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SEC Finalizes General Solicitation and “Bad Actor” Rules

Executive Summary

On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (as amended, the “JOBS Act”), a bill intended to promote economic growth by facilitating access to capital through a less burdensome regulatory framework. The JOBS Act, among other things, instructs the Securities and Exchange Commission (the “SEC”) to revise Regulation D and Rule 144A (“Rule 144A”) of the Securities Act of 1933, as amended (the “Securities Act”), to eliminate the prohibitions against general solicitations and general advertising (hereinafter, “General Solicitation”)[1] for offerings made in accordance with Rule 506 of Regulation D (“Rule 506”) as well as resales effected under Rule 144A. The JOBS Act also instructs the SEC to adopt rules that will preclude the availability of Rule 506 for any securities offering in which certain felons and other bad actors (collectively, “Bad Actors”) are involved.[2]

On July 10, 2013, the SEC approved final rules (the “Final Rulemaking”) eliminating the prohibition against General Solicitation in certain offerings conducted pursuant to Rule 506 and certain secondary offerings under 144A.[3] The SEC also adopted final rules preventing certain Bad Actors from participating in privately placement offerings. These final rules will become effective sixty (60) days after their respective publication in the Federal Register (the “Effective Date”).

Background

The Securities Act requires that any offer to sell securities be registered with the SEC unless the offer is exempt from such registration requirements. Section 4(a)(2)[4] of the Securities Act provides an exemption from such registration for “transactions by an issuer not involving any public offering.” The uncertainty of the language “not involving a public offering” makes Section 4(a)(2) a difficult provision to rely on directly. Issuers, therefore, prefer to rely on Regulation D, which has very specific requirements. Regulation D is comprised of Rules 501-508, and the safe harbors from registration are provided in Rules 504, 505 and 506. The Final Rulemaking amends Rule 506, the most relevant safe harbor for private funds.

The Rule 506 safe harbor provides that a transaction will be deemed to “not involve a public offering,” as described in Section 4(a)(2), and therefore will be exempt from registration, if the offering (i) does not include more than thirty-five (35) non-accredited purchasers (but allows for an unlimited number of accredited investors[5]), and (ii) where there has been no General Solicitation.

Final Rule Amendment to Rule 506

In the Final Rulemaking, the SEC lifted the prohibition on General Solicitation with respect to certain Rule 506 offerings. Specifically, the SEC added new Rule 506(c), which provides that an issuer can offer securities through means of General Solicitation where the following conditions are satisfied:

  1. all purchasers of securities are accredited investors;
  2. the issuer has taken reasonable steps to verify that the purchasers of the securities are accredited investors; and
  3. all terms and conditions of Rules 501, 502(a) and 503 are otherwise satisfied.

New Rule 506(c) represents a significant departure from the existing regulatory scheme. In eliminating the prohibition on General Solicitation, issuers who satisfy the above requirements are permitted to employ significantly broader methods of communications including print, radio and television, to a much larger pool of potential investors.

The Final Rulemaking affects only Rule 506 and not Section 4(a)(2) offerings in general. As such, issuers relying on Section 4(a)(2) outside of Rule 506(c) will still be restricted in their ability to publicly communicate with potential investors.

Accredited Investor Status

New Rule 506(c)(2)(i) requires that all purchasers of securities sold in a Rule 506(c) offering be accredited investors. This differs from Rule 506(b), which allows for up to thirty-five (35) non-accredited investors who meet certain sophistication requirements in respect of their financial and business acumen. Under Rule 506(c), the sale of a security to just one non-accredited investor will bar the availability of the Rule 506(c) exemption and the ability to engage in General Solicitation. However, an issuer will not lose its ability to rely on Rule 506(c) in circumstances where a purchaser’s accredited investor status is determined to be inaccurate, provided the issuer (i) took reasonable steps to verify the purchaser’s accredited status, and (ii) had a reasonable belief that such purchaser was an accredited investor at the time it purchased such securities.

