At its July open meeting, the Securities Exchange Commission (SEC) approved a rule proposal to amend Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 (the Securities Act). The rule proposal was required by the Jumpstart Our Business Startups Act of 2012 (the JOBS Act). The amendments lift the ban on general solicitation in offerings under Rule 506 and 144A (and added Rule 144A requirements to initial sales thereunder). The amended rule represents an important change to the process by which securities may be sold by private investment funds, such as hedge funds, private equity funds, and venture capital funds.
Congress enacted the JOBS Act to significantly ease certain securities law requirements in order to facilitate capital formation and job creation. New Rule 506(c) will permit issuers, including private investment funds, to use general solicitation to engage a larger group of potential investors without engaging in a registered public offering.
Separately, the SEC adopted new Rules 506(d) and (e) and changes to Form D, which make all Rule 506 offerings subject to certain "bad act" disqualification, disclosure and certification requirements. This action was required under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and denies the use of Rule 506 to certain issuers associated with events specified by Congress as indicators of financial or disclosure fraud or misconduct.
Amended Rules 506 and Rule 144A will be effective on September 23, 2013.
Regulation D contains three rules that exempt an offering from the registration requirements under the Securities Act. Rules 504, 505, and 506 provide exemptions from registration so long as specific requirements are met, with each rule having its own requirements and limitations. Rules 504 and 505 were established to help small businesses raise capital, and thus their offering sizes were limited to $1 million and $5 million, respectively. Rule 506, however, is a non-exclusive safe harbor that has no limit on the size of the offering.
One of the most important requirements of an offering under Regulation D has historically been that the securities are not sold via general solicitation or general advertising (except for a narrow exception under Rule 504). While there is no specific definition of what constitutes general solicitation and general advertising, Rule 502(c) provides several examples, including "advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars whose attendees have been invited by general solicitation or general advertising," as well as "other uses of publicly available media, such as unrestricted websites." Thus, issuers participating in Regulation D offerings have been limited in the number of potential investors they can reach.
Rule 506 is a primary means by which companies raise capital through the sale of securities. The rule exempts from registration with the SEC offerings that do not involve public distribution or general solicitation. Under Rule 506 issuers are permitted to sell an unlimited amount of securities to accredited investors. An issuer may sell to 35 non-accredited investors if the issuer reasonably believes with regard to each such purchaser that it has "such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or . . . immediately prior to making any sale that such purchaser comes within this description." The JOBS Act raised the threshold number of shareholders of record for mandatory registration of a class of equity of an issuer under the Securities Exchange Act of 1934 (the Exchange Act) from 500 to 2,000 (or 500 who are not accredited).
BROKER-DEALERS AND FINDERS
While issuers may conduct private placements themselves, many issuers engage broker-dealers or "finders" to assist in placement efforts in Rule 506 offerings. A broker-dealer is a person in the business of effecting transactions in securities for his own account or for the accounts of others and must be registered with the SEC under the Exchange Act. A finder is not registered with the SEC as a broker-dealer. Finders are engaged for the limited purpose of introducing issuers to potential investors. Broker-dealers can charge a commission connected to the size of the capital raise. Finders are limited to an introduction fee.
AMENDED RULE 506 AND GENERAL SOLICITATIONS
At its July 10 meeting, the SEC amended Rule 506 by creating a new paragraph (c), which conditionally permits general solicitation or general advertising in offerings made under the rule. In order to generally solicit and advertise to investors in reliance upon Rule 506(c), all terms and conditions of Rule 501, 502(a), and 502(d), which set forth definitions, general conditions to be met, and limitations on resale, respectively, also must be satisfied and all purchasers must be accredited investors. Issuers must take "reasonable steps" to verify that such purchasers are accredited investors. Issuers relying on Rule 506(c) will no longer be subject to the prohibition against general solicitation found in Rule 502(c).
Reasonable Steps to Verify Accredited Investor Status
Issuers relying on Rule 506(c) must take "reasonable steps to verify" that purchasers are accredited investors. Amended Rule 506 includes a non-exclusive list of methods that issuers may use to satisfy the verification requirement (as it relates to accredited investor status) for purchasers who are natural persons. It is important that issuers recognize that this step must be taken and that an issuer will not avoid an enforcement action on other grounds simply because the purchasers ultimately were all accredited investors.
The Adopting Release indicates that "reasonable" 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." In evaluating the status of an investor, issuers should consider the following factors:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- The amount and type of information that the issuer has about the purchaser; and
- The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as whether it requires a minimum investment amount.
