New SEC rules eliminate the prohibition against general solicitation
On July 10th, the Securities and Exchange Commission (SEC) finalized new rules eliminating the prohibition against general solicitation in certain securities offerings under Rule 506 of Regulation D and Rule 144A. These changes were mandated by Section 201 of the Jumpstart Our Business Startups Act (JOBS Act) passed in April of last year, and add a significant new way in which companies may be able to finance their operations, subject to new restrictions and risks. Such rules will take effect on September 23, 2013 (60 days after the rules’ July 24th publication in the federal register.)
Below please find a high level summary of the new rules.
General Solicitation Now Permitted for Issuers
Rule 506 has been revised to include a new subsection, Rule 506(c), which allows issuers to seek investment by means of general solicitation (including, among other things, websites, social media, newspapers, paper mailings, billboards, e-mailings, and television) provided that such issuer (A) sells only to “accredited investors” and (B) takes “reasonable steps to verify” that such purchasers are actually accredited investors.
It is the second condition that presents the greatest stumbling block to a proposed 506(c) offering, as even the factual presence of only accredited investors will not qualify an issuer for use of Rule 506(c), if it is ultimately determined that reasonable steps to verify such status were not undertaken. Further, because of the unique nature of Rule 506(c) (a “public” offering deemed “private” only by statutory definition), an issuer which uses general solicitation but is later deemed to have failed to meet the conditions set forth in Rule 506(c) will likely be unable to use the Securities Act’s general exemption for “private” offerings. This presents a not insubstantial risk to issuers seeking to use the new Rule.
General Rule for Verification
While not expressly set forth in the language added by the SEC to Rule 506, the SEC’s July 10th release makes clear that issuers are expected to adopt a “principles-based approach” in determining the “reasonable” steps necessary to verify accreditation status. This approach requires two things: (1) that the issuer look at the facts and circumstances regarding a given proposed investor (as well as the transaction itself and method of solicitation), and (2) that the issuer make an informational inquiry of such investor tailored to the likelihood that such investor is not accredited based on those facts and circumstances. In order to maintain the flexibility of such an approach, the release does not go into a great level of detail regarding the treatment of specific facts and circumstances, other than to establish that an issuer’s receipt of a mere “box in a questionnaire” will generally not be sufficient. The SEC does, however, set forth a non-exhaustive list of documentation that an issuer “might” be able to rely on in meeting its verification obligations (depending on the facts and circumstances), including government filings, pay stubs, reliable third party verifications of status and “specific information about the average compensation earned at the purchaser’s workplace.”
Verification Safe Harbors
Given the subjective and uncertain nature of the flexible approach adopted by the SEC as the general standard, certain safe harbors have also been set up, which, if complied with by an issuer, will be deemed to be sufficient to meet the “reasonable steps” requirement (unless the issuer has knowledge that the purchaser is not an accredited investor). There are four:
- Income Test- For an investor claiming to be accredited by means of his or her income, an issuer is deemed to satisfy the verification requirement by (1) reviewing “any Internal Revenue Service form that reports the purchaser’s income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040)”, and (2) obtaining a written representation from the investor that he or she has “a reasonable expectation” of reaching an income level sufficient to meet the applicable income threshold during the current year.
- Net Worth Test - With respect to an investor claiming to be accredited by means of his or her net worth, an issuer is deemed to satisfy the verification requirement by reviewing one or more of the following documents dated within the prior three months: (1) with respect to 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 (2) with respect to liabilities: a credit report from a nationwide consumer reporting agency. In addition to such primary documentation, an issuer must also receive a written representation from the proposed investor that all liabilities necessary to make a determination of net worth have been disclosed.
In either of the above cases, if a spouse is involved in establishing an investor’s accredited status, such spouse must deliver like statements and make the same certifications as the primary investor.
- Third Party Verification- An issuer shall be deemed to have met the “reasonable steps” requirement if it receives a written confirmation from (1) a registered broker-dealer, (2) an SEC-registered investment adviser, (3) a licensed attorney in good standing, or (4) a certified public accountant, duly registered and in good standing, that such person or entity has taken reasonable steps to verify (and has determined) that an investor is an accredited investor within the three months prior to such confirmation.
- Pre-existing 506 Investors - An issuer will be deemed to have taken “reasonable steps” to verify the accredited status of any current investor who purchased securities of the issuer (1) as part of a previous Rule 506(b) offering, (2) as an accredited investor, and (3) prior to the effective date of Rule 506(c), if such investor certifies that it is accredited as of the time of sale in the proposed Rule 506(c) offering. This rule does not extend to investors who did not invest as part of a previous Rule 506 offering.
