The Securities and Exchange Commission adopted a new rule Wednesday to implement a JOBS Act requirement to lift the ban on general solicitation or general advertising for certain private securities offerings for business startups, while also adopting rules to discourage fraudsters from touting the investments and to add new protections for investors.
Companies seeking to raise capital through the sale of securities generally must either register the securities offering with the SEC or rely on an exemption from registration. Most of the exemptions from registration prohibit companies from engaging in general solicitation or general advertising—that is, advertising in newspapers or on the Internet among other things—in connection with securities offerings. Rule 506 of Regulation D is the most widely used exemption from registration.
In an offering that qualifies for the Rule 506 exemption, an issuer may raise an unlimited amount of capital from an unlimited number of “accredited investors” and up to 35 non-accredited investors. Under SEC rules, accredited investors are individuals who meet certain minimum income or net worth levels, or certain institutions such as trusts, corporations or charitable organizations that meet certain minimum asset levels.
In April 2012, Congress passed the Jumpstart Our Business Startups Act, or JOBS Act. Section 201(a)(1) of the JOBS Act directs the SEC to remove the prohibition on general solicitation or general advertising for securities offerings relying on Rule 506 provided that the sales are limited to accredited investors and an issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors. By requiring the SEC to remove this general solicitation restriction, Congress wanted to make it easier for a startup company to find investors and thereby raise capital.
While issuers will be able to widely solicit and advertise for potential investors, the JOBS Act required the SEC to adopt rules that “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” In other words, there is no restriction on who an issuer can solicit, but an issuer faces restrictions on who is permitted to purchase its securities.
The law also directed the SEC to amend Rule 144A under the Securities Act, an exemption from registration that applies to the resale of securities to larger institutional investors known as qualified institutional buyers, or QIBs. Under current Rule 144A, offers of securities can only be made to QIBs. Under the new rule, Rule 144A is amended so that offers of securities can be made to investors who are not QIBs as long as the securities are sold only to persons whom the seller reasonably believes are QIBs.
Last August, in order to comply with the congressional mandate to implement Section 201(a)(1) of the JOBS Act, the SEC proposed a rule that would remove the general solicitation ban for certain 506 offerings in which sales of securities would be limited to accredited investors and issuers would be required to take reasonable steps to verify such accredited status. After doing so, the SEC received numerous comments, including requests seeking greater clarification on the types of verification that would be considered reasonable under the rule. Commenters also suggested that the SEC consider measures that they believed would provide additional protections for investors in connection with removing the general solicitation ban. Several of those additional measures identified by these commenters are included in a separate proposal that the SEC approved Wednesday.
The final rule approved Wednesday makes changes to Rule 506 to permit issuers to use general solicitation and general advertising to offer their securities provided that the issuer takes reasonable steps to verify that the investors are accredited investors. In addition, all purchasers of the securities must fall within one of the categories of persons who are accredited investors under an existing rule (Rule 501 of Regulation D) or the issuer reasonably believes that the investors fall within one of the categories at the time of the sale of the securities.
Under the existing Rule 501, a person qualifies as an accredited investor if he or she has either an individual net worth or joint net worth with a spouse that exceeds $1 million at the time of the purchase, excluding the value (and any related indebtedness) of a primary residence; or an individual annual income that exceeded $200,000 in each of the two most recent years or a joint annual income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year.
The determination of the reasonableness of the steps taken to verify an accredited investor is an objective assessment by an issuer. An issuer is required to consider the facts and circumstances of each purchaser and the transaction. Nevertheless, in response to commenters’ requests, the final rule provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement for individual investors.
The methods described in the final rule include the following:
• 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.
• Receiving a 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.
The existing provisions of Rule 506 as a separate exemption are not affected by the final rule. Issuers conducting Rule 506 offerings without the use of general solicitation or general advertising can continue to conduct securities offerings in the same manner and aren't subject to the new verification rule.
Under the final rule, securities sold pursuant to Rule 144A can be offered to persons other than QIBs, including by means of general solicitation, provided that the securities are sold only to persons whom the seller and any person acting on behalf of the seller reasonably believe to be QIBs.
The final rule also amends Form D, which is the notice that issuers must file with the SEC when they sell securities under Regulation D. The revised form adds a separate box for issuers to check if they are claiming the new Rule 506 exemption that would permit general solicitation or general advertising.
In connection with this new rule, the SEC voted to issue a rule proposal requiring issuers to provide additional information about these securities offerings to better enable the SEC to monitor the market with that ban now lifted. The proposal also provides for additional safeguards as this market changes and new practices develop.
The SEC also adopted rules that disqualify felons and other bad actors from participating in certain securities offerings as required by the Dodd-Frank Act.
“As we fulfill our mission to facilitate capital formation and maintain fair and efficient markets, the Commission must always focus on strong investor protections,” said SEC chair Mary Jo White in a statement. “We want this new market and the private markets in general to thrive in a safe and efficient manner, and these rules we adopt and propose are designed to facilitate that objective.”
The rule amendments become effective 60 days after publication in the Federal Register. The rule proposal will undergo a 60-day public comment period following its publication in the Federal Register.