In the Adopting Release, the SEC noted that Rule 506(c) does not require any particular method of verifying accredited investor status. For example, issuers may collect publicly available information in filings with a federal, state, or local regulatory body or obtain third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories in the accredited investor definition, so long as the issuer has a reasonable basis to rely on such third-party verification.
Non-Exclusive List of Methods to Confirm Accredited Investor Status
The SEC offered a non-exclusive list of four specific methods for satisfying the verification requirement of Rule 506(c). Issuers employing any of the following methods will be deemed to satisfy the verification requirement, unless the issuer or its agent has knowledge that the purchaser is not an accredited investor:
- Verifying whether a natural person is an accredited investor on the basis of income through reliance on a combination of tax reporting forms and written investor representations.
- Verifying whether a natural person is an accredited investor on the basis of net worth through reliance on (i) recent statements from financial institutions, tax assessments, third party appraisals or a recent credit report and (ii) related investor representations.
- By relying upon written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a certified public accountant that a person or entity has taken reasonable steps to verify that a purchaser is an accredited investor within the prior three months and has determined that such a purchaser is an accredited investor.
- With respect to any natural person who invested in an issuer's Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c), the issuer is deemed to satisfy the verification requirement if, at the time of sale, the purchaser has maintained the prior investment and provides a certification that he/she qualifies as an accredited investor.
The SEC also noted that the means by which the issuer solicits potential investors is relevant in reviewing the appropriateness of the issuer's reasonableness evaluation (e.g., more steps required for a website available to general public than a database of pre-screened accredited investors).
CHANGES TO THE FORM D UNDER ADOPTING RELEASE
The SEC also approved amendments to the Form D that add a separate check box where an issuer can indicate that it is relying on Rule 506(c) and revising the current check box "Rule 506" to read "Rule 506(b)." The Adopting Release notes that an issuer may not check both the Rule 506(b) and Rule 506(c) boxes at the same time for the same offering. While amended Rule 506 represents a major change to the securities laws with respect to how an issuer or promoter may contact, target and solicit, the amendments do not alter who may actually participate in the Rule 506 offering. Issuers conducting Rule 506(c) offerings must indicate that they are relying on Rule 506(c) by marking the new check box in Item 6 of Form D. Once a general solicitation is made, an issuer may no longer claim reliance on Rule 506(b).
RULE 506(c) AND PRIVATE FUNDS
The JOBS Act did not address the effect of the new general solicitation rules on private investment funds, such as hedge funds, private equity funds, and venture capital funds. The Adopting Release established that private funds may engage in general solicitation or general advertising under Rule 506(c) and still rely on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the Company Act), which exempts such funds from registration under the Company Act.
Amended Rule 506 should substantially increase the permitted fundraising activities of private funds. Under Rule 506(c) fund managers generally will be permitted to engage in all forms of communication with prospective investors, including forms of communication traditionally viewed as general solicitation, so long as: (i) the only investors actually admitted into the fund qualify as "accredited investors" or the fund manager reasonably believes that they would so qualify; and (ii) the fund manager takes reasonable steps to verify the accredited status of each of the investors admitted to the fund.
The SEC specifically noted that private funds will still be subject to the "truth in securities" transactions and anti-fraud provisions of the federal securities laws. Registered Investment Advisers to private funds will also continue to be subject to the anti-fraud provisions of the Investment Advisers Act of 1940, and the rules thereunder, including prohibitions on testimonials, past recommendations, and use of performance data.
USE OF NON BROKER-DEALERS IN A 506(c) OFFERING
The use of parties that are not registered broker-dealers as part of a Rule 506(c) offering and the compensation of those parties should also be a concern for issuers. In April 2013, in a speech before the American Bar Association's Subcommittee on Trading and Markets, David Blass, the Chief Counsel of the SEC's Division of Trading and Markets, discussed the SEC's views with respect to when a solicitor or finder must be registered as a broker-dealer. Blass noted that employees of private funds that are engaged in the solicitation of investors as their primary responsibility or that receive transaction-based compensation may require the adviser or its employees engaged in those activities to be registered as a broker-dealer. Consistent with current Exchange Act Rule 3a4-1, he noted that when advisory personnel engage in any of the following activities, they may be deemed "in the business of effecting transactions in securities for the account of others":
- Marketing fund interests to investors;
- Soliciting or negotiating securities transactions in the funds; or
- Holding customers' funds or securities.
