At an open meeting held on August 29, 2012, the Securities and Exchange Commission approved a proposed rule pursuant to Section 201(a) of the Jumpstart Our Business Startups (“JOBS”) Act that would amend:
- Regulation D and Rule 506 under the Securities Act to remove the ban on general solicitation and general advertising for offerings sold only to accredited investors
- Rule 144A to permit offerings to persons other than qualified institutional buyers, including by means of general solicitation or general advertising, provided the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are qualified institutional buyers
Section 201(a) of the JOBS Act called for the SEC to adopt rules to enable general solicitation and general advertising in these private capital raising transactions, provided the issuer takes reasonable steps to verify that purchasers of the securities are accredited investors. Under the proposed rule, the SEC outlines a flexible approach to determining if an investor is accredited.
The proposed rule was delayed one week from the previously announced date, and was changed from an intended interim final rule which would have been effective right away to a proposed rule with an indefinite effective date. As further discussed below, statements issued by each of the five Commissioners indicate a deeply divided Commission and highlight uncertainty about the ultimate regulatory regime that will emerge for general solicitation and general advertising.
The proposed rule also clarifies how these measures would impact:
- private funds
- non-U.S. issuers
- issuers that can successfully raise capital under existing rules, including to non-accredited investors
Once a final rule is promulgated, the removal of the ban on general solicitation will usher in a new era of private fundraising through traditional and new forms of widespread media, potentially increasing access to and lowering the cost of private capital.
As we previously commented, the JOBS Act was enacted on April 5, 2012 and, among other things, eases some of the regulatory burden for small businesses and startups to raise capital.
Rule 506 is the most common exemption used by companies to raise capital in non-public offerings. Rule 144A is a further resale exemption enabling initial purchasers in certain private placements to resell securities immediately to persons believed to be qualified institutional buyers, often referred to as “QIBs.”
Section 201(a)(1) of the JOBS Act directed the SEC, not later than 90 days after the date of enactment, to amend Rule 506 of Regulation D to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors. As we noted in a prior blog entry, the SEC allowed the 90-day statutory deadline in the JOBS Act to expire on July 4, 2012 without action. The Commission was scheduled to consider rules to implement Section 201(a) at an open meeting on August 22, 2012. In an unusual notice dated August 21, 2012, the Commission delayed its consideration of such rules to August 29, 2012 and in a separate notice, indicated that the August 29 hearing would consider a proposed rule rather than a final rule or an interim final rule.
In the August 29, 2012 open meeting, the Commission voted 4 to 1 in favor of the proposed rules that would:
- provide a flexible approach to determining what will be considered reasonable steps to verify accredited investor status for the purposes of satisfying the new Rule 506(c) requirements, or QIB status for the purposes of satisfying the new Rule 144A requirements
- revise Form D to add a separate check box for issuers to indicate whether they are using general solicitation or general advertising in a Rule 506 offering
- reiterate 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 to be amended
- clarify that privately offered funds which make a general solicitation under amended Rule 506 may do so without losing either of the two most common exclusions under the Investment Company Act of 1940
- clarify that issuers may continue to rely on existing provisions of Rule 506 without the use of general solicitation
What changes now?
The SEC is seeking public comments on the proposed rules through the thirtieth day after publication in the Federal Register, after which time it could issue final or interim final rulemaking. The SEC could in the meantime further amend Regulation D or other rules, as was encouraged or suggested by three of the five Commissioners in public statements issued at the August 29 open meeting.
Why are these proposed rules significant?
As noted above, Rule 506 is the most common exemption used by companies to raise capital in non-public offerings, and debt offerings conducted under Rule 144A represent a very large market. According to the SEC, in 2011, the estimated amount of equity and debt capital raised in Rule 506 offerings and Rule 144A offerings was $895 billion and $168 billion, respectively, compared to $984 billion raised in registered public offerings.
