The Securities and Exchange Commission (the “SEC”) has adopted amendments to Rule 506 of Regulation D (“Rule 506”) and Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”) to permit issuers to engage in general solicitation or general advertising in connection with: (i) private offerings under newly added Rule 506(c), provided all purchasers are accredited investors; and (ii) offerings made pursuant to Rule 144A, provided the securities are sold only to persons reasonably believed to be qualified institutional buyers.1 These changes will take effect on September 23, 2013 (the “Effective Date”).2 This memorandum discusses Rule 506(c), the related changes to Form D and the amendment to Rule 144A, and highlights certain issues that issuers should consider prior to engaging in general solicitation or general advertising.
In a companion release, the SEC adopted amendments to disqualify securities offerings involving certain “bad actors” from relying on Rule 506. This means that even offerings without any general solicitation or general advertising under the current Rule 506 may be disqualified.3 Further, in another companion release, the SEC proposed certain other related amendments to Regulation D, Form D and Rule 156 of the Securities Act, which would impose significant additional obligations on issuers electing to engage in general solicitation or general advertising. The adopted amendments and the proposed amendments should be considered together, as each is related to the changing regulatory landscape affecting private offerings made under Rule 506.
A. Background
Rule 506 is a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act, which exempts transactions by an issuer “not involving any public offering” from registration under the Securities Act. An issuer may currently sell securities under Rule 506 to an unlimited number of accredited investors and no more than 35 non-accredited sophisticated investors, subject to certain conditions. Most significantly, Rule 506 currently prohibits the issuer (and persons acting for the issuer) from offering or selling securities through any form of “general solicitation” or “general advertising.”4 The SEC has historically interpreted the prohibition on general solicitation to require an issuer to only offer securities to persons with whom the issuer (or persons acting on behalf of the issuer) has a pre-existing substantive business relationship.
Rule 506(c) will permit an issuer to engage in general solicitation or general advertising, provided that it (i) makes sales only to accredited investors,5 (ii) takes reasonable steps to verify that the purchasers are accredited investors, and (iii) otherwise complies with the applicable requirements of Regulation D.
B. Transition Provisions
For ongoing offerings that commenced before the Effective Date, an issuer may elect to continue the offering in accordance with either the existing Rule 506(b) or the new Rule 506(c). If an issuer elects to use Rule 506(c), the general solicitation or general advertising that it conducts after the Effective Date will not affect the exempt status of offers and sales of securities that occurred prior to the Effective Date in reliance on Rule 506(b). Accordingly, the verification condition will not apply to any purchasers who acquired securities prior to the Effective Date.6
After the Effective Date, an issuer may continue to rely on Rule 506(b), and remain subject to the prohibition against general solicitation and general advertising, but cannot elect to rely on both Rule 506(b) and Rule 506(c) for the same offering.7
C. Reasonable Steps to Verify that Purchasers are Accredited Investors
The SEC explained in the Adopting Release that the verification requirement included in Rule 506(c) is intended to reduce the risk that general solicitation or general advertising will result in sales to purchasers that are not accredited investors. The SEC indicated that issuers must determine what constitutes reasonable steps to verify accredited investor status on a case-by-case basis using a “principles-based” or facts and circumstances approach. Accordingly, the issuer (or those acting on its behalf) must make an objective determination in each case taking into account the particular facts and circumstances pertaining to each purchaser and each transaction. The SEC further indicated that after considering the facts and circumstances associated with the purchaser and the transaction, the more likely it appears that the purchaser is an accredited investor, the fewer steps an issuer would have to take to verify accredited investor status.
As stated in the Adopting Release, factors that issuers should consider under the facts and circumstances analysis include:
1. Investor Type. The nature of the purchaser and the type of accredited investor the purchaser claims to be based on:
(a) Status. Some purchasers will be accredited investors based on their status (e.g., for a registered broker or dealer, which is defined as an accredited investor, the verification requirement could be satisfied by checking the entity’s status on the Financial Industry Regulatory Authority’s publicly available BrokerCheck website).
(b) Status and Total Assets. Other purchasers may be accredited investors based on a combination of their status and the amount of their total assets (e.g., for state pension plans with total assets in excess of $5 million, which is defined as an accredited investor, the verification requirement could be satisfied by checking a government website that posts the plan’s net asset value, etc.).
(c) Annual Income and Net Worth. For natural persons, accredited investor status is determined on the basis of annual income or net worth.8
2. Amount and Type of Information About the Purchaser. Examples of the types of information issuers may rely on include:
(a) Publicly Available Information. Filings with a federal, state or local regulatory body (e.g., executive officer compensation information listed in an SEC filing or assets of a tax exempt entity listed on Form 990).