The potential regulatory issue is compounded when the personnel or finders receive transaction-based compensation.
Blass advised private funds to consider the following:
- How does the adviser solicit and retain investors?
- Do employees who solicit investors have other responsibilities?
- How are personnel who solicit investors for a private fund compensated?
Based on Blass's speech, and past SEC guidance with respect to broker-dealer registration and the use of finders, any party using amended Rule 506 to solicit investors should not pay any form of transaction-based compensation to a party that is assisting in those efforts unless that party is a registered broker-dealer. Also, advisers to private funds should refrain from assigning to employees as their primary responsibility the task of soliciting investors or paying them any form of transaction-based compensation.
STATE LAW AND AMENDED RULE 506
It is also unclear how state securities regulators will respond to amended Rule 506. The Adopting Release notes that accredited investors need not be experienced or sophisticated. Many state divisions of securities have expressed concern that general solicitation may make it harder for state securities commissions and other law enforcement agencies to enforce their securities laws. While securities issued under Rule 506 are preempted from state securities or "blue sky" laws with respect to registration or qualification of offerings, state laws with respect to registration as a broker-dealer or an investment adviser are not preempted.
Registration as a Broker-Dealer
Earlier this year, the SEC's Division of Trading and Markets published a series of frequently asked questions (the FAQ) regarding Section 201(c) of the JOBS Act, which offers a limited exemption from broker-dealer registration for intermediaries facilitating Rule 506 offerings. However, those intermediaries may not receive transaction-based compensation. In addition to other issues addressed in the FAQ, the SEC highlighted the fact that Title II of the JOBS Act does not extend the exemption from federal broker-dealer registration to registration as a broker or a dealer under applicable state laws. While many states have certain limited exemptions from registration as a broker or a dealer, it is unclear whether those exemptions will apply to an issuer or a platform that is using the internet to potentially solicit a large number of investors in multiple states.
Firms that rely on Rule 506(c) to engage in general solicitation are encouraged to consult with counsel with respect to the laws in all states in which they will solicit potential investors to determine whether they must register as a broker or a dealer.
Registration as an Investment Adviser
Until the passage of the National Securities Markets Improvements Act in 1996 and the passage of the Dodd-Frank Act in 2010, most investment advisers were subject to regulation by the SEC and one or more states. Today most small and mid-size advisers are subject to state regulation and prohibited from registering with the SEC. Generally, advisers with less than $100 million of assets under management are regulated by one or more states. It is common for registered investment advisers to use Rule 506 to sell interests in their funds to potential investors.
By lifting the ban on general solicitation, amended Rule 506 virtually guarantees that Rule 506(c) offerings will reach more potential investors for private funds than traditional Rule 506(b) offerings. Based on the SEC's statements in the FAQ, it is also unclear whether an investment adviser to a private fund engaging in a Rule 506(c) offering may have to register in all 50 states and the District of Columbia if it is offering securities over the Internet. While most states have a de minimis exemption from registration, most of the exemptions require an investment adviser with more than five clients in the state to register in that state.
Investment advisers that plan to use Rule 506(c) to engage in general solicitation of investors in private funds are encouraged to consult with counsel with respect to the laws in all states in which they will solicit potential investors to determine whether they must register as an investment adviser.
WHAT DID NOT CHANGE
While the amendments do not alter the other requirements relating to offerings under existing Rule 506 (new Rule 506(b)), the rule changes that are meant to address the disqualification of bad actors (Rules 506(d) and (e)), apply commencing on September 23, 2013, to all Rule 506 offerings. The amendments do not affect the exempt status of offers and sales of securities that occurred prior to the effective date of Rule 506(c). Also the amendments discussed in the Adopting Release retain the ability of an issuer to conduct an offering that does not use general solicitation. Rule 506(b) remains an alternative for private placements by issuers that do not want to engage in general solicitation. Similarly, the amendments do not impact Section 4(a)(2) offerings in general. Issuers that do not intend to use general solicitation in their private offerings may avoid the added expense of complying with the requirements of Rule 506(c) offerings. Under Rule 506(b), issuers may continue selling privately to up to 35 non-accredited investors who meet existing Rule 506 sophistication requirement and timely receive information required by current Rule 502(b)(2).
