In the past two weeks, the U.S. Securities and Exchange Commission (SEC) has issued two long-awaited final rules amending Rule 506, the most widely used Regulation D exemption from registration of securities offerings. 

The first of these rules, implementing a change mandated by last year’s Jumpstart Our Business Startups Act (“JOBS Act”), eliminates the long-standing prohibition against general solicitation and advertising in Rule 506 provided that all purchasers of the securities are accredited investors.

The second rule, implementing a change mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), amends Rules 501 and 506 and Form D to disqualify felons and other ‘bad actors’ from Regulation D offerings.

These rules are expected to become effective on September 23, 2013, 60 days after their publication in the Federal Register.

Changes Permitting General Solicitation in Regulation D Offerings

The rule allowing “general solicitation” and “general advertising” of Regulation D offerings was mandated by Section 201(a) of the JOBS Act.  While neither “general solicitation” nor “general advertising” is defined, the final rule adopted by the SEC has interpreted general solicitation and general advertising to mean advertisements “published in newspapers and magazines, communications broadcast over television and radio, and seminars where attendees have been invited by general solicitation or general advertising.  Further, the SEC has “confirmed that other uses of publicly available media, such as unrestricted Web sites, also constitute general solicitation and general advertising.”  The implemented rule adds a sub-section (c) to Rule 506 which lists particular conditions for permitting the use of general solicitation to offer and sell securities pursuant to this rule.  The new Rule 506(c) requires issuers to take “reasonable steps” to verify the accredited investor status of purchasers but recognizes that whether the steps are reasonable is an objective determination by the issuer in the context of the particular facts and circumstances of each purchaser and transaction. The rule provides a non-exhaustive list of factors issuers should consider as part of this analysis, including:

  • 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 final rule release provides detailed commentary on each of these factors.

The new rule also lists four non-exclusive methods of specific verification to supplement what the SEC has termed the “principles-based framework” for verifying accredited investor status.  The listed methods are not required and issuers may still use the broader “reasonableness” standard described above.  The four methods are:

  • Reviewing tax records of individuals for the two most recent years along with a written representation from the individual that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
  • Reviewing third-party documentation from the prior three months such as bank and brokerage statements, tax assessments, appraisal reports, and credit reports that identify the potential purchaser’s net worth, including assets and liabilities, together with a written representation from the individual that all liabilities necessary to make a determination of net worth have been disclosed;
  • Obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that such individual has taken reasonable steps to verify that the potential purchaser is an accredited investor within the prior three months and has determined that the potential purchaser is an accredited investor; and
  • Regarding an existing investor who qualified as an accredited investor prior to the effective date of the new rule 506(c), obtaining a certification by the investor at the time of sale that he or she qualifies as an accredited investor.

The SEC further noted in its release that the “reasonable” steps necessary for the verification requirement would not be satisfied if the potential investor merely “check[s] a box in a questionnaire or sign[s] a form, absent other information about the purchaser indicating accredited investor status.”

Changes Disqualifying Felons and Other ‘Bad Actors’ from Regulation D Offerings

The rule disqualifying “bad actors” from Regulation D offerings was mandated by Section 926 of the Dodd-Frank Act.  Under the new rule, an issuer cannot take advantage of the Rule 506 exemption if the issuer or any other covered person had a “disqualifying event” (see below).  “Covered persons,” as defined under Rule 506(d), include:

  • The issuer and any predecessor of the issuer or affiliated issuer;
  • Any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
  • Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • Any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;
  • Any promoter connected with the issuer in any capacity at the time of the sale;
  • Any person that has been or will be paid renumeration (directly or indirectly) for solicitation of purchasers in connection with sales of securities in the offering; and
  • Any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.

The list of “disqualifying events” is substantial and includes the following:

  • Criminal convictions entered within the last five years in the case of issuers and 10 years in the case of other covered person, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Final orders issued by state securities commission, state banking, credit union, and insurance regulators, federal banking regulators, the CFTC and the NCUA that either create a bar from association with any entity regulated by the regulator or from engaging in the business of securities, insurance of banking or from savings association or credit union activities, or are based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last 10 years;
  • SEC disciplinary orders entered pursuant to Sections 15(b) or 15B(c) of the Exchange Act or Section 203(e) of the Advisers Act that suspends registration as a broker, dealer, municipal securities dealer or investment adviser, or place limitation on the activities, functions, or operations of such person or bar such person from association with any entity or from participating in the offering of penny stock;
  • SEC orders entered within the last five years that order the person to cease and desist from committing violations of any scienter-based anti-fraud provision of the federal securities laws;
  • Suspension or expulsion from membership in an SRO;
  • Stop orders applicable to a registration statement within the past five years; or
  • U.S. Postal Service false representation orders within the past five years.

The new rule provides an exception from disqualification if the issuer can establish that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event was involved in the offering.  The rule also only applies to disqualifying events that occur after the effective date of the new rule. The rule provides, however, that any pre-existing disqualifying events known to the issuer give rise to a disclosure requirement to investors.