EQUITY CROWDFUNDING HAS FINALLY ARRIVED – SEC ADOPTS FINAL RULES ON CROWDFUNDING

On October 30, 2015, the Securities and Exchange Commission (“SEC”), in a 3-1 vote of the SEC Commissioners, approved final rules to adopt Regulation Crowdfunding, which sets forth the framework by which companies can “equity crowdfund” – sell small amounts of securities (typically for a small purchase price) to a large number of investors over the Internet. The final rules, which will become effective 180 days after they are published in the Federal Register, follow the SEC’s adoption of proposed rules in October 2013 (which we previously blogged about). The SEC’s proposed rules were widely criticized as unworkable and elicited more than 480 comment letters that raised a host of concerns regarding, among other things, the effectiveness of the proposed rules in promoting capital formation and protecting investors.

Issuers and investors, particularly in the startup community, have been abuzz about equity crowdfunding since the Jumpstart Our Business Startups Act (“JOBS Act”) was enacted in April 2012.  Title III of the JOBS Act added Section 4(a)(6) to the Securities Act of 1933 (the “Securities Act”) to provide an exemption for equity crowdfunding transactions from the registration requirements of the Securities Act.  After seeing the success of non-equity crowdfunding – the Kickstarter fundraising campaigns of Pebble (~$20M raised) and Pono (~$6M raised) come to mind – it is understandable why issuers and investors have placed so much hope in the promise of equity crowdfunding.  With the SEC’s final rules in place, equity crowdfunding, with its numerous limitations and requirements, will shortly become a reality.

Under the final rules, an issuer may raise up to $1 million in a 12-month period in a crowdfunding offering conducted via a single intermediary – either a broker-dealer or a funding portal registered with the SEC.  An issuer engaging in a crowdfunding offering must complete and file with the SEC a newly-created Form C (similar to the Form 1-A offering statement under Regulation A, but with fewer required disclosures), which will require the disclosure of certain business and financial information including  financial statements of the issuer. Depending on the amount sought in the crowdfunding offering and whether an issuer has previously conducted a crowdfunding offering, the final rules will require that an issuer provide audited or reviewed financial statements.  For example, an offering of more than $500,000 of securities will require reviewed financial statements unless the issuer is not a first time issuer, in which case audited financial statements will be required.

The final rules also limit the amount of funds that an individual investor may invest in all crowdfunding offerings over a 12-month period, based on an investor’s annual income and net worth. Interestingly, despite criticism on the workability of the investment limitations set forth in the proposed rules, the final rules have more stringent limitations than those included in the proposed rules.  An investor with either annual income or net worth less than $100,000 can invest up to 5 percent of the lesser of annual income or net worth, or $2,000, whichever is greater, every 12 months. An investor with both annual income and net worth greater than $100,000 can invest up to 10 percent of the lesser of annual income or net worth every 12 months, subject to a cap of $100,000 in a 12-month period.   One effect of the limits will be that crowdfunding issuers may end up with numerous investors providing small investments – for example, an issuer raising $1 million would have 500 shareholders if the $2,000 limitation applied to those investors.

Only time will tell whether the regulatory environment created by the final rules will allow equity crowdfunding to reach the heights envisioned by many proponents. Among other reasons, the costs and compliance burden for issuers and the potential returns to investors are difficult to forecast at this time.  Regardless, many issuers, especially startups, now have an additional tool to raise capital in the United States. A more detailed summary of the final rules is provided below.

Sales Limitations

The following sales limitations apply to a crowdfunding offering:

  • An eligible issuer (see below for a description of ineligible issuers) is permitted to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period. In addition, entities controlled by, or under common control, with the issuer are aggregated for purposes of determining compliance with the offering ceiling.
  • Individual investors, over the course of a 12-month period, are permitted to invest in the aggregate across all crowdfunding offerings up to:
    • If either their annual income or net worth is less than $100,000, then the greater of: (1) $2,000, or (2) 5% of the lesser of their annual income or net worth.
    • If both their annual income and net worth are equal to or more than $100,000, then 10% of the lesser of their annual income or net worth, subject to a cap of $100,000 in a 12-month period.
  • The JOBS Act requires that the SEC adjust the issuer sales limitation and investor investment limitations not less than every five years to account for changes in the CPI.

