On July 10, 2013, the Securities and Exchange Commission (SEC) adopted amendments to its safe harbor rule for private placements of securities, Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”). One amendment will permit an issuer, including a private fund, to engage in general solicitation and advertising in a private offering under a new paragraph (c) of Rule 506, provided that the securities are sold only to accredited investors and that the issuer takes reasonable steps to verify that all purchasers are accredited investors. Another amendment will prohibit certain “bad actors” from relying on Rule 506 for private placements. Under amended Rule 506, issuers that do not wish to utilize general solicitation and advertising may continue to conduct offerings under existing Rule 506(b), which prohibits general solicitation but permits an issuer to offer and sell securities to up to 35 sophisticated non-accredited investors. In addition, the SEC also amended Rule 144A under the Securities Act to permit a person reselling securities under Rule 144A to engage in general solicitation and advertising provided that the securities are sold only to “qualified institutional buyers.”
The final rules will be effective on September 23, 2013. Issuers may begin generally soliciting investors in a Rule 506 offering after that date so long as the securities are only sold to accredited investors and the issuer takes reasonable steps to verify the accredited investor status of investors, as described below.
Contemporaneously with the adoption of the above rules, the SEC proposed additional requirements and conditions on issuers using Rule 506 that would, if adopted, create significant compliance burdens, especially on private funds. For offerings pursuant to Rule 506(c), the proposed rules would, among other things:
In addition, other proposed rules would be applicable to all Rule 506 offerings (whether or not the issuer is engaging in general solicitation). These rules would, among other things:
New Rule 506(c) permits an issuer to generally solicit or advertise to investors so long as (i) it complies with all other applicable conditions of Regulation D, such as limitations on resale, (ii) all purchasers of securities sold in the Rule 506(c) offering are accredited investors (as defined in Rule 501 of Regulation D), either because they are within one of the enumerated categories of persons that qualify as an accredited investor or the issuer reasonably believes that they are, and (iii) the issuer takes reasonable steps to verify that the purchasers are accredited investors.1
Whether the procedures used to verify accredited investor status are reasonable will be determined by an objective analysis based on the facts and circumstances surrounding the offering and the issuer, including:
If the above factors indicate a low risk of non-accredited investors having invested in the offering, reduced efforts to verify may be objectively reasonable. For example, if an issuer advertises in a newspaper of general circulation, it will be required to take more steps than if it contacted names in a prescreened database. The SEC also stated that, in an offering with a minimum investment amount that is sufficiently high so that only accredited investors would reasonably be expected to meet it, it may be reasonable, absent facts to indicate that the investor was not accredited, to “take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party.”
The information requested and methods used to verify the accredited investor status of the potential purchaser also must be reasonable, but the final rule provides four methodologies that will be deemed to satisfy the reasonable procedures requirement for potential natural person purchasers:
While the SEC clarified that the above methods for verifying accredited investor status for natural persons are not meant to be an exclusive list, many commentators expect that most issuers relying on Rule 506(c) will use the verification methods in the above list. The SEC did not provide guidance for entities, but financial statements will likely be used to verify the requisite $5 million in total assets threshold, and database searches may be used for those entities whose accredited investor status depends on their regulatory status.
The SEC amended Form D to add a separate box that an issuer must check if it is relying on new Rule 506(c). Issuers that have previously relied on Rule 506 but are opting to generally solicit must transition to Rule 506(c), because they may not rely on both parts of Rule 506 for the same offering.
Issuers may choose to continue an offering that commenced prior to the effective date of Rule 506(c) in accordance with new Rule 506(c) or under the previous version of Rule 506 in Rule 506(b). Issuers that choose to continue an offering under Rule 506(c) will not negatively affect the exemption for the portion of the offering prior to the effectiveness of the rule amendments due to its general solicitation in the 506(c) offering. The SEC did not, however, provide guidance permitting an offer to be transitioned from prior Rule 506 to a Rule 506(c) offering if non-accredited investors had participated in the prior portion of the offering, nor did it provide guidance on the transition of an offering that commences after the date of the effectiveness of the rules from 506(c) to 506(b).
Although Rule 506 was adopted under Section 4(a)(2) of the Securities Act,3 the SEC has stated that offerings conducted without the benefit of the safe harbor rule will remain subject to the prohibition on general solicitation. Therefore, if an issuer is disqualified from relying on Rule 506 due to the bad-actor provisions or the proposed disqualifications below, it would not be permitted to engage in general solicitation, and it may be required to cease offering for a period of time in order to establish a separate Section 4(a)(2)4 offering.
