Financial Services Alert - July 23, 2013 July 23, 2013
In This Issue

SEC Adopts Rule Changes to Implement JOBS Act Mandate to Remove General Solicitation Prohibition for Rule 506 and Rule 144A Offerings

At its open meeting on July 10, 2013, the SEC voted 4-1 to adopt final amendments that eliminate the current prohibition against general solicitation or general advertising (collectively, “general solicitation”) in certain private offerings and sales relying on the safe harbor exemptions from registration pursuant to the Securities Act of 1933 (the “Securities Act”) provided by Rule 506 and Rule 144A under the Securities Act.  Rule 506 and Rule 144A are widely used by U.S. and foreign issuers, including sponsors of privately-offered investment pools to raise capital.  The final amendments are designed to implement a directive in Section 201(a) of the Jumpstart Our Business Startups Act (H.R. 3606) (the “JOBS Act”).

In conjunction with adopting the final amendments, the SEC also proposed amendments to Regulation D, Form D, and Rule 156 under the Securities Act that are part of a coordinated initiative on the part of various branches of the SEC to analyze the market impact of, and market practices that develop as result of, permitting general solicitation in connection with private offerings under new Rule 506(c).  The proposed amendments and related initiative are discussed here.

Goodwin Procter has issued a client alert that addresses the final amendments from the perspective of private fund managers and a client alert that addresses the impact on operating company issuers of the final amendments and related SEC rulemaking action regarding private offerings.

Elimination of Prohibition on General Solicitation

The amendments add to Rule 506 a new paragraph (c), which permits the use of general solicitation in connection with the offer and sale of securities pursuant to the Rule, provided that (i) all purchasers of securities are accredited investors, (ii) the issuer takes “reasonable steps” to verify that purchasers are accredited investors, and (iii) the offering complies with the other applicable requirements of Regulation D.  (Under Rule 501, the definition of “accredited investor” includes persons whom the issuer reasonably believes come within any of the enumerated categories of accredited investor at the time of the sale of the securities to that person.)  The amendments leave unchanged existing paragraph (b) of Rule 506 that permits an issuer to offer and sell securities, without any limitation on the offering amount, to an unlimited number of “accredited investors,” as defined in Rule 501(a) of Regulation D, and to no more than 35 non-accredited investors, subject to a number of conditions, among which is the requirement that neither the issuer, nor any person acting on its behalf, offer or sell the securities in question through any form of general solicitation.  Rule 506(b) will not require the issuer to undertake the verification process mandated under Rule 506(c).

Rule 144A currently allows for the resale of certain privately offered securities to institutional investors that meet the definition of “qualified institutional buyer” (“QIB”), provided, among other things, that offers are made only to QIBs.  The final amendments to Rule 144A will permit securities sold pursuant to Rule 144A to be offered to persons other than QIBs, including by means of general solicitation, 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.

Verification of Accredited Investor Status

An issuer relying on Rule 506(c) must take reasonable steps to verify the accredited investor status of purchasers of its securities.  An issuer must satisfy this requirement even if all purchasers are in fact accredited investors.  The adopting release describes this process as “an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction.”  The adopting release provides the following factors that issuers should consider, and discusses how they may affect an issuer’s determination of accredited investor status in particular situations: (1) the nature of the purchaser and the type of accredited investor that the purchaser claims to be; (2) the amount and type of information that the issuer has about the purchaser (including reliance on trusted third parties); and (3) the nature and terms of the offering, such as the manner in which the purchaser was solicited to participate in the offering, or the existence and magnitude of a minimum investment amount.

The adopting release notes that the SEC determined not to require particular methods of verifying accredited investor status.  The final amendments do, however, include a non-exclusive list of four specified methods for satisfying the verification requirement:

  • verifying whether a natural person is an accredited investor on the basis of income through reliance on a combination of tax reporting forms and written investor representations;
  • verifying whether a natural person is an accredited investor on the basis of net worth through reliance on (a) recent statements from financial institutions, tax assessments, and third party appraisals, and a recent credit report, and (b) related investor representations;
  • relying on a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that such party has verified the accredited investor status of the investor within the past three months; and
  • relying on an accredited investor representation from a natural person investor who invested prior to the effective date of Rule 506(c) as an accredited investor in a Rule 506(b) offering by the issuer and has maintained that holding.

The adopting release makes clear that in each case “self-accreditation” by an investor, e.g., a check-the-box representation in a subscription agreement, without more, will not meet the Rule 506(d) verification requirement.  The adopting release highlights the importance of creating records that adequately document an issuer’s efforts to verify accredited investor status.

Private Fund Offerings

In the adopting release, the SEC reaffirmed its view that by conducting an offering under Rule 506, a private fund has met the condition to the exclusions provided by Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 that it not conduct a public offering.  The SEC also reminded advisers to private funds that they are subject to Rule 206(4)-8 under the Investment Advisers Act of 1940, a broad anti-fraud rule governing their relationship with current and prospective private fund investors, and that the SEC has brought enforcement actions against private fund advisers and others under Rule 206(4)-8 for material misrepresentations regarding matters such as fund performance, strategy, and investments.

Form D Amendment

The final amendments include changes to Form D that add a separate check box where an issuer can indicate that it is relying on Rule 506(c) and revise the name of the check box currently labeled “Rule 506” to read “Rule 506(b).”  The adopting release notes that an issuer may not check both the Rule 506(b) and Rule 506(c) boxes at the same time for the same offering.

Non-Integration with Offshore Offerings

In the adopting release, the SEC reaffirmed its view expressed in the release proposing the amendments that a concurrent offering relying on Regulation S under the Securities Act will not be integrated with domestic offerings under amended Rule 506 (including new Rule 506(c)) or amended Rule 144A.

