United States: SEC Proposal Would Allow General Solicitation In Regulation D (Rule 506) And Rule 144A Offerings

Overview

On August 29, 2012, the Securities & Exchange Commission (the "SEC"), by a vote of 4-1, approved proposed rules to implement Section 201(a) of the Jumpstart Our Business Startups Act (the "JOBS Act") which would permit general solicitation or general advertising in offerings made under Rule 506 of Regulation D and permit offers of securities pursuant to Rule 144A to persons other than qualified institutional buyers ("QIBs").¹

The SEC had initially indicated that it would approve an interim final rule implementing these provisions, but ultimately the SEC elected—over the objection of two SEC commissioners—to propose rule amendments instead, notwithstanding that the 90-day period during which the rules were required to be adopted had already lapsed.

Rule 506 allows issuers to offer and sell an unlimited amount of securities to an unlimited number of "accredited investors" without registration. Rule 144A allows the private resale of an unlimited amount of securities to an unlimited number of QIBs (in general, institutions with over $100 million of assets) without registration. The safe harbors provided by current Rule 506 and current Rule 144A are conditioned on, among other things, not offering or selling securities through any form of general solicitation or general advertising.

The proposed rules would:

• allow general solicitation or general advertising (including for example newspaper/magazine ads, television/radio broadcasts, seminars whose invitees were invited by general solicitation, and publicly available websites) in private placements under Rule 506 of Regulation D, so long as all purchasers of the securities are accredited investors;
• require that, in Rule 506 offerings that use general solicitation, the issuer take "reasonable steps" to verify that purchasers of the securities are accredited investors;
• continue to allow Rule 506 offerings without general solicitation in accordance with current rules, in which case issuers could offer and sell securities to up to 35 non-accredited investors and would not need to take reasonable steps to verify whether purchasers are accredited investors;
• revise Form D to add a separate check box for issuers to indicate whether they are using general solicitation in a Rule 506 offering; and
• amend Rule 144A(d)(1) to impose no limit on who securities may be offered to and require only that the securities are sold to a QIB or to a purchaser that the seller and any person acting on behalf of the seller reasonably believes is a QIB.

The ability to consummate Regulation D offerings with general solicitation has the potential to significantly change existing private placement practice. It potentially expands the universe of eligible offerees, but also imposes a new incremental requirement to take reasonable steps to verify accredited investor status. Comments on the proposed rules are due 30 days after the proposing release (the "Release") is published in the Federal Register.²

Reasonable Steps to Verify Accredited Investor Status

Most of the Release addresses what constitutes "reasonable steps" to verify that purchasers are accredited investors. The SEC decided not to specify any particular method issuers must use to verify that the purchasers of the securities are accredited investors. The Release states, "Whether the steps taken are reasonable‟ would be an objective determination, based on the particular facts and circumstance of each transaction." In proposing a flexible approach, the Release states that requiring issuers to use "specific methods of verification would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor" and that a prescriptive rule could be "overly burdensome" and "ineffective." For similar reasons, the Release does not propose to provide a non-exclusive list of specified methods for satisfying the verification requirement.

While the Release indicates that written representations or questionnaires filled out by purchasers generally are not, in and of themselves, sufficient, it states that the SEC anticipates that many practices currently used by issuers in connection with existing Rule 506 offerings would satisfy the verification requirement. The Release provides the following guidance on whether the steps taken to verify accredited investor status are reasonable:

