Additional Rules to Protect Investors Also Proposed
The US Securities and Exchange Commission (“SEC”) has adopted final rules implementing Section 201(a) of the Jumpstart Our Business Startups Act (the “JOBS Act”) to eliminate the prohibition against general solicitation and advertising in offerings exempt from registration pursuant to Rule 506 and Rule 144A under the Securities Act of 1933 (the “Securities Act”). New Rule 506(c) and the amendments to Rule 144A permit general solicitation and advertising in offerings provided that sales are made only to accredited investors or qualified institutional buyers (“QIBs”), respectively, and the issuer takes reasonable steps to verify accredited investor status for Rule 506(c) offerings. The SEC also approved rules disqualifying certain felons and other “bad actors” from relying on Rule 506.
The new rules will go into effect 60 days after publication of the adopting releases in the Federal Register, which should result in an effective date as early as September 2013. Until the rules are effective, issuers may not use general solicitation or advertising in offerings under Rule 506 or Rule 144A.
The SEC also proposed new Form D and other disclosure requirements, primarily for issuers engaging in general solicitation or advertising in connection with Rule 506(c) offerings. The proposed amendments are intended to enhance the SEC’s ability to assess developments in the market for Rule 506 offerings and to address potential concerns with respect to Rule 506(c) offerings.
The adoption of Rule 506(c) has the potential to change the markets for offering securities, both private and public. In 2012, capital raised through offerings under Regulation D, 99% of which was raised under Rule 506, was estimated at just over $900 billion, nearly eclipsing the amount of capital raised in the public debt markets and more than three times the amount raised in the public equity markets.1 Rule 506 permits sales of an unlimited dollar amount of securities without registration to an unlimited number of accredited investors and up to 35 non-accredited investors. The new ability to conduct these offerings using general solicitation and advertising in reliance on Rule 506(c) is likely to enhance further the preference for raising capital privately by allowing issuers to find potential investors more easily and quickly through unrestricted means such as an Internet website posting, a newspaper or TV advertisement, or cold calls by brokers. Combined with recent changes to the registration thresholds in Section 12(g) under the Securities Exchange Act of 1934 (the “Exchange Act”), earlier reductions to the waiting periods under Exchange Act Rule 144 and the continued development of secondary trading markets for restricted securities, the IPO market may see less activity if companies, including emerging growth companies, are able to raise necessary capital under Rule 506(c). The SEC, as noted below, intends to monitor the Rule 506 market more closely in order to understand the impact of the amendments both to the markets and on investors.
Elimination of Prohibition Against General Solicitation and Advertising
New Rule 506(c) permits issuers to engage in general solicitation and advertising provided that:
- the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors (as defined in Rule 501 and unchanged by the amendments);
- all purchasers in fact qualify as accredited investors; and
- all other provisions of Regulation D, including resale restrictions, are satisfied.
The SEC stated that the test for whether verification steps are “reasonable” under Rule 506(c) is an objective one, based on the particular facts and circumstances of the transaction and purchaser. Factors an issuer should consider 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 how the purchaser was solicited, and the terms of the offering, such as whether it was subject to a minimum investment amount.
In response to comments received on the proposing release, final Rule 506(c) provides a much-welcomed list of non-exclusive methods that issuers may use to satisfy the verification requirement for purchasers who are natural persons. These methods include:
- reviewing specified documentation of income or net worth, such as IRS forms, bank and brokerage statements and credit reports; or
- obtaining third-party verification from a registered broker-dealer, SEC-registered investment advisor, licensed attorney or certified public accountant; and
- obtaining written representations from the purchaser regarding, as applicable, expected future qualification as an accredited investor or the accuracy of information provided to the issuer.
The final rules amend Form D to provide a box for issuers to check when they are conducting offerings in reliance on Rule 506(c). As noted below, the SEC proposed other changes to Form D that are far more significant.
