On July 10, 2013, the Securities and Exchange Commission adopted final rules that remove the longstanding prohibition on the use of general solicitations or general advertising (“general solicitations”) in certain private placements. New Rule 506(c), which implements the requirements of Section 201(a)(1) of the JOBS Act of 2012, will allow issuers making private placements under Rule 506 of Regulation D to broadly advertise their securities offerings to potential investors, provided they sell the securities only to accredited investors and take reasonable steps to verify that their purchasers genuinely are accredited investors. This is a major and welcome change for issuers that rely on private placements to raise money, such as startups, hedge funds, venture capital funds and private equity funds, because it will give them access to much wider groups of investors and much deeper pools of capital than they have available to them today.
At the same time, the SEC adopted new Rule 506(d), which disqualifies certain “bad actors” from participation in all Rule 506 private placements, and proposed for public comment rules that would expand issuers’ filing requirements for all Rule 506 offerings.
The Current Legal Framework for Private Placements
Issuers seeking to sell securities in the United States have historically had two routes under the federal securities laws:
- Transactions registered under the Securities Act of 1933, which allow solicitation of and sales to virtually any investor but are impracticable for many issuers because they are time-consuming and expensive and subject issuers to ongoing compliance and disclosure requirements.
- Private placements, which allow issuers to avoid the cost-prohibitive registration process but significantly limit the ways in which they can solicit investors.
As a practical matter, under the current legal framework issuers can generally privately place securities only to purchasers with whom they (or certain agents they employ) have existing relationships, and they cannot use the Internet to publicize their private placements. While these are significant limitations for all issuers, they place a particular burden on early-stage companies seeking a second or third round of funding. Earlier rounds may have exhausted the capital available from friends and family, and the issuers may not yet have grown enough to develop broader networks of potential investors.
New Rule 506(c)
Rule 506(c) permits issuers to make general solicitations for their private placements if they comply with two new conditions:
- All purchasers must be accredited investors.
- The issuer must take “reasonable steps” to verify that the purchasers are accredited investors.
“Accredited investor” is a term well known to participants in the private placement market, and Rule 506(c) does not change it. Accredited investors include institutions such as banks, broker-dealers and other financial institutions; corporations, partnerships, trusts and similar entities with total assets of more than $5 million; and natural persons who meet minimum income or net worth requirements.
As discussed more fully below, other private placement exemptions and safe harbors that permit sales to purchasers who are not accredited investors, such as Rule 506(b), remain available, but issuers generally will not be able to use these at the same time they are making a Rule 506(c) offering.
Rule 506(c) does not prescribe what constitutes reasonable steps to verify a purchaser’s status as an accredited investor. Instead, the related adopting release (the “Release”) explains that the issuer must make “an objective determination in the context of the particular facts and circumstances of each purchaser and transaction,” and cites three non-exclusive factors an issuer should consider in its analysis:
- The nature of the purchaser and the type of accredited investor it claims to be.
- The amount and type of information the issuer has about the purchaser.
- The nature of the offering, such as the manner of solicitation and the terms of the offering, including the minimum investment amount.
The Release includes extensive discussion and numerous examples of how an issuer should approach this analysis for different types of purchasers and transactions. Key examples of sources of information that would be sufficient “in and of themselves” include publicly available information, such as regulatory filings, and materials produced by independent third parties, such as pay stubs and bank statements. The Release also notes that the manner of the offering, such as whether the issuer makes a truly general solicitation through a newspaper advertisement or an open website, for example, or uses more targeted methods like approaching investors found through a pre-screened database, should affect the issuer’s verification process.
The Release acknowledges that verifying the accredited investor status of natural persons may “pose greater practical difficulties as compared to other categories of accredited investors.” To address these difficulties, Rule 506(c) offers four “non-exclusive and non-mandatory” methods of satisfying the verification requirement for natural persons:
- IRS forms that report income may be used to verify that a purchaser meets the minimum income requirement.
- Bank statements, tax assessments and third party appraisals may be used to verify the asset portion of the minimum net worth requirement, and a credit report from a national reporting agency may be used to verify the liability portion of the requirement.
- Written confirmation from a registered broker-dealer or investment advisor, a licensed attorney or a certified public accountant may be used to verify that the purchaser meets either requirement.
- Written certification from the purchaser may be used under certain circumstances if the purchaser has previously purchased securities from the issuer as an accredited investor pursuant to Rule 506(b).
