The Securities and Exchange Commission (“SEC”) recently took action to implement certain provisions of the Jumpstart Our Business Startups Act (“JOBS Act”) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). As mandated by the JOBS Act, the SEC amended existing rules to eliminate the prohibition against the use of general solicitation and advertising in the sale of securities in “private” offerings, as long as certain conditions are met. For the purposes of this discussion, we refer to these new rules as the “Rule 506(c) Amendments.” The changes imposed by the Rule 506(c) Amendments are intended to allow companies to reach a greater number of potential investors, thereby increasing their access to capital.
With the loosening of these regulations, however, comes increased risk of fraudulent behavior and unlawful sales of securities to investors who do not satisfy the qualifications imposed by the new rules. In an effort to combat these risks, the SEC also adopted rule amendments, as mandated by the Dodd-Frank Act, to disqualify companies and certain other market participants from conducting any private offering under Rule 506 of Regulation D if felons or certain other “bad actors” participate. We refer to these new rules as the “Bad Boy Prohibitions.” In addition, with the goal of enhancing its ability to evaluate the development of market practices and the risks associated with such offerings, the SEC has proposed a series of new rules and reporting obligations that would apply to Rule 506 offerings. We refer to these proposals as the “Proposed Offering Rules.”
The three rules, each of which is summarized in more detail below, are expected to transform the landscape for companies wishing to raise capital through the sale of restricted securities in private placement transactions. While loosening the restrictions on the ways a company can solicit potential investors, the rules simultaneously tighten the restrictions on who can use the exemptions and, if the Proposed Offering Rules are adopted, how the offering must be conducted. Compliance with these rules will thus require careful planning and diligence. Although the Rule 506(c) Amendments and the Bad Boy Prohibitions do not become effective until September 23, 2013, as discussed below, there are various steps that we recommend companies take now to prepare for the new regulatory structure.
The Rule 506(c) Amendments: Eliminating the Prohibition Against General Solicitation and General Advertising in Certain Rule 506 and Rule 144A Offerings (Final Rule)
Under the Securities Act, all offers and sales of securities must either be registered with the SEC or be exempt from registration. Under one of the most common exemptions, provided for by Rule 506 of Regulation D, companies have been permitted to raise an uncapped amount of capital from an unlimited number of “accredited investors” and up to 35 investors who are sophisticated but do not meet such qualification. Until the adoption of the JOBS Act and the Rule 506(c) Amendments, companies and their representatives were prohibited from using any form of general solicitation or general advertising in connection with Rule 506 “private placement” offerings.
The Rule 506(c) Amendments lift the ban on general solicitation and general advertising on Rule 506 offerings. Under the new Rule 506(c), companies are permitted to engage in general solicitation and general advertising as long as all purchasers are accredited investors and the company issuing the securities takes reasonable steps to verify that such persons are accredited investors. Pursuant to the JOBS Act, Rule 506(c) offerings are not deemed public offerings under the federal securities laws (despite the use of general solicitation), and the SEC made it clear that the exemption is available for offerings initiated by private funds (such as hedge funds, venture capital funds, and private equity funds), as well as operating companies.
When adopting these new rules, the SEC also made it clear that the “existing” Rule 506 safe harbor (now codified as Rule 506(b)) continues unchanged as a separate exemption. This will allow issuers to continue conducting private offerings without general solicitation or advertising involving up to 35 non-accredited investors, without taking the additional verification steps with respect to accredited investors. However, the Bad Boy Prohibitions (discussed below) will apply to offerings under both Rule 506(b) and 506(c).
Because the burden of proving the availability of a particular exemption lies upon the entity wishing to claim such exemption, it will be important for companies and their representatives to develop appropriate verification methods and to retain adequate records regarding the steps taken to verify that each purchaser under a Rule 506(c) offering was an accredited investor. The SEC has stated that whether the steps taken to make such verification are “reasonable” is an objective determination, which will be based on the facts and circumstances of each purchaser and transaction. Under this principles-based approach, companies (or those acting on its behalf) should consider a variety of interconnected factors to determine what steps are reasonable, including:
the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
the amount and type of information that the company (or its representatives) has about the purchaser; and
the nature of the offering, such as the manner in which the purchaser was solicited to participate, and the terms of the offering, such as a minimum investment threshold.
