On August 29, 2012, the Securities and Exchange Commission (SEC) proposed new rules that would, under certain circumstances, eliminate the bans on “general solicitation and general advertising” (hereafter referred to as “general solicitation”) in connection with securities offerings made to accredited investors or qualified institutional buyers (QIBs) pursuant to either Rule 506 of Regulation D or Rule 144A of the Securities Act of 1933.
Some commentators have suggested that under these proposals, private placements under Rule 506 or Rule 144A will soon become, essentially, public offerings to accredited investors and QIBs.
The proposals would also allow hedge funds and other private investment funds to market their products to wealthy individuals in a more public manner. As a result, private companies looking to raise capital could soon have a path to funding through public marketing to accredited investors, but not yet to a “crowd” of ordinary subscribers.
“I believe that the proposed rules fulfill Congress’s clear directive that issuers be given the ability to communicate freely to attract capital, while obligating them to take steps to ensure that this ability is not used to sell securities to those who are not qualified to participate in such offerings,” said SEC Chairman Mary Schapiro.
Given the fact that the amount of capital raised in 2011 by means of Rule 506 and Rule 144A offerings, combined, was in excess of $1 trillion (compared to $984 billion raised in public offerings), these proposals could have a major impact on capital fundraising strategies for many companies.
What follows is a detailed summary of the proposed rules, which more generally would:
- Add a new private offering exemption, Rule 506(c), under Section 4(a)(2) of the Securities Act, available to any issuer that wishes to use general solicitation to offer securities only to accredited investors;
- Authorize and permit Rule 144A offerings by means of general solicitation under appropriate conditions;
- Clarify the legal status of such offerings when they are combined with concurrent offerings outside the U.S. pursuant to Regulation S;
- Authorize and permit privately offered funds, such as hedge funds, to utilize general solicitation under the conditions specified by the new rules; and Amend Form D, which must be filed in connection with Regulation D sales, in accordance with the proposals.
The rules were legislatively mandated by Section 201(a) of the Jumpstart Our Business Startups (JOBS) Act which was previously described in our April 2012 Securities Law Update entitled, “JOBS Act Makes It Easier to Raise Capital,” and available on our website here.
The full text of the 69-page SEC Release no. 33-9354 regarding relaxation of general solicitation bans (the “Release”) can be viewed here.
Public comments on the proposed rules are due to the SEC by October 5, 2012.
IMPETUS FOR PROPOSED RULES
The current version of Rule 506 exempts from public registration requirements any transaction by an issuer “not involving any public offering.” Under this rule, an issuer may offer and sell securities to an unlimited number of “accredited investors” (generally wealthy or institutional investors, as defined by Rule 501(a) of Regulation D) and to no more than 35 non-accredited investors who meet certain “sophistication” requirements.
This is a popular tool for capital-raising by issuers, but the availability of the Regulation D exemption is currently conditioned on the issuer not making use of any form of general solicitation, which includes material disseminated in newspaper and magazine advertisements, television and radio broadcasts, public seminars and Internet media, according to the SEC. Issuers generally must have some pre-existing substantive relationship with potential investors.
Issuers currently have another safe harbor from registration under Rule 144A for the resale of certain “restricted securities” (as defined by Rule 144(a)(3)) to QIBs, which are generally defined as large institutional purchasers by Rule 144A. This rule does not expressly prohibit general solicitation, but it does restrict offerings to QIBs only, and thus, is not compatible with the use of general solicitation.
Recognizing that these bans on general solicitation were impeding the ability of issuers to connect with accredited investors and QIBs, Congress passed the JOBS Act, which required the SEC to formulate rules that would: (1) permit general solicitation in Rule 506 offerings while insuring that sales are made only to accredited investors; and (2) allow offers of securities under Rule 144A by means of general solicitation, provided that the securities are sold only to persons that the seller or its agents reasonably believe to be QIBs.
