The SEC adopted rule changes on July 10, 2013 that will permit general solicitation and general advertising in connection with certain unregistered securities offerings. These new rules, which were adopted essentially as proposed, represent one of the most fundamental changes to the regulation of private capital raising in decades. The changes implement the requirements of the Jumpstart Our Business Startups (JOBS) Act. The SEC also adopted the “bad actor” disqualification provisions for unregistered offerings in reliance on Rule 506 as directed by the Dodd-Frank Act.
The new rules become effective 60 days after publication in the Federal Register (expected to be some time in September). Until then, general solicitation in connection with both Rule 506 and Rule 144A offerings remains prohibited.
At the same time that it adopted rule changes, the SEC, in response to criticism from some quarters that the changes do not adequately protect investors, proposed additional changes for comment. The proposed changes are designed to provide additional information for the SEC to monitor the use and impact of the new offering opportunities and to address investor protection concerns.
Permitting General Solicitation
Regulation D currently provides in Rule 506 a safe harbor from the registration requirements of the Securities Act of 1933 for certain offerings of securities that do not involve a “public offering” under section 4(a)(2) of that Act.1 Since its adoption, one of the conditions to use of the Rule 506 safe harbor – and to any offering under a private placement exemption – has been that the offer not involve any general solicitation or general advertising (for purposes of this memo, “general solicitation”). A new provision of Rule 506 – called Rule 506(c) – will extend the safe harbor to an offering that involves a general solicitation, provided that:
- the issuer takes “reasonable steps” to verify that all purchasers qualify as accredited investors, and
- each purchaser is an accredited investor, either through meeting one of the listed criteria under the accredited investor definition2 or because the issuer reasonably believes that the purchaser meets one or more of those criteria at the time of sale.
Offerings under new Rule 506(c) also must continue to comply with the other requirements of Regulation D, including the issuer’s taking reasonable care to assure that the purchasers are not underwriters through investment representations, legends and disclosure as to the restricted nature of the securities being sold.
The Rule 506 safe harbor will continue to be available for offerings that do not meet the added requirements of Rule 506(c) so long as the existing requirements of Regulation D are met under a newly designated Rule 506(b).
While many issuers will no doubt continue to raise private capital without general solicitation through networks of established contacts or through intermediaries, the new rule will open the doors for companies seeking capital, especially early-stage companies and private funds, to promote their securities offerings widely so long as they take reasonable steps to assure that all purchasers qualify as accredited investors. In addition, the new rule can add certainty to the availability of an exemption for offerings that are not intended to involve general solicitation by eliminating the often difficult task of deciding whether certain activities will be considered to have been general solicitation, so long as the added requirements of Rule 506(c) are met. As a consequence of the change, the traditional distinction between public and private offerings can now be more accurately thought of as a distinction between registered and unregistered offerings, either of which can be marketed to the public.
Reasonable Verification Steps
The new rule imposes additional verification requirements upon an issuer that wishes to use general solicitation in a Rule 506 offering. The SEC declined to prescribe definitively what is meant by “reasonable steps,” noting that any mandated set of steps may prove to be ill-suited and more onerous than is needed in some circumstances, while being not rigorous enough in others. Rather, whether steps taken by an issuer are “reasonable” will be an objective test based on the facts and circumstances of each transaction. The adopting release suggests a number of factors that could be relevant in determining the reasonableness of steps taken to verify an investor’s status, such as:
- The nature of the purchaser and the type of accredited investor the person claims to be. For example, some categories under the accredited investor definition (such as registered broker-dealers) are easily confirmed with publicly available resources. Likewise, an executive officer or director of an issuer is, by definition, accredited.
- The amount and type of information that the issuer has about a purchaser. The more information an issuer has already about a purchaser, the fewer steps it would need to take. An issuer might rely on publicly available information, such as where a natural person is a named executive officer of an SEC registrant whose annual compensation is presented in his or her employer’s proxy statement, or where a 501(c)(3) organization’s total assets are disclosed in a publicly available tax return. It might rely on copies of a Form W-2 for a natural person to verify income. There may also be cases where it is appropriate to rely on third-party certifications or even published data on average compensation in an industry for certain levels of employee.