With the goal of providing more legal certainty for companies seeking to utilize the exemption, the new rules also provide a non-exclusive list of methods to verify whether natural persons are accredited investors (which for natural persons include minimum income or net worth thresholds). These include (1) reviewing tax forms that report income plus obtaining relevant representations from the purchaser supporting the determination, (2) reviewing various reports and documents (such as bank statements, brokerage statements, credit reports, etc.) supporting the individual’s net worth plus obtaining relevant representations from the investor, and (3) obtaining written confirmation from various third parties (such as a registered broker-dealer, registered investment advisor, or CPA) that an individual meets the standard. Lastly, an individual who participated in a prior Rule 506 offering as an accredited investor and remains an investor of the company will be deemed to satisfy the verification process if the investor certifies that he or she remains qualified as an accredited investor.
As required by the JOBS Act, the adopting release covering the Rule 506(c) Amendments also adopted amendments to Rule 144A of the Securities Act, which provides a safe harbor from registration for the resale of unregistered securities by persons (other than the issuer) to institutions the seller reasonably believes to be qualified institutional buyers (“QIBs”). Under the amended Rule 144A, investors may now use general solicitation and general advertising to offer restricted securities, as long the ultimate purchasers are institutions that the seller reasonably believes are QIBs.
The Bad Boy Prohibitions: Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings (Final Rule)
As mandated by the Dodd-Frank Act, the SEC also adopted a final rule that disqualifies offerings from either of the Rule 506 safe harbors (Rule 506(b) or Rule 506(c)) if the company issuing the securities or other relevant persons (such as underwriters, placement agents, or the directors, officers or significant shareholders of such company) involved in the offering have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws. Until the adoption of the Bad Boy Provisions, codified as new Rule 506(d), Rule 506 did not impose any bad actor disqualification requirements.
Participants covered by the new rule include, among others:
the issuer (i.e., the entity issuing the securities) and any predecessor or affiliated issuer;
directors and executive officers of the issuer and any other officers participating in the offering and general partners or managing members of the issuer (all such persons referred to for these purposes as “insiders”);
beneficial owners of 20% or more of the issuer’s outstanding voting securities (calculated on the basis of voting power);
any person who has been or will be paid remuneration for solicitation of purchasers in connection with such sale of securities (generally referred to as a “compensated solicitor”); and
the insiders of such compensated solicitor.
Rule 506(d) provides a list of disqualifying events involving these participants, some of which were specified in the Dodd-Frank Act, including certain criminal convictions involving securities, regulatory orders, and disciplinary action by various regulators and organizations. Under limited circumstances, the SEC may grant waivers from the disqualification rules or the court or relevant regulatory authority can determine (in writing) that disqualification under Rule 506(d) should not be imposed in connection with the circumstances giving rise to an otherwise disqualifying event. In addition, disqualification will not apply with respect to any disqualifying event that occurred prior to the effective date of the new rule (or September 23, 2013); however, written disclosure of those events that would have otherwise triggered disqualification (but for the fact that they occurred prior to the effective date) must be furnished to each purchaser a reasonable time prior to the sale.
As previously mentioned, the Bad Boy Prohibitions will apply to all private placement offerings conducted under Rule 506, irrespective of whether they involve general solicitation. The new rules establish a “reasonable care” standard, in that an issuer will not be disqualified from using Rule 506 if it can establish that it “did not know and, in the exercise of reasonable care, could not have known” that a disqualification under the rule existed. (A similar standard applies to the requirement to disclose prior bad acts.) Thus, to ensure compliance with the rules, it will be necessary for issuers and their representatives to undertake careful diligence of each group of persons covered by the Bad Boy Prohibitions well in advance of conducting any Rule 506 offerings.
Proposed Offering Rules: Amendments to Regulation D, Form D, and Rule 156 under the Securities Act (Proposed Rule)
The SEC also proposed several amendments to Regulation D, Form D, and Rule 156 under the Securities Act. These amendments are intended to enhance the SEC’s ability to monitor the development of market practices in Rule 506 offerings and to provide safeguards in connection with the lifting of the general solicitation and general advertising ban in Rule 506 offerings.