Ineligible Issuers

The following issuers are not eligible to utilize a crowdfunding offering:

  • Non-U.S. companies.
  • Reporting companies under the Securities Exchange Act of 1934 (the “Exchange Act”).
  • Certain investment companies.
  • Companies that are disqualified under Regulation Crowdfunding’s disqualification rules (i.e., bad actors).
  • Companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement (i.e., Form C).
  • Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Disclosure Requirements

An issuer conducting a crowdfunding offering is required to file certain information with the SEC on new Form C and to provide this information to investors and the applicable crowdfunding portal facilitating the offering. Among other things, in its offering documents, the issuer is required to disclose:

  • Information about officers and directors as well as owners of 20 percent or more of the issuer;
  • A description of the issuer’s business and the use of proceeds from the offering;
  • The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the issuer will accept investments in excess of the target offering amount;
  • Certain related-party transactions;
  • A discussion of the issuer’s financial condition; and
  • Financial statements of the issuer that are, depending on the amount offered and sold during a 12-month period:
  • If $100,000 or less, based on information from the issuer’s tax returns and certified by the principal executive officer,
  • If more than $100,000 and but not more than $500,00, reviewed by an independent public accountant, and
  • If more than $500,000, audited by an independent auditor, except that an issuer engaging in a crowdfunding offering for the first time would be permitted to provide reviewed rather than audited financial statements.
  • In any case, if audited financial statements of the issuer are available, then they must be provided.

Issuers are required to amend the offering document during the offering period to reflect material changes and provide updates on the issuer’s progress toward reaching the target offering amount.

In addition, issuers relying on the Regulation Crowdfunding exemption are required to file an annual report with the SEC and provide it to investors.  The reporting requirements will continue until:

  • the issuer is required to file reports under the Exchange Act;
  • the issuer has filed at least one annual report and has fewer than 300 holders of record;
  • the issuer has filed at least three annual reports and has total assets that do not exceed $10 million;
  • the issuer or another party purchases or repurchases all of the securities issued pursuant to the crowdfunding exemption), including any payment in full of debt securities or any complete redemption of redeemable securities; or
  • the issuer liquidates or dissolves in accordance with state law.

Crowdfunding Platforms

Each crowdfunding offering must be conducted exclusively through a single platform operated by an “intermediary” which is either a registered broker or a funding portal – a new type of SEC registrant. The rules require that such an intermediary:

  • Provide investors with educational materials;
  • Take measures to reduce the risk of fraud;
  • Make available information about the issuer and the offering;
  • Provide communication channels to permit discussions about offerings on the platform; and
  • Facilitate the offer and sale of crowdfunded securities.

The rules also prohibit a crowdfunding portal from:

  • Offering investment advice or making recommendations;
  • Soliciting purchases, sales or offers to buy securities offered or displayed on its platform;
  • Compensating promoters and others for solicitations or based on the sale of securities; and
  • Holding, possessing, or handling investor funds or securities.

The final rules provide a safe harbor under which crowdfunding portals can engage in certain activities, consistent with these restrictions.

Miscellaneous Restrictions

Securities acquired in a crowdfunding offering are generally subject to a one year holding period before they can be resold, subject to certain exceptions. Holders of securities acquired in a crowdfunding offering do not count toward the threshold that requires an issuer to register its securities with the SEC under Section 12(g) of the Exchange Act if the issuer is current in its annual reporting obligation, retains the services of a registered transfer agent and has less than $25 million in assets.

The Alphabet Soup of Raising Capital: Regulation A or Regulation D — What Would You Prefer?

On June 19, 2015, amended Regulation A recently adopted by the SEC will become effective. The new Regulation A, mandated by the JOBS Act and often dubbed as Regulation A+, is a significant improvement over the old Regulation A, which was rarely used as a capital raising vehicle. The old Regulation A permits unregistered offerings of up to $5 million of securities in any 12-month period, including no more than $1.5 million of securities offered by security holders of the company. Permissible thresholds of Regulation A+ are much higher. It provides for two tiers of offerings: “Tier 1, for offerings of securities of up to $20 million in a 12-month period, with not more than $6 million in offers by selling security-holders that are affiliates of the issuer; and Tier 2, for offerings of securities of up to $50 million in a 12-month period, with not more than $15 million in offers by selling security-holders that are affiliates of the issuer.”

