United States: SEC Adopts Significant Amendments To Private Placement Rules: JOBS Act Rules Eliminate Ban On General Solicitation And Dodd-Frank Mandate Disqualifies Bad Actors

I. INTRODUCTION

On July 10, 2013, the U.S. Securities and Exchange Commission ("SEC") adopted rule changes that will permit "general solicitation and general advertising" ("GSGA") in "private" securities offerings effected under either Rule 506 of Regulation D under the Securities Act of 1933 (the "Securities Act") or Rule 144A under the Securities Act.1 The SEC's rule changes – which fulfill rulemaking requirements imposed on the SEC by the Jumpstart Our Business Startups Act (the "JOBS Act") – will become effective on September 23, 2013; i.e., 60 days after publication of the rule changes in the Federal Register (the "Effective Date").

At that same July 10, 2013 meeting, the SEC adopted rule changes (the "Bad Actor Rules") to disqualify offerings from relying on the Rule 506 exemption from Securities Act registration if felons and other "bad actors" are associated with or participate in the offering.2

In conjunction with its approval of GSGA, the SEC also proposed certain disclosure and Form D filing rules relating to securities offerings effected under Rule 506, as well as certain other rules designed to enhance the SEC's information gathering on, and thus understanding of, the Rule 506 market and to protect investors (collectively, the "Proposed Amendments").3

A. Executive Summary of the GSGA Changes

The SEC adopted the GSGA amendments to Rule 506 and Rule 144A to comply with Section 201(a) of the JOBS Act, which requires the SEC to remove the prohibition on GSGA for securities offered under those rules. While the new GSGA rules permit issuers and their agents to solicit potential investors through GSGA materials (including mass mailings, newspaper advertisements, unrestricted websites, television spots and social media), issuers should understand the requirements, restrictions and legal implications of the GSGA rules before using them. Certain issuers will likely find it easier to rely on traditional private placement methods, which will continue to be available, although the new Bad Actor Rules will be relevant.

Pursuant to newly-added paragraph (c) of Rule 506, an issuer can offer securities through GSGA methods if: (1) the issuer continues to satisfy all terms and conditions of Rules 501, 502(a) and 502(d) of Regulation D; (2) all purchasers of the securities are "accredited investors," as defined in Rule 501(a) of Regulation D (subject to the "reasonable belief" standard in Rule 501(a)); and (3) the issuer takes "reasonable steps to verify" that the purchasers are accredited investors.

Rule 506(c) identifies certain non-exclusive and non-mandatory methods of verifying that natural persons who purchase securities are accredited investors.

In addition, the issuer will be required to indicate on the amended Form D that the offering is being effected pursuant to Rule 506(c).

Pursuant to Rule 144A, as amended, securities may be offered and resold through GSGA methods, provided the securities are sold only to qualified institutional buyers ("QIBs") (as defined in Rule 144A) or to purchasers the seller reasonably believes are QIBs.

B. Executive Summary of the Bad Actor Rules

The SEC also adopted a new paragraph (d) to Rule 506, which disqualifies securities offerings from relying on Rule 506 if certain felons and other "bad actors" are associated with the issuer, any investment manager or any paid solicitor for the offering. This rule change was mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") and applies regardless of whether an offering is effected pursuant to paragraph (c) or paragraph (b) of Rule 506.

A paragraph (d) disqualification will be triggered if an enumerated disqualifying event occurs on or after the Effective Date with respect to a varied range of persons associated with the issuer or the offering (as further enumerated in the body of this Memorandum).

The disqualifying events include certain criminal convictions, certain orders by courts or regulators (at the state or federal level), or suspension or expulsion from securities self-regulatory organizations.

A disqualifying event that occurred prior to the Effective Date will not result in disqualification under Rule 506. However, pursuant to newly-added paragraph (e) of Rule 506, a disqualifying event occurring prior to the Effective Date must be disclosed by the issuer at a reasonable time prior to any sale, unless the issuer did not know, and in the exercise of reasonable care, could not have known, of the event.

C. Executive Summary of the Proposed Amendments

In that same July 10, 2013 meeting, the SEC, in a 3-2 vote, proposed additional amendments to Regulation D, Form D and Rule 156 under the Securities Act. With respect to offerings conducted with GSGA pursuant to Rule 506(c), the timing of the Form D filing would change, as would its content. More significantly, an issuer would be disqualified from relying on the Rule 506 safe harbor for future offerings if it (or any of its predecessors or affiliates) fails to comply with the Form D filing requirements. With respect to GSGA materials, the SEC proposed that certain legends or cautionary statements be included and that such materials be submitted to the SEC on a temporary basis, via a portal on the SEC website.

