US Private Offerings: SEC Approves JOBS Act Requirement to Permit General Solicitation and Dodd-Frank Requirement to Disqualify “Bad Actors” from Using Rule 506 to Offer Securities
The SEC has amended1 Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 (“Securities Act”) to (1) permit, in certain circumstances, an issuer to engage in general solicitation and general advertising in connection with Rule 506 and Rule 144A offerings (“General Solicitation Rules”) and (2) disqualify securities offerings involving certain “felons” and other “bad actors” from relying on Rule 506 of Regulation D (“Bad Actor Rules”), whether or not the issuer is relying on the new General Solicitation Rules. These rules took effect on September 23, 2013. The SEC also has proposed rules that are intended to enhance the SEC’s ability to monitor how the General Solicitation Rules will affect the private offering market and to provide additional investor protection safeguards (“Proposed Rules”).2 The new General Solicitation Rules and the Bad Actor Rules are discussed below. The Proposed Rules were addressed in a separate OnPoint.3
Permitting General Solicitation and General Advertising in Rule 506 Offerings
Background: The Pre-Existing Rule 506(b) Safe Harbor Remains Available
Many U.S. private placements rely on Rule 506(b), a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act, which exempts transactions by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act. The SEC has retained, in its current form, the existing Rule 506(b) safe harbor as a separate exemption that continues to prohibit general solicitation or general advertising.4 Rule 506(c) represents a separate, but related, safe harbor under Rule 506 that permits an issuer to engage in general solicitation and general advertising (such as mass mailings, emails, public websites, social media, print media and broadcast media), subject to the conditions described further below.
Adopted Amendments to Rule 506: Creation of the Rule 506(c) Safe Harbor
As directed by Section 201(a) of The Jumpstart Our Business Startups Act (“JOBS Act”), the SEC adopted the General Solicitation Rules to create a new exemption that permits general solicitation and general advertising in connection with a Rule 506 offering of securities, subject to the following conditions:
- The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors;
- All purchasers of securities are accredited investors either because they come within one of the eight enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes they qualify as such at the time of sale;5 and
- The issuer meets all terms and conditions of Rule 501,6 Rule 502(a)7 and Rule 502(d).8
Reasonable Steps to Verify Accredited Investor Status
In the General Solicitation Release, the SEC described two possible means of determining that such verification procedures are reasonable. First, an issuer (or those acting on its behalf) may make this determination using a principles-based approach, whereby the issuer makes an “objective determination,” based on the “particular facts and circumstances” of the applicable offering, in deciding what steps to take to verify a purchaser’s accredited investor status. The General Solicitation Release provides the following non-exhaustive and non-mandatory list of factors that may be appropriate for an issuer to consider:9 (i) nature of the purchaser and the type of accredited investor the purchaser claims to be; (ii) information that the issuer has about the purchaser; and (iii) nature and terms of the offering.
Second, as an alternative to the principles-based approach, the General Solicitation Rules contain four specific non-exclusive methods of verifying accredited investor status for a natural person that, if properly followed, are deemed to satisfy the reasonableness requirement of such verification. This non-exclusive safe harbor is comprised of the following methods: (i) income verification; (ii) net worth verification; (iii) third-party verification; and (iv) verification of current investors of an issuer. Issuers utilizing other accredited investor verification means will not be deemed or presumed to have acted unreasonably but, instead, must consider whether the verification method selected is reasonable based on the principles-based approach described above. For a more detailed discussion regarding the principles-based approach and the safe harbor approach, please refer to DechertOnPoint, SEC Approves Final Rules that (1) Permit General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings and (2) Disqualify “Bad Actors” from Using Rule 506 to Offer Securities.
Permitting General Solicitation and General Advertising in Rule 144A Offerings
Prior to the adoption of the General Solicitation Rules, Rule 144A served as a non-exclusive safe harbor that provided an exemption from the registration requirements of the Securities Act for offers and sales of securities by persons, other than the issuer, to Qualified Institutional Buyers (“QIBs”) or persons reasonably believed to be QIBs. Prior to the adoption of the General Solicitation Rules, although Rule 144A did not explicitly prohibit general solicitation, offers were only permitted to be made to QIBs or persons reasonably believed to be QIBs.
Under the General Solicitation Rules, Rule 144A has been amended so that offers of securities to persons who are not QIBs would be permitted, including by means of general solicitation and general advertising, so long as the securities are sold only to QIBs or persons reasonably believed to be QIBs.
Implications of Rule 506(c) for Private Funds and Their Investment Advisers
Private funds generally rely on the exclusions from the definition of an “investment company” available under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (“Investment Company Act”) (a “Section 3(c)(1) Fund” or “Section 3(c)(7) Fund,” as applicable). However, these exclusions are not available if a fund makes or proposes to make “a public offering of its securities.” In the General Solicitation Release, the SEC confirmed that a private fund engaged in general solicitation and general advertising under Rule 506(c) would not be making a “public offering” for purposes of the Investment Company Act and, thus, would not forfeit its exclusion from registration under the Investment Company Act.
