The Securities and Exchange Commission on Wednesday, July 10, issued final rules lifting the longstanding prohibition of general solicitation and general advertising in private offerings of securities conducted in reliance on Rule 506 of Regulation D under the Securities Act of 1933. The new rules, which take effect September 23, 2013, implement changes mandated by the Jumpstart Our Business Startups Act (the “JOBS Act”) of 2012. The changes are intended to make it easier for companies to raise money through exempt sales of securities to qualified “accredited investors” as defined in Regulation D. Companies that comply with the new rules will be able to promote their offerings using general solicitation and general advertising and sell to accredited investors that learn of the securities offering through these newly-permitted marketing avenues.
New Rule 506(c) for Offerings Using General Solicitation and General Advertising
For decades, Rule 506 has been the primary private-placement exemption for companies raising capital through securities sales to venture capitalists, angels and other private investors, and companies conducting Rule 506 offerings have been barred from offering or selling their securities by any form of general solicitation or general advertising. The new rules change the Rule 506 picture dramatically, giving companies the possibility of reaching many more accredited investors than they could before.
“General solicitation and general advertising” for purposes of Rule 506 includes articles, notices or other communications published in newspapers, magazines or similar media (including content of publicly-accessible websites), or broadcast over television and radio, as well as seminars or meetings whose attendees have been invited by any general solicitation or general advertising. Social media activities and “email blasts” are commonly also considered to be general solicitation.
The new rules require companies to verify that all purchasers are accredited investors, and will not be attractive or appropriate for every company or every offering. Companies that wish to can instead rely on Rule 506 as it exists today. Those making this choice will not be able to use general solicitation or general advertising and will not be required to comply with the new requirements for verifying accredited investor status. Under the new rules, SEC Form D will add a check box for filers to indicate if they are claiming the new Rule 506(c) exemption for their offering.
The meat of the new rules is new paragraph (c) of Rule 506. Securities sold in compliance with Rule 506(c) are excluded from the restriction against general solicitation and general advertising. Rule 506(c) requires that all purchasers of securities sold in the offering must be accredited investors, and that the company “take reasonable steps to verify that purchasers of securities sold” in the offering are accredited investors. For individual accredited investors, Rule 506(c) provides that the company will be deemed to have taken reasonable steps if it opts to use one of a number of enumerated “non-exclusive and nonmandatory” verification methods. Individuals may qualify as accredited investors on the basis of income or net worth, and non-exclusive verification methods are identified for each basis (see items 1 and 2 below). In addition, there are approved non-exclusive methods for verification by third parties (see item 3 below) and a special provision for existing securityholders of the company who purchased in reliance on Rule 506(b) (i.e., “old” Rule 506) prior to the effectiveness of new Rule 506(c) (see item 4 below).
1. Individual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000 in each of those years, with a reasonable expectation of reaching the same income level in the current year. The non-exclusive verification method is reviewing any Internal Revenue Service form that reports the purchaser’s income for the two most recent years(including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining 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. Individual net worth, or joint net worth with a spouse, in excess of $1,000,000. The non-exclusive verification method is reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
• With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
• With respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.
3. Third-party verification of accredited investor status. The non-exclusive verification method is obtaining written confirmation from one of the following persons or entities 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:
• A registered broker-dealer;
• An investment adviser registered with the SEC;
• A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
• A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.
4. An existing securityholder who purchased under Rule 506(b) as an accredited investor prior to the effectiveness of new Rule 506(c). The non-exclusive verification method is obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.
The new verification requirements are an important part of Rule 506(c) and the new scheme allowing general solicitation and general advertising. Under current Rule 506, companies can rely on investor-completed accredited investor representations or questionnaires. By contrast, to rely on new Rule 506(c), companies will need to become actively involved in the verification process on an investor-by-investor basis, which is likely to consume resources and staff time, and which could extend closing timelines in some cases while status verifications are completed. It will be critical for any company relying on Rule 506(c) to keep thorough records of how each purchaser’s accredited investor status was verified, because the offering exemption will fail if verification cannot be documented.
New “Bad Actor” Restrictions on the Availability of Rule 506
In a related rulemaking action on Wednesday, the SEC also promulgated new Rule 506(d), stating that the Rule 506 exemption is not available for sales of securities if the company, a predecessor company, an affiliated company, or a director, executive officer, other officer involved in the offering, general partner or managing member, 20% beneficial owner, or others involved in the offering, have a conviction or other official finding against them for a range of specified “bad acts” mostly relating to securities, banking and brokerage transgressions.
The “bad actor” rule was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, but in comments at the meeting adopting the rules released Wednesday, SEC Commissioners made clear that the “bad actor” exclusion is intended to protect against potential harms from opening up Rule 506 offerings to general solicitation and general advertising. Companies intending to use Rule 506—whether in its “old” form (Rule 506(b)) or taking advantage of newly available general solicitation avenues—will need to ensure that associated individuals and entities do not have any “bad actor” history that could deprive the company of the Rule 506 exemption. It appears, among other things, that companies will need to perform “bad actor” due diligence on major (20%) shareholders and others in order to make certain the companies are not inadvertently engaging in an unregistered sale of securities, as they could be if an unexpected “bad actor” issue deprives them of the Rule 506 exemption.
Proposed New Rules Impacting Rule 506 Offerings
Rounding out rulemaking action on Wednesday, the SEC proposed a number of new rules related to Rule 506 that, if adopted, could further impact companies seeking to rely on Rule 506(c) and pursue the general solicitation and general advertising it permits. A stated goal of the new proposed rules is to provide the SEC with information about how allowing companies to use general solicitation and general advertising in offerings is affecting the private securities market. Among the proposed rules:
• A requirement to file a report with the SEC on Form D at least 15 calendar days before commencing an offering involving general solicitation or general advertising;
• A requirement to file a final amendment to a Rule 506 offering’s Form D within 30 calendar days of completing the offering;
• Amendments to Form D to collect additional information about companies, offered securities, offering participants, use of proceeds and, for Rule 506(c) offerings, the types of solicitations and accredited-investor verification methods used;
• A provision—with a five-year look-back—disqualifying companies that fail to comply with Form D filing requirements from relying on the Rule 506 exemption until one year after all required Form D filings and amendments have been made;
• Required legends to be placed on all written general-solicitation and general-advertising materials, reminiscent of the legends now placed on the certificates for private-placement securities, and also mentioning investor qualifications, the risk of the investment and that investors should be able to bear the loss of the investment; and
• A temporary rule, expiring after two years, requiring companies to submit any written general solicitation or general advertising material to the SEC not later than the date of first use. Submissions would be made via an intake page on the SEC’s website and would not be publicly available.
In the same Release with the proposed rules, the SEC also requested public comment on several significant matters, including whether changes should be made to the definition of “accredited investor” and whether companies using new Rule 506(c) should be required to provide an investor with an offering document containing certain required information before completing any sale of Rule 506(c) securities to the investor.
These are major developments in the marketing of private securities offerings, probably representing the most significant changes in a generation to Regulation D and the private-securities-offering landscape in the United States. The Ashbaugh Beal Corporate/Securities Law Group has been following developments in these important rulemaking areas closely for our clients and friends and will continue to do so. The new final rules will—and the new proposed rules may—have significant and lasting impact for our clients, their fundraising efforts and compliance obligations. This blog will continue to cover important developments and considerations involving these rules, focusing on the practical opportunities and pitfalls they present.
If you have any questions about private placements of securities generally, the Regulation D offering process or the new rules permitting general solicitation and general advertising, please do not hesitate to contact Joe Campos, Matt Runkel or Aaron Thomson, all at 206-386-5900.