In the Proposed Amendments Release, the SEC also proposed extending the antifraud guidance contained in Rule 156 under the Securities Act – which currently is applicable only to SEC-registered investment companies – to sales literature of private funds. In addition, the SEC solicited comments regarding the restrictions on the content of performance information in GSGA materials used by private funds, as well as regarding the Rule 501(a) definition of "accredited investor."

II. THE GSGA CHANGES

A. Conditions for Utilizing GSGA

1. In a Rule 506(c) Offering

If an issuer wishes to utilize GSGA, as permitted under new paragraph (c) of Rule 506, the following conditions must be met:

  1. the issuer must satisfy all terms and conditions of Rules 501, 502(a) and 502(d) of Regulation D;
  2. all purchasers of the offered securities must be "accredited investors" or are reasonably believed to be such;4 and
  3. the issuer must take "reasonable steps to verify" that the purchasers of the securities are accredited investors.

The GSGA Adopting Release emphasizes that the "reasonable steps" requirement is in addition to the requirement that sales be limited to accredited investors. That is, an issuer that fails to take "reasonable steps" of verification will not have complied with the GSGA requirements even if the ultimate purchasers turn out to be accredited investors. However, footnote 111 of that release notes that, "[i]f an issuer has actual knowledge that the purchaser is an accredited investor, then the issuer will not have to take any steps at all."

An issuer conducting an offering pursuant to Rule 506(c) must indicate its reliance on Rule 506(c) in a new check box on the amended Form D.

2. In a Rule 144A Offering

Under revised Rule 144A – which provides a non-exclusive safe harbor from registration under the Securities Act for resales of certain restricted securities to QIBs – resales can be conducted using GSGA, provided the securities are sold only to QIBs or to purchasers the seller reasonably believes are QIBs. Footnote 172 of the GSGA Adopting Release confirms that the general solicitation that is permitted in connection with Rule 144A resales will not affect the availability of the Section 4(a)(2) exemption or Regulation S for the initial sale of securities by the issuer to the initial purchasers.

B. Accredited Investor Verification Methods for Rule 506(c) Offerings

1. Principles-Based Verification Approach

As noted, issuers that utilize GSGA methods in reliance upon Rule 506(c) must take "reasonable steps" to verify that the purchasers of the securities are "accredited investors." The SEC stated that it will take a principles-based approach to determining reasonableness, in light of the facts and circumstances. In the GSGA Adopting Release, the SEC noted that relevant factors for issuers to consider include: (1) the nature of the purchaser and type of accredited investor the purchaser claims to be; (2) the amount and type of information 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, as well as the terms of the offering, such as minimum investment amount. That release indicates that, the more likely it appears, after consideration of the facts and circumstances, that the purchaser is an accredited investor, the fewer steps the issuer will have to take to verify accredited investors status. The SEC specifically declined to prescribe uniform verification methods, concluding that those "may be ill-suited or unnecessary to a particular offering or purchaser." Rather, it emphasized that market participants have the flexibility to adopt different verification approaches depending on the circumstances. The GSGA Adopting Release notes that the types of information regarding a purchaser that can be reviewed include publicly available information in regulatory filings and information obtained from a reliable third-party service that verifies accredited investor status for purposes of Rule 506(c). Regardless of the particular verification methods undertaken, the GSGA Adopting Release emphasizes that issuers and their agents should retain adequate records regarding the steps taken.

With respect to the nature of the offering itself, the GSGA Adopting Release acknowledges that less due diligence may be required with respect to a purchaser that was solicited based upon inclusion in a database of pre-screened accredited investors than with respect to a purchaser solicited through less selective means (e.g., through a widely-disseminated email or a newspaper ad). Additionally, a less extensive verification process may be reasonable where a high minimum investment is required. However, if an issuer intends to utilize minimum investment amount as the primary method of verifying accredited investor status, it may be appropriate (depending upon the facts) to confirm that the purchaser's investment is not being financed by a third party.

The GSGA Adopting Release states that an issuer will be entitled to rely on a third party that has verified a purchaser's accredited investor status, so long as the issuer has a reasonable basis for this reliance. That release emphasizes that merely requiring a purchaser to self-identify as an accredited investor (e.g., by checking a box or signing a form) does not, in and of itself, constitute a reasonable step to verify accredited investor status.

2. Non-Exclusive Verification Methods for Natural Person Investors

The GSGA Adopting Release acknowledges that verifying the accredited investor status of natural persons may pose greater practical difficulty than verifying the accredited investor status of certain institutional investors, particularly those as to which there is publicly available information. Accordingly, in the case of natural person investors, Rule 506(c) identifies certain "non-exclusive and non-mandatory" methods that are deemed to satisfy the accredited investor verification requirement. (Note that Rule 506(c) does not suggest any specific verification methods for institutional accredited investors.)

Rule 506(c) indicates that an issuer can verify that a natural person is an accredited investor on the basis of income by:

  1. reviewing copies of any IRS form that reports income (e.g., Form W-2 or Form 1099) for the two most recent years; and
  2. obtaining a written representation from the investor that he or she has a reasonable expectation of reaching the necessary income level in the current year.