Issuers that do not use general solicitation should still be able to rely on past guidance from the SEC regarding the method of verification of accredited investor status. It appears the SEC will continue to allow issuers to use an accredited investor questionnaire in these offerings, rather than imposing the heightened requirements of Rule 506(c). We also believe issuers that do not use general solicitation should be able to continue to rely on previous SEC guidance, such as the Lamp Technologies and IPONET no-action letters, which set forth the steps an issuer must follow to avoid being deemed to have engaged in general solicitation when using a private website to identify potential investors.
ADDITIONAL MONITORING RULES PROPOSED
At the same meeting described above, the SEC also proposed exercising its regulatory authority to adopt several amendments to Regulation D, Form D and Rule 156 under the Securities Act. These proposed rules would require advance notice filings for general solicitation (Rule 506(c)), submission of offering materials to the SEC concurrent with first use and certain mandatory disclosures (some of which relate only to private funds). In addition, they would change Form D to require expanded data from all Rule 506 offerings, enhanced data from Rule 506(c) offerings, and closing amendments. Failure to timely file notices for a Rule 506 private or general solicitation offering would deny reliance on that rule for at least a year.
The comment period for these proposed rules ends September 23, 2013.
It is unclear whether the JOBS Act and amended Rule 506 will be the "game-changer" envisioned by President Obama and supporters of the act. We believe Rule 506(c) and lifting the ban on general solicitation will have a positive impact on small business capital formation. We anticipate there will be initial hesitancy by advisers to well-established funds to use amended Rule 506(c) to solicit new investors, the use of general solicitation by advisers to smaller funds, may lead advisers to larger funds to use general solicitation in the future. However, we also believe there will be heightened scrutiny of these offerings by the SEC and state securities regulators. In light of the heightened requirements for screening accredited investors, the degree to which issuers will rely on amended Rule 506 to conduct offerings in lieu of other methods that do not employ general solicitation is unclear. Amended Rule 506 should benefit broker-dealers who are well equipped to perform the screening of accredited investors since broker-dealers already must perform know your customer, customer identification and suitability analysis on customers.
If you have any questions about the material presented in this alert, please contact any member of BakerHostetler's Securities Offerings and Reporting, Corporate Governance, Securities Litigation and Regulatory Enforcement and Hedge Fund Industry Teams.
Authorship Credit: Richard B. Levin, Kenneth C. Wright and Aaron A. O'Brien
 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. 33-9354 (Aug. 29, 2012) (Proposing Release).
 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. 33-9415 (July 10, 2013); 78 Fed. Reg. 4471 (July 24, 2013) (the Adopting Release).
 P.L. 112-106, 126 Stat. 305 (2012). View a copy of the JOBS Act.
 Disqualification of Felons and Other "Bad Actors" from Rule 506 Offerings, SEC Release No. 33-9414 (July10, 2013) (the "Bad Actor Release"). View the Bad Actor Release.
 Proposing Release; see also Use of Electronic Media for Delivery Purposes, Release No. 33-7233 (Oct. 6, 1995); Use of Electronic Media, Release No. 33-7856 (Apr. 28, 2000).
 17 C.F.R. § 230.506 section (2)(ii).
 Review of copies of IRS forms that report income (including but not limited to: Form W-2, Form 1099, Schedule K-1 of Form 1065, and a copy of filed Form 1040) for the two most recent years along with obtaining a written representation from such a person that he/she has reasonable expectation of reaching the income necessary to qualify as an accredited investor during the current year. If accredited investor status is based on joint income with a spouse, copies of these forms must be reviewed and written representation from both spouses must be obtained.
 Adopting Release at 77.
 SEC, Jumpstart Our Business Startups Act Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act (Feb. 5, 2013).
 IPONET, SEC No-Action Letter, 1996 WL 431821 (Jul. 26, 1996) and Lamp Technologies, Inc. SEC No-Action Letter
(May 29, 1998) (view a copy of the Lamp Technologies No-Action Letter).
 Amendments to Regulation D, Form D and Rule 156, SEC Release No. 33-9416 (the Monitoring Release). View the Monitoring Release.
 President Obama Signs JOBS Act Into Law, ABC News online (April 15, 2012).
Baker & Hostetler LLP publications are intended to inform our clients and other friends of the firm about current legal developments of general interest. They should not be construed as legal advice, and readers should not act upon the information contained in these publications without professional counsel. The hiring of a lawyer is an important decision that should not be based solely upon advertisements. Before you decide, ask us to send you written information about our qualifications and experience.