On July 10, the SEC adopted highly-anticipated rule amendments that eliminate the prohibition against "general solicitation" and "general advertising" in securities offerings conducted in accordance with Rule 506 of Regulation D and Rule 144A under the Securities Act. The amendments, which implement Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act), dramatically expand the types of communications that operating companies and private funds may use to solicit investors in private offerings conducted in reliance on the rules. Issuers and persons acting on their behalf in such offerings now will be permitted to find investors through a public process. The rule amendments will be effective on September 23, 2013. The SEC's adopting release for the amendments (Release No. 33-9415) can be viewed here.
In a companion release issued on July 10, the SEC adopted additional amendments to Rule 506 to implement Section 926 of the Dodd-Frank Act to disqualify securities offerings involving "certain felons and other 'bad actors'" from reliance on Rule 506. Under the disqualification provisions, which are codified as new paragraph (d) of Rule 506, an issuer will not be permitted to engage in a Rule 506 offering if it or certain persons related to it or participating in the offering have been convicted of certain felonies or misdemeanors or are subject to other "disqualifying events" on or after the date on which Rule 506(d) comes into effect. Although a triggering event that occurred before the effective date of the rule change will not disqualify an offering, the issuer will have to disclose the event to prospective investors before it sells securities. The rule amendments adding the disqualification provisions will be effective on September 23, 2013. The SEC's adopting release for the amendments (Release No. 33-9414) is available here.
Rule amendments permitting general solicitation
Section 201(a) of the JOBS Act directs the SEC to amend Rule 506 and Rule 144A to allow general solicitation and general advertising in connection with offers of securities under those "safe harbor" rules so long as all purchases of the securities are made solely by accredited investors (in the case of Rule 506) or qualified institutional buyers (in the case of Rule 144A). Because the use of public solicitation can vastly enlarge the pool of potential investors, Section 201(a) requires issuers to verify, by reasonable methods determined by the SEC, that the purchasers of their securities come within one of the accredited investor categories specified in Rule 501(a) of Regulation D. Section 201(a) also requires that sellers under Rule 144A and persons acting on their behalf have a reasonable belief that the purchasers in the offering are qualified institutional buyers. If issuers and sellers satisfy these conditions, offers and sales of the securities will not be deemed a "public offering" subject to registration under the Securities Act as a result of the use of general solicitation or general advertising.
Although the SEC's rules do not define "general solicitation" or "general advertising," Rule 502(c) of Regulation D states that covered public communications would include any advertisement, article, notice or other communication published in any newspaper, magazine or similar media or broadcast over television or radio, as well as any seminar or meeting whose attendees have been invited by general solicitation or general advertising. In its rule release, the SEC added to this list solicitations conducted through a website accessible to the general public, through a widely disseminated e-mail, or through social media. References below to "general solicitation" include communications that would constitute general advertising.
Rule 506 amendments. 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. Under existing Rule 506, an issuer may offer and sell securities to an unlimited number of accredited investors and up to 35 non-accredited investors so long as the issuer, or any person acting on its behalf, does not offer or sell the securities through any form of general solicitation and the other conditions of the rule are satisfied.
To implement Section 201(a) of the JOBS Act, the SEC amended Rule 506 to:
- Create a new Rule 506 private offering safe harbor designated as Rule 506(c), which permits an issuer to use general solicitation in offering securities so long as (a) all purchasers in the offering are accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or because the issuer reasonably believes that they come within any of the categories, and (b) the issuer has taken reasonable steps to verify that all purchasers of the offered securities are accredited investors; and
- Retain the existing Rule 506 private offering safe harbor in newly designated Rule 506(b), thereby preserving for issuers the alternative of conducting offerings without the use of general solicitation, which allows issuers to sell their securities to non-accredited investors as well as accredited investors and to assess the accredited investor status of purchasers in the offering without complying with the Rule 506(c) reasonable verification standard.
Reasonable steps to verify accredited investor status under Rule 506(c). In accordance with Section 201(a)'s directive, the SEC has conditioned the Rule 506(c) exemption on the requirement that issuers using general solicitation "take reasonable steps to verify" that the purchasers of the offered securities are accredited investors. The SEC noted in the rule release that the purpose of the verification mandate is to reduce the risk that purchasers of securities solicited by public means are not, in fact, accredited investors.
