On July 10, 2013, the United States Securities and Exchange Commission ("SEC") adopted final rules to eliminate the prohibition against general solicitation and general advertising (together, "general solicitation") in private securities offerings conducted pursuant to the Rule 506 safe harbor of Regulation D under the Securities Act of 1933 (the "Securities Act"). These types of private securities offerings are some of the most common methods by which private companies, as well as many public companies, raise money from outside investors, including venture capital and private equity firms.
The existing prohibition on general solicitation has historically impacted the conduct of private securities offerings and so, for many companies, the new final rules will substantially increase the scope of permitted fundraising activities. The SEC also adopted on July 10, 2013 final rules disqualifying securities offerings involving certain “bad actors” from reliance on the Rule 506 safe harbor and proposed for public comment a number of amendments to Regulation D and related rules intended to enhance the SEC’s ability to evaluate the development of market practices and to address concerns that may arise in connection with the elimination of the prohibition against general solicitation in Rule 506 offerings.
The new rules lifting the ban on general solicitation and disqualifying private placements by certain "bad actors" will take effect 60 days after publication in the Federal Register. The proposed amendments to Regulation D are now the subject of a 60-day public comment period.
Lifting the Ban on General Solicitation
The Jumpstart Our Business Startups Act (the "JOBS Act") was signed into law by President Obama on April 5, 2012. Among other things, it directed the SEC to eliminate the prohibition against general solicitation in private securities offerings conducted pursuant to Rule 506 of Regulation D or Rule 144A under the Securities Act. Although general solicitation has never been precisely defined for purposes of the Securities Act, various forms of guidance indicate that it includes advertisements published in newspapers and magazines, communications over broadcast television and radio, seminars whose attendees have been invited by general solicitation and communications via unrestricted websites. Other potential forms of general solicitation include press interviews and email marketing campaigns.
New Final Rule
New Rule 506(c) of the Securities Act will permit issuers to solicit prospective investors generally through all forms of communication, whether or not traditionally viewed as general solicitation, so long as:
- All investors actually purchasing securities in the offering qualify as "accredited investors"[i] or the issuer reasonably believes that they so qualify;
- The issuer takes reasonable steps to verify the accredited investor status of each such investor; and
- The other applicable requirements of the Rule 506 safe harbor are met.
Under new Rule 506(c), whether an issuer has taken "reasonable steps" to verify the accredited investor status of each investor will be an objective determination, based on all facts and circumstances, which may include factors such as the nature of the investor, the amount and type of information known by the issuer concerning the investor and the nature of the offering. New Rule 506(c) provides a non-exclusive list of verification methods that will be deemed sufficient which includes:
- Reviewing copies of any IRS form that reports the income of the investor and obtaining a written representation that the investor has a reasonable expectation of continuing to earn the necessary income in the current year;
- Reviewing specified types of documentation for assets, such as bank or investment account statements, and reviewing a consumer report from a nationwide consumer reporting agency and obtaining a written representation from the investor that all liabilities to make a determination of the investor’s net worth have been disclosed; or
- Receiving a written confirmation from a registered broker-dealer or investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the investor's accredited status.
Unless an investor is an existing investor in a company, mere self-verification by a prospective investor (e.g., checking a box on a subscription agreement to represent that the investor is accredited) will not be deemed sufficient.
New Rule 506(c) will not affect offerings conducted pursuant to the private placement exemption of Section 4(a)(2) (formerly 4(2)) of the Securities Act or Rule 506(b), which will remain as alternatives for private placements. Rule 506(b) will continue to include a prohibition against general solicitation, but also will continue to permit the issuance of securities to not more than 35 non-accredited investors who meet certain "sophistication" requirements and receive certain information about the offering. Issuers will be entitled to rely upon Rule 506(b) or new Rule 506(c) in connection with any particular offering (assuming that the requirements of the applicable Rule are satisfied).[ii]
New Rule 144A(d)(1) repeals the de facto ban on general solicitation in Rule 144A offerings[iii], provided that all investors actually purchasing securities in the Rule 144A offering are “qualified institutional buyers” (or QIBs) or investors that the seller and any person acting on behalf of the seller reasonably believes are QIBs. In the adopting release the SEC states that the use of general solicitation in an offering or sale of securities under Rule 506 or Rule 144A will not impair an issuer’s ability to conduct a concurrent offshore offering under Regulation S. Accordingly, issuers will have new flexibility in private offerings to find potential investors in ways previously only permitted in registered offerings.
