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SEC Lifts Ban on General Solicitation, Adopts “Bad Actor” Rules and Proposes Changes to Regulation D and Form D

By · July 24, 2013 · 2013 Ark. L. Notes 1380
In categories: Administrative Law, Business Law, Corporate and In-House Counsel, Financial Institutions Law, Government Practice, Securities, Snapshot

James W. Smith, Rebecca B. Hurst, and Nicole L. Chapman[1]

Smith Hurst, PLC

This article is also available here.

On July 10, 2013, the Securities Exchange Commission (“SEC”) adopted and released a number of highly anticipated amendments to Rule 506 of Regulation D of the Securities Act of 1933, as amended, that (i) effectively lift the ban on general solicitation and general advertising of securities in certain private offerings under Rule 506, as mandated by Section 201(a) of the Jumpstart Our Business Startups Act (the “JOBS Act”), and (ii) disqualify securities offerings involving certain “bad actors” from relying on the exemption under Rule 506, as mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank”).[2]  These final rules and amendments are a reaction in part to the increasingly large reliance on and prevalence of capital raising activities by companies under Rule 506 of Regulation D.[3]  In addition to the final rules on general solicitation and “bad actors” disqualification, the SEC proposed new rules and amendments to Regulation D and Form D.[4] Essentially, the proposed amendments and rules are intended to enhance the SEC’s ability to assess developments in the private placement market now that the ban on general solicitation and general advertising is lifted. More specifically, the proposals should improve the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and address investor concerns.[5]

I. Final Rules Allowing General Solicitation and General Advertising.

Under the currently existing Rule 506 of Regulation D, now referred to as the Rule 506(b) exemption, issuers are allowed to raise an unlimited amount of capital without registering the securities with the SEC provided that they comply with certain requirements, which include in addition to several other requirements, the following:  (i) the issuer did not solicit or advertise the offering, and (ii) the issuer may sell to an unlimited number of accredited investors but only up to thirty-five (35) non-accredited, sophisticated investors.[6]  However, new amendments to Rule 506 of Regulation D add the new Rule 506(c) that permits an issuer relying on this exemption to engage in general solicitation or general advertising when offering and selling securities under Rule 506 if (i) all purchasers are accredited investors, (ii) the issuer takes reasonable steps to verify the accredited investor status of each purchaser, and (iii) the issuer complies with all other applicable provisions of Regulation D.[7] Although not specifically defined in Regulation D, the terms “general solicitation” and “general advertising” include advertisements published in newspapers and magazines, communications broadcast over television and radio, solicitation of investments through a website accessible to the general public, and solicitation through widely disseminated email or social media.[8]

Verification of Accredited Investor Status.

As defined in Rule 501 of Regulation D, an accredited investor includes:

(1) A bank, insurance company, registered investment company, business development company or small business investment company;

(2) An employee benefit plan, whose investment decisions are made by a bank, insurance company, or investment adviser, or the plan assets exceed Five Million Dollars ($5,000,000);

(3) A charitable organization, corporation, or partnership with assets exceeding Five Million Dollars ($5,000,000);

(4) A director, executive officer, or general partner of the issuer;

(5) A business in which all equity owners are accredited investors;

(6) A natural person with an individual or joint net worth, including the person’s spouse, exceeding One Million Dollars ($1,000,000) at the time of purchase, excluding the value of the primary residence;

(7) A natural person with an individual income exceeding Two Hundred Thousand Dollars ($200,000) (Three Hundred Thousand Dollars ($300,000) joint income with spouse) in each of the past two (2) years and a reasonable expectation of the same income in the current year; or

(8) A trust with assets in excess of Five Million Dollars ($5,000,000) not formed to acquire the securities offered and which shows purchases are made by a sophisticated person.[9]

Under the new Rule 506(c), issuers are required to take reasonable steps to verify the accredited investor status of purchasers. The new Rule 506(c) does not specify a uniform verification method to determine whether a purchaser is an accredited investor, but the SEC has provided guidance on this issue and has implemented a “principles-based” approach, which stipulates that the issuer, who also bears the burden of proof, must take “reasonable steps to verify” the purchasers of the offered securities are indeed accredited investors and must have a “reasonable belief” that such purchaser was an accredited investor at the time of sale.[10]  In determining whether an issuer has taken “reasonable steps to verify” an investor’s accredited status, the SEC states an issuer should examine the totality of the circumstances surrounding the potential purchase and identifies the following factors that should be considered:

(1) The purchaser’s nature and type of accredited investor the purchaser claims to be;

(2) The amount and type of information the issuer has about the purchaser; and

(3) 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 a minimum investment amount.[11]

In practice, the more likely an investor appears to be an accredited investor based on the prescribed factors, the fewer steps are needed to verify accredited investor status, and vice versa.[12]  Thus, the totality of the circumstances will largely determine what further steps, if any, are necessary in determining an investor’s accredited status.[13] 