Effectiveness and Transition

The final amendments are effective 60 days after their publication in the Federal Register.  For an offering that was already underway, the issuer may choose to continue the offering after the effective date in accordance with the requirements of either Rule 506(b) or Rule 506(c).  If an issuer chooses to continue the offering in accordance with the requirements of Rule 506(c), any general solicitation that occurs after the effective date will not affect the exempt status of offers and sales in reliance on Rule 506(b) that occurred prior to the effective date.  Similarly, for an ongoing Rule 144A offering that commenced before the effective date of the final amendments, offering participants will be entitled to conduct the portion of the offering following the effective date using general solicitation, without affecting the availability of Rule 144A for the portion of the offering that occurred prior to the effective date of the final amendments.

SEC Proposes Additional Reporting and Disclosure Requirements for Private Offerings, Describes Plan to Monitor Impact of Permitting General Solicitation in Private Offerings

In conjunction with creating a new category of private offering in Rule 506(c) of Regulation D under the Securities Act of 1933 (the “Securities Act”) that permits an issuer to engage in general solicitation and general advertising, the SEC also proposed amendments to Regulation D, Form D, and Rule 156 under the Securities Act (the “Proposed Amendments”).  The SEC’s adoption of Rule 506(c) is discussed here.  Goodwin Procter has also issued a client alert that discusses the operating company perspective on the proposed amendments, as well as the adoption of Rule 506(c) and related SEC rulemaking action regarding private offerings.

At this point, the additional requirements discussed in this article are only proposals; any changes to Regulation D, Form D, and Rule 156 will be adopted only after the SEC has had the opportunity to consider public comment on the Proposed Amendments.

The Proposed Amendments would:

  1. require an issuer conducting a Rule 506(c) offering to file Form D before engaging in general solicitation;
  2. require an issuer to file a closing amendment to Form D after the termination of a Rule 506 offering;
  3. disqualify an issuer from relying on Rule 506 for one year for future Rule 506 offerings (whether under Rule 506(b) or 506(c)) if the issuer, or any predecessor or affiliate of the issuer, did not comply, within the last five years, with the Form D filing requirements for a Rule 506 offering;
  4. require an issuer to provide additional information about Regulation D offerings;
  5. require written general solicitation materials used in a Rule 506(c) offering to include certain legends and other disclosures, some specific to the presentation of performance data for private funds (i.e., funds that rely on either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940);
  6. for a two-year period following adoption, require issuers to file with the SEC on a non-public basis written general solicitation materials used in Rule 506(c) offerings; and
  7. disqualify an issuer from relying on Rule 506 if the issuer, or any predecessor or affiliate of the issuer were subject to an injunction for failure to comply with the proposed disclosure and temporary filing requirement for general solicitation materials in the Proposed Amendments.

The Proposed Amendments would also extend to private funds the anti-fraud guidance regarding sales literature that Rule 156 currently provides with respect to registered investment companies.

The Proposed Amendments are part of a broader effort by the SEC to analyze the market impact of, and market practices that develop as result of, permitting general solicitation in connection with private offerings under new Rule 506(c).  This initiative will be a coordinated effort on the part of various branches of the SEC (the “Rule 506(c) Work Plan”), including the Office of Compliance Inspections and Examinations (“OCIE”) and the Division of Enforcement.

Form D – Filing Prior to General Solicitation 

The Proposed Amendments would require an issuer to file an “Advance Form D” no later than 15 calendar days before the first use of general solicitation in a Rule 506(c) offering.  In an Advance Form D, an issuer would be required to respond to only some of the Form D items.  The issuer would subsequently have to file an amendment providing the remaining information required by Form D within 15 calendar days after the date of first sale of securities in the offering.

Form D – Filing After Rule 506 Offering Terminates 

The Proposed Amendments would require an issuer to file a closing Form D amendment within 30 calendar days after it terminates a Rule 506 offering (whether under Rule 506(b) or involving general solicitation under Rule 506(c)).

Form D – Disqualification from Rule 506 Offerings for Failure to File 

The SEC is not proposing to make Form D filing a condition of Rule 506.  The Proposed Amendments would, however, revise Rule 507 of Regulation D so that an issuer would automatically be disqualified for one year from relying on Rule 506 for any new offering (whether under Rule 506(b) or 506(c)) if the issuer, or any predecessor or affiliate of the issuer, did not comply, within the past five years, with the Form D filing requirements of Rule 503 with respect to a Rule 506 offering.  The one year period would start upon the filing of all required Form D filings or, if the offering had been terminated, upon the filing of a closing amendment.  Disqualification would arise only with respect to Rule 503 non-compliance that occurred after the effectiveness of the proposed disqualification provision.  The proposed disqualification provision would be in addition to the existing Rule 507 disqualification from Rule 504, 505 and 506 exemptions that arises when an issuer is subject to an injunction for failure to comply with the Form D filing requirement of Rule 503.

The proposed disqualification would not apply to offerings of an issuer or an affiliate that are ongoing at the time of the non-compliance with Rule 503, including the offering for which the issuer failed to make a required filing.  Those offerings could continue to rely on Rule 506 as long as the conditions of Rule 506 continue to be met; disqualification would apply only to future offerings.

A disqualification from using Rule 506 for future offerings would be subject to a 30 day cure period that would be available only for the first failure to file in any offering.  In addition, under the Proposed Amendments a proposed disqualification would be subject to the existing provision of Rule 507 that permits the SEC to waive a disqualification under the rule if it determines “upon a showing of good cause, that it is not necessary under the circumstances that exemption be denied.”

