August 31, 2012
On August 29, 2012, the Securities and Exchange Commission (the “SEC” or the “Commission”) proposed rules to implement Section 201(a) of the Jumpstart Our Business Startups (JOBS) Act, which requires the SEC to eliminate the prohibition against general solicitation and general advertising (together, “general solicitation”) in securities offerings conducted pursuant to Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”) and Rule 144A under the Securities Act. The comment period for the proposed rules will expire 30 days after the proposing release (the “proposing release” or the “release”) is published in the Federal Register; that is, likely around the end of September.
Notably, the JOBS Act directed the Commission to issue final rules within 90 days of enactment of the JOBS Act, or by July 4, 2012, and at the Commission’s Open Meeting, Chairman Schapiro and Commissioners Paredes and Gallagher all expressed a desire to move expeditiously to a final rule.[1] As a result, commenters should submit their comments on the proposal promptly in order to ensure that the Staff and Commission have ample time to consider them before issuing a final rule.
The proposing release is available at http://www.sec.gov/rules/proposed/2012/33-9354.pdf.
Highlights of the Proposal
Background
Rules 506 and 144A provide safe harbors from the registration requirements of Section 5 of the Securities Act. Rule 506 permits an issuer to raise an unlimited amount of capital in an offering sold only to accredited investors and up to thirty-five nonaccredited investors[2] who meet certain sophistication requirements. Rule 144A permits the resale of an unlimited amount of securities to QIBs.[3] A Rule 144A offering is typically structured as an initial sale of securities by the issuer to an investment bank in a transaction that is exempt from registration pursuant to Section 4(a)(2) of the Securities Act or, potentially, Regulation S under the Securities Act,[4] followed by the immediate resale of those securities to QIBs pursuant to Rule 144A.
Under existing Rules 506 and 144A, issuers and other participants may not use general solicitation to attract investors. The exemption provided by Rule 506 is explicitly conditioned on the absence of offers or sales by any form of general solicitation, and Rule 144A provides that both offers and sales of securities sold in reliance on that Rule must be limited to QIBs, which effectively precludes general solicitation. Critics have noted for many years that these limitations may significantly limit the pool of potential investors in an offering, thus limiting a company’s access to capital.
Title II of the JOBS Act, entitled “Access to Capital for Job Creators,” is designed to broaden the pool of potential investors for these offerings and expand access to capital. Section 201(a) directs the SEC to eliminate the prohibition on general solicitation in securities offerings conducted pursuant to Rules 506 and 144A so long as all purchasers of the securities are accredited investors (in the case of an offering pursuant to Rule 506) or persons reasonably believed to be QIBs (in the case of an offering under Rule 144A). In addition, Section 201(a)(1) requires that the issuer “take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission” in Rule 506 offerings where offering participants engage in general solicitation.
Thus, Title II seeks to address investor protection concerns that may be associated with allowing general solicitation by permitting sales only to investors that have the resources or sophistication to fend for themselves.
Overview of the Proposed Amendments
Proposed Amendments to Rule 506
The proposed amendments to Rule 506 would effectively create two related exemptions under Rule 506 — one for offerings using general solicitation and one for offerings that do not use general solicitation. The rules governing offerings that do not use general solicitation would be unchanged from the rules that currently govern offerings conducted under Rule 506.[5] Offerings that use general solicitation would be governed by new paragraph (c).
Proposed Rule 506(c) would provide that general solicitation is permitted if the issuer takes reasonable steps to verify that purchasers of securities sold in the offering are accredited investors, and all purchasers sold in the offering are accredited investors. The Commission clarified that the legal standard for accredited investor under the proposal would be the same for purposes of Rule 506(c) as it is under the existing exemption under Rule 506 — that is, that a purchaser would satisfy the definition of accredited investor “either because they come within one of the enumerated categories of persons that qualify as accredited investors[6] or the issuer reasonably believes that they do, at the time of the sale of the securities.”[7] Thus, Rule 506(c) would allow general solicitation where the issuer takes reasonable steps to verify, and reasonably believes, that each purchaser in the offering satisfies one of the categories of persons defined as an accredited investor.