Given the inaccessibility of Rule 506(c) to issuers wishing to place securities with certain non-accredited investors, issuers will still be able to conduct Rule 506(b) offerings, which remain subject to the prohibition against General Solicitation. The option to conduct such an offering permits issuers to avoid the requirement to take reasonable steps to verify a purchaser’s accredited investor status and enables such issuers to sell privately to non-accredited investors who meet the Rule 506(b) sophistication requirements.

Verification Requirement

New Rule 506(c)(2)(ii) requires that an issuer take “reasonable steps to verify” a purchaser’s accredited investor status.

The SEC expects an issuer to objectively determine the reasonableness of its verification steps by considering the context of the particular facts and circumstances of each purchaser and each transaction. To assist issuers in making such determination (which determination should be adequately documented and a record thereof retained), the final rules provide a short list of factors that should be considered, including (i) the nature of the purchaser and type of accredited investor that the purchaser claims to be, (ii) the amount and type of information the issuer has about the purchaser, and (iii) the nature and terms of the offering. Rule 506(c)(2)(ii)(A) provides a non-exclusive list of methods that issuers may use to verify a potential natural person investor’s accredited investor status, including:

  1. with respect to income, any IRS form (e.g., Schedule K-1 and Forms W-2, 100, 1065 and 1040) that reports the purchaser’s income for the two (2) most recent years, provided such documentation is accompanied by a written representation from the purchaser that he/she has a reasonable expectation of reaching the necessary income level for the current year;
  2. with respect to net worth, bank statements, brokerage statements and other statements of assets dated within the prior three (3) months, accompanied by a recently generated consumer report and a written representation from the purchaser that all liabilities necessary to make the net worth determination are disclosed;
  3. written confirmation from either a broker-dealer, an SEC-registered investment adviser, or a licensed and duly-registered attorney or certified public accountant, which confirmation will provide that such person or entity has taken reasonable steps within the prior three (3) months to verify the purchaser’s accredited investor status; or
  4. with respect to any natural person who invested in an issuer’s Rule 506(b) offering as an accredited investor prior to the Effective Date, and remains an investor of the issuer, the issuer is deemed to satisfy the verification requirements of Rule 506(c) in regards to any such person by obtaining a certification by such person at the time of sale that he/she qualifies as an accredited investor.

These steps do not constitute a verification safe harbor. Certain of these steps may be inappropriate or unnecessary in light of the facts and circumstances of a particular transaction or where such issuer has reason to believe that the verifications provided therein may be inaccurate or incomplete. As such, an issuer should use a reasonableness standard in assessing the adequacy of its verification procedures. As noted in the Final Rulemaking, many practices currently used by issuers in connection with existing Rule 506 offering (other than merely having investors complete an “accredited investor” questionnaire) will be sufficient to satisfy the Rule 506(c) verification requirement.

Rule 144A

Current Securities Act Rule 144A provides would-be offerors with a safe harbor from registration of the resale of “restricted securities” to qualified institutional buyers ("QIBs"). QIBs include, among others, registered investment companies, registered investment advisers and registered dealers that, when acting on their own account or the accounts of other QIBS, own and invest on a discretionary basis at least $100 million in the securities of unaffiliated issuers. “Restricted securities” are securities acquired in an unregistered, private sale from an issuer or an affiliate of an issuer. The current Rule 144A safe harbor is only available where securities are offered or sold solely to QIBs or to offerees or purchasers that the seller (or its affiliates) reasonably believed to be QIBs. In other words, an offeror cannot take advantage of the Rule 144A safe harbor if an offer was made to just one non-QIB and even if that offer did not result in a sale.

Pursuant to the Final Rulemaking, the SEC amended Rule 144A so that securities may now be offered to persons other than QIBs (including by way of General Solicitation), provided that such securities are sold only to persons that the seller (and any person acting on its behalf) reasonably believes to be QIBs.

