On July 10, 2013 the SEC adopted long-awaited rules eliminating the prohibition on general solicitation and general advertising in securities offerings conducted pursuant to Rules 506 and 144A under the Securities Act of 1933. The rule change is one step of a broader rulemaking process underway at the SEC required by the JOBS Act, originally adopted by Congress on April 5, 2012. Proponents of the JOBS Act argue that removing the prohibition on general solicitation will enhance the ability of companies to access investors and raise capital, thereby creating jobs and economic activity. Still in process at the SEC are JOBS Act-required rules on crowdfunding which proponents hope will allow start-up companies to raise money from large numbers of small investors through web-based platforms. Critics of the JOBS Act fear that the new rules will result in more fraud on investors.

To safeguard against fraud, the July 10, 2013 rules adopted by the SEC include rules disqualifying an offering from reliance on Rule 506 if felons or other bad actors are participating in the offering. The rules will be effective 60 days after publication in the federal register.

Also on July 10, 2013, the SEC proposed new rules that would require issuers conducting an offering in reliance on Rule 506 to file offering materials with the SEC as well as a new Form D with additional information requirements. In addition, the proposed rules would apply the antifraud rules of the federal securities laws to the sales literature of any investment companies relying on Rule 506 with general solicitation. These proposed rules are subject to comment and possible revisions before the SEC considers them for adoption. Some have criticized the SEC for adopting the changes to Rule 506 ending the ban on general solicitation before determining whether the additional protections included in the proposed rules are necessary to prevent fraud.

New Rule 506(c) Permitting General Solicitation

The SEC has amended Rule 506 to add a new subsection 506(c) pursuant to which issuers can offer securities through means of general solicitation, provided that:

  • all purchasers of securities must be accredited investors, and
  • the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.

Issuers will continue to have the ability under Rule 506(b) to conduct Rule 506 offerings as permitted prior to this amendment, subject to the prohibition against general solicitation.

Reasonable Steps to Verify that the Purchasers of the Securities Are Accredited

Much of the debate preceding the adoption of the new rule and a good portion of the SEC’s release discussing the new rule relates to the question of what constitutes “reasonable steps to verify that the purchasers are accredited investors.” It is important to note that this requirement is separate from and independent of the requirement that sales be limited to accredited investors, and must be satisfied even if all purchasers happen to be accredited investors. The SEC has adopted a principles-based approach that is intended to allow issuers to make an objective determination, in the context of the particular facts and circumstances of each purchaser and transaction, regarding what steps are reasonable to verify that the investor is accredited. Based on comments received following the initial proposal, the SEC also added a non-exclusive list of verification methods that are deemed to meet the reasonable verification requirement.

Regarding the “principles-based approach”, the SEC encourages issuers to examine:

  • 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;
  • 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.

The SEC notes that after consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa. This general guidance is instructive, but the examples provided by the SEC are more helpful in guiding issuers in their determination of what will be considered reasonable verification. The excerpts below from the SEC’s release provide instructive examples:

Example 1

“…if the terms of the offering require a high minimum investment amount and a purchaser is able to meet those terms, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party.”

Example 2

“…the steps that may be reasonable to verify that an entity is an accredited investor by virtue of being a registered broker-dealer – such as by going to FINRA’s BrokerCheck website – will necessarily differ from the steps that may be reasonable to verify whether a natural person is an accredited investor.”

Example 3

“Examples of the types of information that issuers could review or rely upon – any of which might, depending on the circumstances, in and of themselves constitute reasonable steps to verify a purchaser’s accredited investor status – include, without limitation:

  • publicly available information in filings with a federal, state or local regulatory body – for example, without limitation:
    • the purchaser is a named executive officer of an Exchange Act registrant, and the registrant’s proxy statement discloses the purchaser’s compensation; or
    • the purchaser claims to be an IRC Section 501(c)(3) organization with $5 million in assets, and the organization’s Form 990 series return filed with the Internal Revenue Service discloses the organization’s total assets;
  • third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories in the accredited investor definition – for example, without limitation:
    • the purchaser is a natural person and provides copies of pay stubs for the two most recent years and the current year; or
    • specific information about the average compensation earned at the purchaser’s workplace by persons at the level of the purchaser’s seniority is publicly available; or
    • verification of a person’s status as an accredited investor by a third party, provided that the issuer has a reasonable basis to rely on such third-party verification.”

It’s clear that issuers relying on new Section 506(c) will have do more to verify accredited status than has been typical in the past with Regulation D offerings. The common practice of asking investors to sign representations that they meet accredited investor definitions will not be sufficient without additional information indicating accredited status. Moreover, issuers will not be able to rely on third parties who verify accredited status if the third party’s only basis for doing so is asking investors to sign forms claiming accredited status.

