The SEC recently issued long-awaited proposed rules to remove existing general solicitation and advertising prohibitions for private offerings and sales of securities under Rule 506 and Rule 144A under the Securities Act of 1933, as amended. These proposed rules implement Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act) enacted earlier this year. The SEC's proposed amendments leave intact the existing ability of a company to conduct a Rule 506 offering (under Rule 506(b)) without engaging in general solicitation or advertising.
This Update provides a summary of key aspects of the proposed rules and offers practical advice.
New Proposed Rule 506(c) Will Allow General Solicitation and Advertising
The proposed rules add a new subsection (c) to existing Rule 506, which would permit general solicitation and advertising for private offerings of securities under Rule 506 as long as:
the company takes reasonable steps to verify that the purchasers of the securities are accredited investors; and
all purchasers of securities are, in fact, accredited investors, or the company reasonably believes that such purchasers are accredited investors at the time of sale.
The SEC will be soliciting comments regarding the proposed rules during a comment period that will extend for a period of 30 days following publication of the proposed rules in the Federal Register.
Reasonable Steps to Verify Accredited Investor Status. The SEC declined to impose specific methods that a company must undertake under Rule 506(c) to verify accredited investor status. Further, the SEC declined to provide even a non-exclusive list of specific methods that would satisfy the "reasonable steps" requirement based on its stated belief that imposing specific methods for determining accredited investor status would be impractical and potentially ineffective in light of the wide range of verification issues that may arise in connection with a particular offering. The SEC chose instead to pursue a more flexible and adaptable (albeit less certain) facts-and-circumstances approach to determine whether, in a particular case, reasonable steps have been taken by the company to verify accredited investor status. Companies face significant consequences for failing to meet this burden of proof, since a company that relies on the new Rule 506(c) exemption and fails to meet the "reasonable steps" standard cannot rely on the statutory exemption provided by Section 4(a)(2) of the Securities Act, which would leave the company without any exemption from the registration requirement.
Reasonable Belief as to Accredited Investor Status. The proposed rules will continue to employ the same reasonable belief standard currently applied to Rule 506 offerings, meaning that as long as a company takes reasonable steps to verify that a purchaser is an accredited investor and reasonably believes that the purchaser is accredited at the time of sale, the fact that a purchaser ultimately turns out not to have been accredited at the time of sale will not cause the company to lose its ability to rely upon Rule 506(c).
Amended Form D. The proposed rules would include modest changes to Form D. Among the changes are that a new box titled "Rule 506(c)" would be added for companies relying on the new exemption and that the existing box currently titled "Rule 506" would be renamed "Rule 506(b)."
Proposed Rules Amend Rule 144A
The proposed rules would amend Rule 144A to permit securities sold pursuant to Rule 144A to be offered by means of general solicitation and advertising to investors who are not qualified institutional buyers ("QIBs"), so long as the ultimate sales of securities under Rule 144A are made only to investors that are, or that the seller reasonably believes are, QIBs. Prior to the JOBS Act, sellers could not offer securities under Rule 144A to investors who were not QIBs, which effectively prohibited the use of general solicitation and advertising under Rule 144A.
New Rule 506(c) Would Not Affect Availability of Existing Exclusions for Private Funds Under the Investment Company Act
In the release, the SEC states its view that privately offered funds such as hedge, private equity and venture capital funds, will be permitted to engage in general solicitation and advertising under the new Rule 506(c) without endangering their ability to rely on the private investment company exclusions under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the "1940 Act"). There had been some concern surrounding this issue in light of the fact that the language of Sections 3(c)(1) and 3(c)(7) conditions the exclusion from the 1940 Act on a company not making a "public offering" of its securities. The SEC alleviates this concern by reiterating its intent that all Rule 506 transactions should continue to be regarded as non-public offerings for purposes of Sections 3(c)(1) and 3(c)(7) of the 1940 Act.
Proposed Rules Would Not Affect Regulation S Compliance
The SEC confirms in the release that, consistent with its historical approach, compliant offerings under Regulation S (which exempts offers and sales of securities outside the United States) would not be integrated with concurrent unregistered domestic offerings that are conducted in compliance with Rule 506 or Rule 144A, as amended. There had been some concern as to whether the removal of the prohibitions on general solicitation and advertising under Rule 506 and Rule 144A would have a negative impact on the availability of existing safe harbors under Regulation S, which requires that no directed selling efforts be made in the United States.
Revisit Existing Accredited Investor Verification Process and Consider Enhancing Documentation. Companies wishing to rely upon Rule 506(c) should carefully revisit historical practices for verifying accredited investor status and develop a robust system for maintaining adequate records of the process and steps taken to verify accredited investor status, as the ultimate burden will be on the company to prove that it has met the "reasonable steps" standard under the new Rule 506(c) exemption.
Consider Whether Risks Outweigh Potential Benefits of General Solicitation or Advertising. Companies face significant consequences for failing to meet the burden of proof under these proposed rules, since a company that relies on the new Rule 506(c) exemption and fails to meet the "reasonable steps" standard cannot rely on the statutory exemption provided by Section 4(a)(2) of the Securities Act, which would leave the company without any exemption from the registration requirement. Importantly, the SEC's proposed amendments leave intact the existing ability of a company to conduct a Rule 506 offering (under Rule 506(b)) without engaging in general solicitation or advertising. As in the past, a company taking this approach may target sophisticated investors (including up to 35 non-accredited investors) without having to address the "reasonable steps" verification requirement under Rule 506(c) and without the risk that a technical violation of Rule 506(c) will leave the company without any potential fallback exemption from registration under Section 4(a)(2) of the Securities Act.
Click here to find the full text of the proposed rules. You can find the full text of the JOBS Act here. For more information regarding the JOBS Act, please see our March 30, 2012 Update.