On August 29, 2012, the U.S. Securities and Exchange Commission (the “Commission”) announced proposed rules eliminating the prohibition on general solicitation and advertising in offerings under Rule 506 of Regulation D under the Securities Act of 1933 (the “Act”) provided that all purchasers of securities are accredited investors and the issuer has taken reasonable steps to verify that all purchasers are accredited investors. The rules also propose eliminating the prohibition on general solicitation and advertising in Rule 144A offerings, provided that all purchasers of securities and persons acting on their behalf are qualified institutional buyers (“QIBS”). The proposed rules were promulgated by the Commission to comply with the requirements of Section 201(a) of the Jumpstart Our Business Startups Act (otherwise known as the JOBS Act). The proposed rules can be found here. Until final rules are adopted and become effective, general solicitation and advertising in connection with Rule 506 and Rule 144A offerings remains prohibited.
Rule 506 is a safe-harbor under Section 4(a)(2) of the Act which exempts transactions "not involving any public offering" from the Act's registration requirements. Under Rule 506, as it currently exists, an issuer may offer and sell securities to accredited investors and to no more than 35 sophisticated non-accredited investors so long as there is no general solicitation or advertising by the issuer or any person acting on their behalf in connection with the offering. General solicitation and advertising have been found to include advertisements (including magazines, newspapers, television, radio and the internet) and seminars whose attendees have been invited through such general solicitation or advertising.
An "accredited investor" is defined under Rule 501 of Regulation D as an investor who meets certain income or asset requirements that permit them to invest in certain types of higher-risk investments, as unregistered sales of securities under Regulation D are seen as being. An individual is deemed to be an "accredited investor" if he or she has annual income of at least $200,000 (or $300,000 in conjunction with the individual's spouse) for the prior two years or has a net worth of at least $1 million, excluding the value of the individual's residence. Certain companies, partnerships and trusts also qualify as “accredited investors,” and information about entities that qualify as “accredited investors” can be found here.
Rule 144A is a similar safe harbor exempting from the registration requirements of the Securities Act the resale of certain "restricted securities" (which include securities acquired directly or indirectly from the issuer in a chain of transactions not involving a public offering) to QIBs. Rule 144A by its terms is limited to resale transactions, but it is often used for capital-raising by issuers through sales of securities to a financial intermediary, who then resells such securities to QIBs under Rule 144A. A QIB is defined as an institution that manages at least $100 million in securities from issuers not affiliated with the institution, and, if the institution is a bank or savings and loan thrift, it must have a net worth of at least $25 million.
The Proposed Rules
On April 5, 2012, President Obama signed the JOBS Act into law. The purpose of the JOBS Act is to encourage capital formation by small companies. Section 201(a) of the JOBS Act directs the Commission to amend Rule 506 and Rule 144A to eliminate, under certain circumstances, the prohibition on general solicitation and advertising in such offerings.
In response, the Commission has proposed Rule 506(c) under Regulation D, permitting general solicitation and advertising in the offer and sale of securities under Rule 506 provided that certain conditions are satisfied:
- all purchasers of securities must be accredited investors, or the issuer must reasonably believe that all purchasers of securities are accredited investors;
- the issuer must take reasonable steps to verify the accredited investor status of all purchasers; and
- all other required terms of Regulation D, including Rule 501 and Rules 502(a) and 502(d), must continue to be satisfied.
The new rules are intended to be non-exclusive, and the safe-harbor exemption from the registration requirements of the Act contained in old Rule 506 are continued, such that offerings to accredited investors and up to 35 sophisticated non-accredited investors where there is no general solicitation and advertising in connection with the offering of the securities continue to be exempt from the registration requirements of the Act.
The proposed rules provide guidance on what constitutes an issuer taking "reasonable steps" to verify accredited investor status. However, the Commission has not established specific steps that must be taken to verify accredited investor status, with the view that the flexibility of a facts and circumstances approach is needed to accommodate different types of issuers and different types of accredited investors and is therefore the best approach under the circumstances.
The Commission did, however, provide some examples in the proposing release of facts that issuers might consider in verifying that a potential purchaser of securities is an accredited investor:
- The first example provided by the Commission considers the nature of the purchaser and the type of accredited investor the purchaser claims to be. For example, the Commission suggested that if a purchaser claims to be an accredited investor by virtue of its being a registered broker-dealer, reasonable inquiry would include checking with FINRA to determine whether the investor is indeed a registered broker-dealer. Other types of accredited investor claims would require other levels of inquiry, and the Commission has stated that it recognizes the difficulty that may be seen in investigating whether an individual is an accredited investor, due to privacy concerns as to the investor's personal financial information. As a result, the Commission has stated that it is a facts and circumstances test as to whether an individual buyer is an accredited investor.
- The second example provided by the Commission considers the amount and type of information that an issuer has about the proposed purchaser. The more information the issuer has indicating that an investor is an accredited investor, the fewer steps that it would need to take to verify accredited investor status, and vice versa. The types of information the Commission discussed in its release include: (i) publicly available information (for example, if an individual is a named executive officer of a registered issuer and the registrant's proxy statement sets forth the individual's income for the prior three fiscal years; or if the investor is a 501(c)(3) organization and the issuer looks at such organization's publicly disclosed Form 990 to determine whether it meets the accredited investor definition of having $5 million in total assets); (ii) third party information (for example, if an individual is a natural person and provides copies of his or her most recent Form W-2 to show income levels); and (iii) other third party verification, so long as the issuer has a reasonable basis to rely on such verification.
