On August 29, 2012, the SEC proposed amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act to eliminate the prohibition on general solicitation in transactions effected under those rules, as required by Section 201(a) of the Jumpstart Our Business Startups Act (the “JOBS Act”).1
The proposed rules provide the following:
- Rule 506 would be amended to add paragraph (c), providing a new and separate exemption under the Rule that would permit 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.
- The proposed rules would continue to apply the “reasonable belief” standard to the condition that all purchasers are accredited investors.
- Whether the steps taken by the issuer to verify the accredited investor status of the purchasers are “reasonable” would be an objective determination, based on the particular facts and circumstances of each offering and investor. The proposed rules do not prescribe particular verification procedures.
Additionally, the SEC confirmed in the proposing release that:
- Consistent with the historical treatment of concurrent Regulation S and Rule 144A/Rule 506 offerings, 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.
- Privately offered funds would be permitted to make a general solicitation under amended Rule 506 without losing the ability to rely on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act, which provide commonly used exclusions from the definition of “investment company”.
Comments on the proposed rules will be due 30 days after publication in the Federal Register. Sullivan & Cromwell LLP is planning to submit a comment letter.
Section 201(a) of the JOBS Act, which was enacted on April 5, 2012, directs the SEC to amend Rule 506 of Regulation D and Rule 144A under the Securities Act to eliminate the prohibition on general solicitation in transactions effected under those rules. Specifically, Rule 506 must be amended to provide that the prohibition against general solicitation and general advertising shall not apply to offers and sales of securities made pursuant to the Rule, provided that all purchasers of the securities “are accredited investors”. The amendments must also require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, “using such methods as determined by the Commission”. Similarly, subsection (d)(1) of Rule 144A must be amended to provide that securities sold under the Rule may be offered to persons other than “qualified institutional buyers”, including by means of general solicitation or general advertising, provided that 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.
At the SEC Open Meeting held on August 29, 2012 (the “Open Meeting”), the SEC proposed rules to implement the requirements of Section 201(a) of the JOBS Act.
Proposed New Rule 506(c)
Existing Rule 506 provides an exemption from registration under the Securities Act for private placements by an issuer2 where, among other things, “the issuer reasonably believes” that no more than 35 purchasers are not “accredited investors” and neither the issuer nor any person acting on its behalf makes offers or sales by “any form of general solicitation or general advertising”. The conditions to the exemption are specified in paragraph (b) of the Rule, which incorporates the general conditions of Rules 501 and 502 of Regulation D. The proposed rules would preserve the exemption under Rule 506(b) without imposing any additional requirements, and would add a new and separate exemption, Rule 506(c), which would be available to an issuer that wishes to use general solicitation and general advertising to offer securities.
At the Open Meeting, the SEC noted that the proposed rules are narrowly focused on implementing the statutory mandate under Section 201(a) of the JOBS Act and that the SEC and its staff will continue to monitor the private placement market as a whole to analyze the impact, including any unintended consequences, of the proposed rules on investors, issuers and the markets. The SEC also noted that that the Dodd-Frank Act requires ongoing evaluations of the definition of “accredited investor”,3 and that there are currently rule changes pending that would limit the availability of the Rule 506 exemption for “bad actors”.4
Under proposed Rule 506(c), an issuer (and any selling agents) would be permitted to use general solicitation and general advertising to offer and sell securities, provided that the following conditions are satisfied:
- The issuer must take reasonable steps to verify that all purchasers of the securities are accredited investors.
- All purchasers of the securities must be accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or because the issuer reasonably believes that they do, at the time of the sale of the securities, in each case as defined under existing Rule 501 of Regulation D.
- All terms and conditions of existing Rules 501 (definitions), 502(a) (integration restriction) and 502(d) (resale limitations) of Regulation D must be satisfied. Existing Rule 502(c), prohibiting general solicitation and general advertising, would not apply.
The SEC did not propose specific verification methods that the issuer must use to verify the accredited investor status of the purchasers that would be deemed “reasonable” for the purposes of proposed Rule 506(c). Rather, the SEC proposed an objective test for determining the reasonableness of the steps that an issuer has taken, under which the issuer must consider the facts and circumstances of the transaction, including, among other things:
- 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 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.
This new verification requirement, which is discussed further below, would only apply to offerings of securities conducted pursuant to the new Rule 506(c). Other offerings conducted pursuant to existing Rule 506(b) that do not involve general solicitation or general advertising will not be subject to the verification requirement.
Verification – Nature of the Purchaser
Under this factor, the SEC recognized that taking reasonable steps to verify the accredited investor status of natural persons poses greater practical difficulties as compared to other categories enumerated in the definition of “accredited investor” in Rule 501(a), such as a registered broker-dealer or a registered investment company. Natural persons may be accredited investors based on either the “net worth test” or the “income test”.5 As between the two tests, the SEC recognized that it may be more difficult for an issuer to obtain information about a person’s assets and liabilities than it would be to obtain information about a person’s income, although the SEC noted there could be privacy concerns with respect to either test.
Verification – Information about the Purchaser
Under this factor, the SEC noted that the more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take to verify the purchaser’s status. If an issuer had actual knowledge that the purchaser is an accredited investor, the issuer would not have to take any steps at all. 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 Form W-2 provided by a natural person.
- Third-party verification of a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification.
