At its meeting on July 10, 2013, the Securities and Exchange Commission adopted final rules that permit the use of advertising and other forms of "general solicitation" in private offerings under Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 (the "Securities Act") if certain conditions are met. At the same meeting, the Commission proposed a series of rule amendments, which will require issuers to make additional filings and provide additional information in Rule 506 offerings to help the Commission analyze the market impact and market practices resulting from the use of general solicitation in offerings under new Rule 506(c).
New Rule 506(c)
If an issuer wants to use advertising or general solicitation in a private offering under new Rule 506(c), all of the purchasers in the offering must be accredited investors and the issuer must take reasonable steps to verify that the purchasers are accredited investors.
Prior to the adoption of Rule 506(c), Rule 506 provided a safe harbor for private sales to purchasers who the issuer reasonably believes are accredited investors at the time of sale and up to 35 other purchasers, but only if the issuer and persons acting on its behalf did not engage in general advertising or general solicitation. New Rule 506(c) now permits the use of general advertising or general solicitation in a Rule 506 offering, but only if all of the purchasers are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors. An issuer can still make an offering under Rule 506 as in effect prior to the adoption of new Rule 506(c) so long as no general advertising or general solicitation are used and the other requirements of Rule 506 are met.
New Rule 506(c) requires an issuer to take reasonable steps to verify that all of the purchasers in a Rule 506 offering using general solicitation are accredited investors. These steps must be taken even if all of the purchasers are, in fact, accredited investors. While the new rule identifies four verification procedures that are deemed reasonable for purchasers who are natural persons, the rule and the adopting release emphasize that those specific procedures are not mandatory and that other procedures may be employed. If these procedures are not followed or not applicable (because the purchasers are not natural persons), the adopting release provides a principles based approach based on the particular facts and circumstances of an offering.
The four specific procedures that the SEC deems reasonable to verify the accredited investor status of a natural person are:
- Reviewing copies of any Internal Revenue Service form that reports income (such as a Form W-2 or a filed Form 1040) for the two most recent years, along with a representation that the purchaser has a reasonable expectation of reaching the required income level during the current year.
- Reviewing bank statements, brokerage statements or other statements of securities holdings, certificates of deposit, tax assessments or appraisal reports issued by independent third parties, along with a consumer credit report from one of the nationwide consumer reporting agencies and a written representation from the purchaser that he or she has disclosed all liabilities necessary to make a determination of net worth. These documents should be dated within the prior three months.
- Obtaining written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney or certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the past three months and has determined that the purchaser is an accredited investor. In the case of a natural person who invested in a Rule 506 offering as an accredited investor prior to the effective date of new Rule 506(c) and who continues to hold the purchased securities, obtaining a written certification at the time of sale that he or she qualifies as an accredited investor.
If these steps are not taken or if the purchaser is not a natural person, the adopting release indicates that an issuer should take the following factors into consideration in determining what verification measures are reasonable based on the facts and circumstances of its offering:
- The type of accredited investor the purchaser claims to be. The level of inquiry will differ based on which category of accredited investor the purchaser claims to be. For a broker dealer, a reasonable inquiry might be as simple as verification through FINRA’s BrokerCheck website. Verification of a natural person as an accredited investor is acknowledged to be more difficult, particularly in the case of the net worth test.
- The information the issuer has about the purchaser. The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it may need to take. The adopting release suggests that the review of publicly available information in filings with a regulatory body, such as the compensation of an executive officer in a proxy statement filed with the SEC, could be sufficient in and of itself to constitute reasonable steps. Third party information such as pay stubs for a two year period and the current year is also mentioned as a source of verification.
- The nature and terms of the offering. The method used to solicit investors can impact the steps that need to be taken. An issuer that solicits investors through widely disseminated email, social media or print media will likely be required to take more verification measures than an issuer who only solicits investors from a database of accredited investors which are prescreened by a reliable third party. If the terms of the offering involve a minimum investment amount that only an accredited investor could be reasonably expected to make, the release suggests that it may only be necessary to verify that the investment is not being financed by the issuer or a third party.
A Rule 506 offering involving general solicitation will also need to satisfy the requirements of Rule 502(a) (Integration) and Rule 502(d)(Limitations on Resale).
Amendment to Form D
An issuer conducting a Rule 506(c) offering must indicate that it is relying on the Rule 506(c) exemption by checking a new box for that rule on Form D. The prior box for Rule 506 offerings has been renamed Rule 506(b). The adopting release indicates that an issuer should not check both boxes because once a general solicitation has been made, an issuer will not be able to claim an exemption under Rule 506(b).
The adopting release makes it clear that private funds that are excluded from the definition of investment company under Section 3(c)(1) or 3(c)(7) of the Investment Company Act will not lose their excluded status if they use general solicitation in compliance with new Rule 506(c).
Proposed Additional Amendments
The SEC proposed amendments to Form D, Regulation D and Rule 156 to require additional filings and information. It also proposed a temporary rule 510T to require issuers relying on the Rule 506(c) exemption to provide the SEC with copies of their solicitation materials. The Commission expressed its belief that the ability to use general solicitation in Rule 506(c) offerings will have a significant impact on the types of issuers raising capital using Rule 506, the investors who are solicited, the practices that will be used by intermediaries and issuers and the amount of capital raised using Rule 506. The following rule changes are proposed:
- Rule 503 of Regulation D would be amended to require a Form D used in a Rule 506(c) offering to be filed at least 15 days before the first use of general solicitation and to require the filing of a closing Form D amendment within 30 days after the termination of all Rule 506 offerings.
- Form D would be amended to require additional information for Rule 506 offerings, including the number of accredited and non-accredited investors that have purchased, whether they are natural persons or entities and the amount raised from each category of investors, the use of proceeds, the types of solicitation used in Rule 506(c) offerings and the methods used to verify accredited investor status in Rule 506(c) offerings.
- Rule 507 would be amended to disqualify an issuer from using Rule 506 for a one year period if the issuer, or any predecessor or affiliate, did not comply with all of the Form D filing requirements for a Rule 506 offering within the last five years.
- A new Rule 509 would be added to Regulation D to require issuers to include prescribed legends in general solicitation materials used in Rule 506(c) offerings.
- Rule 156 under the Securities Act, which currently provides guidance to investment companies in complying with the anti-fraud provisions of the federal securities laws with their use of sales literature, would be amended to apply to sales literature used by private funds.
- A new temporary rule, Rule 510T, would be adopted to require issuers to submit to the SEC through an intake page on the SEC’s website any written general solicitation materials used in a Rule 506(c) offering no later than the date of their first use. These materials would not be made public by the SEC.
What You Should Do Now
New Rule 506(c) will be effective 60 days after it is published in the Federal Register. If you are an issuer contemplating a private offering under Rule 506 using general solicitation, you will need to limit the investors in the offering to accredited investors and you will need to take and document reasonable steps to verify the accredited investor status of each purchaser. If you are unable to use the specific steps identified by the SEC because your offering involves purchasers other than natural persons or if you want to use other procedures, you should consult with counsel. It is clear that in almost all instances, the widely employed existing practice of self-certification will not be sufficient. Since an issuer will have the burden of establishing that it has taken reasonable verification steps, it is equally important to make sure you maintain documentation evidencing the steps you have taken.
Issuers should also monitor the proposed additional rule changes to make sure they comply with them once they are finally adopted.
Investment advisers should be prepared for increased client demand for participation in private offerings as their clients are exposed to general solicitation. If their clients invest in a Rule 506(c) offering, investment advisers may also be asked to provide verification of their clients’ accredited investor status.