Beginning September 23, 2013, issuers will be able to advertise an offering to raise capital in any amount from an unlimited number of investors without filing a registration statement with the SEC as long as the issuer reasonably believes all of the purchasers are “accredited investors” and has taken reasonable steps to verify that they are so accredited. Now that the SEC has adopted its long-awaited rules implementing the JOBS Act mandate to eliminate the prohibition against the use of general solicitation and general advertising in private offerings made in reliance on Rule 506 of Regulation D or Rule 144A under the Securities Act, issuers will be able to solicit investors through solicitations on Internet websites or social media, ads in the Wall Street Journal, in mass mailings, even ads on billboards or the side of a bus.
The elimination of the prohibition against general solicitation or advertising represents a fundamental change in capital raising for many types of issuers, ranging from small startups to public companies to private equity funds and hedge funds. It is hoped that this change will broaden the pool of potential investors for an unregistered offering, thereby improving an issuer’s chances of raising the capital it needs and reducing the cost of that capital. The following is a summary of the new rule and concurrent rulemaking and proposals made by the SEC.
Rule 506(c) Offerings
The amendment to Regulation D adds new Rule 506(c), which permits an issuer that complies with other general requirements of Regulation D to engage in general solicitation or advertising in connection with an offer and sale of securities under Rule 506 if:
- The issuer reasonably believes all purchasers of securities in the offering are accredited investors; and
- The issuer has taken reasonable steps to verify that all of the purchasers are accredited investors.
The SEC also preserved intact Rule 506(b) so that issuers may continue to conduct Rule 506 offerings without general solicitation and without the additional verification requirements of Rule 506(c). Nothing in the revised rule exempts any general solicitation or advertising materials from the general anti-fraud provisions of the securities laws.
Reasonable Steps to Verify
According to the SEC, whether the steps taken under Rule 506(c) to verify accredited investor status of the purchasers are “reasonable” would be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction. Under this principles-based approach, the SEC stated that issuers should consider a number of factors when determining the reasonableness of the steps taken to verify that a purchaser is an accredited investor, such as:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- The amount and type of information that the issuer has about the purchaser; and
- The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
According to the SEC, after consideration of the facts and circumstances of the purchaser and of the transaction, the more information the issuer already has and the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa. For example, if the terms of the offering require a high minimum investment amount and a purchaser is able to meet those terms, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party. Of course, if an issuer already has actual knowledge that an investor is an accredited investor, no further steps are required. Conversely, the SEC’s Adopting Release notes that an issuer that solicits investors through widely accessible means, such as mass e-mail, generally available internet solicitations or a newspaper ad, will likely be obligated to take greater measures to verify accredited investor status than an issuer who solicits investors from a pre-screened database.
In response to commenters’ concerns, the SEC has provided a non-exclusive and non-mandatory list of four methods that will be considered “reasonable steps” to verify accredited investor status for individual investors, absent actual knowledge that an investor is not accredited.  Issuers will be deemed to have taken reasonable steps to verify an individual investor’s accredited investor status if they use any of the following methods:
- Income - review copies of IRS forms for the two previous years that report the income of the investor (such as Form W-2, Form 1099, Schedule K-1 or Form 1040), along with obtaining a written representation from such person that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
- Net Worth - review (i) one or more of bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties, dated within three months, and (ii) a consumer report (a “credit report”) from at least one of the nationwide consumer reporting agencies, and obtain a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed;
- Third-Party Verification - receive 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 investor’s accredited status; and
- Grandfathered Investors – obtain a certification at the time of sale from a natural person who previously invested in the issuer’s Rule 506 offering as an accredited investor and remains an investor of the issuer that he or she then qualifies as an accredited investor.
The Adopting Release makes clear that inclusion of the list in the rule is not meant to imply that one of these methods must be used; other means may be reasonable under the circumstances. Some of these other means listed in the Release include:
- Review of publicly available information in filings with a regulatory body (including SEC and IRS filings and FINRA’s Internet listing of registered broker-dealers);
- Review of reasonably reliable third party information, like pay stubs or publicly available information regarding the average compensation earned at the investor’s employer by persons with similar seniority; or
- Verification by another third party service provider if the issuer has a reasonable basis to rely on the third party.
