On August 29, 2012, the Securities and Exchange Commission (the “SEC”) proposed several amendments (the “Release”) to Regulation D and Rule 144A under the Securities Act of 1933. If adopted, these amendments will significantly change the environment in which issuers of securities, including issuers of asset-backed securities and other structured finance products, can raise investor capital without making a public offering registered under the Securities Act. In particular, the proposed amendments to Rule 506 of Regulation D under the Securities Act would eliminate, subject to certain conditions, the existing prohibition on general solicitation and general advertising in Rule 506, and clarify that there is no ban on general solicitation in offerings made pursuant to Rule 144A.
The proposed rules were adopted by a divided Commission in a 4-1 vote. While voting for the proposal, Chairman Schapiro and Commissioner Walter recognized that there are credible investor protection concerns about the impact of lifting the ban on general solicitation. Commissioner Aguilar voted against the proposal for this reason. On the other hand, while Commissioners Paredes and Gallagher voted in favor of the proposal, both noted that they would have preferred the SEC to adopt an interim final rule, allowing issuers to take advantage of the favorable changes now, while the SEC solicited comment on whether those changes should be revised.
Eliminating General Solicitation Restrictions
Currently, it is a requirement of most private placement exemptions from the registration requirements of the 1933 Act, including Rule 506 and (in the view of the staff of the SEC) Rule 144A, that issuers may not use “any form of general solicitation or general advertising” when conducting an unregistered offering of their securities. This restriction is generally interpreted broadly and prohibits, among other things, the use of publicly available websites, media broadcasts (such as radio and television advertisements), mass email campaigns, and/or public seminars or meetings as part of an issuer’s capital raising activities. Title II of the Jumpstart Our Business Startups Act requires the SEC to eliminate these restrictions in offerings made under Rule 506 and Rule 144A.
To implement this requirement, the SEC’s proposal would amend Rule 506 by adding Rule 506(c), which would permit the use of general solicitation in connection with an offering of securities, provided that (i) all purchasers of securities in such offering are “accredited investors,” as defined in Rule 501(a) of Regulation D, (ii) the issuer in such offering takes reasonable steps to verify that all purchasers of the securities are accredited investors, and (iii) all terms and conditions of Rule 501 and Rules 502(a) and 502(d) are satisfied.
Rule 144A provides a safe harbor exemption from registration under the Securities Act for resales of certain restricted securities, if they are offered and sold solely to “qualified institutional buyers” (“QIBs”), as defined in Rule 144A(a)(1). Although technically Rule 144A is a resale exemption, it is most often used for institutional private placements, particularly of debt securities and asset-backed securities, made through a financial intermediary acting as “initial purchaser.” While a prohibition on general solicitation is not explicit in the language of the rule, the SEC staff has long taken the position that there can be no general solicitation in Rule 144A offerings. According to the Release, this prohibition is implicit because Rule 144A safe harbor is only available if the restricted securities are both offered and sold only to QIBs and a general solicitation would be tantamount to making offers to non-QIBs. The SEC’s proposed amendment to Rule 144A would eliminate the references to “offer” and “offeree,” enabling 144A securities to be offered to persons other than QIBs, including by means of general solicitation, so long as they are actually sold only to persons that the seller and any person acting on behalf of the seller reasonably believes is a QIB.
“Reasonable Steps to Verify”
Proposed Rule 506(c) requires that an issuer that engages in general solicitation must take “reasonable steps” to verify that the purchasers of its securities are accredited investors. Although the Release contains some guidance about the “reasonable steps” that an issuer should take to verify that the purchasers of its securities are accredited investors, the SEC expressly declined to propose specific methods of verification that it would deem reasonable. The Release states that whether the steps actually taken by an issuer in this regard are reasonable would be “an objective determination, based on the particular facts and circumstances of each transaction.” The Release provides that issuers should consider a number of factors to determine the reasonableness of the steps to verify that a purchaser is an accredited investor, including:
The SEC stated that these factors are interconnected and the information gained by looking at these factors would help an issuer assess the reasonable likelihood that a potential purchaser is an accredited investor. Regardless of the particular steps taken, it would be important for issuers to retain adequate records that document the steps taken to verify that a purchaser is an accredited investor. The SEC declined to provide uniform verification methods, in part because doing so might be ill-suited or unnecessary to a particular offering or purchaser. Instead, the SEC expects that issuers and market participants will have the flexibility to adopt different approaches to verification depending on their particular circumstances and to adapt to changing market practices and implement innovative ways to meet the verification requirements, such as the development of third party databases of accredited investors.
