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by Laura Anthony, Esq.

New SEC Rules Have Eliminated the Prohibition Against General Solicitation and Advertising in Rules 506 and 144A Offerings

In a historic 4-1 vote on July 10, 2013, the SEC has adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act.  On the same day, the SEC adopted amendments to Rule 506 to disqualify “felons and bad actors” from participating in Rule 506 offerings.  This blog discusses the rules eliminating the prohibition against general solicitation and advertising.  A separate blog will discuss the felon and bad actor disqualifications.

The SEC has also adopted modifications to Form D to require Issuers to specify if they are conducting an offering that permits general solicitation and advertising and to change the required time of filing the Form D for such offerings.  Finally, also on July 10, 2013, the SEC issued proposed rules amending Regulation D, Form D and Rule 156 and requested comments on such proposed amendments.  A separate blog will also discuss those proposed changes.  The entire text of the final and proposed rule releases is available on the SEC website.

Background

Title II of the JOBS Act requires the SEC to amend Rule 506 of Regulation D to permit general solicitation and advertising in offerings under Rule 506, provided that all purchasers of the securities are accredited investors.  The JOBS Act calls for the same amendment to Rule 144A provided all purchasers are qualified institutional buyers (QIB).  In both cases, the JOBS Act requires that the rules require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors or QIBs as the case may be, using such methods as determined by the SEC.  Most of the pre-rulemaking comments and commentary by the public and advocacy groups centered on what steps and methods would be required by the SEC to verify purchaser qualification.

Rule 506 is a safe harbor promulgated under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act of 1933, exempting transaction by an issuer not involving a public offering.  In a Rule 506 offering an issuer can sell an unlimited amount of securities to accredited investors and up to 35 unaccredited sophisticated investors.  The standard to determine whether an investor is accredited has historically been the reasonable belief of the issuer.  Currently, Rule 506 offerings must abide by certain general conditions set forth in Rule 502, including Rule 502(c), which prohibits general solicitation and advertising. 

Presently, Rule 144A does not explicitly prohibit general solicitation and advertising but it does limit all offers of securities to QIBs, which has the same practical effect.  Section 5 of the Securities Act of 1933 (the registration requirement) as well as most of the exemptions and safe harbor exemptions regulate both the offers and sales of securities.  As further brief background on Rule 144A, it is noted that technically Rule 144A is not an Issuer’s exemption, but rather is a safe harbor for the resale of restricted securities to QIBs, much as Rule 144 is a safe harbor for the resale of restricted securities generally.  However, since its passage in 1990, market participants have used Rule 144A as a means of raising capital for issuers by engaging in a Regulation S offering followed by the immediate resale of such securities to QIBs in reliance on Rule 144A.  This method of raising capital  has become widely known as a Rule 144A Offering.

The Amendment to Rule 506

The SEC has adopted a new Rule 506(c) which permits the use of general solicitation and advertising to offer and sell securities under Rule 506 provided that the following conditions are met:

1.            the issuer takes reasonable steps to verify that the purchasers are accredited;

2.            all purchasers of securities must be accredited investors, either because they come within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and

3.            all terms and conditions of Rule 501 and Rules 502(a) and (d) must be satisfied.   

Rule 501 sets out definitions, including the definition of accredited investors.  Rule 502(a) is the integration rule providing a six-month safe harbor from integration for successive Regulation D offerings and setting out a five-factor fact test analysis which can be used if the six-month rule is not available.  Rule 502(d) provides that securities sold in Regulation D offerings (with certain Rule 504 exceptions) are restricted under Rule 144.

The new Rule 506(c), unlike the proposed rule published August 29, 2012, includes a non-exclusive list of methods that issuers may use to verify that investors are accredited.

The current Rule 506 will also remain in place.  Accordingly, an issuer that does not wish to engage in general solicitation and advertising can rely on the old Rule 506 and offer and sell to up to 35 unaccredited sophisticated investors.  An issuer opting to rely on the old Rule 506 does not have to take any additional steps to verify that a purchaser is accredited.  Both the old 506 and new 506(c) offerings are deemed to be federally covered securities and accordingly the offering provisions preempt state law.

Reasonable Steps to Verify Accredited Investor Status

In its proposed rule issued in August 2012, the SEC declines to define what actions suffice as reasonable steps to verify accredited investor status or in fact that such steps would be necessary in every case.    However, in response to numerous comments on the issue, the SEC final rule requires that an Issuer take reasonable steps to verify that purchasers are accredited.  Moreover, the SEC included a non-exclusive list of methods that issuers may use to satisfy the verification requirement.  Note that the verification requirement is separate from the requirement that all investors in fact be accredited. 

According to the SEC, “whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction.”  Among the factors that issuers should consider under the fact and circumstance analysis are:

a.            The nature of the purchaser and type of accredited investor they claim to be.  For instance, if the purchaser is claiming that they are accredited because they are a broker dealer registered with the SEC, verification could be a simple check on the FINRA website.  Of course, the hardest status to verify will be natural persons claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements.  Accordingly, as set forth below, the SEC final rule sets forth non-exclusive methods that issuers may use to satisfy the verification requirement.

b.            The amount and type of information that the issuer has about the purchaser.  Clearly, the more information, the better.  The SEC lists the obvious (W-2; tax returns; letters from a bank or broker dealer).  Moreover, although not required, it is assumed that an issuer should at least conduct a check of publicly available information. 

c.             Nature and terms of the offering, such as type of solicitation and minimum investment requirements.  The example proffered by the SEC is an offering conducted by soliciting preapproved accredited investor lists from a reasonably reliable third party, vs. open-air solicitation via social media or television or radio advertising—the latter, of course, requiring greater verification than the former.  The SEC highlights the obvious, such as that the higher the minimum investment required, the fewer steps an issuer would need to take to verify accreditation. 

