The US Securities and Exchange Commission has adopted much-anticipated amendments to its regulations on private offerings under Rule 506 of Regulation D of the Securities Act of 1933, as amended, that lift the more than 80-year ban on general solicitation and advertising for certain purchasers, as mandated by Section 201(a) of the Jumpstart Our Business Startups Act (popularly called the JOBS Act).1
Once effective, these amendments will permit issuers to use advertising and other forms of mass communication to sell securities solely to “accredited investors” under Rule 506 of Regulation D. However, these amendments also include several new requirements and procedures. You will want to be aware of these changes before you launch a general solicitation campaign.
In remarks and in the adopting release, the SEC commissioners expressed concern over the potential for abuse and fraud under these new rules and cautioned issuers that the SEC would be closely monitoring general solicitation and advertising activities. SEC Chairman Mary Jo White said, “As we fulfill our mission to facilitate capital formation and maintain fair and efficient markets, the Commission must always focus on strong investor protections. . . . We want this new market and the private markets in general to thrive in a safe and efficient manner, and these rules we adopt and propose are designed to facilitate that objective.”
In addition to the rules on general solicitation, the SEC adopted rules disqualifying securities offerings involving certain “bad actors” from reliance on the Rule 506 exemption (regardless of whether general solicitation or general advertisement are utilized), as mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The SEC also proposed new rules for Rule 506 private offerings that, if adopted, will subject such offerings to additional procedures and requirements, including special requirements for offerings using general solicitation or general advertising. In its release, the SEC said the additional “proposed amendments are intended to enhance the Commission’s ability to evaluate the development of market practices in Rule 506 offerings and to address concerns that may arise in connection with permitting issuers to engage in general solicitation and general advertising under new paragraph (c) of Rule 506,”2 but are not mandated by either the JOBS Act or the Dodd-Frank Act.
FINAL RULES ALLOWING GENERAL SOLICITATION AND GENERAL ADVERTISING
Current Rule 506 of Regulation D provides issuers a “safe harbor” under Section 4(a)(2) of the Securities Act for sales of securities not involving any public offering. If issuers comply with the requirements of Rule 506, then they do not need to register the offered securities with the SEC or any state securities regulator and usually do not need to file reports with the SEC other than a Form D within 15 days of the first sale of a security under this exemption.3
Under this existing Rule 506 exemption, issuers may sell an unlimited amount of securities, provided that they comply with the following requirements:
- the issuer may not use general solicitation or general advertising
- the issuer may sell to an unlimited number of accredited investors, but only up to 35 other purchasers, who must themselves be sophisticated
- if non-accredited investors are included in the offering, the issuer must provide certain disclosures and financial information to them and
- the securities received are “restricted.”
The new amendments to Rule 506 add subsection (c) that permits an issuer relying on this exemption to engage in general solicitation or general advertising when offering and selling securities, provided that:
- all purchasers are accredited investors (or investors that the issuer reasonably believes are accredited at the time of sale)
- the issuer takes reasonable steps to verify the accredited investor status of each purchaser and
- the issuer complies with other applicable provisions of Regulation D.
See also the SEC’s Fact Sheet regarding the lifting of the ban on general solicitation and advertising.
General solicitation or general advertising could include soliciting investments through a website accessible to the general public, through a widely disseminated email or social media solicitation, through print media, such as a newspaper or magazine, or through other public statements. Issuers are not required to use general solicitation or general advertising and may continue to engage in private placements as they did under “old Rule 506” under new Rule 506(b). In connection with the new Rule 506(c) provisions, Form D is being revised to add a box that must be checked by those issuers who use general solicitation or general advertising in the offering.
However, several other regulatory schemes apply in the context of general solicitation or general advertising, and issuers must take steps to ensure compliance with not just Regulation D, but other applicable laws as well. For example, issuers must comply with applicable state securities laws and with the regulation of broker-dealers, as more thoroughly discussed in the sections below entitled “Broker-dealer implications of general solicitation changes” and “Sponsors that conduct a limited number of offerings.” Further, private funds must comply with applicable requirements of the Investment Company Act of 1940 and the Investment Advisers Act of 1940, as discussed under “Investment Company Act implications of general solicitation changes,” below, as well as the Commodity Exchange Act and regulations of the Commodity Futures Trading Commission.
