On Wednesday, July 10, 2013, the U.S. Securities and Exchange Commission (SEC) adopted amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933, as amended (Securities Act), to permit general solicitation and general advertising in certain securities offerings, as required by Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act).
The amendments to Rule 506 permits an issuer to engage in general solicitation or general advertising in offering and selling securities pursuant to Rule 506, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors. The amendments to Rule 506 also includes a non-exclusive list of methods that issuers may use to satisfy the verification requirement for purchasers who are natural persons, and includes provisions to disqualify issuers and other market participants from relying on Rule 506 if “felons and other ‘bad actors’” are participating in the Rule 506 offering.
The amendment to Rule 144A provides that securities may be offered pursuant to Rule 144A to persons other than qualified institutional buyers (QIBs), provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs.
In addition, the SEC proposed amendments to Regulation D, Form D and Rule 156 under the Securities Act that are intended to enhance the SEC’s ability to evaluate the development of market practices in Rule 506 offerings.
Lifting General Solicitation Ban for New Rule 506(c) Offerings
The SEC added a new paragraph (c) to Rule 506 of Regulation D to enable an issuer to use general solicitation and general advertising to offer and sell securities, provided the issuer satisfies each of the following conditions of this new exemption:
- all of the terms and conditions in Rule 501(definitions), Rule 502(a) (integration) and 502(d) (resale restrictions) are satisfied;
- all of the purchasers of the securities are accredited investors; and
- the issuer takes reasonable steps to verify that the purchasers are accredited investors.
Whether an issuer’s steps taken to verify accredited investor status are “reasonable” depends on the particular facts and circumstances of each purchaser and the transaction. The SEC provided the following factors that issuers should consider under this facts and circumstances analysis:
- 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 issuer has about the purchaser; and
- the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
Issuers relying on Rule 506(c) for their offerings will not be subject to the prohibition against general solicitation found in Rule 502(c). The existing provisions of Rule 506, continue as a separate exemption under Rule 506(b), so that issuers conducting Rule 506 offerings without the use of general solicitation and general advertising are exempt from the new verification rule, and can continue to conduct their offerings in the same manner as was permitted pursuant to prior offering practices under Rule 506.
Non-Exclusive Methods of Verifying Accredited Investor Status of Natural Persons
The risk of participation by non-accredited investors is highest in offerings involving natural persons as purchasers. As a result, the SEC included four specific non-exclusive, non-mandatory methods of verifying accredited investor status for natural persons under Rule 506(c), which, if used, are deemed to satisfy the verification requirement.
If basing the decision on net income, the issuer:
- reviews any Internal Revenue Service form that reports a person’s income for the two most recent years; and
- obtains a written representation that the person reasonably expects to reach the income level required to qualify as an accredited investor in the current year.
If basing the decision on net worth, the issuer:
- reviews one or more types of documents dated within the past three months, including bank statements, brokerage statements, certificates of deposit, tax assessments, and for liabilities, a credit report from at least one of the national consumer reporting agencies; and
- obtains a written representation that the person has disclosed all liabilities necessary to make a net worth determination.
The issuer obtains a written representation from a third party (a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant) that they have taken reasonable steps to verify the person’s accredited investor status within the past three months and have determined that the person is an accredited investor.
With respect to an existing securityholder who had acquired the issuer’s securities in a previous Rule 506 offering and had qualified as an accredited investor at that time, the issuer obtains a certification from the securityholder that confirms his or her accredited investor status at the time of the sale.
General Solicitation to be Permitted in All Rule 144A Transactions
Pursuant to Section 201(a)(2) of the JOBS Act, the SEC revised Rule 144A to permit securities to be offered under Rule 144A to persons other than QIBs, including by use of general solicitation or general advertising, if those securities are actually sold only to investors which the seller and any person acting on behalf of the seller reasonably believe is a QIB. The SEC also amended Regulation M to reflect and conform with the changes to Rule 144A.
Disqualifying Felons and Bad Actors in Rule 506 Offerings
The SEC adopted amendments to Rule 506 of Regulation D that disqualify securities offerings based on the safe harbor provided by Rule 506 if any felons or other bad actors are involved in the offering, as required by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the new Rule 506(d), the Rule 506 exemption will not be available for an offering if any “person” covered by the rule was involved in a "disqualifying event."
