On July 10, 2013, the Securities and Exchange Commission (the “SEC”) released two sets of final rules which revised the regulation of Rule 506 and Rule 144A offerings in response to Congressional direction in the 2012 Jumpstart Our Business Startups Act (the “JOBS Act”).1 The amendments eliminated the prohibition on “general solicitations” in private placement offerings under Regulation D and Rule 144A. It is expected that these new rules will result in a substantially different private placement market under Rules 506 and 144A, which were used to raise $898 billion and $640 billion, respectively, in 2012.2 The SEC further released proposed rules containing amendments to Regulation D and Rule 156 of the Securities Act of 1933 (the “1933 Act”) meant to address the new regulatory scheme for offerings of private investment funds.3
The offering of securities for sale in the United States is prohibited unless the offering is either registered pursuant to the 1933 Act or is within one of the exemptions from registration offered by the 1933 Act and its implementing regulations. One regulation, Regulation D, provides a number of exemptions to registration based on the offering’s size or the targeted investors’ perceived sophistication. Currently, issuers relying on a Regulation D exemption must file a Form D containing information about the issuer’s corporate governance, the size of the offering, and the identity of any promoters used with the SEC within fifteen days after the offering. Offerings made pursuant to Rule 506, which does not rely on the limited size of the offering, must be made to “accredited investors.”4 As defined by Rule 501, that term includes certain types of entities,5 individuals with individual or spousal net worth exceeding $1 million, individuals earning at least $200,000 annually, and entities in which every equity owner is itself an accredited investor. Rule 506 allows unregistered securities to be issued in an offering to an unlimited number of accredited investors plus up to 35 “sophisticated” non-accredited investors possessing sufficient knowledge and experience in financial and business matters to enable them to evaluate the merits and risks of the potential investment, provided certain other requirements are met. Until the promulgation of the rules at issue, one such requirement was that the offering is not made via general solicitation or general advertisement, such as on a public website.
Rule 144A offerings are exempt from registration under Rule 144A of the 1933 Act if the offered securities are restricted securities offered and sold exclusively to qualified institutional buyers who own and invest certain minimum amounts of assets on a discretionary basis (“QIBs”), generally $100 million. In determining whether an offeree is a QIB, there is a non-exclusive list of tests the offeror may rely on. QIBs are buyers deemed sophisticated enough to participate in the Rule 144A market, which is not heavily regulated.
In addition to the revisions to Rules 506 and 144A, the rules at issue propose to expand the scope of antifraud liability for offerings of interests in private investment funds. Currently, Rule 156, which imposes liability on issuers for materially misleading sales literature, including literature disseminated pursuant to a Regulation D or Rule 144A offering, applies only to issuers who are “investment companies” within the definition of Section 3 of the Investment Company Act of 1940 (the “1940 Act”). The SEC proposes to expand the scope of Rule 156 to include offering materials for investment funds exempted from the definition of an “investment company” by operation of Sections 3(c)(1) and 3(c)(7) of the 1940 Act, which would subject essentially all hedge funds, private equity funds, and real estate funds to such liability.
The Dodd–Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law in July 2010.6 Section 926 of the Dodd-Frank Act required the SEC to adopt rules disqualifying offerings involving certain “felons and other ‘bad actors’” from reliance on the exemption from Securities Act registration provided by Rule 506.7 The SEC was directed to draft rules “substantially similar” to Rule 262, the disqualification provision under Regulation A. Currently, there is no rule prohibiting reliance by felons and other bad actors, or entities controlled by such felons and bad actors, on Regulation D’s safe harbor.
The JOBS Act was passed in March 2012 and signed into law by President Obama in April 2012. Its stated goal is to “increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies.”8 Section 201(a) of the JOBS Act required the Commission to eliminate the prohibition in Rule 506 against general solicitation and advertising for offers of securities made pursuant to the rule, provided all purchasers are accredited investors and the issuer takes reasonable steps to verify the purchasers’ status. It further required the SEC to promulgate rules allowing the offering of securities under Rule 144A to persons other than qualified institutional buyers, including by means of general solicitation or general advertising, provided that securities are sold only to persons that the seller reasonably believes is a qualified institutional buyer.
