At its meeting on July 10, 2013, the Securities and Exchange Commission (SEC):
- adopted amendments to Rules 506 and 144A under the Securities Act of 1933 (Securities Act) to eliminate the existing prohibition 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
- adopted further amendments to Rule 506 to make the exemption in Rule 506 unavailable to issuers if one or more of the issuer and certain related persons have been the subject of certain felony or misdemeanor convictions or other disqualifying events and to require disclosure regarding bad actors in certain instances;2 and
- proposed additional amendments to Regulation D that would require disclosure of additional information about Rule 506 offerings made by general solicitation in order to “enable the SEC to monitor the market with [the general solicitation] ban now lifted.”3
The amendments to Rule 506 and Rule 144A to eliminate the prohibition on general solicitation in certain offerings were adopted to implement the requirements of Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act).4 The amendments to Rule 506 relating to the disqualification of bad actors implement the requirements of Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed amendments to Regulation D, if ultimately adopted, would impose additional safeguards for private offerings involving general solicitation.
The amendments adopted on July 10, 2013, will be effective 60 days after the date on which the related adopting release is published in the Federal Register.
This client alert discusses key aspects of the amendments and the proposed amendments and provides practical considerations for issuers to consider.
Amendments to Rule 506 and Rule 144A to Eliminate the Prohibition on General Solicitation in Certain Private Offerings
The Amendments to Rule 506
Background. Section 4(a)(2) of the Securities Act (Section 4(2) prior to enactment of the JOBS Act) exempts from the registration requirements of Section 5 of the Securities Act an issuer’s offers and sales of securities “not involving any public offering.” As the Supreme Court stated in its first decision interpreting this language, “[t]he Securities Act nowhere defines the scope of [Section 4(a)(2)]’s private offering exemption. Nor is the legislative history of much help in staking out its boundaries.”5 With legislative guidance absent, both the courts and the SEC have long and consistently viewed general solicitation in an offering, whether by public advertising or use of the facilities of a securities exchange, as incompatible with the concept of a non-public offering.6
As the SEC has adopted rules under Section 4(a)(2) to provide issuers with non-exclusive safe harbors for non-public offerings, first in the now rescinded Rule 146 (which should not be confused with the current Rule 146 under the Securities Act) and then with the successor rules in Regulation D (including Rule 506), it has allowed 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 if certain conditions were satisfied. The SEC incorporated its historical prohibition on general solicitation as one of the conditions to the availability of the safe harbor, i.e., no offer or sale of securities could be made by any form of general solicitation, such as 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, including unrestricted websites.
The JOBS Act directed the SEC to reverse its almost 75 year-long position that general solicitations are incompatible with the notion of non-public offerings.7 Specifically, the JOBS Act required 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. This dramatic change to private offering practice and interpretation is limited: Congress did not amend Section 4(a)(2) itself; the direction of the JOBS Act only required the SEC to eliminate the general solicitation ban with respect to certain offerings satisfying the conditions set out in Section 506. In view of Section 4(a)(2) retaining its original language, the SEC said in the 506(c) Adopting Release that general solicitation is still inconsistent with offerings being exempt pursuant to Section 4(a)(2) or other Regulation D safe harbors that specifically prohibit general solicitation in an offering.8
The Amendments. The SEC adopted new paragraph (c) to Rule 506 (Rule 506(c)), which will permit the use of general solicitation in unregistered offers and sales of securities by the issuer if:
- all purchasers of the securities are accredited investors;
- the issuer takes “reasonable steps” to verify that the purchasers are accredited investors; and
- all the terms and conditions of Securities Act Rules 501, 502(a) and 502(d) are satisfied.9
In response to commentators’ concerns, the SEC confirmed in the 506(c) Adopting Release that the “reasonable belief” standard found in the existing “accredited investor” definition in Rule 501 remains in place. Thus, if an issuer takes reasonable steps to verify that each purchaser is an accredited investor and, having taken those steps to verify the status of each purchaser, has a reasonable belief the purchaser is an accredited investor, the issuer will not lose the ability to rely on Rule 506(c) if it is discovered subsequently that a purchaser in the offering was not an accredited investor.