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, and vice versa. Moreover, where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.

The more information an Issuer has evidencing that a prospective purchaser is accredited, the fewer additional steps it will have to take to verify the status, and vice versa.  Examples of the type of information that Issuers can review and rely upon include:

                 (i)            Publicly available information in filings with federal, state and local regulatory bodies (for example: Exchange Act reports; public property records; public recorded documents such as deeds and mortgages)

                (ii)           Third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms

                (iii)          Third-party accredited investor verification service providers

 Regardless of the methods an issuer uses to verify accredited status, they should keep adequate and complete records.  If the exemption is challenged, the burden is on the issuer to prove that under the facts and circumstances of their particular offering, they took reasonable steps to verify and they reasonably believed that an investor was accredited at the time of the sale.  However, although the rules do not address the issue, the SEC is cognizant of the privacy concerns raised by having issuers obtain and maintain personal financial records from investors. 

 Non-Exclusive Methods that Issuers May Use to Satisfy the Verification Requirement

 The SEC included four specific non-exclusive methods of verifying accredited investor status for natural persons which, if used, will be deemed to satisfy the verification requirements as long as the Issuer does not have actual knowledge that the purchaser is not accredited.  Issuers are not required to use these methods of verification and can rely on their own reasonableness standard directed to the specific facts and circumstances. The non-exclusive methods of verification include:

                 aa.          Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year.  If such forms and information are joint with a spouse, the written representation must be from both spouses.

                 bb.         Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed.  For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit report from a nationwide agency. 

                 cc.           Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.

                 dd.         A written certification verifying accredited investor status from existing accredited investors of the Issuer that have previously invested in a 506 offering with the same Issuer. 

 Reasonable Belief that all Purchasers are Accredited Investors

In addition to requiring that an issuer take reasonable steps to verify that accredited investor status, the new Rule 506(c) requires that an issuer have a reasonable belief that all purchasers are accredited investors.   Current Rule 506 requires that the issuer have a reasonable belief that investors are accredited, and the SEC desires to continue this standard with the new Rule 506(c).  In particular, the reasonable belief standard ensures that the exemption will not be lost if an issuer takes reasonable steps to verify accredited status and reasonably believes that an investor is accredited, but later learns that such investor was not, in fact, accredited.

Form D Amendment

A Form D is the notice of an offering of securities conducted without registration under the Securities Act in reliance on Regulation D.  Form D has been amended to add a new check box for 506(c) offerings.  A Form D must be filed within 15 days after the first sale of securities in the offering. 

Specific Issues for Hedge Funds

Private funds include hedge funds, private equity funds and other types of pooled investment vehicles that are excluded from the definition of “investment company” under the Investment Company Act of 1940 under either section 3(c)(1) or 3(c)(7).  Section 3(c)(1) is available to a fund that does not publicly offer its securities and has 100 or fewer beneficial owners of its securities.  Section 3(c)(7) is available to a fund that does not publicly offer its securities and limits the owners of its securities to qualified investors.

Section 201(b) of the JOBS Act provides that offers and sales exempt under the new Rule 506(c) shall not be deemed public offerings under the federal securities laws as a result of general advertising or general solicitation. Private funds may engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.

The SEC rule release specifically reminds hedge funds of the anti-fraud provisions under the Advisors Act, including that it is a fraudulent, deceptive and manipulative act for an advisor to “make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading , to any investor or prospective investor in the pooled investment vehicle; or (2) otherwise engage in any act, practice or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.”

The SEC further noted that through its proposed rule releases and general duties, it will monitor the activity of hedge funds conducting general solicitation and advertising and amend rules in the future as necessary.

Amendment to Rule 144A

The JOBS Act directs the SEC to revise Rule 144A to provide that securities may be offered to persons other than QIBs, including by means of general solicitation and advertising, provided that securities are only sold to persons that the seller reasonably believes is a QIB.  Taking the most direct and simplest route, the SEC has proposed to simply remove the terms “offer” and “offeree” to the existing Rule 144A such that only sales are limited to QIBs.  As Rule 144A does not prohibit general solicitation, open offers have the effect of allowing such general solicitation. 

Integration with Offshore Offerings

Regulation S provides a safe harbor for offers and sales of securities outside the United States.   A condition of Regulation S is that there can be no directed selling efforts in the United States.  Many practitioners have been concerned that the new general solicitation rules would de facto eliminate the ability to engage in concurrent Rule 144A or 506 and Regulation S offerings.  However, the SEC notes that Regulation S, by its terms, does not integrate with either registered or “domestic offerings that satisfy the requirements for an exemption from registration under the Securities Act.”  Since general solicitation under the new Rule 506(c) or Rule 144A would satisfy the requirements of a US exemption, the SEC will not view concurrent offerings under Rule 506(c) and/or Rule 144A and Regulation S as integrating such as to destroy the Regulation S exemption. 

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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