United States: SEC Eliminates The Prohibition On General Solicitation And General Advertising In Rule 506 And 144A

In 2012, Congress passed the Jumpstart Our Business Startups Act (the JOBS Act). In seeking to facilitate capital raising by small businesses, Section 201(a)(1) of the JOBS Act directs the SEC to remove the prohibition on general solicitation or general advertising for securities offerings solely to accredited investors under Rule 506 and qualified institutional buyers under Rule 144A. Congress imposed a deadline of July 4, 2012, for adoption of the amendments. On July 10, 2013, the SEC adopted its final rules eliminating the prohibition against general solicitation and general advertising.

Public Solicitation in Limited Offerings under Rule 506

The amendment to Rule 506 permits issuers to engage in general solicitation and general advertising to offer and sell securities, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify the purchasers are accredited investors.

Accredited Investors.The definition of an accredited investor has not changed. Existing Rule 501 provides that a natural person qualifies as an accredited investor if he or she has an individual net worth or joint net worth with a spouse that exceeds $1 million (excluding the value of his or her primary residence) or an individual annual income exceeding $200,000, or a joint annual income with a spouse exceeding $300,000, in each of the two most recent years. Several other categories of entities also qualify as accredited investors.

Reasonable Steps to Verify Accredited Investor Status.The SEC provides that the reasonableness of the steps taken by an issuer to verify that an investor is accredited is an objective assessment by that issuer. The issuer must consider the facts and circumstances of each purchaser and the transaction, including the nature of the purchaser and the type of accredited investor that purchaser claims to be, the amount of information the issuer has about the purchaser, and the nature of the offering such as the manner in which the purchaser was solicited and terms such as a minimum investment amount. The new Rule 506 provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement. The methods include:

  • to verify whether a purchaser is an accredited investor on the basis of income, reviewing copies of any Internal Revenue Service form that reports income;
  • to verify whether a purchaser is an accredited investor on the basis of net worth, reviewing documents such as bank statements, brokerage statements, certificates of deposit, tax assessments, and credit reports (a credit report from a nationwide consumer reporting agency being the only required document under this method), and obtaining a written representation from the purchaser that all liabilities necessary to determine net worth have been disclosed;
  • by obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant providing that such issuer has taken reasonable steps to verify that a purchaser is an accredited investor and has so determined within the prior three months; or
  • with respect to any natural person who invested in an issuer's offering as an accredited investor prior to the effective date of the new Rule 506 and remains an investor of the issuer for any offering under the new rule, by obtaining a certification by such person at the time of the sale that he or she qualifies as an accredited investor. This provision is meant to be a transitional requirement for offerings that began before the effective date of the amendment and will continue after the effective date.

Our firm (and nearly all other law firms) has long recommended using a detailed investor questionnaire to prove that an issuer "reasonably believes" an investor is accredited. The adopting release states that the Commission anticipates that "many practices currently used by issuers in connection with existing Rule 506 offerings will satisfy the verification requirement for offerings pursuant to Rule 506(c)." Although the use of questionnaires is not listed among the Commission's non-exclusive list of verification methods, this statement appears to suggest that questionnaires will continue to be acceptable at some level. However, it is evident that merely checking a box or including a statement in a subscription agreement to the effect that an investor is accredited, will not be enough to satisfy Rule 506 requirements in the future.

The adopting release comments that the Commission expects that their suggested approach of obtaining independent verification of accredited status from a third party such as a broker-dealer, investment adviser or other professional may lead to "innovative approaches to meeting the verification requirement, such as the development of reliable third-party databases of accredited investors and verification services." The idea is perhaps to create a cottage industry that is employed to "accredit" investors for issuers and syndicators.

The issuer has the burden of demonstrating that an offering is entitled to an exemption from the registration requirements, so it will be important for issuers using the new general solicitation rules to retain adequate records regarding the steps taken to verify that a purchaser was an accredited investor regardless of the particular methods used by an issuer.