Form D – Additional Information Requirements

The Proposed Amendments would make a number of changes to specific items in Form D, some of which would apply not only to offerings under Rule 506, but also to those under Rules 504 and 505 and Section 4(5) of the Securities Act.  These changes include providing (a) information about persons controlling the issuer and (b) for Rule 506 offerings, information on (i) the number of accredited investors and non-accredited investors that purchased in an offering, (ii) whether they are natural persons or legal entities, and (iii) the amount raised from each category of investors.  The Proposed Amendments would also add new items that would apply to all Rule 506 offerings, and in some cases would be specific to Rule 506(c) offerings, seeking the  following information:

  • the number and types of accredited investors that purchased securities in the offering (e.g., natural persons who qualified as accredited investors on the basis of income or net worth);
  • if a class of the issuer’s securities is traded on a national securities exchange, ATS or any other organized trading venue, and/or is registered under the Securities Exchange Act of 1934 (the “Exchange Act”), the name of the exchange, ATS or trading venue and/or the Exchange Act file number, and whether the securities being offered are of the same class or are convertible into or exercisable or exchangeable for that class;
  • if the issuer used a registered broker-dealer in connection with the offering, whether any general solicitation materials were filed with FINRA;
  • if the issuer is a pooled investment fund, the name and SEC file number of each registered investment adviser or exempt reporting adviser advising the fund that also acts as a promoter;
  • for Rule 506(c) offerings, the types of general solicitation used or to be used (e.g., mass mailings, emails, public websites, social media, print media and broadcast media); and
  • for Rule 506(c) offerings, the methods used or to be used to verify accredited investor status.

Written General Solicitation Materials - Legends and Disclosure

Under the Proposed Amendments, new Rule 509 would require all written general solicitation materials to include the following legends “in a prominent manner”:

  • The securities may be sold only to “accredited investors,” which for natural persons are investors who meet certain minimum annual income or net worth thresholds;
  • The securities are being offered in reliance on an exemption from the registration requirements of the Securities Act and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act;
  • The Commission has not passed upon the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials;
  • The securities are subject to legal restrictions on transfer and resale and investors should not assume they will be able to resell their securities; and
  • Investing in securities involves risk, and investors should be able to bear the loss of their investment.

Private Funds - Written General Solicitation Materials 

Under the Proposed Amendments, new Rule 509 would require a private fund’s written general solicitation materials to include a legend stating that the securities offered are not subject to the protections of the Investment Company Act.

Private Funds - Written General Solicitation Materials with Performance Data

Under the Proposed Amendments, private fund performance data in written general solicitation materials would have to be as of the most recent practicable date “considering the type of private fund and the media through which the data will be conveyed,” and must include the period for which performance is presented.  The performance data would have to be accompanied by either a telephone number or a website for obtaining current performance data.  A private fund would not be expected to value its portfolio for the sole purpose of providing updated current performance under proposed Rule 509.  Performance data would be current if it were as of the last date on which the private fund customarily valued its holdings.

Under proposed Rule 509, written general solicitation materials for a private fund with performance data that does not reflect the deduction of fees and expenses  would have to disclose that fees and expenses have not been deducted and that if such fees and expenses had been deducted, performance may be lower than presented.

Under proposed Rule 509, written general solicitation materials for a private fund that include performance data would also have to include the following legends (which are similar to those required in advertisements and other sales materials of registered investment companies by Rule 482 under the Securities Act):

  • performance data represents past performance;
  • past performance does not guarantee future results;
  • current performance may be lower or higher than the performance data presented;
  • the private fund is not required by law to follow any standard methodology when calculating and representing performance data; and
  • the performance of the fund may not be directly comparable to the performance of other private or registered funds.

The proposing release notes that the SEC has “determined not to propose standardized calculation methodologies for performance of private funds without further study.”  The release does, however, request comment on whether to prohibit or restrict the use of performance data, and whether other manner and content restrictions for written general solicitation materials would be appropriate.

Written General Solicitation Materials - Temporary Filing Obligation

Under the Proposed Amendments, temporary Rule 510T would require an issuer conducting a Rule 506(c) offering to file any written general solicitation materials prepared by it or on its behalf no later than the date the materials are first used in the offering.   Materials filed pursuant to Rule 510T would not be publicly available on the SEC website, and would not be not be treated as being “filed” or “furnished” for purposes of the Securities or Exchange Acts, including their liability provisions.  Rule 510T would expire two years after its effective date.

Disqualification from Rule 506 Offerings – Non-Compliance with General Solicitation Legending, Disclosure, and Filing Requirements

The SEC is not proposing to make compliance with Rule 509 disclosure obligations and Rule 510T filing obligations a condition of the applicable Regulation D or Section 4(a)(5) exemptions.  The Proposed Amendments would, however, revise Rule 507(a) to disqualify an issuer from relying on Rule 506 if the issuer, or any predecessor or affiliate of the issuer, were subject to an injunction for failure to comply with the new disclosure requirements in Rule 509 or the temporary filing requirement for general solicitation materials in Rule 510T.

Application of Rule 156 Anti-Fraud Guidance to Private Funds

The Proposed Amendments would revise Rule 156 under the Securities Act, which provides guidance on the types of information in investment company sales literature that could be misleading for purposes of the federal securities laws, e.g., Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, so that the Rule would apply to private funds.  Rule 156 lists (a) general factors that could cause a statement about an investment company to be misleading and (b) circumstances in which (i) representations about an investment company’s past or future investment performance or (ii) statements involving a material fact about the characteristics or attributes of an investment company, could be misleading.

