Until Congress passed the Jumpstart Our Business Startups Act (JOBS Act) in April, 2012, those seeking to raise capital through the sale of securities in transactions not registered with the U.S. Securities and Exchange Commission (SEC) generally could not advertise that they were offering and selling their securities. They could not issue a press release, post on their website or even discuss in a seminar that they sought to raise capital through a private placement. At an open meeting on July 10, 2013, the SEC adopted significant amendments to the private placement rules. Specifically, the SEC:
- adopted finals rules permitting general solicitation and advertising in private placements
- adopted final rules prohibiting private placements by so-called "bad actors"
- proposed rules requiring issuers to provide additional information about private placements to better enable the SEC to monitor the market, given the lifting of the ban on general solicitation and advertising
The final rules will go into effect sometime in September, 60 days after their publication in the Federal Register. The proposed rules are open for comments, which may be submitted within 60 days after publication in the Federal Register.
Ban on General Solicitation and Advertising Lifted for Private Placements
To implement Section 201(a) of the JOBS Act, the SEC adopted amendments to its private offering safe harbors under the Securities Act of 1933 (Securities Act) permitting issuers to use general solicitation and general advertising in securities offerings to accredited investors under Rule 506 of Regulation D (the most widely used and important exemption from federal and state registration of offerings) and qualified institutional buyers (QIBs) under Rule144A.
Rule 506 Amendment
The amendment to Rule 506, which creates new Rule 506(c) substantially as proposed, reverses the SEC's longstanding prohibition against using general solicitation and advertising in offerings of securities exempt from registration. An issuer relying on new Rule 506(c) may use general solicitation and advertising, including websites and other media, when raising capital provided that it satisfies the following conditions:
- the issuer takes reasonable steps to verify that all purchasers are accredited investors
- only accredited investors purchase the issuer's securities or the issuer had a reasonable belief that all investors were accredited investors at the time of the sale
This "reasonable steps to verify" condition is structured as a principles-based method of verification, which requires the issuer to make an objective determination in the context of the particular facts and circumstances of each purchaser and transaction. Responding to commenters' requests to assist issuers to make this determination, the SEC suggested that issuers consider factors that include, but are not limited to:
- the nature of purchaser and type of accredited investor the purchaser claims to be
- the amount and type of information about the purchaser available to the issuer
- the nature of the offering, such as how the purchaser was solicited and the terms of the offering, such as a minimum investment amount
The SEC indicated that, after an issuer's consideration of the facts and circumstances of the purchaser and the transaction, and the more likely it appears that a purchaser qualifies as an accredited investor, the fewer the steps the issuer will have to take to verify accredited investor status. Moreover, the SEC indicated that if the terms of an offering require a high minimum investment amount and a purchaser is able to meet those terms, in such context, there could potentially be cases in which no additional steps to verify accredited investor status are required other than confirming that the purchaser’s cash investment is not being financed by a third party. At the same time, in discussing an offering involving solicitation of new investors through a website accessible to the general public, a widely disseminated email or a social media solicitation, the SEC stated, "We do not believe that an issuer will have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status." Accordingly, the SEC contemplates that its principles-based method of accredited investor status verification will require issuers to adopt different approaches to verification depending on the circumstances.
Regardless of the steps taken to verify accredited investor status, it will be important for issuers and their verification service providers to retain adequate records regarding the steps taken, because the issuer bears the burden of demonstrating that its offering is exempt from the registration requirements of Section 5 of the Securities Act.
Issuers typically find it more challenging to determine the accredited investor status of individuals compared to entities. The existing accredited investor requirements continue to apply; to qualify, an individual must have:
- an individual net worth exceeding $1 million, excluding a primary residence
- an individual income in excess of $200,000 in each of the two most recent fiscal years (or a joint income with a spouse exceeding $300,000), with a reasonable expectation of the same level of income in the current year
To provide issuers some measure of certainty, the SEC modified the amendment to Rule 506 to provide issuers with the following non-exclusive list of methods to verify accredited investor status of individuals:
- Income. To determine income, review Internal Revenue Service (IRS) forms that report income for the two most recent years (e.g., Form W-2, Form 1099, Schedule K-1 to Form 1065 and Form 1040), and obtain a written representation from the purchaser that the purchaser reasonably expects to reach the income level necessary to qualify as an accredited investor during the current year.