In response to commentators’ concerns that issuers will have difficulty confirming a specific individual’s accredited investor status, the SEC has included in Rule 506(c) the following four (4) non-exclusive methods that will satisfy the verification requirement and be deemed to constitute “reasonable steps” so long as the issuer or its agent is without knowledge that the purchaser is in fact not an accredited investor:

(1) The issuer reviews copies of any Internal Revenue Service (“IRS”) form that reports the purchaser’s income, including but not limited to a Form W-2 (“Wage and Tax Statement”) or a copy of a filed Form 1040 (“U.S. Individual Income Tax Return”), for the two (2) most recent years, along with a representation from such purchaser, that he or she has a reasonable expectation of reaching the income necessary to qualify as an accredited investor during the current year (corresponding documentation and representation from the individual’s spouse is also required where applicable);

(2) The issuer reviews documents, dated within the past three (3) months, that confirm the purchaser’s assets, such as a bank or brokerage statement; obtains the purchaser’s credit report from at least one of the nationwide consumer reporting agencies to confirm the purchaser’s liabilities; and receives a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed;

(3) The issuer obtains a written confirmation from a third party, such as a certified public accountant or licensed attorney, that such third party took reasonable steps to verify and determine that the purchaser is an accredited investor within the prior three (3) months and has determined that the purchaser is an accredited investor; or

(4) The purchaser invested in a prior offering of the issuer, remains an investor, and the issuer obtains a certification by the purchaser at the time of sale that he or she continues to qualify as an accredited investor.[14]

Effect on Issuers.

The amended rules eliminating the ban on general solicitation and general advertising in certain private offerings allow emerging companies to attract and seek investors outside their local communities. These emerging companies can take advantage of blogs, social media, websites and countless other communication avenues to reach larger pools of potential investors and allow them to communicate with the general public. This could potentially lead to the development of web-based platforms that match issuers to potential investors and facilitate the sales of securities between them. Unfortunately, this puts a new level of pressure on these companies taking advantage of the general solicitation to verify the potential investors accredited investor status. However, even with the heightened burden on issuers to verify the accredited investor status, the allowance of general solicitation and general advertising in certain private offerings will likely increase both access to and the amount of capital raised by emerging companies.

It is important to note that issuers are not required to use general solicitation or general advertising and may continue to engage in private placements under Rule 506(b), which, as mentioned above, is the existing Rule 506 offering rule. Whether relying on Rule 506(b) or Rule 506(c), issuers are still required to file a Form D with the SEC, but the Form D is being revised to add a box that must be checked by those issuers who use general solicitation or general advertising in the offering.[15]

II. “Bad Actor” Disqualification in Private Offerings.

In addition to eliminating the prohibition on general solicitation in certain offerings, the SEC also adopted amendments to Rule 506 of Regulation D that disqualify securities offerings involving certain “felons and other ‘bad actors’” from the use of the Rule 506 exemption, as mandated by Dodd-Frank.[16] If certain “covered persons” have experienced a “disqualifying event,” then the issuer is disqualified from selling securities in reliance upon the Rule 506 exemption. The newly adopted disqualification provisions of Rule 506(d) outline the following persons as “covered persons”: (i) the issuer, (ii) any director, executive officer, other officer participating in the offering, general partner or a managing member of the issuer, (iii) any holder of twenty percent (20%) or more of the issuer’s outstanding voting equity securities, (iv) investment managers of pooled investment funds, (v) any promoter connected with the issuer in any capacity at the time of sale, and (vi) any person that has been or will be paid remuneration for solicitation of purchasers in connection with sales of securities in the offering (including the principals of entities performing such services).[17]

Under the final Rule 506(d), a “disqualifying event” of a covered person includes:

(1) Criminal convictions in connection with the purchase or sale of any security that have occurred within five (5) years if the relevant covered person is the issuer or ten (10) years in the case of other covered persons;

(2) Court injunctions or restraining orders entered into within five (5) years before such sale, that, at the time of such sale, restrains or enjoys such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security;

(3) Final orders issued by state and federal banking, credit union, and insurance regulators, that either create a bar from association with any entity regulated by the regulator issuing the order, or from engaging in the business of securities, insurance or banking or from savings association or credit union activities, or are based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last ten (10) years;

(4) SEC disciplinary orders entered into that, at time of the sale, suspend or revoke a person’s registration as a broker, dealer, municipal securities dealer or investment advisor, place limitations on the activities, functions or operations of such person, or bar such person from being associated with any entity or from participating in the offering of any penny stock;

(5) Suspension or expulsion from membership in a self-regulatory organization;

(6) Stop orders applicable to a registration statement and orders suspending the Regulation A exemption for an offering that an issuer filed or in which the person was named as an underwriter within the last five (5) years; and

(7) U.S. Postal Service false representation orders entered into within the last five (5) years.[18]

However, the final disqualification rule as adopted provides an exception to disqualification from using the Rule 506 exemption when the issuer can show 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.[19] Further, only those events as described above that occur after the new rules become effective will be considered disqualifying events.[20] Although disqualification only applies for disqualifying events that occur after the effective date of the new rule, issuers are required to disclose to investors any events that occurred prior to the effective date of the new rules if such event would have been considered a disqualifying event had it occurred after the effective date of the new rules.[21]

Effect on Issuers.