• The type of accredited investor involved. The steps a company takes will likely vary depending on the type of accredited investor the purchaser claims to be. Purchasers can be accredited investors by virtue of their personal net worth (over $1 million) or annual income ($200,000 for the last two years, or $300,000 when combined with the individual's spouse, with a reasonable expectation of reaching the same income level in the current year), by virtue of their regulatory status (a registered broker or dealer, a registered investment company, or a business development company), or by virtue of their status and their total assets (state benefit plans with total assets above $5 million, or 501(c)(3) organizations with total assets over $5 million). The Release states that "the steps that may be reasonable to verify that an entity is an accredited investor by virtue of being a registered broker-dealer—such as by going to FINRA's BrokerCheck website—would necessarily differ from the steps that would be reasonable to verify whether a natural person is an accredited investor."
• Amount and type of information the issuer has about the purchaser. According to the Release, "the amount and type of information that an issuer has about a purchaser would be a significant factor in determining what additional steps would be reasonable to verify the purchaser's accredited investor status. The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa." Examples of information a company could rely upon, any of which might by itself constitute reasonable steps to verify status, include (1) publicly available information in filings with a federal, state or local regulatory body, such as compensation disclosure in a proxy statement or a 501(c)(3) organization's Form 990 series return disclosing its total assets, (2) third party information, such as copies of Form W-2, or industry or trade publications that disclose average annual compensation for certain levels of employees and specific information about the average compensation earned at the purchaser's workplace, or (3) verification of a person's status by a third party, such as a broker-dealer, attorney or accountant.
• Nature of the offering, such as the manner in which the purchaser was solicited. According to the Release, the nature of the offering may be relevant in determining the reasonableness of the verification. The Release states, "An issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email 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 registered broker-dealer. In the case of the former, we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it 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. In the case of the latter, we believe an issuer would be entitled to rely on a third party that has verified a person's status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification."
• Terms of the offering, such as minimum investment amount. According to the Release, the terms of the offering would also affect whether the steps taken for verification are reasonable. The Release states, "The ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any other third party, could be taken into consideration in verifying accredited investor status."

The Release states that after consideration of the relevant facts and circumstances, if it appears likely that a person qualifies as an accredited investor, the issuer would have to take fewer steps. "For example, if an issuer knows little about the potential purchaser who seeks to qualify under the natural person tests for accredited investor status, but the terms of the offering require a high minimum investment amount, then it may be reasonable for the issuer to take no steps to verify accredited investor status other than to confirm that the purchaser's cash investment is not being financed by the issuer or by a third party, absent any factors that may indicate that the purchaser is not an accredited investor."

Regardless of the particular methods used, the Release states that it would be important for issuers to retain adequate records that document the steps that they took to verify that a purchaser was an accredited investor.

The Release notes that the SEC specifically declined to adopt the following approaches:

• Blessing procedures based solely on current practices or standards (though "we anticipate that many practices currently used by issuers in connection with existing Rule 506 offerings would satisfy the verification requirement proposed for offerings pursuant to Rule 506(c)."
• Mandating specific steps that issuers may take ("could be overly burdensome in some cases, by requiring issuers to follow the same steps, regardless of their particular circumstances, and ineffective in others, by requiring steps that, in the particular circumstances, would not actually verify accredited investor status")
• Providing a non-exclusive list of specified methods for satisfying the verification requirement ("there may be circumstances where such information would not actually verify accredited investor status or where issuers may unreasonably overlook or disregard other information indicating that a purchaser is not, in fact, an accredited investor")
• Viewing representations from the purchaser that it is an accredited investor as sufficient
• Requiring production of documentary evidence
• Allowing only registered broker-dealers, and not other intermediaries, to verify accredited investor status
• Allowing issuers to rely on third party firms to verify accredited investor status
• Requiring letters from a third party with knowledge of the purchaser's financial status (such as a CPA or attorney)
• Requiring the purchaser to certify his or her status under penalty of perjury, in combination with an independent professional's certification as to the purchaser's status

Certain Clarifications

In response to comments received on Section 201(a) of the JOBS Act, the Release clarifies several points. First, the reasonable belief standard for accredited investor status in Rule 501(a) continues to apply for offerings made in reliance on Regulation D that do not engage in general solicitation. That is, the definition of "accredited investor" remains unchanged with the enactment of the JOBS Act and includes persons that come within any of the listed categories of accredited investors, as well as persons that the issuer reasonably believes come within any such category. The Release also confirms that in Rule 506 offerings with general solicitation, "if a person who does not meet the criteria for any category of accredited investor purchases securities in a Rule 506(c) offering, ... the issuer would not lose the ability to rely on the proposed Rule 506(c) exemption for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor."

Second, issuers relying on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the "Investment Company Act") would not lose their exclusions by virtue of relying on Rule 506(c). Section 201(b) of the JOBS Act provides that offers and sales exempt under Rule 506, as amended, shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation. The Release states, "We believe the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the Investment Company Act."

Finally, the Release clarifies that the proposed rules would not alter the historical treatment of concurrent Regulation S and Rule 144A/Rule 506 offerings. "[C]oncurrent offshore offerings that are conducted in compliance with Regulation S would not be integrated with domestic unregistered offerings that are conducted in compliance with Rule 506 or Rule 144A, as proposed."