- Net Worth. To determine net worth, review documents such as bank statements, brokerage statements, certificates of deposit, tax assessments and appraisal reports issued by independent third parties to determine assets, review a consumer report (aka credit report) from at least one of the nationwide consumer reporting agencies to determine liabilities, and obtain a written representation from the purchaser that all of the purchaser’s liabilities necessary to make a determination of net worth have been disclosed.
- Confirmation by Third Party. An issuer may obtain written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the past three months.
- Current Accredited Investor. An issuer may obtain certification from an individual purchaser certifying the purchaser’s accredited investor status if the purchaser invested as an accredited investor in the issuer prior to the adoption of Rule 506(c), and remains an investor in the issuer at the time of the Rule 506(c) offering.
These verification methods represent a significant change for issuers and will require new procedures and due diligence for issuers that choose to generally solicit or advertise. Third-party service providers may offer these types of verification services.
Certain Ramifications of New Rule 506(c)
Get it right the first time. The SEC warned issuers that if they use general solicitation or advertising and fail to satisfy the verification and sales conditions, issuers may be unable to fallback on Section 4(a)(2) (formerly Section 4(2)) of the Securities Act, which provides an exemption from registration for offers and sales not involving a public offering. The SEC noted in the adopting release that public advertising will continue to be incompatible with the Section 4(a)(2) exemption.
Consider impacts on international or concurrent offerings. New Rule 506(c) does not override the private placement regimes of other countries, and it is possible that various types of federal solicitations conducted within or from the United States (such as the use of unrestricted websites) may be deemed a violation of the private placement rules in another country. In addition, integration issues may remain if an issuer conducts multiple concurrent offerings (although, as discussed below, Regulation S offshore offerings should not be integrated).
Rule 506(b) Offerings
The amendment to Rule 506 does not alter existing Rule 506(b). Therefore, issuers may continue to rely on 506(b) for private offerings of securities (offerings with no general solicitation or advertising — now called "Rule 506(b) offerings") to both accredited and non-accredited investors without complying with the new accredited investor verification requirement under Rule 506(c).
Amendment to Form D
The SEC amended Form D as proposed to add a check box for issuers to indicate whether they are relying on the new Rule 506(c) exemption. Once a general solicitation or advertising has been made to the purchasers in an offering, an issuer is precluded from making a claim of reliance on Rule 506(b), which remains subject to the prohibition against general solicitation or advertising, for that same or an integrated (to the extent permitted) offering.
Special Issues for Private Funds
The SEC stated in its proposing release and reaffirmed in its adopting release that private funds, such as hedge funds, venture capital funds and private equity funds, may engage in general solicitation and advertising in compliance with new Rule 506(c) without losing either of the typically relied upon private investment entity exclusions from the definition of "investment company" under the Investment Company Act of 1940 (Investment Company Act). However, many private fund managers rely upon exemptions from regulation by the Commodities Futures Trading Commission (CFTC) (such as the de minimis exemptions available to fund managers with limited trading in commodity interests). These exemptions currently prohibit general solicitation or advertising. Accordingly, absent guidance from the CFTC, fund managers should assume such important exemptions are not available to fund managers who conduct general solicitations.
Rule 144A Amendments
The SEC also adopted an amendment to Rule 144A to permit securities sold under Rule 144A to be offered to investors other than QIBs, including by general solicitation or advertising, so long as the securities are only sold to investors that the issuer reasonably believes to be QIBs at the time of the sale. QIBs include companies with over $100 million in investment securities and certain banks, financial intuitions and registered broker-dealers. The amendment was adopted as proposed.
Integration with Offshore Offerings under Regulation S
The SEC stated in its proposing release and reaffirmed in its adopting release that concurrent offshore offerings that are conducted in compliance with Regulation S of the Securities Act will not be integrated with domestic unregistered offerings that are conducted in compliance with Rule 506(c) or Rule 144A.