The SEC has specifically stated that Congress had intended for private funds to be permitted to use new Rule 506(c). The Commodity Futures Trading Commission (CFTC), however, has not yet proposed changes to its reduced compliance regime under Regulation 4.75 or its exemptions for commodity pool operators under Regulation 4.13(a)(3)6. Until the CFTC or its staff provides guidance, the ability to rely on these exemptions and to conduct general solicitation will be uncertain.
In addition, as discussed below, registered investment advisers to funds that conduct general solicitation will likely be subject to additional scrutiny, and the filing of a Form D to claim the Rule 506(c) exemption may increase the risk of inspection by the SEC’s Office of Compliance Inspections and Examinations. Private fund investment advisers using Rule 506(c) must amend their policies and possibly their subscription documents to reflect their planned practices to verify accredited investor status and should maintain books and records to demonstrate their compliance with the new requirements for each investor and/or offering to prepare for an examination. In particular, they may wish to revise subscription materials to obtain a representation that the investment has not been financed and to request further assurances that necessary information, such as tax returns, financial statements or other documentation, will be provided upon request.
As required by the JOBS Act, the SEC amended Rule 144A to permit security holders to offer securities more generally, including through general solicitation, so long as the securities are sold only to persons that the seller and any person acting on its behalf reasonably believe are “qualified institutional buyers.”
As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, new Rule 506(d) will prohibit an issuer from relying on Rule 506 if the issuer or certain of its affiliates have been convicted of or are subject to court or administrative sanctions for having violated specified laws that occur after September 23, 2013.
Under new Rule 506(d), an issuer may be disqualified for its “bad acts,” as well as the bad acts of its affiliates, its management and certain of its service providers. The final rules reference the following persons that could potentially disqualify the issuer due to their bad acts (each of the following, other than the relevant issuer, an “issuer affiliate”):
The rule will be triggered by the issuer or any issuer affiliate having committed one of the bad acts specified in the rule. In general, an issuer would be disqualified if it or an issuer affiliate was convicted of a felony or misdemeanor in connection with securities purchases or sales, making false filings or in the conduct of operating as an investment adviser or compensated solicitor, or was subject to a court order enjoining the above violations. In addition, the rule will also be triggered by final orders of a state securities authority, banking authority, insurance commissioner, national securities exchange or registered national securities association, the CFTC or the SEC that bars, suspends or limits the ability of the issuer or any issuer affiliate from conducting business. Finally, the rule will disqualify persons who have been subject to a cease and desist order relating to Section 5 of the Securities Act or any scienter-based anti-fraud provision of the federal securities laws. For a complete list of “bad acts,” see Appendix A.
In general, the bad actor provision will prohibit an issuer’s reliance on Rule 506 by issuers or issuer affiliates within the past five or 10 years for convictions or court or SEC orders and current bans for many other regulatory authorities. The prohibition will not apply to convictions, orders, judgments or bars that occurred before September 23, 2013. Issuers will, however, be required to furnish a description of any bad act prior to September 23, 2013, to each purchaser prior to each sale.
An issuer will not be prohibited from relying on Rule 506 due to a bad act or the failure to disclose a bad act if it did not know and, in the exercise of reasonable care, could not have known of that bad act. The rule specifies that reasonable factual inquiry must have been made to establish this defense.
The SEC will also have the ability to waive the disqualification under the rule if the issuer shows good cause. In addition, the regulatory authority or court that entered the relevant judgment or order may prevent the disqualification if it advises in writing before the date of a sale under Rule 506 that disqualification of the bad actor provision should not arise as a consequence of the judgment or order.
Issuers may need to update their subscription documents or questionnaires for their directors, officers and significant securityholders to collect information regarding bad acts that may trigger the effects of the bad actor provisions of the rule. Investment managers will need to update their policies to address the new provision and retain records to demonstrate that they took reasonable steps and made reasonable inquiries of issuer affiliates. Finally, issuers that retain compensated solicitors should consider updating their agreements to obtain representations that such solicitors have not committed any of the enumerated bad acts.
To address investor protection concerns relating to lifting the ban on general solicitation and advertising and to enhance the SEC’s understanding of market practices in Rule 506 offerings, the SEC proposed a number of investor protection and information-gathering measures, which, if enacted, may dissuade some issuers from using a general solicitation in Rule 506 offerings.
The SEC proposed new Rule 510T that would require issuers relying on Rule 506(c) to “submit” written general solicitation materials to the SEC. As proposed, the general solicitation information would be provided to the SEC via a private intake page no later than the date of first use and would not be “filed” with or “furnished” to the SEC. The requirement to submit the information would, if adopted as proposed, apply for only two years after effectiveness. Compliance with Rule 510T’s filing requirement would not be a condition to Rule 506(c), but the SEC could seek an injunction for failure to file general solicitation materials, which would prohibit the issuer’s ability to rely on Regulation D in future offerings.
