The US Securities and Exchange Commission adopts final rules eliminating the prohibition on general solicitation and general advertising in Rule 144A and Rule 506 offerings.
On 10 July 2013, the US Securities and Exchange Commission (the "SEC"), in order to implement Section 201(a) of the Jumpstart Our Business Startups Act (the "JOBS Act"), adopted final rules to eliminate the prohibition against general solicitation and general advertising (together, "general solicitation") for certain offerings to "accredited investors" ("accredited investors") conducted under Rule 506 of Regulation D under the US Securities Act of 1933 (the "Securities Act") and offerings to "qualified institutional buyers" ("QIBs") under Rule 144A under the Securities Act. The SEC also adopted final rules to disqualify offerings from relying on Rule 506 if they involve certain "bad actors". These rule changes will be effective 60 days after their respective publication in the US Federal Register. Until the effective date of the new rules, the SEC's existing rules and regulations for Rule 506 and Rule 144A offerings remain unchanged.
The SEC also proposed on 10 July 2013 further amendments to Regulation D which are designed to increase the SEC's ability to monitor developments in Rule 506 offerings following the elimination of the prohibition on general solicitation. If adopted, the proposed amendments to Regulation D would require issuers to, among other things, file a Form D with the SEC 15 days before engaging in general solicitation, submit written general solicitation materials on a non-public basis to the SEC and publicly disclose additional information about Rule 506 offerings that involve general solicitation (e.g., the types of general solicitation employed and the methods used to verify the accredited investor status of purchasers). The proposed amendments will be open for public comment for 60 days from their publication in the US Federal Register.
Copies of the SEC releases in relation to the final rules and proposed amendments are available here. We also previously published a US Securities e-bulletin discussing various aspects of the JOBS Act relevant to foreign private issuers, a copy of which is available here.
These developments are likely to impact the way in which private securities offerings are conducted in the United States. However, issuers will need to consider a number of factors, including the application of other rules and regulations and previous interpretive guidance from the SEC, before undertaking any private offering involving general solicitation.
2. Amendments to Rule 144A
Rule 144A is a non-exclusive safe harbour from the registration requirements of Section 5 of the Securities Act for resales of certain "restricted securities" to QIBs. Under existing Rule 144A, securities must be offered and sold only to QIBs (or to persons that the seller and any person acting on its behalf reasonably believe are QIBs). Resales to QIBs conducted in accordance with Rule 144A are exempt from registration pursuant to Section 4(a)(1) of the Securities Act, which exempts transactions by any person "other than an issuer, underwriter, or dealer".
By its terms, Rule 144A is available solely for resale transactions; however, since its adoption by the SEC in 1990, market participants have used Rule 144A to facilitate capital raisings by issuers and selling shareholders. As a result, the term "Rule 144A offering" generally refers to a primary offering of securities by an issuer or selling shareholder to one or more financial intermediaries in a transaction that is exempt from registration pursuant to Section 4(a)(2) or Regulation S, followed by the immediate resale of those securities by the intermediaries to QIBs in reliance on Rule 144A.1
In its adopting release, the SEC noted that although existing Rule 144A does not include an express prohibition against general solicitation, it has the same practical effect because offers of securities under existing Rule 144A must be limited to QIBs. The terms "general solicitation" and "general advertising" are not defined in the Securities Act, but Rule 502(c) of Regulation D does provide examples, including advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars whose attendees have been invited through general solicitation or general advertising. By interpretation, the SEC has confirmed that other uses of publicly available media, such as unrestricted websites, also constitute general solicitation.
The amendments to Rule 144A remove the references to "offer" and "offeree" in Rule 144A(d)(1). As a result, once the amendments become effective, resales of securities pursuant to Rule 144A may be conducted using general solicitation, so long as the securities are sold only to QIBs or to purchasers that the seller and any person acting on its behalf reasonably believe are QIBs.
In contrast to the amendments to Rule 506 of Regulation D (as discussed below), the amendments to Rule 144A do not create any additional requirements for issuers and their intermediaries to use "reasonable steps to verify" that a potential purchaser is a QIB. Instead, issuers and intermediaries can continue to use the existing list of non-exclusive methods contained in Rule 144A(d)(1) for establishing a prospective purchaser's ownership and discretionary investments of securities for purposes of determining whether the prospective purchaser is a QIB.
3. Amendments to Rule 506 of Regulation D
Existing Rule 506(b) of Regulation D
Rule 506 is a non-exclusive safe harbour under Section 4(a)(2) of the Securities Act, which exempts transactions by an issuer "not involving any public offering" from the registration requirements of Section 5 of the Securities Act. The availability of the Rule 506 safe harbour is subject to a number of specific requirements. Under existing Rule 506(b), an issuer may offer and sell securities, without limitation on the offering amount, to an unlimited number of accredited investors, and to no more than 35 non-accredited investors who meet certain "sophistication" requirements regarding knowledge and experience in financial and business matters. Reliance on existing Rule 506(b) is also conditioned on the issuer, and any person acting on its behalf, not offering or selling securities through any form of general solicitation.
