On July 10, 2013, the Securities and Exchange Commission (“SEC”) adopted two important rule amendments that significantly impact the private securities offering market:
- under certain circumstances, general solicitation and general advertising (“general solicitation”) will no longer be prohibited for private securities offerings made pursuant to Rule 506 of Regulation D or Rule 144A under the Securities Act of 1933 (the “Securities Act”); and
- private offerings under Rule 506 will be disqualified if certain felons and other “bad actors” are involved.
The SEC also proposed rule amendments that seek to enhance its ability to evaluate changes in the private offering market and address the development of practices in Rule 506 offerings. Most notably, any written general solicitation materials would be required to be submitted to the SEC no later than the date of their first use in the offering.
I. Eliminating the Prohibition on General Solicitation and General Advertising in Certain Offerings
Section 201(a) of the Jumpstart Our Business Startups Act (the “JOBS Act”) directed the SEC to permit general solicitation in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors, and to permit offers of securities pursuant to Rule 144A to persons other than qualified institutional buyers (“QIBs”), including by means of general solicitation, provided that the securities are sold only to persons that the seller reasonably believes are QIBs. The SEC proposed rule amendments on August 29, 2012 to implement the JOBS Act mandate. The final rule amendments that the SEC adopted this month are substantially similar to the proposed rule amendments, with one notable modification discussed below.
Under new Rule 506(c), an issuer may use general solicitation to offer its securities, provided that (1) the issuer takes reasonable steps to verify that all investors are accredited investors (as defined in Rule 501 of Regulation D), (2) all purchasers of the securities are accredited investors at the time of the sale of securities and (3) the issuer otherwise complies with Regulation D.
Reasonable Steps to Verify – Principles-Based Approach
The determination of the reasonableness of the steps taken to verify an accredited investor requires an objective assessment by an issuer. In making such determination, an issuer is required to consider the facts and circumstances of each purchaser and transaction including:
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be (e.g., if the purchaser is an entity that is a registered broker-dealer listed on FINRA’s BrokerCheck website, or if the purchaser is a natural person who claims to satisfy the applicable income test or net worth test);
- the amount and type of information that the issuer has about the purchaser (e.g., if there is publicly available information in filings with a regulatory body, or if there is third-party information that provides reasonably reliable evidence); and
- 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 (e.g., if the purchaser was solicited through a public website or newspaper, or through a database of pre-screened accredited investors maintained by a reasonably reliable third-party; if the minimum investment amount is sufficiently high such that only accredited investors could reasonably be expected to meet it).
In adopting a principles-based approach, the SEC noted the sliding scale nature of the verification requirement: the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa. If an issuer has actual knowledge that the purchaser is an accredited investor, then the issuer will not have to take any steps at all. Regardless of the particular steps taken, issuers should retain adequate records regarding the steps taken to verify that a purchaser was an accredited investor.
Non-Exclusive List of Methods for Verification
In response to the SEC’s proposed Rule 506(c), commenters requested that the SEC provide examples of “reasonable steps” for purposes of the verification requirement. In light of these commenters’ requests, the SEC modified the proposed rule amendments to include in the final rule a non-exclusive list of the following four methods that issuers may use to verify that a natural person is an accredited investor, provided that the issuer does not have actual knowledge that the purchaser is not an accredited investor.
- For accredited investors based on income, an issuer may review copies of any IRS form that reports income (e.g., a Form W-2, Form 1099, Schedule K-1, and Form 1040) for the two most recent years, and obtain a written representation from the investor that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year. The issuer should obtain the written representation from, and review copies of such forms for, both spouses if the accredited investor status is being based on joint income.
- For accredited investors based on net worth, an issuer may review one or more of the following types of documentation, dated within the prior three months, and obtain a written representation from the investor that all liabilities necessary to make a determination of net worth have been disclosed. For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties. For liabilities: a consumer report (i.e., a credit report) from at least one of the nationwide consumer reporting agencies, dated within the prior three months. The issuer should obtain the written representation from, and review copies of such documentation for, both spouses if the accredited investor status is being based on joint net worth.
- An issuer may obtain a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, a certified public accountant, and, depending on the circumstances, certain other third parties, that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor.
- With respect to any existing investor that participated in an issuer’s prior offering as an accredited investor, the issuer may obtain a certification by such investor at the time of sale that he or she qualifies as an accredited investor.
The SEC reaffirmed its view that Congress intended to retain the existing reasonable belief standard in Rule 501(a) in determining whether an investor is an accredited investor. If an issuer has taken reasonable steps to verify that a purchaser is an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of sale, the issuer will not lose its ability to rely on Rule 506(c) for an offering even if it is later discovered that a person who is not an accredited investor purchased securities in such offering.
