The SEC recently adopted rules permitting general solicitation and general advertising in Rule 506 private placements to accredited investors and in Rule 144A offerings to qualified institutional buyers. These rule changes were required to be made pursuant to the JOBS Act. Over time, the scaling back of the general solicitation and general advertising prohibitions in private placements is expected to dramatically affect how many companies raise capital.

At the same time, the SEC adopted the “bad actor” rule, as required by the Dodd-Frank Act, and proposed changes to the Form D filing requirements as well as filing and legending requirements for written materials used in publicly marketed private placements.

New Rule 506(c)

Rule 506 is an exemption from Securities Act registration for transactions by an issuer not involving any public offering. Rule 506 permits an issuer to offer and sell securities to an unlimited number of accredited investors and to no more than 35 non-accredited investors. The availability of Rule 506 previously was conditioned on the issuer not offering or selling securities through any form of general solicitation or general advertising, which include advertisements published in newspapers and magazines, communications broadcast over television and radio, seminars whose attendees have been invited by general solicitation or general advertising and other uses of publicly available media, such as unrestricted websites.

In a significant change to private placement practice, general solicitation and general advertising are permitted in connection with offers and sales of securities made pursuant to new Rule 506(c), provided that all of the following conditions are satisfied:

  • All purchasers of the securities are accredited investors (i.e., a Rule 506(c) offering cannot include non-accredited investors);
  • The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors; and
  • All of the other general requirements relating to a Rule 506 offering are satisfied.

What constitutes reasonable steps to verify that a purchaser is an accredited investor depends on the particular facts and circumstances. Rule 506(c) takes a principles-based approach for the verification process, although the rule also includes specific non-exclusive steps that can be used to verify that an individual is an accredited investor. The SEC felt that requiring specified methods of verification is impractical, given the numerous ways in which a purchaser can qualify as an accredited investor and the wide range of verification methods.

As part of a principles-based approach, the SEC expects an issuer to look at factors such as:

  • The nature of the purchaser;
  • The amount of information that the issuer has about the purchaser; and
  • The nature of the offering (i.e., how the individual was solicited and the minimum investment amount).

Regardless of the particular steps taken, issuers and any third-party verification service providers should retain adequate records regarding the steps taken to verify that a purchaser is an accredited investor since the issuer has the burden of demonstrating that it is entitled to rely on the Rule 506(c) exemption.

The SEC noted in its adopting release that an issuer will not have taken reasonable steps to verify accredited investor status if it required only that an investor check a box in a questionnaire or sign a form, absent other information about the investor indicating accredited investor status.

Nature of the Purchaser

The steps that will be reasonable to verify whether a purchaser is an accredited investor will vary depending on the type of accredited investor that the purchaser claims to be. For example, the steps that may be reasonable to verify that an entity is an accredited investor by virtue of being a broker-dealer will differ from the steps that may be reasonable to verify whether a natural person is an accredited investor.

Information About the Purchaser

The more information that an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it may have to take to verify accredited investor status. Examples of the types of information that an issuer could review or rely upon include: (i) publicly available information in filings with a federal, state or local regulatory body; (ii) third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories in the accredited investor definition; or (iii) verification of a person’s status as an accredited investor by a third party, provided that the issuer has a reasonable basis to rely on the third-party verification.

Nature of the Offering

An issuer that solicits new investors through a website accessible to the general public, through a widely disseminated email or social media solicitation, or through print media, will 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 investors created and maintained by a reasonably reliable third party. In addition, the SEC has indicated that, where the minimum subscription requirement is sufficiently high (i.e., requiring a minimum that is higher than the accredited investor net worth standard), the likelihood of the purchaser satisfying the definition may be sufficiently high for it to be reasonable to take fewer verification steps and to simply confirm that the purchaser did not borrow the investment amount.

Non-Exclusive Methods of Verifying Individual Accredited Investor Status

Although the verification of accredited investor status generally involves a principles-based approach, the SEC included in its adopting release four specific non-exclusive methods of verifying accredited investor status for natural persons that, if used, are deemed to satisfy the verification requirement, absent knowledge that the purchaser is not an accredited investor. Issuers are, however, not required to use these methods.