The General Solicitation Release provides that private domestic Rule 506(c) or Rule 144A offerings would not be integrated with Regulation S offshore offerings. Accordingly, issuers would be able to conduct a Rule 506(c) or Rule 144A offering concurrently with a Regulation S offering while employing general solicitation and general advertising in the United States, without violating the prohibition in Regulation S on “directed selling efforts” in the United States.
While the General Solicitation Rules do not integrate private domestic Rule 506(c) or Rule 144A offerings with an offshore Regulation S offering, the General Solicitation Rules do not address whether an adviser’s domestic Section 3(c)(7) Fund offering, using general solicitation and general advertising in accordance with Rule 506(c), would be integrated with the adviser’s domestic Section 3(c)(1) Fund offering that is relying on Rule 506(b) and not using general solicitation and general advertising. If the SEC were to integrate the two offerings, the Section 3(c)(1) Fund would be held to the accredited investor verification standards of Rule 506(c) (regardless of whether the Section 3(c)(1) Fund was promoted through the use of general solicitation or general advertising).
For investment managers10 of private funds seeking to engage in general solicitation and general advertising under new Rule 506(c), it will be critical to establish appropriate policies and procedures to satisfy the requirement of taking reasonable steps to verify accredited investor status. In addition, regardless of which verification procedure is employed, it should be noted that any issuer claiming an exemption from the registration requirements of Section 5 of the Securities Act bears the burden of proving that such exemption was properly relied upon. Accordingly, it is important for investment managers to maintain adequate records that document the steps they have taken to verify that a purchaser was an accredited investor at the time of purchase and to determine, to the extent that Rule 506(c) is being relied on, that their chosen verification method was appropriate.
In addition, it is important to note that many private funds are also deemed to constitute commodity pools that are subject to the Commodity Exchange Act (“CEA”) and the CFTC regulations thereunder, as well as the rules of the National Futures Association, the designated derivatives self-regulatory organization. Certain operators or advisors to such commodity pools currently qualify for an exemption from registration as a commodity pool operator (“CPO”) pursuant to CFTC Rule 4.13(a)(3) or are registered as a CPO but qualify for operational exemptions pursuant to CFTC Rule 4.7 or 4.12(b) (e.g., disclosure, reporting, record keeping and advertising), provided that certain conditions are met (including with regard to the private nature of the offering of interests in the pools and the pool participants). The CFTC has not yet provided guidance as to the extent to which the above exemptions may continue to be relied on by operators or advisors to private funds that are conducting Rule 506(c) offerings using general solicitation and general advertising. Accordingly, many investment managers of private funds do not intend to engage in general solicitation or general advertising under new Rule 506(c) until the CFTC provides such guidance.
Disqualifying Felons and Other Bad Actors from Rule 506 Offerings
Background: Dodd-Frank Act Requirement to Adopt “Bad Actor” Provisions
Acting on the mandate in Section 926(1) of the Dodd-Frank Act, the SEC adopted disqualification rules “substantially similar” to those in Rule 262 of Regulation A under the Securities Act. The amendments to Rule 506 disqualify securities offerings involving certain “felons” and other “bad actors” from relying on Rule 506 of Regulation D where an issuer or certain “covered persons” have had a “disqualifying event.”
The disqualification provisions in the Bad Actor Rules generally apply to the following categories of persons:
- The investment managers of private fund issuers;
- The directors, executive officers, other officers participating in the offering, and general partners and managing members of such investment managers;
- The directors and executive officers of such general partners and managing members and their other officers participating in the offering;
- The issuer and any predecessor of the issuer or affiliated issuer;
- The directors, executive officers, other officers participating in the offering, and general partners or managing members of the issuer;
- Any 20% beneficial owner of an issuer’s outstanding voting equity securities, calculated on the basis of voting power;
- Certain promoters; and
- Persons compensated for soliciting investors, as well as the general partners, directors, executive officers, other officers participating in the offering and managing members of any compensated solicitor.
Some of the “disqualifying events” in the Bad Actor Rules, which disqualify covered persons from relying on a Rule 506 exemption for a sale of securities, are those that result in any of the following:
- SEC cease-and-desist orders barring or limiting such persons from engaging in certain enumerated activities under the federal securities laws;
- SEC cease-and-desist orders, entered into within the last five years, in connection with violations of anti-fraud provisions of the federal securities laws;
- Criminal convictions, entered within ten years before such sale (or five years in the case of issuers, their predecessors and affiliated issuers), in connection with the purchase or sale of any security, making any false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries such as underwriters and broker-dealers;
- Court restraining orders and injunctions, entered within five years before such sale, in connection with the purchase or sale of any security, making any false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries such as underwriters and broker-dealers;
- Suspension or expulsion from membership in, or restrictions on a covered person’s ability to associate with members of, a securities self-regulatory organization; and
- Final orders of certain enumerated state and federal regulators (including the CFTC, federal banking agencies, state securities regulators and insurance, banking and savings associations) that (1) bar the covered person from associating with the above-referenced regulated entities, or (2) find a violation of any law or regulation prohibiting fraudulent, manipulative or deceptive conduct and that were entered into within ten years before such sale.
