Effective September 23, 2013, the Securities and Exchange Commission (the SEC) lifted the ban on general solicitation of unregistered offerings relying on Rule 506 or Rule 144A under the Securities Act of 1933, as amended (the Securities Act), and adopted a rule prohibiting certain “bad actors” from participating in such offerings.1  In July of this year, the SEC also proposed a new rule and form amendments that seek to monitor the advertising practices of such offerings.2  This Legal Alert summarizes certain recent SEC developments related to these offerings, including guidance related to the “bad actors” rule when conducting a general solicitation.

I. General Solicitation Q&As

On November 13, 2013, the SEC’s Division of Corporation Finance (the Division) issued new Compliance and Disclosure Interpretations (C&DIs) that provide guidance on unregistered offerings made under recently amended Rules 506(c) and 144A. The most helpful aspects of these new C&DIs are summarized below.

Switching Between 506(b) and 506(c) Offerings

  • An issuer that began a Rule 506 offering prior to the September 23, 2013, effective date of Rule 506(c), and now wishes to take advantage of the general solicitation provided under Rule 506(c), must file an amended Form D to indicate that the issuer is now relying on Rule 506(c).  An issuer continuing to rely on Rule 506(b) after September 23, 2013, need not file any amendments to any previously filed Form D.
  • An issuer that commenced an offering intending to rely on Rule 506(c) but did not engage in any form of general solicitation may switch to a Rule 506(b) offering, provided the issuer files an amended Form D indicating its reliance on Rule 506(b) instead of Rule 506(c).
  • An issuer that commenced an offering in reliance on Rule 506(b), but wishes to switch to a Rule 506(c) offering prior to any sales of securities in the offering, may do so if the conditions of Rule 506(c) are satisfied with respect to all sales in the offering, and the issuer’s Form D is amended to reflect its reliance on Rule 506(c) instead of Rule 506(b).
  • An issuer that has engaged in general solicitation but is not eligible to rely on Rule 506(c) cannot rely on the Securities Act Section 4(a)(2) private offering exemption, because the use of general solicitation is not permitted under Section 4(a)(2).

Verification of Accredited Investor Status Under Rule 506(c)

  • An issuer does not lose the ability to rely on Rule 506(c) if, subsequent to a sale of securities, it becomes known that a purchaser was not an accredited investor at the time of sale, provided the issuer took reasonable steps to verify the accredited investor status of the purchaser and formed a reasonable belief that the purchaser was an accredited investor at the time of sale.
  • Even if all of the purchasers of an offering under Rule 506(c) qualify as accredited investors, the issuer loses the ability to rely on Rule 506(c) if it did not take reasonable steps to verify the accredited investor status of such purchasers.  This is because the verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors.
  • In order to comply with the net worth verification method provided in Rule 506(c), the relevant documentation must be dated within three months prior to the sale of securities.  If the documentation is older than three months, the issuer may not rely on the net worth verification method.
  • Issuers employing the third-party verification method provided in Rule 506(c) may utilize and rely on written confirmations from an attorney or certified public accountant that is licensed or duly registered, as the case may be, in good standing in either a foreign jurisdiction or in the United States.
  • The provision in Rule 506(c) relating to existing investors in a 506 offering is not available to new issuers that have the same sponsor as the issuer in which the investor purchased securities in a prior Rule 506(b) offering (i.e., this provision is not available to an investor in a private fund with respect to the investor’s investment in another private fund sponsored by the same investment adviser that also sponsored the first private fund).

General Solicitation Under Rule 144A

  • In a Rule 144A offering, the issuer is not the only entity that can engage in general solicitation.  Initial purchasers and the other distribution participants involved in the offering may also engage in general solicitation.

II. “Bad Actor” Q&As

On December 4, 2013, the Division again issued new C&DIs, this time providing guidance on the scope of the “bad actor” disqualification4 and disclosure5 provisions in Rules 506(d) and 506(e).  We summarize these new C&DIs below.  We first note the following, however, about these C&DIs:

Under Rule 506(d), if “any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power” is a bad actor for purposes of the rule, then the issuer’s offering is disqualified from reliance on the exemptions provided by Rule 506.  While it had been anticipated that the Division would provide guidance on how this aspect of the rule applies in the context of private fund offerings, no such guidance was provided in the new C&DIs.