However, will Regulation A+ become a more popular choice for smaller companies than Regulation D in raising capital? Is Regulation A+ a workable compromise between the company’s need to have access to capital and the SEC’s goal of investor protection?

Rule 506 of Regulation D is one of the most widely used capital raising exemptions under the US securities laws. The main reason of its popularity is its flexibility. Although Rule 506 does not provide an opportunity for selling security holders to participate in the offering as Regulation A+ does, Rule 506 does not have any caps on the dollar amount that can be raised. In addition, any company: public or private, US or foreign can raise capital under Rule 506. However, only a US or Canadian issuer that is not (i) a reporting company under the Securities Exchange Act of 1934 immediately prior to the offering, (ii) an investment company, or (iii) a blank check company is considered an “eligible issuer” under Regulation A+. Note that “bad actor” disqualification applies to both Rule 506 and Regulation A+ offerings. Also, a company that had its registration revoked under Section 12(j) of the Exchange Act within five years before the filing of the offering statement or that has been delinquent in filing required reports under Regulation A+ during the two years before the filing of the offering statement (or for such shorter period that the issuer was required to file such reports) is not eligible to do an offering under such Regulation.

In some instances, Regulation A+ appears to be more accommodating than Rule 506. For example, Rule 506 allows an unlimited number of accredited investors as purchasers (with Rule 506(b) also permitting up to 35 non-accredited investors), and Tier 1 of Regulation A+ does not have any limitation on the number or type of investors. Tier 2 also does not have any limitations on the number of investors, but imposes a per-investor cap for non-accredited investors (unless the securities are listed on a national exchange) of the aggregate purchase price to be paid by the purchaser for the securities to be no more than 10% of the greater of annual income or net worth for individual investors or revenue or net assets most recently completed fiscal year for entities.  In addition, Regulation A+ allows issuers to “test-the-waters” by trying to determine whether there is any interest in a contemplated securities offering (assuming such practice is allowed under applicable blue sky laws for Tier 1 offerings), while the traditional Rule 506(b) does not allow for general solicitation and advertising (Rule 506(c) permits general solicitation and advertisement).

The biggest downside of Regulation A+ structure is that blue sky registration requirements are not preempted for Tier 1 offerings, which significantly limits the use of Tier 1 for offerings in multiple states. Such preemption exists for Rule 506 offerings as well as Tier 2 of Regulation A+ offerings. But the welcomed flexibility of doing nationwide offerings under Tier 2 comes with a heavy price tag of ongoing reporting. After a Tier 2 offering, an issuer must file with the SEC annual reports on Form 1-K, semi-annual reports on Form 1-SA and current reports on Form 1-U (within 4 business days of the event). The SEC also noted that companies may “voluntarily” file quarterly financial statements on Form 1-U, but the practical effect of desired compliance with Rules 15c2-11 and Rule 144 to maintain placement of quotes by market makers and resales of securities, will lead to “voluntary” quarterly reporting becoming essentially mandatory.

Rule 506 offerings are usually accompanied by private placement memoranda, or PPMs, (even when offerings are solely to accredited investors) to protect issuers from Rule 10b-5 liability under the Exchange Act. There is no prescribed format for such PPMs and they are not reviewed by the SEC. In connection with Regulation A+ offerings, an issuer must file Form 1-A (a “mini” registration statement) through EDGAR with the SEC (first-time issuers are eligible to initially do a non-public submission of a draft of Form 1-A). Such Forms 1-A are subject to the SEC review and comment process, which increases the cost of the transaction and extends the time from the beginning of the transaction and the closing.

The good news is that Regulation A+ provides a new way for smaller companies to raise capital and get some liquidity in their securities. However, if a company is confident that it can raise money through the traditional Rule 506 private placement, it may still want to avoid the SEC review process, the hassle of blue sky compliance under Tier 1 or ongoing reporting obligations of Tier 2 introduced by Regulation A+.

