The Securities and Exchange Commission (SEC) recently proposed amendments to Rules 506 and 144A under the Securities Act of 1933 (Securities Act) to eliminate existing restrictions on general solicitation and general advertising (referred to throughout this alert as "general solicitation") in connection with private securities offerings made in accordance with the other requirements of each rule.1 The proposed amendments would implement the requirements of Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act).2
The SEC is requesting comments by October 5, 2012, which creates the possibility that final amendments could be adopted by year-end. However, the timing for the adoption of final amendments is unclear. It is important to note that until final amendments are adopted and effective, general solicitation is not permitted in connection with Rule 506 and Rule 144A securities offerings. However, once adopted and effective the amendments would allow the use of general solicitation to reach a broader audience of potential investors subject to certain conditions.
This client alert discusses key aspects of the proposed amendments and provides practical considerations for issuers to consider.
Background. Rule 506 is a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act (Section 4(2) prior to enactment of the JOBS Act) that exempts from the registration requirements of Section 5 of the Securities Act transactions by an issuer, including private funds, “not involving any public offering.” The rule allows issuers to offer and sell an unlimited amount of securities to an unlimited number of “accredited investors” (as defined in Securities Rule 501(a)), and to no more than 35 non-accredited investors that satisfy certain sophistication requirements. To rely on the rule, certain conditions must be satisfied, including the requirement that the offering does not involve any general solicitation (for example, advertisements published in newspapers and magazines, communications broadcast over television and radio, seminars whose attendees have been invited by general solicitation and other uses of publicly available media, such as unrestricted websites).
The JOBS Act directs the SEC to amend Rule 506 to permit general solicitation in offers and sales made under the rule if all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that purchasers of the securities are accredited investors, using methods to be determined by the SEC.
Proposed amendments. The SEC proposed new subsection (c) to Rule 506, which would permit the use of general solicitation in offers and sales of securities if:
- the issuer takes “reasonable steps” to verify that purchasers are accredited investors;
- all purchasers of the securities are accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors, or at the time of sale the issuer reasonably believes that they do; and
- all the terms and conditions of Securities Act Rules 501, 502(a) and 502(d) are satisfied.3
In response to commentators' concerns, the SEC confirmed that the “reasonable belief” standard found in the existing accredited investor definition remains. Thus, if an issuer takes reasonable steps to verify a purchaser’s accredited investor status and has a reasonable belief that the purchaser is an accredited investor, an issuer would not lose the ability to rely on proposed Rule 506(c) if it was later discovered that the purchaser was not an accredited investor.
While general solicitation would be permitted under the circumstances set forth in proposed Rule 506(c), the SEC specifically declined to propose rules governing the content and manner of solicitations and advertising used in such offerings despite suggestions from commentators to propose such rules, particularly with respect to private funds. However, the SEC did leave the door open for future rulemaking in this area by noting that it was not adopting such suggested amendments “at this time.”
The SEC retained, under existing Rule 506(b), the ability of issuers to conduct Rule 506 offerings without the use of general solicitation. Thus, issuers may continue to utilize existing Rule 506(b) when raising capital, which may be important for those issuers that do not want to use general solicitation to avoid the burden of having to take reasonable steps to verify the accredited investor status of purchasers, want to sell securities to non-accredited investors meeting the rule’s sophistication requirements or want to have Section 4(a)(2) as a possible fallback exemption in the event the issuer cannot rely on the safe harbor provided by Rule 506(b) (although if the issuer inadvertently engages in general solicitation then, as discussed below, Section 4(a)(2) would not be available).
“Reasonable steps to verify” requirement. The proposed amendments should alleviate the concerns of many issuers and investors as they would not impose uniform accredited investor verification measures. Whether the steps an issuer takes to verify accredited investor status are reasonable would be an objective determination based on the facts and circumstances of each transaction. Thus, if the amendments are adopted as proposed, issuers and market participants would have the flexibility to adopt different verification measures and to adapt to changing market practices. However, this aspect of the proposed amendments could be changed in the final amendments as SEC Chairman Schapiro noted at the SEC open meeting that “I hope that we will receive comment on this aspect of the proposal most particularly…”4
While the SEC did not mandate specific steps issuers must take to satisfy the requirement, it did offer some guidance if the amendments are adopted as proposed. The SEC noted that issuers should consider a number of factors in making its reasonableness determination and provided the following non-exclusive list of factors:
- The nature of the purchaser and the type of accredited investor the purchaser claims to be. The SEC recognizes that taking reasonable steps to verify the accredited investor status of natural persons (who can qualify under either a net worth or an annual income test) is practically more difficult as compared to other accredited investor categories. These difficulties are enhanced by natural persons’ privacy concerns over the disclosure of personal financial information. For example, steps that may be reasonable to verify that an entity is an accredited investor because it is a registered broker-dealer (i.e., checking FINRA’s BrokerCheck website) would necessarily differ from steps that would be reasonable to verify that a natural person is an accredited investor.