Who is an accredited investor?
An accredited investor is generally perceived as a sophisticated person who is not in need of enhanced protection by the SEC. The new amendments did not change the definition of “accredited investor” in Rule 501(a). As defined, “accredited investor” includes:
- an individual with a net worth greater than US$1 million (exclusive of the value of a primary residence),5
- either individually or jointly with the individual’s spouse
- a natural person with income exceeding US$200,000 in each of the two most recent years or joint income with a spouse whose annual income exceeds US$300,000 for those years and a reasonable expectation of the same income level in the current year
- a trust with assets in excess of US$5 million, not formed to acquire the securities offered, whose purchases are directed by a “sophisticated person” as described in Rule 506(b)(2)(ii)
- a charitable organization, corporation or partnership with assets exceeding US$5 million
- a bank, insurance company, registered investment company, business development company or small business investment company
- an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of US$5 million
- a director, executive officer or general partner of the issuer or
- an entity in which all the equity owners are accredited investors.
Verification of accredited investor status
Currently, many issuers and funds utilize a check-the-box approach, whereby they rely solely on an investor’s representation that the investor is an “accredited investor” under one of the categories in Rule 501(a). Under the new rules, issuers utilizing general solicitation will also need to take “reasonable steps” to verify the accredited investor status of anyone to whom they sell securities under such offering. New Rule 506(c)(2)(ii) includes several non-exclusive methods that will be deemed to satisfy the verification requirement (provided that the issuer does not have knowledge that the purchaser is non-accredited), including:
- reviewing any US Internal Revenue Service (IRS) form that reports the purchaser’s income for the two most recent years and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year
- reviewing, as to assets, bank, brokerage or other statements and, as to liabilities, a consumer report from at least one of the nationwide consumer reporting agencies dated within three months, and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed or
- obtaining written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser's accredited investor status.6
The SEC also included a form of “grandfather” provision in new Rule 506(c)(2)(ii)(D), which provides that for existing investors who were accredited investors in a Rule 506(b) offering prior to the effective date of Rule 506(c), a self-certification of accreditation status by such investor at the time of sale in a new offering by the same issuer under Rule 506(c) will be deemed to satisfy the verification requirement in Rule 506(c).7
Some commenters have speculated that investors will be reluctant to provide such detailed personal information to issuers and fund managers, but may be willing to provide it to a neutral third party. Several registered broker-dealers have already started developing services to verify investors’ accredited status, such as SecondMarket’s Accreditation Verification Platform (AVP), and more will likely follow.
During the public comment period with respect to the newly adopted rules, several commenters raised concerns that this enhanced verification process could impact the determination of accredited investor status in other private placements that do not utilize the Rule 506(c) general solicitation exemption as a result of “scope creep.” Rule 501(a) defines an accredited investor as one that the issuer “reasonably believes” falls within the enumerated categories, and Regulation D does not include a specific procedure for, or definition of, what satisfies a “reasonable belief” standard. Theoretically, issuers and funds utilizing “old Rule 506” (such as offerings under Rule 506(b) or other private placement exemptions) can continue to rely on self-certification, but many commenters are concerned that this will no longer be considered “reasonable belief” in light of the active verification requirements of new Rule 506(c). Issuers and potential issuers should monitor market practices with respect to this concern as they develop following the effectiveness of the new Rule 506(c).
Amendments to Rule 144A
The SEC has also amended Rule 144A, the exemption for resales of restricted securities to “qualified institutional buyers” (QIBs),8 to provide that securities may be offered under this exemption by general solicitation or general advertising provided that such securities are only sold to those the seller reasonably believes to be QIBs.
The amendments to Rule 144A continue to use a “reasonable belief” standard for QIB status, rather than the enhanced “reasonable steps to verify accreditation” requirement under new Rule 506(c). However, as discussed above, it is unclear whether the check-the-box approach will continue to be considered reasonable in light of the increased requirements for similar private offerings.
