The Securities and Exchange Commission (the “SEC” or the “Commission”) on Aug. 3, 2007, issued a proposing release (the “Proposing Release”) regarding amendments to Regulation D under the Securities Act of 1933. The proposed amendments would, among other things: (a) amend the definition of “accredited investor” under Rule 501(a) of Regulation D to add an alternative “investments owned” test to determine eligibility and to add new categories of entities covered as accredited investors; (b) add a new exemption, Rule 507 of Regulation D, that would relax some of Regulation D’s general advertising prohibitions for the offer and sale of securities solely to a new category of sophisticated investors called “large accredited investors”; and (c) apply a “bad actor” disqualification provision to all offerings under Regulation D. The SEC also requested additional comments on its Dec. 27, 2006, proposing release (the “Private Pooled Investment Vehicle Release”) to heighten investor qualification standards for investments in pooled investment vehicles by adding a new category of accredited investors called “accredited natural persons.”
Proposed Amendment of the Definition of “Accredited Investor”
The Commission has proposed amending the definition of “accredited investor” contained in Rule 501(a) of Regulation D, which serves as the investor qualification standard for issuers offering securities in reliance on the safe harbors provided in Rules 504 through 506 of Regulation D. With respect to individuals, the Commission has proposed adding an alternative “investments-owned” test to supplement the alternative income and net worth tests currently used to qualify an individual as an accredited investor. The proposed investments-owned test would allow an individual to qualify as an accredited investor if he or she has at least $750,000 in qualifying investments, excluding personal residences and places of business. Individuals could continue to qualify as accredited investors if they have more than $200,000 in income (or more than $300,000 in income combined with a spouse) or at least $1 million in net worth. With respect to entities referenced in Rule 501(a), the Commission has proposed an alternative investments-owned test that would allow entities to qualify if they own more than $5 million in investments. Entities could continue to qualify as accredited investors if they have at least $5 million in assets as set forth in Rule 501(a). To address the effects of inflation, the Commission has proposed adjusting the investment thresholds starting on July 1, 2012, and every five years thereafter.
The Commission also has proposed adding a number of entities that may qualify as accredited investors if they satisfy Regulation D’s investor qualification standards. While the current list of entities includes not-for-profit organizations, corporations, Massachusetts and similar business trusts and partnerships, it does not include limited liability companies, Indian tribes, labor unions, government bodies, and similar legal entities. To eliminate uncertainty about what entities may qualify as accredited investors, the Commission has proposed adding those entities not currently listed in Rule 501(a), as well as a “catch-all” category for all entities with “substantially similar legal attributes” to the listed entities.
Proposed Exemption for Limited Offers and Sales to “Large Accredited Investors”
In 2003, the staff of the SEC’s Division of Investment Management released a report of its fact-finding study titled “Implications of the Growth of Hedge Funds.” One of the staff’s recommendations was that the Commission consider eliminating the prohibition on general solicitation or advertising in offerings by Section 3(c)(7) hedge funds whose investors are required to be qualified purchasers. In the Aug. 3, 2007 Proposing Release, the SEC has proposed a relaxation of some of the advertising prohibitions imposed on certain Regulation D offerings, but specifically excluded from this exemption pooled investment vehicles that rely on the exclusion from the definition of an “investment company” contained in Section 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”). Proposed Rule 507 provides that if purchasers of securities are limited to “large accredited investors,” a “tombstone” ad may announce the issuer’s name and provide a brief description of the issuer’s business and the issuer’s contact information. The exclusion of 3(c)(1) and 3(c)(7) funds from the proposed exemption is made explicit in the Proposing Release. Rules 504 through 506 of Regulation D were adopted as safe harbor provisions under Section 4(2) of the Securities Act, which exempts private offerings of securities from the Securities Act’s registration requirements. Pooled-investment vehicles often rely on Section 4(2) (by utilizing Rules 504 through 506) as the basis for satisfying the Section 3(c)(1) and Section 3(c)(7) requirement that an offering must be a private, not public, offering. Proposed Rule 507, however, would be adopted using the Commission’s general rule-making authority granted under Section 28 of the Securities Act. Because Section 4(2) does not serve as the basis for the Commission’s rule-making authority with respect to Rule 507, pooled investment vehicles would not be eligible to utilize this exemption while simultaneously relying on Section 3(c)(1) or 3(c)(7). In the Proposing Release, the SEC indicated that it specifically avoided rule-making under Section 4(2) so that there would not be advertising in connection with offerings under Section 4(2): “Because some advertising would be permitted in Rule 507 transactions, we have chosen not to propose the exemption under Section 4(2) of the Securities Act, which the Commission in the past has viewed as incompatible with a non-public offering under Section 4(2).”