- The nature and terms of the offering. An issuer that solicits investors through a widespread advertisement or website would need to take more rigorous steps than one that solicits from a pre-screened list maintained by a reliable third party. Merely relying on representations from the investors would likely not be enough, especially where the solicitation is widespread. But a high minimum investment amount, combined with representations that it is not financed through borrowing, may also be considered as a factor, where the minimum amount is such that only accredited investors would be likely to meet it.
Each of these factors would be analyzed objectively and in their totality to determine whether the steps an issuer takes to verify accredited investor status are reasonable.
In addition to outlining the types of objective factors that an issuer may consider in making its inquiry, the final rules include a non-exclusive list of four types of inquiries that, if used, would be deemed to satisfy the rule’s verification requirements for natural persons. The inclusion of the list is not meant to preclude the use of alternative measures under the principles-based approach described above. In verifying a natural person’s accredited investor status:
- For purchasers qualifying on the basis of income, an issuer can satisfy the requirement by reviewing copies of any IRS form that reports income, such as a W-2, Form 1099, Schedule K-1 or Form 1040, for the two most recent fiscal years, together with obtaining a written representation from the purchaser that he or she expects to reach the level of income necessary to qualify as an accredited investor in the current year. Where a purchaser qualifies on the basis of joint income with his or her spouse, the issuer would review IRS forms and obtain representations from both spouses.
- For purchasers qualifying on the basis of net worth, an issuer can review both: (i) bank statements, brokerage statements or other statements of security holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties, in order to demonstrate assets; and (ii) a credit report from one of the nationwide consumer reporting agencies summarizing liabilities. These documents should be dated within three months prior to the offering. In addition, the issuer should obtain a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed. Where a purchaser qualifies on the basis of joint net worth with his or her spouse, the issuer would review these documents from both spouses.
- The issuer can alternatively satisfy the requirements by obtaining a written confirmation from a registered broker-dealer, a registered investment adviser, a licensed attorney or a certified public accountant that such person has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such person is an accredited investor.
- Finally, an issuer can rely on a simple accredited investor certification for any person who invested in a Rule 506 offering by the same issuer prior to the effective date of the rule changes and who remains an investor in the issuer. Such investors have a pre-existing relationship with the issuer and are presumed not to have come to the offering as a result of any general solicitation.
Since the rule requires a “reasonable basis” to believe a purchaser is accredited, the methods above will not satisfy the rule if an issuer has actual knowledge that an investor is not accredited.
Issuers raising capital through general solicitations under new Rule 506(c) will need to maintain adequate records demonstrating the steps they have taken to verify the purchasers’ status, consistent with the general principle that issuers claiming an exemption from the registration requirements of the Securities Act have the burden of showing that they qualify for that exemption.
Changes to Form D
To assist the SEC in tracking the use of general solicitation in connection with unregistered offerings under the new rule, the SEC has adopted amendments to Form D by adding a box to check for offerings that will rely on the new Rule 506(c). The SEC has simultaneously proposed additional amendments to Form D, which are described in more detail below.
Rule 144A Offerings
Rule 144A is a non-exclusive safe harbor exemption from the registration requirements of the Securities Act, for the resale of securities to “qualified institutional buyers”, or QIBs. As required by the JOBS Act, the rules now permit general solicitation in connection with a Rule 144A offering, so long as the securities are sold only to a person that the seller and any person acting on behalf of the seller reasonably believe is a QIB.
Venture capital funds, private equity funds and hedge funds typically rely on one of two exclusions from the definition of “investment company” under the Investment Company Act of 1940 in order to avoid the burdensome registration requirements of that Act. Both of those exclusions are available only to an issuer which “is not making and does not … propose to make a public offering” of its securities.3
Section 201(b) of the JOBS Act provided that offers and sales exempt under Rule 506, as revised to permit general solicitation, “shall not be deemed public offerings under Federal securities laws as a result of general solicitation or general advertising.” The SEC’s adopting release confirms its view that the effect of the JOBS Act is to permit a private fund to offer its limited partnership interests through a general solicitation under new Rule 506(c) without losing its Investment Company Act exclusion.
