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SEC Lifts Ban on General Solicitation in Certain Private Securities Transactions, Disqualifies “Bad Actors” from Rule 506 Offerings

On July 10, 2013, the Securities and Exchange Commission (the “SEC”) adopted amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”) that eliminate the long-standing prohibition on general solicitation and general advertising in connection with an unregistered securities offering. These amendments implement Section 201(a) of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”).

At the same time, to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the SEC adopted rules prohibiting issuers from relying on Rule 506 for any offering in which certain felons and other bad actors are involved. The amendments to Rules 506 and 144A will become effective on September 22, 2013.

In a related action, the SEC released proposed amendments to Regulation D, Form D, and Rule 156 under the Securities Act that are intended to enhance the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and to address comments made in connection with implementing certain provisions of the JOBS Act. Among other things, the proposed rules would require issuers to provide additional information in connection with the use of general solicitation in Rule 506 offerings.

General Solicitation and General Advertising Amendments

Eliminating General Solicitation Restrictions under Rule 506:

Currently, most private placement exemptions from the registration requirements of the Securities Act, including Rule 506 and Rule 144A, prohibit issuers from using “any form of general solicitation or general advertising”[1] when conducting an unregistered offering of their securities. This restriction generally is interpreted broadly to prohibit, among other things, the use of publicly available websites, media broadcasts (such as radio or television advertisements), mass email campaigns, or public seminars or meetings as part of an issuer’s capital raising activities.

The amendments add a new paragraph (c) to Rule 506, which permits the use of general solicitation in connection with a Rule 506 securities offering, provided that:

  • All purchasers of securities in the offering are “accredited investors” as defined in Rule 501(a) of Regulation D;[2]
  • The issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors; and
  • All terms and conditions of Rule 501 and Rules 502(a) and 502(d) are satisfied.[3]

When new Rule 506(c) becomes effective, an issuer may engage in all forms of general solicitation in a Rule 506 offering, so long as it complies with the foregoing conditions.

In connection with these changes, the SEC is amending Form D to add a check box for issuers to indicate whether they are relying on Rule 506(c). The SEC noted that this would give it the opportunity to monitor the use of general solicitation in private offerings and would assist it in evaluating the effectiveness of different accredited investor verification practices.

Verifying that Purchasers Are Accredited:

Rule 506(c)(2)(ii) requires an issuer to take “reasonable steps” to verify that purchasers are, in fact, accredited. To that end, investors must make an “objective determination…in the context of the particular facts and circumstances of each purchaser and transaction.” The following are some of the factors that issuers should consider in determining the reasonableness of the steps taken to verify that a purchaser is an accredited investor:

  • The nature of the purchaser and the type of accredited investor it claims to be;
  • The amount and type of information that the issuer has about the purchaser; and
  • The nature of the offering.

Further, the final rule includes the following nonexclusive list of verification methods that are deemed to satisfy the required “reasonable steps” standard for natural persons (so long as the issuer or a person acting on its behalf does not have knowledge that a potential investor is not an accredited investor):

  • Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation from the purchaser that he or she has a reasonable expectation of earning the necessary income in the current year;
  • Reviewing documents dated within the last three months to verify net worth, including bank statements and other financial documentation to verify assets, and a consumer credit report and written representation from the purchaser stating that all liabilities have been disclosed to verify liabilities;
  • Receiving a written confirmation from a registered broker-dealer, SEC-registered investment advisor, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps within the last three months to verify the purchaser’s accredited status; and
  • Obtaining a certification from a natural person who previously participated as an accredited investor in an issuer’s offering under Rule 506(b) and who remains an investor for a subsequent Rule 506(c) offering by that same issuer, that at the time of the sale he or she qualifies as an accredited investor.

Confirming that Rule 144A Does Not Restrict General Solicitation:

Before the rule changes, Rule 144A provided an exemption from the registration requirements of the Securities Act if offers and sales of securities by persons other than the issuer were made to “qualified institutional buyers” (“QIBs”) or persons reasonably believed to be QIBs.

The  rule changes will amend Rule 144A(d)(1) to remove references to the words “offer” and “offeree.” Consequently, sellers (or persons acting on their behalf) will be able to benefit from the exemption from registration provided by Rule 144A regardless of who is the offeree (i.e., QIBs or non-QIBs), so long as only QIBs or persons reasonably believed to be QIBs purchase the securities. The adopting release helpfully clarifies that using general solicitation for resales under Rule 144A will not affect the availability of the Section 4(a)(2) private placement exemption for the initial sale by the issuer to the initial purchasers.

Disqualification of Issuers in Connection with Felons and “Bad Actors”

Several exemptions from registration under the Securities Act, such as those provided by Regulations A and E, contain “bad actor” provisions that render the exemption unavailable for an offering in which certain disqualified persons participate. These disqualification provisions may be triggered, for example, if the issuer or other relevant persons (such as underwriters; placement agents; or directors, officers, or significant shareholders of the issuer) have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws. Rule 506 in its current form does not contain such a disqualification provision.