Non-Exclusive List of Verification Methods Deemed Reasonable

In addition to the principles-based approach for verification of accredited status described above, the SEC has adopted four non-exclusive methods for verification that will be deemed reasonable. The SEC believes that this non-exclusive list will be helpful to issuers seeking greater certainty that they have satisfied the verification requirement. Issuers will be able to use the non-exclusive methods or other reasonable verification methods under the principles-based approach or some combination of the two approaches. The four non-exclusive methods are as follows.

First, in verifying whether a natural person is an accredited investor on the basis of income, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies of any IRS form that reports income, including, but not limited to, a Form W-2, Form 1099, Schedule K-1 of Form 1065, and a copy of a filed Form 1040 for the two most recent years, along with obtaining a written representation from such person that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year. If accredited status is based on joint income with a spouse, documentation for, and representations from, both the person and his or her spouse are required.

Second, in verifying whether a natural person is an accredited investor on the basis of net worth, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing one or more of the following types of documentation, dated within the prior three months, and by obtaining a written representation from such person that all liabilities necessary to make a determination of net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties are deemed to be satisfactory; and for liabilities: a consumer report (also known as a credit report) from at least one of the nationwide consumer reporting agencies is required. If accredited status is based on joint net worth with a spouse, documentation for, and representations from, both the person and his or her spouse are required.

Third, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant 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 such purchaser is an accredited investor.

Fourth, with respect to any natural person who invested in an issuer’s Rule 506 offering as an accredited investor prior to the effective date of Rule 506(c) and remains an investor of the issuer, for any Rule 506(c) offering conducted by the same issuer, the issuer is deemed to satisfy the verification requirement in Rule 506(c) with respect to any such person by obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.

Form D Check Box for Rule 506(c) Offerings

The SEC is adding a check box to Form D for issuers to indicate whether they are relying on new Rule 506(c) and renaming the old Rule 506 check box as Rule 506(b). Issuers relying on Rule 506(c) will be required to check the box designating Rule 506(c). Issuers will not be able to check both Rule 506(c) and Rule 506(b) boxes, since Rule 506(c) contemplates general solicitation which is not permitted under Rule 506(b). The new rules did not change the current rule requiring filing of the Form D within 15 days following the first sale in the offering, but the SEC has proposed changes to the filing requirements as described below.

Private Funds

Studies indicate that private funds, such as hedge funds, venture capital funds and private equity funds, raise much more capital under Rule 506 than operating companies each year, and so it was significant to that industry that the SEC confirmed that private funds will be able to take advantage of Rule 506(c). Private funds generally rely on exemptions from the registration requirements under the Investment Company Act of 1940, Sections 3(c)(1) and 3(c)(7), that prohibit funds from conducting public offerings of their shares. Since Rule 506(c) permits general solicitation, there was uncertainty whether Rule 506(c) offerings would constitute a “public offering” under the Investment Company Act. The SEC confirmed that they would not, thereby opening the door for private funds to use Rule 506(c). In response to concerns that private funds will not provide adequate disclosure to investors in Rule 506(c) offerings, the SEC plans to monitor and review private fund sales literature used in connection with new Rule 506(c) to determine whether further regulation is necessary.

Rule 144A

In addition to the amendments to Rule 506, the JOBS Act required the SEC to amend Rule 144A under the Securities Act to permit general solicitation. In a typical Rule 144A transaction, a company sells unregistered securities to an investment bank or broker dealer, known as an “initial purchaser,” pursuant to a private placement exemption, usually Section 4(a)(2) of the Securities Act. The initial purchaser then resells the securities pursuant to Rule 144A to large institutional buyers, defined as “Qualified Institutional Buyers,” known as QIBs. Prior to this amendment, the initial purchaser had to be careful to offer the securities only to QIBs. The SEC’s new rules will allow the initial purchaser to offer the securities through general solicitation to persons other than QIBs, provided that the securities are sold only persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs.

Felons and Bad Actors

Concurrent with the adoption of new Rule 506(c), the SEC adopted rules in a separate release that disqualify offerings from relying on Rule 506 if “felons or bad actors” are involved in the offering. This new disqualification rule was required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The disqualification provisions are being added as new paragraph (d) of Rule 506, but will apply only to triggering events occurring after effectiveness of the rule amendments. Any pre-existing events will have to be disclosed to investors.

The new rule applies the disqualification provisions to the following categories of persons, referred to as “covered persons”:

  • the issuer and any predecessor of the issuer or affiliated issuer;
  • any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
  • any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;
  • any promoter connected with the issuer in any capacity at the time of the sale;
  • any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering (a “compensated solicitor”); and
  • any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.

