On July 10, 2013, the U.S. Securities and Exchange Commission (SEC) adopted rule changes eliminating the prohibition against general solicitation and advertising in private securities offerings conducted under Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 (Securities Act). The Rule 506 private placement safe harbor is the most widely used exemption from Securities Act registration and is relied upon by many private issuers (i.e., companies that issue and sell their securities, including start-up and emerging companies, EB-5 programs, private equity funds, venture capital funds, and hedge funds) in connection with their capital raising activities. The new rules, which mark a radical departure from longstanding law governing private placements and which are aimed at providing greater and more efficient access to capital markets, implement a congressional mandate under Section 201(a) of The Jumpstart Our Business Startups Act, the so-called JOBS Act.
The amendments approved by the SEC create new Rule 506(c), which provides an additional “safe harbor” exemption from registration for securities offerings marketed using general solicitation and general advertising (together, referred to as “general solicitation”), provided that:
- all of the ultimate purchasers of securities are, or are reasonably believed by the issuer to be, “accredited investors” (as defined under applicable SEC rules) at the time of sale, and
- the issuer takes reasonable steps to verify that each purchaser is an accredited investor.
Alternatively, private issuers may choose to forgo marketing to the general public and continue to rely on Rule 506's existing regulatory framework.
In a companion release also issued on July 10th, the SEC adopted amendments to Rule 506 that disqualify issuers from relying on Rule 506 if certain “felons and other bad actors” participate in the Rule 506 offering, as mandated by the Dodd-Frank Act of 2010.
Market participants and consumer advocates have voiced concerns that lifting the ban on general solicitation in private offerings could adversely affect the investing public and could lead to an increase in fraudulent activity aimed at unqualified investors. In response to these concerns, and in order to enhance the SEC’s ability to monitor and evaluate changes in the private offering market and developing practices in Rule 506 offerings, the SEC also proposed a series of amendments to Rule 506 and Form D (i.e., the form filed with the SEC for claiming a registration exemption). If adopted, these amendments would impose significant new filing and disclosure requirements on Rule 506 private offerings, particularly those conducted with general solicitation. The proposed rule changes are expected to draw significant comments, including concerns about costs versus benefits, the potential chilling effect on the use of general solicitation in private offerings and the resulting frustration of the JOBS Act’s central purpose of facilitating capital formation.
The final rules and related amendments approved by the SEC will become effective on September 23, 2013 (60 days after publication in the Federal Register). The SEC has yet to issue proposed rules permitting so-called “crowd funding” offerings and transactions as mandated under the JOBS Act.
A summary of the new rules, as well as observations regarding practical implications for issuers and market participants regarding these rules, follows.
Rule Changes Permitting General Solicitation in Private Offerings
Summary of New Rule 506(c)
Rule 506 of Regulation D is a non-exclusive safe harbor rule adopted in 1982 under Section 4(a)(2) of the Securities Act, which exempts offers and sales of securities by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act. Under current law, it is a requirement of most private placement exemptions from the registration requirements of the Securities Act, including Rule 506 and (in the view of the SEC’s staff) Rule 144A, that issuers are prohibited from using any form of general solicitation when conducting an unregistered offering of their securities. This restriction has been interpreted broadly to prohibit all public marketing efforts and outlets in an issuer’s capital raising activities, including, among others, publicly accessible websites and social media, media broadcasts (such as radio and television advertisements), newspaper advertisements, mass e-mail campaigns, and public seminars and meetings.
Under new Rule 506(c), issuers will be permitted to use general solicitation in private securities offerings made under Rule 506, provided that the following conditions are met:
- all purchasers of securities in the offering must be “accredited investors,” either because they fall within one of the enumerated categories of accredited investors under applicable SEC rules or because the issuer reasonably believes that they do, at the time of the sale of securities, and
- the issuer must take “reasonable steps to verify” that each purchaser of its securities is an accredited investor.
