Securities Regulation and Corporate Governance

At an Open Commission Meeting on July 10, 2013, the Securities and Exchange Commission (the “SEC” or the “Commission”) adopted final rules to eliminate the prohibition against general solicitation and general advertising (together, “general solicitation”) in securities offerings conducted pursuant to Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”) and Rule 144A under the Securities Act, as required by Section 201(a) of the Jumpstart Our Business Startups Act (the “JOBS Act”).  Rule 506 currently permits an issuer to raise an unlimited amount of capital in a private placement to an unlimited number of accredited investors and up to 35 non-accredited investors provided that the issuer does not engage in general solicitation; it is the most widely used exemption under Regulation D.  Rule 144A permits the resale of an unlimited amount of securities in a private transaction to qualified institutional buyers.  The Commission approved the rules by a vote of 4-1 with Commissioner Aguilar dissenting.

Relatedly, the Commission adopted final rules to disqualify securities offerings involving certain “felons and other ‘bad actors’” from participating in Rule 506 offerings, as required by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), by a unanimous vote.  In addition, the Commission proposed additional amendments to Regulation D, Form D and Rule 156 under the Securities Act that are intended to enhance the Commission’s ability to evaluate changes in the private offering market and to address the development of practices in Rule 506 offerings, and solicited comment on possible changes to the definition of accredited investor under Regulation D.  The proposing release was approved by a vote of 3-2 with Commissioners Paredes and Gallagher dissenting.

The final rules permitting the use of general solicitation and providing for the disqualification of “bad actors” from Rule 506 offerings will become effective in approximately mid to late September (60 days after publication in the Federal Register).  The comment period relating to the additional proposed amendments to Regulation D, Form D and Rule 156 will be 60 days.

The following are links to the adopting releases, the proposing release and the related Fact Sheets:

Final General Solicitation Rules

The final rules to remove the prohibition against general solicitation in offerings pursuant to Rule 506 and Rule 144A are largely unchanged from the proposing release (the “General Solicitation Proposing Release”), except that the final rules include a non-exclusive list of methods that issuers may use to satisfy the verification requirement with respect to investors who are natural persons.  The Commission issued the General Solicitation Proposing Release in August, 2012.

The following are highlights of the final rules:

• Rule 506 will be amended by adding a new paragraph (c), which will allow general solicitation if (i) the issuer takes reasonable steps to verify that the purchasers are accredited investors; and (ii) all purchasers of the securities fall within one of the eight categories of persons who are accredited investors under Rule 501(a) of the Securities Act, or the issuer reasonably believes that the purchasers fall within one of those categories.  Notably, the existing exemption under paragraph (b) for offerings conducted without engaging in general solicitation will continue to permit up to 35 non-accredited investors and will not be subject to the heightened verification requirements for accredited investors.
• If a purchaser in a Rule 506(c) offering does not meet the criteria for any category of accredited investor, the issuer will not lose the benefit of the exemption so long as it has taken reasonable steps to verify, and reasonably believed, that the purchaser was an accredited investor at the time of purchase.
• The determination of whether the steps taken to verify that a purchaser is an accredited investor are reasonable will be an objective determination by an issuer based on the facts and circumstances. The adopting release reaffirmed the non-exclusive list of factors discussed in the General Solicitation Proposing Release that an issuer should consider in this determination.  These factors include (i) the nature of the purchaser and the category of accredited investor that the purchaser claims to satisfy, (ii) the amount and type of information the issuer has about the purchaser, and (iii) the nature of the offering, including the manner in which purchasers were solicited, and the terms of the investment, such as the minimum investment amount.
• In addition to the principles-based approach described above, the final rule will describe a new, non-exclusive list of methods that an issuer may use to satisfy the verification requirement for a purchaser that is a natural person. These methods will include (i) reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year; (ii) reviewing copies of bank, brokerage and similar statements, certificates of deposit, tax assessments and appraisal reports as evidence of the purchaser’s assets, and a consumer credit report as evidence of the purchaser’s indebtedness, and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed; (iii) receiving written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser’s accredited status; and (iv) with respect to a purchaser who invested in a Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c) and intends to invest in a Rule 506(c) offering by the same issuer, obtaining a certification from the purchaser that he or she qualifies as an accredited investor.
• Form D will be amended to include a checkbox to indicate that the issuer is relying upon new Rule 506(c) to engage in general solicitation.  In addition, as discussed further below, in a companion release, the Commission proposed additional changes to the content, filing requirements and consequences for failing to file a Form D in connection with a Regulation D offering.
• The adopting release reaffirmed the Commission's view expressed in the General Solicitation Proposing Release that the use of general solicitation in offerings by privately offered funds such as hedge funds, venture capital funds and private equity funds pursuant to Rule 506(c) will not cause an issuer to be deemed an "investment company" under the Investment Company Act.
• Rule 144A will be amended to permit "offers" to persons who are not qualified institutional buyers, or QIBs, and thus to permit general solicitation in offerings conducted pursuant to Rule 144A.  However, the Rule 144A exemption will continue to be conditioned on the securities being sold only to QIBs or to purchasers that the seller and any person acting on its behalf reasonably believe is a QIB.  The amendments will not add any additional standards for determining whether a seller reasonably believes a purchaser to be a QIB or otherwise.
• The adopting release reaffirmed the Commission's view expressed in the General Solicitation Proposing Release that the use of general solicitation in connection with a Rule 506 or Rule 144A offering would not be a barrier to a concurrent offering by the issuer in an offshore transaction in reliance on Regulation S.