  • In verifying whether a natural person is an accredited investor on the basis of satisfying the income test, an issuer is deemed to satisfy the verification requirement by: (i) reviewing copies of any Internal Revenue Service form that reports income and a copy of a filed Form 1040 for the two most recent years; and (ii) obtaining a written representation from such person that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
  • In verifying whether a natural person is an accredited investor on the basis of satisfying the net worth test, an issuer is deemed to satisfy the verification requirement by: (i) reviewing one or more of the following types of documentation, dated within the prior three months; and (ii) obtaining a written representation from such person that all liabilities necessary to make a determination of net worth have been disclosed; for assets, the documentation consists of bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties, and, for liabilities, the documentation consists of a consumer report from at least one of the nationwide consumer reporting agencies;
  • An issuer is deemed to satisfy the verification requirement by obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant that such person or entity has taken reasonable steps to verify that a purchaser is an accredited investor within the past three months and has determined that such purchaser is an accredited investor; and
  • With respect to any natural person who invests in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of the final rules and remains an investor of the issuer, an issuer is deemed to satisfy the verification requirement by obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.

Existing Regulation D Exemptions Still Available

Issuers continue to have the ability to conduct Rule 506 offerings without the use of general solicitation and general advertising in reliance on the existing Rule 506(b) safe harbor. For example, an issuer may decide to utilize the existing safe harbor because it wants to make offers and sales to a limited number of non-accredited investors as part of the private placement. Although not often used, an issuer also may still utilize the existing Rule 504 and 505 Regulation D safe harbors.

Adopted and Proposed Changes to Form D Filing Requirements

An issuer must indicate in its Form D filing whether it is relying on Rule 506(c).

In response to investor protection concerns expressed by commenters during the Rule 506(c) rule-making process, the SEC also proposed a number of amendments to Form D. Under the proposed amendments:

  • Issuers would be required to file an initial Form D with the SEC at least 15 days before commencing any general solicitation or general advertising with respect to a Rule 506(c) offering; the proposed amendments also would modify the existing requirement to file an initial Form D within 15 days after the first sale of securities into a requirement to file a Form D amendment within such time period; and
  • Issuers would be required to file a final amendment to their Form D within 30 calendar days after the termination of any offering conducted in reliance on Rule 506(b) or (c).

The proposed amendments also would require that issuers disclose on Form D in connection with a Rule 506(c) offering: (i) the method of general solicitation used (i.e., mass mailings, email, social media, print media, etc.); (ii) the individuals who directly or indirectly control the issuer; and (iii) the methods used to verify accredited investor status.

Under proposed Rule 507(b), an issuer would be disqualified from using Rule 506 in any future offering if the issuer, or any predecessor or affiliate of the issuer, did not comply, within the last five years, with the Form D filing requirements in a Rule 506(b) or (c) offering. The disqualification period would end one year after the required Form D filings have been made. The disqualification would not affect offerings of an issuer or an affiliate that are ongoing at the time of the filing non-compliance, including the offering for which the issuer failed to make a required filing. In addition, an issuer would not be disqualified from using Rule 506 if it makes the requisite Form D filings within a 30-day cure period. Disqualification would arise only with respect to non-compliance that occurred after the effectiveness of Rule 507(b).

Applicability of Blue Sky Laws to Rule 506(c) Offerings

Securities offered pursuant to a Rule 506(c) offering are deemed to be “covered securities.” State blue sky registration requirements therefore do not apply.

Proposed Filing and Legending Requirements for Solicitation Materials

The SEC has proposed new Rules 509 and 510T, which would respectively require:

  • Written general solicitation materials used in Rule 506(c) offerings to include legends advising investors that the securities being offered: (i) may be purchased only by accredited investors, which, for natural persons, requires certain minimum annual income or net worth thresholds to be met; (ii) 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 statements; (iii) have not been approved by the SEC, including the terms of the offering and the accuracy and completeness of the offering materials; (iv) are subject to legal restrictions on transfer and resale and investors should not assume they will be able to resell their securities; and (v) involve risk, and investors should be able to bear the loss of their investment; and
  • Submission to the SEC, no later than the date of first use, of written general solicitation materials used in Rule 506(c) offerings; this requirement would apply for a temporary two-year period; the materials would not be filed on EDGAR, would not be made public by the SEC and would not be treated as “filed” or “furnished” for purposes of the liability provisions of the Securities Act and Exchange Act.

Rule 144A Amendments

Rule 144A provides an exemption from Securities Act registration for resales of securities to qualified institutional buyers, or QIBs, which generally are institutional investors with $100 million or more in assets under management. Although Rule 144A does not expressly prohibit general solicitation and general advertising, Rule 144A contained a requirement that offers be made only to QIBs. This requirement served as a practical restriction on general solicitation and general advertising in Rule 144A transactions. The amendments to Rule 144A eliminate references to “offer” and “offeree.” However, the Rule 144A resale exemption will continue to require that the purchasers be QIBs or persons reasonably believed to be QIBs.