Issuers intending to rely on Rule 506(c) to offer securities should note that, even if they know the proposed purchasers in an offering are accredited investors or even if all purchasers are in fact accredited investors, they must still take reasonable steps to verify the status of each purchaser in the offering to comply with the requirements of Rule 506(c). This principle applies even in circumstances in which the status of a purchaser as an accredited investor is readily apparent from the circumstances of an offering, such as when an offering has a high minimum investment, because this is an independent procedural requirement and the issuer must still take reasonable steps to verify the conclusion it draws from those circumstances if the exemption of Rule 506(c) is to be available for the offering.
While general solicitation will be permitted under the circumstances set forth in Rule 506(c), the SEC has not adopted rules governing the content and manner of solicitations and advertising used in such offerings despite suggestions from commentators that it adopt such rules, particularly with respect to offerings by private funds. However, the SEC notes that it will monitor private fund advertising and undertake a review to determine if further action is necessary.10 As discussed below, the SEC has proposed a further amendment to Regulation D to require all issuers to submit any written communication that constitutes general solicitation to the SEC no later than the date of the communication's first use.
The SEC has retained, without amendment, Rule 506(b), which gives issuers the ability to conduct Rule 506 offerings without the use of general solicitation (often referred to as “quiet offerings”). Thus, issuers may continue to utilize existing Rule 506(b) when raising capital, which may be important for those issuers not needing to make a general solicitation to conduct a successful offering and that want to avoid the burden of meeting the reasonable verification steps requirement of Rule 506(c), that want to sell securities to non-accredited investors meeting the rule’s sophistication requirements or that want to have Section 4(a)(2) as a possible fallback in the event the issuer cannot rely on the safe harbor provided by Rule 506(b). However, as we discuss below, if the issuer inadvertently engages in general solicitation in an attempted Rule 506(b) offering, the exemption of Section 4(a)(2) would not be available for the offering. The amendments to Rule 506 do not affect Rule 504 or 505.
Importantly, Section 201(a) of the JOBS Act provided that Section “230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 … .” Moreover, Section 201(b) of the JOBS Act added a new Section 4(b) to the Securities Act, which provides that offers “and sales exempt under section 230.506 of title 17, Code of Federal Regulations (as revised pursuant to section 201 of the Jumpstart Our Business Startups Act) shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.’’ The combination of these two statutory provisions has two important implications. First, securities issued in connection with a Rule 506(c) offering will be restricted securities under Rule 144. Second, the securities issued in such an offering will have the status of securities issued under Section 4(a)(2), qualifying them as “covered securities” under Section 18(b)(4)(E) of the Securities Act for purposes of the state “blue sky” law preemption provision of Section 18 of the Securities Act.
The “Reasonable Steps to Verify” Requirement. Rule 506(c) in its final form does not impose exclusive measures for the verification of the accredited investor status of purchasers. Commentators have been concerned that the original proposal did not include a list of non-exclusive methods for satisfying the reasonable steps to verify accredited investor status requirement. Responding to those concerns, the SEC has adopted Rule 506(c) in a form that allows both a principles-based method of verification and sets forth four non-exclusive, non-mandatory methods for verifying accredited investor status of natural persons (Specified Methods).
Principles-based Method of Verification. When an issuer is to verify a purchaser’s accredited investor status by means of a principles-based method, the determination of whether the steps taken to verify that status are “reasonable” will be an objective one to be made by the issuer based on the facts and circumstances of each purchaser and transaction. Thus, issuers and market participants will have the flexibility to adopt verification methods other than the Specified Methods and to adapt to changing market practices and the circumstances of their potential purchasers.
The SEC noted that issuers would consider a number of factors in making reasonableness determinations 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 investors. These difficulties are increased 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 will have to take, and vice versa. We note that the SEC states that if an issuer has actual knowledge that a purchaser is an accredited investor, the issuer will not have to take any steps. However, this statement appears to be inconsistent with Rule 506(c)'s express procedural requirements and should be viewed with skepticism. 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 by 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 website accessible to the general public, through a widely disseminated email or social media solicitation or through print media, such as newspapers, will have taken reasonable steps where it requires only that a person check a box in a questionnaire or sign a form (which presumably 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 reliable third-party, such as a registered broker-dealer, will 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 and by examining them issuers will be able to assess the reasonable likelihood that a potential purchaser is an accredited investor, which will 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 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 fewer, or, in certain cases 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 will satisfy the proposed verification requirement for offerings under proposed Rule 506(c).
