August 7, 2013
Authored by: Robert Klingler
The SEC recently adopted new rules to lift the ban on general solicitations and general advertising for Rule 506 private placements and Rule 144A offerings. In addition, the SEC also adopted rules disqualifying “bad actors” from taking advantage of the Rule 506 private placement safe harbor. These new rules will be effective on September 23, 2013. The SEC has further proposed new rules that, among other things, require an SEC filing at the start of Rule 506 placements involving general solicitation, the inclusion of additional cautionary legends and disclosures in offering materials as well as a temporary (two-year) requirement to file general solicitation materials with the SEC.
Regulation D’s Rule 506 provides a safe harbor exemption from registration under the Securities Act of 1933 for private offerings made to accredited investors and no more than 35 non-accredited investors who meet certain investment sophistication requirements. The SEC estimates that Rule 506 offerings account for more than 90% of all Regulation D safe harbor private offerings and substantially all of the capital raised under Regulation D. Prior to these new rules, an offering would not satisfy the Rule 506 safe harbor exemption if any general solicitation or general advertising occurred. General solicitation and advertising includes advertisements published in magazines and newspapers or broadcast by television or radio or made available through unrestricted websites. Widely disseminating offering materials absent pre-existing relationships with investors may even be deemed a general solicitation.
General Solicitation Ban Removed
As mandated by the JOBS Act (to be completed by July of last year), the SEC is adding new Section 506(c) to permit general solicitation and advertising to offer and sell securities in a Rule 506 offering if (a) all purchasers are accredited investors or the issuer reasonably believes that they are accredited investors, and (b) the issuer takes reasonable steps to verify that all purchasers are accredited investors.
The new rules do not prohibit issuers from continuing to make a typical Rule 506 offering without general solicitation or advertising in order to include non-accredited investors in the offering or to avoid the heightened verification procedures and proposed additional disclosure and filing requirements (see below).
Reasonable Steps to Verify Accredited Investor Status
New Section 506(c) imposes a general requirement that issuers take “reasonable steps to verify” that all purchasers are accredited investors and includes a non-exclusive list of four verification methods that are deemed to meet the reasonable verification requirement. This verification requirement is separate from the requirement that the Rule 506(c) offering be limited to accredited investors and must be satisfied even if all purchasers happen to be accredited investors. As part of the verification requirement, the issuer must objectively assess the purchaser’s eligibility in light of the particular facts and circumstance of each purchaser and transaction. In determining whether the verification steps are reasonable, the issuer should consider the nature of the purchaser and the type of accredited investor that the purchaser claims to be, the amount and type of information about the purchaser as well as the nature of the offering. For example, an offering using widespread general solicitation may require more rigorous steps to confirm a purchaser’s accredited investor status than an offering in which most of the purchasers have an existing relationship with the issuer. Similarly, a very high minimum investment amount for an offering, which only accredited investors could reasonably be expected to make, could be taken into consideration. An issuer may use third parties to verify the status of a purchaser if the issuer has reasonable basis to rely on such third-party verification.
New Rule 506(c) lists four non-exclusive methods of verifying the accredited investor status for natural persons that, if used, will satisfy the Rule 506(c) verification requirements, provided that the issuer does not otherwise have knowledge that the purchaser is not accredited:
- Two years of tax records filed with the IRS showing an individual’s income (extraneous information may be redacted), together with a written representation that the individual has a reasonable expectation of reaching the necessary income level during the current year;
- Third-party statements identifying the value of the potential purchaser’s assets and liabilities (dated within the last three months, including a credit report from at least one national agency), together with a written representation from the individual that all liabilities necessary to determining net worth have been disclosed;
- A written confirmation from a registered broker-dealer, an SEC-registered investment advisor, a licensed attorney or certified public accountant that such person has taken reasonable steps to verify that, within the prior three months, the individual is an accredited investor; and
- With respect to an existing investor who qualified as an accredited investor prior to the effective date of the new Rule 506(c), a certification from such investor that he or she continues to qualify as an accredited investor.
Once the new rule becomes effective, issuers can choose to continue an ongoing offering under existing Rule 506(b) or take advantage of new Rule 506(c), with general solicitation occurring after the effective date not affecting the exempt status of earlier offering activity.
Tips for Complying with Rule 506(c)
The SEC noted that the verification requirement will not be satisfied merely by requiring that a potential purchaser “check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.” Depending on the type of purchaser and the type of offering, the issuer will likely need to revise and perhaps even customize by each potential purchaser its standard questionnaire and information requests. A written record of the verification steps used for each investor should be maintained. Whether the issuer uses one of the four specified verification methods or other reasonable steps and methods to verify the status, it is critical for the issuers or third-party verifiers to retain adequate records regarding the steps taken and data collected to verify that investors are accredited.