Principles-based framework. The SEC declined to require issuers in a Rule 506(c) offering to use specified methods of verification, concluding that a uniform verification approach would be inadequate in some cases and unnecessary in others. Instead, the SEC stated that whether an issuer or its agent has taken "reasonable steps" under Rule 506(c) to verify accredited investor status will 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." The SEC announced a "principles-based framework" for devising an adequate verification process under which the issuer should consider such factors as the following three "interconnected" factors when evaluating the accredited investor status of a prospective investor:
- Nature of the purchaser and the type of accredited investor that the purchaser claims to be. The SEC noted that information about the net worth or income of natural persons required for the accredited investor determination may be less readily available than information about the nature or assets of an entity on which the entity's accredited investor status will turn. As a result, steps that are reasonable to verify the status of natural persons "necessarily will differ" from those required to verify the status of entities.
- Amount and type of information that the issuer has about the purchaser. This factor reflects the principle that the more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer the steps the issuer may have to take to satisfy the verification standard (and vice versa). The SEC said that the issuer will not have to take any verification steps if it has actual knowledge that the purchaser is an accredited investor.
- 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. The SEC indicated that the broader the public solicitation, the greater the measures that might be required to verify the status of prospective investors, because the issuer, or any person acting on its behalf, can be expected to have less information about investors subject to a widespread solicitation. Of offering terms that might be relevant to the verification process, the SEC highlighted the requirement for a minimum investment amount. The SEC observed that a prospective investor able to pay a high minimum investment in cash might be deemed to meet the net worth or income standard for accreditation of natural persons, or the asset standard for accreditation of particular entities, so long as the investment is not financed with borrowed funds (which presumably would be a matter for inquiry by the issuer).
The SEC emphasized that the issuer has the burden of demonstrating that its offering is entitled to an exemption from registration and therefore that it (and any third party on which it relies in the verification process) should retain adequate records documenting the steps taken to verify the accredited investor status of the purchasers in the offering.
Non-exclusive methods of verifying accredited investor status. At the urging of commenters on the rule proposal, the SEC supplemented the principles-based framework for identifying reasonable verification measures by including in Rule 506(c) four non-exclusive methods of verifying accredited investor status for natural persons only (and not for entities). Unless the issuer, or any person acting on its behalf, knows that the purchaser is not an accredited investor, use of any of the four methods will satisfy Rule 506(c)'s verification requirement. Issuers are not required to use any of these methods. In fact, the SEC stated that it expects that many issuers will prefer to rely on alternative verification measures that are consistent with the principles-based framework.
Two of the four methods permit an issuer to verify whether a natural person is an accredited investor through review of specified types of information documenting the prospective investor's income or net worth and the receipt of related written representations by the prospective investor. A third method contemplates receipt of a written determination regarding a prospective investor's accredited investor status furnished by a regulated or licensed third party of the type specified in Rule 506(c). The fourth method authorizes reliance on a written confirmation of accredited investor status from an existing investor in the issuer's securities. The verification methods are summarized in the chart included at the end of this SEC Update.
Self-certification of accredited investor status. One issue of intense interest to commenters on the rule proposal was whether an issuer could satisfy Rule 506(c)'s reasonable verification standard by relying solely or principally on a prospective investor's self-certification of accredited investor status, which typically is evidenced by the offeree's representation in a subscription agreement, questionnaire or other offering document. Many issuers in Rule 506 offerings have relied on self-certification in forming a reasonable belief concerning accredited investor status under Rule 501(a) of Regulation D. The SEC's principles-based framework does not preclude reliance on self-certification as a reasonable verification measure, but also does not give much scope to the use of self-certification as the sole step for verifying a prospective investor's status. In the rule release, the SEC expressed the view that, "absent other information about the purchaser indicating accredited investor status," an issuer, or any person acting on its behalf, will not have taken reasonable verification steps if it requires "only that a person check a box in a questionnaire or sign a form" in self-certification.
Reliance on third-party verification. Under one of the non-exclusive verification methods set forth in Rule 506(c), an issuer may rely on a determination of a prospective investor's accredited investor status made by a registered brokerdealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant that confirms to the issuer that the third party has taken reasonable verification measures in connection with the status determination. The SEC stated that an issuer may rely on verification of a prospective investor's accredited investor status undertaken by any other type of third party if the issuer has a "reasonable basis" to rely on the third-party verification.
