On July 10, 2013, by a 4-1 vote, the Securities and Exchange Commission (the “SEC”) adopted amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 (the “Securities Act”).1 These amendments, which were required by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”),2 eliminate, subject to certain conditions, the 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 amendments adopted, which are substantially similar to those proposed by the SEC in August 2012,3 will significantly change the environment in which issuers of all types, from emerging growth companies to structured finance vehicles, can raise investor capital without making a public offering registered under the Securities Act. These amendments will become effective 60 days after publication of the General Solicitation Adopting Release in the Federal Register.
At the same time, in a 3-2 vote, the SEC proposed an additional package of amendments to Regulation D, Form D and Rule 156 under the Securities Act.4 Among other things, for Rule 506 offerings involving general solicitation, the proposed amendments would:
Comments on the proposed additional amendments are due 60 days after publication of the Additional Amendments Proposing Release in the Federal Register.
General Solicitation Amendments
Eliminating General Solicitation Restrictions under Rule 506
Currently, it is a requirement of most private placement exemptions from the registration requirements of the Securities 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”5 when conducting an unregistered offering of their securities. This restriction generally is interpreted broadly to prohibit, 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.
The amendments add to Rule 506 a new paragraph (c), which permits the use of general solicitation in connection with an offering of securities under Rule 506, provided that:
When Rule 506(c) becomes effective, an issuer may engage in all forms of general solicitation in a Rule 506 offering, so long as it complies with these conditions.
The SEC also is amending Form D to add a check box for issuers to indicate whether they are relying on Rule 506(c). The SEC noted that this would give it an opportunity to monitor the use of general solicitation in private offerings and would assist it in evaluating the effectiveness of different accredited investor verification practices.
Confirming that Rule 144A Does Not Restrict General Solicitation
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 General Solicitation Proposing 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. As adopted, the amendment to Rule 144A eliminates 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 its behalf reasonably believes are QIBs.
“Reasonable Steps to Verify” Accredited Investor Status — Principles-Based Approach
Rule 506(c)(2)(ii) requires an issuer that engages in general solicitation to take “reasonable steps to verify” that the purchasers of its securities are accredited investors. According to the General Solicitation Adopting Release, the verification condition is a principles-based condition that requires the issuer to make an “objective determination…in the context of the particular facts and circumstances of each purchaser and transaction” that the steps taken to verify a purchaser’s accredited investor status are reasonable.7
Under the principles-based approach, the SEC reiterated 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:
In the General Solicitation Adopting Release, 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 investor is an accredited investor. In addition, the SEC observed that “[i]f an issuer has actual knowledge that the purchaser is an accredited investor, then the issuer will not have to take any steps at all.”8 Regardless of the particular steps taken, the SEC cautioned that it is important for issuers to retain adequate records that document the steps taken to verify that a purchaser is an accredited investor.
The SEC “[does] not believe that an issuer will have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.”9 Thus, the common practice wherein each prospective investor completes a qualification questionnaire certifying its accredited investor status will not by itself satisfy the “reasonable steps” standard imposed by the SEC for Rule 506(c) offerings, at least for retail investors.
“Reasonable Steps to Verify” Accredited Investor Status — Non-Exclusive List of Methods
In the General Solicitation Adopting Release, the SEC, acknowledging concerns that verification of accredited investor status with respect to natural persons poses greater practical difficulties compared to other types of investors, responded to commenters’ calls for specific guidance on what steps the SEC would consider reasonable. Therefore, the SEC adopted four non-exclusive verification methods that are deemed to satisfy the required “reasonable steps” standard for natural persons (so long as the issuer or a person acting on its behalf does not have knowledge that a potential investor is not an accredited investor10):
Verifying QIB Status in a Rule 144A Offering
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 alone would not be sufficient to constitute reasonable steps to verify accredited investor status in a Rule 506(c). Depending upon how an issuer determines to make use of general solicitation in Rule 144A offerings, the SEC’s qualification guidance in the General Solicitation Adopting Release may result in greater attention being paid to verification of investors’ QIB status in Rule 144A offerings.
Continued Availability of Rule 506(b) and Preservation of “Reasonable Belief” Standard
Private issuers that do not wish to avail themselves of the opportunity to engage in general solicitation may continue to offer their securities in reliance on the existing safe harbor under Rule 506(b). If an issuer does not engage in general solicitation, it will not be required to take reasonable steps to verify that all of its purchasers are accredited investors. However, once a general solicitation has been made to potential investors in an offering, the issuer is precluded from relying on Rule 506(b).