Disqualifying Offerings Involving Bad Actors
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law by President Obama on July 21, 2010. Section 926 of the Dodd-Frank Act required the SEC to adopt rules that would prohibit the use of the Rule 506 safe harbor of Regulation D for any securities offering in which certain felons and other bad actors are involved.
New Final Rule
Under the new final rule, which was also adopted by the SEC on July 10, 2013, an issuer will not be able to rely on the Rule 506 safe harbor if the issuer or certain other covered persons related to the issuer or involved in the offering are considered bad actors as described in the new rules, unless the issuer is able to establish that it did not know and, in the exercise of reasonable care, could not have known that it was disqualified from relying on Rule 506 due to the bad actor restrictions.
Covered persons include the issuer as well as:
- Directors and executive officers of the issuer;
- Other officers of the issuer who are participating in the offering;
- General partners, managing members or 20% or more beneficial owner of the issuer;
- Promoters connected with the issuer in any capacity at the time of the sale; and
- Persons that have been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the sale of securities (and investment managers of an issuer that is a pooled investment fund) as well as the general partners, directors, executive officers, other officers participating in the offering and managing members of any such solicitors or investment managers.
A covered person will be considered a bad actor if such covered person has experienced one or more of the following “disqualifying events”:
- Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries (the criminal conviction must have occurred within 10 years of the proposed sale of securities or five years in the case of the issuer and its predecessors and affiliated issuers);
- Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries (the injunction or restraining order must have occurred within five years of the proposed sale of securities);
- Final orders from the Commodity Futures Trading Commission, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations or credit unions that (i) bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities or (ii) are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years of the proposed sale of securities;
- Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons;
- SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws (the order must have been entered within five years of the proposed sale of securities);
- Suspension or expulsion from membership in a self-regulatory organization (“SRO”) or from association with an SRO member;
- SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities; and
- U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.
In an important carveout, the new final rule will not disqualify issuers for disqualifying events involving covered persons that occurred before the effective date of the new final rule itself (which will be 60 days after publication of the new final rule in the Federal Register). Issuer disqualification from reliance on the Rule 506 safe harbor will only result from disqualifying events involving covered persons that occur after the effective date of the new final rule. Notwithstanding this grandfathering provision, the new final rule requires disclosure by the issuer of any grandfathered disqualifying events (i.e., events occurring before the effective date of Rule 506(d)) to investors a reasonable time prior to any sale of securities under Rule 506.
The SEC has stated that the issuer is expected to give reasonable prominence to the disqualifying event disclosure to investors in order to ensure that information about the event is appropriately presented in the total mix of information available to investors. If an issuer fails to disclose disqualifying events to investors in a Rule 506 offering as required by the new final rule, the issuer will lose the protections of the Rule 506 safe harbor for that offering, since the SEC has specifically stated that failure to adequately disclose this information is not an “insignificant deviation” in the language of Rule 508, and therefore not an error in compliance with Regulation D that is deemed minor enough not to result in loss of the protections of the safe harbor.
In addition to excluding grandfathered disqualifying events from triggering issuer disqualification, the new final rule contains an important overarching exception that provides that even if it is later determined that a covered person had experienced a disqualifying event that would have made reliance on the Rule 506 safe harbor unavailable to the issuer for a particular offering, the protections of the safe harbor (which include an exemption from the registration requirements of the Securities Act) for that offering will not be lost if the issuer can establish that it did not know, and in the exercise of “reasonable care,” could not have known that a disqualification existed at the time of the offering. The same “reasonable care” exception also applies to the issuer’s knowledge of historical disqualifying events that are required to be disclosed to investors in a Rule 506 offering.
