At long last, on July 10, 2013, the U.S. Securities and Exchange Commission (SEC) adopted a suite of final and proposed rules, including a new rule to implement a Jumpstart Our Business Startups Act (JOBS Act)1 requirement to lift the ban on general solicitation and general advertising for certain private securities offerings under Rules 506 and 144A. This is perhaps the most important change in SEC rules in many years since it potentially unlocks the ability of companies to access an enormous pool of previously inaccessible investors, and allow this pool to finance small companies that were previously inaccessible to these investors.
The SEC also adopted rules that disqualify felons and other bad actors from participating in certain securities offerings as required by the Dodd-Frank Act.
In connection with these new rules, the SEC issued a rule proposal requiring companies to provide additional information about these securities offerings to better enable the SEC to monitor the market with that ban lifted.
LIFTING THE BAN ON GENERAL SOLICITATION
Securities may generally be sold in the United States only if the sales are registered with the SEC or their sale qualifies for one of a number of exemptions to registration. Rule 506 under the SEC’s Regulation D provides for one of these exemptions, and it operates as a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act of 1933. Regulation D is the principal exemption used by private companies to conduct “private placements.” The Rule 506 exemption under Regulation D is popular because, unlike some other exemptions, there is no limit to the amount of capital it can be used to raise. Further, if the offering is limited to “accredited investors,” there are no technical disclosure requirements that are mandated. Up to 35 non-accredited investors can participate in the offerings, but that route imposes extensive disclosure requirements.
Further, state securities, or “blue sky,” laws are pre-empted for Rule 506 offerings. Importantly, one of the conditions for qualifying for the Rule 506 exemption before the amendment is that potential purchasers of the securities sold who are not previously known to the company may not be solicited or introduced to the offering through advertising, which we refer to in this advisory as “general solicitation.”
The JOBS Act directed the SEC to write rules permitting general solicitation under Rule 506 when securities are sold only to “accredited investors.” Individuals or entities are accredited investors within the meaning of Rule 506 if the company reasonably believes they meet certain enumerated conditions.2 Most commonly, accredited investors include natural persons (as opposed to business entities) if the company reasonably believes that the person has a net worth in excess of $1,000,000, or that the person’s annual income is greater than $200,000 per year.
New Rule 506(c)
Under new Rule 506(c), companies can offer securities through means of general solicitation, provided that they satisfy all of the conditions of the exemption, including:
- All terms and conditions of certain other provisions of Regulation D must be satisfied,
- All purchasers of securities must be accredited investors, and
- The company must take reasonable steps to verify that the purchasers of the securities are accredited investors.
Companies that rely on Rule 506(c) for an offering will not be subject to the prohibition against general solicitation for that offering. Further, in response to comments on the proposed rules, the SEC included a non-exclusive list of methods that companies may use to verify the accredited investor status of natural persons.
Significantly, companies may continue to rely on the existing private placement exemption under Rule 506(b), subject to the prohibition against general solicitation. The amendments adopted by the SEC pertaining to lifting the ban on general solicitation do not amend or modify the requirements of existing Rule 506(b); rather, they add a new avenue for companies that do not want to be constrained by the ban on general solicitation in Rule 506(b).
There are no restrictions on the method of general advertising under the rule. For example, a company with a particular medical device or technology may advertise in a periodical that is directed at an audience with a particular interest in the device or technology.
Whether steps to verify accredited investor status are “reasonable” will be a determination by the company in the context of the facts and circumstances of a transaction. Among the factors to be considered are:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be. For example, some purchasers may be accredited investors based on their status alone, such as brokers, dealers, or investment companies registered under the federal securities laws,
- The amount and type of information that the company 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.
As a practical matter, a company that solicits new investors through a website accessible to the general public, through widely disseminated email or through social media will avoid making subjective judgments in this area, but will instead use procedures specifically sanctioned by the new rule. It should be noted, however, that a company may solicit new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third-party with limited additional verification procedures. Put another way, 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 company would have to take to verify accredited investor status, and vice versa.
The SEC does not believe that a company will have taken reasonable steps to verify accredited investor status if the company requires only that a person check a box in a questionnaire or sign a form, as is common practice in current Rule 506 offerings, absent other information about the purchaser indicating accredited investor status.