As a result, the Commission noted that an issuer would not lose the benefit of Rule 506(c) under the proposed rules, even if a purchaser that does not meet the criteria for any category of accredited investor circumvents the issuer’s verification measures, so long as the issuer has taken reasonable steps to verify, and reasonably believes, that the purchaser is an accredited investor.[8]
It is also notable that Rule 506(c) may serve as a “safety net” for a Section 4(a)(2) private placement or a “quiet” Rule 506 offering in which the issuer inadvertently makes a communication that is deemed a general solicitation. In such a case, so long as the issuer has taken reasonable steps to verify and reasonably believes that all investors in the offering are accredited investors, the issuer would be able to rely on Rule 506(c).
Reasonable Steps to Verify
The proposed rules would not specify the methods that an issuer must employ to satisfy its obligation to “take reasonable steps to verify” that a purchaser is an accredited investor. Instead, in light of the different types of issuers and the different types of accredited investors that may be involved in an offering pursuant to Rule 506(c), the steps that an issuer takes would be required to be reasonable under the facts and circumstances.[9] The proposing release states that the determination of whether the steps taken are reasonable would be an objective determination.
The release includes, in the release text rather than the text of the proposed rule itself,[10] the following non-exclusive list of factors that an issuer should consider when determining the reasonableness of its steps to verify that a purchaser is an accredited investor:
The release discusses each of these factors, and notes that these factors interact with each other. Thus, the stronger the support is under one factor indicating that a purchaser is an accredited investor, the less the need for support under the other factors in order for the issuer to conclude that it took reasonable steps to verify that the purchaser is an accredited investor.
With respect to the nature of the purchaser, the release notes that “the steps that may be reasonable to verify that an entity is an accredited investor by virtue of being a registered broker-dealer — such as going to FINRA’s BrokerCheck website — would necessarily differ from the steps that would be reasonable to verify whether a natural person is an accredited investor.”[11] The release recognizes that “taking reasonable steps to verify the accredited investor status of natural persons poses greater practical difficulties as compared to other categories of accredited investors, and these practical difficulties likely would be exacerbated by natural persons’ privacy concerns about the disclosure of personal financial information.”[12] In these circumstances, an issuer may need to rely more heavily upon other factors relevant to a natural person’s accredited investor status.
Regarding the amount and type of information that is available to the issuer about the purchaser, the release notes that, “The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa.”[13] Information that issuers could consider relevant in verifying accredited investor status includes (i) publicly available information in filings with a federal, state or local regulatory body, (ii) third-party information that provides reasonably reliable evidence that a person is an accredited investor, and (iii) verification of a person’s status as an accredited investor by a third party, such as a broker-dealer, attorney or accountant, whom the issuer has a reasonable basis to rely upon.
The proposing release discusses two relevant aspects of the nature of the offering — the manner in which investors were solicited and the terms of the investment. With respect to the manner of solicitation, the release states that “[a]n issuer that solicits new investors through a website accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer.”[14]
The release notes that merely requiring that the person represent as to their accredited investor status would fail the requirement that an issuer take reasonable steps to verify the accredited investor status of a person solicited through media such as generally accessible websites. In such circumstances, an issuer would need to obtain additional information about the purchaser or otherwise take reasonable steps sufficient to establish a reasonable a belief that the purchaser is an accredited investor.
The terms of the investment, such as the minimum investment amount, would also be relevant to determining accredited investor status. For example, if the minimum investment amount is high enough that only accredited investors could reasonably be expected to meet it, and a purchaser can do so with a direct cash investment that is not financed by the issuer or by any other third party, those facts could be viewed as evidence verifying the purchaser’s accredited investor status. In such a case, the proposing release states that it may be reasonable for an issuer to take no further steps to verify the accredited investor status of a natural person it otherwise knows little about.
Although the Commission proposed a flexible, “facts and circumstances” approach to the “reasonable steps” requirement under Section 201 of the JOBS Act, the proposing release also solicits comments on a variety of other possible approaches to verification. Notably, Division of Corporation Finance Director Meredith Cross stated in her oral presentation at the Commission’s Open Meeting that she would be particularly interested in commenters’ views on the proposed approach to this element of Section 201(a).
Regardless of the method(s) used by the issuer in its effort to verify the accredited investor status of any purchaser of its securities, the Commission reminded such issuers of the importance of maintaining adequate records of its verification process.
Proposed Revision to Form D
Form D would be amended to include a checkbox indicating that an offering was conducted pursuant to new Rule 506(c). Issuers are currently required to file Form D with the SEC when they sell securities pursuant to Regulation D, although the failure to file a Form D does not result in the loss of the exemption provided by Regulation D. The checkbox provision is intended to allow the Commission to monitor the use of general solicitation in offerings and to assess the impact of the changes on the market, including the effectiveness of various verification practices used by issuers.