In addition, in the General Solicitation Adopting Release, the SEC reiterated its position that the “reasonable belief” standard in the definition of accredited investor is unchanged by the amendment to Rule 506. According to the SEC, as long as an issuer takes reasonable steps to verify that a purchaser is an accredited investor and has a reasonable belief that the purchaser is an accredited investor, the issuer would not lose the ability to rely on proposed Rule 506(c) if it is later discovered that the purchaser was not in fact an accredited investor.
3(c)(1) and 3(c)(7) Funds
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 General Solicitation Adopting Release the SEC makes it clear that privately offered funds that rely on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”) will 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 SEC also reminds investment advisers of the application of the antifraud provisions of Rule 206(4)-8 under the Investment Advisers Act of 1940 (the “Advisers Act”). The SEC does not indicate, however, whether the SEC will view an investment adviser to a private fund that conducts an offering under Rule 506(c) as not holding itself out as an investment adviser, which is an important condition required in order to take advantage of certain limited exemptions from registration with the SEC as an investment adviser, such as the foreign private adviser exemption. In addition, advisers that are registered with the SEC must continue to comply with rules relating to advertising under the Advisers Act.
Because Title II of the JOBS Act only applies to “Federal securities laws,” it is unclear how offerings under proposed Rule 506(c) will impact the availability of certain exemptions under the rules of the Commodity Futures Trading Commission (the “CFTC”), including the exemptions from registration as a commodity pool operator under CFTC Rule 4.13(a)(3). This exemption requires that interests in each pool with respect to which the exemption is claimed be “offered and sold without marketing to the public in the United States.” Similarly, an investment adviser that is registered with the CFTC as a commodity pool operator or commodity trading adviser should bear in mind that irrespective of the SEC’s rulemaking, such advisers will be subject to the CFTC’s rules relating to advertising.
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 amendments will permit the use of a much broader array of marketing tools to be used in connection with these types of private offerings.
At least for Rule 144A offerings, these changes also will 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 amendments will eradicate these issues in connection with Rule 144A offerings. For Rule 506(c) offering, this benefit may be significantly limited by some of the additional proposals (e.g., legending and advance Form D filing requirements).
Rule 506 is a non-exclusive “safe harbor” from the registration requirements of the Securities Act under the exemption contained in Section 4(a)(2) (formerly Section 4(2)) of the Securities Act. However, the elimination of the prohibition on general solicitation applies only to private offerings made in reliance on the Rule 506 safe harbor, not to private offerings made under Section 4(a)(2), under the so-called “private resale” exemption, or under any other registration exemption other than Rule 144A. Currently, many private offerings to institutional investors are made “side by side” to QIBs under Rule 144A and to institutional accredited investors under the private resale exemption. Issuers that wish to make similar side-by-side offerings and make use of general solicitation or advertising may need to structure the accredited institutional investor portion of their offerings to qualify for the safe harbor of Rule 506(c).
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 General Solicitation Adopting Release, the SEC reiterated its view 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.
Broker-Dealer Registration ExemptionIn addition to mandating the elimination of the prohibition on general solicitation from Rule 506 and Rule 144A, the JOBS Act also provides that for securities offered and sold in compliance with Rule 506, no person is required to register as broker-dealer under the Securities Exchange Act of 1934, solely because:
There are three conditions to a person’s reliance on this exemption:
On February 5, 2013, the staff of the SEC’s Division of Trading and Markets released a set of FAQs regarding this exemption from broker-dealer registration.11 Among other things, the staff confirmed that:
Proposed Additional Amendments
In her opening statement, SEC Chair Mary Jo White indicated that she believes the SEC should “take steps to pursue additional investor safeguards if and where such measures become necessary once the ban on general solicitation is lifted.”11 Accordingly, over the strong dissent of Commissioners Paredes and Gallagher, who expressed the belief that the proposals would undermine the JOBS Act and impede capital formation, the SEC proposed a package of additional amendments to Regulation D, Form D and Rule 156 under the Securities Act. If adopted, the proposed amendments would:
Timing and Content of Form D Filings
In order to facilitate efforts to evaluate the use of Rule 506(c), the SEC has proposed to amend Rule 503 to require any issuer that seeks to rely on Rule 506(c) to file a Form D at least 15 calendar days prior to beginning any general solicitation with respect to the offering (an “Advance Form D”). The information required in an Advance Form D would be a subset of the information generally required on Form D, including identifying information about the issuer and its related persons, information on the type of security to be offered, information about persons receiving sales compensation, and information on the use of proceeds from the offering. An issuer would not need to have a specific offering in mind to file an Advance Form D if it simply wishes to retain the flexibility to conduct an offering and engage in general solicitation. The issuer would be required to file an amendment providing the remaining information required by Form D within 15 calendar days after the first sale of the securities, as is currently required by Rule 503, unless the Advance Form D contained complete information.