Specified, Non-exclusive Methods of Verification. New Rule 506(c) includes the Specified Methods, which are non-exclusive, non-mandatory methods for verifying that a purchaser who is a natural person is an accredited investor. If the issuer uses one of the Specified Methods to verify the status of a natural person is an accredited investor, Rule 506(c) provides that the issuer will be deemed to have taken reasonable steps to verify that status.
- The first Specified Method relates to determinations of the status of the purchaser who is a natural person based on his or her income. In that case, a review of any Internal Revenue Service form that reports the purchaser’s income for the two most recent years and the obtaining of a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year will be deemed reasonable steps to verify a purchaser’s status.
The second Specified Method relates to determinations of the status of the purchaser who is a natural person based on his or her net worth. In such method, the issuer may review one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
- with respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
- with respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.
- The third Specified Method involves obtaining a written confirmation from (i) a registered broker-dealer, (ii) investment adviser registered with the SEC, (iii) a licensed attorney in good standing under the laws of the jurisdictions in which he or she is admitted to practice law or (iv) a certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office, 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 the purchaser is an accredited investor.
- The final Specified Method is a grandfathering method of verification. That method will permit the issuer to verify the accredited investor status of any natural person who has purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c) and continues to hold such securities, by obtaining a certification from such person at the time of sale that he or she qualifies as an accredited investor.
An issuer may rely on one or more of the Specified Methods only if the issuer does not have knowledge that the individual is not an accredited investor at the time of sale of the securities to the purchaser. The SEC notes that in preparing the proposed amendment it had considered the inclusion of specified methods of verification in the proposed amendment to Section 506, but was concerned with issuers using such means of verification unreasonably or disregarding information indicating that a purchaser was not an accredited investor at the time of the securities’ purchase.
We emphasize that although the non-exclusive methods of verification may appear to offer an attractive means of determination of a purchaser’s accredited investor status, issuers must be cautious when verifying a purchaser’s accredited investor status by a Specified Method and relying on less-than-current information to do so. The review of the most recent information regarding the value of assets shown on brokerage statements or the amount of liabilities reflected in a consumer reporting agency’s report may, in fact, result in the issuer having knowledge that the individual purchaser is not an accredited investor on the date of sale even though earlier dated information demonstrated the purchaser was an accredited investor as of an earlier date. Although the term “knowledge” is not expressly defined in the Securities Act or the rules and regulations thereunder, issuers should proceed on the basis that the SEC will use a definition of “knowledge” similar to one present elsewhere in federal law, i.e., one has knowledge of a fact if one has actual knowledge of the fact or should have known the fact.
Transition Offerings. If an issuer is making an ongoing offering under Rule 506 that commences before the effective date of Rule 506(c), the issuer will have the option to continue the offering after that effective date in accordance with the requirements of either Rule 506(b) or Rule 506(c). If the issuer opts to continue the offering as a Rule 506(c) offering, any general solicitation made by the issuer or on its behalf after the effective date will not taint the exempt status of offers and sales of securities that occurred as a part of the offering that was commenced as a Rule 506(b) offering prior to the effective date of Rule 506(c). Nevertheless, all sales in the offering, including those made before Rule 506(c)’s effective date, must be made to accredited investors whose status as such must be verified by reasonable steps pursuant to the requirements of Rule 506(c).
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 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.
General Solicitation Prohibition Still Applies to Section 4(a)(2), Non-Rule 506(c) 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 adopt such rulemaking, noting that bills that would have amended Section 4(a)(2) to permit general solicitation were introduced and considered by Congress but not enacted.11 The SEC noted that the JOBS Act mandate to allow general solicitation “affects only Rule 506, and not Section 4(a)(2) offerings in general.”12 Thus, unless and until Congress amends Section 4(a)(2) or the SEC reverses its position, general solicitation continues to be prohibited with respect to Section 4(a)(2) offerings (or private resales made in reliance on Section 4(a)(1) (Section 4(1) prior to enactment of the JOBS Act) of the Securities Act (Section 4(a)(1)) pursuant to the so-called “4(1½)” exemption).