Contrary to the request of some commenters, the proposed rules would not require that the issuer file the content of any solicitation or advertising with the Form D, and would not condition the availability of any exemption under Regulation D on filing the Form D.
Implications of General Solicitation in Rule 506 Offerings for Privately Offered Funds
Privately offered funds, such as hedge funds, venture capital funds and private equity funds, generally rely on one of two statutory exclusions[15] from the definition of “investment company” under the Investment Company Act, and thus are not subject to the regulatory provisions under that Act. Those exemptions are unavailable, however, to a fund that engages in a public offering of its securities. The release notes that Section 4(b) of the Securities Act[16] provides that “[o]ffers and sales exempt under [Rule 506] (as revised pursuant to [the JOBS Act]) shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.” Thus, the Commission clarified its view that the use of general solicitation in offerings by privately offered funds pursuant to Rule 506(c) will not cause an issuer to be deemed an investment company under the Investment Company Act.
Proposed Revisions to Rule 144A
Rule 144A(d)(1) would be amended to eliminate the restriction on “offers” to persons who are not QIBs, and thus to permit general solicitation in offerings conducted pursuant to Rule 144A. Subparagraph (d)(1) would continue to condition the exemption on the securities being sold only to QIBs or to purchasers that the seller and any person acting on its behalf reasonably believe is a QIB. The proposed amendments would not add any additional standards for whether a seller reasonably believes a purchaser to be a QIB or otherwise.[17]
No Integration with Regulation S Offering
Issuers and offering participants that conduct an offering pursuant to Rule 506 or Rule 144A often conduct a simultaneous offshore offering of the issuer’s securities in reliance on the exemption from registration provided by Regulation S. One condition to the availability of the Regulation S exemption is that there be no “directed selling efforts” in the United States.[18]
The proposal clarifies that the use of general solicitation in connection with a Rule 506 or Rule 144A offering would not be a barrier to a concurrent offering in reliance on Regulation S.
Issues Not Addressed in Proposing Release
We believe the Commission’s storied integration doctrine will almost certainly undergo another iteration of changes in the upcoming months and years, as the liberalization of the communication rules calls into question the validity of some of the applicable rules, guidance and Federal court decisions relating to offering communications. In particular, Section 201(a) of the JOBS Act, combined with other provisions of the JOBS Act that loosen restrictions on communications[19] raises significant questions about the future of restrictions on communications in connection with securities offerings.
Similarly, although the JOBS Act did not amend Section 4(a)(2),[20] and the proposing release notes that “[a]n issuer relying on Section 4(a)(2) is restricted in its ability to make public communications to attract investors for its offering because public advertising is incompatible with a claim of exemption under Section 4(a)(2),”[21] this principle may come under pressure if issuers and offering participants seek in good faith to comply with Rule 506(c) or Rule 144A but inadvertently fail to comply with a condition or requirement of those safe harbors. Under those circumstances, the effect of such a failure could be that the offering violated Section 5 of the Securities Act[22] — an effect that would have significant consequences for the issuer.
The Commission was not expected to take up these thorny issues in this proposal, nor is it expected to do so when it issues final rules implementing Section 201(a). As a result, in the absence of further guidance from the Commission or court decisions that are binding on the Commission, issuers and offering participants should continue to adhere rigorously to Commission rules relating to offering communications, particularly when engaging in communications that go beyond what has traditionally been permitted.
What Should Investment Banks, Broker-Dealers and Private Funds Do Now?
The elimination of the prohibition on general solicitation in Rule 506(c) and 144A offerings presents risks and opportunities for investment banks, broker-dealers and privately offered funds. On one hand, this change will create new opportunities for these entities to expand their businesses, and create the risk of losing business and investors to competitors that respond more quickly. On the other hand, those that move aggressively without appropriate controls, policies and procedures will face significant compliance risks that could result in reputational damage, fines, penalties, injunctions or other legal ramifications.
Accordingly, banks, broker-dealers and funds that participate in these offerings should begin now to prepare for a fundamentally changed legal environment. For decades, policies, procedures and legal forms relating to a wide array of business practices — from customer and investor intake procedures and handling investor inquiries, to dealing with the press, to transaction agreements — have been crafted with a view to avoiding general solicitation under all circumstances. With the liberalization of the offering communication rules, these entities should start now to reexamine these policies, procedures and form transaction documents so that they can quickly and safely take advantage of the new legal environment.