Amendments to Rule 506
The most fundamental change to Rule 506 is the addition of 506(c), “Conditions to be met in offerings not subject to limitation on manner of offering.” Rule 506(c) eliminates the prohibition on general solicitation and advertising for offerings that fall within its requirements. In order for general solicitation or advertising to be used pursuant to Rule 506(c), two new requirements must be met: the ability to include up to 35 “sophisticated” non-accredited investors is removed, as all purchasers of the securities must be “accredited investors”;9 and the issuer must take “reasonable steps to verify” that the purchasers are accredited investors in light of the facts and circumstances of the offering.
The SEC has provided a non-exhaustive list of processes that would constitute “reasonable steps to verify” the purchasers’ status, which includes:
- for purchasers qualifying based on income, reviewing an official IRS document with such purchasers’ income for the two prior years and obtaining a written representation from each purchaser that he or she has a “reasonable expectation” of meeting the income requirement in the current year;
- for purchasers qualifying based on net worth, reviewing a statement of assets and credit report dated within the last three months and obtaining a written representation from the purchaser that he or she has all disclosed all liabilities relevant to determining his or her net worth;
- for any purchaser, obtaining a representation from a broker-dealer, investment advisor, attorney or CPA that such professional has taken reasonable steps to verify the purchaser’s qualifications; and
- for any purchaser who previously participated in an offering of the issuer as an accredited investor, obtaining a representation from the purchaser that they are still an accredited investor.
The above list, however, is meant as guidance, and any inquiry must consider:
- 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; and
- the nature of the offering, such as the manner in which the purchaser was solicited, and the terms of the offering, such as a minimum investment amount.
The burden of proving that each purchaser is an accredited investor, however, remains with issuer, who should keep full records of steps taken to verify each investor’s status.
In addition to amending Rule 506, the SEC also implemented a small addition to Form D: issuers must now check a box on Form D to indicate that they are relying on the Rule 506(c) exemption. These amendments to the Rule 506 private placement regulation make the offering of securities under Rule 506 less onerous for issuers and are expected to result in an increase in the aggregate amount of securities offered under Regulation D.
Amendments to Rule 144
Rule 144A was amended to allow offering of securities to offerees who may not be QIBs, including by general solicitation, provided sales are made only to purchasers the issuer and anyone acting on its behalf “reasonably believes” is a QIB. Thus, individual and other non-QIB investors may now receive solicitations to invest in Rule 144A offerings, but cannot participate in such offerings unless the issuer and its agents “reasonably believe” such investors are QIBs.
Bad Actor Amendments
In a second release of final rules, the SEC finalized its approach to disqualifying felons and other bad actors from participation in certain private placement offerings in accordance with the JOBS Act. The SEC created a new paragraph (d) in Rule 506, which is triggered if the issuer, any of its affiliates, its executive officers, any officer participating in the offering, its principals, its promoters, its investment manager, its placement agents, or any beneficial owner of 20% of outstanding voting equity is subject to a “disqualifying event.” Disqualifying events include convictions in the last ten years for felonies or misdemeanors related to securities, being subject to court injunctions involving securities in the last five years, being subject to an order from domestic bank and financial regulators in the last ten years, being currently subject to SEC disciplinary orders, being suspended or expelled from certain self-regulatory organizations, and being subject to a stop order or order from the USPS within the last five years.
Past convictions or orders do not affect the eligibility of actors to rely on the exemption under 506 for past offerings, but will affect any offerings going forward and must be disclosed prior to any offering. There is also an exception for issuers who exercised reasonable care in investigating actors’ histories by conducting a factual inquiry, and waivers may be granted by the SEC’s Division of Corporate Finance and by certain issuing authorities, like courts and state regulatory authorities. An addition to Form D of a certification by the issuer that Rule 506(d) is not violated is also being made.
