On July 10, 2013, the Securities and Exchange Commission ("SEC") adopted several significant amendments that will change the way private placements are conducted. The SEC adopted the following amendments:
- Repeal of the ban on general solicitation in private offerings conducted under Rule 506 of Regulation D and Rule 144A under the U.S. Securities Act of 1933 (the "Securities Act"), as required by Section 210(a) of the Jumpstart Our Business Startups Act ("JOBS Act").
- Disqualification of "bad actors" from participating in securities offerings under the Rule, as required by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank").
- Proposed new amendments to Regulation D, Form D, and Rule 156 under the Securities Act. If adopted, these proposals would impose additional Form D filing requirements, including before the use of general solicitation, and would penalize an issuer for not filing a Form D.1
The final amendments will become effective and the comment period for the proposed amendments will end, on September 23, 2013.
This advisory will explain the new rules in detail and their effects as well as describe the opportunities that are now available.
I. REPEAL OF THE BAN ON GENERAL SOLICITATION FOR PRIVATE PLACEMENTS
The SEC approved the long awaited rules that eliminate the prohibition against general solicitation in offerings under Rule 506 of Regulation D and Rule 144A under the Securities Act.
Existing Safe Harbor under Rule 506(b) Remains
Existing Rule 506 permits sales to an unlimited number of accredited investors and up to 35 non-accredited investors, so long as there is no general solicitation, appropriate resale limitations are imposed, applicable information requirements are satisfied, and the other conditions of the rule are met.2 Rule 506 is the most widely used of the three exemptive rules for limited offerings under Regulation D, accounting for an estimated 90% to 95% of all Regulation D offerings.3
Essentially, the new amendments create a new and distinct method of conducting private offerings, leaving the old methods untouched and available for use. Companies seeking investments can now choose whether they want to use one of the classic private placement methods or, alternatively, the new method that permits general solicitation and advertising.
As expected, the new method introduced by the SEC is a mixed blessing. To protect potential investors that may be affected and influenced by public solicitations, the new rules contain a set of checks and balances that, in some cases, may be more burdensome than the classic methods (which require avoiding general solicitation).
An analysis of the choices of private placement exemptions is attached as Appendix 1.
New Rule 506(c) Permits Private Placements with General Solicitation
The SEC has adopted new Rule 506(c), which permits an issuer to offer and sell securities by means of general solicitation, provided that the following conditions are met:
- All purchasers of the securities must be accredited investors (as defined in Rule 501(a) of Regulation D), at the time of the sale of the securities, i.e., either they in fact are all accredited investors or the issuer reasonably believes that they are.4
- The issuer takes "reasonable steps to verify" that all purchasers of the securities are accredited investors (see detailed analysis below).
- All other conditions of existing Rules 501 (definitions), 502(a) (integration restriction) and 502(d) (resale limitations) of Regulation D are met.
Reasonable Steps to Verify Accredited Investor Status is Left Flexible
Under Rule 506(c) issuers must take "reasonable steps to verify" that purchasers of the offered securities are accredited investors. This requirement is separate from the requirement that sales must be limited to accredited investors and must be satisfied even if all purchasers are accredited investors.
Generally, under the new Rule 506(c), it is not sufficient verification for issuers to solely rely on "self-certification" by potential investors who merely check a box in a questionnaire or sign a document containing investor representations. Consequently, issuers conducting an offering under new Rule 506(c) must supplement investor self-certification methods with additional reasonable steps to verify accredited investor status.
Reasonable Verification Steps Must Be Taken
The SEC did not mandate any specific verification steps. Rather, whether the steps taken are "reasonable" will be an objective determination by the issuer (or those acting on its behalf), dependent on the particular facts and circumstances of each purchaser and transaction. This principles-based method of verification by consideration of the particular facts and circumstances of each purchaser and transaction includes a consideration of:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be.
- The amount and type of information that the issuer has about the purchaser.
- 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, such as the minimum investment amount.
