The SEC has adopted final rules eliminating the ban on general solicitation and advertising in Rule 506 offerings. The changes are mostly embodied in new Rule 506(c).
Definition of General Solicitation and Advertising
Although the terms “general solicitation” and “general advertising” are not defined in Regulation D, Rule 502(c) does provide examples of general solicitation and general advertising, including advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars where attendees have been invited by general solicitation or general advertising. By interpretation, the SEC has confirmed that other uses of publicly available media, such as unrestricted websites, also constitute general solicitation and general advertising.
Under new Rule 506(c), issuers can offer securities through means of general solicitation, provided that they satisfy all of the conditions of the exemption. These conditions are:
- all terms and conditions of Rule 501 and Rules 502(a) and 502(d) must be satisfied. Rule 501 consists mostly of definitions, Rule 502(a) addresses integration with other offerings and Rule 502(d) requires issuers to take reasonable steps to prevent purchasers from further distributions of securities so that they are not underwriters;
- all purchasers of securities must be accredited investors; and
- the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors.
Verifying Accredited Investor Status – General Rules
Under Rule 506(c), issuers are required to take reasonable steps to verify the accredited investor status of purchasers. Whether the steps taken are “reasonable” 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.
These factors are interconnected and are intended to help guide an issuer in assessing the reasonable likelihood that a purchaser is an accredited investor – which would, in turn, affect the types of steps that would be reasonable to take to verify a purchaser’s accredited investor status. 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.
Nature of the Purchaser: Rule 501(a) sets forth different categories of accredited investors, such as broker-dealers, investment companies, employee benefit plans established by state governmental entities, and tax exempt organizations. Issuer’s should recognize that the steps that will be reasonable to verify whether a purchaser is an accredited investor will vary depending on the type of accredited investor that the purchaser claims to be. For example, 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.
Information about the Purchaser: The amount and type of information that an issuer has about a purchaser can also be a significant factor in determining what additional steps would be reasonable to take to verify the purchaser’s accredited investor status. The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it may have to take, and vice versa. 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, if 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
- 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.
Nature and Terms of the Offering: The nature of the offering – such as the means through which the issuer publicly solicits purchasers – may be relevant in determining the reasonableness of the steps taken to verify accredited investor status. An issuer that solicits new investors through a website accessible to the general public, through a widely disseminated email or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party. The SEC believes that an issuer will be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification. The SEC does not believe that an issuer will have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, required that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.
The terms of the offering will also affect whether the verification methods used by the issuer are reasonable. The SEC continues to believe that there is merit to the view that a purchaser’s ability to meet a high minimum investment amount could be a relevant factor to the issuer’s evaluation of the types of steps that would be reasonable to take in order to verify that purchaser’s status as an accredited investor. By way of example, the ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any third party, could be taken into consideration in verifying accredited investor status.
Non-Exclusive Methods of Verifying Accredited Investor Status
The SEC has included in Rule 506(c) four specific non-exclusive methods of verifying accredited investor status for natural persons that, if used, are deemed to satisfy the verification requirement in Rule 506(c). Issuers are not required to use any of these methods, and can apply the reasonableness standard directly to the specific facts and circumstances presented by the offering and the investors.
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 Internal Revenue Service (“IRS”) form that reports income, including, but not limited to, a Form W-2 (“Wage and Tax Statement”), Form 1099 (report of various types of income), Schedule K-1 of Form 1065 (“Partner’s Share of Income, Deductions, Credits, etc.”), and a copy of a filed Form 1040 (“U.S. Individual Income Tax Return”), 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. In the case of a person who qualifies as an accredited investor based on joint income with that person’s spouse, an issuer would be 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 person and the spouse.
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. In the case of a person who qualifies as an accredited investor based on joint net worth with that person’s spouse, an issuer would be deemed to satisfy the verification requirement in Rule 506(c) by reviewing such documentation in regard to, and obtaining representations from, both the person and the spouse. 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. The SEC recognizes that it will be difficult for an issuer to determine whether it has a complete picture of a natural person’s liabilities, and therefore, it is requiring a consumer report and a written representation from such person that all liabilities necessary to make a determination of net worth have been disclosed.
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. While third-party confirmation by one of these parties will be deemed to satisfy the verification requirement in Rule 506(c), depending on the circumstances, an issuer may 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.
Fourth, with respect to any natural person who invested in an issuer’s Rule 506(b) 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.
Amendment to Form D
Form D is the notice of an offering of securities conducted without registration under the Securities Act in reliance on Regulation D. Under Rule 503 of Regulation D, an issuer offering or selling securities in reliance on Rule 504, 505 or 506 must file a notice of sales on Form D with the SEC for each new offering of securities no later than 15 calendar days after the first sale of securities in the offering.
The SEC has adopted revisions to Form D. Issuers conducting Rule 506(c) offerings must indicate that they are relying on the Rule 506(c) exemption by marking the new check box in Item 6 of Form D. The prior check box for “Rule 506” has been renamed “Rule 506(b).”
The SEC is of the view that an issuer will not be permitted to check both boxes at the same time for the same offering. According to the SEC’s long-held views, once a general solicitation has been made to the purchasers in the offering, an issuer is precluded from making a claim of reliance on Rule 506(b), which remains subject to the prohibition against general solicitation, for that same offering.
Hedge Funds, Private Equity Groups and Venture Capital Funds
Private funds, such as hedge funds, venture capital funds and private equity funds, typically rely on Section 4(a)(2) and Rule 506 to offer and sell their interests without registration under the Securities Act. In addition, private funds generally rely on one of two exclusions from the definition of “investment company” under the Investment Company Act – Section 3(c)(1)144 and Section 3(c)(7) – which enables them to be excluded from substantially all of the regulatory provisions of that Act. Those exclusions are only available to private funds that are not making or propose to make public offerings. The SEC has historically regarded Rule 506 transactions as non-public offerings for purposes of Sections 3(c)(1) and 3(c)(7). The SEC reaffirmed that the effect of Section 201(b) of the JOBS Act is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act
Reasons to Use Rule 506(b) Without General Solicitation
Issuers will continue to have the ability under Rule 506(b) to conduct Rule 506 offerings subject to the prohibition against general solicitation. The continued availability of existing Rule 506(b) will be important for those issuers that either do not wish to engage in general solicitation in their Rule 506 offerings (and become subject to the requirement to take reasonable steps to verify the accredited investor status of purchasers) or wish to sell privately to non-accredited investors who meet Rule 506(b)’s sophistication requirements. It is also beneficial to investors with whom an issuer has a pre-existing substantive relationship.
No General Solicitations in Section 4(a)(2) Private Placements
This rule making makes clear that the new provisions affect only Rule 506, and not Section 4(a)(2) offerings in general. Section 4(a)(2) is the traditional statutory exemption for private offerings. This means that even after the effective date of Rule 506(c), an issuer relying on Section 4(a)(2) outside of the Rule 506(c) exemption will be restricted in its ability to make public communications to solicit investors for its offering because public advertising will continue to be incompatible with a claim of exemption under Section 4(a)(2).