The SEC has ushered in a new chapter in the marketplace of private placements of securities. For decades, companies seeking to raise capital have been able to rely on safe harbor exemptions from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act"), including Rule 506 of Regulation D. Rule 506 had several requirements, most notably that (i) sales must be to a limited number of investors that are not accredited investors and (ii) no general solicitation or general advertisements by or on behalf of the company may be utilized in connection with the offering.On July 10, 2013, the SEC adopted new rules removing the long-standing prohibitions on the use of general solicitation and general advertising in private placements under Rule 506 and Rule 144A (the "General Solicitation Rule"). In addition, the SEC adopted new rules prohibiting certain "bad actors" from utilizing the Rule 506 safe harbor (the "Bad Actor Rule"). At the same time, new rules and amendments to Regulation D were proposed (the "Proposed Rules") that if adopted would enable the SEC to better monitor the Rule 506 marketplace and to address concerns that may arise in connection with the use of general solicitation and advertising in private placements.
General Solicitation Rule.
The General Solicitation Rule amends Rule 506 by adding a new subsection (c) permitting a company to use general solicitations and general advertisements, provided that the company complies with the following conditions, in addition to other requirements under Regulation D:
- a company must comply with the rules regarding integration of offerings;
- all purchasers of securities must be accredited investors; and
- a company must take "reasonable steps to verify" that the purchasers of the securities are accredited investors.
The SEC has articulated non-exclusive and non-mandatory methods that a company may take as "reasonable steps to verify" that a purchaser of securities in an offering is an accredited investor. The SEC noted that promulgating a uniform set of criteria could result in situations that may be "ill-suited or unnecessary" given the variety of the types of transactions, types of investors and market practices. Whether the steps taken in connection with verifying the status of a particular purchaser are reasonable will depend on the particular facts and circumstances of each purchaser and each transaction. This approach will allow acceptance of changing and innovative market practices, such as the development of third-party databases of accredited investors. Under this approach, a company should avoid following a rigid "check the box" set of procedures that do not take into account the facts and circumstances of a particular purchaser or a particular offering.
When determining the reasonableness of the steps to verify that a purchaser is an accredited investor, a company should consider:
- 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 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.
Certain persons will satisfy the accredited investor standard because of their status, such as a broker dealer, bank or insurance company. Other situations will require a different amount of effort, depending on the amount of reliable information available about a given purchaser and its assets.
The SEC provided certain examples of information that a company could obtain to verify the accredited investor status of investors, including:
- regulatory filings, such as FINRA (to determine broker/dealer status), SEC filings with an investment adviser's Form ADV, compensation disclosures in public company filings or registration statements and the Form 990 filed for tax exempt organizations;
- certain third party information such as W-2 or 1099 statements or general compensation surveys for certain levels of employees or partners; and
- what may be most helpful to third-party marketers, verification of income by third parties as long as the company has a "reasonable basis" to rely on the third-party verification, including verification from accountants, registered investment advisers, broker dealers and attorneys.
The SEC notes that the company would likely be required to take more steps to verify that an investor is an accredited investor if the solicitation was through a public website, widely disseminated email or social media as opposed to a solicitation from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party.
The ability of a company to use third-party verification does not alleviate the company's required verification process. A responsible company must "drill down" and verify the process used by third parties. Periodic review of procedures or other means to confirm the integrity of the third party procedures should be considered.
General Solicitations and Advertisings + Social Media = Vibrant Disclosure.
Under the General Solicitation Rule, companies will be able to use LinkedIn, Facebook, Twitter, other social media and similar media outlets to enhance any of their general solicitations and general advertisings in connection with private placement offerings. The SEC has previously noted in a Report of Examination that social media content will, effectively, be treated as if the content was provided in traditional outlets. The combination of social media and traditional outlets may provide more vibrant presentations that enhance the securities offering process. Responsible companies should evaluate how they will align their advertising and media, including social media campaigns, with their SEC disclosure, so that there is one clear, consistent and coherent message.