Currently, it is common practice in many Rule 506 offerings, particularly offerings that include individual offerees, for each prospective investor to complete a qualification questionnaire in which the investor certifies, among other things, that it is, and exactly why it is, an accredited investor. While the SEC states that many current practices in Rule 506 offerings could satisfy the verification requirements of proposed Rule 506(c), issuers and their advisers should note that, depending on all the facts and circumstances, this practice by itself may not constitute sufficient reasonable steps toward verifying the investor’s accredited status for purposes of Rule 506(c).
As acknowledged by the SEC in the Release, Rule 144A already requires the buyer to be a QIB or for the seller to have a reasonable belief that the buyer is a QIB. Rule 144A already contains a shorter list of non-exclusive methods by which an “offeror” might establish some of the factors required to determine whether a prospective investor is a QIB. While the guidance that the SEC has provided in the Release as to the steps that are reasonable for an issuer to take to verify that all purchasers are accredited investors is not directly applicable to QIBs under Rule 144A, it may be viewed as instructive. In Rule 144A offerings, including many offerings of asset-backed securities, it is not an uncommon practice for the issuer to require an investor to make only a simple representation that it is a QIB, rather than requiring detailed backup for that assertion. As described above, the SEC believes that such an approach would not be sufficient in a Rule 506(c) offering where investors were located through a public website, email blast or social media rather than through a broker-dealer’s database of pre-screened accredited investors. Depending upon how an issuer determines to make use of general solicitation in Rule 144A offerings, the SEC’s qualification guidance in the Release may result in greater attention being paid to verification of investors’ QIB status in Rule 144A offerings.
Preservation of “Reasonable Belief” Standard and Continued Availability of Rule 506(b)
In the Release, the SEC attempted to alleviate the concerns expressed by some commenters that language in Title II of the JOBS Act could be interpreted as precluding the use of a “reasonable belief” standard in the definition of accredited investor for purposes of the new Rule 506(c). The SEC confirmed that the definition of accredited investor is unchanged by the amendment to Rule 506, and that so long as an issuer takes reasonable steps to verify that a purchaser is an accredited investor and has a reasonable belief that such purchaser is an accredited investor, the issuer would not lose the ability to rely on proposed Rule 506(c) if it was later discovered that the purchaser was not in fact an accredited investor.
In addition, the Release confirms the continued availability of the existing safe harbor under Rule 506(b) whereby an issuer may offer and sell securities, without any limitation on the offering amount, to an unlimited number of accredited investors and up to 35 non-accredited investors who meet certain “sophistication requirements.” The availability of this safe harbor is subject to a number of requirements and is conditioned on the issuer or any person acting on its behalf, not offering or selling securities through any form of general solicitation. Issuers relying on Rule 506(b) will therefore not become subject to the new requirement to take reasonable steps to verify that all of their purchasers are accredited investors. The SEC indicated in the Release that it did not wish to deprive issuers that (i) do not want to engage in general solicitation in connection with their offerings of securities, and/or (ii) want to sell their securities privately to purchasers that are not accredited investors, but who meet Rule 506(b)’s sophistication requirements, of this important source of capital.
Amendment to Form D
The SEC is also proposing a revision to Form D, which is a notice filing made in connection with an offering of securities that is not registered under the Securities Act in reliance on an exemption provided by Regulation D. The SEC has proposed to add a check box to Form D where issuers will indicate whether they are claiming an exemption under Rule 506(c). The SEC noted that this would give the SEC an opportunity to monitor the use of general solicitation in private offerings and would assist the SEC in evaluating the effectiveness of different accredited investor verification practices.