For Rule 506(b) offerings, the requirement of Rule 503 to file a Form D within 15 calendar days after the first sale of the securities would remain unchanged.
In addition, the proposed amendments would require the filing of a final amendment to Form D within 30 calendar days after the termination (i.e. after the final sale in the offering or upon the issuer’s determination to abandon the offering) of any Rule 506 offering, whether conducted under Rule 506(b) or Rule 506(c). The SEC’s stated objective for this proposed filing requirement is to gather more complete information about the size and characteristics of the Rule 506 offering market. The SEC notes that until a closing Form D amendment is filed, the offering will be deemed to be ongoing and the issuer will be subject to the existing requirements to file amendments to Form D at least annually and otherwise as needed to reflect changes in previously filed information and to correct material mistakes and errors. A closing Form D amendment will not be required if the issuer included all information required by Form D in an earlier Form D filing and checked the “closing filing” box.
The SEC also proposes to amend Form D to expand the information it requires. The additional information that would be required under the proposed amendments to the Form includes:
In addition, the current option to “Decline to Disclose” issuer size (in terms of revenues for an operating company, or net asset value for a private fund) would be revised to “Not Available to Public.” Therefore, an issuer would only be permitted to select this option if it does not otherwise make this information public (e.g., in its general solicitation materials). As amended Form D would also include separate fields for indicating if a filing is an Advance Form D or closing Form D amendment.
Amendments Relating to Content of Written General Solicitation Materials
Proposed Rule 509 would require issuers conducting a Rule 506(c) offering to include certain legends in any written general solicitation materials. These legends could be combined into a single sentence and modified as long as the wording used clearly communicates the required information. The legends proposed by the SEC are that:
Private funds also would be required to include a legend that the securities offered are not subject to the protections of the Investment Company Act. Additional disclosures required to be included in a private fund’s solicitation materials that include performance data are:
In addition to proposed new Rule 509, the SEC has proposed to amend existing Rule 156. Rule 156 is an interpretative rule that provides guidance to investment companies with respect to application of the antifraud provisions of the federal securities act in connection with the use of sales literature. The SEC proposes to amend Rule 156 to apply to private funds, so that these funds will consider the principles underlying Rule 156 in their communications with, and solicitations of, investors.
Finally, and again with a view toward a comprehensive analysis of the impact of lifting the general solicitation, the SEC has proposed a temporary rule requiring issuers relying on Rule 506(c) to submit their general solicitation materials to the SEC. These materials would be submitted via a website link and would not be publicly available. This temporary rule would expire two years after its effective date.
While the filing of Form D is required for Rule 506 offerings, and the failure to file subjects the issuer to possible SEC enforcement action, it does not result in the loss of the exemption. Rule 507 under Regulation D currently provides for the disqualification of an issuer from relying on Regulation D only if the issuer (or a predecessor or affiliate) has been enjoined by a court for violating the filing requirements in Rule 503. In an effort to improve Form D filing compliance, the SEC has proposed to add much more stringent disqualification provisions to Regulation D.
The SEC proposes to automatically disqualify an issuer from relying on Rule 506 if the issuer (or a predecessor or affiliate) did not comply, within the past five years, with the Form D filing requirements for a Rule 506 offering. The disqualification would apply to any new offering for a period of one year from the date that all required Form D filings of the issuer have been made, or if the offering for which the issuer was delinquent has terminated, following the filing of a closing amendment. The disqualification provision would apply only to new offerings, so the offering in which the failure to comply occurs would not lose its exemption. In addition, issuers would not be required to look back beyond the effective date of new Rule 507(b). Amended Rule 507 would also include a 30 day cure period for an issuer’s first failure to make a Form D filing on a timely basis with respect to a particular offering, and would allow the SEC to grant waivers upon a showing of good cause.
According to the SEC, this disqualification provision should provide issuers and their related persons with the incentive to comply with Rule 503 and make timely and complete Form D filings, without imposing the type of disproportionate penalty that could arise if compliance with Rule 503 were made a condition to reliance on Rule 506.
