On July 10, 2013, the Securities and Exchange Commission adopted final rules implementing amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 to eliminate the prohibition on general solicitation and general advertising in effected under those rules, as required by Section 201 of the Jumpstart Our Business Startups Act (JOBS Act).1
The final rules:
Add a new, stand-alone registration exemption as Rule 506(c) permitting an issuer to use general solicitation and general advertising to offer securities, provided that:
- the issuer takes “reasonable steps to verify” that all purchasers of the securities are accredited investors; and
- all purchasers of the securities are the issuer to be accredited investors.
- Amend Rule 144A(d) to allow persons selling securities under Rule 144A’s resale registration exemption to use general solicitation and general advertising to offer securities, provided that each purchase buyer (“QIB”) as currently defined in the rule or (ii) a person the seller and any person acting on behalf of the seller reasonably believes is a QIB.
The SEC release adopting the final rules
- The exemption fromregulation as an investment company under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, commonly used by privately offered investment funds.
- The Securities Act registration exemption for offshore offerings conducted under Regulation S with a concurrent Rule 506 or 144A offer in which there is general solicitation or advertising.
Rule 506 Background. Rule 506 is a non-exclusive safe harbor which exempts transactions by an issuer “not involving any public offering” fromthe registration requirements of the Securities Act. Under Rule 506, an issuer may offer or sell an unlimited amount of securities to an unlimited number of “accredited investors.” The rule defines accredited investors to include banks, registered broker-dealers, registered investment companies, insurance companies, pension plans and high net-worth and high income individuals, among others. Rule 506 also permits an issuer to offer or sell securities to up to 35 non-accredited investors, if certain other specified conditions are satisfied. Prior to the amendments, an offering or sale of securities was only eligible for the Rule 506 safe harbor if there has been no general solicitation or general advertising in connection with the offer or sale. SEC rules and guidance have defined the terms “general solicitation” and “general advertising” to include public seminars, newspaper, magazine, television and radio advertisements, and publications made over other publicly available media, including un-password-protected websites.
The Jobs Act Mandate. Section 201(a) of the JOBS Act instructed the SEC tomodify Rule 506:
- to permit general solicitation or general advertising in offerings of securitiesmade under Rule 506, so long as all purchasers of the securities are accredited investors; and
- to require any issuer relying on Rule 506 to take reasonable steps to verify that purchasers of the securities are accredited investors.
The Final Rules. To implement the JOBS Act, the final rules add a new subsection (c) to Rule 506. It explicitly permits the issuer (and any selling agents) to use general solicitation to offer and sell securities under Rule 506, so long as the following conditions are satisfied:
- The issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors;
- All purchasersmust be accredited investors, either because they actually come within one of the categories in the definition of that termor because the issuer reasonably believes they do, at the time of the sale of the securities, in each case as defined under existing Rule 501; and
- All terms and conditions of existing Rules 501 (definitions), 502(a) (integration restriction) and 502(d) (resale limitations) of Regulation Dmust be satisfied. Existing Rule 502(c), prohibiting general solicitation and general advertising, would not apply to Rule 506(c) offers.
New Rule 506(c) does not affect the rest of Rule 506 as currently drafted. Thus, issuers may continue to rely on Rule 506 to offer and sell securities to accredited and non-accredited investors, so long as they forego any general advertising or general solicitation, both in offering and selling the securities.
The SEC adopted the amendments to Rule 506 largely as originally proposed in its proposing release. As in the proposing release, the release noted that the determination of reasonableness of the steps that an issuer takes to verify that an investor is an accredited investor is an objective assessment based on the particular facts and circumstances for each investor and transaction. The release lists three non-exclusive—often interconnected—factors to be considered in deciding what steps are reasonable to verify that the purchasers of the securities are accredited investors:
- 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.
- The nature of the offering, such as themanner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as aminimum investment amount.