New Rule 506(c) of Regulation D
To implement the rule changes mandated by the JOBS Act, the SEC adopted new Rule 506(c), which permits the use of general solicitation to offer and sell securities under Rule 506, provided that certain conditions are satisfied. These conditions include the following:
- the issuer must take "reasonable steps to verify" that the purchasers of the securities are accredited investors; and
- all purchasers of the securities must be accredited investors.
Offerings under new Rule 506(c) are not required to comply with Rule 502(c), which contains the prohibition against general solicitation.
Ability to use existing Rule 506(b) (without general solicitation) preserved
While issuers may elect to use general solicitation under new Rule 506(c), the SEC has also preserved, under existing Rule 506(b), the ability of issuers to conduct private offerings without the use of general solicitation. In its adopting release, the SEC stated that it recognises that offerings under existing Rule 506(b) are an important source of capital for issuers and that it believes the continued availability of existing Rule 506(b) will be important for those issuers that do not wish to engage in general solicitation or that wish to sell privately to non-accredited investors who meet Rule 506(b)'s requirements regarding knowledge and experience in financial and business matters. Most importantly, issuers relying on existing Rule 506(b) will not have to comply with the new requirement under Rule 506(c) to take "reasonable steps to verify" the accredited investor status of purchasers (as discussed below).
Reasonable steps to verify accredited investor status under new Rule 506(c)
While Section 201(a)(1) of the JOBS Act mandated that amendments to Rule 506 require issuers using general solicitation "to take reasonable steps to verify that purchasers of the securities are accredited investors", the JOBS Act did not specify the methods necessary to satisfy this requirement and instead required issuers to use "such methods as determined by the [SEC]". In its adopting release, the SEC noted that that the purpose of the verification mandate is to address concerns, and to reduce the risk, that the use of general solicitation under new Rule 506(c) may result in sales to investors who are not, in fact, accredited investors. The SEC also recognised, however, that the amendments to Rule 506 must provide sufficient flexibility to accommodate the different types of issuers that may conduct offerings under new Rule 506(c) and the different types of accredited investors that may purchase securities in such offerings.
As a result, the SEC generally adopted a principles-based approach under which the question of whether the steps taken to verify accredited investor status are "reasonable" is an objective determination, based on the particular facts and circumstances of each transaction. The SEC has indicated that issuers should consider a number of factors when determining the reasonableness of the steps taken to verify that a purchaser is an accredited investor, including:
- 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 to participate in the offering, and the terms of the offering, such as a minimum investment amount.
Regardless of the particular steps taken, the SEC has emphasised that, because the issuer has the burden of demonstrating that its offering is entitled to an exemption from the registration requirements of Section 5 of the Securities Act, it will be important for issuers and their verification service providers to retain adequate records regarding the steps taken to verify the accredited investor status of purchasers.
With regard to natural persons, the SEC also provided a non-exclusive list of methods that are deemed sufficient to satisfy the accredited investor verification requirement (provided that the issuer does not have knowledge that the purchaser is not an accredited investor). The non-exclusive list of methods includes:
- for verifying income, reviewing copies of US Internal Revenue Service forms that report income for the two most recent years and obtaining a written representation that the purchaser has a reasonable expectation of reaching the necessary income level during the current year;
- for verifying net worth, reviewing various types of financial documents demonstrating assets and liabilities, such as bank statements and credit reports, dated within the last three months and obtaining a written representation that all liabilities necessary to make a determination of net worth have been disclosed;
- obtaining a written confirmation from a registered broker-dealer or investment adviser, a licensed attorney or a certified public accountant that such person has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that the purchaser is an accredited investor; or
- for any natural person who, prior to the effective date of new Rule 506(c), invested in a Rule 506(b) offering by the same issuer as an accredited investor and remains an investor of the issuer, obtaining a certification from the purchaser that the purchaser qualifies as an accredited investor.
It is worth noting that even if a purchaser does not, in fact, fall within any of the enumerated categories of an "accredited investor", the issuer will not lose the ability to rely on new Rule 506(c) for the offering so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and it had a reasonable belief that such purchaser was an accredited investor. In this context, the SEC acknowledged that even if an issuer has taken reasonable steps to verify that a purchaser is an accredited investor, it is possible that a purchaser could nevertheless circumvent those measures by, for example, providing false information or documentation.
