On August 29, 2012, the U.S. Securities and Exchange Commission (SEC) published proposed rules that would eliminate the ban on general solicitation and advertising for securities offerings made to qualifying investors pursuant to SEC Rule 506 under the Securities Act of 1933. The proposed rules address the mandate of the Jumpstart Our Business Startups (JOBS) Act, signed into law in April 2012, directing the SEC to remove the general solicitation and advertising prohibition currently in place for private offerings relying on Rule 506 provided that all purchasers of the securities are “accredited investors.” Although the JOBS Act directed the SEC to have rules in place within 90 days of enactment, the Commission determined instead to publish rules for comment, and thus delay adoption pending completion of the comment process. The delay in removing restrictions, as directed by Congress to make it easier for companies to inform the public that they are seeking to raise capital, met with sharp criticism on Capitol Hill. A 30-day comment period has nevertheless been established before further action by the SEC.
Rule 506 offering restrictions and the JOBS Act
Rule 506, which is part of Regulation D under the Securities Act of 1933, provides a non-exclusive “safe harbor” exemption from federal registration requirements for private securities offerings in an unlimited dollar amount to an unlimited number of “accredited” investors, as well as up to 35 non-accredited investors, provided certain conditions are satisfied. Rule 506 plays a major role in capital formation in the United States. Indeed, the SEC has estimated that in 2011 the amount of capital raised in Rule 506 offerings was $895 billion. Rule 506 offerings today are almost always made solely to accredited investors. Accredited investors include various institutional investors, as well as individuals who meet net worth or income tests prescribed by Regulation D. The availability of the Rule 506 safe harbor is subject to several requirements, currently including a manner of offering restriction prohibiting the issuer of the securities and any person acting on its behalf from offering or selling the securities by any form of general solicitation or general advertising. The prohibition applies without regard to the accredited status of investors.
General solicitation and general advertising are not defined terms in Regulation D, but the prohibition has been broadly interpreted by the SEC to bar, for example, the use of publicly available media, such as unrestricted websites. The restriction proved to be a significant challenge with the advent of online platforms of matching services designed to bring together accredited investors with entrepreneurs in need of capital. The restriction also applied to any seminar or meeting when the attendees are invited by any general solicitation or advertising. The congressional concern underlying the JOBS Act was that issuers faced significant hurdles in reaching accredited investors who stood ready to provide needed capital. The JOBS Act addressed the problem by mandating that the SEC modify Regulation D to provide that the prohibition against general advertising or solicitation will not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers are accredited investors. Congress directed that within 90 days after the date of enactment, the SEC was to issue the revision. That revision was also to be carried into Rule 144A under the Securities Act of 1933, which exempts private resales of certain securities to “qualified institutional buyers,” such that general solicitation will be permitted In that setting as well.
The SEC has not yet adopted JOBS Act mandated revisions to Rule 506. On August 29, 2012, however, proposed amendments to Rule 506 were published for comment. Proposed amendments would provide that the prohibition against general solicitation and general advertising currently applicable to Rule 506 offerings would not apply to offers and sales under the Rule provided that all purchasers of the securities are accredited investors, and the issuer takes reasonable steps to verify that the purchasers are accredited investors. The proposals also include an amendment to Form D, the notice filed with the SEC by issuers claiming an exemption under Regulation D, to add a check box to indicate whether an offering is being conducted pursuant to the proposed amended Rule 506 by means of general solicitation or advertising.
Proposed Rule 506 revisions
In an August 29, 2012, news release announcing the proposed amendments to Rules 506 and 144A, SEC Chair Mary Shapiro stated:
“I believe that the proposed rules fulfill Congress’s clear directive that issuers be given the ability to communicate freely to attract capital, while obligating them to take steps to ensure that this ability is not used to sell securities to those who are not qualified to participate in such offerings.”
Implicit in this statement is the point that the recognized utility of Rule 506 private offerings is to be offset against potential abuse in private offerings for which, by design, there is little regulatory oversight beyond the application of antifraud protections and remedies. State securities regulators have expressed particular concerns for the potential abuse of Rule 506 offerings, to the extent that the North American Securities Administrators Association (NASAA) included Rule 506 private placements among the top 10 investor traps in 2011. Given these underlying concerns, the proposed amendments to Rule 506 to eliminate the ban on general solicitation and advertising are subject to the requirement that an issuer take reasonable steps to verify that the purchasers of the securities are accredited investors. As stated by the SEC in the proposing Release: “We believe that the purpose of the verification mandate is to address concerns, and reduce the risk, that the use of general solicitation under Rule 506 may result in sales to investors who are not, in fact, accredited investors.”
Issuers in Rule 506 offerings have always faced the requirement to have a “reasonable belief” that a person is in fact an accredited investor under any category prescribed in the Regulation D definition of accredited investor. In practice, issuers have typically relied on documented representations of investors establishing and affirming their accredited investor status. The proposed amendments to Rule 506 to add a verification requirement will not affect the existing reasonable belief standard, but rather add to it the simply stated requirement: “The issuer shall take reasonable steps to verify that purchasers of securities in any offering under [Rule 506] are accredited investors.”