Currently, the prohibitions on general solicitation for Rule 506 offerings and on directed selling efforts in the United States under Regulation S represent a fundamental divide between private placements and registered public offerings. Once a final rule (or interim final rule) is adopted, issuers will be permitted to raise unlimited amounts of financing in the U.S. without registration using traditional and new forms of widespread media. Issuers will then be able to increase their access to capital by reaching a greater number of potential investors while reducing the costs and delays of locating accredited investors who may be interested in a particular private offering, with the overall goal of lowering the cost of capital for private companies. Already effective provisions of the JOBS Act which increase the threshold for mandatory registration under the Securities Exchange Act of 1934 will operate in tandem to facilitate these efficiencies.
Why did the SEC issue a proposed rule instead of a final (or interim final) rule as previously announced?
Public statements issued by each of the five Commissioners on August 29, 2012 indicate significant disagreement amongst them on the fundamental question of whether the Congressional mandate in Section 201 of the JOBS Act should be applied narrowly as written, or whether the SEC should also implement an array of investor protections along with the regulations required by Section 201. Two Commissioners (Gallagher and Parades) are solidly in the first camp, and two Commissioners (Aguilar and Walters) are solidly in the second camp. Chairman Shapiro appears to hold the deciding vote, and the statements taken together make it clear that she was not comfortable at this time putting forth an interim final rule with immediate effectiveness.
The explicit reason Ms. Shapiro gave for putting out a proposed rule was a desire to get the input of issuers, investors and other market participants on the proposed methodology for determining what are "reasonable steps" for determining the accredited status of an investor. However, Chairman Shapiro also commented in her speech about the need for investor protections, and she referenced both future SEC work and other legislation, including the SEC's pending proposed rule to prohibit "bad actors" from using Rule 506 as required under the Dodd-Frank Act. As pointed out by Commissioners Gallagher and Parades, Ms. Shapiro’s explicit rationale seems to discount the significant number of comments the SEC had already received through its JOBS Act portal, many of which addressed exactly the issues upon which additional comment is now sought, and further discounts the nature of an interim final rule, which facilitates additional changes based on subsequent comments.
The unusual rescheduling and last minute change to the form of regulation may indicate a deeper uncertainty as to the timing and the final form of the regulations to implement this statutory mandate and may also suggest an expectation on the part of certain Commissioners that something will happen in the interim between proposal of this rule and a final rule to change the regulatory landscape. Indeed, one of the SEC’s enumerated requests for comments to the proposed rule reads:
“Are there any other rule amendments necessary or appropriate to implement the statutory mandate of Section 201(a) of the JOBS Act? Are there any other measures that the Commission should consider taking in connection with the removal of the prohibition against general solicitation?”
What “reasonable steps” would issuers be required to implement in the capital raising process to rely on proposed new Rule 506?
As proposed, Rule 506(c) would not include any specific mandatory measures that an issuer would be required to implement to verify that purchasers of securities sold in any offering under Rule 506 are accredited investors. The SEC instead proposes a flexible approach for issuers to determine what constitutes “reasonable steps” to verify accredited investor status. The proposed approach looks at the overall facts and circumstances. While the proposed approach is flexible, the SEC describes the inquiry as to whether reasonable steps were taken as objective.
Some examples of the application of the flexible approach include:
- The Nature of the Purchaser. The SEC indicated that “reasonable steps” would likely vary depending on the type of accredited investor that the purchaser claims to be. The SEC provided an example of the differences between the steps that may be reasonable to verify that an entity is an accredited investor by virtue of being a registered broker-dealer – such as by going to FINRA’s BrokerCheck website – and the steps that would be reasonable to verify whether a natural person is an accredited investor based on the net worth or income test. The SEC also recognized the inherent difficulties in verifying the accredited investor status of individuals, and the related privacy concerns.
- Amount and Type of Information about Purchaser. The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa. The SEC listed the following two examples of the types of information that issuers could review or rely upon: (i) publicly available information in filings with a federal, state or local regulatory body, and (ii) third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories in the accredited investor definition (i.e. copies of Forms W-2).