Investment Company Act implications of general solicitation changes
While private funds, such as hedge funds, private equity funds and venture capital funds, may be jumping at the chance to publicly market their funds without violating their Rule 506 exemption, they will also need to consider the requirements under the Investment Company Act and the Investment Advisers Act. Private funds typically rely on the exclusions from the definition of “investment company” found in either Section 3(c)(1)9 or Section 3(c)(7)10 of the Investment Company Act, both of which require that the fund “is not making and does not presently propose to make a public offering of its securities.” Despite protests from some commenters, the SEC has taken the position in its adopting release that, since Section 201(b) of the JOBS Act provides that offers and sales exempt under new Rule 506(c) allowing general solicitation or general advertising will not be deemed public offerings, private funds may conduct such offerings without losing their exemption under either Section 3(c)(1) or Section 3(c)(7). Private funds and investment advisers will still be subject to state and federal securities law anti-fraud provisions, including Rule 206(4)-8 under the Investment Advisers Act.
This may not be the end of the story for funds, though. As indicated in the release adopting the final general solicitation rules and the release proposing additional requirements for general solicitation offerings described below in the section entitled “Proposed changes to Form D, Regulation D and Rule 156 under the Securities Act,” the SEC “will monitor and study the development of private fund advertising and undertake a review to determine whether any further action is necessary.”11 Depending on the SEC’s analysis over the next two years, we may see additional restrictions imposed on private funds and investment advisers seeking to use general solicitation in marketing.
Broker-dealer implications of general solicitation changes
Lifting the ban on general solicitation may not be quite the blessing issuers desired given limitations imposed on broker-dealer activities by other regulations. If the officers, directors and employees of an issuer engage in the marketing and sale of securities to the public, including statements (whether oral or written) made by such affiliates of the issuer, they must comply with the broker-dealer requirements set forth in the Securities Exchange Act of 1934, as amended, or fit within an exemption to such requirements.
Impact on the sale of Rule 506 offerings
Section 3(a)(4) of the Exchange Act defines a “broker” as any person engaged in the business of effecting transactions in securities for the account of others. The definition of “broker” has customarily been interpreted by the SEC as not requiring the issuer itself to register as a broker because the issuer is not effecting a transaction for the account of others.12 However, the officers, directors and employees of an issuer do not benefit from the same interpretation. Rule 3a4-1 contains “safe harbor” provisions for persons associated with an issuer (i.e., the officers, directors and employees of the isser) which allows them not to register as brokers if the associated person:
- is not compensated based on the sale of the securities
- is not currently registered as a broker-dealer
- has not committed certain bad acts and
- the security is sold through a registered broker-dealer (or other registered person)
- the associated person (a) primarily performs tasks other than the sale of securities for the issuer, (b) is not, and has not for the prior 12 months been, a registered broker-dealer and (c) does not participate in more than one offering every 12 months or
- the associated person (a) only participates in written communications through the mail or means that does not include oral solicitation, (b) only responds to inquiries from potential investors or (c) only performs administrative work with respect to the transaction.
Sponsors that conduct a limited number of offerings
Associated persons that work with a sponsor that conducts only one offering every 12 months or more may be able to take advantage of Rule 3a4-1 because such persons may be able to meet the requirement set forth in subsection (2) above. However, Rule 3a4-1 only provides a “safe harbor” for federal purposes. Certain states have their own requirements regarding registration as a broker-dealer. It is possible that a state exemption will not be available to sponsors that conduct only a limited number of offerings. In addition, the states could amend their broker-dealer registration rules in order to include persons associated with sponsors that conduct Rule 506 offerings through general solicitations.
Sponsors that conduct multiple offerings
The requirements of Rule 3a4-1 will not be easy to meet for persons associated with a sponsor that conducts multiple offerings, unless the transaction is completed through a broker-dealer. What is uncertain is the role of the retail representative in the transaction. It is possible that the industry may adjust so that broker-dealers would be used as clearinghouses to facilitate the sale to the investors. Thus, the registered broker-dealer will still need to comply with the requirements imposed by the Financial Industry Regulatory Authority (FINRA), including the “know your customer” and suitability rules.