Proposed Amendments to Private Offering Rules
Some of the comments on the SEC proposal related to the notice that is required to be filed by an issuer in connection with a Rule 506 offering. This notice, called Form D, is filed with the SEC and available for review by the public. Other suggestions included changing the definition of accredited investor, imposing requirements governing the content and manner of general solicitations, and requiring issuers to file general solicitation materials with, or submit them to, the SEC.
The SEC approved a proposal intended to enhance the SEC’s ability to assess developments in the private placement market now that the rule to lift the ban on general solicitation has been adopted. In particular, the proposal would improve the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and would address certain concerns raised by investors related to issuers engaging in general solicitation.
The proposal requires issuers to file an advance notice of sale 15 days before and at the conclusion of an offering.
Currently, an issuer—such as a company or a fund—selling securities using Rule 506 is required to file a Form D no later than 15 calendar days after the first sale of securities in an offering. That form is a type of notice that provides information about the issuer and the securities offering.
Under the proposal, issuers that intend to engage in general solicitation as part of a Rule 506 offering would, in addition to the current requirements, be required to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. Also, within 30 days of completing an offering, issuers would be required to update the information contained in the Form D and indicate that the offering has ended.
The proposal also requires issuers to provide additional information about the issuer and the offering.
Currently, Form D requires identifying information about the company or the fund selling the securities, any related persons, the exemption the issuer is relying on to conduct the offering, and certain other factual information about the issuer and the offering.
Under the proposal, issuers are required to provide additional information to enable the SEC to gather more information on the changes to the Rule 506 market that could occur now that the general solicitation ban has been lifted.
The additional information would include:
• Identification of the issuer’s Web site;
• Expanded information on the issuer;
• The offered securities;
• The types of investors in the offering;
• The use of proceeds from the offering;
• Information on the types of general solicitation used; and,
• The methods used to verify the accredited investor status of investors.
The proposal disqualifies issuers who fail to file Form D. Under the proposal, an issuer is disqualified from using the Rule 506 exemption in any new offering if the issuer or its affiliates did not comply with the Form D filing requirements in a Rule 506 offering. As proposed, the disqualification would continue for one year beginning after the required Form D filings are made. Issuers would be able to rely on a cure period for a late Form D filing and, in certain circumstances, could request a waiver from the staff.
The proposal requires issuers to include legends and disclosures in written general solicitation materials. Under the proposal, issuers are required to include certain legends or cautionary statements in any written general solicitation materials used in a Rule 506 offering.
The legends would be intended to inform potential investors that the offering is limited to accredited investors and that certain potential risks may be associated with such offerings.
In addition, if the issuer is a private fund (a type of pooled investment vehicle) and includes information about past performance in its written general solicitation materials, it would be required to provide additional information in the materials to highlight the limitations on the usefulness of this type of information. The issuer also would need to highlight the difficulty of comparing this information with past performance information of other funds.
The proposal also requests public comment on whether other manner and content restrictions should apply to written general solicitation materials used by private funds.
The proposal requires issuers to submit written general solicitation materials to the SEC. Under the proposal, issuers are required to submit written general solicitation materials to the SEC through an intake page on the SEC’s Web site. Materials submitted in this manner would not be available to the general public. As proposed, this requirement would be temporary, expiring after two years.
The proposal extends guidance about misleading statements to private funds. Currently, an SEC rule provides guidance on when information in sales literature by an investment company registered with the SEC could be fraudulent or misleading for purposes of the federal securities laws.
Under the proposal, this guidance—contained in Rule 156 under the Securities Act—would be extended to the sales literature of private funds. It would apply to all private funds whether or not they are engaged in general solicitation activities. In the proposing release, the SEC would express its view that private funds should now begin considering the principles underlying Rule 156.
Disqualification of Felons and Other “Bad Actors”
Under the final disqualification rule approved today, an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “disqualifying event.” The final disqualification rule covers the issuer, including its predecessors and affiliated issuers, as well as:
• Directors and certain officers, general partners, and managing members of the issuer;
• 20 percent beneficial owners of the issuer;
• Investment managers and principals of pooled investment funds; and
• Persons compensated for soliciting investors as well as the general partners, directors, officers and managing members of any compensated solicitor.
Under the final rule, a "disqualifying event" includes:
• Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction must have occurred within 10 years of the proposed sale of securities (or five years in the case of the issuer and its predecessors and affiliated issuers).
• Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order must have occurred within five years of the proposed sale of securities.
• Final orders from the Commodity Futures Trading Commission, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations, or credit unions that bar the issuer 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 are based on fraudulent, manipulative, or deceptive conduct and are issued within 10 years of the proposed sale of securities.
• Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons.
• SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws.
• SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities.
• Suspension or expulsion from membership in a self-regulatory organization (SRO) or from association with an SRO member.
• U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.
The final rule provides an exception from disqualification when the issuer can show 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.
Disqualification applies only for disqualifying events that occur after the effective date of this rule. But matters that existed before the effective date of the rule and would otherwise be disqualifying are subject to a mandatory disclosure requirement to investors.