The SEC stated in its adopting release that whether the steps taken by an issuer to verify the accredited investor status of a purchaser are “reasonable” requires a principles-based, objective determination in the context of the particular facts and circumstances of each purchaser and transaction. This is an independent procedural requirement which must be satisfied even if all purchasers are in fact accredited investors. Factors that issuers should consider in making this determination include (1) the nature of the purchaser and the type of accredited investor that it claims to be, (2) the amount and type of information that the issuer has about the purchaser, and (3) 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, including the minimum investment amount).
These factors are interconnected, and may require more, or less, consideration depending upon the specific facts and context. For example, an issuer that solicits new investors through a website accessible to the public or through a widely disseminated e-mail or social media solicitation would 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 accredited investors created and maintained by a reasonably reliable third party, such as a federally registered broker-dealer or investment adviser. Furthermore, if the minimum investment amount in the offering is sufficiently high such that only accredited investors could reasonably be expected to meet it, and the investment is made with a direct cash investment that is not financed by the issuer or any other third party, these factors would be relevant in determining what additional steps should reasonably be taken to verify a purchaser’s accredited investor status.
Regardless of the particular steps taken, given that the issuer bears the burden of proving that the exemption from registration is available, the SEC cautioned in its adopting release that issuers should retain adequate records documenting the steps taken to verify that a purchaser is an accredited investor. In addition, the SEC stated that:
[we do] not believe that an issuer will have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.
Thus, the relatively common practice in which prospective investors complete a suitability questionnaire, or sign a form or agreement, self-certifying as to accredited investor status, will not by itself satisfy the “reasonable steps to verify” standard, at least not for natural person investors.
“Reasonable Steps to Verify” Accredited Investor Status
In response to comments seeking specific guidance on how an issuer can reliably verify accredited investor status, the SEC included in the Rule 506 amendments a non-exclusive list of four verification methods deemed to satisfy the required “reasonable steps” standard as applicable to natural person purchasers (as long as the issuer or person acting on its behalf does not have knowledge that a potential investor is not an accredited investor):
Income Test. If the potential purchaser’s accredited investor status is premised on meeting the (accredited investor) income test – i.e., for a natural person, income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year – reasonable verification can be established by reviewing copies of any IRS form that reports the person’s income (e.g., a Form W-2, Form 1099, Schedule K-1 or a copy of a filed Form 1040) for the two most recent years, and by obtaining a written representation from the person that he or she reasonably expects to meet the required income level during the current year.
Net Worth Test. If the potential purchaser’s accredited investor status is premised on meeting the (accredited investor) net worth test – i.e., for a natural person, individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of such person’s primary residence – reasonable verification can be established by reviewing certain specific documents, dated within the prior three months, and by obtaining a written representation from the person that all liabilities necessary to make a determination of net worth have been disclosed. For assets, the issuer may rely on 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, a credit report from at least one of the nationwide consumer reporting agencies is required.
Third Party Confirmation. An issuer is also deemed to satisfy the verification requirement by obtaining written confirmation from one of the following persons that it has taken reasonable steps within the prior three months to verify the accredited status of the purchaser (and has determined that the purchaser is accredited): an SEC-registered broker-dealer or investment adviser, a licensed attorney, or a certified public accountant. An issuer may be entitled to rely on accredited investor verification by other persons – if the third party takes reasonable steps to verify that potential purchasers are accredited and has determined that they are accredited – so long as the issuer has a reasonable basis to rely on the verification.
Prior/Existing Investor Confirmation. For any person who purchased securities in an issuer’s Rule 506 offering as an accredited investor before the effective date of Rule 506(c) and who continues to own such securities, the issuer is deemed to satisfy the verification requirement by simply obtaining a bring-down certification from such person at the time of sale that he or she still qualifies as an accredited investor.