Because the company has the burden of demonstrating that its offering is entitled to an exemption from the registration, it will be important for companies and any verification service providers to retain adequate records regarding the steps taken to verify accredited investor status.
Non-exclusive List of Verification Requirements
In addition to the principles-based approach described above, the SEC also provided four specific non-exclusive methods of verifying accredited investor status for natural persons.
The procedures most likely to be used are:
In verifying whether a natural person is an accredited investor on the basis of net worth, a company 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 past 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.
- 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, and
- For liabilities: a consumer report (also known as a credit report) from at least one of the nationwide consumer reporting agencies.
- A company 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.
- With respect to any natural person who invested in a company’s Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c) and remains an investor of the company, for any Rule 506(c) offering conducted by the same company, the company is deemed to satisfy the verification requirement in Rule 506(c) by obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.
A method less likely to be used in verifying whether a natural person is an accredited investor on the basis of income, is that a company is deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies of any Internal Revenue Service form that reports income 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.
Companies are not required to use any of the above methods, but rather may apply the reasonableness standard directly to the specific facts and circumstances presented by the offering and the investors. We expect that companies will avoid this approach if possible.
If a person does not meet the criteria for any category of accredited investor purchases securities in a Rule 506(c) offering, the company will not lose the ability to rely on Rule 506 for that offering, so long as it took the reasonable steps described above to verify that the purchaser was an accredited investor and had a reasonable belief based on these steps that such purchaser was an accredited investor at the time of sale.
Changes 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. Companies relying on a Rule 506 exemption will be required to check a box indicating that they are relying on Rule 506(b) or Rule 506(c). Companies may not check both boxes because once a general solicitation has been made, a company is precluded from relying on the Rule 506(b) exemption.
Like Rule 506, Rule 144A provides an exemption from the general requirement that sales of securities be registered. In its present form, Rule 144A operates by permitting unregistered resales of restricted securities if they are offered and sold to qualified institutional buyers (QIBs).3
The safe harbor also applies to resales to those the seller or any person acting on its behalf reasonably believes are QIBs. Though Rule 144A does not expressly prohibit general solicitation, sales of securities made in reliance on Rule 144A may only be offered to QIBs, thereby effectively restricting the communications that can properly be made to others.
The JOBS Act instructed the SEC to write new rules to allow securities sold in reliance on Rule 144A to be offered to persons other than QIBs, and by means that include general solicitation, provided that such securities are only sold to QIBs or to persons that the seller or someone acting on its behalf reasonably believes to be QIBs.
New Rule 144A
The SEC amended Rule 144A(d)(1), which enumerates the conditions a Rule 144A offering must meet, by eliminating references to “offer” and “offeree.” Such revision simply removes Rule 144A’s offering restrictions while preserving its restriction on sales to only QIBs or those reasonably believed to be QIBs. The SEC does not address steps to support a “reasonable belief” that a purchaser is a QIB.
Privately Offered Funds
The SEC again clarified, as it previously did in the proposing release for the rules lifting the ban on general solicitation,4 that privately offered funds may engage in general solicitation under new Rule 506(c) without jeopardizing their exemptions from regulation under the Investment Company Act. Privately offered funds, which include many hedge funds, venture capital funds and private equity funds, are generally not subject to regulation under the Investment Company Act. This is because such funds are able to qualify for certain exclusions from the definition of “investment company” under the Investment Company Act. To qualify for these exclusions, entities must not engage in public offerings. Some commenters on the JOBS Act were concerned that a privately offered fund that engaged in general solicitation under Rule 506(c) could be deemed to have made a public offering and would lose its ability to rely on such exclusions.
In its adopting release, the SEC interprets Section 201(b) of the JOBS Act, which provides that offerings under new Rule 506(c) will not be considered public offerings under federal securities laws, to permit privately offered funds to engage in general solicitation under Rule 506(c) without losing their ability to rely such exclusions.
Integration with Regulation S Offshore Offerings
The repeal of the ban on general solicitation for Rule 506 and 144A offerings has created tension with Regulation S. Regulation S exempts from the registration requirements certain offers and sales of securities that take place outside of the United States. For purposes of the exemption, an offer or sale of a security is deemed to take place outside of the United States if: (1) the offer or sale is made in an offshore transaction; and (2) no directed selling efforts are made in the United States. There has been concern that engaging in general solicitation, once permitted under Rules 506(c) and 144A, will preclude reliance on Regulation S because such solicitation could be considered a prohibited directed selling effort. Both in its proposing release 5 and in its adopting release, the SEC confirmed that Regulation S offerings would not be integrated with concurrent Rule 506(c) or 144A offerings.