Proposed Amendments to Increase the SEC's Ability to Monitor Rule 506 Offerings
Certain consumer and investor advocacy groups, as well as certain commissioners at the SEC, have expressed concern that the changes to Rule 506 could lead to an increase in fraudulent activity in the private securities markets, as well as an increase in unlawful sales to non-accredited investors. Accordingly, on the same day that it approved the amendments to Rule 506 of Regulation D (as discussed above), the SEC also proposed further amendments to Regulation D that are designed to increase the SEC's ability to monitor developments in Rule 506 offerings following the elimination of the prohibition on general solicitation. If adopted, the proposed amendments would, among other things, require issuers to file a Form D with the SEC 15 days before engaging in any general solicitation under new Rule 506(c), submit written general solicitation materials used in new Rule 506(c) offerings to the SEC on a non-public basis during a two-year transitional period, include certain legends on written general solicitation materials used in new Rule 506(c) offerings and publicly disclose additional information about the Rule 506(c) offering (e.g., the types of general solicitation employed and the methods used to verify the accredited investor status of purchasers).
New Rule 506(d) "bad actor" disqualifier
The SEC also adopted new Rule 506(d), which disqualifies offerings from reliance on Rule 506 where the issuer or other relevant persons (including underwriters and directors, officers and significant shareholders of the issuer) have been convicted of, or are subject to sanctions for, securities fraud or other relevant misconduct. However, new Rule 506(d) provides that disqualifying events occurring prior to the adoption of the rule will not preclude reliance on Rule 506; instead, issuers will be required to disclose such events to investors. Although the SEC solicited comments regarding whether disqualifying events should be expanded to include decisions of non-US courts and regulators, the SEC stated in its adopting release that it had concluded that such an expansion was not warranted.
4. Section 4(a)(2) Offerings
Section 4(a)(2) of the Securities Act exempts transactions by an issuer "not involving any public offering". Private offerings conducted pursuant to Section 4(a)(2) are not exempt from registration as a result of a specific regulatory safe harbour, but as a result of case law, interpretive guidance from the SEC and practices and procedures that have developed in the US securities markets to ensure that the offering is only made to sophisticated investors who have access to the type of information normally provided in a prospectus and who agree not to resell or distribute the securities to the public. In previous guidance, the SEC has indicated that issuers may not use any general solicitation in connection with a Section 4(a)(2) offering.
In its adopting release, the SEC reiterated that an issuer relying on Section 4(a)(2) (and not on a specific regulatory safe harbour under Regulation D or Rule 144A) is "restricted in its ability to make public communications to attract investors for its offering because public advertising is incompatible with a claim of exemption under Section 4(a)(2)". Given that the JOBS Act only directs the SEC to eliminate the prohibition against general solicitation in Rule 144A and Rule 506 offerings, the JOBS Act and the amendments to Rule 144A and Rule 506 do not impact Section 4(a)(2) offerings in general. Section 4(a)(2) offerings, therefore, must continue to be conducted without the use of general solicitation.
The JOBS Act and the amendments to Rule 144A and Rule 506 also do not impact private offerings conducted under the so-called Section 4(a)(1½) exemption, which was developed by market participants to allow persons (other than the issuer) to resell unregistered securities without being deemed an underwriter by using practices and procedures similar to those that would be followed for a Section 4(a)(2) offering. Accordingly, Section 4(a)(1½) offerings also must continue to be conducted without the use of general solicitation.
5. Concurrent Regulation S Offerings
Foreign private issuers often sell securities in a concurrent offering in reliance on Rule 144A for offers and sales to QIBs (or in reliance on Section 4(a)(2) or Rule 506 for offers and sales to accredited investors) in the United States and Regulation S for "offshore" offers and sales to persons outside the United States. Regulation S prohibits "directed selling efforts", which is broadly defined to include any activities that have, or can reasonably be expected to have, the effect of conditioning the market in the United States for the securities being offered. Such activity includes, for example, 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 on Regulation S.
The SEC has acknowledged that the amendments to Rule 144A and Rule 506 have raised concerns among market participants regarding the impact the use of general solicitation may have on the availability of the Regulation S safe harbour for concurrent offerings outside the United States, given that activities which will constitute permissible general solicitation under Rule 144A or Rule 506 may still be viewed as impermissible directed selling efforts under Regulation S. In response to these concerns, the SEC reiterated in its adopting release that, consistent with its historical treatment of concurrent Regulation S and Rule 144A/Rule 506 offerings, offers made in the United States in accordance with Rule 144A or Rule 506 (as amended to permit general solicitation) will not be integrated with a concurrent Regulation S offering and therefore issuers will not be precluded from relying on Regulation S for the non-US portion of an offering. Notwithstanding this statement, however, the SEC may need to provide further interpretive guidance as to the circumstances under which US marketing activity in a concurrent US and non-US offering may constitute directed selling efforts, particularly for offerings by foreign private issuers that involve publicly listing the securities on a non-US exchange.