"Bad Actors" Prohibited from Engaging in Private Placements
In a final rules release separate from the release lifting the ban on general solicitation and advertising for private placements, the SEC adopted amendments to Rules 501 and 506, as required under Section 926 of the Dodd-Frank Act, prohibiting the use of the Rule 506 registration exemption for any securities offering by so-called "bad actors." As required under Section 926, the disqualification of bad actors largely resembles the disqualification of bad actors in Regulation A of the Securities Act, a registration exemption for smaller securities offerings.
Prior to amendment, Rule 506 did not impose any bad actor disqualification requirements, and because securities sold under Rule 506 are "covered securities" under Section 18(b)(4)(E) under the Securities Act, state-level bad actor disqualification rules did not apply. Further, issuers who are unable to rely on Rule 506 due to the bad actor disqualification requirements and wish to rely on Section 4(a)(2) would need to register, or find an exemption, with the states where the securities will be sold because the securities would lose their "covered securities" status under Section 18(b)(4)(E) of the Securities Act. Section 18(b)(4)(E) only preempts state blue sky laws where the securities are sold under rules adopted by the SEC, not Section 4(a)(2).
Covered Persons and Disqualifying Events That Impact the Issuer
Under the final rules, adopted with some differences from the proposed rules, an issuer will not be able to rely on the Rule 506 exemption (whether under Rule 506(b) or new Rule 506(c)) if the issuer or another "covered person" had a "disqualifying event."
"Covered persons" include:
- the issuer, its predecessors and affiliated issuers
- 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 equity securities, calculated on the basis of voting power
- any investment manager to an issuer 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 issuer in any capacity at the time of the sale of securities in the offering
- any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering, and any director, executive officer, other officer participating in the offering, general partner or managing member of any such compensated solicitor
"Disqualifying events" (including the associated look-back period associated with each event) include:
a criminal conviction that took place within 10 years before the proposed sale of securities (or five years in the case of the issuer and its predecessor or affiliated issuers), or a court injunction or restraining order occurring within five years before the proposed sale of securities, all necessarily in connection with any of the following:
- the purchase or sale of a security
- a false filing with the SEC
- the conduct of business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities
a final order of certain federal or state regulators of securities, banking, savings associations, credit unions and insurance that either:
- prohibits the issuer from association with a regulated entity, or from the business of securities, insurance, banking, savings associations or credit union activities
- prohibits fraudulent, manipulative or deceptive conduct and was issued within 10 years before the proposed sale of securities
- a disciplinary order issued by the SEC relating to registration of a broker, dealer, municipal securities dealer or investment adviser or the activities, functions or operations of any such person, or relating to barring any such person from associating with any entity or from participating in the offering of any penny stock
- a cease and desist or stop order of the SEC entered within five years before the proposed sale of securities relating to violations of federal securities laws anti-fraud provisions or registration requirements
- a stop order of the SEC entered within five years before the proposed sale of securities relating to suspension of a Regulation A exemption (or an investigation or proceeding at the time of such sale)
- self-regulatory organization membership suspension or expulsion, or the same with respect to association with a self-regulatory member
- a United States Postal Service false representation order within the five years before the proposed sale of securities (or a temporary restraining order or preliminary injunction at the time of such sale)
Pursuant to new Rule 506(d), which identifies who are covered persons and lists disqualifying events, only disqualifying events occurring after the effective date of the amendments to Rule 501 and 506 will disqualify the issuer from the Rule 506 exemption. However, an event that would be a disqualifying event except for having occurred before such effective date must be disclosed to each purchaser under new Rule 506(e).
Reasonable Care Standard and Exception
Under new Rule 506(d), the issuer is obligated to exercise reasonable care in determining whether a disqualifying event exists, which requires a factual inquiry of covered persons to fulfill such reasonable care standard. The nature and scope of the factual inquiry will depend on the facts and circumstances concerning, among other things, the issuer and other offering participants involved. In some circumstances, factual inquiry by an issuer by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient, particularly if there is no information or other indicators suggesting bad actor involvement. However, the SEC also adopted an exception to the disqualification from Rule 506 for instances where the issuer can establish that it did not know and, in the exercise of reasonable care, could not have known that a covered person that is the subject of a disqualifying event participated in the offering. New Rule 506(d) also permits any court or regulatory authority that enters an order, judgment or decree that would cause a covered person to be disqualified under Rule 506 to advise the SEC that, in its view, disqualification under Rule 506 should not arise as a consequence of such order, judgment or decree, and in such circumstances disqualification will not arise.