Rule 506(c) specifies that an issuer can verify that a natural person is an accredited investor on the basis of net worth by:

  1. obtaining information dated within the prior three months with respect to both the person's assets and the person's liabilities; and
  2. obtaining a written representation from the person that all liabilities necessary to determine net worth have been disclosed.

For purposes of the asset side of the new worth test, the issuer can review a person's bank statements, brokerage or other securities holdings statements, certificates of deposit, tax assessments and/or appraisal reports by independent third parties. With respect to liabilities, the issuer can review a consumer report from at least one national consumer reporting agency.

Rule 506(c) also indicates that an issuer can verify a natural person's accredited investor status by obtaining a written confirmation from an SEC-registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant to the effect that the confirming party has taken reasonable steps to verify that the natural person is an accredited investor within the prior three months and has determined that the person is an accredited investor. The GSGA Adopting Release notes that an issuer also may be entitled to rely on accredited investor verification conducted by other types of third parties, provided the issuer has a reasonable basis for such reliance.

Rule 506(c) further provides that, if a natural person purchased securities in an issuer's Rule 506 offering prior to the Effective Date as an accredited investor and remains an investor of the issuer, that person may invest in any Rule 506(c) offering conducted by the same issuer by providing an accredited investor certification at the time of sale. The issuer need not undertake reasonable steps to verify the "accredited investor" status of such prior investors.

C. Amendments to Form D

The SEC also adopted amendments to Form D requiring an issuer to designate the type of exemption being relied upon by the issuer; i.e., Rule 506(b) or Rule 506(c). Note that, in conjunction with the Bad Actor Rules discussed below, Form D also includes an issuer certification that the issuer is not disqualified by Rule 506(d) from relying on Rule 506.

D. Legal Implications of GSGA

1. Relating to the Investment Company Act

The GSGA Adopting Release clarifies that private funds that engage in GSGA in reliance upon Rule 506(c) may continue to rely upon the exclusions from the definition of "investment company" set forth in Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act of 1940, even though those exclusions specify that an issuer relying upon them is "not making and does not [currently] propose to make a public offering of its securities." The SEC reached this conclusion because Section 201(b) of the JOBS Act provides that offers and sales pursuant to Rule 506 "shall not be deemed public offerings under the Federal securities laws" as a result of GSGA.

2. Relating to Regulation S

The GSGA Adopting Release makes clear that offshore offerings that are conducted in compliance with Regulation S under the Securities Act will continue to benefit from that safe harbor and will not be integrated with domestic unregistered offerings that are conducted in compliance with Rule 506 or Rule 144A, even if those offerings involve GSGA.

3. Relating to Section 4(a)(2) and Blue Sky Laws

The GSGA Adopting Release emphasizes that Section 4(a)(2) of the Securities Act exempts from registration "transaction(s) by an issuer not involving any public offering" and issuers that do not intend to engage in GSGA may continue to rely on Section 4(a)(2) or Rule 506(b). Issuers that rely on Section 4(a)(2) or Rule 506(b) exemptions need not take the Rule 506(c)- prescribed steps to verify the "accredited investor" status of purchasers. Additionally, as set forth in the GSGA Adopting Release, securities offered in compliance with Rule 506(c) will be deemed to be "covered securities" for purposes of Section 18(b)(4)(E) of the Securities Act and, thus, will not be subject to state blue sky registration requirements. However, securities that are offered solely pursuant to Section 4(a)(2) are not "covered securities" and may be subject to state blue sky regulations.

4. Relating to the Investment Advisers Act

The GSGA Adopting Release notes that GSGA materials produced by SEC-registered investment advisers to private funds are subject to the antifraud provisions of Rule 206(4)-8 of the Investment Advisers Act of 1940. That release indicates that investment advisers to private funds should carefully review their policies and procedures to determine whether those materials are reasonably designed to prevent the use of fraudulent or materially misleading private fund advertising and should make appropriate amendments if the private fund intends to engage in GSGA.

5. Relating to the Broker-Dealer Registration

The relief from the pre-existing private placement requirements provided by the GSGA Adopting Release does not provide any exemption from the "broker" registration requirement under the Securities Exchange Act. In light of the SEC's recent disciplinary action and statements on the broker registration requirement as to private funds and investment advisers, private funds and investment advisers should be mindful of the permissible conduct of their personnel, whether or not they are using GSGA.

6. Relating to FINRA Rules

The GSGA Adopting Release notes that SEC-registered broker-dealers participating in offerings relying on Rule 506(c) continue to be subject to FINRA rules regarding communications with the public. In particular, FINRA Rule 2210 and the FINRA interpretations thereunder need to be taken into consideration.

