This article is about a new Securities Exchange Commission rule, mandated by The Jump Start Our Business Act of 2012, that gives businesses the right to advertise the sale of their securities. This rule and another rule to be issued under the JOBS Act could reshape equity financing for small and medium size businesses.
This article is not about the new rules’ legal requirements. Rather, it is about the market opportunity I see arising for a tailored D&O cover to be developed and marketed to businesses using this new rule. Questions about financing under the Rule should be asked of a securities lawyer. This article sets out why this rule may be a boon for a limited D&O policy that capitalizes on this rule and the forthcoming rule that will further expand security offerings by small private businesses.
New Rule 506(c) repeals 80-year ban on businesses advertising the sale of their securities without first going through a costly registration process
Before September 23rd, if a client came to me to incorporate or form a Limited Liability Company for a new business with capital investments from family or friends and asked what type of insurance they might need, I would never have suggested director and officer liability.
Now, however, that advice has changed and I may be inclined to include D&O insurance. Why? On that date, September 23rd, the SEC issued Rule 506(c). In one fell swoop, this rule changed the 80-year ban that prohibited companies from publicly offering stock and other securities without going through an expensive federal and state registration process ended. Under Rule 506(c), companies can now advertise their securities, such as common stock; preferred stock; bonds; convertible bonds; and long-term promissory notes, without going through the expensive and time-consuming stock registration process previously required before a public offering could be legally advertised.
So do not be surprised, when you suddenly begin to see businesses soliciting investors by direct advertising. All forms of advertising: radio, television, cable, print, press releases, direct mail, and seminars are now fair game as well as a company’s social networking and marketing sites like LinkedIn, Facebook, email, Twitter, or webinars. The rule allows almost any medium for general solicitation. Already, there are a number of sites on the Internet offering media services to companies that want to advertise their securities for sale.
Accredited Investors are required under the rule to have $1 million in liquid assets but the U. S. currently has 8.7 million of them.
Companies using Rule 506(c) can advertise generally but are limited to actually selling their securities to only “accredited investors”. The rule defines accredited investors as persons who have earned $200,000 thousand dollars ($300,000 thousand, if married) or more for the last two years with the expectation of earning the same amount for the year of the investment. In addition, said investor should also have at least $1 million in liquid assets excluding a primary dwelling’s equity. Government statistics indicate that the U.S. pool of accredited investors totals just over 8.7 million persons. Approximately 8.5 million of these accredited investors have never invested in these types of stocks, bonds or other securities that Rule 506(c) now allows. Additionally, some other specifically designated legal entities (corporations, trusts, pension plans, etc.) also may qualify as accredited investors if they have assets in excess of $5,000,000.
The rule does prohibit persons with certain criminal convictions or regulatory sanctions imposed against them (euphemistically, “bad actors”) from using the rule to raise money or invest. The companies offering the securities must document their own reasonable due diligence to verify that the investor is accredited and not a barred “bad actor”. The companies can contract with third parties to do and document the required due diligence. Although the rule is new, there are already law firms and companies advertising to provide these required services to companies that plan to use this new regulation rule to raise money.
Additionally, companies must also provide to the accredited investors information on the company and the securities that make up the offer. No particular form is required but the information must be “full, fair and complete” for the accredited investor to understand the investment risk. Finally, the company must make certain informational filings with the SEC and any state security regulators within a state where any accredited investor resides.
Agents may find an entirely new market with companies using rule 506(c) to raise money
This new regulation coupled with the statutorily mandated but unapproved crowdfunding [small companies selling $1 million of unregistered securities yearly to the public over the Internet] regulation are two things some economists believe could be real game changers for both financial institutions and smaller private companies. These economists hypothesize that once small companies know that they can sell their stock and their debt through relatively simple and cost-effective public solicitations, they may see local and regional banks bank loans, with their stricter covenants and stockholder guarantees, as less desirable.
I personally believe that this new rule and the proposed crowdfunding rule could create a new market for local insurance agents and brokers to sell director and officer liability policies. Presently, smaller private companies perceive no value in director and officer insurance. Where these small companies that have either family or related parties as investors, lenders, or shareholders that view is probably justified.