No Modification to Existing Exemptions; Updates to Form D
Issuers that do not wish to verify the accredited investor status of purchasers or that wish to sell privately to non-accredited investors may continue to rely on existing Rule 506(b) to conduct offerings subject to the prohibition against general solicitation.1 For an ongoing offering under Rule 506 that commenced before the effective date of the rule amendments, the issuer may choose to continue the offering after the effective date in accordance with the requirements of either Rule 506(b) or Rule 506(c). An issuer relying on the new rule will need to indicate on its Form D that the offering is being made in reliance on Rule 506(c). The SEC revised Form D to add and update the applicable checkboxes. An issuer that checks the box for Rule 506(c) may not also check the box for Rule 506(b). An issuer that initially relies on Rule 506(b) may switch to the exemption in Rule 506(c); however, an issuer that initially relies on Rule 506(c) and conducts a general solicitation will not be able to switch to the exemption in Rule 506(b) for that same offering.
Issuers may also continue to rely on the statutory exemption in Section 4(a)(2) of the Securities Act, which exempts transactions by an issuer not involving any public offering. Such issuers will continue to be restricted in their ability to use general solicitation and be subject to state blue sky requirements.
Issuers should keep in mind that any general solicitation materials would be subject to the anti-fraud provisions of Rule 10b-5 and that new Rule 506(c) does not affect their requirement to comply with other rules that may apply in connection with any solicitation (e.g., rules of the Financial Industry Regulatory Authority, the SEC’s advertising rule under the Investment Advisers Act of 1940 (the “Advisers Act”) and the rules of foreign jurisdictions).2
Changes to Rule 144A
The final rule amendments permit securities offered pursuant to Rule 144A to be offered to persons other than QIBs, including by means of general solicitation, provided that the securities are sold only to persons whom the seller reasonably believes are QIBs.
Integration with Offshore Offerings
The SEC reaffirmed its view that, consistent with their historical treatment, concurrent offshore offerings conducted in compliance with Regulation S will not be integrated with domestic unregistered offerings that are conducted in compliance with Rule 506 or Rule 144A, as amended. We believe this to mean that general solicitation activities undertaken for the domestic offering in compliance with Rule 506(c) should not constitute “directed selling efforts” for purposes of the Regulation S safe harbor.
Specific Issues for Private Funds
Investment Company Act of 1940
The SEC reaffirmed that the effect of Section 201(b) of the JOBS Act is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing their exclusions under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”). The SEC noted that it has carefully considered certain commenters’ concerns that private funds engaging in general solicitation may raise certain investor protection issues. The SEC also noted that other commenters believe that additional measures regarding private fund advertising are not necessary because the anti-fraud provisions of the federal securities laws continue to apply. While the final rule amendments do not place additional limitations on general solicitation by private funds, the SEC stated that it will monitor and study the development of private fund advertising and undertake a review to determine whether any further action is necessary. In addition, the proposed rules described below include additional requirements for private funds.
Investment Advisers Act of 1940
The SEC reminded advisers to private funds that they remain subject to Rule 206(4)-8 under Advisers Act, which provides that it shall constitute a fraudulent, deceptive or manipulative act, practice or course of business within the meaning of Section 206(4) of the Advisers Act for any investment adviser to a pooled investment vehicle to “(1) make any untrue statement of material fact or to omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or (2) otherwise engage in any act, practice or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.” The SEC suggested that advisers to private funds review their policies and procedures regarding, among other things, the nature and content of private fund sales literature, including general solicitation materials, to determine whether they are reasonably designed to prevent the use of fraudulent or materially misleading private fund advertising. Advisers should make appropriate amendments to these policies and procedures, particularly if the private funds intend to engage in general solicitation activity.
Commodity Exchange Act
Many private fund advisers rely on the de minimis exemption from registration as a commodity pool operator (“CPO”) under the Commodity Exchange Act as provided by Rule 4.13(a)(3) of the Commodity Futures Trading Commission (“CFTC”). In addition, private fund advisers registered as CPOs often rely on CFTC Rule 4.7 to claim certain disclosure, reporting and recordkeeping relief with respect to their funds that engage in more than a de minimis amount of commodity interest trading. Both rules include a prohibition against marketing to the public, although we believe that the prohibition in CFTC Rule 4.7(b) applies only to certain collective trust funds offered pursuant to the exemption from registration under Section 3(a)(2) of the Securities Act by banks that are registered as CPOs. Reliance on CFTC Rule 4.13(a)(3) would appear to be inconsistent with engaging in a general solicitation permitted by new Rule 506(c) without action from the CFTC. In this regard, the Managed Funds Association has petitioned the CFTC to amend the CPO regulations to be consistent with the JOBS Act and securities regulations; however, this petition remains pending with the CFTC as of this date.
II. Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings
Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) required the SEC to adopt rules to disqualify certain securities offerings from reliance on Rule 506, in form substantially similar to the bad actor disqualification provisions contained in Rule 262 of Regulation A, but with an expanded list of disqualifying events. The SEC proposed rule amendments to implement this mandate on May 25, 2011. The final rule amendments that the SEC adopted generally are consistent with the proposed rule amendments, with the principal difference being that the final rule will apply only to triggering events occurring after the effectiveness of the rule amendments, and pre-existing events will be subject to mandatory written disclosure (under the proposed rule, pre-existing events would have been covered as disqualifying events). Additional modifications to the proposed rule, as adopted in the final rule, are discussed below.
Under new Rule 506(d), an issuer may not rely on the Rule 506 exemption (regardless of whether it engages in a general solicitation under the new rules) if the issuer or any other person covered by the rule has had a disqualifying event within the applicable timeframe. Persons covered by the rule are:
- The issuer, any predecessor, and any affiliated issuer;
- Any director, officer, general partner or managing member of the issuer;
- Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities;
- Any investment manager to a pooled investment fund issuer, as well as such investment manager’s directors, executive officers, other officers participating in the offering, and the investment manager’s general partners or managing members, as well as such general partners’ or managing members’ directors, executive officers, and other officers participating in the offering;
- Any promoter connected with the issuer in any capacity at the time of the sale; and
- Any directly or indirectly compensated solicitor, as well as its directors, executive officers, other officers participating in the offering, general partners, and managing members.
The proposed rule would have applied to any officer of the issuer or any officer of a compensated solicitor, and to any beneficial owner of 10% or more of any class of the issuer’s securities. The SEC narrowed the final rule’s scope by limiting the rule’s application to an issuer’s or compensated solicitor’s executive officers and other officers participating in the offering, and to beneficial owners of 20% or more of the issuer’s outstanding voting equity securities. Whether an officer participates in an offering will be a question of fact. Further, the SEC did not define “beneficial ownership” or “voting securities”, and it is not clear whether beneficial ownership is determined for this purpose based on voting authority, pecuniary interest, or on some other basis. The adopting release states that the SEC intends the term “voting securities” to be applied based on whether security holders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right. For example, the SEC stated that securities that confer to security holders the right to elect or remove the directors or equivalent controlling persons of the issuer (e.g., the general partner), or to approve significant transactions, such as acquisitions, dispositions, or financings, would be considered voting securities. Conversely, securities that confer voting rights limited solely to approval of changes to the rights and preferences of the class would not be considered voting securities. As a result, whether a large investor in a private fund is a covered person would depend on whether the investor is deemed to hold voting securities, which may depend on the terms of the fund. For example, if an investor holds more than 20% of the limited partnership interests in a fund that provides limited partners with the right to remove the general partner, that investor likely would be deemed a covered person.
While the proposed rule would not have included investment managers to pooled investment funds among the covered persons, the SEC broadened the final rule’s scope by expanding the rule’s application to investment managers to pooled investment funds, as well as their principals.
The disqualifying events enumerated in the final rule include:
- Criminal convictions within 10 years (five years in the case of issuers) in connection with the purchase or sale of any security, making of a false filing with the SEC, or arising out of the conduct of business as an underwriter, broker-dealer, investment adviser, or paid solicitor;
- Court injunctions and restraining orders entered within five years in connection with the activities listed above;
- Final orders by certain state and federal regulators (including the CFTC) that (i) bar the person from association with any entity regulated by such regulator, or from engaging in the business of securities, insurance or banking, or savings association or credit union activities, or (ii) are based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct, issued within 10 years;
- SEC disciplinary orders relating to the registration, activities, functions, operations, or associations of broker-dealers and investment advisers;
- SEC cease-and-desist orders entered into within five years in connection with any scienter-based anti-fraud provision of the federal securities laws or Section 5 of the Securities Act of 1933;
- Suspension, expulsion, or a bar from association with a self-regulatory organization for the duration of the suspension, expulsion, or bar;
- SEC stop orders and orders suspending the Regulation A exemption issued within five years or in the process of being determined whether to be issued; and
- U.S. Postal Service false representation orders including temporary or preliminary orders entered within five years.
The rule looks to the timing of the disqualifying event (e.g., a criminal conviction or court order) and not the timing of the underlying conduct. A triggering event that occurs after effectiveness of the rule amendments will result in disqualification, even if the underlying conduct occurred before effectiveness.