7. Relating to the Commodity Exchange Act, Commodity Futures Trading Commission ("CFTC") Rules and NFA Rules

Managers of "commodity pools" that are offered pursuant to Rule 506 who are currently relying on the exemption under CFTC Rule 4.7 from certain disclosure, reporting and record keeping requirements otherwise applicable to registered commodity pool operators ("CPOs"), or an exemption under CFTC Rule 4.13(a)(3) from registration as a CPO, must consider whether GSGA methods are available for offerings of those commodity pool interests. A condition of CFTC Rule 4.7(b) is that commodity pool interests be offered and sold solely to "qualified eligible persons" (as defined in CFTC Rule 4.7). Based upon the language of the rule and other applicable guidance, it is unclear whether this condition permits the use of GSGA given that offers would not be so limited even if sales were. CFTC Rule 4.13(a)(3) requires that commodity pool interests be "offered and sold without marketing to the public in the United States." The CFTC has yet to harmonize these CFTC rules with Rule 506(c) or otherwise to clarify its approach to the use of GSGA offering methods for these types of pools.5

Further, GSGA materials must be reviewed and considered under CFTC Rule 4.41, which relates to advertising by commodity pool operators and commodity trading advisors, as well as under NFA Rule 2-29, which relates to communications with the public and promotional materials.

8. Relating to Non-U.S. Private Placements of Fund Interests

Managers to private funds that offer interests in non-U.S. jurisdictions also should consider whether the use of GSGA is compatible with the private placement requirements of those jurisdictions. Note, as well, that the Alternative Investment Fund Managers Directive ("AIFMD") came into effect on July 22, 2013 in the European Union ("EU"). The AIFMD is a new regime that regulates managers who market to investors in the EU. The AIFMD defines "marketing" as any "direct or indirect offering or placement at the initiative of the [Alternative Investment Fund Manager ("AIFM")] or on behalf of the AIFM of units or shares of an [Alternative Investment Fund] it manages to or with investors domiciled or with a registered office in the Union." It is generally understood that reverse solicitation is excluded from the definition of "marketing"; however, very little guidance has been provided with respect to the types of interactions that fall outside the definition of "marketing." Moreover, EU member states may permit non-EU AIFMs (who cannot initially participate in the passport regime that is available to EU AIFMS under the AIFMD) to market only to "professional investors" if certain requirements are fulfilled under the AIFMD. Issuers therefore should be aware of the scope of their advertising efforts to ensure they are complying with all relevant private placement regimes in non-U.S. jurisdictions and should consider relevant guidance with respect to non-U.S. and AIFMD implementation as it becomes available.

E. Certain Practical Considerations relating to Private Fund Use of GSGA

Private fund managers intending to offer fund interests under Rule 506(c) must consider their policies and procedures with respect to the offering process and the documentation provided to investors. With respect to offering documents, certain standard selling restriction legends should be removed. In addition, subscription documents should be updated to assist with the process of verifying "accredited investor" status and to remove outmoded representations regarding selling restrictions.

Note also that if a fund manager intends to remove any restrictions on its website, such as password protection, its fund offerings may be deemed to be under Rule 506(c) (depending upon the content of its website) and the measures discussed in Section II.A. above may need to be taken with respect to its offerings. Private fund managers that intend to rely on Rule 506(b) should not remove these website restrictions and should continue to rely on SEC guidance regarding a true private placement (see, for example, Lamp Technologies, Inc., SEC No-Action Letter (May 29, 1998)).

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Footnotes

1 See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 FR 44771, 44771 - 44805 (July 24, 2013) (the "GSGA Adopting Release"), available at http://www.gpo.gov/fdsys/pkg/FR-2013-07-24/pdf/2013-16883.pdf

2 See Disqualification of Felons and Other "Bad Actors" From Rule 506 Offerings, 78 FR 44729, 44729 - 44771 (July 24, 2013) (the "Bad Actor Adopting Release"), available at http://www.gpo.gov/fdsys/pkg/FR-2013-07-24/pdf/2013-16983.pdf

3 See Amendments to Regulation D, Form D and Rule 156, 78 FR 44806, 44806 - 44855 (July 24, 2013) (the "Proposed Amendments Release"), available at http://www.gpo.gov/fdsys/pkg/FR-2013-07-24/pdf/2013-16884.pdf

4 Although Rule 506(c) states that all purchasers must be accredited investors, that status is subject to the reasonable belief standard contained in Rule 501(a) (e.g., to accommodate instances in which an investor may provide false information as to its status).

5 In the CFTC's final rule-making release entitled "Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators" (issued on August 13, 2013), the CFTC acknowledged the disparity between the two regimes but did not address the issue. The CFTC did direct its staff to evaluate the issue and make recommendations for future action regarding harmonization. See Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators, (Aug. 13, 2013), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister081213.pdf

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