However, because the broker-dealer will not necessarily have a pre-existing relationship with the client in an offering using general solicitation or advertising, it may be more difficult for the broker-dealer to comply with the FINRA requirements. FINRA rule changes may be required in order for broker-dealers to operate under the new general solicitation provision.
Pros and cons
Lifting the prohibition against general solicitation and general advertising may provide issuers with direct access to investors that is not currently available. However, issuers who choose to offer securities in this manner, and the persons associated with the issuer, will need to implement procedures for complying with accredited investor verification requirements, as well as updating such verification periodically if the offering is continuing or ongoing. Issuers must also be mindful of the Exchange Act and state requirements related to registration as a broker-dealer. Most sponsors that do more than one offering per year will still need to utilize broker-dealers. However, the roles of the registered broker-dealer and the structure of the transaction are likely to change as a result of the lifting of the ban on general solicitation and general advertising.
The final rules permitting use of general solicitation or general advertising in private offerings under Rule 506 of Regulation D of the Securities Act can be found here. The rules will be effective sometime in mid-September on the date that is 60 days after publication of the rules in the Federal Register. Until that time, general solicitation is still prohibited in connection with offerings under Rule 506 or Rule 144A.
“BAD ACTOR” DISQUALIFICATION IN PRIVATE PLACEMENTS
The Dodd-Frank Act, enacted in 2010, required the SEC to adopt rules to prohibit use of the Rule 506 exemptions under Regulation D for securities offerings in which certain “bad actors” are involved, whether or not general solicitation or general advertising are used in the offering. To fulfill this requirement, the SEC has adopted rules that disqualify an issuer from selling securities in reliance upon the Rule 506 exemption if the issuer, its board members, certain of its officers and its large shareholders, among others covered by the rule, have experienced a “disqualifying event.” This is similar to existing bad actor rules, such as those found in Rule 505 of Regulation D, which relies on the disqualification provisions set forth in Rule 262 of Regulation A.
Disqualifying events include criminal convictions in connection with sales of securities, certain SEC civil and administrative actions and certain other orders from financial service industry regulatory authorities. If the issuer or other covered person is deemed a bad actor under this rule, the Rule 506 exemption will not be available to the issuer.
Who is impacted?
Any issuer that wants to make use of the exemption provided by Rule 506, regardless of whether the issuer engages in general solicitation or general advertising, will need to exercise reasonable care to prevent a covered person with a disqualifying event from participating in the offering.
“Covered persons” include:
- the issuer of the securities (including its affiliates and predecessors), including its directors, certain officers, general partners and managing members
- holders of 20 percent or more of the voting control of the issuer
- investment managers (and their principals) of pooled investment funds and
- promoters and those compensated for soliciting investors (including the principals of entities performing such services).13
Officers of an issuer will be “covered persons” to the extent they are involved with or participate in the offering. In the adopting release, the SEC noted that the determination of which officers will be deemed to have “participated in” an offering will be a question of fact: “Participation in an offering would have to be more than transitory or incidental involvement, and could include such activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.”14
What will disqualify an issuer from using Rule 506?
“Disqualifying events” for covered persons include the following:
- convictions for securities-related crimes that have occurred within 10 years of the proposed sale of securities or 5 years if the relevant covered person is the issuer or its predecessors/affiliates
- securities-related injunctions and restraining orders and similar sanctions such as SEC stop orders and US Postal Service false representation orders, each if within the 5 years prior to the proposed sale
- final orders from various banking agencies and regulators of securities, insurance and financial institutions that prohibit the covered person from engaging in the business of securities, insurance or banking or that are based upon fraudulent, manipulative or deceptive conduct and which were issued within 10 years of the proposed offering
- SEC disciplinary or cease-and-desist orders and
- suspension or expulsion from membership in a self-regulatory organization such as FINRA.15
Disqualifying events that occurred before the new rules become effective
Only events that occur after the new rules become effective (60 days after publication in the Federal Register) will be considered “disqualifying events.” However, issuers will need to disclose events that occurred prior to the effective date of the rules if they would have been considered disqualifying if they occurred after the effective date.