Related Amendments of Form D. The SEC also amended Form D, which is the form that issuers must 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 is redesignated “Rule 506(b)” for those offerings conducted in reliance on Rule 506(b) and, thus, without general solicitation.
The Amendments to Rule 144A
Background. Rule 144A is a non-exclusive safe harbor exemption under Section 4(a)(1) 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 Rule 144A restricts offers to QIBs, general solicitation of potential transferees of the securities is effectively prohibited despite the rule’s lack of an express prohibition against general solicitation. 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.
The Amendments. The amendments to Rule 144A effectively permit securities to be resold to QIBs to be offered 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 Rule 506 amendments eliminating the prohibition on general solicitation in Rule 506(c) offerings, the amendments to Rule 144A impose no requirement for the selling security holder to take reasonable steps to verify QIB status. As a result, the amendments do not require any steps be taken in addition to those required in current practice under Rule 144A in order for the seller and any person acting on its behalf to have a reasonable belief that the offeree or purchaser is a QIB.13 As is the case with 506(c) offerings, the use of general solicitation in a Rule 144A offering after the effective date of the Rule 144A amendments will not taint offers and sales in that offering made prior to that effective date in compliance with Rule l44A. Moreover, the SEC notes that the use of general solicitation in a Rule 144A offering will not affect the availability of the Section 4(a)(2) exemption in a precursor private placement of the securities being offered and resold in the Rule 144A offering.14
In connection with the Rule 144A amendments, the SEC also amended Rules 101, 102 and 104 of Regulation M to make the Rule 144A-related provisions of those rules consistent with amended Rule 144A.
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 of the offering is conducted under Rule 144A or Rule 506 and the offshore portion is conducted under Regulation S. The SEC confirms in the 506(c) Adopting Release that, consistent with its historical treatment of such matter, offshore offerings conducted under Regulation S will not be integrated with concurrent offerings under Rule 506(c) or Rule 144A involving general solicitation.
Amendments to Rule 506 Regarding Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings
At its July 10, 2013 meeting, the Commission adopted new paragraphs (d) and (e) to Rule 506, which reflect a number of changes from the rules as originally proposed. Paragraph (d) of Rule 506 (Rule 506(d)) makes the exemption from the registration requirements of Section 5 of the Securities Act under Rule 506(b) or Rule 506(c) unavailable to an issuer if the issuer or certain persons related to the issuer have been convicted of certain felonies or misdemeanors or have been the subject of certain bars. The disqualification will apply to an issuer if one or more of the following persons is subject to a disqualifying event:
- the issuer, any predecessor of the issuer or an affiliated issuer;
- a director of the issuer, an executive officer (as defined in Rule 405 under the Securities Act) of the issuer or an officer of the issuer who is not an executive officer but who is participating in the offering;
- a general partner or managing member of the issuer;
- a beneficial owner of 20% or more of the issuer’s outstanding voting equity securities;
- a promoter connected with the issuer in any capacity at the time of a sale in the offering;
- any person that has been or will be paid (directly or indirectly) remuneration for the solicitation of purchasers in connection with the sale of securities in the offering or any general partner, managing member, director or executive officer of such solicitor or other officer of such solicitor participating in the offering or a general partner or managing members of such solicitor; or
- any investment manager of an issuer that is a pooled investment fund or any general partner, managing member, director or executive officer of such investment manager or other officer of such investment manager participating in the offering or a general partner or managing members of such investment manager.