Private Offering Safe Harbor and “Reasonable Belief” Standard Continue
New Rule 506(c) leaves the traditional, existing safe harbor under Rule 506 unchanged, and redesignates it as Rule 506(b). Thus, issuers that do not wish to avail themselves of the opportunity to conduct their securities offerings using general solicitation may continue to offer their securities in reliance on the traditional safe harbor under Rule 506(b). Rule 506(b) permits sales of securities (with no limit as to dollar amount), without registration, to an unlimited number of accredited investors and up to 35 non-accredited investors who satisfy certain “sophistication” requirements (i.e., knowledge and experience in financial and business matters so as to be capable of evaluating the merits and risks of the prospective investment), if the required resale limitations are imposed, any applicable information requirements are satisfied and other conditions of the rule are met. If an issuer does not engage in any general solicitation, it will not be required to take reasonable steps to verify (under the new standards) the accredited investor status of its purchasers. However, as discussed further below, once a general solicitation has been made to potential investors in an offering, the issuer is precluded from relying on the Rule 506(b) safe harbor in that offering.
In addition, in its adopting release, the SEC reiterated its position that the “reasonable belief” standard in the definition of accredited investor in Rule 501 of Regulation D is unchanged by the new amendments to Rule 506. In this regard, as long as an issuer takes reasonable steps to verify that a purchaser is accredited and has (and those acting on its behalf have) a reasonable belief that the purchaser is accredited, the issuer would not lose its ability to rely on Rule 506(c) if it is later discovered that the purchaser was not in fact an accredited investor.
Changes to Form D
Issuers relying on Regulation D’s safe harbor exemptions are required to file a Form D with the SEC no later than 15 calendar days after the first sale of securities in the offering. In connection with the rule changes, Form D is being amended by adding a new check box for issuers to indicate whether they are using general solicitation under the Rule 506(c) safe harbor (or instead are relying on Rule 506(b)). Issuers may not check both boxes. In addition, Form D will be amended to require issuers claiming a Rule 506 exemption to confirm that the offering is not disqualified from reliance on the Rule 506 exemption (see the discussion below regarding the new felon and “bad actor” disqualification rules). It should be noted that the SEC, on the same day it issued its final rules, issued certain proposed amendments to Form D that would condition prospective reliance on Rule 506(c) on complying with expanded Form D filing requirements.
Rule 144A Clarification
A Rule 144A offering involves a primary offering of securities by an issuer to one or more financial intermediaries in a transaction exempt from registration under Section 4(a)(2) or Regulation S under the Securities Act, followed by the resale of those securities to qualified institutional buyers (QIBs) in reliance on Rule 144A. QIBS, in general terms, are entities, owned entirely by accredited investors, which own and invest, on a discretionary basis, at least $100 million in securities; for a registered broker-dealer, the threshold is $10 million. In order to qualify for the exemption in existing Rule 144A, offers as well as sales must be made to QIBs. Thus, under current law, it’s not clear whether issuers and sellers may permissibly offer securities under Rule 144A to investors which are not QIBs, which effectively prohibits the use of general solicitation in such offerings. An amendment to Rule 144A under the new rules confirms that securities may be offered to persons other than QIBs (i.e., they may be offered via general solicitation), as long as the securities are sold only to persons that the seller reasonably believes are QIBs.
Disqualification of Offerings Involving Felons and Bad Actors
Separately, in a companion release also issued on July 10 and as mandated under Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC also adopted rule changes adding a felon and “bad actor” disqualification provision applicable to offerings conducted under Rule 506 of the Securities Act. Under this amendment, the Rule 506 registration exemption will not be available for any securities offering, regardless of whether the offering is made using general solicitation under Rule 506(c), if the issuer or any other “covered person” (including directors, executive officers, other officers involved in the offering, general partners and managing members, 20 percent beneficial owners, promoters, placement agents, and persons compensated for soliciting investors) had a “disqualifying event” during a specified time period. The list of disqualifying events is broad, and includes certain securities-related felonies and misdemeanors, SEC cease-and-desist orders barring future violations of specified securities laws, suspensions from registration with national securities exchanges or national securities associations such as FINRA and other regulatory disciplinary actions. The rule does not apply if the issuer can show that it did not know, and in the exercise of reasonable care could not have known, that a covered person with a disqualifying event participated in the offering. In its adopting release, the SEC noted that the steps an issuer should take to satisfy the reasonable care standard – including reasonable factual inquiry into whether any disqualifications exist – will vary according to the particular facts and circumstances of the “bad actor” and the offering. Additionally, the SEC may grant waivers from disqualification under certain circumstances, including a change of control and absence of notice and opportunity for hearing. The rule applies only to disqualifying events that occur after its effective date, but disqualifying events that occurred prior to the effective date must be disclosed to investors at a reasonable time prior to the securities sale date.