More specifically, a company will be able to undertake general solicitation under Rule 506(c) or 144A for a domestic offering without compromising its reliance on Regulation S for a simultaneous offshore offering.
PROHIBITION ON BAD ACTOR PARTICIPATION
As mandated by Section 926 of the Dodd-Frank Act, the SEC adopted disqualification provisions from participating in Rule 506 offerings, which will cover the following persons, which we refer to in this advisory as “covered persons”:
- The company and any predecessor of the company or affiliated company,
- Any director, executive officer, other officer participating in the offering, general partner or managing member of the company,
- Any beneficial owner of 20% or more of the company’s outstanding voting equity securities, calculated on the basis of voting power,
- Any investment manager to a company that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member,
- Any promoter connected with the company in any capacity at the time of the sale,
- Any person that has been or will be paid remuneration for solicitation of purchasers in connection with sales of securities in the offering (a compensated solicitor), and
- Any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.
A company may not rely on a Rule 506 exemption if a covered person has been involved in a disqualifying event, such as being convicted, within ten years before such sale (or five years, in the case of companies, their predecessors and affiliated companies), of felonies or misdemeanors related to the purchase or sale of any security, making of any false filing with the SEC, or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities.
According to the SEC, in order for companies to verify that no such “bad actors” are participating in an offering, factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient company diligence, particularly if there is no information or other indication suggesting bad actor involvement. Continuous, delayed or long-lived offerings will require updating the factual inquiry on a reasonable basis.
Disqualification applies only to disqualifying events that occur after effectiveness of the rule amendments. However, the SEC is mandating disclosure to investors of such events in all Rule 506 offerings. Failure to furnish required disclosure on a timely basis will not prevent a company from relying on Rule 506 if the company establishes that it did not know, and in the exercise of reasonable care could not have known, of the existence of the undisclosed matter.
Disqualifying events that occur while an offering is underway will be treated in a similar fashion: sales made before the occurrence of the disqualifying trigger will not be affected by the disqualifying event, but sales made after the event will not be entitled to rely on Rule 506 unless the disqualification is waived by the SEC or removed, or, if the company is not aware of a triggering event, the company can rely on the reasonable care exemption.
As a result of the new rule, companies conducting private offerings should obtain representations from covered persons that they are not bad actors. Further, companies should consider building restrictions into share acquisition agreements as to whom the shares may be transferred to, so as to not end up inadvertently having a bad actor holding 20% of their shares, and thus preventing the company from relying on Rule 506 in future offerings.
Changes to Form D
Form D will now contain a certification whereby companies claiming reliance on a Rule 506 exemption will confirm that they are not ineligible for such reliance because of disqualifying conduct by covered persons.
ADDITIONAL PROPOSED RULES
In an effort to enhance the SEC’s ability to evaluate market practices in Rule 506 offerings and to address concerns that may arise in connection with permitting general solicitation under Rule 506(c), the SEC proposed additional amendments to Regulation D, Form D, and Rule 156.
Submission of Written General Solicitation Materials to the SEC
The SEC has proposed requiring companies conducting offerings in reliance on Rule 506(c) to submit to the SEC, via the SEC’s website, any written general solicitation materials no later than the date of first use of the materials. As proposed, this rule would expire two years after its effective date. The written general solicitation materials would be submitted for the purpose of furthering the SEC’s understanding of market practice, and as such, would not be made available to the public.
Compliance with such submission requirement would not be a condition to Rule 506(c), but rather, Rule 506 would be unavailable to a company if the company has been subject to any order, judgment or court decree enjoining such person for failure to comply with the submission requirement.
Advance Form D Filing
The SEC has proposed amending Rule 506 of Regulation D to require companies to file a Form D 15 days before an offering relying on Rule 506(c) and 30 days after the conclusion of any offering relying on Rule 506. As proposed, the closing amendment must be filed when a company terminates an offering, whether after the final sale of securities in the offering or upon the company’s determination to abandon the offering. Until the closing amendment is filed, the offering is deemed to be ongoing and the company would be subject to the current Rule 503 requirements to file amendments to Form D at least annually and otherwise as needed to reflect changes in previously filed information to correct material mistakes and errors.