To help our clients and friends to begin this process, we have included below a chart identifying some of these policies, procedures and forms that should be included in this review.
Revisions to Policies, Procedures and Forms
to Take Advantage of General Solicitation
The chart below lists policies, procedures and forms that issuers and other persons that participate in Rule 506(c) and Rule 144A offerings should review in light of the removal of the prohibition on general solicitation and advertising (“general solicitation”). Note that the prohibition on general solicitation will remain for Rule 506 offerings in which any purchasers are not accredited investors (“AI”). In addition, consideration should be given to such other matters as whether an issuer anticipates undertaking a public offering, as the gun-jumping rules for public offerings remain in effect.
| Function / Document | Responsible Person | Potential Revisions to Policies / Procedures / Forms |
| Customer / Investor Intake | Back office |
|
| Inquiry Handling | Back office | No longer need staff scripts to turn away inquiries; instead, develop controls and procedures to screen inquiries arising from general solicitation, based on AI status, and to funnel into customer intake process where appropriate |
| Press Interactions | Legal department | Consider revising policies to reflect that the securities laws no longer prohibit discussion that might lead to publicity for an offering |
| Offering Materials | Legal department | Consider revising / easing policies calling for strict numbering and tracking of private placement memorandum, offering memorandum or offering circular |
| Websites (offerings) | Legal department | Consider revising / easing policies calling for password-protection or questionnaires that confirm preexisting relationship |
| Websites (issuers) | Deal team / legal due diligence | Consider policies and practices for scrubbing issuer websites for discussion of fundraising plans or other materials that could be construed as priming the market |
| Advertising / Publicity | Legal and marketing departments |
|
| Engagement Letter | Legal department | Consider whether revisions are necessary / appropriate regarding investor verification procedures and advertising |
| Investor Purchase / Subscription Agreement (private placement) | Legal department and outside counsel | Consider revisions to investor representations and warranties |
| Agreement Among Underwriters / Initial Purchasers | Industry | Consider revisions to representations and covenants from syndicate members regarding AI verification procedures and regarding advertising of offering |
| Purchase Agreement — Initial Purchaser (144A) | Industry | Consider revisions to representations and covenants from initial purchasers regarding AI verification |
[1] The proposing release was approved by a 4-1 majority, with Commissioner Aguilar dissenting due to concerns regarding potentially increased investor vulnerability to fraud. Commissioner Walter, although supporting the issuance of the proposal, likewise noted her disappointment that the release does not propose or request comment on possible approaches to address these concerns, and asked that commenters nevertheless comment on these issues. Conversely, Commissioners Paredes and Gallagher pointed out the missed July 4 rulemaking deadline, and noted with annoyance that the Commission’s initial planned approach — to adopt an interim final temporary rule that would be effective immediately while requesting comment on possible future improvements — was abandoned only weeks before the Open Meeting, thus further delaying implementation for at least several months. These internal Commission dynamics make the timing of a final rule difficult to predict, particularly in light of the concurrent climax of the hotly-contested presidential election campaign.
[2] “Accredited investor” is defined in Rule 501(a) of Regulation D to include any person who falls within one of eight enumerated categories, or who the issuer reasonably believes falls within one of those categories, at the time of sale.
[3] Rule 144A(a)(1) defines “qualified institutional buyer” to include certain institutions that, in the aggregate, own and invest on a discretionary basis at least $100 million in securities of issuers that are not affiliated with such institutions.
[4] Securities acquired from the issuer pursuant to these exemptions are “restricted securities” as defined in Rule 144(a)(3), and may not be resold except pursuant to an effective registration statement under the Securities Act, pursuant to another exemption from registration such as Rule 144A, or in accordance with the resale restrictions set forth in Rule 144.
[5] The Commission noted that “we do not believe that Section 201(a) requires the Commission to modify Rule 506 to impose any new requirements on offers and sales of securities that do not involve general solicitation.” Release at 13.
[6] These categories generally include “natural persons, public and private for-profit and not-for-profit corporations, general and limited partnerships, business and other types of trusts, and funds and other types of collective investment vehicles.” Release at 14. See Rule 501(a)(1)-(8).
