Introduction

On July 10, 2013, the Securities and Exchange Commission (SEC) adopted the new, much-anticipated rules that lift the ban on general solicitation and advertising in connection with certain private offerings of securities. In April 2012, Congress passed the Jumpstart our Business Startups (JOBS) Act, a revolutionary piece of legislation, which, among other things, directed the SEC to adopt rules permitting general solicitation and advertising in private offerings of securities. We are pleased that the SEC finally took action to remove the ban on general solicitation and advertising in connection with the private placement of securities pursuant to Rule 506 of Regulation D and resales of securities pursuant to Rule 144A. We believe these changes will have a significant positive economic impact.

In addition to the adoption of the rules relating to general solicitation and advertising, the SEC adopted bad actor provisions for Rule 506 offerings as required by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Under the bad actor provisions, an issuer can be disqualified from utilizing the Rule 506 exemption in connection with a private offering of securities if the issuer or certain related persons have committed certain bad acts.

Both of these new rules will be effective 60 days after publication in the federal register, which we expect to occur in the next few days.

Also on July 10, 2013, the SEC issued a series of proposals relating to the proposed amendment of Regulation D and Form D to enhance the SEC’s ability to monitor and analyze Rule 506(c) offerings and to provide guidance to private funds on applying the antifraud provisions of the federal securities laws to such funds’ sales literature. The SEC plans to monitor the use and implementation of Rule 506(c) and undertake a review of market practices in Rule 506(c) offerings and the impact of these amendments on capital formation.

SEC Adopts Amendments to Rule 506 and 144A

The SEC adopted new section (c) of Rule 506 to permit an issuer to use general solicitation and advertising to offer and sell securities under Rule 506, provided that the following new conditions are satisfied:

  • All purchasers of the securities must be accredited investors; and
  • The issuer must take “reasonable steps” to verify that the purchasers are accredited investors.

Reasonable Steps to Verify Accredited Investor Status

According to the SEC’s final rule, whether an issuer has taken reasonable steps to verify that a purchaser is accredited is an objective determination made by the issuer after considering the following factors:

  • 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.

According to the SEC, these factors are interconnected and each should factor into an issuer’s determination regarding which “reasonable steps” must be taken to confirm a purchaser’s accredited investor status. In other words, the facts and circumstances of the offering and purchaser will dictate the depth of the issuer’s investigation into the purchaser’s accredited investor status.

The SEC also included in Rule 506(c) a list of “reasonable steps” that serve as safe harbors that issuers may use to verify the accredited investor status of natural persons. These are more specific verification methods that allow the issuer to have a greater level of certainty that it has complied with the requirements of Rule 506(c). An issuer will be deemed to have taken “reasonable steps” if one of the following methods is used, unless the issuer knows that such person is not an accredited investor.

  • First, reviewing copies of certain IRS forms relating to a purchaser’s income for the two most recent years and obtaining a written representation from such purchaser that he or she reasonably expects to reach the income level to qualify as an accredited investor in the current calendar year.
  • Second, reviewing documentation, dated within the prior three months, to show a purchaser’s total assets and liabilities. The potential documents to be provided by a purchaser to show total assets include bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports. Additionally, a credit report and a written representation as to the full disclosure of liabilities must be obtained by the issuer.
  • Third, obtaining a written confirmation from a third party, such as a registered broker-dealer, an SECregistered investment adviser, a licensed attorney or a certified public accountant, that such third party took reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has, in fact, determined that such purchaser is an accredited investor.
  • Finally, for any purchaser who previously invested in a Rule 506 offering as an accredited investor prior to the adoption of Rule 506(c) and continues to be an equity holder of the issuer, the issuer may satisfy the verification requirement by obtaining a certification by such person at the time of the Rule 506(c) sale that he or she qualifies as an accredited investor.

Because the issuer has the burden of showing that an offering is entitled to the exemption afforded by Rule 506(c), it is imperative for an issuer to keep complete records relating to the steps it takes to verify that each purchaser in the offering is accredited. Additionally, in recognition that a purchaser could provide false information to an issuer, the SEC stated that even if a purchaser was finally determined to not be an accredited investor, “the issuer will not lose the ability to rely on Rule 506(c) for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of the sale.”

We recognize that not all issuers will want to utilize general solicitation and advertising in connection with Rule 506 offerings. The SEC preserved an issuer’s ability to conduct a traditional Rule 506 offering under old Rule 506 (Rule 506(b)) without utilizing advertising and without the added accredited-investor verification requirements of new Rule 506(c).

Note also that for any issuers who commenced a Rule 506 offering prior to the effective date of Rule 506(c), such issuer may choose to continue the offering in accordance with (i) Rule 506(c) and utilize general solicitation and advertising or (ii) Rule 506(b) without the use of general solicitation and advertising. Any general solicitation or advertising that occurs in connection with a Rule 506 offering after the effective date of Rule 506(c) (even if the offering was commenced prior to such date) will not affect the exempt status of any offers or sales of securities that occurred prior to the effective date of Rule 506(c).

Form D Amendment Relating to Rule 506(c)

The SEC also amended the Form D to add a separate check box to disclose whether the issuer is claiming an exemption under new Rule 506(c). The Form D must be filed within 15 days of the first sale of securities in the offering.

Rule 144A

The SEC amended Rule 144A(d)(1) to permit securities sold pursuant to Rule 144A to be offered to persons other than qualified institutional buyers (QIBs), including by utilizing general solicitation and advertising, so long as the securities are only sold to persons that the seller or seller’s representative reasonably believes are QIBs.

SEC Adopts Rules Relating to Bad Actors

Dodd-Frank requires the SEC to adopt rules to disqualify certain securities offerings from reliance on Rule 506 based on bad actions by persons related to an issuer. The SEC adopted final rules on July 10, 2013.