Regulation S Offshore (and Concurrent) Offerings
Many private securities offerings are made concurrently (side-by-side) to the U.S. domestic market under Rule 506 or Rule 144A and to non-U.S. investors in reliance on Regulation S, a safe harbor for offers and sales of securities made outside the United States. These safe harbors are important when U.S. and non-U.S. companies, including EB-5 programs, engage in multi-country securities offerings in which the U.S. portion of the offering is conducted in accordance with Rule 506 or Rule 144A and the non-U.S. (offshore) portion is conducted in reliance on Regulation S. One requirement of a Regulation S offering is that there be no “directed selling efforts” in the United States, a concept similar in some respects to general solicitation (or “conditioning of the market” where the securities will be sold). In its adopting release, the SEC confirmed that concurrent (offshore) non-U.S. offerings that are conducted in compliance with Regulation S will not be integrated with domestic U.S. offerings that use general solicitation and are otherwise conducted in compliance with Rule 506 or Rule 144A, as amended.
Proposed Rules Regarding Form D and Exempt Offering Filing and Disclosure Requirements
In view of lifting the ban on general solicitation, the SEC, in proposed rules published for public comment on July 10, proposed a number of investor protection requirements applicable to Rule 506 private offerings, particularly those conducted with general solicitation. These provisions, in the words of the SEC, are intended to enhance the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and to address concerns that may arise given that issuers are permitted to engage in general solicitation under the new rules. The proposed rule changes cover a variety of significant topics and proposed new requirements, including an expansion of the information required to be included in Form D, new “advance” and “closing” Form D filing requirements, mandated legends and disclosure requirements (particularly regarding offerings using general solicitation), disqualification from the ability to rely on Rule 506 for a failure to make compliant Form D filings and a temporary rule requiring submission of written solicitation materials (where general solicitation is used) to the SEC on a non-public basis. The SEC’s proposing release also includes a request for public comment on the “accredited investor” definition and thresholds. As noted above, the proposed rules (extensive discussion of which is beyond the scope of this article) are expected to draw significant comments, including concerns about costs versus benefits, the potential chilling effect on the use of general solicitation in private offerings and the resulting frustration of the JOBS Act’s central purpose of facilitating capital formation.
Effective Date; Limitations; No Fallback Exemption
The final rules and related amendments described above are effective on September 23, 2013 (60 days following publication in the Federal Register), and the proposed rules provide for a 60-day public comment period (which ends on September 23, 2013). Accordingly, Rule 506 and Rule 144A remain unchanged at present (until September 23), and issuers should continue to comply with the existing requirements of such rules (including Rule 506’s prohibition on general solicitation).
Importantly, the elimination of the prohibition on general solicitation under the new rules applies only to private offerings meeting the requirements of Rule 506(c), and not to other private offerings made under Section 4(a)(2) generally, under the so-called “private resale” exemption or under any other registration exemption other than Rule 144A. In this regard, issuers unable to rely upon the Rule 506 safe harbor that seek instead to qualify under the Section 4(a)(2) statutory exemption for private offerings should tread very carefully (with the advice of securities counsel), since the scope of that exemption as interpreted by the SEC and the courts is substantially more limited and less clearly defined than under Rule 506, and a failure to qualify could lead to possible SEC enforcement action and would possibly trigger rescission rights in favor of investors. As the SEC made clear in its final rules adopting release, issuers engaging in general solicitation in a securities offering in the U.S. face significant consequences if they rely on the new Rule 506(c) exemption but fail to meet the "reasonable steps to verify" accredited investor status standard; in such a case, they will not be able to rely on the statutory exemption provided by Section 4(a)(2) of the Securities Act and thus likely would be left without any exemption from – and would consequently be in violation of – the Securities Act’s registration requirements.