PROPOSED AMENDMENTS TO RULE 506
To implement the mandated rule changes, the SEC proposed in the Release a new Rule 506(c), which would permit the use of general solicitation provided that certain conditions are satisfied. Those conditions are:
- The issuer must take reasonable steps to verify that each of the purchasers of the securities are accredited investors, as defined in Rule 501;
- All purchasers of the securities offered must qualify as accredited investors by rule, either because they come within one of the enumerated categories of persons that qualify, or because the issuer reasonably believes that they do qualify at the time of sale; and
- The issuer must comply with all terms and conditions of Rule 501, which defines “accredited investors” and other key concepts, Rule 502(a), which prohibits issuers from circumventing the rules by making multiple offerings that should be treated as one offering), and Rule 502(d), which places certain restrictions on resale of securities.
The SEC also clarified that new Rule 506(c) will not replace any existing rules, but will give issuers an alternative to complying with the terms of the current Rule 506(b), which would continue to prohibit general solicitation but allow for sales to 35 non-accredited investors.
Retaining the existing safe harbor may be beneficial to investors and issuers who might have positive pre-existing relationships, the Release explained.
1. “Reasonable Steps” to Verify Accredited Investor Status
The SEC has proposed that the determination of whether an issuer has taken “reasonable steps” to verify accredited investor status would be an objective but flexible determination, based on the particular facts and circumstances of each transaction.
Under this approach, the determination of whether an issuer has taken the required “reasonable steps” would depend on a number of factors, including:
- The “nature of the purchaser” and the type of accredited investor that the purchaser claims to be;
- The amount and type of “information • about the purchaser” that the issuer has; 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 any minimum investment amount.
1a. “Nature of the Purchaser”
Currently, Rule 501(a) defines an “accredited investor” to include both natural persons and entities that fall within one of eight enumerated categories based on:
- Their sophisticated financial status (such as a broker-dealer or investment company);
- Their combination of status and total assets (such as a state retirement plan with assets in excess of $5 million); or
- Their net worth or annual income (for individuals whose individual worth or joint net worth with a spouse exceeds $1 million, excluding any primary residence, or whose individual annual income has exceeded $200,000 in each of the two most recent years, or $300,000 together with a spouse’s income, and who has a reasonable expectation of reaching the same level in the current year).
The SEC stated that the “reasonable steps” for an issuer to take to verify a purchaser’s status should vary based on the type of accredited investor that the purchaser claims to be. For example, the steps to verify that an entity is a registered broker-dealer are necessarily simpler and more defined than the steps necessary to verify whether a natural person meets certain net worth or income tests.
“Reasonable steps” should not be defined by a bright-line test because so many factors are involved, the SEC asserted, elaborating further on other equally important factors described below.
1b. “Information about the Purchaser”
The more information that an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps the issuer should have to take to verify the purchaser’s proclaimed status, the SEC stated in the Release.
Examples of information that an issuer might reasonably rely upon, depending on facts and circumstances, could include:
- Publicly available information gleaned from filings with governmental bodies;
- Third-party information that provides reasonably reliable evidence, such as copies of W-2 Forms or data tables published in trade journals about average income earned in the workplace, trade or profession in an investor’s geographic locale.
1c. “Nature of the Offering” and “Terms of the Offering”
The nature of the offering, such as the means by which the issuer solicits its purchasers, may be relevant in determining the reasonableness of steps taken to verify investor status, the SEC added, noting for example, that an issuer which solicits investors through a public Website or social media portal should take greater measures to verify status than an issuer who solicits only from a database of investors pre-screened by a reliable third party, such as a broker-dealer.
Similarly, if an issuer knows little about an investor, but the terms of the offering require such a high minimum investment that a non-accredited investor could not make the purchase, then an issuer might not need to take any steps beyond ascertaining that a purchaser’s cash investment is not being financed through borrowing or pledges.
Again, in discussing the relevance of the nature and terms of an offering, the SEC reiterated that uniform verification methods would likely be ill-suited, inadequate or even unnecessary to a particular offering or purchaser, depending on the facts and circumstances.
Regardless of the steps taken, however, the SEC warned that “it would be very important for issuers to retain adequate records that document the steps taken to verify that a purchaser was an accredited investor [because the issuer] has the burden of showing that it is entitled to that exemption.”
2. “Reasonable Belief” That All Purchasers Are Accredited Investors
Both Rule 506 and Rule 144A currently require an issuer to have a “reasonable belief” regarding the eligibility of investors to participate in an offering, the SEC observed, concluding that an issuer should not lose the ability to rely on the proposed Rule 506(c) exemption so long as that issuer took “reasonable steps” to verify that its purchasers were accredited investors and had a “reasonable belief” that the purchasers were accredited. The SEC cited several federal court cases that were unsympathetic to investors who misrepresented their status to support this reasoning.