Integration with Overseas Offerings
Regulation S, which provides a registration exemption for offers and sales of securities outside of the United States, requires that there not be any “directed selling efforts” in the United States. The SEC’s adopting release confirms that general solicitation used in a Rule 506(c) offering will not be considered “directed selling efforts” that would jeopardize the Regulation S portion of the offering. This is consistent with the traditional SEC position that offshore transactions under Regulation S will not be integrated with either registered offerings in the United States or transactions exempt from registration in the United States.
Existing Rule 506 Remains Available
The SEC rule change does not eliminate the ability of issuers to continue to have the option of using Rule 506 as it currently exists. In other words, issuers that do not engage in general solicitation will not be required to demonstrate “reasonable steps” to verify that all purchasers are accredited investors, and they will be free to sell to non-accredited investors under the conditions of the rule. They will be able to continue to rely on the reasonable belief standard incorporated into the definition of accredited investor, which may in practice often be satisfied through investor questionnaires or similar steps. Thus, issuers will have a choice whether to use general solicitation by limiting the purchasers to accredited investors and taking reasonable steps to verify their status as such or to have the flexibility to sell to non-accredited investors by foregoing using general solicitation. Because of the SEC’s position on integration of offerings, issuers may find it difficult to switch choices.
Anti-Fraud Rules Still Apply
As with any offer and sale of securities, an offering under Rule 506(c) will be subject to the anti-fraud provisions of the securities laws, which among other things prohibit untrue statements of material facts (or omissions of material facts necessary to make the statements that are made not misleading) in connection with the offer or sale of the security. The exemption under Rule 506(c) is merely an exemption from the registration requirements of Section 5 of the Securities Act, and not an exemption from the anti-fraud rules.
Blue Sky Preemption
Offers and sales under Rule 506 are preempted by Section 18 of the Securities Act from substantive state securities (or “blue sky”) regulation other than fee and notice filing requirements. Although the SEC’s non-prescriptive approach to the “reasonable steps” requirement is welcome, it may provide plaintiffs who seek to assert state blue sky law claims by challenging compliance with Rule 506 another basis for such challenge.
Bad Actor Disqualification Provisions
As directed by the Dodd-Frank Act, the SEC also adopted rules to disqualify use of Rule 506 if the issuer, certain affiliates of the issuer or any broker-dealer or other intermediaries involved in the offering has been convicted or sanctioned by federal or state authorities for fraud or securities law and certain other violations within the prior five or ten years, depending on the sanction. Similar bad actor disqualifications have applied to certain other offering exemptions, including Rule 505 under Regulation D.
Persons covered by the rules include the issuer, together with its predecessors and affiliated issuers, as well as the issuer’s directors, executive officers, or other officers participating in the offering; any general partners or managing members of the issuer; any beneficial owner of 20% or more of the issuer’s voting securities; any promoter; any investment manager of an issuer that is a pooled investment fund; any person being paid to solicit purchasers in the offering; and certain affiliates of such investment managers or solicitors.
These disqualification provisions apply to all new Rule 506 offerings after the effective date and, in a change from the proposal, do not cover disqualifying events that occurred before that date. However, disclosure to investors of those prior disqualifying events is required. Under the new rules an issuer would not lose the exemption if, after exercising reasonable care, it did not know of the disqualification. Thus, companies seeking to rely on the Rule 506 exemption, whether or not there is general solicitation, will need to make inquiry to determine that relevant persons are not subject to any of the disqualifications. In many cases, this could be done through appropriate certifications.
Proposed Additional Changes
While making it easier for companies to raise capital, the new rules also have raised concerns about making it easier for promoters of fraudulent schemes or abusive practices to reach a wider audience. In response to these concerns, the SEC has proposed additional measures that might be taken and has asked for comment on them over the next 60 days. These are drawn in part from recommendations of the SEC’s Investor Advisory Committee, and are aimed at both preventing fraudulent practices and assisting the SEC in assessing developments in the marketplace for unregistered offerings. They include the following:
Changes to Form D
The SEC has proposed several changes relating to the notice filing on Form D that is required in connection with offerings under Regulation D. Under the proposals:
- Issuers planning to use new Rule 506(c) to offer securities by means of a general solicitation would be required to file an “advance” Form D with limited information about the offering at least 15 calendar days before commencement of the general solicitation. This is in addition to the Form D filing otherwise required within 15 days of the first sale in a Regulation D offering.