The general solicitation of QIBs will not affect the availability of the private placement exemption used for the sale by the issuer to the initial purchasers in a Rule 144A transaction.

Integration with Regulation S Offerings

Regulation S provides a safe harbor under the Securities Act for offers and sales of securities outside the United States. One of the conditions to the use of Regulation S is that there can be no “directed selling efforts” in the United States. The SEC’s adopting release indicates that a Regulation S offering will not be integrated with an offering conducted in compliance with Rule 506 or Rule 144A.

“Bad Actor” Disqualification — New Rule 506(d)

The Dodd-Frank Act required the SEC to adopt rules disqualifying securities offerings involving “bad actors” from reliance on Rule 506. The bad actor provision is contained in new Rule 506(d). The rule applies to both Rule 506(b) and (c) offerings.

The following persons are “covered persons” for purposes of Rule 506(d):

  • Directors and executive officers of the issuer and other officers who participate in the offering;
  • General partners and managing members of the issuer;
  • Beneficial owners of 20 percent or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • The issuer and any predecessor of the issuer or an affiliated issuer;
  • Any promoter connected with the issuer in any capacity at the time of the sale;
  • Any person that has been or will be paid, directly or indirectly, remuneration for solicitation of purchasers in connection with sales of the securities (a “compensated solicitor”); and
  • Directors, executive officers, other officers participating in the offering, general partners and managing members of any compensated solicitor.

A covered person would be disqualified in the event such person:

  • Has been convicted, within 10 years before the sale of securities in the offering (or five years, in the case of issuers, their predecessors and affiliated issuers), of a felony or misdemeanor: (i) in connection with the purchase or sale of a security; (ii) involving the making of a false filing with the SEC; or (iii) arising out of the conduct of business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Is subject to an order, judgment or decree of a court of competent jurisdiction, entered into within five years before any sale in the offering: (i) that, at the time of the sale, restrains or enjoins the covered person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; (ii) involving the making of a false filing with the SEC; or (iii) arising out of the conduct of business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Is subject to a final order of certain state or federal regulatory authorities that: (i) at the time of the sale in the offering, bars the person from: (a) association with an entity regulated by such regulatory authority; (b) engaging in the business of securities; insurance or banking; or (c) engaging in any savings association or credit union activities; or (ii) constitutes a final order entered within 10 years before such sale based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct;
  • Is subject to an order of the SEC that, at the time of the sale in the offering: (i) suspends or revokes such person’s registration as a broker, dealer, municipal dealer or investment adviser; (ii) places limitations on the activities, functions or operations of such person; or (iii) bars such person from being associated with any entity or from participating in the offering of any penny stock;
  • Is subject to an order of the SEC entered within five years before the sale in the offering that, at the time of the sale, orders the person to cease and desist from committing or causing a violation or future violation of any scienter-based anti-fraud provision of the federal securities laws or Section 5 of the Securities Act;
  • Is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for certain acts or omissions; or
  • Has filed (as a registrant or issuer), or was named as an underwriter in certain offerings that: (i) were the subject of a refusal order, stop order or suspension order; or (ii) are the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued.

Disqualification only will apply for triggering events that occur after the effective date of Rule 506(d). Although prior triggering events will not disqualify the offering, they must be disclosed to purchasers a reasonable time prior to the sale in connection with any offering under Rule 506.

In addition, events relating to an affiliated issuer that occurred before the affiliation arose will not be considered disqualifying if the affiliated entity is not: (i) in control of the issuer; or (ii) under common control with the issuer by a third party that was in control of the affiliated entity at the time of such events.

Rule 506(d) also includes 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. The steps that an issuer should take to exercise reasonable care will vary according to the particular facts and circumstances of the transaction. The SEC indicated in the adopting release that it anticipates that issuers will have in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship; accordingly, in such circumstances, further compliance steps may not be required in connection with a particular offering. The SEC also indicated in the adopting release that factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement. The SEC expects that market participants will develop practices that help issuers to gather the required information.

Effective Date

Rule 506(c) and (d) and the amendments to Rule 144A will take effect on Sept. 23, 2013, which is the date that is 60 days after the rules were published in the Federal Register. The proposed rules relating to Form D filing requirements and filing and legending requirements for written materials used in publicly marketed private placements requirements remain subject to public comment and are therefore not yet effective.

Applicability to Private Investment Funds

For a discussion regarding the applicability of the final and proposed rules discussed above to private investment funds, please see the SRZ Alert titled “The SEC’s JOBS Act Rulemaking: What it Means for Private Fund Managers.”