Reasonable belief standard. The SEC confirmed that the "reasonable belief" standard in Rule 501(a) for the determination of accredited investor status applies to Rule 506(c) offerings. Rule 501(a) defines an "accredited investor" as an investor that comes within one of the eight specified categories of accreditation or that the issuer reasonably believes comes within one of the categories. An issuer that has taken reasonable steps to verify a purchaser's accredited investor status will not forfeit reliance on Rule 506(c) if the purchaser, in fact, is not an accredited investor, so long as the issuer has a reasonable belief that the purchaser is accredited. Because the issuer's belief must be reasonable, the issuer may not ignore information that raises a doubt about the purchaser's accredited investor status.
Effect of electing general solicitation. The SEC sounded some cautionary notes regarding an issuer's use of general solicitation in reliance on Rule 506(c).
- An issuer commencing an offering under Rule 506(c) that entails general solicitation may not complete the offering under Rule 506(b), since the prior offering activity would violate Rule 506(b)'s prohibition on general solicitation.
- An issuer that uses general solicitation to offer securities under Rule 506(c) but fails to comply with all of the rule's conditions may not then claim reliance on the private offering exemption from Securities Act registration afforded by Section 4(a)(2) of the Securities Act. Section 4(a)(2) was not amended by the JOBS Act and continues to be available to exempt from registration only those offerings that do not involve public communications to solicit investors. The SEC noted that the general solicitation of investors in a Rule 506(c) offering would be incompatible with a claim of exemption under Section 4(a)(2).
By contrast, the SEC pointed out that Section 4(a)(2) might be available to exempt an offering without general solicitation that commenced under Rule 506(b) but fails to come within that safe harbor. The SEC recognized this possibility in amending Rule 500(c) of Regulation D to provide that "an issuer's failure to satisfy all the terms and conditions of rule 506(b) shall not raise any presumption that the exemption provided by Section 4(a)(2) of the [Securities] Act is not available."
The SEC reaffirmed its view, expressed in the rule proposal, that the use of general solicitation in a Rule 506(c) offering will not affect the issuer's ability to rely on the Regulation S safe harbor from Securities Act registration for a concurrent unregistered offering it conducts outside the United States.
In multi-jurisdictional offerings, certain forms of general solicitation, including offerings over the internet, may impair the availability of private placement regimes in other jurisdictions or could be viewed as a public offering requiring prior approval of a prospectus.
Rule 506(c) offerings by private funds. Participation in the new offering regime is not limited to operating companies. Private funds, such as hedge funds, venture capital funds and private equity funds, also may raise capital under Rule 506(c). In the rule release, the SEC confirmed that private funds that engage in Rule 506(c) offerings using general solicitation will not be deemed to be making public offerings of their securities that would jeopardize their reliance on exclusions from registration under the Investment Company Act of 1940 afforded by Sections 3(c)(1) and 3(c)(7) of that statute.
The SEC declined the invitation of some commenters on the rule proposal to subject private funds relying on Rule 506(c) to "some form of content and/or other restrictions" on advertisements and other general solicitation materials. The SEC instead used the release to remind investment advisers to private funds of their obligations under the antifraud provisions of the Investment Advisers Act of 1940, and to recommend that they consider whether the nature and content of the sales literature used by their funds are reasonably designed to prevent fraudulent or misleading advertising in connection with any general solicitation activity the funds may undertake under Rule 506(c).
Use of Rule 506(c) in offerings initiated before amendment effective date. Issuers wishing to offer securities under Rule 506(c) after the rule's effective date will not have to launch a new offering before they can find investors through general solicitation. In the rule release, the SEC announced that for an ongoing offering under Rule 506 that commenced before the effective date of Rule 506(c), the issuer may choose to continue the offering after the effective date in accordance with the requirements of either Rule 506(b) or Rule 506(c). If an issuer chooses to continue the offering under Rule 506(c), any general solicitation that occurs after the effective date will not affect the exempt status of offers and sales of securities that occurred before the effective date in reliance on Rule 506 (now designated as Rule 506(b)).
Rule 144A amendment. Rule 144A is a non-exclusive safe harbor exemption from the registration requirements of the Securities Act for resales of certain "restricted securities" to qualified institutional buyers (QIBs). Although Rule 144A does not expressly prohibit general solicitation, offers of securities under existing Rule 144A are limited to QIBs, with the result that transaction participants in effect are precluded from engaging in general solicitation. The amendment to Rule 144A eliminates references to "offered" and "offeree" in Rule 144A(d)(1), so that securities may be offered for resale pursuant to Rule 144A to persons other than QIBs, including by means of general solicitation, so long as the securities are sold only to persons that the seller and any person acting on the seller's behalf reasonably believe are QIBs. The SEC confirmed that the general solicitation permitted in Rule 144A resales of securities from the initial purchaser to the QIBs will not affect the availability of the Section 4(a)(2) exemption or the Regulation S safe harbor for the initial sale of securities by the issuer to the initial purchaser.