In preparing for an offering, any issuer that wants to make use of the Rule 506 exemption must exercise reasonable care to prevent a covered person with a disqualifying event from participating in the offering.

III. Proposed Changes to Form D and Regulation D.

At the same time the SEC announced its lifting of the prohibition on general solicitation and general advertising in certain private offerings and the “bad actor” disqualification, the SEC also published for comment a number of proposed amendments to Regulation D, Form D and Rule 144A under the Securities Act. These proposed amendments are intended to bolster the ability of the SEC to evaluate the development of market practices in Rule 506 offerings and to address concerns that may arise in connection with permitting issuers to engage in general solicitation and general advertising under the new Rule 506(c).[22] It is important to note however that some of the proposed amendments apply to just Rule 506(c) offerings while others apply to all Rule 506 offerings.

Additional Information on Form D.

The SEC is proposing amendments to the Form D in order to add information requirements primarily for Rule 506 offerings.[23] The SEC believes such additional information will allow the SEC to gather information about the use of Rule 506 and evaluate the impact of Rule 506(c) on the existing Rule 506 market. The proposed additional information to be required on Form D would include identification of the issuer’s website, expanded information on the issuer, types of investors in the offering, use of proceeds, and methods used to verify the accredited investor status of the investors, among other information.[24]

General Solicitation and Form D.

Currently, issuers selling securities under Rule 506 are required to file a notice on Form D no later than fifteen (15) days following the first sale of securities. Under the proposed new rules, issuers that intend to engage in general solicitation or general advertising in reliance on new Rule 506(c) in conducting a private offering would be required to file an initial Form D, with expanded informational requirements, at least fifteen (15) days prior to commencing general solicitation for the offering (the “Initial Form D”).[25] Additionally, under the proposal, issuers conducting an offering under Rule 506(c) would be required to submit to the SEC a copy of any written general solicitation materials used in the offering before such materials are used pursuant to a temporary rule.[26] After filing the Initial Form D, the issuer would then file an amendment within fifteen (15) days after the date of the first sale of securities in the offering providing the remaining information required by Form D. [27]

Closing Form D.

In furtherance of helping the SEC monitor development of market practices with respect to all Rule 506 offerings, the proposed amendments require issuers to file a final amendment to Form D within thirty (30) days after the termination or closing of any offering conducted in reliance on Rule 506 (not just those offerings under Rule 506(c)). [28]

Failure to File Form D.

Under the proposed rules, an issuer would be disqualified from relying on and using the Rule 506 exemption for one (1) year if the issuer failed to file Form D or did not comply with the Form D filing requirements within the past five (5) years; provided that such one (1) year period would commence following the filing of all required Form D filings or the filing of a closing amendment. [29]

IV. Effective Dates of Amendments and Proposed Amendments.

With regard to the general solicitation and general advertising and “bad actor” disqualification amendments to Rule 506, the effective date of the new final rules and regulations is sixty (60) days after publication in the Federal Register. With respect to the proposed amendments to Form D and Regulation D, the proposed rules are subject to comments before final rules and amendments are issued.

Footnotes

[1] Special thanks to Brandon Marx for his contributions to this article.

[2] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Securities Act Release No. 33-9415 (Jul. 10, 2013), at *1, http://www.sec.gov/rules/final/2013/33-9415.pdf [hereinafter General Solicitation]; Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings, Dodd-Frank Act Release No. 33-9414 (Jul. 10, 2013),*1, http://www.sec.gov/rules/final/2013/33-9414 [hereinafter Bad Actors].

[3] General Solicitation at *8.

[4] Amendments to Regulation D, Form D and Rule 156 under the Securities Act, Securities Act Release No. 33-9416 (proposed Jul. 10, 2013), http://www.sec.gov/rules/proposed/2013/33-9416.pdf [hereinafter Amendments].

[5] Amendments at *1.

[6] General Solicitation at *6.

[7] Id. at *17.

[8] General Solicitation at *6.

[9] 17 C.F.R. § 230.501.

[10] Id. at *26, *44.

[11] Id. at *27-28.

[12] Id. at *28.

[13] Id.

[14] Id. at *35-39.

[15] General Solicitation at *46.

[16] Bad Actors at *1.

[17] Id. at *28.

[18] Id. at *31-32.

[19] Id. at *63-67.

[20] Id. at *74.

[21] Id. at *77-78.

[22] Amendments at *1.

[23] Id. at *34.

[24] Id. at *37-43.

[25] Id. at *19.

[26] Id. at *87.

[27] Id. at *20.

[28] Id. at *26.

[29] Id. at *47-48.

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