General Solicitation Rule 506(c)
As mandated by the Jumpstart Our Business Startups Act (JOBS Act) signed April 5, 2012, the Securities and Exchange Commission has released a final rule ending (under specific circumstances) the eighty-year ban on general solicitation of private placements. Rule 506(c) of Regulation D became effective September 23, 2013. Since the passage of the Securities Act of 1933, the pool of prospective investors available to be invited to invest in a private placement has been limited to the personal and business relationships of the issuer;, however, the ability to use general solicitation to advertise a private placement of securities will allow for the use of many types of advertising to draw the interest of investors not having a preexisting relationship with the issuer.
Background of Traditional Private Placements
Under the Securities Act of 1933, Regulation D provided a safe harbor for private securities offerings. Under Regulation D, Rule 506 allowed issuers raising capital to do so from those having a substantial and preexisting relationship with the issuer, provided the offering did not involve a general solicitation of the offering and provided the investor was sophisticated, having such knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the prospective investment. An issuer availing himself or herself to Rule 506 could also rely upon the substantial, preexisting relationships of his or her broker-dealers or placement agents with prospective investors. Under Rule 506, the offering was limited to thirty-five unaccredited investors (there was no limit on the number of accredited investors). Accredited investors are defined by SEC Rule 501 of Regulation D to be:
1. A bank, insurance company, registered investment company, business development company, or small business investment company;
2. An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
3. A charitable organization, corporation, or partnership with assets exceeding $5 million;
4. A director, executive officer, or general partner of the company selling the securities;
5. A business in which all the equity owners are accredited investors;
6. A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
7. A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
8. A trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
Under the Rule 506, the standard, when it came to the accredited status of an investor, was that the issuer had a “reasonable belief” that the investor was sophisticated. Issuers would show reasonable belief by relying upon investors’ answers to questionnaires included with subscription packages, wherein prospective investors checked income and net worth boxes to indicate accredited status.
Private Placements Using Rule 506(b)
With the release of the final rule, Rule 506 has effectively been split. The exemption allowing up to thirty-five unaccredited investors with a preexisting relationship requirement and prohibition on general solicitation will continue as Rule 506(b).
Private Placements Using Rule 506(c)
Rule 506(c) embodies the new rule and will allow for general solicitation, including the use of websites and other electronic communications expressly classified as general solicitation in Securities Act Release No. 7233, dated October 6, 1995, provided the issuer limit investment to accredited investors; satisfy all the terms of Rules 501, 502(a) and 502(d); and take reasonable steps to verify the accredited status of each investor. This verification is separate and apart from the requirement that all investors be accredited; therefore, the fact that all investors are indeed accredited under the definition of Rule 501(a) does not relieve an issuer from his or her duty to verify the accredited status of investors.
Reasonable Steps to Verify Accredited Status
The SEC states that reasonable steps to verify the accredited status of an investor will vary with the facts and circumstances of each offering, each investor, and the information the issuer obtains about each investor. However, Rule 506(c)(2)(ii) does provide the following guidance as to steps the SEC will consider as reasonable verification of the accredited status of an investor:
Purchaser is an Accredited Investor on the Basis of Income
In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser’s income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year is satisfactory. In the case of a person who qualifies as an accredited investor based on joint income with that person’s spouse, the issuer would be deemed to satisfy the verification requirement in Rule 506(c)(2)(ii)(A) by reviewing copies of Internal Revenue Service forms that report income for the two most recent years in regard to, and obtaining written representations from, both the person and the spouse.
Purchaser is an Accredited Investor on the Basis of Net Worth
In regard to whether the purchaser is an accredited investor on the basis of net worth, reviewing one or more of the following types of documentation dated within the prior three months and obtaining written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
1. With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
2. With respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.
In the case of a person who qualifies as an accredited investor based on joint net worth with that person’s spouse, the issuer would be deemed to satisfy the verification requirement in Rule 506(c)(2)(ii)(B) by reviewing such documentation in regard to, and obtaining written representations from, both the person and the spouse.
Written Confirmation from Professional Representative of Investor
Obtaining written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:
1. A registered broker-dealer;
2. An investment adviser registered with the Securities and Exchange Commission;
3. A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
4. A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.
Purchaser of Securities as Accredited Investor under Rule 506(b)
In regard to any person who purchased securities under an issuer’s Rule 506(b) offering as an accredited investor prior to 60 days after publication in the Federal Register and continues to hold such securities, under the same issuer’s Rule 506(c) offering, obtaining a certification from such person at the time of sale that he or she qualifies as an accredited investor.
The preceding steps are non-exclusive and non-mandatory methods of verifying the accredited investor status requirement in Rule 506(c)(2)(ii), but an issuer following these steps is deemed to have taken reasonable steps provided, however, that the company does not have knowledge that the investor is not an accredited investor. Issuers may use other reasonable steps to verify the accredited status of an investor, but the SEC has expressly stated that the check-the-box method relied upon using subscription agreements for traditional Rule 506 offerings, now Rule 506(b) offerings, shall not suffice to prove reasonable steps to verify accredited status. Therefore, it is expected that most issuers will closely follow the reasonable steps outlined by the SEC.
Impacts upon Rule 504, Rule 505 and Rule 506(b)
The removal of the ban on general solicitation provided by Rule 506(c) does not apply to any other exemption from registration. General solicitation remains prohibited for Rule 504, Rule 505, Rule 506(b), and other offerings wherein general solicitation has traditionally been banned.
Proposed Changes Regulation D
The SEC has expressed concerns related to allowing general solicitation of private placements under Rule 506(c), and in response has proposed some additional changes to Regulation D.
Proposed Changes to Rule 503 under Regulation D
The first such change would be an amendment to Rule 503 providing that a Form D be filed fifteen days in advance of engaging in general solicitation activities, whereas Rule 503 currently allows for the filing of Form D up to fifteen days after the first sale of securities.
Proposed Rule 509 under Regulation D
Another proposed change would be the creation of Rule 509 that would require (i) legends in any written general solicitation materials used in a Rule 506(c) offering and (ii) additional disclosures for private funds if such materials include performance data.
Proposed Amendments to Rule 156
Finally, the SEC has proposed amendments to Rule 156 under the Securities Act that would extend the guidance contained in the rule to the sales literature of private funds.