Impact on Other Relevant Regulation

As confirmed by the SEC in the Final Rulemaking, offers and sales which are exempt under Rule 506 shall not be deemed public offerings under the federal securities laws as a result of General Solicitation. As such, General Solicitation conducted in reliance on Rule 506(c) will not prevent such issuer’s reliance on the exclusions from the definition of an “investment company” contained in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, as amended.

We note, however, that issuers (particularly private funds), should consider their registration status with the Commodity Futures Trading Commission (the “CFTC”) before conducting a Rule 506(c) securities offering. The availability of certain relief from the requirement to register with the CFTC as a commodity pool operator and/or commodity trading advisor is conditioned on the requirement that interests in the commodity pool are not marketed to the public. Therefore, the availability of this relief is currently incompatible with an offering conducted pursuant to 506(c) and involving General Solicitation, absent any future guidance from the CFTC.

Transition Issues

The prohibition on General Solicitation will remain in effect until the Effective Date. With respect to issuers that commenced an offering prior to the Effective Date and where such offering is ongoing, issuers may choose to continue the offering after the Effective Date in accordance with either Rule 506(b) or Rule 506(c). Where an issuer elects to continue the offering under Rule 506(b), it will remain subject to the prohibition on General Solicitation. Where an issuer elects to continue the offering under Rule 506(c), and, provided that it satisfies the requirements thereof, such issuer may engage in General Solicitation without impacting the status of offers and sales of securities that occurred when it had relied on Rule 506(b). With regard to ongoing offerings conducted pursuant to Rule 144A that commenced prior to the Effective Date, the use of General Solicitation after the Effective Date will not affect the availability of 144A for the portion of the resales that occurred prior to the Effective Date.

Bad Actor Rules

In a separate release, the SEC also adopted a new set of rules preventing certain Bad Actors from participating in Rule 506 securities offerings.[6] Under new Securities Act Rule 506(d), an issuer will be unable to rely on a Rule 506 exemption if the issuer or any of its “covered persons” had a “disqualifying event.”

For purposes of Rule 506(d), a “covered person” of the issuer includes:

  1. any predecessor or affiliate of the issuer;
  2. any director, officer[7], general partner or managing member of the issuer;
  3. any investment manager (and principals of such investment manager) of an issuer that is a pooled investment fund;
  4. any promoter connected with the issuer in any capacity at the time of sale;
  5. any twenty percent (20%) beneficial owner (based on voting power) of the issuer; and
  6. any “compensated solicitor,” which is defined as a person that has been or will be (directly or indirectly) paid for the solicitation of purchasers in connection with sales of securities in the offering, and any director, officer, general partner or managing member of such compensated solicitor.

Under the new rule, a “disqualifying event” pertaining to the issuer or one of its “covered persons” listed above includes any of the following:

  1. a criminal conviction, court injunction or restraining order (a) in connection with the purchase or sale of a security, (b) in connection with making a false filing with the SEC, or (c) arising out of the conduct of certain financial intermediaries;
  2. certain SEC orders, including:
    • disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons;
    • cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws; and
    • stop orders and orders suspending the Regulation A exemption issued within five (5) years of the proposed sale of securities.
  3. final orders from the CFTC and certain other federal or state regulators of securities, insurance, banking, savings associations or credit unions that (a) bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or (b) are based on fraudulent, manipulative or deceptive conduct and are issued within ten (10) years of the proposed sale of securities;
  4. suspension or expulsion from membership in a self-regulatory organization (“SRO”) or from association with an SRO member; and
  5. U.S. Postal Service false representation orders issued within five (5) years before the proposed sale of securities.

The SEC staff also set forth a “reasonable care” exception to the Bad Actor disqualification in respect of Rule 506 offerings. Pursuant to this exception, an issuer will not be barred under the Bad Actor disqualification if it can show that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. This “reasonable care” analysis will vary based on the specific facts and circumstances for each issuer, offering and the offering’s participants in question.