Bad Actor Disqualification
The final rules implement provisions of the Dodd-Frank Act that ban “bad actors” from participating in Rule 506 offerings. Under new paragraph (d) of Rule 506, issuers are disqualified from making offerings under Rule 506 if they or certain other persons associated with them, including predecessors, affiliates, directors, officers or general partners, have been convicted of or are subject to sanctions for securities fraud or other violations of specified laws. Rule 506(d) does not apply to disqualifying events that occurred prior to the effective date of the new Rule.
Private funds, such as hedge funds, venture capital funds and private equity funds, generally rely upon Section 4(a)(2) and Rule 506 to offer or sell their interests without registration under the Securities Act. Private funds generally also rely on one of two exclusions from the definition of “investment company” under the Investment Company Act of 1940 (the “Investment Company Act”) – Section 3(c)(1) and Section 3(c)(7) – which allows them to be excluded from substantially all of the regulatory provisions of the Investment Company Act. Prior to the adoption of new Rule 506(c), private funds were barred from relying on either of these exclusions if they made a “public offering” of their securities. New Rule 506(c) will permit private funds to engage in general solicitation and advertising without losing either of the exclusions under the Investment Company Act.
Amended Rule 144A
Financial intermediaries acting as initial purchasers in primary offerings of securities under Securities Act Section 4(a)(2) frequently rely on Rule 144A to resell those securities immediately after purchase from the issuer without the need for SEC registration. While Rule 144A previously did not specifically prohibit general solicitation or general advertising, there was a de facto ban on such communications because under Rule 144A securities could be “offered or sold” only to QIBs after the prior private placement from the issuer to the seller. The amendment to Rule 144A simply deletes the words "offered or," with the effect that there is no limitation on who the securities can be offered to, as long as they are actually sold only to QIBs or persons the issuer reasonably believes to be QIBs.
As a result, various restrictions on access to information about a Rule144A offering, which in the past have been recommended to avoid a general solicitation or offerings to non-QIBs, will no longer need to be followed for such offerings after the effective date of the amendments. The adopting release also notes that any general solicitation in a Rule 144A resale by an initial purchaser will not affect the availability of the applicable exemption from registration in the sale by the issuer to the initial purchaser.
In contrast to the amendments to Rule 506, the SEC did not adopt heightened verification standards of QIB status for Rule 144A offerings. Sellers may still rely on the Rule 144A exemption from registration for sales made to investors that the sellers reasonably believes to be QIBs even if the investors do not actually qualify as QIBs.
Proposed Amendments to Regulation D, Form D and Rule 156
Form D Filing Requirements
At the same time the SEC adopted new Rule 506(c) and amended Rule 144A, the SEC also proposed new rules that are intended to enhance the SEC’s ability to assess developments in the market for Rule 506 offerings and to address potential concerns with respect to Rule 506(c) offerings.
Under the proposals, issuers proposing to engage in general solicitation or advertising under Rule 506(c) would be required to file a Form D at least 15 calendar days in advance of making any such communications. In this “Advance Form D,” the issuer would be required to disclose other information about itself and the offering, which in some cases can be limited to the extent it is known at the time of the filing. The SEC requests comment on a number of questions concerning this proposal, including whether such an advance filing would, in general, be useful and whether the 15-calendar day period should be longer or shorter. Furthermore, to address potential concerns relating to Rule 506(c) offerings, the SEC proposed the adoption – on a temporary basis – of a Rule that would require issuers to submit any written general solicitation materials used in their Rule 506(c) offerings no later than the date of the first use of these materials.
