Effective September 2013, the Securities and Exchange Commission (“SEC”) will allow general solicitation and advertising in private placements under certain conditions, and new “bad actor” disqualification rules will apply to all private placements conducted under Regulation D, Rule 506. Issuers that rely on private placements pursuant to Rule 506 as a way to raise capital, as well as private equity and accredited investors, should be aware of these new rules.
Use of General Solicitation
The new rules establish an option to use general solicitation or general advertising by creating new Rule 506(c). Issuers can rely on Rule 506(c) under the following conditions:
- all purchasers are accredited investors;
- the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors; and
- the offering meets other Regulation D conditions, including the new bad actor provisions (discussed below).
The traditional Regulation D, Rule 506 offering has been preserved as Rule 506(b). Issuers will state on the Form D whether they are relying on Rule 506(b) or new Rule 506(c).
Under the new rule, issuers will be able to engage in a variety of activities that would have disqualified them from using Rule 506 in the past, such as including information about an ongoing offering on their website, speaking to the media about an ongoing or upcoming offering, or even advertising for investors through any form of media.
Since general solicitation can be expected to identify potential investors with whom the issuer has no pre-existing relationship, the “reasonable steps to verify” condition requires an issuer to make reasonable inquiry as to whether investors are in fact accredited, and to retain records documenting that inquiry. This will replace the current practice of having investors “check the box” in subscription agreements to represent they are accredited, at least for offerings using general solicitation.
The SEC has published a principles-based approach to determining what constitutes reasonable verification, under which issuers should consider these factors:
- the nature of the purchaser (i.e., the type of accredited investor);
- the amount and type of information the issuer has about the purchaser; and
- the nature of the offering (e.g., whether there has been broad solicitation, or whether there is a large minimum investment).
In addition, the SEC provided a supplemental non-exclusive list of methods that may be used to satisfy the verification requirement for natural persons:
- if an investor is accredited based on income, the issuer would review their IRS forms, such as Form W-2 or Schedule K-1, and get a written representation from the investor that they expect to meet the income threshold for the current year;
- if an investor is accredited based on net worth, the issuer would review their bank or brokerage statements, etc., along with a credit report, and get a written representation from the investor that all liabilities necessary to make a determination of net worth have been disclosed;
- in the alternative, an issuer could rely on a written verification of investor status from a registered broker-dealer, registered investment adviser, licensed attorney, or certified public accountant based on an inquiry within the past three months; or
- for existing shareholders making a new investment, an issuer can rely on a certification that he or she qualifies as an accredited investor.
Therefore, taking advantage of general solicitation (or opting to check 506(c) to protect against inadvertent general solicitation) will require issuers to institute appropriate verification procedures and investors to provide information that they have not provided in the past. Individuals should be aware they can redact tax returns and other sensitive documents, and can avoid disclosing them to issuers altogether by obtaining a written verification from their own advisors on a quarterly (or as-needed) basis.
Bad Actor Disqualification (for all Rule 506 Offerings)
New bad actor disqualification requirements will now apply to all Rule 506 offerings. Under these rules, an issuer may not rely on the Rule 506 safe harbor if a “covered person” has been convicted of, or is subject to court or administrative sanctions for, securities fraud or other violations of securities law. Covered persons include:
- the issuer and any predecessor or affiliated issuer;
- any director, executive officer, other officer participating in the offering process, general partner, or managing member of the issuer;
- any beneficial owner of 20% or more of the issuer’s outstanding voting securities;
- if the issuer is a pooled investment fund, its investment manager and its directors, executive officers, other officers participating in the offering, general partner or managing member, and the directors, executive officers, and other officers participating in the offering of such general partner or managing member;
- any promoter connected with the issuer in any capacity at the time of the sale; and
- any person that has been or will be paid, directly or indirectly, remuneration for solicitation of purchasers, and the directors, executive officers, other officers participating in the offering, managing members, or general partner of any compensated solicitor
Violations that occurred before the effective date of the new rules (i.e., late September 2013) must be disclosed to prospective purchasers within a reasonable time prior to the sale, but such violations will not disqualify the issuer from using Rule 506. The involvement of bad actors after effectiveness of the rules may prevent an issuer from relying on Rule 506.
To comply with the new bad actor rules, issuers will need to institute a questionnaire process early in the offering process. Issuers who might otherwise consider engaging finders should be aware of the additional risk to their offerings since paid solicitors are covered persons. Private equity investors and other 20% shareholders should be prepared to respond to such questionnaires.
In addition, the SEC also made various proposals that would restrict the use of general solicitation and Regulation D, including a requirement to file Form D at least 15 days before engaging in general solicitation; disqualification of issuers for one year for failing to file Form D; and specified legend and disclosure requirements for all general solicitation materials.
At this point, these are only proposals, but they are another reminder to issuers and investors that the SEC will be closely monitoring the use of general solicitation for evidence of fraud or abuse, and may make it more burdensome to rely on these rules in the future. Issuers should consider filing a Form D for most private placements to avoid possible disqualification, which would be a change in some market practices.