The new final rule does not define “reasonable care” and does not prescribe specific or non-exclusive methods for establishing reasonable care. In the text of the final rule release, the SEC stated that it did not believe that providing such specific guidance would be appropriate, given the wide range of issuers who rely Rule 506 and their belief that what might be appropriate for one issuer might not be appropriate for another. Instead, the instructions contained in the new final rule itself explain that an issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, a factual inquiry into whether any disqualifications exist. As with the case of the term “reasonable care,” the new rule does not delineate what would constitute an acceptable “factual inquiry.”
It is worth noting that the new final rule does not technically require that all issuers exercise “reasonable care” in all cases as a necessary prerequisite to relying on the Rule 506 safe harbor. However, the failure to use “reasonable care” would necessarily preclude any ability of an issuer to rely on the exception for unknown disqualifying events that are later discovered. For this reason, an issuer that fails to use “reasonable care” involving “factual inquiry” in investigating whether a covered person has experienced a disqualifying event will be assuming the risk that comes with the potential loss of the protections of the Rule 506 safe harbor for a particular offering.
The new final rule also permits waivers of issuer disqualification in the following limited circumstances:
- If, upon a showing of good cause by the issuer, the SEC determines that disqualification under Rule 506 is not necessary under the circumstances; or
- If, before any sale of securities in a Rule 506 offering, the court or regulatory authority that entered the relevant order, judgment or decree determines in writing that disqualification under Rule 506 should not arise as a result of such order, judgment or decree.
The SEC has delegated its authority to grant such waivers to the Director of the Division of Corporate Finance.
Additional Proposed Rules
The SEC also voted on July 10, 2013 to propose for public comment a variety of amendments to Regulation D and in particular Form D (the "Additional Rules") that would seek to limit opportunities for abuse of new Rule 506(c) and enhance the ability of SEC staff to monitor activities pursuant to, and compliance with, new Rule 506(c). These proposed amendments include the following:
Advanced Notice of General Solicitation. The proposed amendments would require issuers that intend to engage in general solicitation as part of a Rule 506 offering to file an advance notice of sale on Form D at least 15 calendar days before engaging in general solicitation for the offering and require issuers to file an amended Form D within 30 days after completing an offering to update the information contained in the original Form D and indicate that the offering has ended.
Additional Information about the Offering. The proposed amendments would require additional information about the issuer and the offering in an effort to assist the SEC with monitoring offerings relying on new Rule 506(c). The additional information would include:
- Identification of the issuer's website;
- Expanded information on the issuer;
- The use of proceeds from the offering;
- Information on the types of general solicitation used; and
- The methods used to verify the accredited investor status of investors.
Disqualification. The proposed amendments would automatically disqualify an issuer from using the Rule 506 exemption in any new offering if the issuer or its affiliates did not comply, within the last five years, with the Form D filing requirements in a previous Rule 506 offering.[iv] As contemplated by the proposed amendment, issuers would be prohibited from using this exemption for a period of one year ending after the required Form D filings are made. Issuers would be able to rely on one 30-day cure period per offering for a late Form D filing and, in certain circumstances, could request a waiver from the Staff of the SEC.
Legends and Disclosures. The proposed amendments would require issuers to include certain legends in any written general solicitation materials used in a Rule 506 offering. The legends would be intended to inform potential investors that the offering is limited to accredited investors and that certain potential risks may be associated with such offerings.
Submission of General Solicitation Materials. The proposed amendments would add a temporary rule, 510T, requiring issuers to submit any written general solicitation materials to the SEC for the next two years in an effort to assist the SEC with monitoring offerings relying on new Rule 506(c). Materials submitted to the SEC under Rule 510T would not be filed via EDGAR so that it would not be available to the general public.
Specific Concerns for Issuers
The prohibition against general solicitation in offerings has been in place for decades and has been built into the assumptions and expectations of many different regulatory regimes at state, federal and international levels. New Rule 506(c) will continue to preempt state registration requirements for Rule 506 offerings. Alternative state exemptions for private offerings that avoid Form D filing (notably, in New York) may become unavailable if general solicitation is used.