- Issuers using Rule 506, whether or not general solicitation was used, would be required to file a “closing” amendment to Form D within 30 days of the termination or completion of any offering.
- Form D would be amended to require additional information about the issuer and the offering, including the issuer’s publicly accessible website (if any), its industry group, the offered securities, whether investors are natural persons or legal entities, how accredited investors qualify (e.g., by income or net worth), and the use of proceeds. Issuers would only be able to withhold information about its size if the information is not otherwise available to the public. In connection with an offering under new Rule 506(c), the revised form also would require information about the issuer’s control persons, the type of general solicitation used, and the methods used to verify the accredited investor status of purchasers.
- Rule 507, which prohibits an issuer from using Regulation D if a court order has enjoined it for failing to comply with the Form D filing requirements, would be amended to automatically disqualify an issuer from using Rule 506 in future offerings for one year if the issuer did not comply, within the past five years, with the Form D filing requirements in a Rule 506 offering. A filing or amendment made within a 30 day cure period of its due date would be considered to comply for this purpose, though not more than once per offering. The one year period would begin when all Form D filings (or closing amendments) are made. The intent of this proposal is to encourage compliance with the Form D filing requirements. However, the consequences to a growth company of losing the ability to use Rule 506 for a year, even for inadvertent filing omissions (which could result, for example, from unintended general solicitation), would appear harsh, especially as Regulation D itself is a non-exclusive safe harbor. The proposed rule would in effect impose a diligence requirement on issuers in a Rule 506 offering to confirm that they remain eligible to use the safe harbor. If this proposal is adopted, it will increase uncertainty regarding the ability to rely upon Rule 506’s safe harbor and, therefore, its exclusion of state blue sky laws. For now, at least, the filing of a Form D is still not a condition to eligibility to use the Rule 506 exemption.
Solicitation Material and Private Funds
The SEC has proposed a temporary rule that would require all issuers conducting an offering under Rule 506(c) to submit any written general solicitation material used in connection with the offering to the SEC no later than the date of first use. The goal is to assist the SEC in understanding developments in the unregistered offering market following the adoption of Rule 506(c). As proposed, the requirement would expire after two years. The submissions would be made through a separate intake page on the SEC’s web site, not through the EDGAR system, and would not be available to the public. The materials would not be considered either “filed” or “furnished” for purposes of the liability provisions of the Securities Act or Exchange Act.
The proposed rules would require all issuers offering securities by means of a general solicitation under new Rule 506(c) to include prominent legends on their written solicitation material regarding investor qualifications, the inapplicability of registration requirements, the resale restrictions that apply to the securities, the absence of SEC approval of the merits of the offering, and the risk associated with such an investment.
Additional legending requirements would apply to private funds that use general solicitation materials, indicating that the securities offered are not subject to the protection of the Investment Company Act. Private funds that advertise performance data would also need to use additional legends emphasizing, among other things, that past performance does not guarantee future results. In addition, any performance data presented must be of the most recent date practicable considering the type of fund and the medium used, and materials presenting data that do not reflect the deduction of fees must contain additional disclosure.
Compliance with these legending and other disclosure requirements would not be a condition to use of Rule 506(c), but an issuer which is subject to a court order or decree for failure to comply with the requirements would be unable to use Rule 506 for future offerings. The SEC has proposed to extend Rule 156, which provides guidance on the types of information in investment company sales literature that could be misleading under Rule 10b-5 and similar securities laws, to apply to the sales literature used by private funds. This would apply to all private funds, whether using general solicitation under Rule 506(c) or not. In the proposing release, the SEC encouraged private funds to consider the principles underlying Rule 156 even before its amendment.
The SEC considered whether to propose rules restricting the use of performance data by private funds. It declined to do so at this time, noting that the general anti-fraud provisions of the securities laws offer protection from misleading use of performance data, but it solicited public comment on the issue.
Without proposing changes, the SEC also asked for comment on the existing net worth and income tests for natural persons under the accredited investor definition, on whether a disclosure document containing specified information should be delivered to a purchaser prior to any sale under Rule 506(c), and on whether an SEC reporting company that is not current in its reporting obligations should be permitted to use Rule 506(c).