To qualify as a “large accredited investor” under the proposed exemption, a natural person must satisfy at least one of the following requirements: (a) have an individual annual income of more than $400,000 (or joint income with a spouse of more than $600,000) in the last two years with an expectation of achieving such income in the current year; or (b) own more than $2.5 million in qualifying investments.1 Entities that have at least $5 million in assets that qualify as “accredited investors” pursuant to Rule 501(a) under Regulation D would also be required to own more than $10 million in investments in order to qualify as “large accredited investors.” Additionally, banks, registered investment companies, private business development companies, and other regulated entities identified in Rule 501(a)(1) and (2) that are not subject to an assets test to qualify for accredited investor status also would qualify for large accredited investor status without being subject to an income, assets, or investments requirement. Note that, unlike Rule 506, which permits offers and sales to up to 35 non-accredited investors, Rule 507 requires that all purchasers must be “large accredited investors.”
Proposed “Bad Actor” Disqualification Provision
The Commission has proposed to adopt new Rule 502(e) to extend disqualification provisions, currently only applicable to Rule 505 offerings, to all offerings made in reliance on Regulation D to disqualify certain “bad actors” from repeatedly offering or selling securities in reliance on Regulation D. The rule would subject the following entities to the disqualification provision: (a) the issuer, any predecessor of the issuer, and any affiliated issuer; (b) any director, executive officer, general partner, or managing member of the issuer; (c) any beneficial owner of 20 percent or more of any class of the issuer’s equity securities; and (d) any promoter connected with the issuer. Note that broker-dealers, underwriters and placement agents are not covered by the proposed disqualification provision.
The disqualification provision would apply to a covered person if such covered person: (a) filed a registration statement within the last five years that is the subject of a currently effective permanent or temporary injunction or an administrative stop order; (b) was convicted of a criminal offense in the last 10 years that was in connection with the offer, purchase or sale of a security or involved the making of a false statement with the Commission; (c) has been subject to an adjudication or determination within the last five years by a federal or state regulator that the person violated federal or state securities or commodities law or a law under which a business involving investments, insurance, banking or finance is regulated; (d) is subject to an order, judgment or decree by a court entered within the last five years that restrains or enjoins the issuer or a person from engaging in any conduct or practice involving securities and other similar businesses, including an order for failure to comply with Rule 503; (e) is subject to a cease-and-desist order entered within the last five years issued under federal or state securities or similar laws; or (f) is subject to a suspension or expulsion from membership in or association with a member of a national securities exchange or national securities association for an act or omission constituting conduct inconsistent with just and equitable principles of trade.
The proposed amendment would be a significant expansion of the disqualification provision and might affect a large number of firms. While the proposed amendment specifies that the Commission would be permitted to waive the disqualification “upon a showing of good cause,” it does not provide any detail as to how the process for obtaining such a waiver would work. The SEC has requested comment on the proposed amendment, asking, inter alia, how many issuers will be affected by the disqualification provision, and whether some alternative to disqualification might be equally effective, such as mandatory disclosure of the prior order, conviction or censure.
Further Comment Sought on the Proposed “Accredited Natural Person” Rule
In December 2006, the SEC proposed new rules regarding persons investing in a private fund that relies on Section 3(c)(1) of the Investment Company Act, which exempts from registration vehicles not offered publicly and held by no more than 100 beneficial owners. Rule 506 of Regulation D provides that a 3(c)(1) fund can have 35 non-accredited investors, but the remainder must meet the “accredited investor” criteria: natural persons with annual income in excess of $200,000 (or joint income with a spouse of $300,000) or a personal net worth (or joint net worth with a spouse) of $1 million. The rules proposed in the Private Pooled Investment Vehicle Release would require that investors also meet the criteria for being an “accredited natural person”: an individual with $2.5 million in securities and financial holdings, excluding the value of personal residences and places of business.
The Aug. 3, 2007 Proposing Release acknowledges the negative commentary received by the SEC in response to the proposed rules, and requests additional comments. Specifically, the Commission asks whether the threshold for qualifying as an “accredited natural person” should be higher or lower than the proposed $2.5 million in investments. One option noted in the Proposing Release would be to use the same thresholds being proposed for the definition of “large accredited investor” in proposed Rule 507 (income of $400,000, or $600,000 with one’s spouse, or investments of $2.5 million).
Other Proposed Revisions
The Commission has also sought comment on a number of other proposals, including: (a) revisions to Rule 504 of Regulation D, an exemption limited to offerings by non-reporting companies that do not exceed an aggregate annual amount of $1 million; (b) conforming changes to Rule 215’s definition of “accredited investor” to conform with that contained in Rule 501(a); and (c) adjusting the safe harbor time frame between offerings, so that two offerings will not be treated as integrated into a single offering as long as they are 90 days or more apart (the existing rule requires that offerings be 180 days apart to avoid being treated as a single offering). Comments on all aspects of these proposals were due on Oct. 9, 2007