Many state securities regulators expressed concern about the impact of new Rule 506(c) on investor protections when a version of new Rule 506(c) was originally proposed in August 2012 and may seek to address their concerns at the state level, consistent with such preemption.[v] New Rule 506(c) also does not override the private placement regimes of other countries, and it is possible that various types of general solicitation conducted within or from the United States (such as use of unrestricted websites) may be deemed a violation of the private placement rules in another country (at least to the extent that a citizen or resident of such country actually purchases securities in an offering).
Issuers will need to pay careful attention to establishing procedures to sufficiently determine accredited investor status in accordance with new Rule 506(c). We anticipate that a variety of third-party service providers will offer verification services in a rapidly evolving marketplace. Issuers will also need to establish procedures, including factual inquiries, to determine with reasonable certainty whether any covered person has had a disqualifying event. This process will likely be easier for issuers with respect to their executive officers and other officers, since an issuer will have knowledge about their employees as a result of the hiring process and information gained in the course of an employment relationship. The process will likely be harder for non-employee third parties who qualify as covered persons.
In the text of the final rule release, the SEC stated that factual inquiry by means of questionnaires or certifications, accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement. Ultimately, until further guidance from the SEC is published on this subject (if at all), the burden will be on issuers and their advisers to determine how best to establish reasonable care through factual inquiries that are appropriate under the issuer’s particular circumstances (including its size, number of employees, line of business, ownership structure, etc.).
Issuers will also need to carefully monitor the Additional Rules. In particular, because filing a Form D is not currently a condition to claiming the safe harbor under Rule 506, issuers wishing to keep the details of their private fundraising activities confidential have in some cases not filed Form Ds on a timely basis, or at all (as the SEC itself acknowledged in the proposed rule release). Other issuers have claimed an exemption under Section 4(a)(2) of the Securities Act, which does not require a public Form D filing, but requires compliance with blue sky laws on a state-by-state basis due to a lack of federal preemption.
Going forward, if the Additional Rules are adopted as proposed, issuers who desire to remain in “stealth” mode or who wish to defer public disclosure of an offering until after closing will not likely be able to take advantage of new Rule 506(c), since the proposed amendments require filing a Form D in advance of a general solicitation in connection with an offering. As a result, many issuers may decide to continue raising money under existing safe harbor protections or under Section 4(a)(2) despite the ban on general solicitations, particularly until the utility of new Rule 506(c) is more fully understood after the final adoption of the Additional Rules.
As noted above, the new rules lifting the ban on general solicitation and disqualifying private placements by "bad actors" will take effect 60 days after publication in the Federal Register. The proposed amendments to Regulation D are now the subject of a 60-day public comment period.
[i] The qualifications for accredited investor status are set forth in Rule 501(a)(1)-(8). In general, an individual may be an accredited investor if such individual has (i) annual income exceeding $200,000 per year (or $300,000 per year collectively with a spouse) or (ii) net worth (individually or collectively with a spouse) in excess of $1 million (disregarding the net value of a primary residence).
[ii] New Rule 506(c) includes an amendment to Form D, pursuant to which an issuer must indicate via checkbox whether it is relying upon Rule 506(b) or new Rule 506(c), and language in the adopting release indicates that only one of the two possible boxes may be checked at the same time for the same offering. Presumably, if the facts warrant, an amended Form D could be filed, although the adopting release does not provide definitive guidance on this point.
[iii] Rule 144A did not include an express prohibition against general solicitation, but did require offers of securities to be limited to QIBs. The limitation on offers had the same practical effect as a prohibition against general solicitation.
[iv] Although new Rule 506(c) includes a five-year look-back provision, the SEC has made clear that it is not proposing that a failure to comply with Form D filing requirements prior to the effectiveness of the Additional Rules would trigger a disqualification. The five-year look-back provision will be prospective beginning upon the effectiveness of the Additional Rules.
[v] The original proposal of new Rule 506(c) in August 2012 was summarized in our September 4, 2012 Financial Services Alert, “SEC Proposes Rule Changes to Implement JOBS Act Mandate to Remove General Solicitation Prohibition for Rule 506 and Rule 144A Offerings.”