On July 10, 2013, the U.S. Securities and Exchange Commission (the "SEC") (a) adopted final rules to implement Section 201(a) of the Jumpstart Our Business Startups Act by eliminating the prohibition on general solicitation in certain offerings conducted under Rule 506 and all offerings conducted under Rule 144A under the Securities Act of 1933, as amended (the "Securities Act"); and (b) proposed rules to add new requirements to Regulation D.
While the SEC adopted Rule 506(c) (the "New Rule") to allow issuers to use general solicitation, such as mass mailings, emails, public websites, social media, print media and broadcast media, in Rule 506 offerings, the SEC also preserved, as Rule 506(b) (the "Current Rule"), the existing ability of issuers to conduct Rule 506 offerings subject to the prohibition against general solicitation. An issuer will not be permitted to rely upon both the Current Rule and the New Rule for the same offering. The New Rule will become effective 60 days after publication in the Federal Register.
Elimination of the Prohibition Against General Solicitation in Rule 506(c) Offerings
Under the New Rule, issuers will be permitted to offer securities through means of general solicitation, provided that the following conditions are satisfied:
all purchasers are accredited investors or the issuer reasonably believes that all purchasers are accredited investors at the time of the sale; and
the issuer takes "reasonable steps" to verify that the purchasers are accredited investors.
Following the effective date of the New Rule, issuers will continue to have the ability to conduct offerings under the Current Rule. This would allow an issuer to sell to an unlimited number of accredited investors and up to 35 non-accredited investors, who (either alone or with their purchaser representatives) have such knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment.
Issuers conducting offerings that begin prior to, but extend beyond, the effective date of the New Rule will be permitted to continue the offering in accordance with the requirements of either the Current Rule or the New Rule. If an issuer decides to continue the offering in accordance with the requirements of the New Rule, any general solicitation that occurs after the effective date will not affect the exempt status of offers and sales that occurred prior to the effective date in reliance on the Current Rule.
Practical Implication: Issuers with preexisting relationships with potential investors who do not qualify as accredited investors may elect to rely on the Current Rule, rather than engage in general solicitation and foreclose the opportunity to raise funds from such non-accredited investors. These investors can represent a significant source of capital for issuers of all sizes, and will be key factors to be considered by issuers in weighing the potential benefits of being able to engage in general solicitation in their private offerings.
Additionally, technology companies that have not fully-protected their intellectual property may determine not to engage in general solicitation out of concern that descriptive advertising material regarding their proposed services or products may prove detrimental to their position in the marketplace.
Reasonable Steps to Verify Accredited Investor Status
In order to address concerns that the use of general solicitation in offerings under the New Rule could result in sales of securities to investors who are not accredited investors, the New Rule requires issuers to take "reasonable steps" to verify that purchasers of the securities are accredited investors. This requirement is independent of the requirement for sales to be limited to accredited investors. (See the definition of "accredited investor" set forth in the Appendix at the conclusion of this Alert.)
The New Rule would implement a flexible standard for determining whether "reasonable steps" have been taken. Among the factors that issuers should consider under this flexible approach are: (a) the type of accredited investor that the purchaser claims to be; (b) the amount and type of information that the issuer has about the purchaser; and (c) the nature of the offering. After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status.
The SEC recognized that verification of individuals as accredited investors may pose greater practical challenges as compared to other categories of accredited investors. These practical challenges likely will be made more problematic by privacy concerns about the disclosure of personal financial information. In an effort to provide certainty with respect to satisfying the verification requirement with regard to individuals, the SEC has identified the following four non-exclusive methods of verifying accredited investor status for individuals that, if used, will be deemed to satisfy the verification requirement in the New Rule:
to verify accredited investor status based on income, reviewing copies of any Internal Revenue Service form that reports income (e.g., Form W-2 or filed Form 1040) for the past two years, and a written certification from the investor that he or she has a reasonable expectation of reaching the same income level during the current year;
to verify accredited investor status based on net worth, reviewing (a) bank statements, brokerage statements, certificates of deposit, tax assessments and appraisal reports; (b) a credit report from a nationwide consumer reporting agency; and (c) a written certification from the investor that all liabilities necessary to make a determination of net worth have been disclosed;
reviewing a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant that such person or entity has taken reasonable steps within the prior three months to verify that the investor is an accredited investor and has determined that such investor is an accredited investor; and
with respect to any individual who qualified to invest as an accredited investor in an issuer's offering under the Current Rule prior to the effective date of the New Rule and remains an investor of the issuer, reviewing a written certification by the investor that he or she continues to qualify as an accredited investor.
Issuers are not required to use any of the methods discussed above, and they can adopt other methods to verify the accredited investor status of a potential purchaser.
The ability to engage in general solicitation may create a new industry of investor identification and qualification services that confirm the accredited investor status of potential investors and aim to increase the potential investment pool to investors previously unknown to issuers. Currently, only the most well-known investors gain access to the best deals, making it more challenging for accredited investors across the country to invest in such deals. With the elimination of the prohibition on general solicitation, it will likely be easier for investors to find issuers that are attractive to them.
It is important to note that the adoption of the New Rule did not change the requirement that anyone who receives compensation based upon the amount of funds obtained from investors in the United States (or from U.S. persons outside of the United States) must be registered as a broker-dealer. The payment of such a "finder's fee" to unregistered persons is a violation of U.S. securities laws and can result in rescission of the transaction or other sanctions imposed by U.S. securities regulators.
Practical Implication: Regardless of the particular steps taken, because the issuer has the burden of demonstrating that its offering is entitled to an exemption from the registration requirements of the Securities Act, it will be vital for issuers and their verification service providers, if any, to retain adequate records regarding the steps taken to verify that a purchaser was an accredited investor.