In addition, issuers should maintain copies or transcripts of all general solicitation materials used and a log of when and how such material was disseminated. Even if the issuer is not required to file such solicitation materials with the SEC (pursuant to the proposed rules discussed below), the issuer should keep copies in case questions arise as to the accuracy of solicitation materials.
Rule 506 Offerings by Privately Offered Funds
In connection with the new rules, the SEC confirmed that hedge funds, private equity funds and other privately offered funds that make Rule 506 offerings through general solicitation in conformity with new Rule 506(c) requirements will not be deemed to be involved in a public offering and thus will maintain their exemptions from being considered investment companies under the Investment Company Act of 1940. At the same time, the SEC reminds investment advisors to private funds that they remain subject to the anti-fraud rule of the Advisers Act and are required to adopt and implement appropriate policies and procedures to comply with such Act.
Rule 144A Resales
As required by the JOBS Act, the SEC also amended Rule 144A to permit general solicitation in the resale of securities under Rule 144A, the safe harbor exemption from registration requirements for resales to qualified institutional buyers (“QIBs”) of certain securities sold initially in a non-public offering. The amendment permits general solicitation if the securities were sold only to QIBs or to purchasers that the seller reasonably believes are QIBs.
Disqualification of Felons and Other “Bad Actors” From Rule 506 Offerings
As mandated by the Dodd-Frank Act, the SEC also recently adopted final rules disqualifying certain felons and other “bad actors” from using the Rule 506 safe harbor exemption from securities offering registration requirements. Under the new Rule 506(d), securities offerings may not be made under Rule 506 if any “covered person” associated with the offering has been involved in any “disqualifying event.”
The rule contains an exception 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 SEC believes the “reasonable care” standard imposes a due diligence obligation on the issuer to inquire into relevant facts, with appropriate steps varying according to the particular facts and circumstances.
Covered Persons and Disqualifying Event Definitions
The following are “covered persons” for purposes of new Rule 506(d):
- The issuer and any predecessor of the issuer or affiliated issuer;
- Any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
- Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
- For issuers that are pooled investment funds, the investment manager to the issuer and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as a director, executive officer or officer participating in the offering of any such general partner or managing member;
- Any promoter connected with the issuer in any capacity at the time of sale; and
- Any compensated solicitor (any person that has been or will be paid, directly or indirectly, remuneration for soliciting purchasers in the offering) and any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.
The occurrence of the following are “disqualifying events” for purposes of new Rule 506(d):
- Criminal conviction (felony or misdemeanor), entered within the last five years (for issuers), or ten years (other covered persons), (a) in connection with the purchase or sale of any security, (b) involving the making of a false filing with the SEC, or (c) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
- Court injunctions and restraining orders within the last five years, that restrains or enjoins such person from engaging (a) in any securities offering or sale, (b) involving the making of a false filing with the SEC, or (c) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
- Final orders issued by state securities, banking, credit union, and insurance regulators, federal banking regulators, the U.S. Commodity Futures Trading Commission or the National Credit Union Administration that either (a) create a bar from association with any entity regulated by the regulator issuing the order, or from engaging in the business of securities, insurance or banking or from savings association or credit union activities; or (b) are based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct that occurred within ten years before the sale;
- Certain SEC disciplinary orders entered pursuant to the Securities Exchange Act of 1934 (the “Exchange Act”) or the Investment Advisers Act of 1940 (the “Advisers Act”) that, at time of the sale, (a) suspend or revoke a person’s registration as a broker, dealer, municipal securities dealer or investment adviser; (b) place limitations on the activities, functions or operations of such person; or (c) bar such person from being associated with any entity or from participating in the offering of any penny stock;
- SEC cease and desist order within the five years before the sale, issued in connection with certain anti-fraud or registration provisions of the Federal securities laws, including Rule 10-5 under the Exchange Act and Section 5 of the Securities Act of 1933;
- Suspension or expulsion from membership in, or suspension or a bar from association with a member of a registered national securities exchange, registered national or affiliated securities association or other self-regulatory organization (SRO);
- Stop orders applicable to a registration statement and orders suspending the Regulation A exemption for an offering statement that an issuer filed or in which the person was named as an underwriter within five years before the sale and being the subject at the time of sale of a proceeding to determine whether such a stop or suspension order should be issued; and
- U.S. Postal Service false representation orders including temporary or preliminary orders entered within five years before the sale.