The disqualification will occur if any of the persons described above:
(i) has been convicted within ten years (five years in the case of issuers, their predecessor and affiliated issuers) prior to any sale of securities in the offering of any felony or misdemeanor or (ii) is subject to any order, judgment or decree of any court of competent jurisdiction entered within five years before the time of a sale in that offering and that, at such time, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice, in the case of either (i) or (ii):
- in connection with the purchase or sale of any security;
- involving the making of a false filing with the SEC; or
- 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;
- is subject to a final order of a state securities commission, a state regulator of banks, savings associations, credit unions or insurance companies, a federal banking agency, the Commodity Futures Trading Commission (CFTC) or the National Credit Union Administration entered (i) that, at the time of a sale in the offering, bars such person from association with an entity regulated by one of those authorities or from engaging in the business of securities, insurance, banking, or savings association or credit union activities or (ii) is a final order (as now defined in Rule 501 of Regulation D) based on a violation of a law or regulation prohibiting fraudulent, manipulative or deceptive conduct and the final order was entered within ten years before the time of a sale in the offering;
- is subject to certain orders of the SEC entered pursuant to the sections of the Securities Exchange Act of 1934 governing brokers and dealers and municipal securities dealers or pursuant to the Investment Advisers Act of 1940 that at the time of a sale in the offering suspends or revokes a person’s registration as a broker, dealer, municipal securities dealer or investment adviser, limits such person’s activities as such or bars such person from association with an entity or from participating in the offer of penny stock offerings;
- is subject to any order of the SEC entered within five years before the sale that, at the time of a sale in the offering, orders the person to cease and desist from committing or causing a future violation of specified scienter-based anti-fraud laws and rules or Section 5 of the Securities Act;
- is suspended or expelled from membership in, or suspended or barred from association with members of, a registered national securities exchange or national or affiliated securities association for an act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
- has filed or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the SEC that, within five years before the time of a sale in the offering, was the subject of a refusal order, stop order or order suspending the Regulation A exemption or is, at the time of such sale, the subjection of an investigation or proceeding to determine if such an order should be issued; or
- is subject to a United States Postal Service false representation order entered within five years before the time of a sale in the offering or, at such time, is subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the USPS to constitute a scheme or device for obtaining money or property through the mail by means of false representations.
As will be noted, some events must have first occurred within a look-back period of five or ten years and must have effect at the time of a sale in the offering in order to be a disqualifying event, while other events need only to have occurred within a stated look-back period to be a disqualifying event. Other events do not have any look-back period and need only have effect at the time of a sale in the offering in order to be a disqualifying event.
The disqualification will not apply with respect to any conviction, order, judgment, decree, suspension, expulsion or bar (i) that occurred or was issued before the effective date of new Rule 506(d), (ii) that is waived by the SEC if it determines that the disqualification is not necessary in the circumstances or (iii) as to which the court or other regulatory authority entering the order, judgment or decree advises in writing that the disqualification should not arise as a result of its judgment, order or decree.
Although occurrence of disqualifying events prior to the effective date of Rule 506(d) will not make the exemption in Rule 506(b) or Rule 506(c) unavailable to an issuer, new paragraph (e) of Rule 506 (Rule 506(e)) requires issuers to disclose to each purchaser in a Rule 506 offering at “a reasonable time prior to sale” of securities to such purchaser, a written description of any matter that would have triggered a disqualification had the conviction, order, judgment, decree, suspension, expulsion or bar occurred or been issued prior to the effective date of Rules 506(d) and 506(e). The timing for the provision of this disclosure is the same as that required for the provision of disclosures to non-accredited investors under Rule 502(b)(1) of Regulation D. In light of the various look-back periods for the disqualifying events, depending on the particular disqualifying event involved and the person subject to that event, this disclosure requirement could continue to affect issuers for a period of up to ten years.
We note that the language of Rule 506(e) does not include any express statement that the exemption under Rule 506 will not be available to any issuer failing to make any disclosure required by Rule 506(e). However, the SEC notes in its release adopting Rules 506(d) and 506(e) that it believes relief under Rule 508 of Regulation D for “insignificant deviations” from Regulation D requirements will not be available for a failure to make such disclosure. We also note that compliance with Rule 506(e) is not one of the conditions that must be met in order to make a valid claim of the exemption in either Rule 506(b) or Rule 506(c). Nevertheless, issuers who might have to make the disclosures required by Rule 506(e) should be cautious about relying on Rule 506(b) or Rule 506(c) to make an unregistered offering of securities without compliance with Rule 506(e) based on what appears to be a drafting oversight by the SEC.
An exemption under Rule 506 for an offering will not be unavailable to an issuer as a result of a disqualification under Rule 506(d) or the failure to comply with the disclosure requirements of Rule 506(e) if the issuer can establish that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed under Rule 506(d) or that any matter or matters required to be disclosed under Rule 506(e) existed. Establishing the exercise of reasonable care will require the issuer to have made, in light of the circumstances surrounding the offering, a factual inquiry as to whether any disqualifications exist. The nature and scope of the inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and other offering participants.