Practical Implications for Issuers and Market Participants
The introduction, for the first time, of the ability to engage in general solicitation in Rule 506 and Rule 144A offerings is expected to have a significant impact on the way that certain issuers approach and market their private placements. The new rules present the opportunity for issuers (including start-up and emerging companies, EB-5 programs, and private investment funds) and their advisors to reach potential investors beyond their traditional relationships and networks, and to take advantage of a wide variety of state-of-the-art, broadly-inclusive and instantaneous communication and marketing tools and platforms, including through newspaper, television and radio advertisements, and via relatively inexpensive Internet-based media. Electing to go the general solicitation route, however, will come at a price. Issuers and their advisers (and, in the case of private investment funds, their sponsors) should bear in mind the increased responsibilities for due diligence with respect to verifying accredited investor status of potential investors and assuring that offering participants and other covered persons are not felons or bad actors subject to a disqualifying event, and should keep a watchful eye on the currently proposed rules and other rulemaking initiatives as these markets and offering practices, as well as SEC enforcement priorities and actions, develop and evolve. Some practical implications for issuers and market participants to consider include:
Many issuers will likely stick with the known, existing regulatory regime (and no general solicitation) for now. Current private offering practices, designed to prevent any form of general solicitation, are well understood and practiced by sophisticated issuers, their owners, advisors (including private placement agents registered as broker-dealers), and other market participants. The SEC has made clear that issuers may continue to rely on the existing regulatory framework (redesignated as Rule 506(b)) and conduct private offerings precisely the way they are being conducted today, provided that no general solicitation is used. Complying with the final and proposed rules (and other possible rulemaking) will significantly increase regulatory burdens and costs associated with compliance – including increased due diligence, verification of accredited investor status and more robust Form D disclosure requirements. Accordingly, initially (and until the regulatory “dust” settles), it is likely that many issuers – and particularly private investment fund issuers – and their advisors will forego general solicitation flexibility in favor of conducting their offerings under the current regulatory regime (i.e., the existing safe harbor exemption under Rule 506(b)).
Taking reasonable steps to verify accredited investor status; due diligence and record keeping; third party verification services. Issuers choosing to engage in general solicitation will be required to take "reasonable steps to verify” that each purchaser of securities in a Rule 506(c) offering is an accredited investor. Having a person check a box on a questionnaire or sign a form or agreement is not sufficient to verify accredited investor status, absent other information about the purchaser. The issuer has the burden of demonstrating that its offering is entitled to an exemption from registration, and thus should retain all records evidencing its “reasonable steps to verify.” As a best practice, issuers should review with counsel their offering and subscription documents and practices, and fund sponsors and placement agents should also review their due diligence investigation protocols and private offering and other policies and procedures, including how best to document and verify that each purchaser qualifies in view of the factors discussed above. Among other things, consideration should be given to maintaining a detailed list of the steps taken and materials reviewed for each prospective purchaser. In addition, it is anticipated that a robust and dynamic “industry” of third-party verification service providers (regarding accredited investor status) may develop, and compete, to participate in and facilitate this process. Verification services will likely be offered by (among others) affiliates of placement agents, investment advisers, and other investment “matchmakers” who also compete for investment offering deal flow. Providing reliable verification regarding potential investors' accredited investor status, via a safe, trusted, and user-friendly access point to personal and financial information, will be important, both from a compliance and marketing point of view.
Addressing investor privacy concerns. Issuers who choose to take advantage of the new general solicitation rules must request personal and private financial information from potential investors, or must find some other acceptable way to demonstrate and document that each purchaser qualifies as an accredited investor (see discussion above regarding third-party verification service providers). Requesting such information, or obtaining other verifications concerning personal financial (including income and net worth) data, will raise privacy and data security concerns and may deter potential investors from participating in Rule 506(c) private offerings.