The legend requirements for general solicitation materials, and the temporary SEC submission requirements for such materials, would not be a condition of the Rule 506(c) exemption from registration. Instead, Rule 507 would be amended so that Rule 506 in its entirety would be unavailable for an issuer if it (or a predecessor or affiliate) is subject to any order, judgment or court decree enjoining such person for failure to comply with these requirements. The SEC noted that its proposals treat noncompliance with the Form D filing requirements (which results in automatic disqualification) differently from noncompliance with the disclosure and content requirements under proposed Rule 509 (which results in disqualification only if the noncompliance ultimately leads to an order, judgment or court decree). The SEC stated that it believes an automatic disqualification provision could result in disproportionate consequences for inadvertent errors or omissions, particularly given the large volume of written communications that issuers may be expected to use during the course of a Rule 506(c) offering. The SEC did not, however, foreclose the possibility that it may reconsider this position after assessing the level of compliance with Rule 509 once it is in effect.
Additional Requests for Comment
In addition to these proposals, the SEC also has requested comment on a wide variety of related matters, including whether additional content restrictions should be imposed on general solicitation materials used by private funds, and whether amendments to the existing accredited investor standards should be made. While noting that its ability to amend the definition of the “accredited investor” standard for natural persons is in some ways constrained by statute, the SEC agreed with the commenters who suggested that the definition should be reviewed. The SEC requested comment on whether the net worth and annual income tests are appropriate for ascertaining that an investor has sufficient knowledge and experience in business and financial matters, and if so, whether the current fixed thresholds are appropriate or whether percentage-based thresholds would be more appropriate.
The elimination of the restrictions on general solicitation in Rule 506(c) and Rule 144A offerings relying is expected to have a significant impact on the way that private placements are marketed. The amended rule presents the opportunity for issuers to reach potential investors beyond their traditional networks and to increase their name recognition and prominence. Issuers and their advisers should bear in mind that the opportunity comes with increased responsibilities for due diligence with respect to verification of the accredited investor status of potential investors, as well as continued compliance with other regulations, including under the Advisers Act and the rules promulgated by the CFTC. The SEC clearly intends to closely monitor the impact of lifting the ban on general solicitation. The proposed additional amendments would significantly increase the regulatory burden associated with Rule 506(c) offerings and, if they are adopted as proposed, many issuers probably would forego general solicitation and abide by the current restrictions on Rule 506(b) offerings. Issuers will need to assess these potential costs as they consider their alternatives under this new private placement regime.
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. Nos. 33-9415, 34-69959, available at http://www.sec.gov/rules/final/2013/33-9415.pdf (the “General Solicitation Adopting Release”).
2 The JOBS Act is available at http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf. Our client alert regarding the JOBS Act is available at http://www.bingham.com/Alerts/2012/04/JOBS-Act-Congress-Attempts-to-Reduce-Regulatory-Burdens-on-IPOS-and-Private-Offerings.
3 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Rel. No. 33-9354, 77 Fed. Reg. 54464 (Sept. 5, 2012), available at http://www.gpo.gov/fdsys/pkg/FR-2012-09-05/pdf/2012-21681.pdf (the “General Solicitation Proposing Release”). Our alert discussing the General Solicitation Proposing Release is available at http://www.bingham.com/Alerts/2012/08/SEC-Proposed-Amendments-to-Rule-506-to-Permit-General-Solicitation-and-General-Advertising.
4 Amendments to Regulation D, Form D and Rule 156 under the Securities Act, SEC Rel. Nos. 33-9416, 34-69960, available at http://www.sec.gov/rules/proposed/2013/33-9416.pdf (the “Additional Amendments Adopting Release”).
5 In this Alert, we refer to both general solicitation and general advertising as “general solicitation.”
6 Rule 501 contains definitions of the terms used throughout Regulation D, including the term, “accredited investor.” For purposes of determining whether the conditions of a Regulation D safe harbor are met, Rule 502(a) requires the integration of all offerings by an issuer that occur within six months of each other. Rule 502(d) imposes limitations on the resale of securities acquired in a transaction under Regulation D.
7 General Solicitation Adopting Release, at 27.
8 General Solicitation Adopting Release at 21, n. 111.
9 General Solicitation Adopting Release, at 33-34.
10 The SEC notes that “[b]ecause an issuer must have a reasonable belief that the purchaser is an accredited investor, the issuer could not form such reasonable belief if it has knowledge that the purchaser is not an accredited investor.” General Solicitation Adopting Release at 36, n. 116.
11Jumpstart Our Business Startups Act Frequently Asked Questions About the Exemption from Broker-Dealer Registration In Title II of the JOBS Act, available at http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-registration-jobs-act-faq.htm.
12 Statement of Chairman Mary Jo White on July 10, 2013, available at http://www.sec.gov/news/speech/2013/spch071013mjw.htm.
This article was originally published by Bingham McCutchen LLP.