Rule 506(c) Work Plan

As discussed in the proposing release, the Rule 506(c) Work Plan will evaluate the use of Rule 506(c) by issuers and market participants, and, in particular, the steps they take to verify that the purchasers of the offered securities are accredited investors.  Under the Rule 506(c) Work Plan, the SEC staff will, among other things:

  • evaluate the range of purchaser verification practices used by issuers and other participants in Rule 506(c) offerings, including whether these verification practices are excluding or identifying non-accredited investors;
  • evaluate whether the absence of the prohibition against general solicitation has been accompanied by an increase in sales to non-accredited investors;
  • assess whether the availability of Rule 506(c) has facilitated new capital formation or has shifted capital formation from registered offerings and unregistered non-Rule 506(c) offerings to Rule 506(c) offerings;
  • examine the information on Rule 506(c) offerings submitted or available to the SEC, including the information in Form D filings and the form and content of written general solicitation materials;
  • monitor the market for Rule 506(c) offerings for increased incidence of fraud, and to assist with this effort, develop risk characteristics regarding the types of issuers and market participants that conduct or participate in Rule 506(c) offerings and the types of investors targeted in those offerings;
  • incorporate an evaluation of the practices in Rule 506(c) offerings in the staff’s examinations of registered broker-dealers and registered investment advisers; and
  • coordinate with state securities regulators on sharing information about Rule 506(c) offerings.

Definition of Accredited Investor

The proposing release notes that in light of public comment on the definition of accredited investor, the SEC has begun a review of the definition of accredited investor as it relates to natural persons, including the need for any changes to this definition following the effectiveness of Rule 506(c).  The SEC expects to coordinate this review with (1) the review of the accredited investor definition in its entirety that Section 413(b) of the Dodd-Frank Act requires it to undertake four years after enactment and (2) the Dodd-Frank Act mandated study regarding the appropriate criteria for determining the financial thresholds or other criteria for qualifying as an accredited investor that the GAO is required to submit by July 20, 2013.

Due Date for Public Comment 

Comments on the Proposed Amendments must be received by the SEC no later than 60 days after the proposing release is published in the Federal Register.

SEC Adopts New Condition for Rule 506 Safe Harbor That Disqualifies Offerings Involving Felons and Other “Bad Actors”

On July 10, 2013, the SEC voted to adopt final amendments to rules and forms under the Securities Act of 1933 (the “Securities Act”) that implement Section 926 of the Dodd-Frank Act.  Section 926 requires the SEC to adopt rules that disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on the safe harbor from Securities Act registration provided by Rule 506 of Regulation D under the Securities Act.  Section 926 directs the SEC to adopt disqualification provisions for Rule 506 offerings that (a) are substantially similar to Rule 262 under the Securities Act, which contains the disqualification provisions of Regulation A under the Securities Act, and (b) incorporate specific disqualifying events enumerated in Section 926, which include certain state regulatory orders and bars.

The final amendments add to Rule 506 new paragraph (d) under a which a sale of securities is disqualified from the Rule 506 exemption if a “covered person” is subject to a “disqualifying event” that occurs after the effective date of the final amendments.  Disqualifying events that occur prior to the effective date must be disclosed to investors.  The occurrence of a disqualifying event will not affect prior sales, but subsequent sales may not rely on Rule 506 unless, as discussed below, the disqualification is waived or removed, or, if the issuer is unaware of a triggering event, Rule 506(d)’s reasonable care exception applies.

This article provides a high level summary of the final amendments, which include significant detail, particularly regarding the precise character of disqualifying events.  Goodwin Procter has also issued a client alert that addresses the impact on operating company issuers of the final amendments and related SEC rulemaking action regarding private offerings, including the modification of Regulation D to permit offerings involving general solicitation.

Covered Persons

A disqualifying event with respect to any of the following covered persons for an issuer that occurs after the effective date of the final amendments will trigger disqualification under Rule 506(d):

  • the issuer and any predecessor or affiliated issuer;
  • any director, executive officer, other officer participating in the offering, general partner, or managing member of the issuer;
  • any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power (a “20% Holder”);
  • any promoter connected with the issuer in any capacity at the time of the sale;
  • each investment manager of an issuer that is a pooled investment fund, as well as (a) each director and executive officer of the investment manager, (b) any other officer of the investment manager participating in the offering, (c) each general partner or managing member of the investment manager, (d) each director and executive officer of such general partner or manager, or (e) any other officer of such general partner or manager participating in the offering; and
  • any person that has been or will be paid (directly or indirectly) remuneration for soliciting purchasers in the offering (a “compensated solicitor”), as well as (i) each director and executive officer of a compensated solicitor, (ii) any other officer of a compensated solicitor participating in the offering, (iii) any general partner or managing member of a compensated solicitor, (iv) each director and executive officer of such general partner or managing member, and (v) any other officer of the such general partner or managing member participating in the offering.

Officers “Participating in an Offering.”  The adopting release notes that “[p]articipation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.  We anticipate that issuers should be able to determine which of their own officers are participating in an offering without undue difficulty, and can exercise control over which officers participate.  We also believe that it is reasonable to expect that compensated solicitors should be prepared to confirm which of their officers are participating in an offering as part of any engagement.”

20% Holders.  Rule 506(d) does not define what will constitute “voting securities” for purposes of determining an issuer’s 20% Holders.  The adopting release states that the SEC intends that “the term should be applied based on whether securityholders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right. [footnote omitted]  For example, we would consider that securities that confer to securityholders the right to elect or remove the directors or equivalent controlling persons of the issuer, or to approve significant transactions such as acquisitions, dispositions or financings, would be considered voting securities for purposes of the rule. Conversely, securities that confer voting rights limited solely to approval of changes to the rights and preferences of the class would not be considered voting securities for purposes of the rule.”