In addition to issuing the above two sets of final rules, the SEC also released proposed amendments to Regulation D, Form D, and Rule 156 under the 1933 Act, and invited public comments. These rules were proposed in response to Section 926 of the Dodd-Frank Act and Section 201(a) of the JOBS Act, in order to allow the SEC to more closely monitor the new Rule 506 offerings address any concerns arising from the new regime. Comments on these proposed rules are due within 60 days after publication of the rule.
The most notable proposed change is to Rule 503, which would require filing of the Form D 15 days before an offering under Rule 506(c) is commenced, rather than within 15 days after. A second proposed change would require the filing of an amendment to the Form D within 30 days after the closing of an offering. Since a pre-offer filing will be required for Regulation D offerings involving a general solicitation, the new rules will not provide relief to offerors who inadvertently engage in a general solicitation in connection with a private offering.
Form D itself will be amended to require additional information, including information about those who control the issuer, information about those owning at least 10% of the issuer, the number of accredited and non-accredited investors in Rule 506 offerings, and information about the use of the proceeds. The earlier filing timeline and increased amount of information is meant to enable the SEC to monitor the new Rule 506 offering market and other private placement markets, and compliance is to be ensured by the newly amended Rule 507 discussed below.
Currently, Rule 507 disqualifies issuers from relying on Regulation D if the issuer has been enjoined by a court in the last year for violating Rule 503’s reporting requirements. The SEC proposed that issuers also be disqualified by Rule 507 from relying on Regulation D if they violated Rule 506’s Form D filing requirements in the five years prior to the proposed offering. This proposed rule is meant to provide the SEC with more complete information on the new Rule 506(c) offerings, as well as incentivize the following of Form D filing requirements.
The SEC also proposed rules meant to govern the new general solicitation process allowed in connection with certain Rule 506 offerings. The SEC proposed the creation of a Rule 509 to address the new ease with which unsophisticated investors can access offering materials. Rule 509 would require issuers to include legends about the high level of risk, the lack of regulatory oversight and the standards of investor eligibility in any solicitation materials used in a Rule 506 offering. To the extent that private funds’ solicitation materials include historical performance data, the funds’ solicitation materials must also contain additional legends stating that performance data represents past performance, which does not guarantee future results; current performance may be lower or higher than the performance data presented; the fund is not required by law to follow any standard methodology when calculating and representing performance data; fees may not have been subtracted from the performance data; and the fund’s performance may not be directly comparable to the performance of other funds. Failure to include the legends may result in the future inability of the issuer and its affiliates to use Rule 506 under the amended Rule 507 discussed above, but will not itself disqualify the current offering from Rule 506(c) treatment.
In addition to the above changes to the Rule 506 regime, the SEC proposed temporary regulations in the newly created Rule 510T of Regulation D. For the first two years following its effective date, Rule 510T would require that any issuer relying on new Rule 506(c) to file its written general solicitation materials with the SEC, which would keep such materials private. Failure to file the solicitation materials would not disqualify the offering under Rule 506(c), but could result in future disqualification under the proposed amendments to Rule 507 discussed above.
The SEC also proposed amendments to Rule 156, which holds investment companies (within the meaning of the 1940 Act) liable for material misleading statements or omissions in its sales literature. The proposed rule broadens the application of Rule 156 to private funds which are exempted from regulation as an investment company through the “private fund” exemptions provided in Sections 3(c)(1) and 3(c)(7) of the 1940 Act. Thus, hedge funds and other private funds’ offering documents would be held to the standard that investment companies’ offering documents currently are, and such funds could be held liable for, for example, including selected financial performance data and omitting less favorable performance data from the offering documents. The SEC noted in the proposed rules release that many commenters expressed concern about the lack of guidance provided to non-investment company issuers regarding sales literature.