Timing of Disqualifying Event
A disqualifying event that arose because of triggering events that occurred before the effective date of new Rule 506(d) will not cause a disqualification from the use of Rule 506. New Rule 506(e), however, requires disclosure to investors regarding such events that occurred prior to the effective date. The disclosure must be in writing and provided to each purchaser “a reasonable time prior to sale.” The SEC notes its expectations that issuers will give “reasonable prominence to the disclosure to insure that
information about pre-existing bad actor events is appropriately presented in the total mix of information available to investors.”
This disclosure requirement will apply to all Rule 506 offerings, regardless of whether purchasers are accredited investors.
Form D Certification in Connection with New Rule 506(d)
The SEC amended Form D, the required filing for all Regulation D offerings, including offerings under Rule 506. The amended form requires issuers to certify that the issuer is not disqualified from relying on the Regulation D safe harbor by new Rule 506(d).
Tips for Complying with New “Bad Actor” Disqualification Rules
The Regulation D exemption would not be available if a disqualified covered person is present or participates in the offering, unless the issuer satisfies the “reasonable care” test. As a result, companies should take steps to ensure collection and analysis of information about the covered persons in the potential offering, including:
- Accurately identifying covered persons, especially those associated with third parties engaged in the offering. An issuer should be conscious of which officers it selects to participate in the offering to minimize the number of covered persons;
- Taking reasonable steps to gather accurate information for each covered person. The “reasonableness” of the inquiry procedure is based on facts and circumstances including how well and long the issuer has been affiliated with each of the covered persons. Although questionnaires can be helpful, the SEC also indicated that consulting publicly available databases for past disciplinary histories may be appropriate in some circumstances; and
- In the case of 20% stockholders, issuers should consider implementing procedures to gather information as part of the investment process to determine whether any such potential stockholders have had any disqualifying events. For such stockholders, as well as certain other covered persons such as placement or soliciting agents, issuers should consider including ongoing covenants in appropriate agreements to notify the issuer about subsequent disqualifying events.
Even if triggering events that would lead to a disqualifying event occurred prior to the effective date of new Rule 506(d), issuers will need to gather information about such events for disclosure pursuant to Rule 506(e). Adequate time will need to be scheduled to gather this information and, if any is identified, to add it in an appropriate manner to the disclosure to be provided to purchasers.
The SEC has delegated authority to the Division of Corporation Finance to grant waivers of the bad actor disqualification. Although no standards were established, the SEC has identified some relevant factors (such as change of control, change of supervisory personnel, absence of notice and opportunity for hearing, and relief from a permanent bar for a person who does not intend to apply to reassociate with a regulated entity) that could, depending on the specific facts, support a waiver request.
Additional Proposed Rules for New Rule 506(c) Offerings
In connection with the final rules described above, the SEC also recently proposed rules intended to enhance its ability to evaluate developing market practices and investor protection in light of the ability to generally solicit investors in Rule 506(c) offerings. The proposed rules would:
- Require the filing of a Form D at least 15 days before the use of general solicitation in a Rule 506(c) offering as well as 30 days after termination of the offering;
- Require additional disclosure in Form Ds about the types of general solicitation used, the methods used to verify the accredited investor status, additional information about persons who directly or indirectly control the issuer, a range of revenue or net asset value if such information is used in general solicitations, and other information about the issuer, investors and offering;
- Prohibit issuers from relying on Rule 506 for one year for future offerings if the issuer did not comply with all of the Form D filing requirements in a Rule 506 offering;
- Require prescribed legends in any written communication that constitutes a general solicitation in any Rule 506(c) offering;
- Require private funds to disclose that the securities are not subject to the protections of the Investment Company Act and in general solicitation materials that include performance data regarding limitations on the usefulness of such data;
- Amend the anti-fraud rule for investment companies (Rule 156) to apply to the sales literature of private funds;
- Disqualify issuers from relying on Rule 506 for future offerings if the issuer, or any predecessor or affiliate, has been subject to any order, judgment or court decree enjoining such person for failing to comply with Rule 506; and
- On a temporary (two-year) basis, require issuers to submit any written general solicitation materials used in Rule 506(c) offerings to the SEC no later than their first use. The materials would not be available to the public. Issuers would be disqualified from relying on Rule 506 for future offerings if it is determined an issuer has failed to comply with this requirement.
If adopted, these proposed rules could deter some issuers from taking advantage of the removal of the general solicitation prohibition because of additional regulatory compliance burden resulting from the disclosure and filing rules.