Disqualifying Events

In general terms, disqualifying events with respect to covered persons consist of serious violations of financial industry rules and regulations; these include: criminal convictions, court injunctions or restraining orders related to the purchase or sale of securities, false SEC filings or the conduct of specified securities industry businesses (e.g., acting as a broker-dealer); certain SEC disciplinary orders involving a suspension of SEC registration, limitations on activities or an industry bar; certain final orders of certain state regulators (such as state securities, banking and insurance regulators), the CFTC, and certain federal bank regulators; suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities industry self‑regulatory organization; SEC stop orders and orders suspending a Regulation A exemption; and U.S. Postal Service false representation orders.  Some of these events are subject to look-back periods of five, and in some cases, ten years.

Reasonable Care Exception.  Rule 506(d) includes a “reasonable care” exception that allows an issuer to rely on Rule 506 despite the existence of a disqualifying event, if the issuer can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification.  The instruction to this exception states that “[a]n issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualifications exist.  The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and the other offering participants.”

Neither Rule 506(d) nor the adopting release describe how to satisfy this reasonable care standard.  The adopting release does, however, observe “that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.  Factual inquiry by means of questionnaires or certifications, perhaps 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. . . . [I]n the case of a registered broker-dealer acting as placement agent—it may be sufficient to make inquiry of an entity concerning the relevant set of covered officers and controlling persons, and to consult publicly available databases concerning the past disciplinary history of the relevant persons.”

With respect to continuous, delayed or long-lived offerings, the adopting release states that “reasonable care includes updating the factual inquiry on a reasonable basis.  Again, the frequency and degree of updating will depend on the circumstances of the issuer, the offering and the participants involved, but in the absence of facts indicating that closer monitoring would be required (for example, notice that a covered person is the subject of a judicial or regulatory proceeding or knowledge of weaknesses in an organization’s screening procedures), we would expect that periodic updating could be sufficient.  We expect that issuers will manage this through contractual covenants from covered persons to provide bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.”

Conditional Exclusion of Certain Affiliated Issuers.  Rule 506(d) disregards a potentially disqualifying event with respect to an affiliated issuer that arose prior to the affiliate relationship if the affiliated issuer is not (i) in control of the issuer or (ii) together with the issuer, under common control of a third party that controlled the affiliated issuer at the time of that event.

Waiver of Disqualification by SEC.  Rule 506(d) allows the SEC to waive disqualification “upon a showing of good cause and without prejudice to any other SEC action” if it determines “that it is not necessary under the circumstances that an exemption be denied.”  In discussing the various disqualifying events, the adopting release identifies a number of examples of circumstances (such as a change of control, change of supervisory personnel, absence of notice and opportunity for hearing, and relief from a permanent bar for a person who does not intend to apply to reassociate with a regulated entity) that could, depending on the specific facts, be relevant to the SEC’s evaluation of a waiver request.

Waiver of Disqualifying Event By Issuing Authority.  An otherwise disqualifying event will not trigger disqualification under Rule 506(d) if, prior to a sale in reliance on Rule 506, the court or regulatory authority responsible for the relevant order, judgment or decree advises in writing, whether in the relevant judgment, order or decree, or separately to the SEC or its staff, that the order, judgment or decree should not result in  disqualification under Rule 506.

Disclosure of Disqualifying Events that Pre-Date Rule 506(d)’s  Effective Date

A disqualifying event that pre-dates the effectiveness of the final amendments will not trigger disqualification under Rule 506(d).  However, under new Rule 506(e) an issuer will be required to provide each purchaser with written disclosure of “pre-effective disqualifying events” a reasonable time prior to sale.  SEC expects this disclosure to be given “reasonable prominence” and to be “appropriately presented in the total mix of information available to investors.”  The adopting release cautions that in the SEC’s view, an issuer that does not fulfill the disclosure requirements of Rule 506(e) cannot avail itself of Rule 508, under which insignificant deviations from Rule 506’s conditions do not necessarily result in the loss of the Rule 506 exemption.

Rule 506(e) includes a “reasonable care” exception mirroring that under Rule 506(d).

Effectiveness

The effective date of the final amendments is 60 days after their publication in the Federal Register.

Federal District Court Denies Motion To Dismiss SEC Suit Alleging General Partnership Interests Were Securities

A California federal court recently declined to dismiss an SEC lawsuit over alleged fraud and securities registration violations in the sale of general partnership interests. In denying the Defendants’ motion to dismiss, the court held that the SEC had pled sufficient facts to establish that the general partnership interests at issue in the case were securities under federal securities laws.

In 2012, the SEC filed a complaint against Louis Schooler and First Financial Planning Corporation (the “Defendants”), alleging that the Defendants defrauded investors by offering and selling approximately $50 million worth of general partnership interests without disclosing material facts regarding the true value of the underlying land, the mortgages encumbering the properties, and the timing of the transfer of ownership of the underlying land from the Defendants to the general partnerships, and in so doing had violated Sections 5(a), 5(c), and 17(a)(1) of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.