The new disqualification rule, Rule 506(d), provides that an issuer may be disqualified from relying on Rule 506 for an offering if such offering involves the issuer or certain enumerated persons related to the issuer (listed below) with respect to whom a disqualifying event has occurred. Rule 506(d) will only apply to disqualifying events that occur after Rule 506(d) becomes effective, but pre-existing disqualifying events are subject to mandatory disclosure to all of the purchasers in the Rule 506 offering. Rule 506(d) will apply to the following persons:

  • The issuer and any predecessor of the issuer or affiliated issuer;
  • Any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
  • Any beneficial owner of 20 percent or more of the issuer’s outstanding voting securities, calculated on the basis of voting power;
  • Any investment manager of an issuer that is a pooled investment fund, and any director, general partner, managing member, or certain officers of any such investment manager, as well as any director or officer of any such general partner or managing member;
  • Any promoter connected with the issuer in any capacity at the time of the sale;
  • Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the offering (a “compensated solicitor”); and
  • Any director, general partner, managing member or certain officers of any such compensated solicitor.

The following non-exclusive list of events relating to the above-mentioned bad actors will disqualify an issuer from relying on Rule 506 in a private offering:

  • Criminal convictions relating to violations of securities laws and disclosure requirements entered within 10 years before such sale (or five years, in the case of the issuer);
  • Court injunctions and restraining orders relating to violations of securities laws and SEC disclosure requirements issued within five years before such sale;
  • Final orders of regulators relating to violations of securities laws;
  • Final orders of regulators relating to fraudulent, manipulative, or deceptive conduct entered within 10 years before such sale;
  • Certain SEC disciplinary orders;
  • SEC cease-and-desist orders relating to violations of certain anti-fraud provisions of the federal securities laws and violations of the registration requirements in Section 5 of the Securities Act entered within five years before such sale; or
  • Suspension or expulsion from a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade.

Reasonable Care Exception

Rule 506(d) also includes an exception from disqualification for offerings where the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed. The exercise of reasonable care by an issuer requires the issuer to examine the facts and circumstances of the offering and the participants involved. This factual inquiry and determination should be made before the issuer conducts the Rule 506 offering. The SEC does not provide specific steps an issuer can take to establish reasonable care but indicates that such steps will vary depending on the particular facts and circumstances.

Amendment to Form D Relating to Rule 506(d)

The SEC also adopted an amendment to the signature block of Form D to contain a certification of the issuer that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(d).

Further Proposed Amendments to Regulation D and Form D

In addition to the final rules introduced by the SEC, on July 10, 2013, the SEC issued a set of proposed rules relating to potential further amendments to Regulation D and Form D to assist the SEC in the evaluation of market practices in Rule 506 offerings. Specifically, the proposed rules (if adopted) would require the following:

  • Filing a Form D at least 15 days prior to the date an issuer begins general solicitation or advertising in connection with a Rule 506(c) offering;
  • Filing an amended Form D within 30 days following the termination of a Rule 506 offering;
  • Additional disclosures on Form D including, among other things, disclosure of any party that directly or indirectly controls the issuer, the number and type of accredited and non-accredited investors in each offering, and the amount raised from each category of investors; the percentage of offering proceeds to be used (1) to repurchase or retire the issuer’s existing securities, (2) to pay offering expenses, (3) to acquire assets outside the ordinary course of business, (4) to finance acquisitions of other businesses, (5) for working capital, and (6) to discharge indebtedness; and for Rule 506(c) offerings, the types of general solicitation used or to be used and the methods used to verify accredited investor status;
  • The disqualification of an issuer from relying on Rule 506 for one year if the issuer did not comply with all of the Form D filing requirements in a Rule 506 offering within the past five years, subject to a 30-day cure period to correct an issuer’s failure to make one timely Form D filing;
  • Issuers to include certain prescribed legends in any written general solicitation or advertising materials;
  • Private funds to include legends disclosing that the securities being offered are not subject to the protections of the Investment Company Act of 1940 and additional disclosure regarding any performance data set forth in such written general solicitation materials setting forth such data’s limitations and a context to understand such data;
  • The application of the antifraud provisions of the federal securities laws to sales literature of private funds; and
  • For the first two years of the proposed rule, issuers to file, on a non-public basis, any written general solicitation materials used in a Rule 506(c) offering, on or prior to the first date an issuer utilizes such written materials.

In connection with the proposed rule, the SEC plans to undertake a comprehensive evaluation of the use and impact of new Rule 506(c) offerings in the market. The SEC intends that the proposed amendments described above would assist the SEC in its evaluation and provide further investor protection in Rule 506(c) offerings.

Finally, the SEC is reviewing and seeking public comment on the definition of accredited investor as it relates to a natural person to determine if amendments should be made to such definition in light of the lifting of the ban on general solicitation and advertising. Specifically, the SEC seeks comment on whether net worth and annual income are the appropriate tests for a natural person to qualify as an accredited investor and whether there should be a knowledge and experience component. In addition, the SEC seeks public comment on whether there should be a requirement for purchasers to receive an offering document with specified information in Rule 506(c) offerings.

Final Thoughts

We appreciate that the SEC has finally adopted rules permitting general solicitation and advertising in connection with Rule 506 offerings. While we understand that utilizing general solicitation and advertising will place an additional burden on issuers to take “reasonable steps” to verify the accredited investor status of its purchasers, we believe that the rules set forth an appropriate balance between the need for capital formation and the need for adequate investor protection. Notwithstanding our positive outlook on the new rules, the proposed rules introduced simultaneously with Rule 506(c) seem to indicate that the regulatory framework surrounding general solicitation is far from complete. More rules for general solicitation and advertisement in private offerings are undoubtedly on the horizon.