In addition, the SEC amended Form D to provide for a certification by the issuer that, if the issuer is claiming a Regulation D exemption for the offering, the issuer is not disqualified from relying on Regulation D for one of the reasons stated in Rule 505(b)(2)(iii) (which do not apply to Rule 506 offerings) or Rule 506(d).
Proposed Amendments to Regulation D, Form D and Rule 156
During the meeting in which the SEC adopted the amendments to Rules 506 and 144A discussed above, the SEC also proposed additional amendments to Regulation D and companion amendments to Form D.15 These rule proposals are intended to address certain risks that the SEC perceives may follow as a result of the adoption of Rule 506(c). The proposed amendments include:
- proposed amendments to Rule 503 that would require: (i) an issuer intending to make a general solicitation in an offering in reliance on Rule 506(c) to file a Form D at least 15 calendar days prior to its first use of general solicitation in the offering; and (ii) an issuer that has filed an advance Form D to file an amendment to its Form D no later than 15 calendar days after the first sale of securities is made in the offering;
- a proposed amendment to Rule 503 that would require an issuer making an offering in reliance on Rule 506(b) or Rule 506(c) to file a closing amendment to its Form D not later than 30 calendar days after the offering is terminated unless the prior Form Ds filed by the issuer regarding the offering contain all information that would be included in the closing amendment to the Form D;
- a proposed amendment to Rule 507 that would make the exemption under Rule 506(b) or 506(c) unavailable to an issuer, if it or any of its predecessors or affiliates: (i) has been subject to a court order, judgment or decree temporarily, preliminarily or permanently enjoining such person for failure to comply with proposed new Rule 509 or proposed new Rule 510T (each described below); or (ii) has failed, within the five preceding years, to comply with the requirements of Rule 503 regarding the filing of Form Ds in connection with an offering conducted in reliance on Rule 506 and did not cure that failure within cure periods provided in proposed new paragraph (b) of Rule 507. As proposed, new paragraph (b) of Rule 507 would permit an issuer to rely again on Rule 506 one year after: (a) the filing of all required Form D filings for all offerings conducted in reliance on Rule 506(b) or Rule 506(c) that have not been terminated; and (b) the filing of closing amendments to its Forms D for all previous offerings conducted in reliance on Rule 506(b) or Rule 506(c) within the preceding five years that have terminated;
- a proposed new Rule 509 that will require certain legends be included in any written general solicitation materials in any offering being made in reliance on Rule 506(c), including legends indicating that the securities being offered may be sold only to accredited investors and are being offered in reliance on an exemption from the registration requirements of the Securities Act and the issuer is not required to comply with the disclosure requirements applicable to registered offerings. Legends would also be required regarding the SEC not passing on the merits of or approving the offering, its terms or the offering materials, the applicable restrictions on resale of the securities offered and the existence of investment risk and the need for the investor to be able to bear the loss of their investment. Additional legends would be required for private funds; and
- a proposed new temporary Rule 510T (which would remain in effect for two years) that would require issuers making offerings in reliance on Rule 506(c) to submit (but not file) by means other than the SEC’s EDGAR system any written communication that constitutes a general solicitation with respect to the offering no later than the date of the communication’s first use.
If adopted, these already controversial amendments could well have a chilling effect on issuers’ willingness to use general solicitation in Rule 506(c) offerings. Particularly troublesome is the proposed requirement for the filing of a Form D at least 15 calendar days in advance of the commencement of the first general solicitation in an offering. That proposed amendment would require an issuer wanting to launch a Rule 506(c) offering to signal its intention to do so to the markets well in advance of the time the issuer could launch the offering. In other situations, the proposed amendment could cause a Rule 506 offering period to be extended beyond the time that might otherwise be needed to complete a successful offering.
Also troublesome is the proposed penalty for failing to file a Form D in connection with a Rule 506 offering. Many issuers do not file Form Ds now, but that failure does not thereafter disqualify them from relying on Rule 506. Barring an issuer’s access to private capital markets through Rule 506 offerings for one year is a harsh sanction for not making a Form D filing within a preceding five-year period.
Although the amendments to Rule 506 that have been adopted and those that have been newly proposed do not contain an amendment of the definition of the term “accredited investor,” in the 506(d) Proposing Release, the SEC requests comments on the definition of “accredited investor” in Rule 501 of Regulation D, including as to whether the current thresholds for the net worth and income tests for natural persons are appropriate and whether the fixed dollar thresholds should be changed to another type of threshold.