Nature of the Purchaser
The steps that will be reasonable to verify whether a purchaser is an accredited investor will vary depending on the type of accredited investor that the purchaser claims to be. For instance, verification of accredited investor status of natural persons poses greater practical difficulties than other categories of accredited investors. Natural persons may be accredited investors based on either a "net worth test" or an "income test."5 It might be more difficult for an issuer to obtain information about the assets and liabilities that determine a person's net worth, particularly the liabilities, than it would be to obtain information about a person's annual income. There could also be privacy concerns with either test.
Information about the Purchaser
The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer additional verification steps it may have to take, and vice versa. If an issuer has actual knowledge that the purchaser is an accredited investor, then the issuer will not have to take any additional verification steps at all. The following are examples of the types of information an issuer could rely upon:
- Publicly available information in filings with a federal, state or local regulatory body.
- Third-party information that provides reasonably reliable evidence that a person is an accredited investor, such as Form W-2 provided by a natural person.
- Third-party verification of a person's status as an accredited investor, provided that the issuer has a reasonable basis to rely on the third-party verification.
The Nature and Terms of the Offering
An issuer that solicits new investors from the general public (e.g., through a generally accessible website, a widely disseminated e-mail, social media, or through print media, such as a newspaper), will likely have 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 (provided that the issuer has a reasonable basis to rely on that third-party verification).
Additionally, if a purchaser must meet a minimum investment amount that is sufficiently high such that only accredited investors could reasonably be expected to participate, and the issuer has taken reasonable steps to verify that such purchaser's investment is not being financed by the issuer or by any third party, then such minimum investment requirement might be considered sufficient verification, and the issuer need not take any additional steps to verify the purchasers' accredited investor status. However, the SEC did not provide any guidance as to what amount might be high enough.
The principles described above are interconnected and would affect the types of steps that would be reasonable to take to verify a purchaser's accredited investor status. After considering the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa.
Issuer Must Keep Adequate Records of Verification Steps
The issuer has the burden of demonstrating that its offering is entitled to an exemption from the registration requirement of Section 5 of the Securities Act. Consequently, issuers and their verification service providers must retain adequate records of the steps taken to verify that a purchaser was an accredited investor.
Appendix 2 is a chart describing the interaction of the verification factors described above.
Non-Exclusive, Optional Methods of Verifying Accredited Investor Status of Natural Persons
In addition to the principles based approach to verification described above, the SEC included in Rule 506(c) four specific "safe harbor" methods of verifying accredited investor status for natural persons that, if used, meet the verification requirement in Rule 506(c). However, if the issuer or its agent has actual knowledge that the purchaser is not an accredited investor, none of these methods will meet the verification requirement. These methods are not exclusive and issuers are not required to use any of the methods discussed below. Issuers can alternatively use the principles-based approach by applying the reasonableness standard directly to the specific facts and circumstances presented by the offering and the investors.
Reports to the IRS
For verifying a natural person as an accredited investor on the basis of income, an issuer may rely on any Internal Revenue Service ("IRS") form that reports income6 for the two most recent years, along with obtaining a written representation from the person that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.7
For verifying a natural person as an accredited investor on the basis of net worth, an issuer will rely on one or more of the following types of documentation, dated within the prior three months, together with a written representation from the person that all liabilities necessary to make a determination of net worth have been disclosed.8
- 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 consumer report (i.e., a credit report) from at least one of the nationwide consumer reporting agencies.
Third Party Certifications
For verifying a natural person as an accredited investor under either the "income test" or the "net worth test," an issuer may rely on a written confirmation from a registered broker-dealer, a registered investment adviser, a licensed attorney, or a certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor. An issuer may rely on the verification of accredited investor status by a person or entity other than one of these parties, provided that the third party takes reasonable steps to verify that purchasers are accredited investors and the issuer has a reasonable basis to rely on the verification.
For any natural person who invested in an issuer's Rule 506(b) offering as an accredited investor before the effective date of Rule 506(c) and remains an investor of the issuer, then for any Rule 506(c) offering conducted by the same issuer, the issuer may rely on a certification by that investor at the time of sale that he or she qualifies as an accredited investor.