Other Changes Not Proposed by the SEC

The Release notes that the SEC was electing not to make other changes which commenters had suggested, including:

• amendments to the definition of "accredited investor" as it relates to natural persons, including increasing the thresholds required for individuals to become accredited;
• conditioning the availability of the new Rule 506 exemption on the filing of Form D, requiring the Form D to be filed in advance of any general solicitation, and adding to the information requirements of Regulation D; and
• rules governing the content and manner of advertising and solicitations used in offerings conducted under the Rule 506 exemption.

The proposals would only allow general solicitation in Rule 506 and Rule 144A offerings and not in Section 4(a)(2) offerings generally. The Release notes that bills that would have amended Section 4(a)(2) itself to permit the use of general solicitation were introduced and considered by Congress but were ultimately not enacted.

Footnotes

1. The JOBS Act was enacted on April 5, 2012. Section 201(a)(1) of the JOBS Act requires that the SEC, not later than 90 days after the date of enactment, amend Rule 506 of Regulation D under the Securities Act of 1933 (the "Securities Act") to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors and issuers relying on the new Rule 506 take reasonable steps to verify that the purchasers of the securities are accredited investors, using such methods as determined by the SEC. In addition, Section 201(a)(2) of the JOBS Act requires that the SEC, not later than 90 days after the date of enactment, revise Rule 144A(d)(1) under the Securities Act to permit offers of securities pursuant to Rule 144A to persons other than qualified institutional buyers ("QIBs"), including by means of general solicitation or general advertising, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs.

The SEC proposing release was issued on August 29, 2012. Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Release No. 33-9354, available at http://www.sec.gov/rules/proposed/2012/33-9354.pdf. Commissioner Luis Aguilar delivered the sole opposing vote, stating that the proposal "presents a framework that is not balanced and that fails to address the acknowledged increased vulnerability of investors." Commissioners Troy Paredes and Daniel Gallagher voted in favor of proposing the rules. However, they both supported the adoption of an interim final rule, which had been the Commission's original intention. See Statement at Open Meeting to Propose Rule Amendments Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings by Commissioner Troy Paredes, available at http://sec.gov/news/speech/2012/spch082912tap.htm ("It is regrettable that the Commission is only now considering a proposal well after the statute's 90-day implementation deadline has passed. This raises a problem that I have with how the process of this rulemaking has unfolded. For some time, the Commission was set to consider an interim final rule giving effect to Section 201(a)'s directive. But then, after the rulemaking already was far along, the Chairman abruptly decided to change the rulemaking's course, turning what was an interim final rule into a proposal. To be clear, I had very much supported proceeding with the interim final rule."); Statement at SEC Open Meeting: Proposed Rules to Eliminate the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings by Daniel Gallagher, available at http://sec.gov/news/speech/2012/spch082912dgm.htm ("I am not happy to be sitting here today, almost two months after the JOBS Act deadline for a final rule, voting on a proposal. For months, the Commission had been told that the Staff was recommending that we vote on an interim final rule. That always made sense to me given the clear mandate we had to implement. Indeed, it still makes sense today. An interim final rule would have ensured that we had a final rule in place reasonably soon after the Congressional deadline.") (emphasis in original).

2. For a description of various important aspects of the JOBS Act, see The Enactment of the Jumpstart Our Business Startups Act: Simplifying the IPO Process While Transitioning to Full Public Company Status, Fried Frank Client Memorandum, Valerie Ford Jacob, Andrew B. Barkan, Bonnie A. Barsamian, Daniel J. Bursky, Stuart H. Gelfond, David B. Hardison, Michael A. Levitt, Paul D. Tropp, Vasiliki B. Tsaganos & Anuja A. Majmudar, Apr 3, 2012; Impact of JOBS Act on Private Investment Funds, Fried Frank Client Memorandum, Jonathan S. Adler & Justin Nasatir, Apr 5, 2012; The Jumpstart Our Business Startups Act and Its Impact on Equity Research Analysts, Fried Frank Client Memorandum, David B. Hennes & Carmen J. Lawrence, May 18, 2012; Market Practice Evolves Under the Jumpstart Our Business Startups Act, Fried Frank Client Memorandum, Valerie Ford Jacob, Andrew B. Barkan, Bonnie A. Barsamian, Daniel J. Bursky, Stuart H. Gelfond, Michael A. Levitt, Paul D. Tropp & Vasiliki B. Tsaganos, May 15, 2012; US$500 and a Click: Investing the "Crowdfunding" Way, Fried Frank Client Memorandum, Stuart H. Gelfond & Anthony D. Foti, Jun 12, 2012.

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