Issuers interested in making Rule 506(c) offerings should monitor the SEC’s actions regarding these proposed amendments to Regulation D and may want to comment on the proposals during the comment period. The comment period will end 60 days after the publication of the release proposing these amendments to Regulation D and Form D in the Federal Register.
Note that the SEC is also proposing to amend Rule 156 under the Securities Act (Rule 156) to apply to the sales literature of private funds the guidance supplied by Rule 156 as to the type of information regarding investment companies that may be false and misleading. The amendment will also make clear that information provided by a private fund to purchasers in a general solicitation made in connection with a 506(c) offering will be deemed sales literature for purposes of Rule 156.
Issuers should consider taking the following actions in response to the amendments.
Carefully consider whether general solicitation is necessary. 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 such general solicitation would impact state “blue sky” law analysis;
- the application of the anti-fraud provisions of the federal securities laws to the content of the general solicitation;
- the possibility of losing a registration exemption and either having to terminate an offering immediately prior to the first sale or facing rescission offers if all of the conditions of proposed Rule 506(c) are not satisfied and Section 4(a)(2) and Rule 506(b) cannot serve as fallback exemptions due to their prohibition against general solicitation;16
- a Rule 506(c) offering cannot be converted to a Rule 506(b) offering in the way a Rule 506(b) offering could be converted to a Rule 506(c) offering if no sales have been made to non-accredited investors in the Rule 506(b) offering and the verifications of the accredited investor status of all of the purchasers in the offering, including those persons purchasing securities prior to the time of the conversion, meet the verification by reasonable steps standard of Rule 506(c); and
- in particular, a Rule 506(c) offering conducted by making serial closings of sales will not give the issuer the flexibility to rely instead on Rule 506(b) and sell to an otherwise desirable purchaser that proves not to be an accredited investor after a general solicitation has been made in the offering.
Public companies may determine it would be better to rely on existing Rule 506(b) to avoid the foregoing concerns and to eliminate the possibility that certain types of general solicitation (for example, seminars) may raise Regulation FD concerns.
Consider what changes to offering processes and documents are necessary. Issuers that plan to use general solicitation under proposed Rule 506(c) should consider how their offering processes and documents will need to change to provide for reasonable verification steps.
Issuers should keep in mind that a purchaser must be an accredited investor at the time of sale. As a result, the process of verifying the status of a purchaser as an accredited investor, other than through a Specified Method, must be designed to ensure that the issuer has taken the steps necessary to obtain reasonable assurance that the purchaser is an accredited investor at the time of sale.
Rule 506(c) does not preclude the use of a mixture of verification methods, and issuers will want to retain flexibility when designing their verification procedures.
An issuer relying on a Specified Method to verify any purchaser’s accredited investor status should also keep in mind that, despite two- or three-month old information showing a purchaser to be an accredited investor, if the issuer has more recent information showing that the purchaser’s status has changed, it cannot ignore the more recent information and treat the purchaser as an accredited investor. In this regard, issuers following a Specified Method of verifying a purchaser’s accredited investor status may wish to conclude their information gathering with respect to a purchaser after confirming that the purchaser is an accredited investor, although issuers may not disregard any information of which they thereafter become aware that is inconsistent with a conclusion that a purchaser is an accredited investor.
Issuers may also want to consider the nature and content of materials used in any general solicitation activities. The anti-fraud rules of the Securities Act and the Securities Exchange Act of 1934 will continue to apply, and issuers should assume that the SEC will scrutinize the scope and content of general solicitations relating to Rule 506(c) and Rule 144A offerings. In addition, if certain of the proposed changes to Form D and related rules are adopted, an issuer relying on Rule 506(c) will be required to make a Form D filing at least 15 calendar days before its first use of general solicitation in the offering and to submit to the SEC its written general solicitation materials.