No Effect on Other Securities Laws
Rule 506(c) offerings are not intended to be treated as “public” offerings under federal securities laws despite the presence of general solicitation. As such, despite being (potentially quite) public in reality, under the law a Rule 506(c) offering is a private one and, as such:
- offerings qualify as private 4(a)(2) offerings under the Securities Act;
- securities issued in such offerings qualify as “covered securities” for purposes of Section 18(b)(4)(E) of the Securities Act (exempting them from registration in the various states under the National Securities Markets Improvement Act of 1996 (NSMIA));
- private funds (such as hedge funds, venture capital funds and private equity funds) engaging in general solicitation under Rule 506(c) shall remain exempt from treatment as “investment companies” under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act, as applicable, even though these Investment Company Act exemptions are conditioned on the issuer not making a “public offering” of its securities;
- Rule 506(b) will remain available as an avenue of financing for issuers which do not wish to generally solicit (or be subjected to the requirements that they undertake “reasonable steps” to verify accredited investor status.) and
- though Rule 506(c) offerings are legally “private,” it remains true that all communications related to an offering, regardless of whether or not Rule 506(c) is utilized, remain subject to Rule 10b-5 and other anti-fraud rules. Issuers will no doubt wish to have the form and substance of any kind of general solicitation reviewed carefully by their advisors to ensure that they contain no misstatements or omissions that might run afoul of such rules.
Given concerns about the activities authorized under new Rule 506(c) and as required under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC has also revised Rule 506 to prohibit issuers from using Rule 506 if certain individuals associated with the issuer or the offering have engaged in specified “bad acts.” Generally, these bad acts relate to criminal convictions, injunctions, and disciplinary orders arising out of the sale of securities or filings related thereto, the conduct of securities professionals, or other fraudulent, deceptive or manipulative conduct. An issuer will be affected if any of its (1) directors, (2) certain officers, (3) owners having a 20% or greater interest, (4) promoters, (5) investment managers (and their directors, executive officers and participating officers), or (6) individuals compensated for the solicitation of investment (and their directors, executive officers and participating officers), were known or should have been known by the issuer to be disqualified for bad acts.
Rule 144A Also Revised
In connection with the changes made to Rule 506, the SEC also revised Rule 144A to allow for general solicitation in Rule 144A secondary offerings, provided that the seller in a Rule 144A transaction reasonably believes that all purchasers are Qualified Institutional Buyers. It is worth noting that since the SEC believes that this market is generally less risky (as compared to the Rule 506 market) given the nature of Qualified Institutional Buyers (well-capitalized and sophisticated), there are no other rules imposed by the SEC on Rule 144A general solicitations at this time.
More Changes Contemplated
While only presently in the form of proposed (rather than final) rules, the SEC has, in connection with the changes to the general solicitation rules, proposed a number of additional changes to Regulation D. The new rules as proposed would:
- Require the filing of a Form D before commencing general solicitation (rather than after the first sale) in an offering made pursuant to Rule 506(c);
- Require the provision of additional information on Form D, including information on the issuer’s website, controlling investors, use of proceeds, revenue range, number and type of each category of accredited investors (i.e., “natural persons who qualify on the basis of income”), types of general solicitation used and methods used to verify accredited investor status;
- Require the filing of an amendment to a filed Form D for all Rule 506 offerings (not just Rule 506(c) offerings) within 30 days after the closing of such offering;
- Require the inclusion of certain protective legends and disclosures on all written general solicitation materials used by an issuer in a Rule 506(c) offering;
- Require the submission of the written general solicitation materials proposed to be used in a Rule 506(c) offering to the SEC by the date of first use (temporary requirement);
- Prohibit the use of Rule 506 by an issuer for one year if the issuer failed to meet the Form D filing requirements in a Rule 506 offering; and
- Directly apply SEC guidance prohibiting misleading statements and omissions in offering materials to all private funds (not just those soliciting funds under Rule 506(c)). Private funds would also require a legend on written general solicitation materials, and another legend on general solicitation materials that include performance data.
As stated above, these rules are not yet finalized and may be altered after the comment period has ended. That being said, companies should be aware that these rules, or rules generally similar thereto, are likely to be enacted in the short term.
This memorandum represents only a high level overview of Rule 506(c) and the SEC’s general solicitation regulations. As the SEC has set forth a highly fact-specific methodology for determining the applicability of such regulations, issuers will need to seek advice on a case-by-case and investor-by-investor basis with respect to this new Rule.
If you have any questions about this or any other Corporate matter, please contact your Honigman attorney or any of the attorneys listed here.