Law 360 – Expert Analysis
On July 10, 2013, the Securities and Exchange Commission (SEC) adopted final rules amending Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 to implement Section 201(a) of the Jumpstart Our Business Startups (JOBS) Act and amending Rule 506 to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank) Act.
Both sets of amendments to Rule 506 had languished in rulemaking for some time. The JOBS Act directed the SEC, not later than July 4, 2012, to amend Rule 506 to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers are accredited investors. However, the SEC did not even propose amendments until August 12, 2012. The amendments required by Section 926 of the Dodd-Frank Act to prohibit “bad actors” from Rule 506 offerings were required to be adopted not later than July 21, 2011. The SEC proposed amendments on May 25, 2011, but did not take any further action relating to the amendments until the July 10, 2013 final rules. SEC Chairman Mary Jo White has repeatedly stated that completing JOBS Act rulemaking is among her top priorities. With the amendments to Rule 506 now final, my prediction is that we should expect to see proposed rules under Title III of the JOBS Act (crowdfunding) early in the fourth quarter of 2013.
The two releases (No. 33-9415 and 33-9414) adopting these amendments total more than 300 pages. If SEC rulemaking is not high on your summer reading list, here are the…
Top 10 Things You Need to Know about Rule 506 Amendments
1. Both sets of amendments will become effective 60 days after they are published in the Federal Register. If publication occurs as expected around July 19, 2013, the amendments will become effective around September 17, 2013.
2. Remember that there are three kinds of offerings: (1) registered, (2) exempt and (3) illegal. Until the amendments are effective, no general solicitation or advertising may be lawfully used in connection with a Rule 506 offering. If the offering is not exempt because the issuer used general solicitation or advertising in advance of the effectiveness of the amendments, those investors have an automatic right of rescission.
3. All issuers can still use “old” Rule 506 – which is now Rule 506(b) – to offer and sell an unlimited dollar amount of securities to accredited investors and up to 35 non-accredited investors without general solicitation and advertising. Those issuers need only establish a reasonable belief that the investors are accredited. For this purpose, the historical practices of a representation and warranty or check-the-box certification is sufficient to substantiate a reasonable belief (absent actual knowledge of non-accredited status). The definition of accredited investor has not changed by these amendments.
4. Securities issued under Rule 506 offerings, whether or not general solicitation or advertising are used, are considered “covered securities.” Securities issued in Rule 506(c) offerings are deemed to be covered securities for purposes of Section 18(b)(4)(E) of the Securities Act by virtue of Section 201(a)(1) of the JOBS Act. Securities issued in Rule 506(b) offerings continue to be covered securities under Section 18(b)(4)(D). This is great news for compliance with state securities laws (blue sky).
5. If the issuer will use general solicitation or advertising in connection with the Rule 506 offering, sales of the securities may be made only to accredited investors. Offers can be made to anyone, but sales must be made only to accredited investors.
6. If general solicitation or advertising is used, the issuer must take reasonable steps to verify that an investor is accredited. In the amendments, the SEC provided a non-exclusive and non-mandatory list of verification methods for natural persons as follows:
- For the income standard ($200,000 individual, $300,000 with spouse): IRS form showing income for the last two years (for example, Form 1040, W-2 or K-1) and a written representation from the investor that he or she expects to reach the required level of income for accredited status in the current year.
- For the net worth standard ($1 million, excluding principal residence/mortgage): One of the following documents dated within 3 months:
- For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties
- For liabilities: a consumer report from at least one of the nationwide consumer reporting agencies. The issuer must also obtain a written representation from the person that all liabilities have been disclosed.
- Written confirmation from a registered broker-dealer, a registered investment adviser, a licensed attorney in good standing, or a registered CPA in good standing stating that they have taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and that they have determined that such purchaser is an accredited investor.
- For a person that was an accredited investor in the issuer’s Rule 506 offering before the effective date of the amendments and continues to hold the securities, obtaining a certification by such person at the time of sale in that same issuer’s Rule 506(c) offering that he or she qualifies as an accredited investor.
If an issuer uses one of these four methods for verifying that a natural person is accredited, that issuer is deemed to satisfy the verify requirement.
