On April 5, 2012, the Jumpstart Our Business Startups Act (the “JOBS Act”) was enacted. The stated objective for the JOBS Act is to improve access to the public capital markets for startup and emerging companies and thus increase job creation and economic growth in the United States.
Title II of the JOBS Act (“Title II”) mandated the Securities and Exchange Commission (the “Commission”) to amend applicable rules within 90 days of its enactment (i.e., July 5, 2012) in order to eliminate the prohibitions against general solicitation or general advertising (collectively, “General Solicitation”) in Rule 506 of Regulation D1 (“Rule 506”) under the Securities Act of 1933, as amended (the “Securities Act”), and under Rule 144A under the Securities Act2 (“Rule 144A”). These changes are intended to allow issuers to advertise broadly when conducting private placements and thus enable them directly to reach a greater number of potential investors at lower costs without an intermediary, subject to certain requirements, as described more fully below. For a complete overview of all provisions of the JOBS Act, please click here3.
On August 29, 2012, the Commission issued Release No. 33-93544 (the “Release”) which, belatedly, proposed a new Rule 506(c) (“Proposed Rule 506(c)”) and an amendment to Rule 144A (collectively, the “Proposed Rules”) to implement Title II. The Proposed Rules would:
- Create Proposed Rule 506(c) which does not prohibit General Solicitation for offers and sales of securities that otherwise comply with Rule 506, provided that all purchasers of the securities are “accredited nvestors” and the issuer takes “reasonable steps to verify” that the purchasers are “accredited investors;”
- Amend Form D5 to add a check box to indicate whether an offering is being conducted pursuant to Proposed Rule 506(c); and
- Amend Rule 144A to allow securities resold pursuant to Rule 144A to be offered to persons other than “qualified institutional buyers”6 (“QIBs”), including by way of General Solicitation, provided that the securities are sold only to persons that the seller (or any person acting on behalf of the seller) “reasonably believes” are QIBs.
Comments on the Proposed Rules are due on or before October 5, 2012. A more comprehensive summary of the Proposed Rules is annexed hereto.
Controversy Surrounding the Rulemaking Process and the Scope of Proposed Rule 506(c)
The significance of the reforms contained in Title II, its implications for the investment management industry, and the capital markets, generally, is illustrated by the statements made by individual Commissioners at the Open Meeting at which the Proposed Rules were approved and the substance of the Release itself7. Although Commissioners Gallagher and Paredes voted in favor of the Proposed Rules, they expressed great disappointment and frustration that the proposal brought before the Commission were proposed rules, not interim final rules, as had been anticipated8. Moreover, Commissioner Walter, who voted in favor of the Proposed Rules, and Commissioner Aguilar, who voted against the Proposed Rules, expressed disappointment that Proposed Rule 506(c) is narrow in scope and does not address various substantive issues raised in comment letters to the Commission. Such issues include: (i) amending the definition of accredited investor to require consideration of the investor’s financial sophistication; and (ii) amending Form D notice requirements to enhance the timing and content of the form. Chairman Schapiro, who voted in favor of the Proposed Rules, acknowledged that there are “very real concerns about the potential impact of lifting the ban on general solicitation[,] many thoughtful letters [have been submitted] suggesting both specific and broad reforms to Rule 506 offerings and Regulation D more generally” and “it will be incredibly important for the Commission to take a thorough look at the private placement market in the future.” She concluded, however, that “at this point it is appropriate that [the Commission] undertake this more narrow mandate that Congress placed upon [the Commission] through the JOBS Act.”
As a further indication of the controversy surrounding the Proposed Rules, in addition to providing a detailed, lengthy analysis of each of its provisions and the rationale for the approach taken, the Release solicits comments on sixteen topics, including more than forty separate open-ended questions, only four of which exclusively concern the proposed amendment to Rule 144A.
“Reasonable Steps to Verify” Accredited Investor Status and the “Reasonable Belief” Standard Under Rule 506
Perhaps the most significant issue under Proposed Rule 506(c) is the distinction between actions that will suffice as “reasonable steps to verify” that a prospective purchaser is an “accredited investor” and, in light of this standard, what will suffice as a basis for a “reasonable belief” that a prospective purchaser is an “accredited investor.”
A number of commentators expressed concern that “unduly prescriptive or burdensome rules for verifying a purchaser’s accredited investor status,” among other things, “could lead to reluctance on the part of issuers to access the relevant capital markets, or would contravene the purposes of the JOBS Act.”
In order to address this concern and, at the same time, the desire to provide objective standards that could reduce uncertainty, the Commission stated that: “Whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction”9 (emphasis added), but explained that an issuer would have a great deal of flexibility and could exercise a great degree of subjectivity in determining how to make this “objective” determination:
We believe that, at present, proposing to require issuers to use specified methods of verification would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor, as well as the potentially wide range of verification issues that may arise, depending on the nature of the purchaser and the facts and circumstances of a particular Rule 506(c) offering. We are also concerned that a prescriptive rule that specifies required verification methods could be overly burdensome in some cases, by requiring issuers to follow the same steps, regardless of their particular circumstances, and ineffective in others, by requiring steps that, in the particular circumstances, would not actually verify accredited investor status10.
As noted in the Release11, a number of commentators also raised concerns that the “reasonable steps to verify” requirement could be “interpreted as precluding the use of the “reasonable belief” standard in Rule 501(a) which provides maximum flexibility to issuers.
A critical element of the regulatory analysis set forth in the Release is the recognition that Title II did not amend the definition of “accredited investor” in Rule 501(a): “Accredited investor” shall mean any person who comes within any of the following categories or who the issuer reasonably believes comes with any of the following categories, at the time of the sale of the securities to that person.” (Emphasis added.) Rather, Title II added a new requirement that an issuer must satisfy if it does not wish to be bound by the prohibition on General Solicitation. Accordingly, issuers continue to have the ability to rely upon their own “reasonable belief” regarding a purchaser’s status as an accredited investor.
