Amendments to Rule 506 become effective September 23, 2013 and include "bad boy" provisions
The SEC has adopted amendments to Rule 506 under the Securities Act of 1933 that permit general solicitation and general advertising in securities offerings under this exemption from securities registration provided all purchasers are accredited investors. (The SEC adopted a parallel amendment to Rule 144A that permits general solicitation under that rule so long as all purchasers are limited to Qualified Institutional Buyers ("QIBs")). The SEC also amended Rule 506 to make that exemption from registration unavailable if "bad actors" are participants in the offering. All of these amendments will become effective September 23, 2013. The general solicitation amendments were required by the JOBS Act and the "bad boy" amendments were required by the Dodd-Frank Act. The exemptions from registration under Rules 506 and 144A are available to both publicly traded and private companies, both domestic and foreign.
General Solicitation Amendments to Rule 506
To implement the change mandated by the JOBS Act, the SEC has divided Rule 506 into two alternative exemptions. Rule 506(b) continues the current exemption, which permits purchases by up to 35 non-accredited investors and prohibits general solicitation. New Rule 506(c) permits the use of general solicitation, subject to the following additional conditions:
The SEC adopting release clarifies that, as required by the JOBS Act, Rule 506(c) will be treated as a "private placement" exemption even though general solicitation is permitted under the Rule; however, the statutory "private placement" exemption otherwise provided by Section 4(a)(2) of the Securities Act (commonly referred to as "Section 4(2)" before the re-codification of the Securities Act necessitated by the JOBS Act) continues to be conditioned on the absence of general solicitation. Because offerings conducted under Rule 506(c) are deemed by the JOBS Act to not involve a public offering, hedge funds, private equity funds, and similar "private" funds may sell their securities using general solicitation under Rule 506(c) without losing the ability to satisfy the exemptions from registration under the Investment Company Act that are conditioned on the fund not making a public offering of its securities.
Except for a limited transition provision discussed below, the SEC staff has clarified that an issuer cannot rely on both Rule 506(b) and Rule 506(c) in the same offering. The current integration rules will remain in effect for determining what constitutes a separate offering.
Reasonable Steps to Verify Accredited Investor Status. Rule 506(c) as adopted contains both a general requirement that issuers take "reasonable steps" to verify that purchasers are accredited investors, as well as a non-exclusive list of methods that can be used to satisfy this requirement.
As originally proposed, Rule 506(c) did not mandate a particular verification process or even identify a set of "safe harbor" procedures that would be deemed to be "reasonable." Instead, the proposing release identified certain factors that issuers would need to consider in determining whether their verification process is "reasonable." In the release adopting the final rules, the SEC retained the "principles-based" method of determining whether the verification steps taken by an issuer were reasonable, but supplemented it with four specific verification methods that will be deemed to constitute "reasonable steps" to verify a purchaser's status unless the issuer or its agent has knowledge that the particular purchaser is not an accredited investor.
Under the "principles-based" method, the extent to which an issuer needs to verify the accredited investor status of a proposed purchaser is to be determined based on the facts and circumstances of the particular purchaser and transaction. The adopting release identifies the following as among the factors that an issuer should consider in determining whether the verification steps taken in any particular case were "reasonable."
The four verification methods that are deemed "reasonable" (absent knowledge to the contrary) all relate to the status of individuals, and are as follows:
Transition Matters. An issuer that commenced a Rule 506 offering before the effective date of new Rule 506(c) may choose to use either Rule 506(b) or Rule 506(c) for the portion of the offering conducted after the effective date of the new rule. Use of Rule 506(c) will not affect the availability of Rule 506(b) for sales in the same offering that were made to non-accredited investors before the effective date of Rule 506(c). However, except for these limited transition provisions, an issuer cannot use both Rule 506(b) and Rule 506(c) in the same offering.
Bad Actor Amendments to Rule 506
The "bad boy" provisions have been added as a new paragraph (d) to Rule 506. These provisions disqualify an offering from utilizing the Rule 506 exemption from registration if certain persons related to the issuer or the offering have engaged in specified "bad acts." The disqualification provisions apply to offerings under Rule 506(b) and Rule 506(c).
Covered Persons. The disqualification provisions apply to the following categories of persons ("covered persons"):
Disqualifying Events. Rule 506 is unavailable if any covered person has engaged in any of the following disqualifying events, unless either the SEC or the court or regulatory body that issued the relevant order determines that disqualification is not necessary in the particular circumstances and grants a waiver of disqualification. In addition, even if there is a disqualifying event, an offering will not lose the Rule 506 exemption if the issuer can establish that it did not know, and in the exercise of reasonable care based on factual inquiry could not have known, that a disqualification existed.
Transition Matters. Disqualifying events that occurred before the effective date of the Rule 506 amendments will not make Rule 506 unavailable. However, a description of any such events must be provided to each purchaser a reasonable time before the Rule 506 sale. In addition, disqualifying events relating to an affiliated issuer will not disqualify the offering if they occurred before the affiliate relationship existed.
Proposed Amendments to Reg D and Form D
Anticipating that Rule 506 offerings are likely to undergo significant changes when such offerings are made using general solicitation, the SEC has proposed a number of additional amendments to Regulation D and Form D to help it monitor the changes, as well as certain additional disclosure requirements intended to address concerns that general solicitation could increase the potential for abuse.
Timing of Form D.
Content of Form D. Existing Items of Form D would be expanded to include information such as the issuer's website address and controlling persons, as well as the trading symbol and CUSIP number of the securities being offered. Information about the size of the issuer, which is currently optional, would be required unless the issuer does not otherwise make this information publicly available. Additional information would be required about the number of accredited and non-accredited investors and the amount invested by each category, with each of these categories further broken down into natural persons and legal entities. The Item dealing with use of offering proceeds would be expanded to call for information about the percentage of offering proceeds expected to be used for each of six specified purposes.
Six new Items would be added to the Form, calling for the following information:
Conditions on the Availability of Rule 506. Under the SEC proposal, an issuer would be disqualified from using Rule 506 for an offering if it failed to comply with the Form D filing requirements within the past five years in connection with an earlier offering under Rule 506. The disqualification would end one year after the required filings were made, or if the offering had already terminated, one year after a final Form D was filed for the offering. The disqualification would not apply to the offering with respect to which the failure to file occurred, but only to subsequent offerings. Failures to file that occurred before the effective date of the rule amendment would not trigger disqualification. The SEC would have the ability to waive this disqualification in appropriate circumstances. Rule 506 would also be unavailable if the issuer or any of its predecessors or affiliates has been subject to any court order enjoining it for failure to comply with the disclosure or SEC submission requirements discussed below.
Additional Disclosures in General Solicitation Materials. Offerings under Rule 506(c) would be required to include five specified legends in any written general solicitation materials. In addition to typical private placement legends (e.g., that the offering is not registered under the Securities Act, that there are restrictions on transfer of the securities, and that investing in securities involves risk), the materials would be required to contain a legend that the securities may be sold only to accredited investors, which for natural persons are investors who meet certain minimum annual income or net worth thresholds.
Private funds, such as hedge funds, venture capital funds and private equity funds, would be required to include a legend to the effect that the fund is not subject to the Investment Company Act, and if the general solicitation materials include performance data would be required to include additional legends and disclosures related to such data.
Submission of General Solicitation Materials to SEC. In order to help it assess market developments, the SEC has proposed that all written general solicitation materials used in connection with a Rule 506(c) offering be submitted to the SEC no later than the date of their first use. These materials would not be deemed "filed" or "furnished" and would not be publicly available. This rule would be a temporary rule and would expire two years after it became effective.