On July 10, 2013, the Securities and Exchange Commission (“SEC”) adopted final rules to eliminate the prohibition against general solicitation and general advertising in certain securities offerings under Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933, as amended (“Securities Act”), as mandated by the Jumpstart Our Business Startups Act (“JOBS Act”). The final rules will take effect on the 60th day after publication in the Federal Register (the “Effective Date”). Accordingly, the Effective Date will likely be in September 2013. In addition, the SEC: (1) proposed customer protection rules that are intended to enhance the SEC’s ability to assess market developments in the private placement market; and (2) adopted rule amendments that disqualify securities offerings involving certain felons and other bad actors from reliance on Rule 506.
I. Offerings Involving Use of General Solicitation — New Rule 506(c)
In its final form, new Rule 506(c) has been expanded to list non-exclusive methods for verifying that investors who are natural persons are accredited. Otherwise, the final Rule 506(c) is the same as proposed on August 29, 2012.1
Under Rule 506(c), an issuer may use general solicitation and general advertising in a securities offering that satisfies the requirements of Rule 501 and Rules 502(a) and 502(d) of Regulation D if the purchasers are “accredited investors” as defined in Rule 501 of Regulation D, and if the issuer takes reasonable steps to verify that the purchasers are accredited investors.
An issuer generally is required to consider all relevant facts and circumstances to assess whether the verification steps taken are reasonable for purposes of relying on Rule 506(c). Rule 506(c) mandates an objective, principles-based verification process in lieu of rigid rules. Under this standard, issuers will be required to consider the particular conditions surrounding the offering to determine whether the process used to verify each purchaser’s accredited investor status is sufficient, including:
The adopted guidance sets forth flexible and sliding scale approaches toward assessing these factors. For a description of the similar related guidance provided by the SEC in the proposing release.
The final rule provides additional guidance to issuers that wish to comply with Rule 506(c) by including a non-exclusive list of methods that may be used to verify that purchasers who are natural persons are accredited investors. An issuer shall be deemed to have taken reasonable steps to verify accredited investor status if the issuer uses, at its option, one of the following methods of verifying (provided that the issuer does not know that the person is not accredited):
– For assets: 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;
The Rule 506(c) verification requirement does not supplant the “reasonable belief” standard that is part of the Rule 501 definition of accredited investor in Regulation D. The final rule confirms the SEC’s view, articulated in the proposed rule release, that, if the purchaser actually meets the Rule 501 enumerated requirements for an accredited investor but the issuer has not taken reasonable steps to verify accredited status, the Rule 506(c) safe harbour would not be available (unless the issuer has actual knowledge that the purchaser meets one or more of the Rule 501 enumerated categories). Thus, the verification requirement is separate and distinct from the requirement that all purchasers be accredited investors.
Offerings Not Involving Use of General Solicitation – Renumbered Rule 506(b)
The final rule preserves the existing ability of issuers to conduct Rule 506 offerings without the use of general solicitation and without verifying purchasers’ accredited status, under renumbered Rule 506(b). Thus, if there is no general solicitation, an issuer must only have a reasonable belief that a purchaser is an accredited investor.
Considerations to Take into Account Before Relying on Rule 506(c)
Each issuer relying on Rule 506 will be required to disclose in Form D whether it is relying on Rule 506(b) or Rule 506(c) with respect to each securities offering that it conducts. A sponsor of multiple private funds should not conduct offerings concurrently under Rule 506(b) and Rule 506(c) without first considering whether any general solicitation conducted under the Rule 506(c) offerings would compromise the safe harbour for the Rule 506(b) offerings. An issuer will not be permitted to check both the Rule 506(b) box and the Rule 506(c) box in Form D at the same time for the same offering.
Investment pools that trade commodity interests may be unable to engage in general solicitations despite the adoption of Rule 506(c) if their general partners, managers or advisers rely on the de minimis exemption from commodity pool operator (“CPO”) registration. The de minimis exemption in Commodity Futures Trading Commission (“CFTC”) Regulation 4.13(a)(3) requires interests in the commodity pool to be offered and sold without marketing to the public in the United States. Similarly, investment pools whose general partners, managers or advisers are registered as CPOs and rely on the exemptive relief set forth in CFTC Regulation 4.7(b) (for offerings limited to sophisticated investors) may be unable to engage in general solicitations due to a similar prohibition against marketing to the public. We understand that CFTC staff intends to consider whether to modify these exemptions in response to the adoption of Rule 506(c).
Rule 506(c) may not be retroactively available to issuers who inadvertently used general solicitation in an offering, since the Rule requires issuers to verify the accredited investor status of an investor before a sale is made. An issuer that is conducting a Rule 506 offering at the time Rule 506(c) becomes effective may elect to continue that offering in accordance with Rule 506(b) or Rule 506(c).
Amendments to Rule 144A
As mandated by Section 201(b) of the JOBS Act, the final rule also amends Rule 144A(d)(1) under the Securities Act to provide that securities can be offered pursuant to Rule 144A to persons other than Qualified Institutional Buyers (“QIBs”), including by means of general solicitation, so long as the securities are purchased only by persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs (as defined in Rule 144A). This rule amendment effectively permits general solicitations in Rule 144A offerings.
II. Proposed Customer Protection Rules
Due in part to concerns about the greater potential for fraud in connection with general solicitations, the SEC proposed amendments to Regulation D, Form D and Rule 156 under the Securities Act. These proposed amendments would:
The SEC has described these proposed amendments as providing “better tools to evaluate this changing market,” which would assist federal and state enforcement efforts. In fact, the SEC describes how these proposed amendments would support its plan to review and analyse the use of Rule 506(c) through the coordinated efforts of staff from the Division of Corporation Finance, the Division of Economic and Risk Analysis, the Division of Investment Management, the Division of Trading and Markets, the Office of Compliance Inspections and Examinations, and the Division of Enforcement. Taken as a whole, if adopted, these changes would make Form D more integral to the private offering process and could mark the start of evolving “regulatory creep” that uses Form D to regulate the private offering process, much as Form ADV has evolved from a “census-like” document into a regulatory and disclosure document.
III. Bad Actor Provisions
The SEC also adopted rule amendments, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, that disqualify securities offerings involving certain felons and “bad actors” from relying on Rule 506. The disqualification provisions cover the following persons, among others— (1) the issuer; any general partner or managing member of the issuer; (2) any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities; (3) any investment manager to an issuer that is a pooled investment fund; and (4) any compensated solicitor (collectively, “Covered Persons”). The disqualifying events include, among others—(1) certain criminal convictions; (2) certain injunctions and restraining orders; and (3) certain SEC disciplinary orders. These Rule amendments will take effect on the Effective Date. Significantly, they will apply only to triggering events occurring after the Effective Date, with pre-existing events being subject to mandatory disclosure.
Considerations for Issuers that are Conducting or are Planning to Conduct Rule 506 Offerings
The Rule amendments require that an issuer furnish to each purchaser, a reasonable time prior to sale, a description in writing of any matters that would have triggered disqualification but that occurred before the Effective Date. Accordingly, an issuer must be prepared to provide such a description to investors a reasonable time prior to any sale that takes place on or after the Effective Date. To that end, issuers should identify all Covered Persons and determine whether they are subject to any disqualifying event under the Rule. An issuer may want to consider sending a questionnaire to each beneficial owner of 20% or more of the issuer’s outstanding voting equity securities to obtain the information needed to comply with Rule 506.