The SEC adopted, as proposed, an amendment to Form D for the signature block of Form D to contain a certification, similar to the current certification by Rule 505 issuers, whereby issuers claiming a Rule 506 exemption must confirm that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(d).
Proposed Rules to Amend Regulation D, Form D and Rule 156
In connection with the final rules releases discussed above, the SEC released proposed rules which, if adopted, would amend Regulation D, Form D and Rule 156 under the Securities Act. These rules are intended to enhance the SEC’s ability to monitor market practices and developments in Rule 506 offerings and to address concerns that may arise in connection with general solicitation and advertising in private placements under new Rule 506(c).
Strict Compliance with the Filing Requirements of Form D
Under proposed amendments to Rule 503 of Regulation D, issuers would be required to file Form D at least 15 days prior to using general solicitation in a Rule 506(c) offering. Additionally, issuers would have to file a closing amendment to Form D 30 days after termination of the Rule 506(c) offering. Under proposed amendments to Rule 507 of Regulation D, noncompliance by the issuer, or any predecessor or affiliate of the issuer, within the previous five years would disqualify an issuer from using the Rule 506 exemption for future offerings for one year. The proposed rule allows for one cure period per offering of 30 days, as well as application to the SEC for a waiver for good cause shown.
Expanded Disclosure under Form D
Under proposed amendments to Form D, issuers would be required to disclose the following additional information in regard to offerings conducted in reliance on new Rule 506(c) (and, in certain cases, in reliance on other exemptions under Regulation D or Section 4(a)(5) of the Securities Act):
- Item 2: the issuer’s publicly-accessible (Internet) website address, if any
- Item 3: in addition to information on “Related Persons,” the name and address of any person who directly or indirectly controls the issuer
- Item 4: clarification field for issuers selecting “Other” as their industry classification
- Item 5: in lieu of the current "Decline to Disclose" option for issuer size, a "Not Available to the Public" option
- Item 7: check boxes to indicate whether form being filed is an advance Form D or a closing Form D amendment
- Item 9: offered securities trading symbol or security identifier, if any
- Item 14: a table requiring disclosure of the number of accredited and non-accredited investors that have purchased the offering, whether they are natural persons or legal entities, and the amount raised from each category of investors
- Item 16: the percentage of Rule 506 offering proceeds that was or will be used: (1) to repurchase or retire the issuer's existing securities; (2) to pay offering expenses; (3) to acquire assets, otherwise than in the ordinary course of business; (4) to finance acquisitions of other businesses; (5) for working capital; and (6) to discharge indebtedness
New Items 17 through 22 would require Rule 506 issuers to disclose the following:
- the number and types of accredited investors that purchased securities in the offering (e.g., individuals who qualified as accredited investors on the basis of income or net worth)
- if the securities are traded on an organized exchange, the name of the exchange
- if the issuer is a registered broker-dealer, disclose whether any general solicitation materials were filed with FINRA
- if the issuer is a pooled investment fund advised by registered or exempt investment advisers, disclose the name and SEC file number for each investment adviser who functions directly or indirectly as a promoter of the issuer
- the types of general solicitation materials used or to be used in 506(c) offerings (e.g., mass mailings, emails, public websites, social media, print media and broadcast media)
- for 506(c) offerings, the methods used or to be used to verify accredited investor status (e.g., principles-based method using publicly available information, documentation provided by the purchaser or a third party, reliance on verification by a third party or other sources of information; one of the methods in the non-exclusive list of verification methods in Rule 506(c)(2)(ii); or another method)
Legends and Related Disclosures
Proposed new Rule 509 of Regulation D would require issuers to include the following legends on any written general solicitation materials:
- the securities may be sold only to accredited investors, which for natural persons, are investors who meet certain minimum annual income or net worth thresholds
- the securities are being offered in reliance on an exemption from the registration requirements of the Securities Act and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act
- the SEC has not passed upon the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials
- the securities are subject to legal restrictions on transfer and resale and investors should not assume they will be able to resell their securities