Section 926 of the Dodd-Frank Act requires the SEC to issue disqualification rules for Rule 506 offerings and that these rules be “substantially similar” to the bad actor provisions contained in Rule 262 of Regulation A. Section 926 also provides an expanded list of disqualifying events, including certain actions by state regulators, that must apply to Rule 506 offerings.

In addition to the issuer, persons covered by this new rule include: (i) directors, certain officers, general partners, and managing members of the issuer; (ii) 20% beneficial owners of the issuer; (iii) promoters; (iv) investment managers and principals of pooled investment funds; and (v) anyone compensated for soliciting investors, including general partners, directors, officers, and managing members of any compensated solicitor.

New Rule 506(d) will be triggered if a covered person is subject to any of the following disqualifying events: (i) criminal conviction involving certain securities and financial matters; (ii) court injunction or restraining order related to certain securities and financial matters; (iii) final order from certain banking and financial organizations that bar association or is based on fraudulent, manipulative, or deceptive conduct; (iv) certain SEC disciplinary orders; (v) an SEC cease-and-desist order; (vi) an SEC stop order; (vii) suspension or expulsion from a self-regulatory organization (“SRO”) or from association with an SRO member; and (viii) a U.S. Postal Service false representation order.

The new rule does, however, provide an exemption from disqualification when the issuer is able to show that it did not know and could not have known (exercising reasonable care) that a covered person with a disqualifying event participated in the offering. Also, the disqualification triggers will apply only to acts that occur after the effective date of these new rules.

Proposed Rules Add Further Filing Requirements under Regulation D

Last, the SEC released proposed new rules for comment, “Amendments to Regulation D, Form D and Rule 156 under the Securities Act,” which are intended to enhance the SEC’s ability to evaluate and monitor the development of market practices in Rule 506 offerings and, in particular, the need for added investor safeguards. The proposed rules would impose additional filing and disclosure requirements on issuers that use general solicitation in Rule 506 offerings.

Specifically, the proposed rules would, in addition to the current requirements, impose the following requirements for issuers using general solicitation and advertising in a Rule 506 offering:

  • Filing a Form D no later than 15 calendar days in advance of the first use of general solicitation;
  • Filing a closing Form D amendment within 30 calendar days after the termination of the offering;
  • Including in the Form D additional information concerning the offering, including the types of general solicitation used, the methods used to verify the accredited investor status of purchasers, categories of investors, and additional information about the issuer;
  • Including certain legends in any written general solicitation materials; and
  • Requiring additional disclosures for private funds if the fund’s general solicitation materials include performance data, including a telephone number or a website where an investor may obtain current performance data.

Under the proposed rules, an issuer would be disqualified from using Rule 506 for future offerings if it, or its predecessors or affiliates, has failed to comply within the past five years with the Form D filing requirements in connection with a securities offering under Rule 506. The proposed disqualification would end one year after the required Form D filings are made. Also, the proposed disqualification would not affect reliance on Rule 506 for ongoing offerings at the time of the filing non-compliance. Disqualification would apply to future offerings only. The proposals do provide for a cure period and a waiver process.

The proposed rules would also amend Rule 156, which provides guidance on the types of information in sales literature of investment companies that could be misleading to investors. The proposed rules would explicitly extend the application of the guidance in Rule 156 to the sales literature of private funds.

In addition, a proposed new temporary rule, Rule 510T, would require any issuer relying on new Rule 506(c) to file with the SEC its offering memoranda or other written communications that constitute a general solicitation or advertising. The filings would not be accessible by the public but, until the rule’s expiration after two years, would allow the SEC to scrutinize the terms and disclosures of private offerings and to compile data. Before relying on Rule 506(c), issuers may wish to assess the expenses and administrative burdens of such proposed SEC filing requirements. The comment period for the proposed rule ends on September 22, 2013.

For additional information or if you have any questions, please contact Margaret Farrell at mfarrell@hinckleyallen.com or Jacquelyn Mancini at jmancini@hinckleyallen.com.

[1]  In this Client Update, we refer to both general solicitation and general advertising as “general solicitation.”

[2]  Pursuant to Rule 501(a) of Regulation D, an accredited investor is: (1) a bank, insurance company, registered investment company, business development company, or small business investment company; (2) an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; (3) a charitable organization, corporation, or partnership with assets exceeding $5 million; (4) a director, executive officer, or general partner of the company selling the securities; (5) a business in which all the equity owners are accredited investors; (6) a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; (7) a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or (8) a trust with assets in
excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

[3] Rule 501 contains definitions of the terms used throughout Regulation D, including the term, “accredited investor.” For purposes of determining whether the conditions of a Regulation D safe harbor are met, Rule 502(a) requires the integration of all offerings by an issuer that occur within six months of each other. Rule 502(d) imposes limitations on the resale of securities acquired in a transaction under Regulation D.