Is the SEC Doing Enough to Promote Capital Formation?

If you believe Commissioner Daniel M. Gallagher, the answer is an emphatic “no”, at least with respect to small businesses. On September 17, 2014, at a Heritage Foundation event, Commission Gallagher gave a speech criticizing the Securities and Exchange Commission’s failure to adequately promote capital formation by small businesses:

[S]adly, we at the SEC are not doing nearly enough to ensure that small businesses have the access to capital that they need to grow. We layer on rule after rule until it becomes prohibitively expensive to access the public capital markets.

After noting that not all of the regulatory burden is the SEC’s fault as “much of the ever-growing rulebook is a direct result of congressional mandates,” Commissioner Gallagher makes a number of recommendations for the SEC. Highlights include recommendations to:

  • Withdraw the proposed amendments to Regulation D. (Commission Gallagher did not support the proposed amendments as he stated in the SEC’s July 10, 2013 open meeting.)
  • Consider more deeply Regulation D, including considering broadening the blue sky exemption to help make the choice between the various exemptions available under Regulation D more meaningful.  According to Commissioner Gallagher, nearly all Regulation D offerings are conducted under Rule 506, even though 2/3 of the offerings are small enough that they could have been conducted pursuant to Rule 504 or 505, because Rule 506 offerings are exempt from blue sky regulations.
  • Analyze the secondary market for private company shares, where innovation has slowed. “We need more facilities to improve trading among accredited investors in the private secondary market.”
  • Finish implementing the JOBS Act’s reforms to Regulation A and couple the reforms with the formation of venture exchanges (national exchanges with listing rules tailored for smaller companies, including those issuing shares issued pursuant to Regulation A). Commission Gallagher noted that the SEC had proposed a robust set of rules, including blue sky preemption in certain larger Regulation A Offerings. (Commissioner Gallagher also noted, with respect to the proposal for blue sky exemption, that an “outpouring of anger from state regulators . . . wasn’t unexpected. After all, state regulators have been “protecting” investors from investment opportunities that are too risky for decades – I’m sure the Massachusetts residents who missed out on the offering of Apple Computer in 1980 because of their regulator’s concerns about the risk know this all too well.”)
  • Reconsider the current thresholds for scaled disclosure and the amount of disclosure that is required at each level – including having two tiers of scaling: significant scaling of disclosure for “nanocap” companies (i.e., companies with market capitalizations of up to $50 million) and moderate scaling for “microcap” companies with market capitalizations of $50 million to $300 million.

Coincidently, the SEC released its 2014 – 2018 Strategic Plan on September 19, 2014, two days after Commissioner Gallagher’s speech. Featured on the cover of the Strategic Plan is the SEC’s mission statement – “Protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation” (emphasis added).

But, judging by the SEC’s own Strategic Plan and its current rulemaking agenda, it is unlikely that the SEC will be vigorously addressing many of Commissioner Gallagher’s concerns regarding capital formation for small businesses in the near future.

SIFMA Issues Guidance on Rule 506(c) Verification

On June 23, 2014, the Securities Industry and Financial Markets Association (“SIFMA”) issued a memorandum (the “Memorandum”) containing guidance for broker-dealers and investment advisers with respect to verifying the status of purchasers as accredited investors in connection with offerings made pursuant to Rule 506(c) (Reg D offerings utilizing general solicitation, as we have previously blogged about).

Pursuant to Rule 506(c), an issuer utilizing general solicitation for a Reg D offering must, among other things, take reasonable steps to verify that purchasers in the offering are accredited investors. The reasonable verification requirement is a separate condition from the condition that all purchasers in a Rule 506(c) offering must be accredited investors, and the requirement has generated significant commentary.

The Rule 506(c) adopting release provided four non-exclusive safe harbor methods that an issuer can utilize for such reasonable verification, two of which require the issuer to obtain detailed financial information from a purchaser. An issuer may also rely on the written confirmation of a purchaser’s accredited investor status issued by a registered broker-dealer or investment adviser, licensed attorney or certified public accountant. Any such third party must, however, take reasonable steps to verify the purchaser’s accredited investor status before providing written confirmation to the issuer.