(b) Reliable Third Party Information.
(i) Information about a person’s compensation (e.g., pay stubs for the two most recent years and current year).
(ii) An issuer will be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification. Accordingly, the issuer must take reasonable steps, which may vary depending on the type of third party providing the verification, to determine that such third party’s verification process is reliable.
3. Nature and Terms of the Offering.
(a) Manner of Solicitation. An issuer that solicits new investors through a website accessible to the general public, through a widely disseminated email or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits investors through less “public” means.
(b) Terms of the Offering. If the terms of an offering require a high minimum investment amount and the purchaser is able to meet the minimum, it may be reasonable for the issuer to take no additional steps to verify such purchaser’s accredited investor status other than to confirm that the purchaser’s cash investment is not financed by a third party.
The requirement under Rule 506(c) that an issuer must take “reasonable steps to verify” that the purchasers of the offered securities are accredited investors is an affirmative obligation, independent of the requirement that sales be limited to accredited investors. As such, an issuer that fails to take reasonable steps to verify each purchaser’s accredited investor status will not satisfy Rule 506(c) even if each purchaser is in fact an accredited investor. The SEC also stated that an issuer will not be deemed to have taken reasonable steps to verify accredited investor status if it only required that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status
D. Non-Exclusive Verification Methods for Natural Persons
The SEC stated that the potential for uncertainty and the risk that non-accredited investors will seek to participate in Rule 506(c) offerings is highest for natural persons. Accordingly, Rule 506(c) sets forth four non-exclusive “safe harbor” methods for verifying accredited investor status for natural persons. An issuer that uses these methods is deemed to satisfy the verification requirement of Rule 506(c), provided the issuer does not have knowledge that the purchaser is not an accredited investor.
1. Income Test
(a) a review of copies of any Internal Revenue Service form that reports income, including, without limitation:
(i) a Form W-2 (“Wage and Tax Statement”);
(ii) Form 1099 (report of various types of income);
(iii) Schedule K-1 of Form 1065 (“Partner’s Share of Income, Deductions, Credits, etc.”);
(iv) a copy of a filed Form 1040 (“U.S. Individual Income Tax Return”) for the two most recent years;
and
(b) a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
2. Net Worth Test
(a) a review of the following types of documentation of net worth:
(i) for assets: bank, brokerage or other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties; and
(ii) for liabilities: a consumer/credit report from at least one of the nationwide consumer reporting agencies;
(b) if dated within the prior three months; and
(c) supplemented by a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed, is deemed sufficient.
3. Third Party Confirmation
(a) a written confirmation from one of the following persons or entities:
(i) a registered broker-dealer;
(ii) a SEC registered investment adviser;
(iii) a licensed attorney; or
(iv) a certified public accountant
(b) that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor.
4. Existing Natural Person Investors. With respect to any natural person who invested in an issuer’s Rule 506(b) offering as an accredited investor prior to the Effective Date that makes a subsequent investment in a Rule 506(c) offering by the same issuer (i.e., the same private fund), obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.
E. Failure to Comply with Rule 506(c)
An issuer that engages in general solicitation or general advertising in reliance on Rule 506(c), but fails to comply with all requirements under the Rule would be unable to rely on the statutory exemption for a private offering under Section 4(a)(2) of the Securities Act. As a result, the issuer would be in violation of the registration requirement of the Securities Act, which could entitle investors in the issuer to rescission rights and could also create additional regulatory exposure
F. Commodity Futures Trading Commission (“CFTC”) Implications
Many issuers, including private investment funds, CLOs and CDOs, rely on an exemption from commodity pool operator (“CPO”) registration under the Commodity Exchange Act, as amended (the “CEA”). Rule 4.13(a)(3) under the CEA, which prohibits “marketing to the public,” provides an exemption where commodity interest trading is limited (de minimis), pool participants are sophisticated and pool interests are not marketed to the public in the U.S. Many registered CPOs rely on Rule 4.7 under the CEA, which provides an exemption from certain disclosure, reporting and record-keeping provisions of the CEA. Until the CFTC issues new rules removing the prohibition on “marketing to the public” or otherwise harmonizes its exemptions with Rule 506(c), it is unclear whether advisers managing pools that rely on the aforementioned exemptions will be able to simultaneously rely on Rule 506(c).9
G. Form D and State “Blue Sky” Notice Filings
The SEC has amended Form D to require an issuer conducting a Rule 506(c) offering to indicate that it is relying on the Rule 506(c) exemption.