The proposed revision of Rule 506 to include the “reasonable steps to verify” condition does not prescribe any specific or sufficient action to be taken. Rather, in the proposing Release, the SEC notes that whether steps taken are reasonable would be an objective determination, based on the particular facts and circumstances of each transaction. That said, several factors likely to be taken into consideration by issuers are identified. Examples include:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- The amount and type of information that the issuer has about the purchaser; and
- 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.
Eschewing any desire to identify any particular means by which an issuer may satisfy the verification requirement, the SEC notes that a method that is reasonable under one set of circumstances may not be reasonable under a different set of circumstances and, more to the point, any non-exclusive list of specified verification methods could be viewed by issuers as the required methods. In the end, the concern is not to eliminate the flexibility that is intended by the simply stated requirement in amended Rule 506. The SEC offered this illustration of the point:
[I]f an issuer knows little about the potential purchaser who seeks to qualify under the natural person tests for accredited investor status, but the terms of the offering require a high minimum investment amount, then it may be reasonable for the issuer to take no steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by the issuer or a third party, absent any facts that may indicate that the purchaser is not an accredited investor.
One thing is certain: With the new verification requirement in place, issuers must plan on documenting whatever steps are taken to verify that a purchaser is an accredited investor. As has always been the case, any issuer relying on an exemption from registration requirements spelled out in the Securities Act of 1933 has the burden of showing that it is entitled to the exemption, and documenting the verification process for Rule 506 offerings will now be central to meeting that burden. Obviously, there are many questions about what will in practice suffice. For a natural person accredited investor, for example, must the issuer obtain verified third party information that provides reliable evidence that the person falls within the income or net worth tests? What privacy concerns impact the process? As issuers reach out to access sources or databases identifying accredited investors to whom a solicitation may be addressed, may the issuer rely on third party verification of accredited investor status? Will investor “certification” in the absence of any documentary evidence suffice as verification? Not likely. On the other hand, will a sworn investor questionnaire accompanied by a financial statement be sufficient in the absence of third party verification of the financial information?
The premise in all of this is that the elimination of the ban on general solicitation and advertising opens the door to a vast new and unfamiliar universe of potential investors in Rule 506 offerings. There are no pre- existing relationships, and no basis upon which to know that represented accredited investor status is true. Some have suggested that the absence of guidance on appropriate verification procedures will actually chill the expanded capital formation opportunity and process the JOBS Act intended to create. It appears that the SEC elected to solicit comments on the proposed revision to Rule 506 as opposed to adopting them as prescribed by the JOBS Act to further consider possible approaches to verification. The SEC specifically invited comments on possible approaches to verification and addressing a number of questions which encompass those noted above. Moreover, the Commission made clear that it intended to “monitor and study the development of verification practices” by issuers and others as they are implemented.
Impact on private funds?
Privately offered funds typically rely on the Rule 506 safe harbor in the offer and sale of fund interests. Proposing the revisions to Rule 506, the SEC considered whether opening the door to general solicitation and advertising for privately offered funds would impact the qualification of funds for exclusion from regulation under the Investment Company Act of 1940. Exclusions on which funds rely are conditioned on the fund not making a “public offering” of their securities. The JOBS Act mandate for revisions to Rule 506 made no reference to privately offered funds. However, offerings carried out in compliance with Rule 506 historically have not been considered to be public offerings, and the revisions to Rule 506 to permit general solicitation and advertising are specifically intended to mean that offers and sales carried out under Rule 506 will not be deemed to be public offerings as a result of general solicitation or advertising. Accordingly, in the proposing Release, the SEC makes clear that privately offered funds using general solicitation and advertising will not lose any exclusion from the Investment Company Act of 1940.
Form D revision
With the adoption of JOBS Act mandated revisions to Rule 506 to eliminate the ban on general solicitation and advertising, Form D -- the notice of sales of securities under Regulation D -- will be revised to include a check box to disclose that an issuer is relying on Rule 506, as amended, specifically to engage in general solicitation or advertising. As described by the SEC, the check box disclosure is intended to permit effective monitoring of the use of general solicitation, evaluate the effectiveness of verification procedures employed by issuers, and to assess the size of the offering market for which general solicitation of accredited investors is viable. The revised Form D also will be available to state securities regulators who, under Blue Sky Laws and regulations, may likewise monitor the use of general solicitation and advertising in their particular jurisdictions under general antifraud rules.
Rule 144A under the Securities Act of 1933 addresses private sales of securities to “qualified institutional buyers” (QIBs). Sales of securities to QIBs by persons other than issuers or dealers are exempt from registration requirements provided certain conditions are satisfied. The JOBS Act directed the SEC to revise Rule 144A to provide that securities sold pursuant to Rule 144A may be offered to persons other than QIBs, including by means of general solicitation and advertising, provided that securities are sold only to persons that the seller, and any person acting on behalf of the seller, reasonably believes is a QIB. The SEC proposed amendment to Rule 144A would eliminate any reference to offer or offeree in the Rule, and require simply that securities must be sold to a QIB or a purchaser reasonably believed to be a QIB. Thus, sales under Rule 144A could be conducted using general solicitation or advertising, so long as the actual purchaser is a QIB.