The Proposed Offering Rules would add a number of reporting and disclosure obligations that would impact current practices under Rule 506. For example, an issuer engaged in an offering under Rule 506(c) would be required to (1) file a Form D at least 15 days prior to engaging in general solicitation and file an amendment to such Form D within 30 days after the termination of any Rule 506 offering (current practice only requires a filing no later than 15 days after the first sale of securities in the offering) and (2) include specific legends on any written communication that constitutes a general solicitation under the rule (with additional disclosure required for private funds conducting offerings). In addition, the Proposed Offering Rules would require (on a temporary basis) issuers to submit those written communication materials to the SEC no later than the date of first use of such materials. The Proposed Offering Rules would prohibit an issuer that failed to comply with the new Form D filing requirements during the past five years from relying on Rule 506 for one year after the required filings are made.
The proposed amendments to Rule 156 would extend the anti-fraud guidance contained in the rule to the sales literature of private funds (not just investment companies, as currently is the case).
Comments on the Proposed Offering Rules are due by September 23, 2013 (the same date as the effective date of the Rule 506(c) Amendments and the Bad Boy Prohibitions). While there is no certainty that these proposals will be adopted in the forms presented, if at all, the SEC seems keen on expanding its ability to monitor the developments under Rule 506 offerings, particularly those involving general solicitation under new Rule 506(c). As a result, it seems reasonable to expect the SEC to move more quickly on these proposals.
The newly adopted and proposed rules will transform the manner private offerings are conducted. Although the newly adopted rules will not be effective until late September, we recommend that companies that are currently involved in or contemplating Rule 506 offerings take the following five initial steps to be prepared.
Assess the Impact of Bad Boy Prohibitions. Issuers wishing to utilize Rule 506 should identify those persons covered by the Bad Boy Prohibitions, take steps to confirm that they are not disqualified from using Rule 506 and determine whether any written disclosure of prior bad acts may be necessary. Since the disqualification trigger is tied to the effective date of the new rules, we would not expect many companies to find themselves facing immediate disqualification; however, the disclosure requirements remain a critical component for compliance with the rules and the availability of the exemption. Prompt completion of this diligence will be particularly important for issuers currently conducting Rule 506 offerings. Public companies should consider revising their D&O Questionnaires to include questions about disqualifying events in order to be prepared for potential issues in future private placements.
Review Communications Procedures. Companies should review their media and communications policies to ensure that the solicitation process and offering communications (including general solicitation) are appropriately covered by such policies. Individuals that are authorized to speak on a company’s behalf should be informed of the new rules.
Establish Verification Standards and Recordkeeping Procedures. Companies should consider the different verification methods and develop appropriate verification standards to be used in future offerings. Third-party verification services should also be assessed. Because the burden of proving the availability of a particular exemption lies upon companies claiming an exemption, companies should also ensure that adequate recordkeeping procedures are in place to document the verification process.
Involve Counsel Early in Planning for Offerings. Since the new rules will significantly impact market practice and the legal practice associated with conducting private placements, we recommend that you seek counsel early in your planning process to help you assess the best path forward. Challenges and pitfalls can develop even for the most seasoned issuers who are well-versed in the use of the Rule 506 exemption.
For instance, companies will need to consider, before initiating any offers, whether they would like to include non-accredited investors and whether any investors will be uncomfortable with the verification steps required in Rule 506(c) offerings, which may dissuade an issuer from utilizing new Rule 506(c). The ban on the use of general solicitation and advertising in private placements remains in place under Rule 506(b) (which permits up to 35 non-accredited investors to participate in the offering) and Section 4(a)(2) of the Securities Act. Companies undertaking any form of general solicitation in an offering that somehow fails to meet the requirements of Rule 506(c) may find that they can no longer avail themselves of Rule 506(b) or Section 4(a)(2), and thus there may not be any exemption available for their offering.
Monitor Market Practice and Rule Making. Companies will need to monitor how market practice develops with respect to general solicitation and advertising, including the investment community’s response to and appetite for different verification methods. Companies will also need to watch for any final rules related to the Proposed Offering Rules and ensure that they comply with any new Regulation D requirements, especially since the Proposed Offering Rules provide serious consequences for failing to comply with Form D requirements.