The Jumpstart Our Business Startups (JOBS) Act required the SEC to change its rules so that advertising will be permitted in certain private placements. This change has the potential to significantly alter the manner in which money is raised for start-ups, operating businesses and private funds.
The SEC adopted these changes to Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 on July 10, 2013. The adopting release is available here.
The changes as adopted are very similar to the changes that were proposed in August 2012, except that the SEC has added a nonexclusive “safe harbor” for verification of accredited investor status of natural persons.
These changes will become effective 60 days from the publication of the adopting release in the Federal Register; in other words, in mid-September 2013.
At the same meeting, the SEC adopted provisions preventing felons and other “bad actors” from using Rule 506, and also proposed a number of significant changes to the private placement rules to enhance investor protections.
For the purposes of this article, the word “advertising” includes what is commonly understood as general solicitation or general advertising under existing Regulation D.
Summary of the Revised Rule
- General advertising will be permitted in a private placement of securities so long as the issuer has taken reasonable steps to verify, and reasonably believes, that all purchasers in the offering are accredited investors.
- The reasonableness of steps taken to verify accredited status can proceed on a “principles-based” approach. Accredited investor status will be determined on a case-by-case basis.
- The SEC also adopted several nonexclusive “safe harbor” methods for verifying accredited investor status for individuals.
- Advertising will be permitted but all other provisions of Regulation D must still be satisfied.
- Issuers can continue to use the existing Rule 506 exemption for offerings that do not involve advertising.
- Form D has been amended to add a separate box for issuers to check if they are using advertising in their offerings.
- Rule 144A has been amended to permit the offering of securities to persons other than qualified institutional buyers (QIBs) including by means of general solicitation, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs.
- The adopting release confirms that offshore offerings made in compliance with Regulation S will not be integrated with advertised private placements made in compliance with the new provisions.
Detailed Analysis of the Changes to Rule 506
The SEC is implementing the changes to Rule 506 in a new subsection (c) of Rule 506. The adopting release makes it clear that the existing provisions of Rule 506 will continue to be available if there is no advertising and that the new Rule 506(c) is in addition to the current exemption.
Reasonable Belief Standard – Not Strict Liability
The JOBS Act directs the SEC to permit advertising in Rule 506 offerings so long as all purchasers are accredited investors. In various comments, several state regulators and public interest groups advocated the position that the failure of any purchaser in the offering to be accredited should result in the loss of the exemption.
Regulation D currently requires that an issuer have a “reasonable belief” that investors are accredited. This provision is included in the definition of accredited investor in Rule 501(a). In preproposal comments, several industry participants said that this approach should also apply in offerings where advertising is used.
The SEC’s changes adopt this approach, rather than the “strict liability” standard advocated by the state regulators and others.
Principles-based Approach for Verification of Accredited Investor Status
The JOBS Act requires that revised Rule 506 provide that issuers who use general solicitation or advertising take “reasonable steps” designated by the SEC to verify that investors are accredited. (This requirement must be satisfied even if all investors “happen to be” accredited.)
The SEC adopted a “principles-based” approach, which does not require any particular methods to verify that a purchaser is an accredited investor. Instead, under the “principles-based” approach, the reasonableness of an issuer’s verification process is determined on a case-by-case basis, taking into account the facts and circumstances of each offering, including:
- the nature of the investor, including the category of accreditation;
- the nature and amount of information available about the investor; and
- the nature of the offering, including the manner of solicitation and terms of the investment.
In effect, the “principles-based” approach is a flexible method for which the verification procedures can be tailored to the facts and circumstances. The issuer must consider all the factors in order to determine what “reasonable verification procedures” are under the circumstances.
Nature of the Investor
There are a wide variety of types of investors who qualify as accredited investors. The characteristics that result in accredited investor status vary depending on the category of investor.
For example, broker-dealers have accredited investor status because of their broker-dealer registration. Entities generally have accredited investor status because their assets are greater than $5 million. Individuals have accredited investor status because they satisfy an income or asset (net worth) test.
Under the new rule, the degree and nature of verification will vary depending on the characteristics of the investor. The verification would focus on the specific characteristics that result in accredited investor status.
Nature and Amount of Information about the Investor
The more information that an issuer already has indicating that an investor has accredited investor status, the fewer steps the issuer will need to take to verify the investor’s status. Publicly available information, such as compensation data or a proxy statement, may confirm accredited investor status. An issuer can also use third-party verification sources, as long as reliance on those sources is reasonable.
Nature of the Offering
The adopting release also notes that verification of accredited investor status can vary in different types of offerings. For example, more extensive verification should be used for broadly advertised offerings, such as on a publicly available website or an offering widely disseminated via email or social media.
The terms of the offering will also affect whether the verification methods used by the issuer are reasonable. For example, an investor’s ability to meet a high minimum investment amount could be relevant to the evaluation of the types of steps that are reasonable to take in order to verify accredited status so long as the investment is not financed by the issuer or a third party.