Rule 506(c) Securities are "Covered Securities" for Blue Sky Purposes
As new Rule 506(c) will continue to be treated as a regulation issued under Section 4(a)(2), the securities issued in a Rule 506(c) offering will be "covered securities" for purposes of Section 18(b)(4)(E) of the Securities Act. Therefore, state "blue sky" registration requirements will be pre-empted and not apply to securities offered and sold in Rule 506(c) offerings.
Form D Check the Box for Rule 506(c) Offerings
Form D is the notice of sales, which is filed for an exempt offering of securities conducted under Regulation D. An issuer offering or selling securities in reliance on Rule 506 must file a Form D with the SEC for each new offering of securities within 15 calendar days after the first sale of securities in the offering. Issuers conducting a Rule 506(c) offering must indicate that they are relying on the Rule 506(c) exemption by marking a new check box in Item 6 of Form D. An issuer will not be permitted to check both the Rule 506(b) and Rule 506(c) boxes at the same time for the same offering because once a general solicitation has been made to the purchasers in the offering, an issuer cannot rely on Rule 506(b) (because it remains subject to the prohibition against general solicitation).
Implications for Private Funds
Private investment funds typically rely on the Section 3(c)(1) or 3(c)(7) exclusion from registration under the Investment Company Act of 1940 (the "Investment Company Act"), which prohibit issuers relying on those exclusions from making a public offering of their securities. The SEC confirmed that private funds may engage in a Rule 506(c) offering with general solicitation and still rely on Section 3(c)(1) or (7). However, the rule amendments did not address CFTC exemptions relating to "marketing to the public". Additionally, if private funds choose to engage in general solicitation, they should review their policies and procedures regarding the nature and content of their sales literature so that those policies and procedures are reasonably designed to prevent the use of fraudulent or misleading materials.
Pre-Existing Substantive Relationships With Investors
The SEC also reaffirmed its 2007 guidance regarding general solicitation and pre-existing, substantive relationships. Consequently, where an issuer had pre-existing, substantive relationships with the offerees, it may still rely on Rule 506(b) notwithstanding a general solicitation.9
Inability to Fall back on the General 4(a)(2) Exemption
The elimination of the ban on general solicitation applies only for offerings conducted under Rule 506(c), and not to offerings conducted under Section 4(a)(2). Therefore, an issuer relying on Section 4(a)(2) will not be permitted to make public communications to solicit investors for its offering. Accordingly, an issuer engaging in a general solicitation under Rule 506(c) must take particular care to satisfy all the Rule's requirements because Section 4(a)(2) will not be available for a failed Rule 506(c) offering.
General Solicitation Permitted in Rule 144A Offerings
The SEC revised Rule 144A to provide that in a Rule 144A offering, securities may be offered to persons who are not qualified institutional buyers ("QIBs"), including by means of general solicitation, provided the securities are sold only to persons that the seller and any person acting on its behalf reasonably believe is a QIB.
The SEC also amended Regulation M (Rules 101, 102 and 104) to permit transactions in Rule 144A securities during a distribution of those securities under Rule 144A, even if the securities were offered to non-QIBs.
The general solicitation that is now permitted in Rule 144A resales from the initial purchaser to the QIBs, will not affect the availability of the Section 4(a)(2) exemption or the Regulation S exclusion for the initial sale of securities by the issuer to the initial purchaser.
Regulation S Offerings Remain Unaffected
Regulation S provides a safe harbor for offers and sales of securities outside the United States, provided that the securities are sold in an offshore transaction and the issuer has not engaged in any "directed selling efforts" in the United States. Consistent with the historical treatment of concurrent Regulation S and Rule 144A/Rule 506 offerings, offerings outside the United States under Regulation S will not be integrated with concurrent unregistered offerings in the United States under Rule 506(c) or Rule 144A with general solicitation.
For an ongoing offering under Rule 506 that commenced before September 23, 2013, the effective date of new Rule 506(c), the issuer may choose to continue the offering after the effective date under either Rule 506(b) or Rule 506(c). If an issuer chooses to continue the offering under Rule 506(c), any general solicitation after the effective date will not affect the exempt status of offers and sales of securities that occurred before the effective date under Rule 506(b).