The Defendants filed a motion to dismiss contending that the SEC failed to state a claim upon which relief can be granted because the interests offered and sold by the Defendants in the general partnerships were not securities. The court began its analysis with the Supreme Court’s holding in SEC v. W.J. Howey Co. that an interest is an investment contract, and thus a security, if it is “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. While noting the general presumption that general partnership interests are not securities, the court stated that the mere fact that an investment takes the form of a general partnership interest “does not inevitably insulate it from the reach of the federal securities laws. Articulating the test laid out by the Fifth Circuit decision in Williamson v. Tucker, the court noted that a general partnership is an investment contract if one of the following factors is present: (1) the general partnership agreement leaves so little in the hands of the partners that the arrangement in fact distributes power as would a limited partnership; (2) the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or (3) the partners are so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

The court analyzed each factor in turn:

  • Allocation of Power. The court concluded that the SEC’s claims did not satisfy the first Williamson factor because the SEC did not sufficiently allege that the general partnership agreements left “so little power in the hands of the partners” as to render the general partnerships limited partnerships. The court found that the SEC’s allegations instead supported the conclusion that the partnership agreements afforded the partners significant legal power by providing “investors with sufficient legal authority to exercise power over the partnerships and ‘access to important information and protection against dependence on others.”
  • Experience and Knowledge of Partners. The court concluded that the SEC satisfied the second Williamson factor because the SEC’s allegations supported the conclusion that the partners were so inexperienced and unknowledgeable in the general partnerships’ business affairs that they were incapable of intelligently exercising their partnership powers. The court noted that the relevant inquiry under the second factor is “whether the partners are inexperienced or unknowledgeable ‘in business affairs’ generally, not whether they are experienced and sophisticated in the particular industry or area in which the partnership engages.” According to the SEC’s allegations, the investors included a water filter salesman, a retired school teacher, and a pharmacist, and “signatory partners,” who legally assumed significant responsibilities on behalf of the general partnerships, were often unsophisticated in business affairs and unaware that they had signed material documents on behalf of the general partnerships, such as general partnership formation paperwork, bank signature cards, and purchase agreements between one of the Defendants and their respective general partnerships.
  • Dependence on Managerial Ability. The court concluded that the SEC satisfied the third Williamson factor because it alleged sufficient facts to support the conclusion that the partners were so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they could not replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers. The court noted that a relationship with the requisite dependence may exist where investors rely on the managing partner’s unusual experience and ability in running a particular business. Under the SEC’s pleadings, the properties selected and purchased were divided among several general partnerships. As a consequence, the court noted, the individual investors were dependent on the Defendants because the investors could only exercise control over their fractional portion of a real estate parcel and could only exercise general partner control and decision-making within each partnership, but not over the entire property belonging to several general partnerships. The court also pointed to the SEC’s allegations that the Defendants made certain representations and promises regarding the real estate experience of the firm and its personnel to induce reliance upon their entrepreneurial abilities and that the investors thereafter relied on and were dependent on the Defendants’ unique entrepreneurial abilities.

On the basis of the foregoing, the court denied the Defendants’ motion to dismiss.

SEC v. Schooler, No. 3:12-cv-2164-GPC-JMA, Dkt No. 43 (S.D. Cal. July 1, 2013).

FRB Amends Discount Window Operating Circular to Comply with Dodd-Frank Act Swaps Pushout Rule

The FRB revised its Operating Circular No. 10 (“OC-10”) to add a new appendix 6 entitled “Prohibition Against Federal Assistance to Any Swaps Dealer” (“Appendix 6”).  OC-10 concerns the FRB’s discount window and sets forth the terms under which an entity may, in accordance with the Federal Reserve Act, obtain advances from, incur obligations to, or pledge collateral to a Federal Reserve Bank.  Appendix 6 amends OC-10 to bring the FRB discount window operations and procedures  into compliance with Section 716 of the Dodd-Frank Act (the “Swaps Pushout Rule”), which prohibits any “federal assistance” from being provided to any “swaps entity.”  A “swaps entity” is: (1) a swap dealer registered under the Commodity Exchange Act; (2) a security-based swap dealer registered under the Securities Exchange Act; (3) a major swap participant registered under the Commodity Exchange Act that is not an FDIC-insured depository institution; or (4) a major security-based swap participant registered under the Securities Exchange Act that is not an FDIC-insured depository institution.  The Swaps Pushout  Rule requires (subject to certain exemptions, transition periods, grandfathering and other relief provisions) that an FDIC-insured depository institution that is registered as a swap dealer “push out” its swap activities to a non-FDIC-insured, non-bank affiliate if the institution wishes to borrow from the FRB’s discount window.

Appendix 6 became effective on July 16, 2013.

CFTC Publishes Final Cross-Border Guidance

The CFTC published the final version of its document entitled “Interpretive Guidance and Policy Statement Regarding Compliance with Certain Swap Regulations” (the “Guidance”), providing the CFTC’s official interpretation of how the swaps provisions of the Commodity Exchange Act (the “CEA”) and related CFTC regulations apply in the cross-border context.  The Guidance is derived from Section 2(i) of the CEA, which provides that the swaps provisions of the CEA and related CFTC regulations may apply to cross-border activities when such activities have a “direct and significant connection with activities in, or effect on, commerce of the United States.”

The Guidance is not technically a rule or regulation.  The Guidance explains that, while a rule would “state with precision when particular requirements do and do not apply to particular situations,” the Guidance is merely a “statement of the [CFTC’s] general policy regarding cross-border swap activities and allows for flexibility in application to various situations.”  A footnote indicates that the Guidance is “intended to provide an efficient and flexible vehicle to communicate the [CFTC’s] current views on how the Dodd-Frank swap requirements would apply on a cross-border basis,” while indicating that the CFTC may consider adopting formal rules on certain aspects of the Guidance in the future.

The Guidance covers a number of topics, including the definition of the term “U.S. person,” swap dealer and major swap participant registration requirements applicable to non-U.S. persons, the categorization of swap regulations as “Entry-Level Requirements” or “Transaction-Level Requirements,” and how the various requirements apply to swaps between various categories of U.S. persons and non-U.S. persons.

