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.

Have you been a “Bad Actor”? Maybe You Should Just Beg for Forgiveness.

Rule 506 under the Securities Act of 1933 is the most widely used exemption from the registration requirements of the Securities Act. The exemption is used by a wide range of issuers from small, start-up companies to the largest investment and hedge funds. Rule 506 generally permits issuers to sell an unlimited amount of securities to an unlimited number of accredited investors. However, pursuant to Section 926 of the Dodd-Frank Act, the SEC adopted Rule 506(d) disqualifying securities offerings involving certain felons and other “bad actors” from reliance on the Rule 506 exemption. Rule 506(d) became effective on September 23, 2013.  

Rule 506(d)(2)(ii) provides that the disqualification shall not apply “upon a showing of good cause . . . if the Commission determines that it is not necessary under the circumstances that an exemption be denied.” Similar disqualification provisions are applicable to offerings exempt from registration pursuant to Regulation A and Rule 505(b). However, neither Regulation A nor Rule 505 is relied upon nearly as often as Rule 506 because of the inherent limitations of those rules. Therefore, the impact of the bad actor disqualifications under Regulation A and Rule 505 has been somewhat limited. However, given the wide use of the Rule 506 exemption, we can expect many more issuers and others involved in securities offerings to request waivers.    

Since Rule 506(d) became effective, the SEC has granted exemptions to five issuers, four of which are financial institutions. In each case, the “bad act” which led to possible disqualification (I say possible because none of the entities requesting exemption actually admitted to disqualification) was an order or judgment entered with the consent or acquiescence of the financial institution.

Generally, each of the requests for exemption cited the following facts: the bad conduct did not involve the offer or sale of securities pursuant to Regulation A or Regulation D; steps have been taken to address the underlying conduct; and disqualification would have an adverse impact on third parties. In addition, each company requesting the exemption also committed to furnishing to each purchaser in certain exempt offerings disclosure of the “bad acts.”

In each case, the order or judgment giving rise to the disqualification, the letter from the financial institution requesting an exemption from Rule 506(d)’s disqualification provision and the letter from the SEC staff confirming that the exemption had been granted, all bear the same date. Most likely the granting of the exemption was part of the overall settlement of the matters that were the subject of the various orders. The four letters can be found here, here, here and here.

New SEC Guidance on “Bad Actor” Disqualifications from Rule 506 Offerings

On December 4, 2013, the SEC issued new Compliance and Disclosure Interpretations (C&DIs) clarifying the application of the “bad actor” disqualifications from Rule 506 offerings.  Generally, under the new Rule 506(d), an issuer may not rely on a Rule 506 exemption from registering the offering under the Securities Act of 1933 if the issuer or any other person covered by Rule 506(d) has a relevant conviction, judgment, suspension or other disqualifying event that occurred on or after September 23, 2013 (the effective date of Rule 506(d)).  Please see below a summary of some C&DIs issued by the SEC.

When is an issuer required to determine whether bad actor disqualification under Rule 506(d) applies?

An issuer must determine if it is subject to “bad actor” disqualification any time it is offering or selling securities in reliance on Rule 506.  After the initial inquiry, an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to, for example, contractual covenants, bylaw requirements, or an undertaking in a questionnaire or certification.  However, if an offering is continuous, delayed or long-lived, the issuer must update its factual inquiry periodically through bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.

If a placement agent or one of its covered control persons becomes subject to a disqualifying event while an offering is still ongoing, could the issuer continue to rely on Rule 506 for that offering?

Yes, if a placement agent or one of its covered control persons, such as an executive officer or managing member, becomes subject to a disqualifying event while an offering is still ongoing, the issuer could rely on Rule 506 for future sales in that offering if the engagement with the placement agent was terminated and the placement agent did not receive compensation for the future sales.  If the triggering disqualifying event affected only the covered control persons of the placement agent, the issuer could continue to rely on Rule 506 for that offering if such persons were terminated or no longer performed roles with respect to the placement agent that would cause them to be covered persons for purposes of Rule 506(d).

What does it mean to participate in the offering?

Participation in an offering is not limited to solicitation of investors. For example, participation in an offering include participation or involvement in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors or other offering participants about the offering.  However, to constitute “participation,” such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering.

Is disqualification triggered by actions taken overseas?

No, disqualification under Rule 506(d) is not triggered by convictions, court orders, or injunctions in a foreign court, or regulatory orders issued by foreign regulatory authorities.

When does the “reasonable care” exception apply?

The reasonable care exception to new rules applies whenever the issuer can establish that it did not know and, despite the exercise of reasonable care, could not have known that a disqualification existed under Rule 506(d).  This may occur when, despite the exercise of reasonable care, the issuer was unable to determine the existence of a disqualifying event, was unable to determine that a particular person was a covered person, or initially reasonably determined that the person was not a covered person but subsequently learned that determination was incorrect.  An issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide additional disclosure under Rule 506(e), or take other remedial steps to address the Rule 506(d) disqualification.

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.

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.

No Rule 506 Offerings for Bad Boys: Felons and Other “Bad Actors”

On July 10, the SEC revamped the way private placements under Rule 506 of Regulation D can be conducted by permitting general solicitation and general advertising in offerings where all purchasers are accredited investors (see To Use or Not to Use General Solicitation and General Advertising in Private Placements?) and by disqualifying felons and other “bad actors” from all Rule 506 offerings (i.e., irrespective of whether the offering involves or does not involve general solicitation and general advertising).  New SEC “bad actor” rules, effective 60 days after publication in the Federal Register, implement Section 926 of the Dodd-Frank Act and were originally proposed two years ago (May 25, 2011).

