The Jumpstart Our Business Startups Act (JOBS Act) enacted on April 5, 2012, directed the Securities and Exchange Commission (SEC) to eliminate the prohibition against general solicitation and general advertising in securi-ties offerings conducted pursuant to Rule 5061 of Regulation D2 or Rule 144A3 promulgated under the Securities Act of 1933 (Securities Act).4 On August 29, 2012, the SEC proposed amendments to its rules to implement that mandate.5 As intended by the JOBS Act, these proposed amendments would make it easier for issuers to raise capital for potential offerings and sales of securities made under Rule 506 and Rule 144A.
The proposed amendments would create a new Rule 506(c) permitting an issuer to conduct an offering using general solicitation and general advertising, provided that all purchasers of the securities in that offering are “accredited investors,” and the issuer of the securities takes reasonable steps to verify that all purchasers of the securities are accredited investors. Under the proposed amendments to Rule 144A, offers made pursuant to Rule 144A by the financial intermediaries who buy securities from an issuer and, in turn, sell such securities under Rule 144A to qualified institutional buyers (QIBs) by means of general solicitation and general advertising, would fall within the exception from registration found in Section 4(a)(1), provided that the actual purchasers were QIBs or persons reasonably believed to be QIBs.
The existing Rule 506 is a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act, which exempts transactions by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act.6 Under this safe harbor, an issuer may offer and sell securities, without any limitation on the offering amount, to an unlimited number of “accredited investors,” as defined in Rule 501(a) of Regulation D, and to no more than 35 non-accredited investors who meet certain “sophistication” requirements. The availability of Rule 506 is subject to a number of requirements and, pursuant to Rule 502(c), is conditioned on the issuer, or any person acting on its behalf, not offering or selling securities through any form of general solicitation or general advertising.
The existing Rule 144A is also a non-exclusive safe harbor that provides an exemption from the registration requirements of the Securities Act for offers and sales of securities by persons other than the issuer to QIBs or persons reasonably believed to be QIBs. Although Rule 144A currently does not explicitly prohibit general solicitation, offers may be made only to QIBs or persons reasonably believed to be QIBs.
Proposed Amendments to Rule 506
Under the proposed amendments, new Rule 506(c) would provide that the prohibition against general solicitation and general advertising contained in Rule 502(c)7 does not apply to offerings of securities made pursuant to Rule 506(c), subject to the following conditions:
- the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors;
- all purchasers of securities are accredited inves-tors either because they come within one of the enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes so at the time of sale; and
- the issuer meets all terms and conditions of Rule 5018 (which provides the definitions used in Reg-ulation D, including the multiple categories of ac-credited investors), Rule 502(a)9 (which outlines the factors to be considered in determining whether a Rule 506 offering should be integrated with another offering), and Rule 502(d)10 (which provides that securities sold under Regulation D are restricted securities under the Securities Act and cannot be resold without registration under the Securities Act or an exemption therefrom).
It is important to note that the proposed amendments would preserve the existing Rule 506 as a separate exemption, so that issuers conducting Rule 506 offerings without the use of general solicitation or general advertising would not be subject to the new accredited investor verification requirement. Therefore, the proposed amendments to Rule 506 would effectively create two related exemptions under Rule 506: one for Rule 506(c) offerings that employ general solicitation and general advertising, and one for Rule 506(b) offerings that do not use such general solicitation or general advertising.
Reasonable Steps to Verify Accredited Investor Status
Although Section 201(a)(1) of the JOBS Act states that such rules adopted by the SEC must require the issuer to take reasonable verification steps “using such methods as determined by the Commission,” the proposed amendments to Rule 506 do not detail specific methods that an issuer must employ in verifying the accredited investor status of a purchaser under Rule 506(c).11 Accordingly, the Proposing Release states that issuers would be required to undertake an “objective determina-tion” based on the “particular facts and circumstances” of the applicable offering, in evaluating whether the steps taken by the issuer to verify a purchaser’s accredited investor status are “reasonable.”12 To that end, the Proposing Release provides the following non-exhaustive list of examples of such factors that may be appropriate for an issuer to consider:13
- Nature of the purchaser.
- Information that the issuer has about the purchaser.
- Nature and terms of the offering.
Please see Exhibit A hereto for an excerpt of the Proposing Release’s discussion regarding verification of accredited investor status. In the event that the pro-posed amendments to Rule 506 become effective in substantially the same form as proposed, issuers may wish to internally retain a copy of Exhibit A for compliance purposes given that it contains direct SEC guidance on the process of verifying an investor’s accredited investor status.14
Regardless of the specific method of verification employed by an issuer, it should be noted that any issuer claiming an exemption from the registration requirements of Section 5 of the Securities Act bears the burden of proving that such exemption was properly relied upon. Accordingly, it is important for issuers to maintain adequate records that document the steps they have taken to verify that a purchaser was an accredited investor.
