comment is not intended, nor could it within the confines of such a short piece, address all the issues and complexities of the new law. Anyone intending to get involved with crowdfunding should certainly hire an attorney with securities experience that may show them the way.

Federal law governs offerings that cross state lines. Wisconsin law only covers offerings that take place entirely within the State of Wisconsin. The federal law already had a term, “accredited investor” or “AI.” An accredited investor is someone of wealth and sophistication that is expected to know the risks involved with certain financial investments and be more able to sustain losses on such investments without being destroyed. That person generally has to have an annual income of at least $200,000 for two years in a row ($300,000 including spouses), or a combined net worth of at least $1,000,000.  Wisconsin has created a new classification of “certified investor” or “CI,”  who only has to have $100,000 annual income($150,000 including spouse) or $750,000 net worth.

There are also limits on how much can be raised. The feds limit the amount to $1 Million, with certified financial statements ($500,000, if not) and Wisconsin doubles those amounts. Likewise, there are limits as to how much an investor may invest. The feds limit Non-AI investors to $2,000 or 5% of income or net worth, if under $100,000 of  income or net worth, and 10%, if above $100,000. Wisconsin just sets the limit at $10,000. Neither limits AI’s or CI’s (for Wisconsin). That means a much less wealthy person can invest a lot of money in Wisconsin.

The following table may help:

 

Federal AI

Federal non-AI

 Wisconsin CI

Wisconsin – non CI

Accredited Investor (AI) 2 year annual income at least $200,000 ($300,000 with spouse) or $1,000,000 net worth N/A Same as Federal N/A
Certified Investor (CI) N/A N/A 2 year annual income at least $100,000 ($150,000 with spouse) or $750,000 net worth N/A
Limit on Investment by an Investor with income or net worth <$100,000 None $2,000 or 5% of net worth or net income None $10,000
Limit on Investment by an Investor with income or net worth >$100,000 None 10%, up to $100,000 investment None $10,000
Maximum Amount Entrepreneur may Raise with Certified Financials $1,000,000 $1,000,000 $2,000,000 $2,000,000
Maximum Amount Entrepreneur may Raise without Certified Financials $500,000 $500,000 $1,000,000 $1,000,000

 

Now, my thoughts: I think this new system takes away all the protections we have in place for small investors. I think many shady people will hide behind these legitimate offerings and gather money and it will be gone before the investors can know what happened. And since the amount they have put at risk is relatively small, no prosecutor will be interested in going after the wrongdoers. This scheme makes no sense under any circumstances, because even if investors only put in $10 each, if the crook getting all the money gets a million or two, it won’t make any difference, it will just hurt a lot of people a little bit, instead of a few people a lot. This is just a very bad idea!