Under new Rule 506(d), “Bad Actor” Disqualification, an issuer will not be able to rely on the Rule 506 exemption from registration under the Securities Act of 1933 if the issuer or any other “covered person” is or was involved in a disqualifying event.

Covered Persons

“Covered persons” under Rule 506(d) include:

  • the issuer, any predecessor of the issuer, or any affiliated issuer;
  • directors, executive officers, other officers participating in the offering, general partners or managing members of the issuer;
  • beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • promoters connected with the company at the time of such sale;
  • investment managers of a pooled investment fund;
  • persons compensated (directly or indirectly) for soliciting investors; and
  • directors, executive officers, or other officers participating in the offering, of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.

Disqualifying Events

Rule 506(d) “disqualifying events” include the following:

  • criminal convictions, within ten years before the sale of securities (or five years, in the case of issuers, their predecessors and affiliated issuers) in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; or arising out of the conduct of an underwriter, broker, dealer, or other financial intermediary;
  • court injunctions and restraining orders, entered within five years before such sale, in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; or arising out of the conduct of an underwriter, broker, dealer, or other financial intermediary;
  • final orders of a state securities commission; a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission; an appropriate federal banking agency; the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration that: 

     (i)  bar the person 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

     (ii)  are based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale;

  • SEC disciplinary orders suspending or revoking a person’s registration as a broker, dealer, municipal securities dealer or investment adviser; placing limitations on the activities of such person; or barring such person from being associated with any entity or from participating in the offering of any penny stock;
  • SEC cease and desist orders, entered within five years before such sale, that, orders the person to cease and desist from committing or causing a violation of any scienter-based anti-fraud provision of the federal securities laws (e.g., Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 or Section 5 of the Securities Act of 1933).
  • suspensions or expulsions from membership in, or suspension or a bar from association with a member of, a registered national securities exchange for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
  • SEC stop orders in connection with a registration statement or orders suspending the Regulation A exemption, issued within five years before such sale; or investigation to determine whether a stop order or suspension order should be issued; or
  • U.S. Postal Service false representation orders, entered within five years before such sale, or being subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the U. S. Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations.

Exceptions

Rule 506(d) disqualification does not apply if:

  • the triggering event occurred before the effective date of the new rules;
  • the SEC waives the disqualification;
  • before the relevant sale, the court or regulatory authority that entered the relevant order, judgment or decree advises in writing that Rule 506(d) disqualification should not arise as a consequence of such order, judgment or decree; or
  • the company establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

 Disclosure of Pre-Existing Disqualifying Events

The company must furnish to each purchaser, a reasonable time prior to sale, a description in writing of any matters that would have triggered Rule 506(d) disqualification but occurred before the effective date of new rules.  The failure to furnish such information timely will not prevent a company from relying on Rule 506 exemption from registration if the company establishes that it did not know and, in the exercise of reasonable care, could not have known of the existence of the undisclosed matter or matters.

Reasonable Care

In connection with “reasonable care” requirements, a company will not be able to establish that it has exercised reasonable care unless it has made a factual inquiry into whether any disqualifications exist. The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the company and the other offering participants.  For example, the SEC anticipates companies to have “an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.”

The SEC suggested that “factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.”  The SEC also clarified that for continuous, delayed or long-lived offerings, “reasonable care includes updating the factual inquiry on a reasonable basis,” which can be “managed through contractual covenants from covered persons to provide bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.”

Companies that are contemplating a Rule 506 private placement need to establish internal procedures for conducting a factual inquiry into whether “bad actors” may be involved in its offering.

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.

GET READY TO UPDATE YOUR SPAM FILTER – THE SEC PROPOSES AMENDMENTS ALLOWING GENERAL SOLICITATION AND ADVERTISING IN PRIVATE PLACEMENTS

On August 29, 2012, the Securities and Exchange Commission issued its proposed rules to eliminate the prohibition against general solicitation and general advertising in certain securities offerings made pursuant to Securities Act Rules 506 and 144A.  The rules were proposed pursuant to Section 201(a)(1) of the JOBS Act.  The SEC will seek public comment for 30 days after the publication of the rules in the Federal Register.

Under the proposed rules, issuers would be permitted to offer securities using general solicitation and advertising if:

  • The issuer takes reasonable steps to verify that the purchasers are accredited investors; and
  • All purchasers are accredited investors because either:
    • They come within one of the categories of persons who are accredited investors under Rule 501, or
    • The issuer reasonably believes they come within one of the categories at the time the securities are sold.

The proposed rules do not require specific methods to verify accredited investor status.  Instead, the proposed rules require issuers to consider the facts and circumstances of the transaction.  In its release proposing the new rules, the SEC enumerated certain factors issuers should consider and noted that “whether the steps taken are “reasonable” would be an objective determination, based on the particular facts and circumstances of each transaction.” 

For those issuers that do not want to engage in general solicitation and verification procedures, the proposed rules would preserve the existing portions of Rule 506 as a separate exemption so that companies conducting offerings without the use of general solicitation or advertising would not have to comply with the new verification provisions. 

In addition, under the proposed rules, securities sold pursuant to Rule 144A could be offered to persons other than “qualified institutional buyers,” including by means of general solicitation, if the securities are sold only to persons whom the seller and any person acting on the seller’s behalf reasonably believes to be qualified institutional buyers.