All Purchasers Must be Accredited Investors: Reasonable Belief Standard Preserved
In the Proposing Release, the SEC confirmed that Section 201(a)(1) of the JOBS Act does not replace the existing “reasonable belief” standard in the accredited investor definition of Rule 501(a) with an absolute standard. Accordingly, the SEC stated that if a person were to provide an issuer with false information as to its accredited investor status within one of any of the eight enumerated categories in Rule 501(a), the issuer would not lose the ability to rely on Rule 506(c) for that offering, provided the issuer “took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.”15
Proposed Amendment to Form D
The SEC also is proposing to amend Form D,16 which issuers are currently required to file with the SEC when they sell securities pursuant to Regulation D. The revised Form D would add a separate box for an issuer to check if it is claiming the new Rule 506(c) exemption permitting general solicitation and general advertising. This would help the SEC gather data on the use of general solicitation and general advertising in offerings relying on Rule 506(c).
Proposed Amendment to Rule 144A
Under the proposed Rule 144A, offers made pursuant to Rule 144A to persons who are not qualified institutional buyers (QIBs) would be permitted, including by means of general solicitation and general advertising, so long as the securities are sold only to QIBs or persons reasonably believed to be QIBs. The Proposing Release does not address what would constitute “reasonable belief” of QIB status, and is seeking comments as to whether the current list of non-exclusive methods for establishing a prospective purchaser’s QIB status under the existing Rule 144A has been effective in practice.
Implications of General Solicitation and General Advertising in Private Placements Under Rule 506 and Rule 144A
In not registering as an “investment company” under the Investment Company Act of 1940 (Investment Company Act),17 private funds generally rely on the exclusions from the definition of an “investment company” available under Section 3(c)(1) and 3(c)(7) of the Investment Company Act (a 3(c)(1) Fund or 3(c)(7) Fund, as applicable). However, these exclusions are not available if the funds make a public offering of their securities. The SEC confirmed in the Proposing Release that such private funds would be permitted to engage in a general solicitation and general advertising under Rule 506(c) without losing either exemption under the Investment Company Act, even though such exemptions currently prohibit the “public offering” of a private fund’s securities. It should be noted, however, that the Proposing Release did not explicitly extend this confir-mation to the new Rule 144A offerings, although a footnote to the Proposing Release states that many issuers of asset-backed securities rely on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act, and participate in Rule 144A offerings.18
Integration of Offerings
Integration of Domestic Offerings
With respect to satisfying the Rule 506(b) or Rule 506(c) safe harbors under Regulation D, the Proposing Release does not address the circumstances under which (i) an adviser’s 3(c)(7) Fund that is conducting a domestic offering pursuant to the Rule 506(c) with the use of general solicitation and general advertising would be integrated with (ii) such adviser’s 3(c)(1) Fund that is contemporaneously conducting a domestic offering pursuant to Rule 506(b) without the use of general solicitation and general advertising. If the SEC were to integrate the two offerings, the 3(c)(1) Fund would be held to the higher standards of Rule 506(c) (regardless of whether the 3(c)(1) Fund was promoted through the use of general solicitation or general advertising). To protect against this outcome, all prospective investors for both funds should be subjected to the same vetting procedures to ensure they are accredited, and caution should be exercised in accepting an investment in the 3(c)(1) Fund from an investor who is not accredited — limiting such investments, for example, to employees of the adviser or to other investors having a close pre-existing relationship with the adviser.
Integration of Domestic and Offshore Offerings
The Proposing Release provides that private domestic offerings conducted pursuant to the new Rule 506(c) or Rule 144A would not be integrated with offshore offerings made in compliance with Regulation S19 under the Securities Act. Accordingly, issuers would be able to conduct a Rule 506(c) or Rule 144A (as applicable) offering concurrently with a Regulation S offering while employing general solicitation and general advertising in the United States, without violating the prohibition in Regulation S with respect to “directed selling efforts” in the United States.
Commodity Futures Trading Commission (CFTC) Regulation
With respect to private funds that are considered commodity pools under the Commodity Exchange Act20 and regulations thereunder, certain advisers to such commodity pools currently qualify for an exemption from registration as a commodity pool operator pursuant to CFTC Rule 4.13(a)(3),21 or are registered as a commodity pool operator yet provide limited disclo-sure to investors pursuant to CFTC Rule 4.7,22 provided that interests in the pools are offered and sold “without marketing to the public,” among other conditions. Because the CFTC has not yet provided guidance on the extent to which the above exemptions may continue to be relied on by advisers to private funds that are conducting Rule 506(c) offerings with the use of such general solicitation and general advertising, such advisers should consider the implications of any general solicitation and general advertising on their CFTC exemptions.
The amendments to Rule 506 and Rule 144A are not yet effective. The SEC is soliciting comments regarding numerous questions raised in the Proposing Release. Public comments will be due by October 5, 2012 (within 30 days of publication in the Federal Register, which occurred on September 5, 2012).