Disclosure of Prior Disqualifying Events
While Rule 506(d), as adopted, does not cover disqualifying events that occurred prior to the rule’s effectiveness, new Rule 506(e) requires issuers to furnish to each purchaser, a reasonable time prior to sale, a description in writing of any event that would have triggered disqualification but for the fact that it occurred prior to the effectiveness of the new rule. The disclosure requirement will apply to all offerings under Rule 506, regardless of whether purchasers are accredited investors. The SEC stated that it expects that issuers will give reasonable prominence to the disclosure to ensure that information about pre-existing bad actor events is appropriately presented in the total mix of information available to investors. A “reasonable time prior to sale” has the same timing that currently applies to disclosures to non-accredited investors under Rule 502(b)(1). Only sales made after the effective date of the new rule will be subject to mandatory disclosure.
Reasonable Care Exception
The final rule amendments include an exception from disqualification for offerings where the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed because of the presence or participation of another covered person. In addition, the failure to furnish required disclosure on a timely basis will not prevent an issuer from relying on Rule 506 if the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, of the existence of the undisclosed matter. The steps an issuer should take to exercise reasonable care will vary according to the particular facts and circumstances. For continuous, delayed, or long-lived offerings, reasonable care will include updating the factual inquiry on a reasonable basis.
The SEC’s Director of the Division of Corporation Finance may grant a disqualification waiver if it determines that an issuer has shown good cause that it is not necessary under the circumstances that the registration exemption be denied. Additionally, disqualification will not arise if, prior to the relevant sale, the court or regulatory authority that entered the relevant order, judgment, or decree advises in writing, whether in the relevant judgment, order, or decree, or separately to the SEC or its staff, that disqualification should not arise as a consequence of such order, judgment, or decree. No waiver will need to be sought for a person subject to such an order, judgment, or decree, since disqualification will not arise in these circumstances.
Certification on Form D
Issuers claiming a Rule 506 exemption will need to confirm in the signature block of Form D that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(d).
III. Proposed Amendments to Private Offering Rules
In response to certain comments received on proposed Rule 506(c) on the elimination of general solicitation, the SEC proposed a number of amendments in conjunction with the adoption of new Rule 506(c). The proposals include changes to filing requirements for Form D, additional items in Form D, requirement to include legends in written general solicitation materials, requirement to submit written general solicitation materials to the SEC, application of registered fund sales literature guidance to private fund sales literatures, and additional disqualification provisions.
Changes to the Timing of Filing Form D
The SEC proposed amendments to Rule 503 of Regulation D. As proposed, issuers would be required to make an advance filing of Form D in a Rule 506(c) offering, due no later than 15 calendar days in advance of the first use of general solicitation. The “Advance Form D” would include
- Basic identifying information on the issuer;
- Information on the issuer’s principal place of business and contact information;
- Information on related persons;
- Information on the issuer’s industry group;
- Identification of the exemption or exemptions being claimed for the offering;
- Indication of whether the filing is a new filing or an amendment;
- Information on the type(s) of security to be offered;
- Indication of whether the offering is related to a business combination;
- Information on persons receiving sales compensation; and
- Information on the use of proceeds from the offering.
After the filing of an Advance Form D, an issuer would be required to file an amendment providing the remaining information required by Form D within 15 calendar days after the date of first sale of securities in the offering.3 An issuer that provided all of the information required by Form D in the Advance Form D would not need to file an amendment unless otherwise required. An issuer would also be able to file an Advance Form D without contemplating a specific offering, in order to have the flexibility to conduct an offering using general solicitation.
As proposed, issuers would also be required to file a final amendment to Form D within 30 calendar days after the termination of any offering conducted in reliance on Rule 506 (whether or not general solicitation was used).
Additional Items in Form D
The SEC proposed to amend Form D to require additional information, primarily in regard to offerings conducted in reliance on Rule 506. Additional items in Form D for offerings conducted pursuant to Rule 506 would require the following information:
- the number and types of accredited investors that purchased securities in the offering;
- if a class of the issuer’s securities is traded on a national securities exchange, ATS, or any other organized trading venue, and/or is registered under the Exchange Act, the name of the exchange, ATS, or trading venue, and/or the Exchange Act file number, and whether the securities being offered under Rule 506 are of the same class or are convertible into or exercisable or exchangeable for such class;
- if the issuer used a registered broker-dealer in connection with the offering, whether any general solicitation materials were filed with FINRA;
- in the case of a pooled investment fund advised by investment advisers registered with, or reporting as exempt reporting advisers to, the SEC, the name and SEC file number for each investment adviser who functions directly or indirectly as a promoter of the issuer;
- for Rule 506(c) offerings, the types of general solicitation used or to be used; and
- for Rule 506(c) offerings, the methods used or to be used to verify accredited investor status.