Entirely consistent with this analysis, the Commission assured issuers that:
"If a person who does not meet the criteria for any category of accredited investor purchases securities in a Rule 506(c) offering, we believe that the issuer would not lose the ability to rely on the proposed Rule 506(c) exemption for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.”12
This makes sense since if an issuer satisfies the requirement that it has taken reasonable steps to verify that a purchaser is an accredited investor, it also should have established the basis for a reasonable belief that a purchaser is an accredited investor. However, if the new “reasonable steps to verify” requirement is to be meaningful, just because an issuer has a reasonable belief that a purchaser is an accredited investor should not mean that in all instances the issuer will have, de facto, satisfied such requirement.13
An issuer that wishes to include up to 35 non-accredited investors in an offering pursuant to Rule 506(b) will continue to be subject to the Regulation D prohibition on General Solicitation, but will not be subject to the requirement of Proposed Rule 506(c) that it take “reasonable steps to verify” that all purchasers are accredited investors - de facto a less burdensome standard for an issuer that limits the scope of its offering.
Unresolved Issues and Concluding Observations
Private Funds and Harmonization of Title II with Regulations of the Commodity Futures Trading Commission
As discussed in detail in the Annex, the Commission confirmed in the Release that since Title II provides that “[o]ffers and sales exempt under [Rule 506] shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation . . . the effect of [Title II] is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions [of Section 3(c)(1) and Section 3(c)(7)] under the Investment Company Act.”14
The definition of “Federal securities laws,” however, does not include the Commodity Exchange Act and, accordingly, concerns have arisen that the regulatory relief provided under certain regulations adopted by the Commodity Futures Trading Commission on which managers of privately offered funds rely15 will continue to be available to them if the fund offers interests through any form of General Solicitation.16 Specifically, CFTC Regulation 4.13(a)(3) provides an exemption from registration to a commodity pool operator that makes offerings in commodity pools, if, among other things, they are “offered and sold without marketing to the public in the United States.” CFTC Regulation 4.7 provides relief from certain onerous disclosure and other requirements for registered commodity pool operators if, among other things, participations in a commodity pool are offered and sold in an offering that "qualifies for exemption from the registration requirements of the Securities Act pursuant to section [4(a)(2) thereof] or pursuant to Regulation S [and] any bank registered as a commodity pool operator in connection with [a] collective trust fund whose securities are . . . offered and sold, without marketing to the public . . . ."
Impact of the Proposed Rule on United States Domiciled Private Fund Managers Who Market Interests in the United Kingdom
The marketing of private placements in the U.K. is governed by two regulatory regimes – the Prospectus Rules17 and the Financial Services and Markets Act 2000 (“FSMA”). The Prospectus Rules operate to determine whether a prospectus must be produced for the proposed offering of securities. FSMA then determines the manner in which, and to whom the securities may be promoted. A prospectus is not needed for a private placement which constitutes an “exempt public offer”18 by virtue of one of the following requirements being met: (i) the offer is made to qualified investors only (as defined by MiFID19); (ii) the offer is directed at fewer than 150 people; or (iii) the offer is below certain thresholds in respect of the total consideration or denomination of securities. Notwithstanding the question of whether a prospectus is required in order to market securities, regard must always be had to the rules on financial promotions set out in section 21 of FSMA.
The Proposed Rules introduced pursuant to the JOBS Act are broadly similar to the U.K. provisions in this area, which prevent an authorized person from communicating a financial promotion unless: (i) the promotion has been approved by an authorized person; or (ii) the promotion is exempt. The notable exemptions that are particularly comparable with the Proposed Rules are set out in the FSMA (Financial Promotion Order) 2005 (the "FPO") and include promotions made publicly to "Sophisticated Investors,"20 "Certified High Net Worth Individuals"21 and "Investment Professionals."22 Similarly to the safeguards in the Proposed Rules relating to the verification of accredited investors and the resale of securities to QIBs, the FSA has issued guidance in respect of public promotions targeting Investment Professionals which requires that, among other things, there are proper systems and procedures in place to prevent recipients other than Investment Professionals from engaging in the investment activity.
As envisaged when the JOBS Act was enacted into law, the Proposed Rules should operate to more closely align the U.S. and U.K. regulatory regimes in respect of private placements and will hopefully stimulate cross-border offerings of securities as well as improve the internal U.S. economy.
Notwithstanding its thoroughness, the Release does not address a number of important issues, including the concern that an issuer that conducts an offering in reliance on Rule 506(c) might be precluded from shortly thereafter conducting an offering based upon Proposed Rule 506(b) because the two offerings might be integrated for purposes of Regulation D.23
State Blue Sky Laws
The National Securities Markets Improvement Act of 1996 (“NSMIA”) preempts state “blue sky” laws governing the registration and qualification of certain securities offerings, including securities offered and sold in compliance with Rule 506. NSMIA, however, expressly preserves the states’ general antifraud enforcement authority and some state courts have placed the burden on the issuer to demonstrate actual compliance with Rule 506 in order for the issuer to assert that pre-emption applies to a purported Regulation D offering.24
The Release perpetuates the rulemaking process and has not resolved the controversies surrounding the rescission of the ban on General Solicitation under Title II. Moreover, given the concerns of individual Commissioners and the large number of issues on which further comments have been solicited, it remains to be seen whether the rulemaking process will come to a swift conclusion, with a thorough re-examination of the private placement market to be left for another day, or the desire to address all of these issues on a holistic basis will lead to further extensive delays.
Click here to view Annex.