SEC Issues Changes to Rule 506 Allowing General Solicitation and Advertising in Certain Private Placements
On July 10, 2013, the Securities and Exchange Commission issued long awaited amendments to Rule 506 under Regulation D, one of the most widely used exemptions for selling securities without registration under the Securities Act of 1933 (the “Securities Act”). These amendments are mandated by the JOBS Act, which was passed last year, and will become effective sixty (60) days from the date they are published in the Federal Register. The SEC had issued proposed rule changes in August 2012 and these attracted widespread comments.
Rule 506 is a rule promulgated by the SEC under Section 4(a)(2) (formerly 4(2)) of the Securities Act, which exempts from registration, sales by an issuer of securities “not involving any public offering.” In its current form, the rule allows issuers to sell securities to investors who qualify as “accredited investors” (i.e., who meet certain financial and/or institutional criteria) and up to 35 non-accredited investors (provided, that in such case, investors are provided with certain required disclosures about the issuer and the offering), subject to certain requirements, which include: (i) placing restrictions on the resale of the offered securities and (ii) not offering the securities by means of any “general solicitation or general advertising,” including through the use of mass communications, or meetings whose attendees have been invited by such means.
The amendments to the rule bifurcate it in two parts: (i) Rule 506(b) which is the existing rule, unchanged and (ii) Rule 506(c), which will allow issuers to offer securities using general solicitation and advertising to the public; provided that: (a) the securities are sold exclusively to accredited investors; and (b) the issuer takes “reasonable steps” to verify that the purchasers of the securities are accredited investors.
Form D is also being amended to require issuers to indicate whether they are using Rule 506(c).
The SEC stated that issuers engaged in ongoing offerings under Rule 506 that began before Rule 506(c) became effective can choose to continue that offering after the effective date under Rule 506(b) (i.e., the exiting rule) or transition that offering to Rule 506(c). Any general solicitations occurring after such transition will not affect the exempt status of offers and sales of securities that occurred prior to such transition.
In response to comments on the proposed rule changes requesting more guidance as to what would constitute “reasonable steps,” Rule 506(c) provides four non-exclusive methods for verifying that an individual is an accredited investor (provided the issuer has no actual knowledge to the contrary):
- review of IRS forms, including, but not limited to, Form W-2, Form 1099, Schedule K-1 and Form 1040;
- review of financial records, such as bank statements, brokerage statements and consumer reports, along with a written representation from the purchaser as to their completeness;
- written confirmation from a registered broker-dealer, an SEC registered investment adviser, a licensed attorney or a certified public accountant; and
- a certificate from a current investor who invested in the issuer pursuant to a Rule 506 offering prior to the effective date of the rule amendment, confirming that such investor still qualifies as an accredited investor.
Aside from the four methods covered in the rule amendment, the SEC has declined to give specific rules or formulations as to what would constitute reasonable steps to verify that the purchasers of the offered securities are accredited investors. According to the SEC, whether there have been “reasonable steps to verify” is “an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction.” The SEC has indicated that issuers should consider a number of relevant factors, such as: (i) the nature of the purchaser and the type of accredited investor the purchaser claims to be; (ii) the amount and type of information that the issuer has about the purchaser; and (iii) the nature of the offering. The SEC believes that requiring a purchaser to check a box in a questionnaire or sign a form, absent other information about the purchaser, will not constitute “reasonable steps.”
Note that the SEC takes the view that any issuer which has not taken reasonable steps to verify that all purchasers of the securities are accredited investors has not complied with Rule 506(c) even if all such purchasers are in fact accredited investors.
Rule 506 is also being amended to provide that it is not available where certain “bad actors” are involved in the offering. This prohibition will apply to offerings under new Rule 506(c), as well
as under existing Rule 506(b).
Special Considerations for Private Funds
Rule 506(c) will be available for use by private funds. The SEC indicated that the exemptions used by private funds from registration under the Investment Company Act of 1940 (the “Investment Company Act”) (Sections 3(c)(1) and 3(c)(7) of the Investment Company Act), which provide that exempt funds cannot sell their securities in a public offering, will remain available to private funds that engage in general solicitation and advertising in accordance with Rule 506(c), as the SEC considers offerings under Rule 506 not to be public offerings for purposes of the Investment Company Act exemptions.
In its release the SEC was clear that the amendments to Rule 506 will apply to that rule only, and not to transactions under Section 4(a)(2) of the Securities Act generally. So issuers seeking the benefit of the amendments allowing general solicitation must comply will all of the Rule 506 requirements.
The utility of new Rule 506(c) to private funds which trade commodity interests (which include swaps other than security-based swaps) is unclear. Two important Commodity Futures Trading Commission exemptions, one exempting fund managers from commodity pool operator registration where the fund’s trading of commodity interests is limited (CFTC Regulation 4.13(a)(3)), and another exempting certain commodity pool operators from certain reporting and disclosure obligations (CFTC Regulation Rule 4.7), are conditioned on no public marketing of interests in the fund. The CFTC has not yet indicted whether it will interpret these exemptions to be compatible with the use of general solicitation and advertising under Rule 506(c), although the Managed Funds Association has made a request to the CFTC for such an interpretation.