- Nature and Terms of the Offering. The SEC indicated that the nature and terms of the offering, such as the means through which the issuer publicly solicits purchasers to participate in the offering, and the terms of the offering, such as a minimum investment amount (which may on its own indicate accredited investor status), may be relevant in determining the reasonableness of the steps taken to verify accredited investor status. If general solicitation in connection with an offering is made through a website accessible to the general public or widely disseminated emails, the issuer would likely be obligated to take greater measures to verify accredited investor status than if an issuer solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer. Specifically, the SEC indicated that, in the case of the former offering, requiring a purchaser to check a box in a questionnaire or sign a form may not be sufficient, absent other information about the purchaser indicating accredited investor status. In the case of the latter offering, an issuer could satisfy the requirement that the issuer take reasonable steps to verify accredited investor status by relying upon a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification.
Regardless of the particular steps taken, the SEC emphasized the importance for issuers to retain adequate records that document the steps taken to verify that a purchaser is an accredited investor, since any issuer claiming an exemption from the registration requirements of Section 5 has the burden of showing that it is entitled to that exemption.
What is the significance of the proposed rule to issuers that wish to sell to non-accredited investors that meet existing Rule 506(b)’s sophistication requirements or to investors with whom the issuer has a pre-existing relationship?
The proposed rule would preserve the existing rules for issuers who wish to conduct Rule 506 offerings without the use of general solicitation. Some issuers may determine that the benefits of general solicitation do not justify the detriments – particularly the inability to sell to non-accredited investors. While the new requirements to take reasonable steps to verify the accredited status of purchasers will not explicitly apply to offerings without general solicitation, the issuer will retain the burden it has always had under Rule 506(b) to establish the availability of the exception, including the accredited status of investors to the extent relevant to the availability of the exemption. We anticipate that the standard practices that emerge for complying with Rule 506(c) will become commonplace for complying with Rule 506(b).
What is the significance of these proposed rules to non-U.S. issuers and the private capital markets in the United States?
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. Regulation S requires that there be no “directed selling efforts” in the United States. Many commentators urged the SEC to clarify that a general solicitation in compliance with Rule 506 as amended by the JOBS Act would not be deemed a “directed selling effort” under Regulation S. The proposing release acknowledges these comments and reiterates the SEC’s long-held view 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, and confirms this view would apply to Rule 506 and Rule 144A as amended. However, the proposing release stopped short of stating explicitly that a general solicitation in the United States would not be deemed a directed selling effort in the United States. We hope that the SEC will provide more clarity on this point in the final rule or in Staff interpretations.
What is the significance of the proposed rule to venture capital, private equity and other private investment funds?
Venture capital, private equity funds and other private investment funds must comply with extra layers of regulation when raising capital, including the Investment Company Act. Many private investment funds avoid triggering registration with the SEC by complying with the exemptions in Rule 3(c)(1) or Rule 3(c)(7) under the Investment Company Act , both of which depend on the fund not making or proposing to make a public offering of its securities.
While the JOBS Act did not contain any requirement for the SEC specifically to facilitate the fundraising process for venture capital, private equity or other private investment funds, the SEC clarified in the proposing release that privately offered funds could make a general solicitation under amended Rule 506 without losing either of those exclusions under the Investment Company Act.
What happens next?
Comments on the proposed rules will be due 30 days after publication in the Federal Register. The SEC could implement an interim final rule or a definitive final rule thereafter. As noted above, the divide amongst the Commissioners and Chairman Shapiro’s enigmatic speech at the August 29, 2012 open meeting may indicate further twists and turns on the regulatory path before or concurrently with the effectiveness of any rule that finally implements Section 201 of the JOBS Act.
The SEC is also mandated by Congress to adopt regulations enabling Title III of the JOBS Act – the “Crowdfunding” exemption – before the end of 2012. It is unclear whether the SEC will make this deadline.
The SEC is also mandated by Title IV of the JOBS Act to adopt rules enabling a new limited offering exemption, commonly known as “Regulation A+” (see this blog entry). There is no deadline for these rules and the SEC has not announced a target date.
Finally, the Wall Street Journal recently reported a letter from Chairman Shapiro to Rep. Darrell Issa stating that that there is an ongoing review by the SEC staff to review the SEC’s communications rules applicable to all registered offerings. The results of that review and the timing for such results remain unknown.