Use of New Rule by Hedge Funds, Venture Capital Funds and Private Equity Funds
Hedge funds, venture capital funds and private equity funds have typically relied on the Current Rule to offer and sell their securities without registration under the Securities Act. In addition, such funds have generally relied on one of two exclusions from the definition of "investment company" under the Investment Company Act—Section 3(c)(1) and Section 3(c)(7)—which enables them to be excluded from substantially all of the regulatory provisions of the Investment Company Act. These funds are precluded from relying on either of these two exclusions if they make a "public offering" of their securities. The SEC clarified that offers and sales under the New Rule will not be deemed "public offerings" under the federal securities laws as a result of general advertising or general solicitation.
Practical Implication: Issuers, such as hedge funds, venture capital funds and private equity funds, who have a preexisting relationship with potential investors may decide to continue to rely on the Current Rule, rather than engage in a general solicitation and be required to file solicitation materials and other information with the SEC prior to commencing an offering.
Elimination of the Prohibition Against General Solicitation in Rule 144A Offerings
Rule 144A is an exemption from the registration requirements of the Securities Act for resales of certain "restricted securities" to "qualified institutional buyers" ("QIBs"). Although Rule 144A does not include an express prohibition against general solicitation, offers of securities under Rule 144A currently must be made only to QIBs, which has the same practical effect. Under the final rules adopted by the SEC, securities sold pursuant to Rule 144A can be offered to persons other than QIBs, including by means of general solicitation, provided that the securities are sold only to persons the seller and any person acting on behalf of the seller reasonably believe to be QIBs.
Proposed Rules to Add New Requirements to Regulation D
The SEC also proposed rules designed to enhance the SEC's ability to assess developments in the private placement market following the elimination of the prohibition on general solicitation. The proposed rules generally relate to (a) the filing of, and information to be provided in, Form D (which is a notice required to be filed with the SEC by each issuer claiming a Regulation D exemption); and (b) the filing of, and legends and disclosures to be included in, written general solicitation materials.
Presently, an issuer selling securities under the Current Rule is required to file a Form D no later than 15 calendar days after the first sale of securities in an offering. The proposed rules would require issuers to file a Form D at least 15 calendar days before engaging in general solicitation for the offering (if relying on the New Rule), and to file a Form D to provide final information regarding the offering within 30 days after completing an offering (regardless of whether relying on the Current Rule or the New Rule).
The current Form D requires the disclosure of limited information about the issuer selling the securities, any related persons, the exemption upon which the issuer is relying to conduct the offering and certain other factual information about the issuer and the offering. Under the proposed rules, issuers will be required to provide additional information, including (a) the issuer's website address; (b) expanded information about the offered securities, including the trading symbol; and (c) the methods used to verify the accredited investor status of investors. An issuer would be disqualified from using either the New Rule or the Current Rule in any new offering if the issuer fails to comply with the Form D filing requirements. As proposed, this disqualification would continue for one year, beginning after the required Form D filings are made.
Under the proposal, an issuer would be required to include certain legends or cautionary statements in any written general solicitation materials used in an offering conducted under the New Rule. The legends would inform potential investors that the offering is limited to accredited investors and that certain potential risks may be associated with such offerings. In addition, if the issuer is a private fund and includes information about past performance in its written general solicitation materials, it would be required to provide additional information in the materials to highlight the limitations on the usefulness of this type of information.
Additionally, issuers would be required to submit written general solicitation materials to the SEC; however, such materials would not be available to the general public. As proposed, this requirement would be temporary and expire after two years.
Practical Implication: Although the filing of a Form D is currently a requirement of Regulation D, it is not a condition to the availability of the exemptions under Regulation D. The proposed advance filing requirement could limit issuers’ willingness to engage in general solicitation in offerings under the New Rule for various reasons, including a desire to maintain the confidentiality of unsuccessful fundraising activities.
Definition of Accredited Investor
The federal securities laws define the term "accredited investor" in Rule 501 of Regulation D as:
any bank as defined in section 3(a)(2) of the Securities Act, savings and loan association or other institution as defined in section 3(a)(5)(A) of the Securities Act; broker or dealer registered pursuant to section 15 of the Securities Exchange Act; insurance company as defined in section 2(13) of the Securities Act; investment company registered under the Investment Company Act; or business development company as defined in section 2(a)(48) of the Investment Company Act;
any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act;
any plan established and maintained by a state, its political subdivisions or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000;
any employee benefit plan within the meaning of the Employee Retirement Income Security Act if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
any private business development company as defined in section 202(a)(22) of the Investment Advisers Act;
any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
any director, executive officer or general partner of the issuer of the securities being offered or sold, or any director, executive officer or general partner of a general partner of that issuer;
any natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000.
As used above, the term "net worth" means the excess of total assets over total liabilities. The value of the investor's primary residence may not be included in the net worth calculation. The amount of indebtedness secured by a primary residence (e.g., a mortgage) up to the fair market value of the residence does not have to be included as a liability in making the net worth determination, unless indebtedness secured by the primary residence was incurred within 60 days prior to the acquisition of the securities and was not incurred as a result of the acquisition of such residence. In addition, if there is any amount of indebtedness that is secured by the primary residence (e.g., a mortgage) in excess of the fair market value of the residence, such excess of the value of the residence should be considered a liability and deducted from the investor's net worth.
any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and who has a reasonable expectation of reaching the same income level in the current year;
any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
any entity in which all of the equity owners are accredited investors.