New SEC Rules Permitting General Solicitation
On September 23, 2013 the new Securities and Exchange Commission (SEC) rules permitting general solicitation and advertising of private securities offerings pursuant to the Jumpstart Our Business Startups Act of 2012 (JOBS Act) go into effect.
Under the new Rule 506(c) of the SEC’s Regulation D, a company offering preferred stock, convertible notes or other securities to investors in a private offering may solicit and advertise that offering to the general public, provided that:
the company only sells the securities to “accredited investors,” as defined by the SEC;
the company takes “reasonable steps” to verify that all those purchasers meet the SEC’s accredited investor requirements; and
the offering meets the other applicable requirements of Rule 506.
Bad Actor Disqualification
The changes to Rule 506 also include the less publicized yet important addition of a “bad actor” disqualification pursuant to the Dodd–Frank Wall Street Reform and Consumer Protection Act. This new rule, which appears in new Rule 506(d), denies any Rule 506 exemption. Disqualification under this new rule occurs for all 506 offerings - whether or not general solicitation occurs. The new rule applies, and disqualification of the offering occurs, if the company, or certain persons related to the company deemed “covered persons” by the SEC, have committed serious violations of securities laws or other financial industry rules and regulations.
New Rule 506(d) contains several exceptions to disqualification despite the existence of a person who has committed the enumerated violations. Most importantly, disqualification will not occur if the company did not know and, in exercising “reasonable care,” could not have known that a disqualification existed. The rule applies a facts-and-circumstances test to determine whether a company has exercised reasonable care.
Practice tip: Companies that plan to offer and sell securities under Rule 506 in the future must exercise reasonable care to ensure that none of the company’s directors, executive officers, or other persons involved with the offering (including shareholders holding 20% or more of the company’s voting securities) have committed such violations.
In practice, this means conducting a factual inquiry before the offering which, depending on the facts and circumstances of the issuer and other offering participants, could be accomplished by requiring directors, officers and other covered persons to complete “bad actor” questionnaires.
What Remains Unchanged Under the New Rules
In our July 11, 2013 Client Update following the release of these new rules, we describe these changes and the additional obligations of companies engaging in general solicitation of private securities offerings in greater detail.
Not surprisingly, all these changes have generated some confusion in the private investment community. To help realign the discourse, we offer this brief list of what the new rules do NOT change:
For companies that do not seek to solicit or advertise their private securities offering to the general public, the pre-existing Rule 506 exemption remains as Rule 506(b) with no new purchaser-verification obligations for the issuer.
There is no change to the prohibition of general solicitation and advertising of private securities offerings under Section 4(a)(2) of the Securities Act of 1933, the statutory exemption from which the Rule 506 exemption is derived. So, unlike with a traditional Rule 506(b) offering, there is no “fallback” under Section 4(a)(2) for a general solicitation that fails to qualify under Rule 506(c) because Section 4(a)(2) prohibits general solicitation otherwise. Therefore, if an issuing company engages in general solicitation but otherwise fails to meet all the requirements of Rule 506, including through a technical lapse, such as missing the Form D filing deadline for the offering, an illegal securities offering may result.
Although there is now, for the first time, a private offering exemption that permits general solicitation and advertising, there is no change to the law governing what constitutes a general solicitation. So, if yesterday a private securities offering did not involve general solicitation or advertising and qualified under the old Rule 506, a substantively similar offering today would not need to qualify under new Rule 506(c).
The proposed rules released by the SEC on the same date as the final changes to Rule 506 and Regulation D (see our July 11, 2013 Client Update), which include additional filing and disclosure requirements for Rule 506 offerings, have not gone into effect and, judging by their poor reception from the investment community, face considerable hurdles before becoming law.