- The third example provided by the Commission looks at the nature and terms of the offering. An issuer that solicits new investors through a website accessible to the general public or through broadly available social media sites would be required to take greater verification steps than, for example, an issuer that solicits new investors pre-screened by a reasonably reliable third party, such as a registered broker dealer. The Commission stated that in an internet solicitation, an issuer would not be seen as having taken reasonable steps if it relies on a questionnaire filled out by the potential investor, while in the case of a more limited solicitation, coupled with the issuer having a reasonable basis to rely on a reliable third party's pre-screening, the issuer might be seen as having taken reasonable steps if it relies on such a questionnaire. The Commission also stated that the terms of the offering may affect whether the verification methods used by the issuer are reasonable. For example, a high minimum offering would be relevant to the issuer's evaluation, since the ability of an investor to satisfy a high minimum investment amount (sufficiently high such that it is likely that only accredited investors would be able to participate) could be taken into consideration.
An issuer looking to take advantage of the new general solicitation and advertising rules should be careful to keep adequate records regarding its determination of accredited investor status, consistent with the general principle that an issuer claiming an exemption from the registration requirements of the Act has the burden of showing that they qualify for the exemption.
Modification of Form D
The proposed rules would modify Form D, the notice form for offerings made without registration under reliance on Regulation D, including Rule 506. Under the proposed rules, a check box would be added to indicate whether the issuer is claiming an exemption under Rule 506(c) from the general solicitation rules. This would be separate from the box indicating that the issuer claims exemption under Rule 506 generally. Consistent with current rules (at least for now), the filing of a Form D will not be a condition to the availability of the safe harbor.
This change to Form D will, among other things, assist the Commission and its Staff in monitoring the use of general solicitation in Rule 506 offerings and the size of that market.
Integration with Offshore Offerings and Offerings by Private Funds
In the proposing release, the Commission confirmed that offshore offerings pursuant to Regulation S and concurrent Rule 144A/Rule 506 offerings will not be integrated. Further, under the proposed rules, since offerings under Rules 506(c) with general solicitation and advertising will continue to be defined as “private offerings,” under Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act of 1940 privately offered investment funds will be allowed to utilize amended Rule 506 without losing their ability to rely on these exemptions from registration as an investment company.
Commentary on the Proposed Rules
The Commission made clear that in proposing these rules, it is taking a narrow action strictly intended to comply with the requirements of Section 201(a) of the JOBS Act. Thus, many issues associated with private offering reform that have been suggested for consideration over the last few years are not discussed or dealt with in the proposed rules. In the same vein, two Commissioners (one of who voted for the proposed rules and one of whom voted against the proposed rules) have suggested that the proposed rules do not further the interests of investors or provide reasonable measures to protect investors from fraud. Further, two Commissioners who voted for the proposed rules were upset that the Commission had issued proposed rules rather than interim final rules (since the Commission did not satisfy the Congressional mandate that the Commission adopt final rules to implement Section 201(a) of the JOBS Act by July 4, 2012). Finally, many issuers will be disappointed that the proposed rules do not provide bright guidelines as to the steps that need to be taken to support a proposed unregistered offering using general solicitation and advertising.
Additionally, issuers should recognize that while offerings under proposed Rule 506(c) are exempted from the registration requirements of the Act, they are not exempted from the anti-fraud rules. Thus, unregistered offerings will continue to be subject to the anti-fraud provisions of the securities laws which, among other things, prohibit untrue statements of material facts or omissions to state material facts required to make the statements are that are made not misleading in connection with the offer and sale of securities. Additionally, issuers should recognize that while offers and sales of securities under Rule 506 are preempted from state blue sky laws by Section 18 of the Act (other than the fee and notice requirements), the non-prescriptive approach to the reasonable steps requirements in the proposed rules leaves open the door to state blue sky law claims challenging compliance with Rule 506 because the issuer did not take reasonable steps to verify the accredited investor status of purchasers in the offering.
Finally, we are reticent to conclude the ultimate impact of these proposed rules on the private offering market. Some will argue that the proposed rules may represent the first step towards fundamental change in the way that unregistered offerings are conducted (opening the door to broadly marketed unregistered offerings and sales of securities to "accredited investors"). However, time and politics will tell whether these proposed rules represent steps towards fundamental change or something substantially less than that.
The proposed rules have a 30-day comment period, and it is likely that the Commission will finalize these proposed rules late this year or in early 2013. We also anticipate that various organizations will begin to publish information about what they view as reasonable steps to verify that all purchasers in an unregistered offering are accredited investors, which will hopefully provide more specific guidance that issuers can follow. Further, since the Staff of the Commission has reported that they will be studying the steps that issuers are taking to verify accredited investor status, we would hope that over time the Staff will publish guidance as to its views on whether certain steps in certain circumstances are or are not sufficient under those circumstances.