Plan for flexibility in Rule 506(b) offerings. If an issuer encounters difficulties in marketing a Rule 506(b) offering, the issuer may find itself needing to undertake a general solicitation to increase the chances of the offering’s success. In addition, issuers making Rule 506(b) offerings may make inadvertent general solicitations that will make the exemption of Rule 506(b) unavailable. As a result, issuers that plan to rely on Rule 506(b) and forgo general solicitation may want to consider how their offering processes and documents should change to provide for reasonable verification steps in order to retain Rule 506(c) as an alternative exemption if they need to expand their marketing efforts or in the event of an inadvertent general solicitation. However, if the proposed amendments to Regulation D requiring the filing of a Form D 15 calendar days in advance of a general solicitation in a Rule 506(c) offering and the submission of written general solicitation materials are adopted as proposed, such a conversion in the case of an inadvertent general solicitation would not be possible.
Conduct due diligence regarding bad actors. An issuer intending to offer securities in reliance on an exemption under Rule 506 should conduct due diligence investigations regarding each of the persons that could be subject to a disqualifying event described in Rule 506(d) prior to commencing the offering. To make certain the issuer can establish that it did not know of a disqualification and took reasonable care in establishing that there was no undisclosed matter that could cause a disqualification under Rule 506(d) or that would have to be disclosed under 506(e), the issuer should obtain written certifications from each person that, if subject to a disqualifying event, would result in the unavailability of the exemption under Rule 506. Moreover, prior to engaging any underwriter, placement agent or solicitor with respect to a Rule 506 offering, issuers will want to inquire as to whether that person or any of the directors, executive officers, officers that would be involved in the offering, general partners or managing members of that person or their general partners or managing members are subject to any disqualifying event and should obtain appropriate representations as to the absence of any such disqualifying events in any underwriting, placement, solicitation or advisory agreement.
Keep records of verifications. Whichever method of verification of accredited investor status of purchasers in Rule 506(c) offerings is used or whatever steps are taken pursuant to any method of verification, issuers should keep adequate records to document the verification steps taken as the issuers bear the burden of showing that they are entitled to a registration exemption. In addition, issuers should keep adequate records demonstrating the steps taken to confirm that they were not disqualified from making a Rule 506(b) or Rule 506(c) offering under Rule 506(d) or have made any required disclosures pursuant to Rule 506(e).
Filing Form D. The SEC takes the view in the 506(c) Adopting Release that an issuer may not check both the Rule 506(b) box and the Rule 506(c) box on a Form D for the same offering. An issuer conducting a Rule 506(b) “quiet” offering and that makes an inadvertent general solicitation during the pendency of the offering may need to amend a previously filed Form D relating to the offering to change the indication that it is making a Rule 506(b) offering to an indication that it is making a Rule 506(c) offering, if the offering can otherwise qualify as a Rule 506(c) offering. As noted above, this alternative would not be available if the proposed amendments regarding advance filing of Form Ds and submission of general solicitation materials are adopted as proposed. Issuers making 506(c) offerings with general solicitations can expect that the SEC will be reviewing various media to identify issuers making Rule 506(c) offerings involving general solicitation and will review the Form Ds filed with the SEC to ensure that a Form D has been filed with respect to each unregistered offering involving general solicitation and the issuer has checked the correct box in the Form D.
Consider private fund specific matters. While private funds may rely on Rule 506(c) to make general solicitations without jeopardizing exclusions from the definition of “investment company” in the Investment Company Act of 1940, private funds and their sponsors will need to consider whether other regulatory requirements may curtail or preclude them from making Rule 506(c) offerings. Thus, for example, private fund sponsors trading in commodities that rely on CFTC Rule 4.7 or 4.13(a)(3) exemptions are subject to CFTC regulations that prohibit marketing to the public, preventing those sponsors, for now, from conducting a general solicitation in a Rule 506(c) offering. Also, fund sponsors that are registered under the Investment Advisers Act will need to review solicitation materials used in a Rule 506(c) offering in light of the advertising restrictions and anti-fraud provisions of the Investment Advisers Act and related rules.
Monitor developments. As the SEC receives questions from issuers regarding the application of the newly adopted rules and gains insights into how issuers are making use of general solicitation in Rule 506(c) offerings, the Division of Corporation Finance may issue interpretative guidance regarding the new rules and their application in the form of an interpretative release, frequently asked questions or compliance and disclosure interpretations. Issuers should watch for such guidance, as well as action by the SEC regarding the proposed additional amendments to Regulation D, Form D and Rule 156.