To this end, the Memorandum provides two verification methods for broker-dealers and investment advisers to use in verifying natural persons as accredited investors that SIFMA believes satisfies the “reasonable verification” requirement.

One verification method (the “account balance method”) is essentially a determination by the broker-dealer or investment adviser of the purchaser’s net worth. For a broker-dealer or investment adviser to utilize the account balance method, a purchaser must have been a client of the broker-dealer or investment adviser for at least six months, must have (either individually or together with a spouse, if applicable) at least $2 million in cash and marketable securities in the purchaser’s account prior to making the investment in the Rule 506(c) offering, must make certain representations (pursuant to purchaser representations provided by SIFMA as part of the Memorandum) regarding, among other things, the purchaser’s indebtedness, and the broker-dealer or investment adviser must be unaware of any facts to indicate that the client is not an accredited investor.

The other method (the “investment amount method”) uses the purchaser’s investment amount as a proxy for the purchaser’s status as an accredited investor. For a broker-dealer or investment adviser to utilize the investment amount method, a purchaser must have been a client of the broker-dealer or investment adviser for at least six months, must invest, or unconditionally commit to fund, at least $250,000 in a Rule 506(c) offering, which commitment is callable in whole at any time, must make certain representations (pursuant to purchaser representations provided by SIFMA as part of the Memorandum) including, among other things, that the investment in the Rule 506(c) offering is less than 25% of the purchaser’s net worth (either individually or together with a spouse), and the broker-dealer or investment adviser must be unaware of any facts to indicate that the client is not an accredited investor and, in the case of a commitment, the broker-dealer or investment adviser has knowledge that the purchaser has fulfilled a call under a prior commitment.

The Memorandum also provides a method for broker-dealers and investment advisers to use in verifying legal entities (i.e., corporations, LLCs, etc.) as accredited investors. For a broker-dealer or investment adviser to utilize this method, a purchaser-entity must be named on the broker-dealer’s or investment adviser’s current list of clients that qualify as “institutional accounts” as defined in FINRA Rule 4512(c)(3)or as Qualified Institutional Buyers (which are required to have investible assets of at least $100 million), or the purchaser-entity must make an investment in the Rule 506(c) offering in excess of $5 million and must provide a written representation that it was not formed for the purpose of making that investment and that it has made at least one prior investment in securities (whether in a primary offering or in the secondary market).

If issuers begin to use Rule 506(c) offerings with increasing frequency, SIFMA’s guidance in the Memorandum may be an important guidepost for broker-dealers and investment advisers and other third parties (e.g., attorneys and accountants) in assisting issuers to comply with the “reasonable verification” requirement set forth in Rule 506(c). This guidance may also be useful to issuers and other market participants.

Effective Date of New Reg D Rules Revealed

On July 10, the SEC adopted new rules which provide:

Such new rules were to become effective 60 days after publication in the Federal Register.  The new rules were published in the Federal Register today.  Accordingly, such new rules will become effective on September 23, 2013.

Burn, Baby, Burn – Reg D Inferno*

A recent report issued by SEC’s Division of Economic and Risk Analysis shows that Regulation D remained “hot” as a means to raise capital – even before the recent amendments to that rule take effect. The report updates a 2012 SEC report that analyzed Form D filings from the beginning of 2009 through the first quarter of 2011. The updated report contains information through the end of 2012 and provides additional analysis.

Among the highlights of the report:

• Capital raised through Regulation D offerings continues to be sizeable – $863 billion reported in 2011 and $903 billion in 2012. By contrast, public equity offerings raised less than $250 billion in each of those years.

• Since 2009, hedge funds reported raising $1.3 trillion through Regulation D offerings. Private equity funds reported $489 billion; non‐financial issuers reported $354 billion. Foreign issuers account for 19% of the total amount sold.

• Since 1993, the number of Regulation D offerings fluctuates directly with the S&P 500, suggesting that the health of the private market is closely tied to the health of the public market (and thereby contradicting the view that the private capital markets step in during times of public market stress).