6. General Solicitation by Non-US Investment Funds
In addition to ensuring that any offering of securities is exempt from registration under the Securities Act, private investment funds, such as hedge funds and private equity funds, need to ensure that they are not subject to substantive regulation under the US Investment Company Act of 1940 (the "Investment Company Act"). Many private investment funds seek to be excluded from the definition of an "investment company" by virtue of Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act, which excludes investment funds with, in the case of Section 3(c)(1), not more than 100 beneficial owners or, in the case of Section 3(c)(7), owners that are all "qualified purchasers" as defined in Section 2(a)(51) of the Investment Company Act ("qualified purchasers"). Under both exclusions, the private investment fund must not have conducted a "public offering" of its securities.
In a series of no-action letters, the SEC has indicated that foreign investment funds, including those with securities listed on a non-US exchange, can rely on Section 3(c)(1) or Section 3(c)(7) in the context of a US private placement, so long as the US private placement does not result in the foreign investment fund having more than 100 US beneficial owners (in the case of Section 3(c)(1)), or US owners that are not qualified purchasers (in the case of Section 3(c)(7)), and so long as the foreign investment fund institutes reasonable procedures in respect of secondary market sales by such US persons so that the required status is maintained on an on-going basis. In establishing such procedures, the foreign investment fund has not been required to limit the number of non-US offerees or to take steps to prevent US persons from acquiring securities in certain valid secondary market transactions outside the United States so long as the foreign investment fund (or persons acting on its behalf) has not engaged in "directed selling efforts" or other attempts to condition the market, or facilitate secondary market trading, for the securities in the United States.
In its adopting release, the SEC confirmed that the use of general solicitation in Rule 506 offerings will not constitute a "public offering" under Section 3(c)(1) or Section 3(c)(7) and, as result, will not preclude a private investment fund from continuing to rely on those exemptions from registration under the Investment Company Act.2 However, notwithstanding this confirmation, the extent to which 3(c)(1) or 3(c)(7) foreign investment funds may use general solicitation is not entirely clear. The SEC's no-action letters interpreting Section 3(c)(1) and Section 3(c)(7) for foreign investment funds emphasised the importance of the foreign investment fund not engaging in attempts to condition the market, or facilitate secondary market trading for, the securities in the United States. Particularly in the case of foreign investment funds with securities listed on a non-US exchange, US marketing activity could lead to significant secondary market activity outside the United States by US persons without appropriate procedures to ensure their status to invest in a Section 3(c)(1) or Section 3(c)(7) investment fund. Absent further guidance from the SEC, foreign investment funds with offshore public listings will need to consider carefully the extent to which they can use general solicitation in a Rule 144A or Rule 506(c) offering.
7. Practical Impact on Private Offerings by Foreign Private Issuers
The amendments to Rule 144A should generally have a beneficial effect on the ability of foreign private issuers to conduct such offerings in the United States as they should reduce the uncertainty as to the availability of the Rule 144A exemption for certain offering activities. For example, an inadvertent leak of information about an offering to entities or persons with whom the foreign private issuer does not have a pre-existing relationship should no longer raise material concerns about the issuer's ability to rely on the Rule 144A exemption. In addition, some foreign private issuers have historically been reluctant to respond to press inquiries or to correct inaccurate reports due to concerns about these discussions being misconstrued as a general solicitation. Under the amendments to Rule 144A, any such uncertainty as to the availability of the exemption will be reduced. Foreign private issuers who conduct Rule 506 offerings should also find new Rule 506(c) generally beneficial, but they will need to consider the additional time and effort that may be required to verify the accredited investor status of purchasers. Also, any additional amendments to Regulation D, if adopted substantially in the form currently proposed by the SEC, would impose further burdens on issuers wishing to utilise Rule 506(c) (including additional public disclosure requirements).
Foreign private issuers that take advantage of the increased flexibility provided by these rules will also need to continue to exercise caution in how they conduct any widespread marketing activity in the United States, particularly given the risk of litigation under the anti-fraud provisions of Rule 10b-5 under the US Securities Exchange Act of 1934, which will continue to apply to any oral or written communications by, or on behalf of, the issuer in connection with any US private placement transaction. The SEC may also need to provide additional interpretive guidance on the applicability of these final rules to foreign private issuers (including foreign investment funds) conducting concurrent US and non-US offerings where the primary trading market for the securities will be a non-US exchange that does not limit the ability of any US purchaser, qualified or otherwise, from purchasing the relevant securities in the secondary market.