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SEC Lifts Ban On General Solicitation for Some Private Placements; Proposes Additional Safeguards

Michael Andresino, David Barbash, Thomas Brennan July 29, 2013

On July 10, 2013, the SEC adopted two new long awaited rules implementing a 2012 JOBS Act requirement lifting the ban on general solicitation and general advertising in certain private securities offerings and disqualifying felons and other bad actors from participating in certain securities offerings as required under the 2010 Dodd Frank Act.  Additionally, in connection with lifting of the ban on general solicitation and general advertising, the SEC voted 3-2 to approve a new rule proposal that the SEC believes will provide additional safeguards for investors and better enable the SEC to monitor the Rule 506 private placement market.

Eliminating the Ban on General Solicitation in Certain Rule 506 Offerings

Rule 506 is a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act that exempts offers and sales of securities by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act.  Under Rule 506, an issuer could sell an unlimited amount of securities to an unlimited number of “accredited investors” and (with extra disclosures) to no more than 35 sophisticated non-accredited investors.  The availability of the Rule 506 exemption was subject to a number of requirements, which included a ban on “general solicitation and general advertising.”

In order to improve capital formation for early-stage companies, the JOBS Act required the SEC to reverse this ban.  In response, the SEC has added a new paragraph (c) under Rule 506 that allows general solicitation and general advertisement if all purchasers in the offering are “accredited” and the issuer takes reasonable steps to verify that such purchasers are “accredited”.  The SEC has stated that whether an issuer has taken “reasonable steps” to verify accredited investor status would be an objective determination by the issuer in the context of the particular facts and circumstances of each purchaser and transaction.  Some of the factors that the issuer should consider in this principal based approach to verify the purchaser’s status as “accredited” include: (i) the nature of the purchaser and type of “accredited” investor that the purchaser claims to be, (ii) the amount and type of information that the issuer has about the purchaser, and (iii) the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as the minimum investment.  

Responding to concerns raised during the rule making process, the SEC adopted a non-exclusive and non-mandatory list of methods that an issuer may use to satisfy the verification requirements for individual investors.  An issuer will be deemed to have taken “reasonable steps” in qualifying an individual investor as “accredited” under the income test by reviewing IRS forms (W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) that report the income of the purchaser for the past two fiscal years and a written representation that the purchaser has a reasonable expectation or reaching the necessary income in the current year. “Reasonable steps” under the net worth portion of the accredited investor test could be demonstrated by reviewing certain documents that are no more than three months old to determine assets and liabilities, including  bank statements, brokerage statements and other third party statements of securities holdings, certificates of deposits, tax assessments, appraisal reports issued by independent third parties, a consumer report from a nationwide consumer reporting agency and a statement from the individual that all liabilities have been disclosed.   In addition, an issuer may also rely upon written confirmation from a registered broker, an SEC registered investment adviser, a licensed attorney, or a certified public accountant that such entity or person has taken “reasonable steps” to verify a purchaser’s “accredited” status within the last three months and has determined that such person is “accredited”.  For persons who purchased securities from the issuer in a Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c), the same issuer may obtain a certification by such person at the time of sale stating he or she qualifies as an accredited investor.

The addition of Rule 506(c) does not amend, modify or impose any new requirements on offers and sales of securities under Rule 506 that do not involve general solicitation, and does not alter the existing reasonable belief requirement with respect for accredited investors in qualifying for Rule 506 exemption.  The old form of raising capital under Rule 506 remains available to issuers and is now codified under Rule 506(b).  For those issuers that either do not wish to engage in general solicitation, or who wish to sell to non-accredited investors, this exemption remains a valuable capital raising tool.

The Form D will contain a box for the issuer to check if it is relying on Rule 506(c).  The final rule is effective sixty days from its publication date in the federal register.

Disqualification of Issuers from Rule 506 Offerings Involving Bad Actors 

Section 926 of the Dodd-Frank Act required the SEC to adopt rules to disqualify certain securities offerings from reliance on Rule 506 of Regulation D that involve felons and other “bad actors.”  The SEC’s initial rule proposal was published on May 25, 2011.   Under new Rule 506(d), the Rule 506 exemption will not be available to an issuer that involves any of the following “covered persons” in their Rule 506 offering who has been involved in a disqualifying event: 

  • the issuer and any predecessor or affiliated issuer;
    any director, executive officer, general partner or managing member of the issuer;
    any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of total voting power;
  • any investment manager of issuer that is a pooled investment fund, and any of its directors, executive officers, other officers participating in the offering, and any general partner or managing member of such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;
  • any promoter connected with the issuer in any capacity at the time of sale;
  • any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering, any of its directors, executive officers, or other officers participating in the offering, and any general partner or managing member of such solicitor, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member.

A disqualifying event includes felony or misdemeanor convictions within ten years before the sale of the security (five years for issuers) in connection with sales or purchases of securities or false filings with the SEC, judgments or orders entered into within the past five years before such sale that at the time of such sale restricts or enjoins a person from engaging in the purchase and sale of a security or conducting business as an underwriter or broker, orders from state securities or banking commissions and the CFTC that at the time of such sale bars such person from engaging in the business of securities, insurance or banking, or has filed (as registrant or issuer) or was named as an underwriter in a registration statement filed with the SEC that within five years before the sale of the security was subject to a refusal or stop order.