The amendment does not preempt state regulation of Rule 144A transactions where securities are being issued by a company that does not file reports with the SEC under the Securities Exchange Act, which account for a substantial portion of Rule 144A transactions undertaken by foreign private issuers. In such offerings, securities laws in states that prohibit advertising in connection with securities transactions would prevent the offering participants from seeking investors in those states through the use of general solicitation.
Form D amendment. In connection with the Rule 506 amendments, the SEC amended Form D, which is the notice to the SEC of an offering of securities conducted in reliance on Regulation D, to allow an issuer to indicate by checking a box whether it is conducting its offering under Rule 506(b) or Rule 506(c). Issuers will not be permitted to check both boxes at the same time for the same offering because, as discussed above, use of general solicitation in a Rule 506(c) offering is incompatible with a claim of exemption under Rule 506(b).
Rule amendments adopting "bad actor" disqualification provisions
In the second release it issued on July 10, the SEC further amended Rule 506 to implement the mandate of Section 926 of the Dodd-Frank Act directing it to disqualify securities offerings involving “certain felons and other ‘bad actors’" from reliance on Rule 506. The disqualification provisions in new Rule 506(d) are substantially similar to those in Rule 262 under the Securities Act applicable to offerings under Securities Act Regulation A. The SEC made a number of significant changes to the rule proposal in response to comments.
Covered persons. The disqualification provisions of Rule 506(d) apply to the following "covered persons": • The issuer and any predecessor of the issuer or affiliated issuer;
- Any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
- Any beneficial owner of 20% or more of the issuer's voting equity securities, calculated on the basis of voting power;
- Any promoter connected with the issuer in any capacity at the time of sale;
- Any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member; and
- Any person that has been or will be paid (directly or indirectly) remuneration for the solicitation of purchasers in connection with sales of securities in the offering (such as a placement agent or finder) and any director, executive officer, other officer participating in the offering, general partner or managing member of any such compensated solicitor.
The SEC clarified that, for an officer to be considered participating in the offering, the officer must have more than a "transitory or incidental involvement" in the offering.
A disqualifying event relating to any affiliated issuer that occurred before the affiliation arose will be not considered disqualifying if the affiliated entity is not (a) in control of the issuer or (b) under common control with the issuer through a third party that controlled the affiliated entity at the time of the event.
Disqualifying events. The disqualification will be triggered if a covered person is or was the subject of any one of the following "disqualifying events":
- Criminal convictions within ten years before the sale of securities (or five years, in the case of issuers, their predecessors and affiliated issuers) of any felony or misdemeanor (a) in connection with the purchase or sale of any security, (b) involving the making of any false filing with the SEC or (c) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
- Court order, judgment or decree (including a court injunction or restraining order) entered within five years before the sale of securities that, at the time of the sale, restrains or enjoins such person from engaging or continuing to engage in such conduct or practice (a) in connection with the purchase or sale of any security, (b) involving the making of any false filing with the SEC or (c) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
- Final orders of certain state regulators (including state securities, banking and insurance regulators), federal banking regulators and the Commodity Futures Trading Commission that, at the time of the sale of securities, bars the person from (a) association with an entity regulated by any of the foregoing authorities, (b) engaging in the business of securities, insurance or banking or (c) engaging in savings association or credit union activities, or that constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct entered within ten years before the sale;
- Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons for so long as such orders are in effect;
- SEC cease and desist orders, entered into within five years before the sale of securities, for scienter-based antifraud violations or violations of the registration provisions of Section 5 of the Securities Act;
- Suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization for the duration of the suspension or expulsion;
- SEC refusal order, stop order and order suspending a Regulation A exemption issued within five years before the sale of securities, or investigation or proceeding, at the time of the sale, to determine whether a stop order or suspension order should be issued; and
- U.S. Postal Service false representation order entered within five years before the sale of securities, or, at the time of the sale, a temporary restraining order or preliminary injunction with respect to conduct alleged to have violated the false representation statute that applies to U.S. mail.
