On July 10, 2013, the Securities and Exchange Commission (the “SEC”) adopted rules to amend Rule 506 of Regulation D and Rule 144A,1 as required by Section 201(a) of the Jumpstart Our Business Startups Act (the “JOBS Act”) enacted in 2012. The amendments permit general solicitation and advertising in unregistered offerings, including offerings by private funds, made pursuant to Rule 506 of Regulation D, provided all purchasers are accredited investors, and resales of securities pursuant to Rule 144A so long as the issuer believes purchasers to be qualified institutional buyers (“QIBs”). In addition, the SEC proposed rules2 to amend SEC Form D and Regulation D to include new disclosures on Form D, require the filing of a “closing” Form D and prohibit the use of Rule 506 for the failure to file a Form D.
Rule 506 Offerings
Existing Rule. Existing Rule 506, which is re-designated as Rule 506(b) in the amendments, provides a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”), from registration under Section 5 of the Securities Act for issuances of securities “not involving any public offering.” Under this rule, issuers may offer and sell securities in unlimited amounts to an unlimited number of accredited investors and/or up to 35 non-accredited investors that meet certain sophistication standards. To be eligible for the safe harbor, among other conditions, the issuer, or any person acting on its behalf, must refrain from using general solicitation or advertising in offering the securities. While the terms “general solicitation” and “general advertising” are not defined by the SEC, examples include newspaper and magazine ads, radio and TV announcements, publicly advertised seminars and advertisements on unrestricted websites. “Accredited investor” is defined in Rule 501(a) as any natural person or entity that qualifies, or the issuer reasonably believes qualifies, under certain listed categories including: (1) banks and savings and loan associations; (2) broker dealers; (3) investment companies; (4) 501(c)(3) non-profits, corporations, partnerships and Massachusetts business trusts having total assets in excess of $5 million that were not formed for the purpose of acquiring the securities offered; and (5) natural persons who individually, or jointly with a spouse, have a net worth greater than $1 million (excluding principal residence) or who have had income greater than $200,000 (or $300,000 if combined with a spouse’s income) in each of the last two years and expect to maintain such income in the current year.
We note that the final rules do not impact the effectiveness of Rule 506(b). Any issuer may issue securities under the prior rules, provided that the issuer refrains from engaging in general solicitation or advertising.
Final Amended Rule. The amendments create a new rule under Regulation D, Rule 506(c). Offerings conducted under Rule 506(c) are not subject to the prohibition against general solicitation and advertising found in Rule 502(c), so long as:
- all purchasers are accredited investors (or the issuer reasonably believes that all purchasers are accredited); and
- the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.
In addition, the general requirements regarding Rule 501’s definitions used in Regulation D, Rule 502(a)’s treatment of the integration of multiple offerings and Rule 502(d)’s designation that securities acquired under a Regulation D offering will be “restricted securities” are each still applicable to offerings conducted under the new Rule 506(c). However, as noted above, the prohibition against general solicitation and advertising will not apply to issuers relying on Rule 506(c), allowing such issuers to advertise in newspapers or magazines or on websites accessible to the general public, among other options.
Reasonable Steps to Verify Accredited Status. In conducting an offering under new Rule 506(c), issuers are required to take reasonable steps to verify that purchasers of securities offered under Rule 506(c) are accredited investors. The SEC provides that an issuer make an objective assessment of whether the steps are reasonable in the context of the particular facts and circumstances of each purchaser and transaction. Factors issuers are to consider include: (i) the nature of the purchaser and the type of accredited investor the purchaser claims to be; (ii) the type and amount of information the issuer possesses about the purchaser; and (iii) the nature of the offering (e.g., manner in which the purchaser was solicited to participate in the offering) and the terms of the offering (e.g., minimum investment amount). In addition, the final rule provides a non-exclusive list of safe harbors that issuers may use to verify that individual investors are accredited investors, which include:
- Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation from the purchaser that he or she has a reasonable expectation of earning the necessary income in the current year;
- Reviewing documents dated within the last three months to verify net worth, including bank statements and financial other documentation to verify assets and a consumer credit report and written representation from the purchaser stating that all liabilities have been disclosed to verify liabilities;
- Receiving a written confirmation from a registered broker-dealer, SEC-registered investment advisor, licensed attorney, or certified pubic accountant that such entity or person has taken reasonable steps within the last three months to verify the purchaser’s accredited status; and
- Obtaining a certification from a natural person who previously participated as an accredited investor in an issuer’s offering under Rule 506(b) and who remains an investor for a subsequent Rule 506(c) offering by that same issuer that at the time of the sale he or she qualifies as an accredited investor.