Offerings involving felons and bad actors disqualified from using Rule 506; due diligence on covered persons and disqualifying events. In view of the new felon and “bad actor” disqualification rules, and the reasonable care exception to the rule, issuers and placement agents will need to adopt and implement due diligence and verification procedures and practices to ferret out whether the issuer, any placement agent or any other covered person is, or during the applicable look-back period was, subject to a “disqualifying event.” Registered broker-dealer firms and their employees are often subject to certain disqualifying events and thus will not be able to promote or assist with Rule 506 offerings without an SEC waiver. Issuers should consider adding appropriate additional questions to D&O questionnaires, requiring 20 percent or greater owners to complete questionnaires, and requiring placements agents, compensated finders, their personnel, and other covered persons to provide appropriate contractual representations. Judgment searches and review of broker-dealer compliance and other public records should also be conducted. Placement agents, broker-dealers and private fund advisors should adopt and implement new and more robust protocols and procedures in light of the rule changes, including (1) making sure their “houses are in order” (and that they, their affiliates and personnel are not subject to a “disqualifying event”), and (2) reviewing and revising, with their counsel, their due diligence requests and activities, disqualification protocols, form of placement agent agreement and other documents to address and conform to the requirements of the new rules.
Potential unintended consequences of general solicitation offerings. For issuers choosing to take advantage of the new general solicitation rules, careful consideration should be given to what information should be included in the marketing effort and what impact, positive or negative, the general solicitation may have on the image or credibility of their company and management team, or on the company's customers, vendors, or employees, or its ability to attract accredited investors. Information accessible on an issuer’s website in advance of and during a private offering is deemed to be part of the general solicitation. Once marketing information is “out there,” despite confidentiality notices and precautions, the publicity (and related communications) may take on a life of its own, whether or not the subject offering is ultimately successful.
Antifraud rules continue to apply. The new rules do not incorporate any exemption from traditional anti-fraud rules under the securities laws, including under Section 10(b) of and Rule 10b-5 under the Securities Exchange Act of 1934 (and related sanctions for making false or misleading statements in connection with securities offerings). Issuers and their agents should carefully review and consider the form, content, and distribution of all marketing, advertising, and solicitation information and materials, however communicated or accessible (including via website and social media outlets). Issuers should expect the SEC to be vigilant in surveying the market for examples of improper conduct to target for enforcement action.
Having a high degree of confidence in the success of an offering sold solely to accredited investors before any general solicitation. Once an issuer commences any general solicitation activities, if it is later unable to meet the requirements of Rule 506(c) (including the "reasonable steps to verify" accredited investor status standards and assuring that all purchasers are accredited investors), it may be left without any exemption from the Securities Act’s registration requirements, and thus be unable to pursue or close any private offering of securities for some time. In addition, start-up, early stage, and other issuers that may need frequent access to private investment capital will need to be careful to avoid possible “integration” of offerings conducted within a six-month period – for example, when an offering to friends, family and known persons (including non-accredited investors and without general solicitation, under the traditional Rule 506(b)) is planned to be conducted concurrently with or following one or more offerings to other investors (using general solicitation, under new Rule 506(c)).
Regulatory “Soup” – watch for additional related, perhaps significant, private offering reforms. In embarking upon this new era of securities offering reform, the SEC will monitor closely the impact of its rule changes, and developing market practices, in the private, exempt offering arena. The proposed rules discussed above signal the SEC’s desire, while implementing congressional mandates, to craft “speed bumps” and safeguards for the protection of investors (including by requiring new, rather extensive filing and disclosure requirements in offerings sold entirely to accredited investors). In addition, for startup and early stage companies seeking to raise capital in relatively small amounts from a wide audience, the SEC has yet to issue proposed rules to permit “crowd funding” offerings and transactions (as mandated under the JOBS Act). Issuers and their advisors will need to assess carefully the new rules, proposed rules, and future rulemaking efforts – and the associated costs, burdens, potential liabilities, and other consequences – as they consider and plan for their capital raises and related offering alternatives.