On July 10, 2013, the Securities and Exchange Commission (the “SEC”) held an open meeting during which it took action required under Section 201(a) of the Jumpstart Our Business Startups Act enacted on April 5, 2012 (the “JOBS Act”) and Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). New Rule 506(c) of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”), eliminates the prohibition against general solicitation and general advertising in private securities offerings conducted pursuant to Rule 506, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors. The amendment to Rule 144A of the Securities Act allows general solicitation in connection with securities to be offered pursuant to Rule 144A, provided that the securities are sold only to buyers that the seller and any person acting on behalf of the seller reasonably believe are qualified institutional buyers as defined in Rule 144A(a)(1) (“QIBs”). The SEC also approved revisions to Form D which will require issuers to indicate whether they are relying on the provision which permits general solicitation or general advertising in a Rule 506 offering.
The SEC also unanimously adopted amendments to Rule 506 to disqualify issuers and other market participants from relying on Rule 506 if “felons and other ‘bad actors’” are participating in the Rule 506 offering and published for comment several proposed amendments to Regulation D, Form D, and Rule 156 under the Securities Act that are intended to enhance the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and address comments made in connection with implementing Section 201(a) of the JOBS Act.
Elimination of Prohibition on General Solicitation and General Advertising in Certain Rule 506 Offerings
Companies seeking to raise capital through the sale of securities must either register the securities offering with the SEC or rely on an exemption from registration. Currently, issuers relying on the exemption provided under Rule 506 can raise an unlimited amount of capital from an unlimited number of “accredited investors” and up to 35 non-accredited investors, however the exemption prohibits issuers from engaging in general solicitation or general advertising in connection with such offerings. As mandated by Section 201(a) of the JOBS Act, the amendments add to Rule 506 a new paragraph (c) which permits the use of general solicitation or general advertising for securities offerings relying on Rule 506, provided that sales are limited to accredited investors and provided that an issuer takes reasonable steps to verify that all purchasers of such securities are accredited investors.
While the proposed rules did not articulate the steps that an issuer must take in order to satisfy its obligation to take reasonable steps to verify that a purchaser is an accredited investor, the final rules are consistent with the proposed rules in that the determination of whether the steps are reasonable should be an objective determination by the issuer (or those acting on its behalf) in the context of the particular facts and circumstances of each purchaser and the transaction. As noted in the proposed rules, among the factors that issuers should consider under this facts and circumstances analysis are:
- 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.
The above factors are intended to assist an issuer in evaluating the reasonable likelihood that a purchaser is an accredited investor, which evaluation in turn affects the types of steps that would be reasonable for the issuer to take to verify a purchaser’s accredited investor status. An issuer that solicits new investors through a website accessible to the general public, through a widely circulated email or social media solicitation, or through print media such as a newspaper would likely be required to take greater measures to verify accredited investor status than an issuer that solicits new investors through a database of pre-screened accredited investors created and maintained by a reasonably reliable third party. The SEC noted that an issuer would be entitled to rely on verification of accreditor investor status by a reliable third party, provided that the issuer has a reasonable basis to rely on such third-party verification. On the other hand, an issuer would not have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, relied solely on a the potential investor’s verification of its accreditor investor status by way of checking a box in a questionnaire or signing a form, which has been a historically customary practice for Rule 506 offerings to qualify investors as accredited investors under the “reasonable belief” standard that existed prior to the adoption of the new amendments. A purchaser’s ability to meet a high minimum investment amount may also be a relevant factor to the issuer’s evaluation of the types of steps that would be reasonable to take in order to verify such purchaser’s status as an accredited investor.
Based on substantial comments since the proposed rules, the SEC also decided to include in Rule 506(c) the following non-exclusive list of methods that will be deemed to be sufficient for verifying the accredited investor status for natural persons:
- Verification on the basis of net income, including the review of copies of any Internal Revenue Service form that reports income, including, but not limited to, a Form W-2 (“Wage and Tax Statement”), Form 1099 (report of various types of income), Schedule K-1 of Form 1065 (“Partner’s Share of Income, Deductions, Credits, etc.”), and a copy of a filed Form 1040 (“U.S. Individual Income Tax Return”), 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;
- Verification on the basis of net worth, including the review of assets as shown on any bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issues by independent third parties and review of liabilities as shown on a consumer report from at least one of the nationwide consumer reporting agencies, along with a written representation from such person that all liabilities necessary to make a determination of net worth have been disclosed;
- Verification by a reliable third-party, including receipt of 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; and
- Verification by means of an existing relationship, including, with respect to any natural person who has previously invested in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c) and remains an investor of the issuer, receipt of certification by the person at the time of sale that he or she qualifies as an accredited investor.
Consistent with the provisions of Title II of the JOBS Act that exempt third party intermediaries from regulation as brokers or dealers in connection with offering portals maintained for Rule 506 offerings, it is anticipated that many third party services will offer verification services.
The new rule will not eliminate Rule 506(b), which includes a prohibition against general solicitation but permits the issuance of securities to no more than 35 non-accredited investors who meet certain “sophistication” requirements and receive certain information about the offering. As a result, private issuers that do not wish to engage in general solicitation may continue to offer their securities in reliance on the existing safe harbor under Rule 506(b). Although the existing “reasonable belief” standard with respect to a prospective investor’s accredited investor status remains intact under Rule 506(b), issuers are strongly encouraged to undertake the reasonable steps under Rule 506(c) in connection with all Rule 506 offerings to qualify accredited investors. Further, the new rule will not eliminate the longstanding prohibition against fraudulent or misleading communications or other requirements for private placements, including those arising under Rules 501 and 502, or rules under the Investment Advisers Act and similar laws related to advertising by registered investment advisers.