The amount and type of information that the issuer has about the purchaser. The more information an issuer has indicating that a purchaser is an accredited investor, the fewer steps the issuer would have to take, and vice versa. If an issuer has actual knowledge that a purchaser is an accredited investor, the issuer would not have to take any steps. Examples of the types of information that issuers could review or rely upon, any of which on their own may, depending on the circumstances, constitute reasonable steps, include:
- publicly available information in federal, state or local regulatory filings;
- third-party information that provides reasonably reliable evidence that a person falls within one of the accredited investor categories (for example, copies of a natural person’s W-2); or
- third-party verification, such as a broker-dealer, attorney or accountant, provided the issuer has a reasonable basis to rely on the verification.
- 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 sufficiently high minimum cash investment amount. The SEC does not believe, absent other information indicating accredited investor status, that issuers soliciting new investors through a publicly accessible website or through a widely disseminated email or social media solicitation would have taken reasonable steps where it requires only that a person check a box in a questionnaire or sign a form (presumably by “form” the SEC means a form containing representations as to accredited investor status). On the other hand, the SEC believes that issuers that solicit new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliably third-party, such as a registered broker-dealer, would have taken reasonable steps if the issuers have a reasonable basis to rely on the third-party verification.
The SEC noted that these factors are interconnected as by examining them issuers will be able to assess the reasonable likelihood that a potential purchaser is an accredited investor, which would impact the types of verification steps that would be reasonable to take under the circumstances. After considering the facts and circumstances of the potential purchaser and the offering, if it appears likely that a person is an accredited investor, the issuer could take fewer verification steps, and vice versa. As an example, the SEC noted that if an issuer knows little about a potential purchaser seeking to qualify under the natural person tests for accredited investor status, but the offering requires a high minimum investment amount, it may be reasonable, in the absence of any facts that may indicate the purchaser is not an accredited investor, for the issuer to take no further verification steps other than to confirm that the purchaser’s cash investment is not being financed by the issuer or a third party.
Depending on the facts and circumstances, issuers may be able to rely on existing verification practices. The SEC noted its anticipation that many current verification practices utilized in connection with existing Rule 506 offerings would satisfy the proposed verification requirement for offerings under proposed Rule 506(c).
Regardless of the steps taken, issuers would need to keep adequate records to document the verification steps taken as they will bear the burden of showing that they are entitled to a registration exemption.
The SEC proposed to amend Form D, which is the form that issuers file with the SEC in connection with Regulation D offerings, to add a check box to indicate whether the offering being reported is conducted using general solicitation under proposed Rule 506(c). In addition, the existing check box for Rule 506 would be renamed “Rule 506(b)” for those offerings conducted without general solicitation.
Availability of General Solicitation for Privately Offered Funds
The SEC confirmed its belief that privately offered funds, including hedge funds, venture capital funds and private equity funds, may use general solicitation under proposed Rule 506(c) without losing the ability to rely on the exclusions from the “investment company” definition available under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (Investment Company Act).
Despite requests from commentators, the SEC did not amend the accredited investor definition to include persons that are “knowledgeable employees” under the Investment Company Act. As a result, private funds that engage in general solicitation under proposed Rule 506(c) would not be able to sell fund interests to “knowledgeable employees” unless the employees qualify as accredited investors.
Availability of General Solicitation for Section 4(a)(2) Offerings
While many had sought SEC rulemaking that would also eliminate the prohibition against general solicitation in Section 4(a)(2) private offerings, the SEC did not propose such rulemaking noting that Congress introduced and considered, but did not enact, bills that would have amended Section 4(a)(2) to permit general solicitation.5 The SEC noted that the JOBS Act mandate to allow general solicitation “affects only the Rule 506 safe harbor, and not Section 4(a)(2) offerings in general.”6 Thus, unless and until the SEC changes its mind the use of general solicitation is not permitted in Section 4(a)(2) offerings (and private resales under the so-called “4(a)(1½)” exemption).