Proposed Rule 509 would require issuers to include the following prominent legends in all written general solicitation materials used in a Rule 506(c) offering:
As with the temporary requirement to submit general solicitation materials, the requirement to include legends on those materials would not be a condition to the use of Rule 506. An issuer that is subject to an order, judgment or court decree enjoining it for failing to include the legends would, however, be prohibited from relying on Rule 506 in future offerings.
The SEC proposed to amend Form D to require the issuer to provide more specific information in Rule 506 offerings. The amended Form D would require information on, among other things, (i) the issuer’s publicly accessible website address, (ii) the use of proceeds (for issuers other than pooled investment funds), (iii) the manner in which investors qualified as accredited investors, (iv) whether general solicitation materials were filed with the Financial Industry Regulatory Authority, Inc., (v) the name and file number of the investment adviser (for pooled investment vehicle issuers), (vi) the types of general solicitation used (for 506(c) offerings), (vii) the methods of verification of accredited investor status used (for 506(c) offerings) and (viii) the amounts raised from each type of investor.
Under the existing rules, issuers selling securities in a Rule 506 offering are required to file a notice of sale on Form D with the SEC no later than 15 calendar days after the first sale of securities in the offering. The SEC proposed to amend this filing requirement to require issuers relying on Rule 506(c) to file an initial Form D not later than 15 calendar days prior to conducting any general solicitation activities. Issuers may omit certain information from this “advance Form D” but must then amend the advance Form D to provide the remaining information within 15 calendar days after the first sale occurs. In addition, the SEC has proposed that issuers be required to file a final amendment to Form D within 30 calendar days after the termination or abandonment of a Rule 506 offering, which form would include final information regarding the offering (including the amount of capital actually raised in the offering).
Under current rules, although an issuer is required to file a Form D, the failure to file does not disqualify the issuer from relying on Regulation D, nor does it limit the issuer’s ability to use Regulation D in future offerings unless a court enjoins an issuer for violating the filing requirements. The SEC has proposed to amend the filing requirements to automatically disqualify an issuer from using Rule 506 for any new offering for one year if the issuer or any of its affiliates or predecessors failed to file a Form D in a Rule 506 offering within the five-year period preceding the new offering. The one-year period would commence following the filing of all required Form D filings for the previous offering. This disqualification would be subject to a once-per-offering cure period of 30 calendar days. The disqualification would only result from Form Ds that are not filed starting after the rules are effective.
Given the number of proposed changes to Form D, issuers would need to closely monitor their Form D filing practices if this amendment is adopted. The proposed disqualification provision is broadly drafted and could, as the SEC alludes to in the proposing release, result in a portfolio company of a private fund being prohibited from using Rule 506 because of the failure of its affiliated fund to file a Form D.
A number of the proposed changes and the SEC’s supervisory efforts are specifically targeted at private funds, including additional legending and marketing requirements. The SEC is also considering, but has not proposed, mandated standardized methodologies of calculating past performance for private funds.
In addition to the legends that would be required for any issuer conducting a general solicitation, a private fund issuer would be required to include an additional legend and make additional disclosures in their written general solicitation materials. First, private funds would be required to include a legend that the securities offered are not subject to the protections of the Investment Company Act of 1940. Also, any private fund issuer that includes performance data in any written general solicitation materials would be required to disclose the following:
In addition, all performance data disclosed must be as of the most recent practicable date and must disclose the period for which performance is presented, and the private fund would be required to disclose a telephone number or publicly accessible website where an investor may obtain current performance data.
Rule 156 under the Securities Act provides guidance on the types of information in investment company sales literature that could be misleading for the purposes of the federal securities laws. The SEC proposes to extend the application of Rule 156 to private funds. The definition of sales literature under the proposed rule would be broad and would include any communication used by any person “to offer or sell or induce the sale of securities of any investment company or private fund,” including communications between issuers, underwriters and dealers that can reasonably be expected to be used in marketing the investment company or private fund.
Rule 156 provides an interpretation of what constitutes a misleading statement that could give rise to liability under the Securities Exchange Act of 1934, including Section 10(b) and Rule 10b-5 thereunder, and under the Investment Company Act of 1940. As under Rule 10b-5, sales literature is materially misleading if it (i) contains an untrue statement of a material fact or (ii) omits to state a material fact necessary in order to make a statement made, in the light of the circumstances of its use, not misleading. Whether a statement may be materially misleading is a facts and circumstances evaluation depending on the context of the statement. Rule 156, however, provides specific examples of statements that may, depending on the surrounding context, be misleading, such as:
The rule also states that information in sales literature may be misleading depending on general economic or financial conditions or circumstances in which a statement is made and other statements that have been made in connection with the offer or sale of the securities in question.