However, the accredited investors that companies may seek under this new rule, might start out as ‘angel investors’ but are of the type that can easily turn into avenging angels if their investment tanks. Human nature is such that investors who lose all or a good part of their investment will quite often ascribe the worst motives and actions to the management team as the reason why the company has gone onto the rocks. When the investors in a company that becomes insolvent or bankrupt are family or friends, hard feelings and family feuds sometimes-lasting generations can occur. Lawsuits involving family businesses can and do happen but they are not common in relation to the number of family businesses that exist. When independent investors substitute for family and friends as a private company’s source of capital, the likelihood of a legal claim against officers or directors for an impaired or lost investment increases significantly.
These private companies will need D&O coverage because the broad SEC fraud regulations apply to their securities offerings under Rule 506(c).
For any small company that might use the new rule to raise money from accredited investors, I would suggest that they obtain, if available, D&O insurance to protect their corporate and personal assets from the risk of investor claims or regulatory proceedings arising out of a rule 506(c) offering.
The risk to officers and directors of companies seeking to use the new rule to raise money is quite different than what they might initially perceive as a risk. Yes, the new rule waives the formal registration process. However, the new rule does not affect the liability of a company and its officers or directors from claims under SEC regulation 10b-5.
This regulation, in part, would give accredited investors the right to sue the company for “untrue statement of a material fact” or where they claim the company “omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. ..” In other words, accredited investors who sue claiming that the security offering was misleading because they did not get all the information they should have gotten, could cost a company or its officers or directors a lot of money to defend or ultimately settle. Based on the size of many of the companies expected to use rule 506(c) to raise money, such a lawsuit could easily bankrupt the company and deplete the personal assets of its directors or officers if there is no D&O insurance in place.
Will there be a tailored D&O policy for the specific 506(c) risk of companies raising money under the rule?
Most private companies that make a security offering under the rule, if educated as to the real risks involved, will understand that they have entity and personal risks that they should insure. This understanding should create a very specific market for D&O insurance that would protect companies soliciting business under the new version of rule 506 (c). A policy that specifically tailors coverage to this private placement risk, I believe, would be the most cost-effective insurance protection for the assets of these companies and their officers and directors.
A specifically tailored policy that was limited to just this 506(c) private placement risk would also offer insurance companies developing this form more than a few underwriting advantages. There is no public market for the securities offered so the risk of class actions that plague publicly traded companies is not a material risk factor.
Most importantly, though, as opposed to any other D&O policy, a carrier developing a 506(c) policy would have a unique underwriting tool. In a regular D&O underwriting situation, the carrier has no discretion with regard to selecting the stockholders for the company it may insure. The legal requirement under rule 506 (c) that compels due diligence to determine accredited investors affords underwriters just such an opportunity. Some security lawyers have suggested that in conducting due diligence, companies or their third party administrators should require as part of their due diligence questionnaires and information releases from purported accredited investors along with tax returns and asset statements.
It is not hard to see how this information (as well as the company’s offering information), if legally made available to an underwriter could substantially reduce the loss exposure. For example, if a company were proposing to sell $1 million in stock to an accredited investor who makes $200,000 thousand per year and has just over the required $1 million in liquids assets, the risk of a lawsuit from that investor would be high if there an investment were lost or substantially impaired. On the other hand, a similar company selling $100,000 thousand in stock to each of 10 accredited investors who each have over $5 million in liquid assets would have nowhere near the same risk. They may not like that they lost $ 100,000 thousand each if the company became insolvent but, the risk of a lawsuit in this latter case is substantially less than in the former case.
Interested in discussing a product for this market?
I am interested in the possibilities of a specialized D&O policy targeted to businesses seeking accredited investors under Rule 506(c) or under the crowdsourcing rules that the SEC will be issuing in the near future and would be happy to talk with any underwriter, program manager, MGA or agency interested in developing and marketing specific products for this new and unique market.