On August 29, 2012, the Securities and Exchange Commission ("SEC") proposed amendments of Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 (the "Securities Act") to eliminate the prohibition on general solicitation and general advertising in transactions effected under those rules, as required by Section 201 of the Jumpstart Our Business Startups Act (the "JOBS Act").1
If adopted, the proposed amendments (the "Proposed Rules") would:
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 or any person acting on its behalf takes "reasonable steps to verify" that all purchasers of the securities are accredited investors; and
- all purchasers of the securities are (i) accredited investors or (ii) reasonably believed by 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 purchaser of the securities is (i) a qualified institutional 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 release accompanying the Proposed Rules (the "Release") also clarified the interaction of the Proposed Rules with:
- The exemption from regulation 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, if those funds use general solicitation or general advertising to offer their securities under the Proposed Rules.
- The integration of offshore offerings conducted under Regulation S with a concurrent Rule 506 or 144A offer in which there is general solicitation or advertising.
The Jobs Act Mandate. Section 201(a) of the JOBS Act instructed the SEC to modify Rule 506 to:
- permit general solicitation or general advertising in offerings of securities made under Rule 506, so long as all purchasers of the securities are accredited investors; and
- require any issuer relying on Rule 506 to take reasonable steps to verify that purchasers of the securities are accredited investors.
Rule 506 Background. Rule 506 is a non-exclusive safe harbor which exempts transactions by an issuer "not involving any public offering" from the 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 brokerdealers, 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. Currently, an offering or sale of securities is only eligible for the Rule 506 safe harbor if there has not been any 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 Proposed Rules. To implement the JOBS Act, the Proposed Rules add a new subsection (c) to Rule 506. It explicitly permits the issuer (and any selling agents) to use general solicitation or general advertising 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 purchasers must be accredited investors, either because they actually come within one of the categories in the definition of that term or 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 D must be satisfied. (Existing Rule 502(c), prohibiting general solicitation and general advertising, would not apply to Rule 506(c) offers.)
The Release notes that new Rule 506(c) would 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 Proposed Rules do not include specific verification methods that an issuer must use to verify the accredited investor status of the purchasers that would be deemed "reasonable steps." Rather, the SEC proposed an objective test under which the issuer must consider the facts and circumstances of the transaction. The Proposed Rules list 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 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.
Verification - Nature of Purchaser. The Release notes that the steps that may be reasonable to verify that a person 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. For individual investors, however, privacy concerns regarding his or her net worth and income may make verifying accredited investor status more onerous.
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. The more 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 Release indicates that 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 Form W-2 provided by a natural person.
- Third party verification of a person's status as an accredited investor, such as a broker-dealer, attorney or accountant, 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. The Release notes that, in the case of a solicitation through a website accessible to the general public or through a widely disseminated email or social media posting, simply requiring that a potential investor check a box or sign a form affirming 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 thirdparty verification. The Release also notes that the terms of the offering (e.g., a high minimum 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 maintaining adequate records to document the steps it took 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 506 must make a notice filing on Form D with the SEC, providing basic identifying information about the issuer, certain details of the offering, and specifying exactly which exemption from registration the issuer is relying on in making the offering and sale. The Proposed Rules would add a new check box to Form D for offerings made pursuant to the new Rule 506(c).
The Jobs Act Mandate. Section 201(a) of the JOBs Act instructed the SEC to modify Rule 144A to permit offerings of securities made under Rule 144A to persons other than QIBs, including by means of general solicitation or general advertising, so long as the securities are only sold to persons that the seller reasonably believes are QIBs.
The Proposed Rules. The Proposed Rules implement the JOBS Act by removing the Rule 144A(d)(1) requirement that securities may only be offered to QIBs; instead only requiring that sales of securities be made to QIBs. Thus, an underwriter or placement agent in a Rule 144A transaction may 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 proposed Rule 506(c), sellers of securities in "advertised" 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 confirm that the purchasers in "advertised" 144A resales are QIBs.
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, the SEC staff has historically taken the position that general solicitation and advertising are inconsistent with the exemption.
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 Release makes 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.
Privately Offered Funds
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."
Proposed Rules. In the Release, the SEC states its belief that "the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the Investment Company Act."
Integration with Offshore Offerings
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 are made in connection with offshore offers made in accordance with the registration exemption provided by Regulation S under the Securities Act.
The Proposed 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 proposed to be amended.
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 from the 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, these funds could lose their Investment Company Act exemption if they use general solicitation in offering and selling securities under proposed Rule 506(c), absent Section 2.01(b) of the JOBS Act.
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 United States. 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 United States 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 United States" that refers to the offering of securities being made in reliance upon Regulation S.
Regulation S offers are often made in connection with concurrent United States exempt offerings under Rule 506 or Rule 144A. The use of general solicitation in those offers raises questions whether the directed selling efforts condition in Regulation S could be satisfied if the United States and offshore offerings are integrated.