New Marketing Tools, Greater Certainty of Permitted Communications
The prohibition on general solicitation in Rule 506 and Rule 144A offerings has restricted the use of advertising, newspaper or magazine articles; public Internet websites; media broadcasts; mass email campaigns; and public seminars or meetings to sell the offering. By eliminating the prohibition on general solicitation in two of the most widely used private placement exemptions, the proposed rules would permit the use of a much broader array of marketing tools to be used in connection with these types of private offerings.
These changes also would eliminate a variety of fine distinctions that have bedeviled issuers and securities practitioners alike. For example, the difference between a communication that impermissibly “conditions the market” for the securities, and is therefore a prohibited general solicitation, and ordinary course factual communications for the benefit of customers, employees and existing shareholders, is often unclear. Inadvertent communications that are determined after the fact to have crossed the line can delay or disrupt a private offering. The proposed rules should eradicate these issues in connection with Rule 506(c) and Rule 144A offerings.
Rule 506 is a non-exclusive “safe harbor” from the registration requirements under the Securities Act under the exemption contained in Section 4(a)(2) (formerly Section 4(2)) of the Securities Act. However, the proposed elimination of the prohibition on general solicitation would apply only to private offerings made in reliance on the Rule 506 safe harbor, not to private offerings made under Section 4(a)(2). Currently, many private offerings to institutional investors are made “side by side” to QIBs under Rule 144A and to institutional accredited investors under Section 4(a)(2). In the future, issuers that wish to make similar side-by-side offerings and make use of general solicitation or advertising would need to structure the accredited institutional investor portion of their offerings to qualify on the safe harbor of Rule 506(c), rather than relying solely on the statutory exemption in Section 4(a)(2).
Regulation S is a safe harbor for offers and sales of securities made outside the United States. One requirement of a Regulation S offering is that there can be no “directed selling efforts” in the United States, a concept that is quite similar to general solicitation. Many private offerings are made side by side to the U.S. domestic market under Rule 144A or Rule 506 and offshore in reliance on Regulation S. In the Release, the SEC has confirmed that concurrent Regulation S and Rule 144A/Rule 506 offerings would not be integrated so that the use of general solicitation in the Rule 144A/Rule 506 component of such an offering would not preclude reliance on Regulation S for the offshore component of the transaction.
Effect on Investment Company Act Exemptions
The JOBS Act provides that offers and sales under Rule 506 “shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.” Accordingly, in the Release the SEC made it clear that “privately offered funds” that rely on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 would be able to engage in general solicitation in a Rule 506 offering without losing their ability to continue to rely on Section 3(c)(1) or 3(c)(7). In many Rule 144A offerings of asset-backed securities, the issuing trust relies on Section 3(c)(1) or Section 3(c)(7) for its exemption from Investment Company Act registration. Based on the SEC’s guidance, the use of general solicitation in such an offering should not impede the ability of the issuing trust to rely on these exemptions.
The proposed elimination of the restrictions on general solicitation in offerings relying on the exemptions in Rule 506 and Rule 144A is expected to have a significant impact on the way that private placements are marketed. The changes to these rules would present the opportunity for issuers to reach potential investors beyond their traditional networks and to increase their name recognition and prominence on a broader scale. Issuers and their advisers should bear in mind, however, that the opportunity may come with an increased responsibilities for due diligence with respect to verification of the accredited investor or QIB status of potential investors.
Comments on the proposed amendments must be submitted within 30 days of their publication in the Federal Register, which is expected imminently. While one of the commissioners expressed his desire for the amendments to become effective before the end of the year, it is not certain exactly when that will happen. Until final rules are adopted, issuers and persons acting on their behalf should not engage in any general solicitation in connection with Rule 506 or Rule 144A offerings.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Sweet-Charles
1 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Rel. No. 33-9354, available at http://www.sec.gov/rules/proposed/2012/33-9354.pdf.
2 In this Alert, we refer to both general solicitation and general advertising as “general solicitation.”