It should also be noted that any evidence of an issuer’s subjective doubt or non-belief in a purchaser’s purported accredited investor status might defeat an exemption, regardless of whether the issuer has taken reasonable steps to verify a purchaser’s representations.
PROPOSED AMENDMENTS TO RULE 144A
The SEC’s proposed amendments would allow resales of Rule 144A restricted securities by means of general solicitation, provided that “the securities are sold to a QIB or to a purchaser that the seller and any person acting on behalf of the seller reasonably believe is a QIB.” This means that offers can be made to both QIBs and non-QIBs (i.e., without checking prior to an offer being made that an offeree is a QIB), as long as actual sales are made only to QIBs. Under the current rules, Rule 144A does not expressly prohibit general solicitation, but offers of securities can only be made to QIBs, which has the same practical effect.
The SEC noted that Rule 144A already provides a list of non-exclusive methods of establishing a prospective purchaser’s ownership and investments of securities for purposes of determining whether the purchaser is a QIB, but invited further public comment on the adequacy of this non-exclusive list.
PROPOSED TREATMENT OF CONCURRENT OFFSHORE OFFERINGS
As a result of the mandate in Section 201(a) of the JOBS Act requiring that the SEC permit the use of general solicitation in transactions under Rule 506 and Rule 144A, a number of commentators raised questions about the impact of general solicitation upon concurrent unregistered offerings made pursuant to Regulation S.
Rule 902(c)(1) currently provides that “directed selling efforts” in a Regulation S offshore offering, which might be used to “condition” U.S. markets, could defeat a Regulation S exemption. Some commentators asked the SEC to confirm that the use of general solicitation in Rule 506 or Rule 144A offerings would not be deemed to constitute “directed selling efforts” by that issuer in connection with concurrent Regulation S offerings offshore. Others went further and asked the SEC to consider allowing general solicitation in Regulation S offerings.
The SEC simply responded that “concurrent offshore offerings that are conducted in compliance with Regulation S would not be integrated with domestic unregistered offerings that are conducted in compliance with Rule 506 or Rule 144A, as proposed.” No other guidance was provided in the Release.
PROPOSED TREATMENT OF PRIVATE FUNDS USING RULE 506(c)
The JOBS Act directed the SEC to eliminate the prohibition against general solicitation for a subset of offerings, but it made no specific reference to what impact a general solicitation would have on privately offered funds, such as hedge funds and venture capital funds.
These funds often rely on the Rule 506 safe harbor to offer and sell their interests to qualified purchasers without registration under the Securities Act. They can also legally avoid registration requirements of the Investment Company Act of 1940 (the “1940 Act”) if their securities are owned exclusively by “qualified purchasers,” or if their securities (other than short-term paper) are beneficially owned by not more than 100 owners and they are not making or proposing to make a “public offering” of their securities.
Because the SEC has historically regarded Rule 506 transactions as “non-public” offerings for purposes of the 1940 Act, it concluded that “the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the [1940 Act].” Section 201(b) of the JOBS Act provides that “[o]ffers and sales exempt under [Rule 506, as revised pursuant to Section 201(a)] shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.”
PROPOSED AMENDMENTS TO FORM D
In accord with the changes proposed to Rule 506, the SEC proposed to amend Form D to add a separate field or check box for issuers to indicate whether they are claiming an exemption under Rule 506(c). In addition, the current check box for Rule 506 would be renamed to apply to Rule 506(b), thus providing issuers with a mutually exclusive choice of Rule 506 exemptions.
Also, the current check box for Section 4(5) would be renamed to apply to Section 4(a)(5) to update the reference to that section of the Securities Act.
The SEC has not yet suggested any new rules related to the actual content that might be used in any general solicitation, but issuers are advised to check with counsel regarding possible content hazards that could affect their other securities-regulated activities.
Issuers should also be aware that the SEC is still in the process of promulgating rules that would limit the availability of Rule 506 exemptions for offerings that involve certain “bad actors.” Plans for any future offering should be made with the pendency of these rules in mind.