- investing in securities involves risk, and investors should be able to bear the loss of their investment
Additionally, private funds, such as hedge funds, venture capital funds and private equity funds, would be required to include a legend disclosing that the funds are not subject to the protections of the Investment Company Act. If a private fund's written general solicitation materials contain performance data, they would be required to contain the following legends regarding limitations of the usefulness of such data and providing context to understand the data presented:
- performance data represents past performance
- past performance does not guarantee future results
- current performance may be lower or higher than the performance data presented
- the private fund is not required by law to follow any standard methodology when calculating and representing performance data
- the performance of the fund may not be directly comparable to the performance of other private or registered funds
Mandatory Submission of Written General Solicitation Materials
Under proposed Rule 510T, issuers would be required to submit to the SEC any general solicitation materials used in a Rule 506(c) offering on or before the date that such materials are first used. Such materials would not be submitted through EDGAR and would not be made available to the general public. The rule would be temporary and would expire after two years. Amended Rule 507(a) would disqualify an issuer from reliance on Rule 506(c) if a court issues an injunction for the issuer’s or any predecessor or affiliate of the issuer's for failure to comply with Rule 501T.
Proposed Amendments to Rule 156
Rule 156 of the Securities Act provides guidance on the types of information in investment company (e.g., public mutual funds) sales literature that could be misleading for purposes of the federal securities laws, by outlining certain situations in which a statement could be misleading. Proposed amendments to Rule 156 would extend the sales literature anti-fraud guidance included in Rule 156 to sales of securities by private funds, including private funds engaged in general solicitation activity under new Rule 506(c), and related private fund sales materials.
Practical Effects of Amendments to Rule 506
It remains to be seen how issuers and underwriters will take advantage of the use of general solicitation and advertising because its use comes with a price, and it remains to be seen how effective general solicitation and advertising will be to attract accredited investors to a particular offering. Some of the ways issuers can take advantage of the removal of the general solicitation and advertising ban under new Rule 506(c) are:
- Issuers conducting private placements and Rule 144A offerings to accredited investors and QIBs, respectively, will be able to include much more information in press releases and on their websites regarding the offerings. Previously, qualifying issuers could only include the limited information permitted by Rule 135c in communications releases discussing the offering.
- Issuers will be able to conduct private placements and Rule 144A offerings on the internet without using a broker dealer or password protected sites, as previously required under SEC guidance.
- Placement agents not concerned about CFTC compliance may provide information on their websites about offerings they are bookrunning as a means to alert institutional investors about opportunities to co-invest, but old fashioned relationships may prove ultimately the most efficient and successful way to approach institutional investors.
In order to take advantage of new Rule 506(c), issuers will need to revise their diligence procedures in order to obtain the additional information required under the rule to ensure that "reasonable steps" were taken to verify accredited investor or QIB status and keep detailed records of such steps. Further, all issuers conducting private placements under Rule 506 must obtain information from the "covered persons" described above, including executive officers, directors, 20 percent stockholders, promoters, underwriters, placement agents and other offering participants as to whether they have any disqualifying events that would make Rule 506 unavailable.
Issuers also should keep in mind that the SEC still has not adopted rules permitting the use of crowdfunding. Issuers cannot rely on the lifting of the ban on general solicitation to crowdfund an offering. When the SEC releases its proposed crowdfunding rules, issuers should expect significant restrictions on its use plus monitoring and verification requirements as well.
While it is possible general solicitation or advertising may reach some accredited investors who otherwise may not have known about an issuer, a perception could develop in the market that issuers who use general solicitation and advertising lack the resources and relationships to attract capital from institutional investors. If this occurs, issuers may need to reconsider their strategy and opt not to use any form of general solicitation or advertising to distinguish themselves and raise their perceived sophistication in the market.