Under the proposals, Rule 507 of Regulation D would be amended to disqualify an issuer from relying on Rule 506 for one year for future offerings if the issuer, or its predecessor or affiliate, did not comply, within the last five years, with all of the Form D filing requirements in a Rule 506 offering (disregarding failures to comply that occurred before the effective date of the rule).
Requirements for Written General Solicitation Materials
The SEC proposed new requirements and amendments in connection with Rule 506(c) offerings. First, the SEC proposed to add new Rule 509 to require all issuers to include: (i) legends in any written general solicitation materials used in a Rule 506(c) offering; and (ii) additional disclosures for private funds if such materials include performance data. Second, the SEC proposed amendments to Rule 156 under the Securities Act that would extend the guidance contained in the rule to the sales literature of private funds.
Proposed Rule 509 of Regulation D would require all issuers to include, in a prominent manner, the following legends in all written general solicitation materials:
- The securities may be sold only to accredited investors, which for natural persons are investors who meet certain minimum annual income or net worth thresholds;
- The securities are being offered in reliance on an exemption from the registration requirements of the Securities Act and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act;
- The SEC has not passed upon the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials;
- The securities are subject to legal restrictions on transfer and resale, and investors should not assume they will be able to resell their securities; and
- Investing in securities involves risk, and investors should be able to bear the loss of their investment.
A private fund would also need to include a legend disclosing that the securities offered are not subject to the protections of the Investment Company Act. Any written general solicitation materials of a private fund that include performance data would be required to include a legend disclosing that:
- performance data represents past performance;
- past performance does not guarantee future results;
- current performance may be lower or higher than the performance data presented;
- the private fund is not required by law to follow any standard methodology when calculating and representing performance data; and
- the performance of the fund may not be directly comparable to the performance of other private or registered funds.
All performance data would need to be as of the most recent practicable date considering the type of private fund and the media through which the data will be conveyed, and the private fund must disclose the period for which performance is presented. If the performance presentation does not include the deduction of fees and expenses, the private fund would need to disclose that the presentation does not reflect the deduction of fees and expenses and that if such fees and expenses had been deducted, performance may be lower than presented.
Under the proposed rules, an issuer would be disqualified from relying on Rule 506 for future offerings if such issuer, or its predecessor or affiliate, has been subject to any order, judgment, or court decree enjoining such person for failure to comply with proposed Rule 509.
Submission of Written General Solicitation Materials to the SEC
The SEC proposed Rule 510T that would require an issuer conducting an offering in reliance on Rule 506(c) to submit to the SEC any written general solicitation materials used in connection with the offering. Under the proposed rule, the materials would need to be submitted no later than the date of first use. The materials submitted to the SEC would not be publicly available and would not be treated as being “filed” or “furnished” for purposes of the Securities Act or Exchange Act, including the liability provisions of those Acts. Proposed Rule 510T would expire two years after the effective date.
Under the proposed rules, an issuer would be disqualified from relying on Rule 506 for future offerings if such issuer, or its predecessor or affiliate, has been subject to any order, judgment, or court decree for failure to comply with proposed Rule 510T.
Amendments to Rule 156
The SEC proposed to amend Rule 156 to apply the guidance contained in the rule to sales literature used by private funds. Rule 156 under the Securities Act is an interpretive rule that provides guidance on the types of information in investment company sales literature that could be misleading for purposes of the federal securities laws. Whether a statement involving a material fact is misleading depends on an evaluation of the context in which it is made. Rule 156 outlines certain situations in which a statement could be misleading.
The effective date of the new rules, and the deadline for comments on the proposed rules, is September 23, 2013. Although the elimination of the ban on general solicitation is a significant change to the law, it remains to be seen how widely Rule 506(c) will be used by issuers given the costs and administrative burden associated with verifying the accredited investor status of every purchaser. Additionally, if the SEC adopts the proposed rules amending Form D and the new requirements for general solicitation materials, issuers may find that the costs of relying on Rule 506(c) may simply outweigh the benefits. Finally, Rule 506(d), as adopted, represents an improvement from its proposed version, given that disqualification will apply only to triggering events occurring after the rule’s effectiveness. However, Rule 506(e) requires issuers to disclose any disqualifying event that pre-dates the effectiveness of the rule amendments. This disclosure must be furnished to purchasers a reasonable time prior to sale for all securities sold beginning on September 23, 2013.