Final Rules Disqualifying Bad Actors from Offerings Under Rule 506

The final rules to disqualify “felons and other ‘bad actors’” from reliance on the exemption from Securities Act registration pursuant to Rule 506 are largely unchanged from the proposing release (the “Bad Actor Proposing Release”).  Notably, these “bad actor” disqualification provisions apply to all Rule 506 offerings, not merely offerings in which an issuer engages in general solicitation pursuant to new Rule 506(c).  The Commission issued the Bad Actor Proposing Release in May, 2011.

The following are highlights of the final rules:

• Persons covered by the rule will include issuers, including predecessors and affiliated issuers; any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer; 20 percent beneficial owners of the issuer; promoters; investment managers to issuers that are pooled investment funds; any director, executive officer, other officer participating in the offering, general partner or managing member of such investment managers; persons compensated for soliciting investors; and any director, executive officer, other officer participating in the offering, general partner or managing member of any compensated solicitor.
• “Disqualifying events” that would disqualify a person from participating in Rule 506 offerings will include: (i) criminal convictions, court injunctions, and restraining orders in connection with the purchase or sale of a security, making a false filing with the SEC, or arising out of the conduct of certain financial intermediaries; (ii) certain final orders from the Commodity Futures Trading Commission, state securities regulators and other federal and state banking, insurance and similar regulators; (iii) certain SEC disciplinary, cease-and-desist, and stop orders; (iv) suspension or expulsion from membership in a self-regulatory organization; and (v) U.S. Postal Service false representation orders. Some of these disqualification events will be subject to look-back periods of up to ten years.
• The final rule will include a “reasonable care” exception, under which an issuer will not be subject to disqualification if it can show that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.
• The “bad actor” disqualification provisions will apply only to events that occur after the rule’s effective date.  However, issuers relying on Rule 506 will be required to disclose events that would otherwise be disqualifying that took place prior to the effective date.

Proposed Regulation D and Related Amendments

In addition to adopting the final rules discussed above, the Commission proposed for public comment broader revisions to Regulation D, Form D and Rule 156 under the Securities Act.  The proposed rules, if adopted, would enable the SEC to collect additional information on the private offering market, including the effects of general solicitation on the market and on developing offering practices.  In addition, in response to concerns raised by some commenters in connection with the General Solicitation Proposing Release, the Commission proposed significant other provisions, which are oriented to investor protection but which could potentially hamper the use of general solicitation in private offerings.

In particular, the proposal would:

• Require, in addition to the Form D filings that are currently required, that an issuer file a Form D 15 days before engaging in general solicitation for a Rule 506(c) offering, and that an issuer update the information contained in its Form D filings within 30 days of completing a Rule 506 offering;
• Expand the information required to be included on Form D in connection with all Rule 506 offerings to include the issuer’s website address, expanded information about the issuer and the offered securities, the types of purchasers in the offering, the use of proceeds from the offering, and, in the case of Rule 506(c) offerings, the types of general solicitation used and the methods used to verify the accredited investor status of purchasers;
• Disqualify an issuer from relying on Rule 506 for one year for future offerings if the issuer (or any of its affiliates or predecessors) fails to comply with its Form D filing obligations in connection with a Rule 506 offering (subject to a 30-day cure period);
• Require issuers to include, in any written general solicitation materials, legends stating that the offering is limited to accredited investors and that the offering may involve certain risks;
• In the case of written solicitation materials relating to securities of private funds, require issuers to include a legend disclosing that the securities being offered are not subject to the protections of the Investment Company Act of 1940 and, if the materials include information about the fund’s past performance, require issuers to include language highlighting the limitations on the usefulness of this type of information and highlighting the difficulty of comparing this information with past performance information of other funds.  The release also solicits comment on recommendations raised by commenters in response to the General Solicitation Proposing Release to impose additional manner and content restrictions on written general solicitation materials used by private funds;
• For a period of two years, require issuers to submit written general solicitation materials to the SEC no later than the date of first use of these materials (such materials would not be available to the general public and would not be filed via EDGAR); and
• Extend the guidance contained in Rule 156 under the Securities Act, which currently describes when information in sales literature by a registered investment company could be fraudulent or misleading under the federal securities laws, to apply to sales literature of private funds.  This guidance would apply to all private funds, whether or not they engage in general solicitation activities.

In addition to these proposals, the release notes that the Commission has directed the Staff to “execute a comprehensive work plan upon the effectiveness of Rule 506(c) to review and analyze the use of Rule 506(c),” including, among other things, evaluating accredited investor verification practices used by issuers and evaluating the effects of the removal of the general solicitation ban on incidences of sales to non-accredited investors, incidences of fraud, capital formation in registered and unregistered transactions, and other matters.

In addition, unrelated to any of the proposed rules, the Commission noted its belief that the definition of accredited investor as it relates to natural persons should be reviewed and, as appropriate, amended, and noted that Commission Staff has begun a review of this definition.  Notably, the proposing release explicitly solicits comment on the definition of accredited investor, potentially laying the foundation for the Commission to adopt final rules to amend the definition without issuing a further proposing release.

* * * * *

This summary of the final rules and the new proposed rules are based on our preliminary review of the adopting releases and the proposing release, the Fact Sheets provided by the Commission relating to the releases, oral presentations by the SEC Staff at the Open Meeting and the oral statements of the Commissioners at the Open Meeting.  We expect to issue a Client Alert on the final and proposed rules, following a more detailed review and analysis of the releases.