[7] Release at 11. Comment letters submitted prior to the proposal exhibited confusion as to whether, because Section 201(a)(1), which provides for the removal of the prohibition on general solicitation in offerings under Rule 506, does not include the words “reasonable belief” while Section 201(a)(2), which provides for the removal of the prohibition on general solicitation in offerings under Rule 144A, does include the words “reasonable belief,” the reasonable belief element in the definition of accredited investor would be eliminated in offerings that use general solicitation. The proposing release notes that “[in] our view, the difference in language between Section 201(a)(1) and Section 201(a)(2) reflects only the differing manner in which the reasonable belief standard was included in the respective rules at the time they were adopted, and does not represent a Congressional intent to eliminate the existing reasonable belief standard in Rule 501(a) or for Rule 506 offerings.” Release at 29.
[8] Conversely, it appears to be theoretically possible under the proposed rules that an issuer that fails to take reasonable steps would lose the benefit of Rule 506(c) even if all purchasers are accredited investors. In this case, the offering would likely not qualify for the exemption provided by Section 4(a)(2), and thus would violate Section 5 of the Securities Act. This possibility may be clarified in the final rules. In this regard, see n.24, below, and accompanying text.
[9] In this regard, the Commission notes that “we anticipate that many practices currently used by issuers in connection with existing Rule 506 offerings would satisfy the proposed requirement for offerings pursuant to Rule 506(c).” Release at 25. The SEC also stated its desire to leave room for future methods of ascertaining accredited investor status, such as third-party services.
[10] If the Commission adopts the rules as proposed, these factors would serve as guidance for issuers.
[12] Release at 16-7. Indeed, the comment letters received prior to the proposal that addressed the “reasonable steps to verify” element of Section 201(a) focused largely on issues relating to the verification of accredited investor status for natural persons and the attendant privacy concerns relating to these verification methods.
[17] Note however that, unlike the “facts and circumstances” approach described above that applies to the determination of whether a purchaser in a Rule 506(c) offering is an accredited investor, Rule 144A specifies non-exclusive methods by which a seller may establish that an investor is a QIB.
[18] See Rule 902(c). Comment letters submitted prior to the proposal sought guidance from the Commission as to whether the Regulation S exemption would be available where a concurrent offering in the United States uses general solicitation. The proposal notes that the adopting release for Regulation S made clear that “[o]ffshore transactions made in compliance with Regulation S will not be integrated with registered domestic offerings or domestic offerings that satisfy the requirements for an exemption from registration under the Securities Act.” Release at 39.
[19] In particular, Section 105(c), which amended Section 5(d) of the Securities Act to permit certain issuers and persons acting on their behalf to “test the waters” with QIBs and institutions that are accredited investors in connection with a potential initial public offering.
[20] In this regard, the proposing release notes that the “mandate [to remove the prohibition against general solicitation] affects only the Rule 506 safe harbor, and not Section 4(a)(2) offerings in general.” Release at 11.
[22] It appears, however, that such instances would be rare if, as proposed, issuers and offering participants would not lose the benefit of Rule 506(c) so long as they take reasonable steps to verify, and reasonably believe, that all purchasers in an offering are accredited investors. This is particularly true in light of Rule 508, which provides that, in most cases, “a failure to comply with a term, condition or requirement under [Rule 506] will not result in the loss of the exemption . . . .”
An abbreviated version of this Alert was posted on August 29, 2012, as a blog on the Gibson Dunn Securities Regulation and Corporate Governance Monitor, available at https://www.securitiesregulationmonitor.com. We encourage you to sign up at the Monitor website to receive email alerts when we post information on developments and trends in securities regulation, corporate governance and executive compensation.
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Stewart L. McDowell (415-393-8322, [email protected])
James J. Moloney (949-451-4343, [email protected])
Douglas D. Smith (415-393-8390, [email protected])
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Jeffrey A. Chapman (214-698-3120, [email protected])
Robert B. Little (214-698-3260, [email protected])
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J. Alan Bannister (212-351-2310, [email protected])
Barbara L. Becker (212-351-4062, [email protected])
Andrew L. Fabens (212-351-4034, [email protected])
John T. Gaffney (212-351-2626, [email protected])
Lois F. Herzeca (212-351-2688, [email protected])
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Howard B. Adler (202-955-8589, [email protected])
Anne Benedict (202-955-8654, [email protected])
Blaise F. Brennan (202-887-3700, [email protected])
Stephen I. Glover (202-955-8593, [email protected])
Amy L. Goodman (202-955-8653, [email protected])
Elizabeth Ising (202-955-8287, [email protected])
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John F. Olson (202-955-8522, [email protected])
C. William Thomas, Jr. (202-887-3735, [email protected])
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