SEC issues rule proposals to strengthen SEC oversight of Rule 506 offerings

On July 10, 2013, the Securities and Exchange Commission (SEC) issued long-awaited final rules eliminating the prohibition against general solicitation and advertising in connection with offerings under Rules 506 and 144A under the Securities Act of 1933 made solely to accredited investors.  A link to the final rules is available here.  In a separate release, the SEC adopted final rules that disqualify issuers from effecting securities offerings in reliance on Rule 506 of Regulation D in cases where the issuer or certain other persons involved in the offering have in the past been convicted of a felony or committed other “bad acts”.  The new final rules will go into effect sometime in September, 60 days after their publication in the Federal Register.  The SEC also issued separate rule proposals designed to strengthen SEC oversight of Rule 506 offerings. 

The rules lifting the ban on general solicitation were mandated by Section 201(a) of the Jumpstart Our Business Startups (JOBS) Act and were to be adopted in final form by the SEC by July 4, 2012.  Section 201(a) directs the SEC to eliminate the prohibition against general solicitation and general advertising (together, “general solicitation”) in private securities offerings conducted pursuant to Rule 506 of Regulation D or Rule 144A under the Securities Act.  The SEC issued proposed rules on August 29, 2012; however, the proposals garnered significant comments which contributed to the significant delay in adopting final rules.

Background -- Ban on “General Solicitation”

General solicitation is not defined in the Securities Act. However, Securities Act Rule 502(c) provides examples of general solicitation and general advertising, including advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars where attendees have been invited by general solicitation. In addition, SEC interpretations have confirmed that general solicitation includes communications via unrestricted websites. 

Requirements of the Rule 506(c) Exemption

Under new Rule 506(c), issuers generally will be permitted to engage in all forms of communication to prospective investors, including forms of communication traditionally viewed as general solicitation.  In order to use the exemption, however, the offer and sale must satisfy the following conditions:

  • all terms and conditions of Rules 501 and 502(a) (relating to integration with other offerings) and 502(d) (relating to limitations on resales) must be satisfied;
  • all purchasers must be accredited investors or the issuer must reasonably believe that they so qualify; and
  • the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors.

Verifying Accredited Investor Status -- In General

Under Rule 506(c), issuers are required to take reasonable steps to verify the accredited investor status of investors.  Whether the steps taken are “reasonable” is an objective assessment by the issuer (or those acting on its behalf) based on the particular facts and circumstances of each purchaser and transaction.  Among the factors that issuers should consider under this facts and circumstances analysis are:

  • the type of investor and the type of accredited investor that the purchaser investor claims to be;
  • the amount and type of information that the issuer has about the purchaser; and
  • the nature of the offering, including:
    • the manner in which the purchaser was solicited to participate in the offering; and
    • the terms of the offering, such as the minimum investment amount.

These principles-based factors are interconnected and are intended to help an issuer assess the reasonable likelihood that a purchaser is an accredited investor.  The issuer’s review of these factors will also determine the types of steps that would be reasonable to take to verify a purchaser’s accredited investor status. 

Non-Exclusive Methods of Verifying Accredited Investor Status

In the August 2012 proposing release, the SEC declined to provide any list of specific verification methods (even a non-exclusive list) out of concern that a list could lead issuers to rely on a particular method in circumstances where the method would not actually verify accredited investor status.  In response to numerous comment letters requesting clearly-defined methods of determining accredited investor status, the SEC has included in Rule 506(c) four specific non-exclusive methods of verifying accredited investor status for natural persons. Issuers are not required to use any of these methods, and can apply the reasonableness standard directly to the specific facts and circumstances presented by the offering and the investors.

Meeting the Income Requirement.  An issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies of any Internal Revenue Service form that reports income, including, but not limited to, a Form W-2 (Wage and Tax Statement), Form 1099 (report of various types of income), Schedule K-1 of Form 1065 (Partner’s Share of Income, Deductions, Credits, etc.), and a copy of a filed Form 1040 (U.S. Individual Income Tax Return), for the two most recent years, 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. In the case of a person who qualifies as an accredited investor based on joint income with that person’s spouse, an issuer would be deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies of these forms for the two most recent years in regard to, and obtaining written representations from, both the person and the spouse.

Meeting the Net Worth Requirement.  An issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing one or more of the following types of documentation, dated within the prior three months, and by obtaining a written representation from such person that all liabilities necessary to make a determination of net worth have been disclosed. In the case of a person who qualifies as an accredited investor based on joint net worth with that person’s spouse, an issuer would be deemed to satisfy the verification requirement in Rule 506(c) by reviewing such documentation in regard to, and obtaining representations from, both the person and the spouse. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties are deemed to be satisfactory; and for liabilities: a consumer report (also known as a credit report) from at least one of the nationwide consumer reporting agencies is required.  The SEC recognizes that it will be difficult for an issuer to determine whether it has a complete picture of a natural person’s liabilities, and therefore, it is requiring a consumer report and a written representation from such person that all liabilities necessary to make a determination of net worth have been disclosed.