Impact on issuers
Issuers will need to evaluate entities and individuals that hold or are being considered for roles that would be deemed covered persons (among them directors, officers, promoters or prospective purchasers of the issuer’s securities) to determine whether any disqualifying events have occurred with respect to such persons. For events that occurred prior to the effective date of the rules, issuers will need to disclose information about such disqualifying events in their offering materials. For events occurring after the effective date of the rules, if covered persons experience disqualifying events, then the issuer will not be able to rely upon the exemption from registration contained in Rule 506.
In preparing for an offering, issuers will need to obtain updated information regarding covered persons. For entities such as hedge funds that may have continuous offerings, periodic updates will need to be undertaken. The SEC did not issue specific guidance for the frequency of such updating, but it did indicate that it expects “that issuers will manage [the need for periodic updating] through contractual covenants from covered persons to provide bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances,” which gives some indication of the type of factual inquiry and updating that is expected.16
Effectiveness of final rules
The final rules regarding the “bad actor” disqualification can be found here; also, see the SEC’s Fact Sheet regarding such disqualification here. The rules will be effective sometime in mid-September on the date that is 60 days after publication of the rules in the Federal Register.
PROPOSED CHANGES TO FORM D, REGULATION D AND RULE 156 UNDER THE SECURITIES ACT
At the time of the announcement of its lifting of the ban on general solicitation and general advertising in certain private offerings, the SEC published proposals for additional amendments and new rules aimed at bolstering its ability to monitor related market practices and address investor concerns. These proposed rules would add significant procedural requirements to both Rule 506 offerings utilizing general solicitation and to private placement offerings in general. If adopted, these proposed rules would impose significant burdens and reduce the attractiveness of a general solicitation offering. See the SEC’s Fact Sheet regarding the proposed rules. Note that some of the proposed changes apply to Rule 506(c) offerings (using general solicitation or general advertising), while others would apply to all Rule 506 offerings.
These proposals will be subject to a 60-day comment period during which the SEC will review opinions from interested parties. Thereafter, the SEC may choose to revise its proposals before issuing final rules, to continue considering related issues for some period or not to issue any new rules. The rules allowing general solicitation will thus go into effect before any additional proposed rules are finalized. The SEC has not proposed transitional provisions covering this interim period and, to date, has not indicated that it is considering doing so.
The proposed changes include:
Advance and post-offering filing requirements
Currently, issuers selling securities under Rule 506 are required to file a Form D no later than 15 days following the first sale of securities. Although filing a Form D is not technically a condition for claiming the federal exemption, it may be required in certain states. Under the proposed rule changes, issuers who intend to engage in the soon-to-be permissible general solicitation of investors would, in addition to the current requirements, be required to file a Form D at least 15 days prior to engaging in general solicitation. Additionally, a “closing” Form D amendment would be required to be filed within 30 days of the termination of any Rule 506 offering (not just those that rely on general solicitation).
Additional disclosures in Form D
Under the proposed rule changes, issuers conducting a Rule 506 offering would be required to provide certain additional information on Form D filings, including the following, with some of the proposed changes limited to offerings under Rule 506(c) where noted below:
- expanded information on the issuer, including information regarding its revenues and net asset value (which may be marked “Not Available to Public” if the issuer has not otherwise made such information publicly available, such as in general solicitation materials)
- a broader definition of related persons to be disclosed, and for Rule 506(c) offerings in particular, each person who directly or indirectly controls the issuer, which could require beneficial owners with a significant equity stake to be disclosed
- the types of investors in the offering, including numbers of accredited and non-accredited investors participating in the offering, the amounts raised from each category and whether they are natural persons or legal entities
- the use of proceedsfrom offerings by issuers other than pooled investment funds, including proposed payments to related persons and whether such proceeds will be used to repurchase or retire the issuer’s existing securities, acquire assets, finance acquisitions of other businesses, as working capital or to discharge indebtedness
- whether any of the issuer’s securities are traded on a national securities exchange, alternative trading system or other organized trading venue and, if applicable, the trading symbol and security identifier
- identification of theissuer’s website address
- in Rule 506(c) offerings, the types ofgeneral solicitation used or planned to be used (such as mass mailings, email, public websites, social media, print media and broadcast media) and
- in Rule 506(c) offerings, the methods used to verify accredited investor status (such as reliance on verification by a third-party or reliance on publicly available information).