Considerations for Broker-Dealers Participating in Offerings under Rule 506(c)
Regulation of broker-dealers has consistently increased and become more complex in the past few years, requiring more diligence on the part of broker-dealers and a higher standard of investigation. This level of regulation will only increase once general solicitation is permitted in private placements. Broker-dealers participating in offerings with issuers relying on Rule 506(c) will face new challenges and obligations in their compliance efforts, which include:
A broker-dealer participating in a private placement must exercise a "high degree of care" in conducting a due diligence investigation of the issuer and the securities being sold through the private placement. While a broker-dealer's participation in the general solicitation of a private placement through the use or distribution of marketing or offering materials does not, by itself, require the broker-dealer to conduct an analysis of whether the recommended transaction is "suitable" for the investor, the broker-dealer does have a duty to conduct adequate due diligence. Broker-dealers will also likely be called on by issuers to assist in the investor verification process.
Communications with the public
Broker-dealers engaged in preparing general solicitation offering materials must ensure that the materials comply with all FINRA Rules relating to communications with the public,10 which, among other things (a) generally require all member communications to be based on principles of fair dealing and good faith, to be fair and balanced and to provide a sound basis for evaluating the facts in regard to any particular security, industry or service; and (b) prohibit broker-dealers from making false, exaggerated, unwarranted, promises or misleading statements or claims in any communications.
On June 20, 2013, FINRA amended Rule 5123 to require the electronic filing of certain information and to seek due diligence information (to the extent known by the broker-dealers) concerning the offering, the issuer and its management by asking several new questions, including whether the issuer engaged, or is anticipated to engage, in general solicitation. These new disclosure obligations are an easy means for FINRA to determine whether members are satisfying their due diligence obligations in private placements and it is expected that examinations and disciplinary actions will result from the new disclosure requirement.
Summer associate Anup Khatri contributed to the preparation of this client advisory.
1 The rule releases are as follows:
a. Final Rule Release – General Solicitation and Advertising: http://www.sec.gov/rules/final/2013/33-9415.pdf
b. Final Rule Release – Disqualification of "Bad Actors": http://www.sec.gov/rules/final/2013/33-9414.pdf
c. Proposed Rule Release – Filing and Disclosure: http://www.sec.gov/rules/proposed/20123/33-9416.pdf
2 See 17 CFR 230.501 – 230.506.
3 See SEC Release No. 33-9414; File No. S7-21-11, fn. 15.
4 If a person who does not meet the criteria for any category of accredited investor purchases securities in a Rule 506(c) offering, then the SEC believes that the issuer will not lose the ability to rely on Rule 506(c) 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 at the time of sale.
5 Under Rule 501(a)(5) of Regulation D, a natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000, excluding the value of the person's primary residence, is an accredited investor (the "net worth test"). Under Rule 501(a)(6) of Regulation D, a natural person who had an individual income in excess of $200,000 in each of the two most recent years, or joint income with that person's spouse in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same level of income in the current year, is an accredited investor (the "income test").
6 This includes a Form W-2 ("Wage and Tax Statement"), Form 1099 (report of various types of income), Schedule K-1 of Form 1065 ("Partner's Share of Income, Deductions, Credits, etc."), and a copy of a filed Form 1040 ("U.S. Individual Income Tax Return").
7 For a person who qualifies as an accredited investor based on joint income with that person's spouse, an issuer would meet the verification requirement in Rule 506(c) by reviewing copies of these forms for the two most recent years for, and obtaining written representations from, both the person and the spouse.
8 For a person who qualifies as an accredited investor based on joint net worth with that person's spouse, an issuer would meet the verification requirement in Rule 506(c) by reviewing the documentation described above for, and obtaining representations from, both the person and the spouse.
9 The 2007 guidance appears in Release No. 33-8828 (http://www.sec.gov/rules/proposed/2007/33-8828.pdf).
10 See FINRA Rule 2210. Further, FINRA already requires the pre-review of advertising materials and the same will be true for those materials distributed in a general solicitation. Accordingly, FINRA members may find it difficult to advertise effectively while still complying with FINRA rules.
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.