The existing provisions of Rule 506 as a separate exemption are not affected by the new rule. Issuers conducting Rule 506 offerings without the use of general solicitation or general advertising can continue to conduct offerings in the same manner and are not subject to the new verification requirements.

Form D Amendment

Form D is the notice of an offering of securities conducted without registration in reliance on Regulation D. The information required to be provided in a Form D filing includes basic identifying information, such as the name of the issuer, issuer's year and place of incorporation or organization, the exemption or exemptions being claimed for the offering, and other factual information about the offering. The amendment to Rule 506 adopted by the SEC creates a separate field for issuers to indicate whether they are claiming an exemption under the new rule, to identify issuers who are using general solicitation in their offerings.

Proposed Future Amendments Regarding Form D

In conjunction with the changes to Form D adopted by the SEC, the SEC proposed further modifications to the rules that would significantly increase the Form D reporting burdens on issuers and impose stiff penalties for noncompliance. The proposed amendment would mandate the filing of a Form D for qualification for a Regulation D exemption. Furthermore, the amendment would provide a six-year disqualification from using any provision of Rule 506 for private placement for any issuer that failed to file a Form D for a Regulation D offering in the past five years. Currently, issuers are required to file a Form D within 15 days after the first sale of securities, and are required to report additional sales through amended filings only under certain conditions. The amendment would require the filing of an amended Form D at the close of the offering, as well as a detailed presentation of use of proceeds. Finally, the proposed amendment would provide that Form Ds without all the information filled in are deemed to be non-conforming and apparently not effective filings. For all issuers relying on one or more Regulation D exemptions in offerings, the proposed amendments concerning Form D requirements should be closely monitored. Commissioners Gallagher and Paredes vigorously dissented from this proposal. This proposal will likely generate considerable public comment.

At present, failure to file a Form D is not considered to be a significant violation of Regulation D at the federal level, although failure to file a Form D is considered to be a significant violation under many state coordinating exemptions. This proposal represents a major change at the federal level that considerably increases the consequences of failure to fully comply with the filing requirement.

Bad Boy Provisions

The Commission also adopted amendments to Rule 501 and 506 which disqualify certain issuers and their executive officers who participate in the Rule 506 securities offering from being able to use Rule 506. These "bad boy" disqualifiers were mandated by the Dodd-Frank financial reform legislation. The specific disqualifiers are similar to, but not the same as, the disqualifiers currently contained in Rule 262 of Regulation A. They apply prospectively, in that they will apply only for triggering disqualifications that occur after the effective date of the amendments. However, preexisting matters will be subject to mandatory disclosure.

Since most states have already adopted bad boy disqualifiers in their coordinating state exemptions for Rule 506 offerings, the adoption of these provisions at the federal level may not have a large practical impact on Rule 506 offerings.

Public Solicitation in Limited Offerings under Rule 144A

The amendment to Rule 144A provides securities can be offered to persons other than qualified institutional buyers, including by means of general solicitation, provided that the securities are sold only to persons whom the seller and any person acting on behalf of the seller reasonably believe to be qualified institutional buyers.

Timing: Don't Jump the Gun

The SEC adopted the rules eliminating the prohibition on general solicitation on July 10, but the rules do not become effective until 60 days after publication in the Federal Register – which puts the effective date somewhere in mid-September. So, while you may start to see and hear advertisements for offerings under the new rule, general solicitation and general advertisement is not sanctioned until after the effective date of the new rules. The prohibition against general solicitation is in full force and effect until the new rule becomes effective, meaning issuers who jump the gun and publicly solicit or advertise offerings will be subject to enforcement actions under the current rules, and enforcement agencies will be waiting for eager issuers to do so. For all issuers planning to capitalize on general solicitation and advertising in their offerings, be patient and wait until the new rules are effective or otherwise risk violating SEC rules.

It is worth noting that FINRA has already begun to ask broker-dealers, who must file notices of private placement sales with FINRA under Rule 5123, whether the private placement issuer has engaged or will engage in a general solicitation for the offering. Prior to the effective date of the SEC amendments, this could be a trap for the unwary.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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