Verification – Nature and Terms of the Offering
Under this factor, the SEC noted that an issuer that solicits new investors from the general public (for example, through a public website or a widely disseminated email) would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party. Specifically, in the case of the former, the SEC does not believe that it would be sufficient for the issuer only to require that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status. In the case of the latter, the SEC believes that an issuer would be entitled to rely on a third-party verification of a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification.6
A required minimum investment amount would be an example of an offering term that may be relevant under this factor. When the required minimum investment amount is sufficiently high such that only accredited investors could reasonably be expected to meet it, it may be reasonable for the issuer to take no steps other than to confirm that the purchaser’s cash investment is not being financed by the issuer or any other third party.
An issuer must consider these interconnected factors to determine the types of steps that would be reasonable to take to verify a purchaser’s accredited investor status. The SEC emphasized that it would be important for issuers to retain adequate records that document the steps taken throughout the verification process. The SEC anticipates that many practices currently used by issuers in connection with existing Rule 506 offerings would satisfy the verification requirement under proposed Rule 506(c), but that issuers will also have the flexibility to adopt different approaches to verification depending on the circumstances.
The SEC confirmed that the new verification requirement would not affect the existing requirement that all purchasers must be, or that the issuer must reasonably believe they are, accredited investors. This “reasonable belief” standard is incorporated into the definition of “accredited investor” in existing Rule 501(a) and would not change. Thus, in the event that an issuer sold securities in reliance on the new Rule 506(c) to a person who in fact was not an accredited investor, the exemption would still be available as long as the issuer reasonably believed that all purchasers were accredited investors under the existing standard and had taken reasonable steps to verify their status as required under the proposed new rules. The proposing release makes clear, however, that the verification requirement would not be merely duplicative of the existing reasonable belief standard.
Proposed Amendment to Form D
The proposed rules also amend Form D, which an issuer must file with the SEC when it sells securities under Regulation D. The revised form adds a separate check box for the issuer to check if it is claiming the new Rule 506(c) exemption that would permit general solicitation and general advertising.
Proposed Amendments to Rule 144A
Under the proposed amendments to Rule 144A, securities sold pursuant to Rule 144A may be offered to persons other than “qualified institutional buyers”, including by means of general solicitation or general advertising, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer.7
Impact on Concurrent Regulation S Offerings
Regulation S provides a safe harbor for offers and sales of securities outside the United States, provided that the securities are sold in an offshore transaction and the issuer has not engaged in any “directed selling efforts” in the United States. Since the enactment of the JOBS Act, various commentators have raised concerns regarding the impact of the use of general solicitation on the availability of the Regulation S safe harbors for concurrent Regulation S and Rule 144A/Rule 506 offerings, given the Regulation S prohibition on directed selling efforts. In the proposing release, the SEC confirmed that, consistent with the historical treatment of concurrent Regulation S and Rule 144A/Rule 506 offerings, 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.
Investment Company Act Exclusion for Private Funds
Privately offered funds, such as hedge funds, venture capital funds and private equity funds, generally rely on the exclusions from the definition of “investment company” set forth in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act.8 These exclusions are not available, however, if the fund makes a public offering of securities. The SEC has historically regarded Rule 506 transactions as non-public offerings for purposes of Sections 3(c)(1) and 3(c)(7). In proposing amendments to Rule 506, the SEC affirmed its belief that Section 201(b) of the JOBS Act, which provides that offers and sales exempt under Rule 506 of Regulation D (as revised pursuant to the JOBS Act) “shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation”, permits privately offered funds to make a general solicitation under proposed new Rule 506(c) without losing the benefit of either exclusion under the Investment Company Act.
Open Issues for Private Funds
The proposed rules and the proposing release did not address the following issues relating to private funds:
- The National Securities Markets Improvement Act of 1996 and Rule 3c-5 under the Investment Company Act permit “knowledgeable employees” of an investment adviser to invest in a private fund. Commentators have noted that Section 201 of the JOBS Act is designed to permit general solicitation and advertising in connection with offers and sales under Rule 506 so long as all purchasers are sophisticated investors, and that those knowledgeable employees who are permitted to own interests in a 3(c)(1) or 3(c)(7) fund should be treated as “accredited investors” under Regulation D. The release did not address whether such “knowledgeable employees” must also qualify as accredited investors in order for a fund to use general solicitation or advertising under the proposed rules.
- The Investment Advisers Act and the rules promulgated thereunder limit advisers’ ability to publish, circulate or distribute advertising materials that refer to any testimonial or past specific recommendations of such adviser and place restrictions on the presentation of performance data in such advertising materials. Commentators have noted that, in eliminating the ban on general solicitation and advertising under Section 201 of the JOBS Act, Congress expressed an intention to permit greater disclosure of information related to registered and exempt private fund advisers in advertising materials. In light of the elimination of the ban on general solicitation and advertising under the proposed rules, Section 201’s effect on the scope of advertising limitations created by the Advisors Act remains to be seen.
- Commodity Futures Trading Commission Section 4.7(b) provides an exemption from certain part 4 requirements for commodity pool operators (“CPOs”) with respect to offerings to qualified eligible persons. CFTC Section 4.13(a)(3) provides an exemption from CPO registration where commodity interest trading is limited and pool participants are sophisticated. Certain aspects of both exemptions currently prohibit “marketing to the public”.9 Commentators have noted that the Section 4.7(b) and Section 4.13(a)(3) exemptions should be harmonized with Section 201 of the JOBS Act by removing the prohibition on “marketing to the public”. In light of the elimination of the ban on general solicitation and general advertising under the proposed rules, Section 201’s effect on the Section 4.7(b) and Section 4.13(a)(3) exemptions for hedge funds and CPOs also remains to be seen.