Covered Persons for Purposes of “Bad Actor” Disqualification Under Rule 506(d)

  • Rule 506(d) provides that if “any affiliated issuer” is deemed a bad actor for purposes of the rule, the offering is subject to disqualification.  The Division clarified in the C&DIs that an “affiliated issuer” does not mean every affiliate of the issuer that has issued securities.  Rather, under Rule 506(d) an “affiliated issuer” means an affiliate of the issuer that is issuing securities in the same offering, including offerings subject to integration pursuant to Rule 502(a) of Regulation D.
  • Issuers must only determine if they are subject to bad actor disqualification when they are offering or selling securities in reliance on Rule 506.  An issuer that is not offering securities, such as a fund that is winding down and is closed to investment, need not determine whether Rule 506(d) applies unless and until it commences a Rule 506 offering.
  • An issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to, for example, contractual covenants, bylaw requirements, or an undertaking in a questionnaire or certification. However, if an offering is continuous, delayed or long-lived, the issuer must update its factual inquiry periodically through bring-down of representations, questionnaires and certifications, negative consent letters, periodic rechecking of public databases, and other steps, depending on the circumstances.
  • If a placement agent or one of its covered control persons, such as an executive officer or managing member, becomes subject to a disqualifying event while an offering is still ongoing, the issuer may continue to rely on Rule 506 for that offering if it terminates the engagement with the placement agent and does not pay the placement agent compensation for future sales.  Alternatively, if the triggering disqualifying event only affects the covered control persons of the placement agent, the issuer can continue to rely on Rule 506 for that offering if such persons are terminated or are reassigned to roles that would not cause them to be covered persons for purposes of Rule 506(d).
  • All persons who have been or will be paid, directly or indirectly, remuneration for solicitation of purchasers are covered by Rule 506(d), regardless of whether they are, or are required to be, registered as broker-dealers under the Exchange Act or are associated persons of registered broker-dealers.
  • The term “participating” in Rule 506(d) does not include a person whose sole involvement with a Rule 506 offering is acting as a member of a compensated solicitor’s deal or transaction committee that is responsible for approving such compensated solicitor’s participation in the offering.
  • “Participating” in an offering for purposes of Rule 506(d) is not limited to solicitation of investors.  Examples of participation in an offering include participating in due diligence activities or preparing offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors, or other offering participants about the offering.  To constitute participation for purposes of the rule, such activities must be more than transitory or incidental.  Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering

Disqualifying Events Under Rule 506(d)

  • Disqualification under Rule 506(d) is not triggered by actions taken in jurisdictions other than the United States, such as convictions, court orders, or injunctions in a foreign court, or regulatory orders issued by foreign regulatory authorities.
  • Disqualification under Rule 506(d)(1)(v) is triggered only by orders to cease and desist from violations of scienter-based provisions of the federal securities laws, including scienter-based rules.  An order to cease and desist from violations of a non-scienter-based rule would not trigger disqualification, even if the rule is promulgated under a scienter-based provision of law.  For example, an order to cease and desist from violations of Exchange Act Rule 105 would not trigger disqualification, even though Rule 105 is promulgated under Exchange Act Section 10(b).
  • Because the provisions of Rule 506(d)(2)(iii) are self-executing, it would not be necessary to seek a waiver from the SEC or to take any other action to confirm that bad actor disqualification will not apply as a result of an order by a court or regulator providing that disqualification from Rule 506 should not arise as a result of the order.
  • Rule 506(d) provides for a “reasonable care” exemption which applies whenever the issuer can establish that it did not know and, despite the exercise of reasonable care, could not have known that a disqualification existed under Rule 506(d)(1).  This may occur when, despite the exercise of reasonable care, the issuer was unable to determine the existence of a disqualifying event, was unable to determine that a particular person was a covered person, or initially reasonably determined that the person was not a covered person but subsequently learned that determination was incorrect. Issuers will still need to consider what steps are appropriate upon discovery of Rule 506(d) disqualifying events and covered persons throughout the course of an ongoing Rule 506 offering. An issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide Rule 506(e) disclosure, or take such other remedial steps to address the Rule 506(d) disqualification.