Elimination of Prohibition on General Solicitation and General Advertising in Rule 144A Offerings
Rule 144A currently provides a safe harbor exemption from registration for the sale of securities to QIBs, provided that the offers were only made to QIBs. Rule 144A is most often used for institutional private placements, particularly of asset-backed securities and debt securities made through a financial intermediary acting as an “initial purchaser”. While there is currently no explicit prohibition on general solicitation in the Rule, the SEC has taken the position that there can be no general solicitation in Rule 144A offerings. The amendment to Rule 144A eliminates the references to “offer” and “offeree” such that, while securities may only be sold to QIBs, or to purchasers reasonably believed to be QIBs, there is no longer any restriction on the general solicitation of the securities pursuant to Rule 144A.
Rule 144A already provides a short list of non-exclusive methods by which an “offeror” may establish certain factors required to determine whether a prospective investor is in fact a QIB. Although the guidance that the SEC provided in regard to taking reasonable steps to determine whether a prospective investor is an accredited investor is not directly applicable to Rule 144A offerings, it may also be viewed as instructive in evaluating the types of steps that would be considered reasonable in determining whether a prospective investor is a QIB. Currently, it is not uncommon for issuers to simply require prospective investors to give a representation that they are a QIB, with issuers relying solely on such representation in selling the securities to the purchaser. Based on the analysis provided by the SEC in regard to determining whether a prospective investor is an accredited investor, depending on how an issuer makes use of general solicitation, such representation by a prospective purchaser in a 144A offering without any other verification is likely insufficient for the purpose of taking reasonable steps to verify QIB status under Rule 144A.
Disqualification of Felons and Other Bad Actors from Rule 506 Offerings
Pursuant to Section 926 of the Dodd-Frank Act, the SEC also unanimously adopted amendments to Rule 506 to disqualify issuers and other market participants from relying on Rule 506 if “felons and other ‘bad actors’” are participating in the Rule 506 offering. Specifically, once the rule becomes effective, issuers may not rely on Rule 506 of Regulation D if the issuer or any other “covered person” under the Rule has had a “disqualifying event” including, among others, a securities-related criminal conviction, a SEC cease-and-desist order, a securities-related court injunction or restraining order, or a suspension or expulsion from members in a Self-Regulatory Organization such as FINRA. Unlike the proposed rule, the final rule does not apply to disqualifying events that occurred prior to the effective date of the rule, however, pre-existing events that occurred must be disclosed to investors under certain circumstances. The new disqualification provisions will be codified as Rule 506(d) and the disclosure of prior bad actor events will be codified as Rule 506(e).
Proposed Amendments to Regulation D, Form D, and Rule 156
Finally, the SEC published for comment several proposed amendments to Regulation D, Form D, and Rule 156 under the Securities Act that are intended to enhance the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and address comments made in connection with implementing Section 201(a) of the JOBS Act. The proposed amendments would:
- Change the timing and frequency of Form D filings, including requirements for an advance filing and closing amendment;
- Require additional information about the issuer, its securities and investor characteristics to be included in the Form D filing;
- Automatically disqualify an issuer from relying on Rule 506 for one year for any new offering if the issuer, any predecessor of the issuer, or any affiliate of the issuer has failed to comply with all of the Form D filing requirements in a Rule 506 offering within the last five years;
- Apply certain guidelines and requirements to the content of materials used in general solicitation, including the use of certain legends and the application of Rule 156 under the Securities Act to the general solicitation materials used by private funds in reliance on Rule 506(c); and
- For a period of two years, require issuers engaging in general solicitation to submit their written solicitation materials to the SEC on a nonpublic basis.
Comments on the proposed additional amendments are due 60 days after publication of the Additional Amendments Proposing Release in the Federal Register.
Effect on the Private Fund Market
It is anticipated that the new rules will substantially increase the scope of permitted fundraising activities for many private fund managers and materially change the fundraising landscape for the private fund industry. By lifting the ban on general solicitation and advertising, it is anticipated that the use of the Internet, advertisements published in newspapers and magazines, communications over broadcast television and radio, public seminars, and communications via unrestricted websites will be widely utilized as means to communication information about the offerings of private funds. These sources of solicitation and advertisement present an opportunity for issuers to present information to investors who have previously been outside their traditional networks and to promote their name recognition and brand.
Notwithstanding the foregoing, the prohibition against general solicitation in private fund offerings has been in place for decades and has been integrated into the regulatory regimes at the various state, federal and international levels. Issuers utilizing the 506(c) safe harbor exemption should understand the increased responsibilities in connection with the due diligence of prospective investors, as well as understand how the new rules may affect the issuer’s compliance with other regulations. Fund managers are cautioned that the new rules only provide exemptions under the Securities Act, but do not alter the registration and reporting requirements, or exemptions therefrom, under the Investment Company Act of 1940, as amended, or the Investment Advisers Act of 1940, as amended. Based on the proposed amendments to Form D, Regulation D, and Rule 156, it is likely that the SEC intends to closely monitor the use of general solicitation and general advertising and its impact.
The new rules under Rule 506 and 144A will take effect 60 days after publication in the Federal Register.