Nonexclusive Safe Harbor Methods of Verifying Individual Accredited Investor Status
In addition to adopting a principles-based method of verification, the SEC included in Rule 506(c) four specific nonexclusive methods for verifying accredited investor status for natural persons that, if used, are deemed to satisfy the verification requirement in Rule 506(c). None of these methods will be deemed to satisfy the verification requirement if the issuer or its agent has knowledge that the purchaser is not an accredited investor. Issuers are not required to use any of the methods discussed below, and can apply the reasonableness standard directly to the specific facts and circumstances presented by the offering and the investors.
Individual Income Test. 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) if it reviews copies of any Internal Revenue Service (IRS) form that reports income, including, but not limited to, a Form W-2, Form 1099, Schedule K-1 of Form 1065 or a copy of a filed Form 1040, for the two most recent years, and obtains that investor’s written representation that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
In the case of an investor who qualifies as an accredited investor based on joint income with that person’s spouse, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies of these forms for the two most recent years in regard to, and obtaining written representations from, both the investor and the spouse.
An investor can provide a redacted version of an IRS form so as to disclose only information about annual income and to avoid disclosure of personally identifiable information, such as a Social Security number, or other information that would not be relevant to the determination of annual income.
Individual Net Worth Test. 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) if it reviews one or more of the following types of documentation, dated within the prior three months, and obtains a written representation from such an investor that all liabilities necessary to make a determination of net worth have been disclosed.
For proving 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.
For proving liabilities: a consumer report (also known as a credit report) from at least one of the nationwide consumer reporting agencies is required. The SEC also requires a written representation from the investor that all liabilities necessary to make a determination of net worth have been disclosed.
In the case of an investor who qualifies as an accredited investor based on joint net worth with that investor’s spouse, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing such documentation in regard to, and obtaining representations from, both the investor and the spouse.
An investor can provide redacted versions of these documents so as to disclose only information about the amounts of assets and liabilities and to avoid disclosure of personally identifiable information, such as a Social Security number, or other information that would not be relevant to the determination of a person’s net worth.
Third-Party Verification. An issuer is deemed to satisfy the verification requirement in Rule 506(c) if it obtains a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant that it 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. In addition, depending on the circumstances, an issuer may also be entitled to rely on the verification of accredited investor status by a person or entity other than one of these parties, provided that any such third party takes reasonable steps to verify that purchasers are accredited investors and has determined that such purchasers are accredited investors, and the issuer has a reasonable basis to rely on such verification. We expect that a number of third-party verification companies will offer to provide this service for issuers.
Existing Investors. For a natural person who has invested in an issuer’s Rule 506(b) offering as an accredited investor before the effective date of Rule 506(c) and remains an investor of the issuer, an issuer will be deemed to satisfy the verification requirement in Rule 506(c) if it obtains a certification by such investor at the time of the later investments that he or she still qualifies as an accredited investor.
The SEC included this verification method so that existing accredited investors who purchased securities in an issuer’s Rule 506(b) offering before the effective date of Rule 506(c) can participate in subsequent offerings by the same issuer conducted pursuant to Rule 506(c) based on their preexisting relationships with the issuer. Accordingly, for these existing investors who were accredited investors in a Rule 506(b) offering before the effective date of Rule 506(c), a self-certification at the time of sale that he or she is an accredited investor will be deemed to satisfy the verification requirement in Rule 506(c). This provision does not extend to existing investors in an issuer who were not accredited investors in a Rule 506(b) offering that was conducted before the effective date of Rule 506(c).
Of course, issuers should keep records documenting the process the issuer used to establish a reasonable belief of accredited investor status.
Revisions to Form D
The SEC also adopted a revision to Form D to add a separate box for an issuer to check if it is relying on Rule 506(c), which permits using advertising in an offering. An issuer cannot check this box and also check the box for a conventional offering under Rule 506, which does not use advertising.
Offshore Offerings under Regulation S Will Not be Integrated with Advertised Private Placements
Regulation S provides an exemption for offshore offerings that is generally lost when there are “directed selling efforts” in the United States. Because it is common to have simultaneous domestic Rule 506 and offshore Regulation S offerings, general solicitation or advertising for a Regulation D offering could be considered “directed selling efforts,” resulting in the inability to use Regulation S for the offshore component.
The SEC indicated in the adopting release that an advertised offering under the new Rule 506 or Rule 144A provisions will not be integrated with a concurrent offshore offering under Regulation S.
Rule 144A(d)(1) is amended to allow securities to be offered to persons who are not qualified institutional buyers (QIBs), provided that the seller and persons acting on behalf of the seller reasonably believe that all purchasers are QIBs. Advertising can be used in a Rule 144A offering after the effective date.