Background. Rule 144A is a non-exclusive safe harbor exemption under Section 4(a)(1) of the Securities Act (Section 4(1) prior to enactment of the JOBS Act) that exempts from the registration requirements of Section 5 of the Securities Act offers and resales of certain “restricted securities” by persons “other than an issuer, underwriter, or dealer” to qualified institutional buyers (QIBs). As the rule restricts offers to QIBs, general solicitation is practically prohibited despite the rule’s lack of an express prohibition against those activities. While the rule is limited to resale transactions, issuers utilize the rule to raise capital by conducting a primary offering of securities to financial intermediaries in a transaction exempt from registration under Section 4(a)(2) or Regulation S, followed immediately by a resale of the securities by the intermediaries to QIBs pursuant to the rule.
The JOBS Act directs the SEC to amend Rule 144A to permit offers of securities under the rule to persons other than QIBs, including by means of general solicitation, if the securities are sold only to persons that the seller and any person acting on its behalf reasonably believe are QIBs.
Proposed amendments. The proposed amendments to Rule 144A would provide that securities may be offered under the rule to persons other than QIBs, including by means of general solicitation, if the securities are sold only to QIBs or to persons that the seller and any person acting on its behalf reasonably believe are QIBs. Unlike the proposed Rule 506 amendments, there is no requirement to take reasonable steps to verify QIB status, so the proposed amendments would not require any additional steps as compared to current practice under Rule 144A that requires the seller and any person acting on its behalf to have a reasonable belief that the offeree or purchaser is a QIB.
No Integration with Regulation S Offerings
Regulation S provides a safe harbor that exempts from the registration requirements of Section 5 of the Securities Act offers and sales of securities outside the United States. One of the conditions to the exemption is that there be no “directed selling efforts” in the United States. The JOBS Act mandate to amend Rules 144A and 506 raised questions as to the impact of the use of general solicitation on the availability of Regulation S in connection with a concurrent global offering where the U.S. portion is conducted under Rule 144A or Rule 506 and the offshore portion is conducted under Regulation S. The SEC confirmed that concurrent offshore offerings conducted under Regulation S would not be integrated with domestic offerings conducted using general solicitation under the proposed amendments to Rules 144A and 506.
Issuers should consider taking the following actions in response to the proposed amendments.
Carefully consider whether general solicitation is necessary. While general solicitation may not be used until the SEC adopts final amendments, issuers that expect to raise capital using Rule 506 should consider whether the use of general solicitation would be beneficial after considering:
- the burden of taking “reasonable steps” to verify purchasers’ accredited investor status;
- whether the use of general solicitation would impact the State “blue sky” analysis and require notice filings and associated fees in states where such filings and fees are not required when Rule 506 is utilized without general solicitation;
- the application of the anti-fraud provisions of the federal securities laws to the content of the general solicitation; and
- the possibility of losing a registration exemption and facing rescission offers if all of the conditions of proposed Rule 506(c) are not satisfied as Section 4(a)(2) and Rule 506(b) could not serve as fallback exemptions due to their prohibition against general solicitation.7
For public companies, they may determine it would be better to rely on existing Rule 506(b) to avoid the foregoing matters and to eliminate the possibility that general solicitation may raise Regulation FD concerns.
Consider what changes to offering processes and documents are necessary. As any final amendments could differ from the proposals, issuers that plan to use general solicitation under proposed Rule 506(c) should not yet begin to change their offering processes or documents. However, these issuers should begin to consider how their offering processes and documents would need to change to provide for reasonable verification steps assuming the proposed amendments are adopted without any changes.
Issuers that plan to use general solicitation under proposed Rule 506(c) may also want to begin to consider the form and content of possible general solicitation activities. Unless the SEC provides rulemaking or guidance in this area, we expect issuers would proceed cautiously with the types of general solicitation that are used.
Even issuers that plan to rely on Rule 506(b) and forego general solicitation may want to consider how their offering processes and documents would need to change to provide for reasonable verification steps in order to retain Rule 506(c) as an alternative exemption in the event of inadvertent general solicitation.
Consider submitting comments on the proposed amendments. Consider responding by October 5, 2012 to the SEC’s questions contained in the proposing release, especially any comments on the “reasonable steps to verify” requirement.