The Securities Act generally prohibits states from applying their securities registration requirements to securities issued under Rule 506; however, state securities regulators may require issuers relying on Rule 506 to submit notice filings on Form D. Issuers often rely on state level exemptions to avoid making notice filings. Since state exemptions from such notice filing requirements often apply only to securities offered without any general solicitation or advertising, an issuer relying on Rule 506(c) will need to determine whether any additional state notice filings will be required.
H. Amendment to Rule 144A
The SEC revised Rule 144A to permit offers of securities to persons other than qualified institutional buyers (“QIBs”), including by means of general solicitation or general advertising, 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. Accordingly, amended Rule 144A(d)(1) eliminates references to “offer” and “offeree,” and only requires that the securities be sold to a QIB or a purchaser that the seller and any person acting on behalf of the seller reasonably believe is a QIB.
For an ongoing Rule 144A offering that commenced before the Effective Date, the offering may be conducted following the Effective Date using general solicitation without affecting the availability of Rule 144A for the portion of the offering that occurred prior to the Effective Date.
I. Proposed Amendments to Regulation D, Form D and Rule 156
Simultaneously with the adoption of Rule 506(c), the SEC proposed a number of additional amendments to Regulation D, Form D and Rule 156. When evaluating whether to conduct an offering in reliance on Rule 506(c), issuers should consider the proposed amendments that, if adopted, will apply to Rule 506(c) offerings. These proposed amendments would: (i) require the filing of a Form D in Rule 506(c) offerings 15 days before the issuer engages in general solicitation or general advertising; (ii) prohibit an issuer from relying on Rule 506 for certain future offerings if it fails to file a Form D for a prior offering;10 (iii) require an issuer to include certain legends and other disclosures in all written general solicitation and general advertising materials used in a Rule 506(c) offering; (iv) require the submission, on a temporary basis, of written general solicitation materials used in Rule 506(c) offerings to the SEC; and (v) require an issuer to disclose on Form D in Rule 506(c) offerings (a) each person who directly or indirectly controls the issuer, (b) each type of general solicitation and general advertising used and (c) each method used to verify that the purchasers are accredited investors.
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If you have any questions concerning this memorandum, please contact an attorney at Seward & Kissel LLP.
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1 See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Securities Act Release No. 9415. 78 Fed. Reg. 44771 (July 24, 2013) (the “Adopting Release”).
2 The amendments were required by Section 201(a) of the Jumpstart Our Business Startups Act (the “JOBS Act”).
3 Please see Seward & Kissel’s Memorandum entitled “SEC Adopts Rules Disqualifying Certain Regulation D Offerings Involving Bad Actors” for more detailed information.
4 General solicitation and general advertising, as interpreted by the SEC, broadly includes, among other activities, cold calling, advertisements published in most newspapers and magazines, communications broadcast over or appearances on television or radio, and seminars whose attendees have been invited through such general solicitation or general advertising. Further, the SEC has stated that other uses of publicly available media, such as unrestricted websites or certain uses of social media, also constitute general solicitation and general advertising.
5 Generally, an accredited investor is a natural person with a net worth that exceeds $1 million or income in each of the two most recent years that exceeds $200,000 ($300,000 for married couples) with the reasonable expectation of obtaining that level of income in the current year, an entity that has total assets in excess of $5 million or an entity in which all of the equity owners are accredited investors.
6 However, the verification condition would apply to any existing investor that elects to make additional purchases after the Effective Date, unless the purchaser is a natural person who invested as an accredited investor, in which case the verification safe harbor under Rule 506(c) for natural persons would apply.
7 The Adopting Release also reaffirmed that an offshore offering conducted in compliance with Regulation S (which prohibits directed selling efforts in the United States) will not be integrated with unregistered U.S. offerings conducted in compliance with Rule 506 (or Rule 144A). Additionally, the Adopting Release affirmed that the effect of Section 201(b) of the JOBS Act is to permit issuers that are private funds to engage in general solicitation or general advertising in compliance with Rule 506(c) without losing the exclusions under Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act of 1940, as amended, which are relied on by private investment funds.
8 The SEC has indicated that verification of accredited investor status of natural persons may pose greater practical difficulties compared to other categories of accredited investors. As further discussed below, Rule 506(c) includes a “safe harbor” for natural persons to address this concern.
9 The Managed Funds Association submitted a letter “Harmonization of Compliance Obligations and the Jumpstart Our Business Startups Act and CFTC Regulations” (July 17, 2012) to the CFTC seeking clarification.
10 In addition, the SEC did not propose, but requested comment on, conditioning the availability of Rule 506 on filing the Form D (i.e., whether issuers who fail to file a required Form D should lose the exemption).