Persons covered by Rule 506(d) include:
- The issuer and any predecessor of the issuer or affiliated issuer.
- Any director, executive officer, or other officer participating in the offering, general partner or managing member of the issuer.
- If the issuer is a pooled investment fund, its investment managers, the general partners and managing members of the investment managers.
- Any beneficial owner of 20 percent or more of the issuer's outstanding voting equity.
- Any promoter connected with the issuer in any capacity at the time of sale.
- Any person that has been or will be compensated for soliciting investors, as well as the general partners, directors, certain officers and managing members of any compensated solicitor.
Under Rule 506(d), “disqualifying events” include the following:
- Criminal convictions (felony or misdemeanor) entered within five years before the proposed offering in the case of issuers (or ten years, in the case of other covered persons) or court injunctions or restraining orders entered within five years before the proposed offering:
- in connection with the purchase or sale of a security;
- in connection with making a false filing with the SEC; or
- arising out of the conduct of the business of certain types of financial intermediaries.
Final orders issued by state banking, credit union, and insurance regulators, federal banking regulators, the Commodity Futures Trading Commission (CFTC) and the National Credit Union Administration (NCUA) that bar the covered person from:
- associating with the regulated entity issuing the order;
- engaging in the business of securities, insurance or banking; or
- engaging in savings association or credit union activities.
Final orders issued by state banking, credit union, and insurance regulators and federal banking regulators, the CFTC or the NCUA within ten years before the proposed offering that are based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct.
Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons, which would be disqualifying for as long as the order is in effect.
SEC cease-and-desist orders arising out of any scienter-based anti-fraud violation or violation of Section 5 of the Securities Act.
Suspension or expulsion from membership in a self-regulatory organization, which would be disqualifying for the period of suspension or expulsion.
SEC stop orders applicable to a registration statement and orders suspending the Regulation A exemption for an offering statement issued within five years before the proposed offering.
US Postal Service false representation orders entered within five years before the proposed offering.
Disqualification events that occurred prior to the effective date of the new rules will not be subject to the disqualification rules. However, under Rule 506(e), the issuer must provide written disclosure to investors of any disqualifying events that occurred before the effective date of the new rules.
The new rule also provides for a reasonable care exception from disqualification that applies if an issuer can prove that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.
The amendments to Rule 506 of Regulation D and Rule 144A of the Securities Act become effective 60 days after publication in the Federal Register.
Proposed Amendments to Regulation D, Form D and Rule 156
In addition to the aforementioned final amendments, the SEC proposed the following amendments that are designed to provide information on the Rule 506 market once general solicitation is permitted and offer additional investor protection safeguards.
Issuers relying on new Rule 506(c) would have to:
- File a Form D no later than 15 days before first engaging in general solicitation.
- File a closing amendment to Form D within 30 days after the offering has been completed or abandoned.
- Disclose additional information in the Form D (including the types of general solicitation used or to be used and the methods used or to be used to verify the accredited investor status of purchasers).
The SEC also proposed an amendment that would disqualify an issuer that failed to file any required Form D reports in the past five years from using any provision of Rule 506 for a future offering. This disqualification would end one year after all required Form D filings were made.
The SEC proposed to add a new Rule 509 that would require prescribed legends in any written materials used for general solicitation in a Rule 506(c) offering. In addition, the SEC proposed a new Rule 510T that would require issuers to submit any general solicitation materials to the SEC by no later than the date of first use of the materials. This new Rule 510T would expire two years after its effective date and the submitted materials would not be made publicly available.
Under proposed amendments to Rule 156, which interprets the antifraud provisions of the federal securities laws in connection with sales literature used by investment companies, the anti-fraud guidance in Rule 156 would also apply to the sales literature of all private funds.
 The existing Rule 506(b) exemption allows issuers to sell privately to up to thirty-five (35) non-accredited investors who meet existing Rule 506’s sophistication requirements.
 Natural persons may be accredited investors provided that either (i) their individual net worth (or joint net worth with that person’s spouse), exceeds $1 million, excluding the value of the person’s primary residence, or (ii) their individual annual income has exceeded $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 such person has a reasonable expectation of reaching the same income level in the current year.
 Prior to this amendment, Rule 144A prohibited offers to non-QIBs, which would likely be violated by any kind of general solicitation or general advertising in connection with the offering.