An offering will disqualified from reliance on Rule 506 if any of the covered persons becomes subject to a disqualifying event following the effective date of the new rule. The Dodd-Frank Act required the SEC to designate disqualifying events similar to those applicable to Regulation A under the Securities Act and also specified certain criminal convictions and regulatory orders that were to be named as disqualifying events. The SEC’s new rules define the following as disqualifying events:

  • Criminal convictions (felony or misdemeanor), entered within the last five years in the case of issuers and ten years in the case of other covered persons, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; 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;
  • Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; 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;
  • Final orders issued by state securities, banking, credit union and insurance regulators, federal banking regulators, the U.S. Commodity Futures Trading Commission and the National Credit Union Administration that either: (i) at the time of such sale, bar the person from association with an entity regulated by such regulator issuing the order, or from engaging in the business of securities, insurance or banking or from savings association or credit union activities; or (ii) constitute a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct entered within ten years before such sale;
  • Commission disciplinary orders entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of any scienter-based anti-fraud provision of the federal securities laws, including without limitation Section 17(a)(1) of the Securities Act, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Investment Advisers Act of 1940, or any other rule or regulation thereunder; or Section 5 of the Securities Act;
  • Suspension or expulsion from membership in, or suspension or a bar from association with a member of, an SRO, i.e., a registered national securities exchange or a registered national or affiliated securities association;
  • Stop orders applicable to a registration statement and orders suspending the Regulation A exemption for an offering statement that an issuer filed or in which the person was named as an underwriter within the last five years and being the subject at the time of sale of a proceeding to determine whether such a stop or suspension order should be issued; and
  • U.S. Postal Service false representation orders including temporary or preliminary orders entered within the last five years.

Even though several of the disqualifying events have look back periods, it is important to note that an offering will not be disqualified as a result of triggering events that occurred prior to the effective date of the new rules. In lieu of imposing disqualification for pre-existing triggering events, the rule amendments require written disclosure of matters that would have triggered disqualification, but for the fact that they occurred before the effective date of the new disqualification provisions. The SEC expects that issuers will give reasonable prominence to the disclosure to ensure that information about pre-existing bad actor events is appropriately presented in the total mix of information available to investors.

Reasonable Care Exception

If a covered person is subject to a disqualifying event as described above, an offering will not be subject to disqualification 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. The SEC’s rule on this point includes an instruction that states:

An issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualifications exist. The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and the other offering participants.

There is also a reasonable care exception to the requirement to disclose triggering events that occurred prior to the effective date of the new rule. The failure to furnish required disclosure on a timely basis will not prevent an issuer from relying on Rule 506 if the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, of the existence of the undisclosed matter or matters.

As a result of the new disqualification provisions and the reasonable care exceptions, Issuers conducting offerings in reliance on Rule 506 should conduct a factual inquiry of the covered persons to determine whether there have been any triggering events before the effective date of the rules that require disclosure and triggering events after the effective date of the rules that disqualify the offering from reliance on Rule 506. In some cases—for example, in the case of a registered broker-dealer acting as placement agent—it may be sufficient to make inquiry of an entity concerning the relevant set of covered officers and controlling persons, and to consult publicly available databases concerning the past disciplinary history of the relevant persons. Broker-dealers are already required to obtain much of this information for their own compliance purposes. In general, issuers should document their inquiry and the responses in written representations, questionnaires or certifications or written records or database searches. For continuous, long-lived or delayed offerings, reasonable care will require updating the inquiry periodically.

If the issuer is aware of facts that cause the issuer to question the veracity or accuracy of the responses to its inquiries, then reasonable care would require the issuer to take further steps or undertake additional inquiry to provide a reasonable level of assurance that no disqualifications apply.

Proposed Rules

One of the more controversial actions of the SEC at its July 10, 2013 meeting was the approval of proposed rules intended to improve the ability of the SEC to track and police the offerings conducted under the revised Rule 506. The proposed rules would amend Form D to require additional information regarding Rule 506 offerings and require filing of Form D no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering. Issuers would also be required to file a closing Form D amendment within 30 calendar days after the termination of any Rule 506 offering. Although failure to comply with the Form D filing requirements would not result in the loss of the exemption for the offering to which the unfiled Form D related, the issuer would be disqualified for one year from relying on Rule 506 for future offerings.

The proposed rules would require issuers relying on Rule 506(c) to file written general solicitation offering materials with the SEC not later than the date of first use, at least on a temporary basis. The filing would not be made pursuant to Edgar and would not be publically available. The proposed rules would also require that the general solicitation offering materials contain certain prescribed legends.

Finally, the proposed rules would clarify that the anti-fraud rules of the federal securities laws apply to the sales literature of private funds.