The Traditional Regulation D Offering May Continue.
It is interesting to note that the new era of private placements does not restrict or limit the traditional safe harbor exemption under Rule 506 for the private placement of securities that do not use general solicitations or general advertisements. The SEC had noted that continuation of the existing rule might be helpful for companies that make offerings that include non-accredited investors and investors with whom there is a pre-existing relationship.
The "Bad Actor Rule" - Keeping the Barbarians Outside the Gate.
Many commentators have expressed concern that the ability to use general solicitations and general advertisements would compromise investor protection. One can easily see how the new freedoms to solicit and obtain investment capital can serve malicious intentions. The SEC agreed, and addresses these concerns in part with its adoption of the Bad Actor Rule.The Bad Actor Rule applies to specified broad categories of covered persons:
- the company and any predecessor of the company or affiliated company;
- any director, executive officer, other officer participating in the offering or the general partner or managing member of the company;
- any beneficial owner of 20% or more of any class of the company's outstanding voting equity securities;
- any promoter (such as finder) connected with the company in any capacity at the time of the sale;
- any investment manager of a company that is a pooled investment fund;
- 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;
- any general partner or managing member of any such investment manager or solicitor; and
- any director, executive officer or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.
The Bad Actor Rule specifies the scope of covered felonies or bad acts:
- criminal convictions (felony or misdemeanor) regarding specified securities and related matters, with a five year look back period in the case of companies and a ten year look back period in the case of other covered persons;
- any order, judgment or decree of any court of competent jurisdiction, regarding specified securities and related matters, with a five year look back period;
- final orders issued by a state securities commission, bank regulators, insurance regulators, and certain federal regulators for specified securities, insurance or banking and related matters;
- specified SEC disciplinary orders, suspensions or expulsions, including disbarment;
- specified SEC stop orders and similar actions; and
- U.S. Postal Service false representation orders including temporary or preliminary orders.
The Bad Actor Rule provides several exceptions including that a company will not be disqualified from using the Rule 506 safe harbor if it establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed. The extent of factual inquiry required by the company to comply with this exception is subject to the specific facts and circumstances of the private placement. In addition, the SEC may grant a waiver of disqualification if it determines that the company had shown good cause that it is not necessary under the circumstances that the registration exemption be denied. This waiver will likely be provided in certain limited circumstances.
Proposed Rules - Amendments to Regulation D.
The SEC has also proposed amendments to Regulation D that should strengthen efforts by responsible companies to fully comply with the requirements of Regulation D. Amendments to Rule 507 would provide that a company that has not complied with the requirements of Regulation D during a five year look back period will be disqualified from using Rule 506 for one year from the date the non-compliance was corrected or the offering is terminated, unless the non-compliance was corrected within a specified 30 day grace period. Additional amendments would require filing of the Form D 15 days prior to the commencement of a Rule 506(c) offering, inclusion of certain specified legends to raise investor awareness to certain risks and, as a temporary rule that would expire two years from its adoption, the submission to the SEC of written solicitation materials. Companies would also be required to file an amendment to Form D that evidences the termination of the offering and provides additional data to the SEC. Additional disclosures would also be required for performance data that are included in the offering materials.
In connection with the Proposed Rules, the SEC noted that it will initiate a Rule 506(c) work plan that will monitor the impact and developing market practices resulting from companies using general solicitation or general advertisements in Regulation D private placements.
Actions to Take in Light of the New Rules.
This new chapter of private placements should greatly assist companies to acquire additional capital and enhance their offering materials. Responsible companies should recognize that Regulation D, before and after this new chapter, is an exemption from the registration requirements of the Securities Act and not the anti-fraud provisions. In addition, the new rules do not address any applicable false advertisement laws. Companies and their executives should remember that the means for conducting an offering has changed but there has not been any diminishment in the fundamental obligation to provide all material facts in offering materials that a reasonably prudent investor would want to review and consider.