The proposals would also require all issuers relying on Rule 506(b) or (c) to file a “closing amendment” to the Form D within 30 calendar days after the termination of a Rule 506 offering. The SEC has indicated gaps in its ability to fully analyze the Rule 506 market in part because issuers are not required to amend Form D filings following termination of an offering where the offer is completed within one year and the amount sold does not exceed the original offer size by more than 10%. The “closing amendment” is intended to close this gap by requiring all issuers relying on Rule 506 to disclose information about their terminated offerings within 30 calendar days. To promote compliance with the proposed filing requirements, the SEC proposes to disqualify any issuer from relying on Rule 506 for one year for future offerings if the issuer, including its predecessors or affiliates, had failed to make a required Form D filing within the past five years (not extending prior to the effective date of the rule).
The SEC did not propose to make compliance with the Form D filing requirements a condition to reliance on Rule 506. Therefore, if an issuer failed, for example, to file a closing amendment on Form D, the issuer could nevertheless claim the Rule 506 exemption for the terminated offering. The SEC requests comment, however, on whether the Form D filing requirements should be a condition to reliance on Rule 506 for the related offering.
Legend Requirement for Written Materials that Constitute a General Solicitation or Advertisement
The SEC proposed new Rule 509 to require issuers to include prescribed legends in any written communication that constitutes general solicitation or advertising in a Rule 506(c) offering. In general, the legends would need to indicate that:
- the securities may only be sold to accredited investors;
- the securities are being offered in reliance on an exemption from the registration requirements of the Securities Act;
- the SEC has not passed upon the merits of or approved the securities in the offering;
- the securities are subject to legal restrictions on transfer and resale; and
- investing in securities involves risk and investors should be able to bear the loss of their investment.
New Rule 509 would also require private funds to include a legend disclosing that the securities being offered are not subject to the protections of the Investment Company Act and additional disclosures in written general solicitation and advertising materials if such materials include performance data.
As with the proposed Form D filing requirements, the SEC seeks to promote compliance with the legend requirements by proposing to disqualify any issuer from relying on Rule 506 for future offerings if such issuer, or any predecessor or affiliate of the issuer, has been subject to any order, judgment or court decree enjoining such person for failure to comply with proposed Rule 509. This requirement is intended to provide a strong incentive for compliance with the legend requirements at the same time that issuers are not overly harmed by any inadvertent error in or omission of the legends and other required disclosures.
Rule 156 Amendment
The SEC also proposed amendments to prescribe the types of information in investment company sales literature that may be deemed to be fraudulent or misleading. In the proposing release, the SEC stated that private funds should consider the principles in Rule 156 to avoid making statements in their sales literature that could be deemed fraudulent under the US securities laws.
Offerings Outside the United States
Issuers and offering participants seeking to rely on Rule 506(c) and Rule 144A must be cautious as general solicitation and advertising activities conducted within or from the United States may still be found to violate private placement rules in other countries. The SEC has not amended Regulation S, which provides a safe harbor from Securities Act registration requirements for offerings carried out outside the United States, and therefore procedures for Regulation S offerings will not change. However, the SEC did restate its long-held view that domestic offerings under Rule 506 or Rule 144A will not be integrated with concurrent offshore offerings conducted in compliance with Regulation S.
The elimination of the ban on general solicitation and advertising in Rule 506(c) and Rule 144A is expected to facilitate greatly and expand the use of private offerings to raise capital. Nonetheless, issuers seeking to rely on Rule 506(c) must develop and take reasonable steps to help ensure that they make sales only to accredited investors and, if the SEC adopts its proposed rules, comply fully with requirements to make Form D filings and legend disclosures on any written general solicitation and advertising materials. Issuers should also keep in mind that the antifraud rules apply to any communications that constitute a general solicitation for or advertisement of securities offerings.
We strongly encourage issuers to consider the SEC’s proposals to require enhanced Form D and other disclosures. The SEC requests comment on these proposals and a number of other important questions. The SEC will consider all comments received, so issuers that have concerns or comments about the proposals should seriously consider responding to the SEC’s request for comment. Already, there is some view that the proposed rules to amend Regulation D, the Form D filing requirements in particular, may negate at least somewhat the benefits of new Rule 506(c).