“U.S. Person” Definition

The Guidance defines “U.S. person” as one of the following:  (i) any natural person who is a resident of the United States, (ii) an estate of a decedent who was a resident of the United States at the time of death, (iii) any corporation, partnership, limited liability company, fund, or similar legal entity that is organized or incorporated under the laws of a state or other jurisdiction of the United States or has its principal place of business in the United States, (iv) a pension plan for the employees, officers, or principals of such a legal entity, (v) any trust governed by the laws of a state or other jurisdiction in the United States, (vi) any commodity pool, investment fund, or other collective investment vehicle that is majority-owned by one or more U.S. persons, except those that are not offered to U.S. persons, (vii) any legal entity that is directly or indirectly majority-owned by one or more U.S. persons in which such person bears unlimited responsibility for the obligations and limitations of the legal entity, and (viii) any individual account or joint discretionary account where the beneficial owner is a U.S. person.

The Guidance also states that the term “U.S. person” generally includes a foreign branch of a U.S. person, because branches are considered “a part, or an extension” of the U.S. person.

The definition of “U.S. person” begins with a statement explaining that the CFTC will interpret the term “generally to include, but not be limited to” the above categories.  The Guidance explains that although the CFTC’s “policy generally is to limit its interpretation of” the term “U.S. person,” the CFTC intends to maintain the flexibility to apply the term in currently unforeseen circumstances.  The Guidance states that such determinations will be based on a facts-and-circumstances test that may include, for example, the strength of the connections between the person’s swap activities and U.S. commerce, the extent to which they are conducted in the United States, and the extent to which another jurisdiction may be a more appropriate source of regulation to the particular parties or matter.

Swap Dealer and Major Swap Participant Registration Requirements

The definition of “swap dealer” includes a de minimis threshold such that an entity whose swap dealing activity is less than the threshold is not required to register as a swap dealer.  The definition of “major swap participant” also includes certain thresholds below which registration is not required.  The Guidance clarifies which swaps should or should not be included for those threshold determinations in the cross-border context.

For purposes of the swap dealer definition, the general rule is that both U.S. persons and non-U.S. persons must generally aggregate all the relevant swap dealing activity of all of its U.S. and non-U.S. affiliates under common control, excluding the swap dealing activity of an affiliate (whether a U.S. person or a non-U.S. person) that is a registered swap dealer.  All swap dealing activity of a U.S. person and a non-U.S. affiliate guaranteed by a U.S. person must be counted, regardless of its counterparty.  For non-U.S. persons that are not guaranteed by a U.S. person, all dealing activity with counterparties who are U.S. persons (excluding foreign branches of U.S. swap dealers) must be counted, as must all dealing activities with affiliates guaranteed by a U.S. person, subject to certain exceptions.  In addition, in the case of non-U.S. affiliates that are not guaranteed by a U.S. person, any swap entered into anonymously on a registered designated contract market, swap execution facility, or foreign board of trade, and cleared may be excluded.

For purposes of the major swap participant definition, a non-U.S. person must include any swap position between it and a U.S. person, any swap position between it and a non-U.S. person that is an affiliate of a U.S. person and guaranteed by a U.S. person, and any swap position between another person and a U.S. person or guaranteed affiliate where the potential major swap participant guarantees the obligations of the other person.

Entry-Level Requirements and Transaction-Level Requirements

The Guidance divides the CEA’s swap provisions and related CFTC regulations into “Entity-Level Requirements” and “Transaction-Level Requirements” and divides each group into two further categories.  The manner in which different regulations will apply to different types of entities, discussed in more detail below, depends on its category.

Entity-Level Requirements are generally those that pertain to the entity as a whole.  They include, among others, requirements pertaining to capital adequacy, chief compliance officer, risk management, and record-keeping.  Entity-Level Requirements also include swap data repository reporting and physical commodity large swaps trader reporting.  Although the Guidance indicates that “a number of commenters” argued that these reporting requirements should be categorized as Transaction-Level and not Entity-Level, the CFTC concluded that these regulations relate to overall market transparency and the CFTC’s ongoing market surveillance responsibilities, and are therefore properly classified as Entity-Level.

The Entity-Level Requirements are further divided into “First Category” and “Second Category.”  Most Entity-Level Requirements are in the First Category, except that the regulations concerning swap data repository reporting and physical commodity large swaps trader reporting, as well as certain parts of the record-keeping requirements, are in the Second Category.

As the name implies, Transaction-Level Requirements generally apply on a transaction-by-transaction basis.  They include regulations pertaining to clearing, segregation and margin for uncleared swaps, mandatory trade execution, swap trading relationship documentation, portfolio reconciliation and compression, real-time public reporting, trade confirmation, daily trading records, and external business conduct standards.

Like the Entity-Level Requirements, Transaction-Level Requirements are also divided into two categories.  The external business conduct standards are in “Category B,” while all the other Transaction-Level Requirements are in “Category A.”

The categories are relevant in determining how the various regulations apply to certain cross-border swap transactions.  This is discussed in more detail below.

Substituted Compliance

The Guidance contemplates a “substituted compliance” mechanism in which the CFTC will, upon request of a market participant or foreign regulator, consider whether the provisions of a foreign regulatory regime offer comparable (not necessarily identical) protections to those of the CEA and CFTC.  The CFTC will evaluate foreign regulatory regimes separately in 13 different regulatory categories.  The CFTC will then issue a comparability determination giving its findings with respect to a particular jurisdiction.  Once this has been done, the determination will apply for all entities or transactions in that jurisdiction, except that the CFTC will re-evaluate the initial determination within four years and consider making changes as it deems appropriate.

In the event that the CFTC determines that the requirements of a particular regulatory regime are comparable to and as comprehensive as those of the CEA and CFTC regulations in a particular category, a person based in that jurisdiction may comply with the applicable regulations of its home jurisdiction in lieu of CEA and CFTC requirements in that category, to the extent that substituted compliance is available.  As discussed below, this depends on whether the person is a swap dealer or major swap participant, the nature of the counterparty, and the category of the regulation in question.