Additional Aspects of the Bad Actor Rules
It is also important to note the following additional aspects of the Bad Actor Rules:
- Only disqualifying events occurring on or following the effective date will trigger disqualification, although disqualifying events occurring before the effective date must be disclosed to investors;
- The Bad Actor Rules provide an exception from disqualification where the issuer can demonstrate that it did not know and, using reasonable care, could not have known that a disqualification existed because of the presence or participation of another covered person in the offering; and
- The SEC may grant a waiver of disqualification where an issuer has shown good cause that it is not necessary, under the circumstances, that the registration exemption be denied. In addition, disqualification of a covered person subject to a disqualifying event will not occur if, before the relevant sale is made pursuant to Rule 506, the court or regulatory authority that entered the relevant order, judgment or decree advises the SEC, in writing, that disqualification is inappropriate.
For private funds engaging in a Rule 506 offering, it will be important for investment managers of such funds to establish appropriate policies and procedures. Initially, such policies and procedures should be designed to ascertain whether any covered person has been subject to a disqualifying event occurring prior to September 23, 2013. In the event there is any such instance, this fact should be disclosed to the investors of the relevant private fund issuer, and the Rule 506 offering will not be subject to disqualification as a result of such prior event. On a going-forward basis, such policies and procedures should be designed (i) to prevent the presence or participation of a covered person with a disqualifying event in an offering and (ii) in the event such presence or participation nonetheless occurs, to demonstrate that the disqualification exception should apply to the offering based on the fund’s exercise of reasonable care.
In particular, these policies and procedures might include requirements, among others, to:
- Circulate written questionnaires to current fund investors that are 20% beneficial owners thereof, fund directors, executive officers of the investment manager and other “participating” officers of the investment manager, inquiring whether they have been subject to a disqualifying event. Investment managers might consider instructing recipients to promptly inform them upon becoming subject to a disqualification event in the future;
- Review distribution and placement agent agreements in order to ascertain the identity of all compensated solicitors. Once identified, investment managers might consider circulating written questionnaires to all such solicitors, inquiring whether they have been subject to a disqualifying event; and
- Require prospective employees (or at least officer candidates), fund directors and solicitors to complete a written questionnaire inquiring whether they have been subject to a disqualifying event. Investment managers might consider not hiring or appointing any such persons that have been subject to a disqualifying event.
1) Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44771 (July 24, 2013) (“General Solicitation Release”); Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings, 78 Fed. Reg. 44730 (July 24, 2013) (“Bad Actor Release”).
2) Release No. 33-9416, Amendments to Regulation D, Form D and Rule 156 under the Securities Act (July 10, 2013).
3) For further information, please refer to DechertOnPoint, SEC Proposes Additional Requirements to Regulation D, Form D and Rule 156.
4) Under the Rule 506(b) safe harbor, an issuer may sell securities, without any limitation on the offering amount, to an unlimited number of “accredited investors,” as defined in Rule 501(a) of Regulation D, and to no more than 35 non-accredited investors who meet certain “sophistication” requirements. The availability of the Rule 506(b) safe harbor is subject to a number of requirements and, pursuant to Rule 502(c), is conditioned on the issuer, or any person acting on its behalf, not offering or selling securities through any form of general solicitation or general advertising.
5) In the General Solicitation Release, the SEC confirmed that Section 201(a)(1) of the JOBS Act does not alter the existing “reasonable belief” standard. The General Solicitation Release notes that if a prospective investor were to provide an issuer with false information as to its accredited investor status within one of any of the eight enumerated categories in Rule 501(a), the issuer would not lose its ability to rely on Rule 506(c) for that offering, provided the issuer “took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.”
6) Rule 501 provides the definitions used in Regulation D, including the multiple categories of accredited investors.
7) Rule 502(a) outlines the factors to be considered in determining whether a Rule 506 offering should be integrated with another offering.
8) Rule 502(d) provides that securities sold pursuant to Regulation D are restricted securities pursuant to the Securities Act and cannot be resold without registration pursuant to Securities Act or an exemption therefrom.
9) The General Solicitation Release notes that “these factors are interconnected” and the more the “facts and circumstances” analysis of a purchaser indicates that the purchaser likely qualifies as an accredited investor, the fewer steps would be needed to verify accredited investor status.
10) As used herein, the term, “investment manager” includes entities that provide discretionary and/or non-discretionary advisory services to private funds.