It seems likely that the SEC will extend Rule 156 to private funds, as the staff stated that advisers to private funds should begin preparing for the application of Rule 156 as soon as possible. Many of the above restrictions are similar or less restrictive than the guidance that many registered investment advisers are already following due to the advertising rule under the Investment Advisers Act of 1940 and its related no-action letters.
The SEC stated in the proposing release that the SEC’s staff will execute a “comprehensive work plan upon the effectiveness of Rule 506(c) to review and analyze the use of Rule 506(c).” The work plan will involve a coordinated effort with, among others, the Office of Compliance Inspections and Examinations and the Division of Enforcement. The group of staff participating in the plan will examine the information submitted and “incorporate an evaluation of practices in Rule 506(c) offerings in the staff’s examinations of registered. . . investment advisers.” Given the risk-based approach that the staff currently takes in investment adviser examinations, it is likely that the decision to opt into general solicitation by checking the Rule 506(c) box may impact the likelihood that an investment adviser to a private fund will be examined by the SEC staff.
Issuers that are planning to use general solicitation in a Rule 506 offering need to address the requirements of the Rule 506(c) discussed above, including the methods they will use to verify whether the investors are accredited. Issuers will also need to address the bad actor rules by making relevant inquiries to confirm that they will be able to use Rule 506 and whether disclosure will be required prior to the sale of securities.
Although many issuers may welcome the use of general solicitation in Rule 506 and Rule 144A offerings, the additional compliance burdens that the SEC has proposed, including presubmission of general solicitation materials, legending requirements and advanced filing of Form D, may, if adopted, discourage issuers from taking advantage of general solicitation. Private fund advisers in particular may be disappointed by the proposed changes. Many private fund advisers were expecting to be able to remove the password protection from the information on their websites or to more freely discuss the funds that they advise. Unfortunately, the SEC designed investor protection measures with the assumption that private funds would generally advertise instead of taking such incremental steps toward general solicitation and general advertisement.
1 Note that the fact that all purchasers are, in fact, accredited investors does not satisfy the conditions of the rule if the issuer does not, in fact, take reasonable steps to verify that the investors are accredited.
2 The $1 million does not include the value of the primary residence, but debt secured by the primary residence is also not included as a liability, except to the extent that it exceeds the value of the residence by which it is secured or it was increased in the 60 days prior to the investment.
3 Section 4(a)(2) was re-designated from Section 4(2) of the Securities Act of 1933 pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act.
4 Note that offerings under Section 4(a)(2) (as opposed to those under a rule promulgated under Section 4(a)(2)) are not exempt from “blue sky” laws. There is also some uncertainty regarding so-called “Section 4(1½)” transfers because of the SEC’s statements regarding the applicability of Section 4(a)(2) when the issuer engages in general solicitation.
5 CFTC Regulation 4.7 permits commodity pool operators who “offer or sell” interests in their commodity pools only to persons who satisfy the criteria to be “qualified eligible persons” in an offering that qualifies for the Section 4(a)(2) exemption from registration or Regulation S to have reduced disclosure, reporting and recordkeeping requirements.
6 CFTC Regulation 4.13(a)(3) requires interests in the pool for which a commodity pool operator exemption is claimed to be “offered and sold without marketing to the public in the United States.”
7 Participation in the offering “would have to be more than transitory or incidental involvement and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.” See SEC Release 33-9414 (July 10, 2013) (the “Bad Actor Adopting Release”), text at notes 47 to 48.
8 The SEC stated that it “intend[s] that the term should be applied based on whether securityholders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right. For example, we would consider that securities that confer to securityholders the right to elect or remove the directors or equivalent controlling persons of the issuer, or to approve significant transactions such as acquisitions, dispositions or financings, would be considered voting securities for purposes of the rule. Conversely, securities that confer voting rights limited solely to approval of changes to the rights and preferences of the class would not be considered voting securities for purposes of the rule.” See the Bad Actor Adopting Release, text at note 62. Any beneficial ownership would be calculated on a consolidated basis, based on the total voting power, as opposed to a class-by-class basis.
9 The term “investment manager” is meant to be broader than the term “investment adviser” as defined in the Investment Advisers Act of 1940. The term “pooled investment fund” includes not only private funds, but also commodity pools and other entities formed for the purpose of collective investment.
10 Neither the release nor the rule attempt to reconcile the limitations regarding presenting performance under the Investment Advisers Act of 1940 and the related no-action letters applicable to registered investment advisers and the language in the required legends and Rule 156.
11 For example, the SEC has brought an enforcement action against a fund that failed to disclose the effect of unusually high initial public offering proceeds that were unlikely to recur and that emphasized past-quarter returns when the returns for the current ongoing quarter were significantly worse.