Reasonable care exception. To clarify the issuer's obligations under Rule 506(d), the rule amendments provide for a "reasonable care" exception, under which an issuer will not lose the benefit of the Rule 506 safe harbor, despite the existence of a disqualifying event, if the issuer can show that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed because of the presence or participation of a covered person. To establish reasonable care, the issuer would have to make a factual inquiry into whether any disqualifications exist. The rule states that the nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other matters, the issuer and the other offering participants. The SEC noted that, for continuous, delayed or long-lived offerings, reasonable care would include updating the factual inquiry on a periodic or other reasonable basis.
Waiver. The Director of the SEC's Division of Corporation Finance will have authority to waive disqualifications upon a showing of good cause. The SEC indicated that a waiver would be appropriate upon a proper showing that there has been a change of control of the entity subject to a disqualifying event and that the persons responsible for the activities resulting in the event are no longer employed by the entity or no longer exercise influence over it.
Disclosure of disqualifying events existing before amendment effective date. All sales made under Rule 506 on or after the effective date of the amendments will be subject to the disqualification provisions. Under new Rule 506(e), a disqualifying event that occurred before the effective date of the rule amendments will not result in disqualification if the issuer discloses the event to prospective investors. The issuer must give reasonable prominence to the disclosure to ensure that information about the pre-existing event is appropriately presented in the "total mix" of information available to the investors. The information must be provided a "reasonable time prior to sale," which is the same timing that currently applies to disclosures of specified information in a Rule 506 offering to non-accredited investors under Rule 502(b)(1).
The SEC cautioned that, if disclosure is required and not adequately provided to an investor, no relief will be available to the issuer under Rule 508. Under that rule, "insignificant deviations" from Regulation D requirements do not necessarily result in loss of the Securities Act exemption with regard to an offer or sale of securities to a particular individual or entity. Rule 506(e), however, does provide that an issuer's failure to furnish required disclosure on a timely basis will not prevent the issuer from relying on Rule 506 if it establishes that it did not know, and in the exercise of reasonable care could not have known, of the existence of the undisclosed matter or matters. This "reasonable care" exception to the disclosure requirement is similar to the "reasonable care" exception to disqualification under Rule 506(d).
Form D certification. As part of the rule changes, the Form D signature block will now contain a certification, similar to the current certification by Rule 505 issuers, in which an issuer claiming a Rule 506 exemption will confirm that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(d).
More rulemaking ahead
In the third release it published on July 10, the SEC proposed additional amendments to Regulation D, Form D and Rule 156 under the Securities Act that, if adopted, would subject companies engaged in Rule 506 offerings to significant additional requirements. The proposed amendments are intended to enhance the ability of the SEC and state regulators to evaluate market developments in Rule 506(c) offerings now that the ban on general solicitation has been lifted, as well as to address investor protection concerns arising from the ability of issuers, including private funds, to use general solicitation in their Rule 506(c) offerings. The SEC is revisiting a number of issues it considered in approving the amendments discussed in this SEC Update, but that it did not address in those rule changes. The SEC's proposing release (Release No. 33-9416) can be viewed here.
Among the potential rule changes, the proposed amendments would:
- Require issuers to file a Form D notice of sale in a Rule 506(c) offering no later than 15 calendar days before the first use of general solicitation;
- Require issuers to file a new "closing Form D amendment" within 30 calendar days after the termination of any Rule 506 offering;
- Significantly expand the nature of the information required in a Form D filing for any Rule 506 offering, including information specific to Rule 506(c) offerings, such as the types of general solicitation used and the methods employed to verify the accredited investor status of purchasers;
- Require issuers to include prescribed legends and other disclosure in written general solicitation materials used in Rule 506(c) offerings;
- Require private funds to include an additional legend disclosing that the securities being offered are not subject to the protections of the Investment Company Act of 1940, as well as additional disclosures in written general solicitation materials that include performance data;
- On a temporary basis, for a two-year period, require issuers to make a confidential submission to the SEC, no later than the date of their first use, of written general solicitation materials used in Rule 506(c) offerings;
- Disqualify any issuer from using Rule 506 for one year for future offerings if the issuer (or any predecessor or affiliate) failed to comply, within the preceding five years, with the Form D filing requirements in a Rule 506 offering; and
- Extend the antifraud guidance contained in Rule 156, which interprets the antifraud provisions of the federal securities laws in connection with sales literature used by registered investment companies, to apply to the sales literature of private funds.
Taken together with the amendments to Rule 506 that will become effective on September 23, the changes envisaged by the proposals would significantly alter market practice for conducting private offerings under Rule 506, particularly when issuers use written general solicitation materials in their marketing efforts.