Interestingly, the SEC states that it does not believe that an issuer will have taken reasonable steps to verify if the issuer only requires the investor to check a box on a questionnaire or sign a form, absent other confirming information or unless the investor is “grandfathered,” as noted above. Regardless of the particular steps taken, because the issuer has the burden of demonstrating that its offering is entitled to an exemption from the registration requirements of the Securities Act of 1933, it will be important for issuers and any third party verification service providers to retain adequate records regarding the steps taken.
In connection with these rule changes, a new check box has been added in Item 6 of Form D that will require issuers to indicate specifically whether they are relying on the Rule 506(c) exemption. The current check box for “Rule 506” being renamed “Rule 506(b).” According to the Adopting Release, this change will help the SEC monitor the practices that may develop to satisfy the verification requirement to assist it in assessing the effectiveness of various verification practices in identifying and excluding non-accredited investors from participation in Rule 506(c) offerings.
As mandated by the JOBS Act and as previously proposed, the SEC also adopted changes to Rule 144A to make clear that general solicitation and advertising are permitted in Rule 144A offerings as long as the seller reasonably believes that all of the purchasers are “qualified institutional buyers.”
Disqualification of “Bad Actors”
Section 926 of the Dodd-Frank Act directed the SEC to adopt amendments to Rule 506 to disqualify securities offerings involving certain “bad actors” from reliance on the Rule 506 offering exemptions. In a separate release, the SEC has now adopted new Rule 506(d) which disqualifies an issuer from using the Rule 506 exemption when a covered person has been the subject of a disqualifying event. Such covered persons include the issuer, any director or executive officer, any other officer participating in the offering, any general partner or managing member of the issuer, a holder of 20% or more of the issuer’s voting securities and any compensated solicitor, among others. The disqualifying events include, among others, any criminal conviction in connection with the sale of securities in the past five years for the issuer and ten years for any other covered person, a court injunction or restraining order in connection with the sale of securities in the past five years, an SEC cease-and-desist order relating to a violation of a scienter-based anti-fraud provision in the past five years, and suspension or expulsion from membership in a self-regulatory organization.
While the disqualification is limited to triggering events that occur after the effective date of the rule changes, Rule 506(d) requires written disclosure to each purchaser of pre-existing events that otherwise would trigger disqualification but occurred before the effective date of the new disqualification provisions. The SEC stated its expectation that issuers “will give reasonable prominence” to the disclosure and will provide such disclosure “a reasonable time prior to sale.” In addition, Form D now includes a new certification whereby issuers claiming a Rule 506 exemption must confirm that the offering is not disqualified for “bad actor” reasons.
The SEC has also proposed several additional rule changes related to new Rule 506(c), including additional changes to the substance and timing of Form D, a requirement for including a legend on general solicitation material, a temporary rule requiring filing of general solicitation materials with the SEC for informational purposes and a request for comment on modifying the definition of “accredited investor.” We will monitor these proposals and communicate further if and when they are adopted.
The Way Forward
These new rules represent a significant change in the private offering landscape and provide some new opportunities for raising capital. Issuers should consider the following, among other matters, if undertaking an offering under Rule 506(c):
- Issuers should be mindful of securities law and general antifraud prohibitions against making misleading statements or failing to disclose material information to investors in connection with any general solicitation or advertising effort or materials. Inaccurate or overly puffed up solicitation or advertising materials that fall into the SEC’s hands (from a disgruntled investor for example) could result in an SEC enforcement action. In addition, other regulators, such as FINRA, may have rules applicable to advertisements used to solicit investors. Issuers should seek counsel to determine whether and the extent to which these may apply.
- Issuers should revisit their accredited investor verification practices and related record retention processes. In this regard, more robust due diligence in validating accredited investor status will be almost certainly be necessary in any Rule 506(c) offering and the prior prevailing practice of check-the-box self-certification of accredited investor status by individual investors will likely not be sufficient. Issuers relying on the Rule 506(c) exemption should reexamine their current verification practices, including standard representations and questionnaires included in subscription documents in light of any proposed plans for marketing the offering to potential investors who are currently unknown to the issuer.
- Careful record keeping will be essential to allow the issuer to support its claim for a Rule 506(c) exemption. The issuer’s steps to verify accredited investor status should be separately documented for each purchaser and associated supporting documents and records should be carefully catalogued and retained.
- Issuers will need to obtain written documentation from placement agents and other covered persons to confirm that there are no triggering events that would disqualify the issuer from using Rule 506(c).