The SEC believes that requiring companies to file an Advance Form D would allow the SEC to evaluate the use of Rule 506(c). Advance filing of Form D may allow investors and securities regulators to see if a company is at least attempting to comply with 506(c) and may allow for advance confirmation that no bad actors are participating in offerings under Rule 506(c). According to a comment letter from the North American Securities Administrators Association, Inc., state securities regulators routinely review Form D filings to ensure that the offerings actually qualify for an exemption under Rule 506 and to look for “red flags” that may indicate that an offering may be fraudulent.
A company may, at its election, provide all of the information requested on Form D when filing the Advance Form D, obviating the need to file an additional amendment unless otherwise required to do so (assuming that the company has all of this information at the time of filing).
Further, the SEC’s proposal would allow a company to file an Advance Form D without contemplating a specific offering, in order to have the flexibility to conduct an offering using general solicitation. The SEC believes that this approach would allow it to gather information needed through Advance Form D filings without unnecessarily burdening companies or requiring companies to disclose specific information about capital-raising plans before these plans have been determined.
Additional Company and Offering Disclosure
The SEC is proposing to amend Form D to require companies to provide additional information, including:
- Identification of the company's website,
- Expanded information about the company,
- The offered securities,
- The types of investors in the offering,
- The use of proceeds from the offering,
- Information on the types of general solicitation used, and
- The methods used to verify the accredited investor status of investors.
The SEC believes that this additional information may be useful to investors seeking to learn more about an offering being conducted pursuant to Rule 506(c) or about the types of companies conducting these offerings. Further, this information may be useful in facilitating enforcement efforts should any fraud or other securities law violations occur in these offerings.
Disqualification from Reliance on Rule 506
In its proposing release, the SEC proposes imposing a one-year disqualification period on companies if they, their predecessors or their affiliates have failed to comply with Form D filing requirements within a five year look-back period. During the one-year disqualification period, companies would be prohibited from relying on the Rule 506 exemption in any new offering. The one year disqualification period would begin at the time the delinquent filings are made, and upon its conclusion, disqualification would terminate. The SEC also proposes subjecting disqualification to a one-time 30 calendar day cure period.
Legends on Written General Solicitation Materials and Additional Disclosures in Private Fund Sales Literature
The SEC proposes to add a new Rule 509 to require all companies to include: (1) new legends in any written general solicitation materials used in a Rule 506(c) offering; and (2) additional disclosures for private funds if such materials include performance data. Further, the SEC proposed amendments to Rule 156 that would extend the antifraud guidance relating to investment company sales literature contained in the rule to the sales literature of private funds. The SEC proposes that private funds include a legend on any general solicitation materials that the securities offered are not subject to the protections of the Investment Company Act.
However, as currently proposed, the requirement to include these legends and other disclosures would not be a condition of the Rule 506(c) exemption. Therefore, the failure to include legends or other disclosures on other written general solicitation materials as required by proposed Rule 509 would not render Rule 506(c) unavailable for the offering. Under the proposed Rules, Rule 506 would not be available for a company if the company has been subject to any order, judgment or court decree enjoining such person for failure to comply with Rule 509.
Request for Comment on the Definition of Accredited Investor
On July 18, 2013, as mandated by Section 415 of the Dodd-Frank Act, the Government Accountability Office (GAO) released a study regarding the appropriate criteria for determining the financial thresholds or other criteria for qualifying as an accredited investor. Under Dodd-Frank, the SEC is required to undertake a review of the accredited investor definition as it relates to natural persons in its entirety every four years. Also, Dodd-Frank stipulates that the net worth standard shall be $1,000,000, excluding the value of the person’s primary residence, until July 2014.6 The GAO determined that the intended purposes of the accredited investor standard are to (1) protect investors by allowing only those who can withstand financial losses access to unregistered securities offerings and (2) streamline capital formation for small businesses. The GAO study recommends that the SEC should consider alternative criteria for the accredited investor standard, such as adding liquid investments and use of a registered adviser as alternative criteria.
The SEC has commenced a review of the accredited investor definition as it relates to natural persons, including the need for any changes given the adoption of Rule 506(c). The SEC has requested comments on the definition of accredited investor.