On July 10, 2013, the Securities and Exchange Commission (SEC) adopted rule amendments that eliminate the 80‐year old prohibition on general solicitation and general advertising in Rule 506 and Rule 144A transactions under the Securities Act of 1933, as amended (Securities Act), and prohibit issuers from reliance on Rule 506 for any offering in which certain felons and other bad actors are involved. In related action, the SEC released proposed rules that would, among other things, require issuers to provide additional information in connection with the use of general solicitation in Rule 506 offerings.
Elimination of the Ban on General Solicitation and General Advertising
The SEC voted 4—1 to adopt amendments to Regulation D and Rule 144A under the Securities Act that eliminate the ban on general solicitation and general advertising1 in certain private securities transactions, subject to compliance with requirements imposed under these amendments. Regulation D and Rule 144A are widely used by public and private issuers in the U.S. and abroad to raise debt and equity without registering the sale of the securities under the Securities Act. Regulation D is particularly popular with early‐stage and start‐up companies seeking financing from individuals and venture capital groups and is frequently utilized in private equity, hedge fund, real estate fund and venture capital fund formation practices. The adoption of the amendments implements Section 201(a) of the Jumpstart Our Business Startups Act, or JOBS Act, signed into law by President Obama in April 2012.
The amendments will likely have major effects on how private placements are conducted and should facilitate much broader access to the capital markets for a wide variety of issuers, both public and private. Moreover, although the SEC has not yet adopted rules to implement the crowdfunding provisions of the JOBS Act, elimination of the ban on general solicitation and general advertising potentially opens the door for the growth of the crowdfunding industry by facilitating access to the broad universe of accredited investors. The amendments take effect 60 days after publication in the Federal Register, which normally occurs several days after SEC approval. Issuers are cautioned not to jump the gun on employing general solicitation or advertising in advance of the effective date.
Specifically, the amendment to Rule 506 under Regulation D adds new subsection 506(c) that permits an issuer to engage in general solicitation or general advertising in connection with an offer and sale under Rule 506, provided that all purchasers of the securities are “accredited investors.” Most important, the mere offer of the securities to someone who is not an accredited investor will not affect the exemption. The issuer is required to take “reasonable steps” to verify that the purchasers are, in fact, accredited. This particular aspect of the amended rule was the topic of much debate by commenters and practitioners when the draft amendments were initially proposed in August 2012. In the proposing release, the SEC gave guidance about the factors an issuer should consider when determining “reasonableness” for purposes of Rule 506; however in response to widespread comment, the adopting release includes a nonexclusive list of methods that issuers may use to satisfy this requirement, depending on the nature of the accredited investor, including:
- Reviewing income tax returns and Forms W‐2 and 1040 to confirm income levels;
- Obtaining written representations from the investor along with reviewing bank, brokerage and other account statements, appraisal reports and consumer credit agency reports to confirm asset and liability levels;
- Obtaining written confirmations from broker dealers, investment advisors, attorneys or CPAs that such persons have taken reasonable steps to verify that the investor is an accredited investor within the prior three months and has determined that the investor is accredited; and
- Obtaining a “bring down certification” from existing holders of an issuer’s securities who, as accredited investors, purchased such securities in the same issuer’s Rule 506(b) offering prior to effectiveness of the amendments.
These methods extend to a great degree current best practices and are suggestive of the level of diligence that may now be required. The SEC stressed in the adopting release, as it did in the proposing release, that whether reasonable steps have been taken “will be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction. Among the factors that issuers should consider under this facts and circumstances analysis are:
- The 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.”
As an example, if an offering requires a high minimum investment, fewer steps may be required to verify accredited investor status. The burden, however, will remain on the issuer to demonstrate that it is entitled to the exemption and care will need to be taken when employing a general solicitation. The SEC has reiterated its position that having an investor check a box on a questionnaire is not sufficient verification of accredited investor status, absent additional confirming information about the purchaser.
In addition, the Form D notice filed with the SEC in connection with a Regulation D offering has been amended by requiring issuers to indicate whether they are relying on the provision that permits general solicitation or general advertising in a Rule 506 offering.
Further, the adopting release amends Rule 144A to eliminate the ban on general solicitation or general advertising in resales of securities conducted in accordance with the rule, provided that the seller (and any person acting on behalf of the seller) reasonably believes the purchaser is a qualified institutional buyer, or QIB, as defined in Rule 144A. Rule 144A is used extensively to facilitate distributions of debt securities of a wide variety of issuers, often in the high yield markets and for acquisition financing, and already contains well known non‐exclusive methods to determine whether a purchaser is a QIB.
The SEC made clear in its proposing release, and re‐emphasized in the adopting release, that these amendments are limited to transactions under Rule 506(c) and Rule 144A and that the elimination of the ban on general solicitation and general advertising does not extend to offerings conducted generally in reliance on Section 4(a)(2) of the Securities Act, nor does it affect reliance on Rule 506(b) without the use of general solicitation or advertising.
Disqualification of Issuers in Connection with Felons and “Bad Actors”
In related action by the SEC, additional amendments to Rule 506 were unanimously adopted to disqualify issuers and other market participants from relying on that rule if “felons and other ‘bad actors’” are participating in the Rule 506 offering. New subparagraph (d) of Rule 506 will apply only to triggering events occurring after effectiveness of the rule amendments, with pre‐existing events subject to mandatory disclosure. These amendments implement Section 926 of the Dodd‐Frank Wall Street Reform and Consumer Protection Act and become effective 60 days after publication in the Federal Register.
Proposed Rules Add Further Filing Requirements under Regulation D
Lastly, the SEC released proposed new rules for comment, “Amendments to Regulation D, Form D and Rule 156 under the Securities Act,” that are intended to enhance the SEC’s ability to evaluate and monitor the development of market practices in Rule 506 offerings and, in particular, the need for added investor safeguards. Under the proposal, issuers relying on Rule 506(c) will be required to file Form D 15 days prior to the offering. The proposed rules would also require the filing of written general solicitation materials no later than the date of first use. If adopted, the rules as proposed are intended to be in effect for two years and the materials would not be available to the public. All Rule 506 offerings would be required to file a final Form D after completion of the offering to permit the SEC to better understand the size of the Rule 506 market. Proposed amendments to Rule 156 would extend the existing antifraud guidance to sales literature of private funds.