Additionally, based on comments to the proposed rules, the SEC decided to provide a nonexclusive list ofmethods that, if used, are deemed to satisfy the verification requirement in Rule 506(c) unless the issuer or its agent has knowledge that the investor is not an accredited investor. These methods are as follows:
- If the purchaser is to qualify as an accredited investor on the basis of income, the issuer reviews any Internal Revenue Service formthat reports the purchaser’s income for the twomost recent years (including, but not limited to, FormW-2, Form1099, Schedule K- 1 to Form1065 and Form1040) and obtains a written representation fromthe purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
If the purchaser is to qualify as an accredited investor on the basis of net worth, the issuer reviews one or more of the following types of documentation dated within the prior threemonths and obtains a written representation fromthe purchaser that all liabilities necessary tomake a determination of net worth have been disclosed:
- with respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposits, tax assessments and appraisal reports issued by independent third parties; and
- with respect to liabilities: a consumer credit report fromat least one nationwide consumer credit reporting agencies.
The issuer obtains written confirmation fromone of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior threemonths and has determined that such purchaser is an accredited investor:
- A registered broker-dealer;
- An investment adviser registered with the SEC;
- A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
- A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.
- If the purchaser purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of the new Rule 506(c) and continues to hold such securities, the same issuer obtains a certification by such purchaser at the time of the new sale of securities pursuant to Rule 506(c) that such purchaser qualifies as an accredited investor.
Verification —Nature of Purchaser. The steps thatmay be reasonable to verify that an entity is an accredited investor depend on the nature of the investor itself. For example, confirming that an entity is an accredited investor by virtue of being a registered broker-dealer can be as straightforward as looking the entity up on the FINRA BrokerCheck website, while the steps thatmay be reasonable to verify that a natural person is an accredited investor will necessarily differ.
Verification—Information about the Purchaser. The amount of information available about a prospective purchaser is another element in determining what constitutes reasonable steps to verify accredited investor status. Themore information an issuer has supporting a prospective purchaser’s accredited investor status, the fewer steps it would have to take to verify that status. The following are examples of the types of information that issuers could review or rely upon:
- Publicly available information in filings with a federal, state or local regulatory body.
- Third-party information that provides reasonably reliable evidence that a person is an accredited investor, such as trade publications for certain industries or a FormW-2 provided by a natural person.
- Third-party verification of a person’s status as an accredited investor, such as a brokerdealer, attorney, accountant or other service thatmay develop in the future to fill this role, provided that the issuer has a reasonable basis to rely on such third-party verification.
Verification—Nature and Terms of Offering. The nature and terms of the offering are also considerations in determining whether an issuer has taken reasonable steps to verify accredited investor status. In the case of a solicitation through a website accessible to the general public or through a widely disseminated email or socialmedia posting, simply requiring that a potential investor check a box or sign a formaffirming its accredited investor status would probably not satisfy the reasonable steps test. In these situations, the issuer would probably also need to have third-party verification of the investor’s status as an accredited investor, and a reasonable basis to rely on such third-party verification. The terms of the offering (e.g., a highminimum investment amount with a limitation on financing by the issuer or any third party) could help to limit the universe of potential purchasers to accredited investors.
Verification—Recordkeeping. The release emphasizes the importance of the issuer and its verification service providersmaintaining adequate records to document the steps taken to verify a purchaser’s accredited investor status, as the burden of proof is on the issuer to show that it is entitled to the Rule 506 safe harbor.
Changes to Form D. An issuer relying on Rule 506mustmake a notice filing on FormD with the SEC, providing basic identifying information about the issuer, certain details of the offering, and specifying exactly which exemption fromregistration the issuer is relying on in making the offering and sale. The final rules would add a new check box to FormD for offerings made pursuant to the new Rule 506(c).
Rule 144A Background. Rule 144A is a non-exclusive safe harbor which exempts non-issuer offerings and resales of securities to QIBs from the registration requirements of the Securities Act. QIBs include financial institutions that manage at least $100 million in securities and registered broker dealers that own and invest at least $10 million in securities, among others. Rule 144A does not include an explicit limitation on general solicitation or general advertising. However, prior to the amendments, the SEC staff had historically taken the position that general solicitation and advertising are inconsistent with the exemption.