While some of this information expands current disclosures in Form D or revives disclosures previously required in prior versions of the form, some of these changes are certain to be controversial for both issuers and investors.
Legends and disclosures in general solicitation materials
In the proposed rules, the SEC has proposed requirements that written general solicitation materials contain certain legends disclosing that the securities may be sold only to accredited investors, are being sold pursuant to an exemption to the Securities Act, have not been reviewed by the SEC and are subject to restriction on transfer.
Private funds would also be required to include a prominent disclosure that the securities are not subject to the protections of the Investment Company Act. If the issuer is a private fund and includes information about past performance in its general solicitation materials, then the proposed rules would require the issuer to provide information regarding the limitations of such information as an indicator of future performance.
Many of the above-described disclosures are frequently included in offering memoranda already. Before the proposed rules are issued as final, or even if the proposed rules are not ultimately adopted, issuers will want to consider including such disclosures in any written offering or general solicitation materials.
Submission of general solicitation materials to the SEC
The SEC is also proposing a temporary rule that would require issuers using general solicitation or general advertising (i.e., a Rule 506(c) offering) to submit “any written communication that constitutes a general solicitation” to the SEC through a new online intake page before such materials are used. The SEC has said that these materials will not be made available to the public but has not stated that they will be treated as confidential and it is not clear whether they could be available pursuant to a Freedom of Information Act request.
The SEC’s stated intention is to collect market data on the implementation of the general solicitation provisions. However, it is as yet unclear how much material the SEC expects may fall under this category. As defined, it is potentially a much broader requirement than perhaps intended. “Any written communication” would include any statement on a website, an email sent in response to an inquiry from an unknown potential investor, a mention in a slide deck, and so forth. The intention of the proposed rule appears to be more focused on an issuer’s more formal offering memoranda, advertisements and the like. We expect this issue to be more fully developed during the comment period and addressed in the final rule release, if any.
Extension of Rule 156 to private funds
Currently, Rule 156 of the Securities Act provides guidance for registered investment companies as to the types of information in sales literature that could be considered materially misleading under federal securities laws. Largely based on context, Rule 156 outlines scenarios in which a registered investment company’s representations could be deemed fraudulent or misleading. The proposed amendments would extend Rule 156 to apply to private funds as well, regardless of whether such funds engage in general solicitation.
Disqualification for noncompliance
Under the proposed changes, an issuer will be disqualified from relying on Rule 506 if it or its predecessors or affiliates failed to comply with the Form D filing requirements at any time within the past five years. A one-year disqualification period would commence upon the filing of all required notices on Form D or amendments thereto. Such disqualification would not apply to the offering for which the issuer failed to file a Form D or an amendment thereto, but would apply to any offerings commenced thereafter.
As proposed, issuers would be provided a 30-day cure period to address the issuer’s first failure to file a timely Form D or Form D amendment in connection with a particular offering. Issuers would otherwise be permitted to obtain a waiver only upon a showing of good cause.
Review of accredited investor definition
The proposed rules do not revise the existing definition of “accredited investor” set forth in Rule 501 of the Securities Act (as described above). However, the SEC has solicited comments with respect to the current definition (in accordance with the mandate of the Dodd-Frank Act to review the current standard) and has posed a number of questions for commenters to consider with respect to the appropriate criteria for accredited investor status.17
As noted above, the final rules regarding general solicitation and bad actor disqualification will be effective sometime in mid-September, 60 days after publication in the Federal Register. Until that time, general solicitation is still prohibited in connection with offerings under Rule 506 or Rule 144A.
The rule amendments regarding general solicitation and bad actor disqualification and, if adopted, the proposed rule amendments, will significantly impact the market for private offerings. Startup companies potentially have new avenues for raising capital, private fund managers may have greater flexibility to market their funds and accredited investors will have more investment opportunities. However, general solicitation materials will need to be carefully crafted to comply with these new rules and with existing federal and state regulations. Participants should also monitor the SEC’s proposed rules as well as changes in market practices as they develop in response to the new rules.