Considerations for Privately Offered Funds
The SEC’s final rule release provides that privately offered funds, such as hedge funds, venture capital funds and private equity funds, would also be able to use general solicitation and advertising to raise capital under proposed Rule 506(c) without running afoul of restrictions under the Investment Company Act of 1940. The SEC noted that because the anti-fraud provisions of the federal securities laws would still be applicable, it did not believe additional limitations on general solicitation and advertising would be necessary for privately offered funds.
Disqualification of Bad Actors
The SEC also approved a disqualification rule, where an issuer is prevented from relying on Rule 506 if it or any other person covered by the rule had a “disqualifying event.” In addition to the issuer, persons covered by this Rule include: (i) directors, certain officers, general partners, and managing members of the issuer, (ii) 20% beneficial owners of the issuer; (iii) promoters; (iv) investment managers and principals of pooled investment funds; and (v) anyone compensated for soliciting investors, including general partners, directors, officers, and managing members of any compensated solicitor. “Disqualifying events” include (i) criminal convictions involving certain securities and financial matters, (ii) court injunctions and restraining orders related to certain securities and financial matters, (iii) final orders from certain banking and financial organizations that bar association or are based on fraudulent, manipulative or deceptive conduct, (iv) certain SEC disciplinary orders, (v) SEC cease-and-desist orders, (vi) SEC stop orders, (vii) suspension or expulsion from a self-regulatory organization or from association with an SRO member; and (viii) U.S. Postal Service false representation orders. The final rule does, however, provide an exemption from disqualification when the issuer is able to show that it did not know and could not have known (exercising reasonable care) that a covered person with a disqualifying event participated in the offering.
Rule 144A Offerings
Similarly, the final rules provide that securities sold pursuant to Rule 144A may be offered to persons other than QIBs, including by means of general solicitation, provided that the securities are sold only to persons whom the seller and any person acting on behalf of the seller reasonably believes is a QIB.
Proposed Amendments to Form D and Regulation D
In conjunction with the amendments to Rule 506 of Regulation D, the SEC proposed to update and make certain amendments to Form D. The proposed rules would require disclosure of additional information, particularly as it relates to Rule 506(c) offerings. In addition, the proposed rules would change the timing for filing a Form D. Under the proposed rules, an issuer would be required to file a Form D no later than 15 days prior to engaging in general solicitation for a Rule 506(c) offering and file a final amendment to Form D within 30 days of the completion of any Rule 506 offering. Under current Rule 503, an issuer is to file a Form D within 15 days of the first sale of securities issued under Regulation D.
The SEC also proposed that a legend be required on any written general solicitation materials used in a Rule 506(c) offering. The proposed rules include a list of disclosures that would be required to be included on written general solicitation materials intended to better inform potential investors of risks that may be associated with such offerings.
In addition, the proposed rules seek to amend Rule 507 of Regulation D to provide for an issuer’s automatic disqualification from using Rule 506 in any new offering for a year if the issuer (or a predecessor or affiliate) did not comply with the Form D filing requirements for a Rule 506 offering within the last five years. The one-year disqualification period would begin following the filing of all required Form D filings, or if the offering was terminated, following the filing of a closing amendment. Currently, an issuer is only disqualified from using Regulation D if it, or a predecessor or affiliate is enjoined by a court for failure to comply with the requirement to file a Form D under Rule 503.
The proposed rules are currently subject to a 60-day comment period.