Notwithstanding the availability of substituted compliance, the CFTC retains its examination and enforcement authority over all registered swap dealers and major swap participants.

Finally, the Guidance includes an acknowledgment by the CFTC that its regulations, particularly regarding reporting, may violate privacy and similar laws of other jurisdictions.  The Guidance indicates that the CFTC “may consider reasonable alternatives” to reconcile the competing interests, and invites regulators and market participants to consult with the CFTC when appropriate.

Application of Entry-Level Requirements and Transaction-Level Requirements

Whether or not a given person must comply with a particular CEA provision and its related CFTC regulations depends, in part, on whether the person is a U.S. person or non-U.S. person, whether it is a swap dealer or major swap participant, the nature of the relevant swap counterparty, and whether the requirement in question is an Entity-Level Requirement (and whether it is in the First Category or Second Category) or whether the requirement is a Transaction-Level Requirement (and whether it is Category A or Category B).

The Guidance goes into significant detail about the applicability of various categories of rules to various combinations of swap counterparties, including foreign branches of U.S. banks, U.S. persons that are swap dealers or major swap participants soliciting and negotiating a swap through a foreign subsidiary or affiliate, and non-U.S. persons guaranteed by or an affiliate conduit of a U.S. person.  In addition, certain exceptions and qualifications apply with respect to particular regulations.  Provided below is a summary of only some of the more important provisions of the Guidance.  Particular care should be taken to carefully review the Guidance for applicability of different regulations to different combinations of swap counterparties.

Swap Dealers and Major Swap Participants—Entity-Level Requirements.  Swap dealers and major swap participants that are not U.S. persons must generally comply with all of the Entity-Level Requirements.  Substituted compliance is generally available to swap dealers and major swap participants for all First Category Entity-Level Requirements, regardless of counterparty.  However, substituted compliance will be generally permitted for Second Category Entity-Level Requirements only where the counterparty is a non-U.S. person.  That is, where the counterparty is a U.S. person, the swap dealer or major swap participant will be required to follow the CEA and CFTC regulations in the Second Category.

In addition, substituted compliance will be available for reporting requirements only if the CFTC is given direct access to all to the reported swap data stored at a foreign trade repository.

Swap Dealers and Major Swap Participants—Transaction-Level Requirements.  Swap dealers and major swap participants that are not U.S. persons must generally comply with all Category A Transaction-Level Requirements for swaps in which the counterparty is a U.S. person, a foreign branch of a U.S. bank that is a swap dealer or major swap participant, or a non-U.S. person that is guaranteed by a U.S. person.  Substituted compliance will generally not be available when the counterparty is a U.S. person, but will generally be permitted when the counterparty is a foreign branch or a non-U.S. person guaranteed by a U.S. person.

Category B Transaction-Level Requirements apply to swap dealers and major swap participants that are not U.S. persons, in each case with respect to swaps with U.S. persons.  Substituted compliance is not permitted.  Category B Transaction-Level Requirements do not apply to swaps between non-U.S. persons that are swap dealers or major swap participants, on the one hand, and non-U.S. persons or foreign branches of U.S. banks that are swap dealers or major swap participants, on the other.

End-Users.  Several of the regulations discussed above are not applicable to persons that are not swap dealers or major swap participants (“end-users”), regardless of whether such end-users are U.S. persons or non-U.S. persons.  For example, neither the chief compliance officer rules nor the external business conduct standards apply to end-users.  Therefore, when discussing end-users in the cross-border context, it is only necessary to consider the regulations generally binding on end-users, which the Guidance refers to as “Non-Registrant Requirements.”  These generally include rules pertaining to clearing, trade execution, record-keeping, and reporting.  The distinction between Entity-Level Requirements and Transactions-Level Requirements is not relevant in the context of end-users.

In a swap between two end-users in which one or both of the counterparties is a U.S. person, the parties to the swap are generally required to comply with the Non-Registrant Requirements.  Substituted compliance is not permitted.  However, with respect to the clearing requirement and its related exceptions and exemptions, the Guidance confirms previous statements indicating that the CFTC will review the clearing mandates of foreign jurisdictions, including their determinations with respect to the clearing of each class of swap for which the CFTC has issued a clearing determination, and will “exercise broad discretion” in determining whether the two regimes are comparable.

With respect to swaps between two non-U.S. persons, neither of which is a swap dealer or major swap participant nor guaranteed by a U.S. person, most Non-Registrant Requirements would generally not apply.  However, the Guidance states that the CFTC’s “policy” is that any non-U.S. clearing member that holds sufficiently large positions in swaps directly or indirectly linked to specified U.S.-listed physical commodity futures markets should be required to report all reportable provisions to the CFTC under the large trader reporting rules included in Part 20 of the CFTC’s regulations.

Goodwin Procter Alert: The Alternative Investment Fund Managers Directive -- Implementation Throughout Europe

Goodwin Procter has issued a client alert that on a country-by-country basis highlights the most important issues for fund investors and outlines the regulatory requirements for EU and non-EU managers under the Alternative Investment Fund Managers Directive that became effective for EU member states on July 22, 2013.

Goodwin Procter Alert: Delaware Court of Chancery Upholds Forum Selection Bylaws

Goodwin Procter’s M&A/Corporate Governance Practice has issued a client alert that analyzes a recent decision by the Delaware Court of Chancery upholding forum selection bylaws adopted unilaterally by the boards of directors of Chevron Corporation and FedEx Corporation, and reviews open questions boards of Delaware corporations should consider before acting on forum selection bylaws.