The final release also clarifies that the Bad Actor disqualification will apply only for disqualifying events that take place after the Effective Date. As with the general solicitation rules discussed above, the Bad Actor rules will become effective sixty (60) days after their publication in the Federal Register. However, any matters deemed to be “disqualifying events” that existed prior to the Effective Date must be disclosed to investors in written form within a reasonable time prior to any sale.

Proposed Regulation D and Form D Rules

Concurrent with the release of the General Solicitation and Bad Actor final rules, the SEC also set forth a series of proposed amendments to Regulation D, Form D and Rule 156 under the Securities Act with regard to offerings of securities that utilize general solicitation pursuant to Rule 506(c).[8] In the release, the SEC staff proposed the following amendments to the private offering rules with regard to issuers engaging in general solicitation under Rule 506(c):

  1. requiring issuers to file an advance notice of sale fifteen (15) days before, and at the conclusion of, an offering via Form D. Issuers would also be required to update the information contained in the Form D and indicate that the offering has ended within thirty (30) days of completing any such offering;
  2. requiring issuers to provide additional information about the issuer and the offering via Form D, including expanded information about, but not limited to, the issuer, the types of investors in the offering, the use of proceeds in the offering, the types of general solicitation used and the methods used to verify the “accredited investor” status of the investors;
  3. disqualifying issuers from taking advantage of a Rule 506 exemption in any new offering for a one (1) year period if the issuer fails to timely comply with the current and newly proposed Form D filing requirements, with such disqualification period beginning after the required Form D filing is made;
  4. requiring issuers to include certain legends and disclosures in written general solicitation materials. If the issuer is a private fund and includes information about past performance in such materials, it would have to provide additional information to highlight the limitations on the usefulness of this type of information and the difficulty of comparing this information with past performance information of other funds;
  5. temporarily requiring issuers to submit written general solicitation materials to the SEC for a period of two (2) years, which such materials would not be available to the public and would not be commented on by the SEC; and
  6. extending guidance about misleading statements currently contained in Rule 156 to private funds with regard to when information in sales materials could be fraudulent or misleading for purposes of the federal securities laws, regardless of whether the issuer utilizes general solicitation.

It is important to note that the requirements of some of these proposed rules may reduce the attractiveness of engaging in General Solicitation for issuers. These proposed rules are subject to a sixty (60) day public comment period, with such period commencing upon the publication of the proposed rules in the Federal Register.


[1] General Solicitation, as such term is used in Regulation D, refers to any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio, and any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.

[2] See Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306.

[3] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Rel. No. 33-9415, Jul. 10, 2013.

[4] Section 4(a)(2) was previously referred to as Section 4(2).

[5] Generally, “accredited investors” (as defined in Rule 501 of Regulation D) include financial institutions, corporations, trusts, limited partnerships and various other legal entities with assets in excess of $5 million, as well as natural persons that meet certain net worth and income standards (i.e., a net worth of at least $1,000,000, subject to certain exclusions, or individual income of more than $200,000 in each of the past two years, or joint income with a spouse of more than $300,000 in each of those years).

[6] See Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings, SEC Rel. No. 33-9414, Jul. 10, 2013.

[7] For purposes of Rule 506(d), an officer means any executive officer or other officer who participated in the offering.

[8] See Amendments to Regulation D, Form D and Rule 156 under the Securities Act, SEC Rel. No. 33-9416, Jul. 10, 2013.


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BulletPoint® is a newsletter of Tannenbaum Helpern Syracuse & Hirschtritt LLP’s Investment Management practice. It is an alert covering recent regulatory and tax developments impacting the financial services industry. To subscribe for the newsletter, send email to marketing@thsh.com.

07.24.2013  |  PUBLICATION: BulletPoint  |  TOPICS: Investment Management, Securities

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