Third-Party Confirmation.  An issuer is deemed to satisfy the verification requirement in Rule 506(c) by obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor.  While third-party confirmation by one of these parties will be deemed to satisfy the verification requirement in Rule 506(c), depending on the circumstances, an issuer may be entitled to rely on the verification of accredited investor status by a person or entity other than one of these parties, provided that any such third party takes reasonable steps to verify that purchasers are accredited investors and has determined that such purchasers are accredited investors, and the issuer has a reasonable basis to rely on such verification.

Accredited Investors who are Prior Purchasers:  With respect to any natural person who invested in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c) and remains an investor of the issuer, for any Rule 506(c) offering conducted by the same issuer, the issuer is deemed to satisfy the verification requirement in Rule 506(c) with respect to any such person by obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.

Continued Availability of Traditional Rule 506 Offerings without General Solicitation

Issuers will continue to have the ability under Rule 506(b) to conduct Rule 506 offerings without engaging in general solicitation. The continued availability of existing Rule 506(b) will be important for those issuers that want to maintain the ability to sell privately to non-accredited investors who meet Rule 506(b)’s sophistication requirements. The requirement to take reasonable steps   to verify accredited investor status under 506(c) will not apply to private offerings under Rule 506(b).

Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings

In a separate rulemaking available here, the SEC also adopted amendments that disqualify securities offerings involving certain “felons and other ‘bad actors’“ from reliance on Rule 506 of Regulation D. Notably, these “bad actor” disqualification provisions apply to all Rule 506 offerings, not merely offerings in which an issuer engages in general solicitation pursuant to new Rule 506(c). The SEC was required to conduct this rulemaking pursuant to Section 926 of the Dodd-Frank Act.

These “bad actor” disqualification provisions will prohibit issuers and others (such as underwriters, placement agents, promoters, and the directors, executive officers and certain other officers, and certain larger beneficial owners of the issuer) from participating in Rule 506 offerings if they have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other specified violations of law. The rule provides an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a bad actor participated in the offering. Notably, among the modifications to the proposed rule, the disqualification only applies to events that occur after the effective date of the rule, though matters that existed prior to the effective date must be disclosed to investors.

Use of Rule 506(c) by Private Funds

Private funds, such as hedge funds, venture capital funds and private equity funds, typically rely on Section 4(a)(2) (formerly Section 4(2)) and Rule 506 to offer and sell fund interests without registration under the Securities Act.  In addition, private funds generally rely on an exclusion  from the definition of “investment company” under the Investment Company Act Section 3(c)(1) or Section 3(c)(7).  Those exclusions are only available to private funds that are not making or propose to make a public offering. The SEC has historically regarded Rule 506 transactions as non-public offerings for purposes of Sections 3(c)(1) and 3(c)(7).  The SEC reaffirmed that the effect of Section 201(b) of the JOBS Act is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.

Amendments to Form D

Form D is the notice of an offering of securities conducted without registration under the Securities Act in reliance on Regulation D.  Under Rule 503 of Regulation D, an issuer offering or selling securities in reliance on Rule 504, 505 or 506 must file a notice of sales on Form D with the SEC for each new offering of securities no later than 15 calendar days after the first sale of securities in the offering.Issuers conducting Rule 506(c) offerings must indicate that they are relying on the Rule 506(c) exemption by marking the new check box in Item 6 of Form D. The prior check box for “Rule 506” has been renamed “Rule 506(b).”

The SEC is of the view that an issuer will not be permitted to check both boxes at the same time for the same offering. According to the SEC’s long-held views, once a general solicitation has been made to the purchasers in the offering, an issuer is precluded from making a claim of reliance on Rule 506(b), which remains subject to the prohibition against general solicitation, for that same offering.

Proposed Rules to Strengthen SEC Oversight of Rule 506 Offerings

The SEC also proposed several new rules and amendments to Regulation D in order to strengthen SEC oversight and enhance its ability to monitor the private placement market. The proposing release is available here.

Under the proposals, issuers that intend to engage in general solicitation in connection with a Rule 506 offering would be required to file a Form D at least 15 days before engaging in general solicitation. Further, issuers would be required to file an amendment to Form D stating that the offering has ended and providing additional information about the offering, including expanded information about the issuer, the purchasers, and the use of proceeds from the offering.  The proposed rules would disqualify issuers that fail to file Form D within the preceding five years from using Rule 506 until one year after the required Form D filing(s) are made.  The SEC also proposed to require legends in any written general solicitation materials used. 

Finally, the SEC proposed a temporary rule that would require issuers relying on the new general solicitation rules to submit copies of general solicitation materials to the SEC no later than the date of first use of such materials. Materials submitted in this manner would not be available to the general public. The temporary rule would expire two years following its adoption.