SEC Issues Rule Proposals
On August 29, 2012, the SEC finally proposed rules required by the Jumpstart Our Business Startups (JOBS) Act to remove the prohibition on general solicitation and general advertising in offers and sales made to accredited investors under Securities Act Rule 506. This action comes well after the July 4, 2012 deadline for final rules provided in Title II of the JOBS Act, so the SEC has provided a relatively short 30-day comment period and indications are that the SEC will issue final rules without significant delay.
The proposed amendments to Rule 506 would eliminate the prohibition on “general solicitation and general advertising” in connection with offers and sales of securities made pursuant to Rule 506, thus eliminating two longstanding pillars of private placements -- the non-public manner of offering and -- the prohibition on general solicitation, which requires the issuer and/or its intermediaries to have a pre-existing relationship with investors. These private offering requirements have established the traditional divide between registered public offerings, such as IPOs, and exempted private placements for over 60 years.
Verification Requirement -- Reasonable Steps
The proposal would create new Rule 506(c) permitting the use of general solicitation and general advertising in Rule 506 offerings where:
- All purchasers are accredited investors, either because the investor actually qualifies under one or more of the categories of accredited investor, or because the issuer reasonably believes that the investor qualifies under one or more of the categories of accredited investor; and
- The issuer takes reasonable steps to verify that purchasers of the securities are accredited investors.
The SEC declined to define what constitutes “reasonable steps” or to create a safe harbor in the new Rule 506(c). Rather, in determining what steps that an issuer must take to verify that a purchaser is an accredited investor, the proposing release provides that issuers are to consider the facts and circumstances of the transaction, including, among other factors:
- The type of 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, including:
- The manner in which the purchaser was solicited to participate in the offering; and
- The terms of the offering, such as the minimum investment amount.
The SEC noted that a method that is reasonable under one set of circumstances may not be reasonable under a different set of circumstances. The SEC also considered but ultimately declined to provide any list of specific verification methods (even a non-exclusive list) out of concern that a non-exclusive list could lead issuers to rely on a particular method in circumstances where the method would not actually verify accredited investor status.
In the proposing release the SEC notes that an investor’s qualification under some accredited investor categories (such as a registered brokerdealer) are easily confirmed with publicly available resources. Also, an executive officer or director of an issuer is, by definition, accredited. Similarly, a 501(c)(3) organization’s total assets are disclosed in a publicly available tax return.
The verification of the accredited status of natural persons poses the greatest practical difficulty. Issuers may rely on a Form W-2 for a natural person to verify income. There is no readily apparent source of verification of the net worth of natural persons. In some circumstances, a balance sheet certified by an investor under penalties of perjury could be sufficient verification, although the SEC did not address this method. In other circumstances it may be appropriate to rely on third-party certifications or published data on average compensation in an industry for certain levels of employee. It is reasonable to assume that many active “angel” investors will have their accredited status certified by a third party source.
Changes to Form D
The SEC intends to monitor the use of general solicitation in Rule 506(c) offerings and has proposed to amend Form D to add a separate checkbox to indicate if the issuer is using general solicitation. The revised Form D also will be available to state securities regulators to monitor the use of general solicitation and advertising in their particular jurisdictions under general antifraud rules.
Rule 144A under the Securities Act of 1933 provides an exemption for private resales of securities to “qualified institutional buyers” (QIBs). As required by the JOBS Act, the SEC has proposed to revise Rule 144A to provide that securities sold pursuant to Rule 144A may be offered to persons other than QIBs, including by means of general solicitation and advertising, provided that securities are sold only to persons that the seller, and any person acting on behalf of the seller, reasonably believes is a QIB.
Impact on Other Securities Laws
The proposing release also addresses the implications of the proposed amendments on other federal securities laws, including:
- That offerings using general solicitation or general advertising pursuant to Rule 506(c) will not be considered a “public offering” under other federal securities laws and thus fund issuers engaging in these offerings will continue to qualify for the exemptions from registration as an investment company available under Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act of 1940.
- That the use of general solicitation or general advertising for a domestic offering under Rule 506 will not constitute “directed selling efforts” in connection with a contemporaneous offshore offering under Regulation S.
No Regulation of Methods of Solicitation or Advertising
Although several commentators and some members of Congress have urged the SEC to regulate the content and manner of public advertising and solicitation activities in Rule 506 offerings using general solicitation, the SEC declined to do so.
Preservation of Records
The SEC noted that any issuer relying on an exemption from the registration requirements of the federal securities laws (such as Rule 506) has the burden of demonstrating that it was entitled to rely on such exemption. Therefore, if the amendments are adopted as proposed, issuers engaging in general solicitation or advertising must retain adequate records that document the steps taken to verify an investor’s accredited status.
Until final rules are adopted and become effective, general solicitation in connection with Rule 506 offerings remains prohibited.
The SEC clearly stated that issuers will continue to have the option of using Rule 506 as it currently exists both before and after the SEC adopts final rules permitting general solicitation in Rule 506 offerings. Thus, existing practices in Rule 506 can continue to be used by issuers and market professionals.
Issuers that are considering using general solicitation once the final rules are in place should be considering how they will verify the accredited investor status of purchasers, especially individual investors relying on the income or net worth tests.