The new “bad actor” rules apply only to triggering events occurring after effectiveness of the new Rule 506(d), with pre-existing events subject to mandatory disclosure to investors.  Additionally, the “bad actor” provisions will not taint the issuer for events related to an affiliated issuer that occurred before the affiliation arose if the affiliated issuer is (i) not in control of the issuer, or (ii) under common control with the issuer by a third party that was not in control of the affiliated issuer at the time of such disqualifying events.

The final rule includes an exception to disqualification from Rule 506 offerings if the issuer can establish that it did not know, and in the exercise of reasonable care, could not have known that a disqualification existed because of the presence of a “covered person”.  An issuer will not be able to establish reasonable care unless it has made a factual inquiry into whether any disqualification existed.  The steps an issuer must take to establish reasonable care will vary according to the particular facts and circumstances of the issuer, its covered persons and the offering.

The Form D signature page will contain a certification that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(d).  The final rule is effective sixty days after publication in the federal register.

Proposed Additional Safeguards for Private Placements

The SEC anticipates that the lifting of the ban on general solicitation will have a significant impact on Rule 506 offerings and current capital raising practices.  As a result of this change, issuers will be able to reach a greater number of potential investors, increasing their access to capital, while investors will have access to a larger and more diverse pool of investment opportunities.  In light of the significance of these changes and the concerns they raise, the SEC has proposed a number of amendments to Rule 506 aimed at improving compliance with Form D filing requirements, expanding the information requirements of Form D, primarily with respect to 506 offerings, and on a temporary basis, requiring the filing of written solicitation material used in Rule 506(c) offerings with the SEC.

With respect to the Form D filing, the SEC is proposing to require the Form D to be filed no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering, and, in any Rule 506 offering, the filing of a closing amendment within 30 calendar days after the termination of the offering.    The Form D is also being revised to require additional information from issuers to enable the SEC to gain market information on Rule 506 practices.  Some of the new requested information only applies to Rule 506(c) offerings, whereas other information requests would apply to all Rule 506 offerings.  

More importantly, the SEC is proposing to disqualify issuers from relying on Rule 506 for one year for future offerings if the issuer, or any predecessor or affiliate of the issuer did not timely comply within the last five years with all the Form D filing requirements in a Rule 506 offering. An initial Form D, and any amendment, including any closing amendment, will be deemed timely filed for purposes of the disqualification rule if filed not later than 30 calendar days after the due date for filing specified in the rule, unless the issuer previously failed to comply with a filing deadline in connection with the same offering. The failure to file a Form D is still not a condition to the 506 offering exemption, as the SEC was reluctant to impose a sanction that would require the loss of the private placement exemption, giving purchasers rescission rights and losing the status of a “covered security” for blue sky pre-emption.  Rather, the failure to timely file will affect the issuer’s future use of the Rule 506 exemption.  Additionally, as proposed, failures to comply with the timely filing requirement prior to the date the final rule is enacted will be disregarded.

To further ensure that prospective investors are sufficiently informed as to whether they can participate in offerings involving general solicitations, the SEC is also proposing that issuers use certain prescribed legends in any written communication that constitutes a general solicitation in any offering conducted in reliance on Rule 506(c).  These prescribed legends must be prominent in all written general solicitation materials.  The legends do not, however, relieve the issuer from the requirement to take “reasonable steps” to verify that a purchaser is accredited as discussed above.  Additionally, private funds would also be required to include a legend disclosing that the securities being offered are not subject to protections of the Investment Company Act of 1940.

Private funds relying on Rule 506(c) that include performance data in their written general solicitation material will also need to include a further additional legend that identifies either a telephone number or website where an investor may obtain current performance data and informing the investor that: 

  • the performance data presents past performance;
  • past performance does not guarantee future results;
  • current performance may be lower or higher than the performance data presented;
  • the private fund is not required by law to follow any standard methodology when calculating and representing performance data; and
  • the performance of the private fund may not be directly comparable to the performance of other funds.

Additionally all performance data must be of the most recent practicable date and the method used and the period for which performance is presented must be disclosed.  If the performance data does not include the deduction of fees and expenses, the private fund must disclose this and the fact that if fees and expenses are deducted the performance may be lower than presented.

The SEC is also amending Rule 156 under the Securities Act, which now interprets the antifraud provisions of the federal securities laws in connection with sales literature used by investment companies, to apply to private funds as well. 

Finally, for a period of two years following the effectiveness of the proposed rule, issuers will be required to submit any written general solicitation materials used in their Rule 506(c) offerings to the SEC no later than the date of first use of these materials.  The material will be submitted through an intake page, not the SEC’s EDGAR system, and will not generally be available to the public.

If you have any questions about this topic, please contact any of the following attorneys in our Securities Group: Thomas S. Brennan, Michael L. Andresino and David M. Barbash.

Client Advisory is provided for information purposes only, and does not constitute legal advice. According to Mass. SJC Rule 3:07, this material may be considered advertising. ©2013 Posternak Blankstein & Lund LLP. All rights reserved.

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