• Rule 506 accounts for 99% of amounts sold through Regulation D. More than two‐thirds of non‐fund issuers could have claimed a Rule 504 or 505 exemption based on offering size, indicating that issuers value the Blue Sky law preemption allowed under Rule 506.

• More capital was raised in Regulation D offerings in 2012 than in public equity offerings or Rule 144A offerings; public debt offerings raised slightly more capital than Regulation D, but, as the authors noted, public debt offerings include many refinancings of existing debt, while approximately two-thirds of Regulation D offerings represent new equity capital.

• There have been more than 40,000 Regulation D offerings by non‐financial issuers since 2009 with a median offer size of less than $2 million.

• Form D filings report that more than 234,000 investors participated in Regulation D offerings in 2012, of which 91,000 participated in offerings by non‐financial issuers, more than double the number of investors participating in hedge fund offerings.

• Nonaccredited investors were present in only 10% of Regulation D offerings (suggesting that the recent amendments permitting general solicitations, provided that there are no sales to nonaccredited investors, should have little adverse effect).

• Only 13% of Regulation D offerings since 2009 reported using a broker‐dealer or finder, which usage may decline after general solicitation becomes permissible.

• Nearly 10% of all SEC reporting companies raised capital through Regulation D offerings during the period 2009-1011, and about 6% in 2012.

The authors noted that the actual amount of capital raised through Regulation D offerings may be higher than reported because there is no requirement to file a final From D showing the total raised and, further, some issuers do not file a Form D at all.

The bottom line is that the recent Regulation D amendments permitting general solicitation will likely add additional fuel to this already hot market.

* With humble apologies to The Trammps and their 1976 hit, “Disco Inferno.”

The SEC Proposed Extensive Additional Requirements for the General Solicitation of Investors Under Rule 506(c)

In addition to adopting the final rules governing general solicitation and advertising in connection with certain securities offerings where all purchasers are accredited investors, on July 10, 2013, the SEC also proposed new rules that in the SEC’s words are intended: 

to enhance the Commission’s ability 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 new paragraph (c) of Rule 506.

All of the excitement all the hoopla over the past few days about the adoption of new general solicitation and advertising rules has been somewhat tempered by concern that these proposed rules will adversely impact the use of general solicitation in Rule 506(c) private placements under Regulation D.

Regulation D and Form D 

With respect to Regulation D and Form D, the proposals would, if adopted:

Add a new Rule 510T Requiring Issuers to Submit to the SEC General Solicitation Materials.  

New Rule 510T would require issuers, on a temporary basis, to submit (not “file” or “furnish”) to the SEC any written general solicitation materials used in a Rule 506(c) offering no later than the date the materials are first used in connection with the offering.  The SEC did not, however proposed that these materials, when filed with the SEC, be publicly available.  The rule would expire two years after its effective date.  The SEC believes that the collection of these materials will facilitate its assessment of market practices through which issuers solicit purchasers in Rule 506(c) offerings.  Prior to the effectiveness of Rule 510T, the SEC will make available an intake page on the SEC’s website to allow issuers, investors and other market participants to voluntarily submit any written general solicitation materials used in connection with a Rule 506(c) offering. 

Compliance with Rule 510T would not be a condition of the Rule 506(c) exemption.  Instead, Rule 507(a) would be amended to provide that Rule 506 would be unavailable for an issuer if the issuer, or any of its predecessors or affiliates, has been subject to any order, judgment or court decree enjoining such person for failing to comply with Rule 510T. 

Amend Rule 503 of Regulation D to Require:

  • For issuers that intend to engage in general solicitation pursuant to Rule 506(c), the filing of a Form D no later than 15 calendar days in advance of the first use of general solicitation.  Currently, Rule 503 requires that the Form D be filed within 15 after the first sale.
  • The filing of a Form D amendment within 30 calendar days after the termination of a Rule 506 offering.  Currently, Rule 503 does not require the filing of such a closing Form D. 

Amend Rule 507 to Disqualify Issuers from Using Rule 506 for New Offerings for Failing to Comply with Their Form D Filing Requirements.