There is no such helpful list of verification methods for entities who are accredited investors. However, it is fairly easy to imagine the analogous types of information that would allow an issuer to verify that a corporation, LLC, partnership, trust, etc. has total assets in excess of $5 million as required by the definition of accredited investor for these entity types under Rule 501(a).
7. For an ongoing offering under Rule 506 that commenced before the effective date of Rule 506(c), the issuer may choose to continue the offering after the effective date in accordance with the requirements of either Rule 506(b) or Rule 506(c). If an issuer chooses to continue the offering in accordance with the requirements of Rule 506(c), any general solicitation that occurs after the effective date will not affect the exempt status of offers and sales of securities that occurred prior to the effective date in reliance on Rule 506(b).
This means if an issuer wants to commence (or continue) a Rule 506 offering, the issuer can later use general solicitation/advertising in a “new” 506(c) offering without affecting the exempt status of the previous offering — as long as the issuer complies with the new rules, once effective.
8. Rule 506(b) is a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act, which exempts “a transaction by an issuer not involving a public offering” from the registration requirements of Section 5 of the Securities Act. Therefore, even if the issuer’s offering is not within the safe harbor of Rule 506(b), the offering may nonetheless be exempt as not involving a public offering.
However, new Rule 506(c) is not a safe harbor under Section 4(a)(2). That is because general solicitation and advertising is fundamentally incompatible with a claim of exemption under Section 4(a)(2). Accordingly, if an issuer uses general solicitation and advertising in connection with the offering under Rule 506(c), an exemption under Section 4(a)(2) is not available as a “fall back” position if all of the particulars of Rule 506(c) are not met. The fact that Rule 506(c) is not a safe harbor will mean that issuers relying on Rule 506(c) will take extra precautions to ensure exacting compliance with the requirements of the rule, including “verification” of accredited status.
9. Issuers will not be able to rely upon Rule 506 if either the issuer or its affiliates (including officers, directors, managing members, +20% owners, placement agents, finders) have been subject to certain disqualifying events, unless the issuer can establish that it did not know and “in the exercise of reasonable care, could not have known” about the disqualification. This bad actor disqualification applies whether or not the issuer takes advantage of Rule 506(c) permitting general solicitation and advertising. In order to exercise reasonable care, the issuer must make a factual inquiry into whether any disqualification exists. The nature and scope of that factual inquiry can vary based upon the facts and circumstances.
10. If the issuer or its affiliates were subject to a disqualifying event prior to the effective date of the rules, the issuer can still rely on Rule 506, BUT must make disclosure to investors prior to the sale of securities about the disqualifying event.
But Wait, There’s More…
As an added bonus, the SEC also on July 10, 2013 proposed amendments to Form D to correspond to the Rule 506 amendments discussed above and proposed new rules relating to Rule 506(c) offerings. Comments are due within 60 days from publication in the Federal Register. These amendments are already generating some controversy. The important highlights of the proposed amendments:
New Form D will require an issuer to file the Form D prior to conducting a Rule 506(c) offering. This will effectively force an issuer to determine whether it is going to use general solicitation and advertising and comply with the verification requirements to confirm that all investors are accredited or rely on the existing rules (without using any general solicitation or advertising and without verification).
New Form D will require the filing of a closing amendment to Form D after the termination of any Rule 506 offering.
New rules would require written general solicitation materials used in Rule 506(c) offerings to include certain legends and other disclosures. The proposed legends and other disclosures are not terribly different from what I consider to be best practices with offering materials.
New rules would require the that issuers submit the written general solicitation materials used in Rule 506(c) offerings to the SEC for a temporary period (proposed to be 2 years). This is so the SEC can be alerted to troublesome marketing practices and monitor the use of Rule 506(c).
And, last but, not least…New rules would disqualify an issuer from relying on Rule 506 for one year for future offerings if the issuer, or any predecessor or affiliate of the issuer, did not comply, within the last five years, with Form D filing requirements in a Rule 506 offering. For those issuers and practitioners who treat the Form D filing as optional, this proposed amendment should be a very clear sign that the SEC is serious about these filings.