Disclosure of Past Disqualifying Events Under Rule 506(e)

  • The SEC will not provide any waivers with respect to the disclosure obligation under Rule 506(e).
  • Rule 506(e) does not require disclosure of past events that would no longer trigger disqualification under Rule 506(d), such as a criminal conviction that occurred more than 10 years before an offering or an order or bar that is no longer in effect at the time of an offering.
  • In an offering in which the issuer uses multiple placement agents or other compensated solicitors, the issuer does not fulfill its disclosure obligation under Rule 506(e) by providing disclosure with respect to the particular compensated solicitor or placement agent and its covered control persons (i.e., general partners, managing members, directors, executive officers, and other officers participating in the offering) only to those investors that were solicited by such solicitor or placement agent.  Issuers are required to provide all investors with the Rule 506(e) disclosure for all compensated solicitors that are involved with the offering at the time of sale and their covered control persons.
  • An issuer is not required to provide disclosure under Rule 506(e) for all solicitors that were ever involved during the course of a continuous offering.  Disclosure need only be provided with respect to compensated solicitors that are involved at the time of sale. Disclosure with respect to compensated solicitors that are no longer involved with the offering need not be provided under Rule 506(e) in order for the issuer to be able to rely on Rule 506.

III. Chair White Letter to Congressman McHenry

Section 413(b)(2)(A) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) requires the SEC to undertake a review of the definition of “accredited investor” in Regulation D under the Securities Act by July 2014.  On October 30, 2013, Congressman Patrick T. McHenry, Chair of the House Oversight and Investigations Subcommittee, sent a letter to SEC Chair Mary Jo White asking several questions regarding the SEC’s review of the accredited investor definition.  Chair White responded to Chairman McHenry’s questions in a letter dated November 15, 2013.6 The more notable points from Chair White’s letter are summarized below.

Non-Income or Net Worth Based Qualification for Accredited Investor Status

  • In her letter, Chair White was receptive to Chairman McHenry’s suggestion that certain certifications and educational backgrounds provide an independent basis to qualify as an accredited investor.  Chair White specifically stated that professional certifications, such as a Certified Public Accountant (CPA) or Chartered Financial Analyst (CFA), are among the potential supplemental or alternative criteria for qualifying as an accredited investor that the SEC staff is considering as part of its review.  In addition, Chair White acknowledged that holding a particular certification or license, such as a CPA, CFA, or a securities license, or a degree in business, finance, accounting or economics, could provide an individual with the knowledge and sophistication necessary to qualify as an accredited investor.  With that said, Chair White also acknowledged the position that an academic background, on its own, would not be sufficient to qualify as an accredited investor
  • Similarly, Chair White noted that the SEC staff, as part of its review, is considering Chairman McHenry’s suggestion that experienced financial professionals, such as registered representatives, investment adviser representatives,7 consultants, brokers, traders, portfolio managers, analysts, compliance staff, legal counsel and regulators, be permitted to independently qualify as accredited investors, regardless of their net worth.

Guidance for Offerings Currently Relying on Rule 506(c)

  • Chair White clarified that issuers engaging in private offerings under Rule 506(c) are not required to comply with any of the Proposing Release’s proposed rule amendments until such time as the SEC approves such rule amendments and such amendments become effective.  Chair White also noted that if the SEC ultimately decides to adopt the Proposing Release’s proposed amendments, the final rules would consider the need for transitional guidance for ongoing offerings that commenced before the effective date of the final rules.

Investor Reliance on Qualified Brokers and Investment Advisers

  • In response to Chairman McHenry’s suggestion that reliance on a qualified broker or registered investment adviser should enable ordinary investors to participate in Rule 506 offerings, Chair White acknowledged that obtaining the advice of a professional adviser may enhance an investor’s ability to make an informed investment decision and therefore strengthen investor protection in Rule 506 offerings.  However, Chair White also cautioned that an investor’s use of such an adviser may not necessarily measure the investor’s understanding of the risks of the investment.