The proposed rules automatically disqualify an issuer from using  Rule 506 in any new offering for one year if the issuer, or any predecessor or affiliate of the issuer, did not comply, within the last five years, with all of the Form D filing requirements in a Rule 506 offering.  The one year disqualification period would not start to run until the required Form D filings had been made and would not affect offerings of an issuer that are ongoing at the time of the filing non-compliance.   In addition, the five year look-back period would not extend back beyond the effective date of the new disqualification rule.  The rule would also provide that if a required Form D or amendment was filed within 30 days after its due date, it would not be considered late for purposes of the new disqualification rule.  The cure period will not be available if the issuer previously failed to comply with a Form D filing deadline in connection with the same offering. 

Currently, issuers are precluded from relying on Rule 506 in connection with a failure to file a Form D only if the issuer, any of its predecessors or affiliates have been subject to a court order enjoining such person for failure to comply with Rule 503, which requires the filing of a Form D.    

Add New Rule 509 Requiring Issuers to Include Legends in Certain Offering Materials. 

A new proposed Rule 509 would require issuers to include certain legends in any written communication that constitutes a general solicitation in any offering conducted in reliance on Rule 506(c) and require additional disclosures for private funds, such as private equity, venture capital and hedge funds in general. 

The generally applicable legends will look familiar to securities law practitioners and would include statements regarding sale only to accredited investors, reliance on an exemption from the registration requirements of the Securities Act, and transfer restrictions under applicable securities laws.

Private funds would be required to include additional legends indicating that the securities offered are not subject to the protection of the Investment Company Act of 1940 and additional disclosures in any written general solicitation materials that include performance data.   

Compliance with these additional disclosure requirements would not be a condition of the Rule 506(c) exemption.  Instead, Rule 507(a) would be amended to provide that Rule 506 would be unavailable if the issuer, or any of its predecessors or affiliates, has been subject to any order, judgment or court decree enjoining such person for failing to comply with Rule 509. 

Amend Form D to Require Additional Information Primarily in Connection with Offerings Conducted in Reliance on Rule 506, such as:

  • The issuer’s publicly accessible website address.
  • For offerings conducted under Rule 506(c), the name and address of any person directly or indirectly controlling the issuer.
  • Information about the size of the issuer (revenues or net asset value) where such information is otherwise publicly disclosed (currently, “decline to disclose” is an option on Form D with respect to this type of information).
  • Additional information about the number and types of accredited investors investing.
  • Additional information about the use of proceeds from offerings conducted under Rule 506.
  • If a registered broker-dealer was used in connection with the offering, whether any general solicitation materials were filed with FINRA.
  • In the case of pooled investment funds advised by investment advisers registered with, or reporting as exempt reporting advisers to, the SEC, the name and SEC file number for each investment adviser who functions directly or indirectly as a promoter of the issuer.
  • For Rule 506(c) offerings, the methods used to verify accredited investor status and the types of general solicitation/advertising used.

Rule 156 Amendments

In addition, the SEC also proposed to amend Rule 156 to apply the guidance in that rule to the sales literature of private funds.  Generally, Rule 156 presently provides guidance on the types of information in investment company sales literature that could be misleading for purposes of the federal securities laws.

To Use or Not to Use General Solicitation and General Advertising in Private Placements?

The SEC’s July 10th meeting has fundamentally changed the world of private placements by eliminating the blanket prohibition against general solicitation and general advertising in Rule 506 offerings.   The SEC has adopted the rules it proposed almost a year ago (in August 2012) to implement Section 201(a) of the JOBS Act.  Under amended Rule 506, a company will essentially have a choice of using Rule 506(b) to conduct a private placement subject to the current prohibition against general solicitation and general advertising or using new Rule 506(c), pursuant to which securities can be offered through general solicitation and general advertising.  This may not be an easy or straightforward choice for a company contemplating a private placement. 

New Rule 506(c), which will be effective 60 days after publication in the Federal Register, permits a company to offer securities using general solicitation and general advertising, only if it meets all of the following conditions:

  • sales must satisfy all the terms and conditions of Rules 501 (Definitions and Terms Used in Regulation D) and 502(a) and (d) (Integration and Limitations on Resales);
  • all purchasers of securities are accredited investors; and
  • the company takes reasonable steps to verify that purchasers of its securities are in fact accredited investors.