The Jobs Act Mandate. Section 201(a) of the JOBs Act instructed the SEC tomodify Rule 144A to permit offerings of securitiesmade under Rule 144A to persons other than QIBs, including bymeans of general solicitation or general advertising, so long as the securities are only sold to persons that the seller reasonably believes are QIBs.
The Final Rules. The final rules implement the JOBS Act by removing the Rule 144A(d)(1) requirement that securitiesmay only be offered to QIBs; instead only requiring that sales of securities bemade to QIBs. Thus, an underwriter or placement agent in a Rule 144A transactionmay conduct general solicitation or general advertising in connection with the offering of securities, so long as the securities are ultimately sold to persons the seller reasonably believes are QIBs. Unlike new Rule 506(c), sellers of securities in “advertised” Rule 144A resales would not be obligated to take “reasonable steps” to verify QIB status. Accordingly, they technically would not be required to undertake any additional procedures than they do currently to confirmthat the purchasers in “advertised” Rule 144A resales are QIBs.
The changes do not affect the need for a registration exemption for the initial offer and sale by the issuer to the underwriter or placement agent, such as Section 4(2) of the Securities Act or Regulation S. The releasemakes clear, however, that general solicitation in connection with resales by financial intermediaries under Rule 144A, as it would be amended, should not affect the exemption for the initial sales by the issuer to the intermediaries.
Private Fund Issues Background. Privately offered funds like those referred to above typically rely on:
- Section 4(a)(2) and the Rule 506 safe harbor to offer and sell their securities without registration under the Securities Act; and
- Either the Section 3(c)(1) or Section 3(c)(7) exclusion fromthe regulatory provisions of the Investment Company Act of 1940, which are not available to persons if they make a public offering of their securities.
Accordingly, absent the SEC’s interpretation as set forth in the release, these funds could have lost their Investment Company Act exemption if they use general solicitation in offering and selling securities under new Rule 506(c).
The JOBS Act Mandate. The JOBS Act gave the SEC no specific directions with respect to general solicitation in offerings of securities by hedge funds, venture capital funds, private equity funds and similar privately offered funds. However, 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.”
The Final Rules. In the release, the SEC states its belief that “the effect of Section 201(b) is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.”
Integration with Offshore Offerings
Regulation S Issues Background. Regulation S provides a safe harbor for offers and sales of securities outside the United States and includes an issuer and a resale safe harbor. Two general conditions apply to both safe harbors: (1) the securities must be sold in an offshore transaction and (2) there can be no directed selling efforts in the US. Regulation S broadly defines “directed selling efforts” as: any activity undertaken for the purpose of, or that could reasonably be expected to have the effect of, conditioning the market in the US for any of these securities offered in reliance on Regulation S. Such activity includes placing an advertisement in a publication “with a general circulation in the US” that refers to the offering of securities beingmade in reliance upon Regulation S.
Regulation S offers are oftenmade in connection with concurrent U S exempt offerings under Rule 506 or Rule 144A. Absent the SEC’s interpretation as set forth in the release, the use of general solicitation in those offers raised questions whether directed selling efforts condition in Regulation S could be satisfied if the US and offshore offerings are integrated.
The JOBS Act Mandate. The JOBS Act gave the SEC no specific directions with respect to general solicitations in offerings under amended Rule 506 and/or 144A that aremade in connection with offshore offers made in accordance with the registration exemption provided by Regulation S under the Securities Act.
The Final Rules. In the release, the SEC states that, consistent with the historic treatment of concurrent Regulation S and Rule 144A/Rule 506 offerings, concurrent offshore offerings under Regulation S would not be integrated with domestic unregistered “advertised” offerings conducted in compliance with Rule 506 or Rule 144A, as amended.
The final rules will go into effect sometime in September 2013 on the date that is 60 days following publication of the rules in the Federal Register.