In each case, these materials must be accompanied by appropriate confirmatory certifications from the purchaser. As the rule makes clear, none of these methods is required, and issuers are free to use other reasonable methods to verify their purchasers’ accredited investor status.
As is the case for all Rule 506 offerings, the terms and conditions of Rules 501, 502(a) and 502(d), including the integration provisions and resale restrictions discussed below, must be satisfied for Rule 506(c) offerings. Issuers making sales under Rule 506(c) will need to make appropriate Form D filings with the SEC, and they must indicate on the form that the sale is being made under Rule 506(c). Like other securities sold under Regulation D, securities sold under Rule 506(c) will be “restricted securities” and therefore will be subject to restrictions on resale under the federal securities laws. Like other securities sold under Rule 506, securities sold under Rule 506(c) will be “covered securities” for purposes of Section 18 of the Securities Act and therefore will not be subject to the substantive requirements of state blue sky laws.
Practical Considerations for Rule 506(c) Offerings
Rule 506(c) does not remove the prohibition on general solicitations for other private placement exemptions and safe harbors that permit sales to persons who are not accredited investors, and the integration provisions of Rule 502(a) apply to Rule 506(c) offerings. Accordingly, issuers generally will not be able to privately place securities to non-accredited investors at the same time that they are making a general solicitation in connection with a Rule 506(c) offering. How long the issuer will need to wait to make sales to non-accredited investors depends on a number of factors, but at a minimum, issuers should consult with counsel if they are considering privately placing securities to non-accredited investors during a Rule 506(c) offering or within six months of completion of one.
Offerings made under Rule 506(c) will be subject to the same antifraud provisions that cover other private placements, including Rule 10b-5 under the Securities Exchange Act of 1934. Accordingly, issuers will be subject to liability for false or misleading statements in their advertisements for Rule 506(c) transactions. While we expect that a range of different practices will develop as to what information will be included in advertising materials and what will be given only to potential investors who respond to their advertisements, issuers should take care to ensure that their advertising materials, as well as information that might be read in conjunction with them such as other pages on a website that includes the advertising materials, have been reviewed carefully, are accurate and are not misleading.
Exclusion of Bad Actors from Rule 506 Transactions
On July 10, 2013, the SEC also adopted final rules disqualifying certain “bad actors” from participating in Rule 506 offerings. New Rule 506(d), which implements a requirement of the Dodd-Frank Act of 2010, disqualifies issuers if they or, subject to certain exceptions, their executive officers, directors or certain significant beneficial owners of their equity have been convicted of or sanctioned for securities fraud or similar violations. The rule applies only to convictions or sanctions that occur after the rule becomes effective. The SEC’s adopting release for Rule 506(d) is available at http://www.sec.gov/rules/final/2013/33-9414.pdf.
Proposed Expansion of Form D Requirements
The SEC also proposed for public comment the following new rules that will increase issuers’ filing requirements for Rule 506 transactions:
- Issuers would be required to file Form D with the SEC 15 calendar days before they make any general solicitation in connection with a Rule 506(c) transaction.
- Issuers would be required to provide additional information about themselves and the offering, including information about the securities offered, the use of the proceeds of the offering and the methods used to verify purchasers’ status as accredited investors.
- For two years after the adoption of final rules, issuers would be required to confidentially submit all Rule 506(c) general solicitation materials to the SEC.
- Rule 506(c) general solicitation materials would be required to include specified legends and disclosures.
- Issuers in all Rule 506 offerings would be required to file a “closing amendment” to their Form D within 30 calendar days of the closing of the offering.
- Issuers that fail to file Form D would be disqualified from relying on Rule 506.
The SEC’s proposal for these rules, which take the form of amendments to Regulation D, is available at http://www.sec.gov/rules/proposed/2013/33-9416.pdf
Rules 506(c) and 506(d) will become effective 60 days after they are published in the Federal Register, which we expect will occur soon. The proposed rules are open for public comment until September 10, 2013.
The SEC has not yet proposed rules for other key provisions of the JOBS Act meant to help smaller businesses raise money, including the eagerly awaited crowdfunding provisions and the provisions for small public offerings under so-called “Regulation A+.” While the SEC has been slow in drafting rules implementing the provisions of the JOBS Act, we are hopeful that the appointment of new chairman Mary Jo White will inspire the Commission to publish at least proposed rules on both topics before the end of the year.
Please do not hesitate to contact any of the attorneys listed in this memorandum or your usual Taft contacts if you have any questions about Rule 506(c) or the other changes the JOBS Act is bringing to the private capital markets.