Some companies may choose not to use Rule 506(c) because the determination of whether the steps taken are “reasonable” is based on a facts and circumstances analysis conducted by the company.  A company conducting a private placement under current Rule 506(b) does not need to engage in the verification process described below and can rely on its reasonable belief that the purchaser satisfies one or more accredited investor criteria set forth in Rule 501(a).  In addition, companies may decide not to use the new Rule 506(c), not only to avoid such verification process, but also in order to make private placements to non-accredited investors who meet the sophistication requirements of Rule 506(b).

For ongoing Rule 506 offerings that commence before the effective date of Rule 506(c), a company may choose to continue the offering after the effective date under either Rule 506(b) or Rule 506(c).  If a company chooses to continue the offering in accordance with the requirements of Rule 506(c), any general solicitation that occurs after the effective date, as permitted under such rule, will not affect the exempt status of offers and sales of securities that occurred under Rule 506(b) prior to the effective date.

A significant part of the SEC’s adopting release is focused on the analysis that a company must conduct to verify that a purchaser of securities in a Rule 506(c) offering is an accredited investor.  The SEC has specifically stated in the adopting release that a company will not be deemed to have taken reasonable steps to verify accredited investor status if it only required an investor to check a box in a questionnaire or sign a form (which is an acceptable practice now under the current “reasonable belief standard” applicable to offerings under Rule 506(b)), in the absence of other information indicating accredited investor status of the purchaser.  The SEC has embraced a principles-based method of verification and believes that a company should consider the following factors in its analysis:

  • the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
  • the amount and type of information that the company has about the purchaser; and
  • the nature of the offering (e.g., 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).

These factors are interconnected and the SEC stated that “[a]fter consideration of the facts and circumstances of the purchaser and the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify the accredited investor status.”  To illustrate this, the SEC produced the following example: “if the terms of the offering require a high minimum investment amount and a purchaser is able to meet those terms, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party.”

A company may rely on a third party that has verified a person’s status as an accredited investor (assuming the company has a reasonable basis to rely on such third-party verification) or on publicly available information in filings with a federal, state or local regulatory body (e.g., proxy statement disclosing the compensation of a purchaser who is a named executive officer of a public company or IRS Form 990 disclosing total assets of a Section 501(c)(3) organization with $5 million in assets). 

The means used by the company to solicit purchasers may be relevant in determining the reasonableness of the steps that a company should take to verify accredited investor status.  The SEC has pointed out that “[a]n issuer that solicits new investors through a website accessible to the general public, through a widely disseminated email or social media solicitation, or through a newspaper, will 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.”

Recognizing the difficulty of determining what steps would be reasonable to verify an accredited investor’s status of a natural person and in response to comments, the SEC has provided the following examples of non-exclusive and non-mandatory methods that a company may use to verify that a natural person purchasing its securities in a Rule 506(c) offering is an accredited investor (assuming that the company does not have knowledge that such person is not an accredited investor):

  • reviewing any IRS form that reports the purchaser’s (or with the purchaser’s spouse in the case of a person who qualifies as an accredited investor based on joint income with that person’s spouse) income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser (or with the spouse) that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
  • reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser (or with the purchaser’s spouse in the case of a person who qualifies as an accredited investor based on joint net worth with that person’s spouse) that all liabilities necessary to make a determination of net worth have been disclosed:
    • with respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
    • with respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies; or
  • obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:
  • a registered broker-dealer;
  • an investment adviser registered with the SEC;
    • a licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
    • a certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.
  • in regard to any person who purchased securities in a Rule 506(b) offering as an accredited investor prior to the effective date of 506(c) and continues to hold such securities, for the same issuer’s Rule 506(c) offering, obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.

Given the facts and circumstances analysis that a company has to perform in order to determine whether the purchaser of its securities in a Rule 506(c) offering is an accredited investor, on the one hand, and the privacy concerns of individual investors, on the other hand, it’s unclear whether general solicitation and general advertising in Rule 506 private placements will become a mainstream trend.