As discussed in our previous update (Prior Update), and as directed by the Jumpstart Our Business Startups Act, the U.S. Securities and Exchange Commission (SEC) on July 10, 2013 adopted rules (Advertising Rule) to eliminate the prohibition against general solicitation and general advertising in any offering of securities pursuant to Rule 506 under the Securities Act of 1933, as amended (Act), provided sales are made only to "accredited investors" and the issuer takes reasonable steps to determine that the purchasers are accredited investors.1
In a separate release also dated July 10, 2013, and as directed by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC approved final "bad actor" disqualification rules (Bad Actor Rule) that prevent an issuer from relying on any Rule 506 exemption if a covered person had a "disqualifying event."
In this Investment Management Update, we offer some practical tips and considerations to help you meet the requirements of the Advertising Rule and the Bad Actor Rule.
Verify Purchasers Are Accredited Investors
A Rule 506 issuer planning to generally solicit or advertise in connection with its offering under new Rule 506(c) must, among other things, take reasonable steps to verify that all purchasers are accredited investors. Note that the SEC takes the position that an issuer will not have taken reasonable steps to verify accredited investor status if it, absent other information about the investor, requires only that an investor check a box in a questionnaire or sign a form indicating accredited investor status.
The release adopting the Advertising Rule directs issuers to consider factors such as the nature of the purchaser, the amount of information the issuer has regarding the purchaser, and the nature and terms of the offering when verifying accredited investor status. Rule 506 issuers planning to use general solicitation or advertising should therefore consider implementing verification procedures to qualify investors, which might include:
Reviewing publicly available information about potential investors, such as:
- SEC filings for public companies that disclose executive officer compensation
- Form 990 for an organization exempt under Section 501(c)(3) of the Internal Revenue Code, which discloses the organization's total assets
- Records available on FINRA's BrokerCheck website that verify the registered status of a broker-dealer
- Reviewing third-party information that provides reliable evidence that an investor is an accredited investor, such as paystubs
- Setting minimum investments for the offering sufficiently high such that only accredited investors could be expected to meet them
For natural person investors, and as discussed in the Prior Update, the Advertising Rule also provides a non-exclusive list (List) of methods an issuer may use to determine whether a natural person is an accredited investor. Rule 506 issuers planning to use general solicitation or advertising in an offering to any natural persons should consider incorporating one or more of the specific methods provided in the List, such as:
- Amending the issuer's investor qualification documents to require potential investors to provide the kinds of financial information enumerated in the List, such as specified tax forms, bank statements or securities holdings reports, and include the applicable investor representations required by the List concerning expected income and completeness of liability disclosures
- Obtaining written confirmation from a third-party registered broker-dealer, an SEC-registered investment adviser, licensed attorney or certified public accountant2 that such person has taken reasonable steps to verify the purchaser is an accredited investor and such purchaser is an accredited investor
- For investors who invested in the issuer's Rule 506(b) offering as an accredited investor before the effective date of Rule 506(c), obtaining certification from the investor that he or she qualifies as an accredited investor at the time of the Rule 506(c) offering
Revisions to Form D
Issuers conducting Rule 506(c) offerings must indicate that they are relying on that rule's exemption by marking the new check box for Rule 506(c) in Item 6 of Form D. The current check box for "Rule 506" will be renamed "Rule 506(b)," and issuers will not be permitted to check both boxes at the same time for the same offering.
In addition, in a separate release, the SEC adopted rules to revise Form D to include a certification that the offering is not disqualified under the Bad Actor Rule, discussed at the end of this update.
Rule 506. For an ongoing offering that began before the effective date of Rule 506(c), an issuer may choose to continue the offering after the effective date in accordance with either Rule 506(b) or Rule 506(c). If an issuer elects to continue with the requirements of Rule 506(c), any general solicitation or advertising that occurs after the effective date will not affect the exempt status of securities offers and sales that occurred before the effective date in reliance on Rule 506(b). Nevertheless, such issuers should amend Form D to indicate reliance on Rule 506(c), making any state Form D amendment filings as required.
Rule 144A. For an ongoing offering that began before the effective date of the amendment to Rule 144A, offering participants may conduct the portion of the offering following the effective date of the amendment using general solicitation and advertising without affecting the availability of Rule 144A for the portion of the offering that occurred before the effective date of the amended rule.
The SEC, recognizing that a potential investor might provide false information to purchase securities under Rule 506(c), clarified in the release adopting the Advertising Rule that an issuer will not lose the exemption provided by Rule 506 if it turns out a purchaser was not an accredited investor at the time of purchase, provided that at the time of sale, the issuer took reasonable steps to verify the purchaser was an accredited investor and had a reasonable belief that the purchaser was an accredited investor.
Exemptions Under the CEA
Some managers of private investment funds relying on Rule 506 may trade commodities or derivatives and rely on Commodity Exchange Act (CEA) Rule 4.13(a), which provides an exemption from registration as a commodity pool operator for certain de minimis amounts of commodity or derivative trading, or CEA Rule 4.7, which provides registered commodity pool operators relief from certain record-keeping and disclosure requirements if fund interests are sold only to "qualified eligible persons." Both rules currently impose marketing restrictions. As a result, such managers should refrain from generally soliciting or advertising until additional guidance or rulemaking by the Commodity Futures Trading Commission clarifies that the use of general solicitation or advertising will not affect the availability of the exemption or relief provided by the rules.
"Bad Actor" Disqualification
As stated above, on July 10, 2013, the SEC approved the Bad Actor Rule, which prevents an issuer from relying on any Rule 506 exemption if a covered person had a "disqualifying event." Covered persons generally include the issuer (including predecessors and affiliated issuers), promoters, 20 percent beneficial owners, solicitors and investment managers (if the issuer is a pooled investment fund). In addition, the issuer's directors, officers and other management personnel, as well as solicitors and investment managers (if the issuer is a pooled investment fund) are also covered by the rule. Disqualifying events include, among other things, certain criminal convictions and other violations in connection with the purchase or sale of a security, final orders from regulators, certain SEC disciplinary and other orders, and suspensions or expulsions from membership in a self-regulatory organization.
The Bad Actor Rule provides certain exceptions from disqualification, including if:
- A disqualifying event occurred before the rule's effective date3
- An issuer can prove it did not know and, in the exercise of reasonable care, could not have known, that a disqualification existed
- The SEC grants a waiver of disqualification upon a showing of good cause
- The court or other authority that issued the order, injunction or decree indicates or advises the SEC that it should not constitute a disqualifying event
As stated above, Rule 506 issuers will be required to certify on Form D that the offering is not subject to disqualification under the Bad Actor Rule. Moreover, an issuer will not be able to establish that it has exercised "reasonable care" unless it has made factual inquiry into whether any disqualifications exist, and the scope of such inquiry will depend on the facts and circumstances of each particular case. As a result, a Rule 506 issuer should consider taking steps such as:
- Determining the nature and scope of the factual inquiry into whether any disqualifications exist, and carrying out such inquiry before commencing an offering
- Requiring covered persons to provide representations concerning disqualification events and reviewing information about covered persons available through public databases
- For continuous offerings, updating the factual inquiry on a reasonable basis (such as by asking covered persons to submit representations or rechecking publicly available information)
- Contractually requiring all covered persons to immediately report disqualifying events to the issuer
Like the Final Rule, the Bad Actor Rule will be effective 60 days after publication in the Federal Register.