The Securities and Exchange Commission proposed yesterday, August 29, 2012, amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 as directed by the Jumpstart Our Business Startups Act. The SEC proposed new Rule 506(c) which allows general solicitation and general advertising, provided that all purchasers are accredited investors, the issuer takes reasonable steps to verify that the purchasers are accredited investors, and the satisfaction of certain other terms and conditions of Regulation D. The SEC also proposed amendments to Rule 144A allowing offers to persons other than qualified institutional buyers, including through general solicitation, provided that the securities are sold only to persons that the seller or its representative reasonably believe are qualified institutional buyers.
A. Current Framework
Section 5 of the Securities Act of 1933 (“Securities Act”) requires that every time a security is sold, it either must be registered with the Securities and Exchange Commission (“SEC”) or exempt from registration. Section 4(a)(2) of the Securities Act exempts transactions by an issuer “not involving any public offering.”
Rule 506 of Regulation D, one of the safe harbors available under Section 4(a)(2), exempts private offerings from registration requirements of the Securities Act of 1933. Currently, Rule 506 allows offers and sales by issuers without any limitation on the offering amount, to an unlimited number of “accredited investors” and up to 35 non-accredited sophisticated investors, subject to certain requirements and conditions, including Rule 502(c)’s requirement that any offer or sale may not be through any form of “general solicitation or general advertising.” By rule and interpretation, examples of “general advertising” include newspaper and magazine, communications broadcast over television and radio, seminars whose attendees were invited by general solicitation, and other uses of publicly available media, such as unrestricted websites. To demonstrate that a general solicitation has not occurred, the issuer or its agent must have a pre-existing, substantive relationship with the potential investor. A substantive relationship exists when the issuer has information regarding a potential offeree such that the issuer can evaluate the prospective offeree’s sophistication and financial circumstances. A relationship is pre-existing if it existed for some duration prior to the current private offering.
Rule 144A is a safe harbor exemption from the registration requirements of the Securities Act for resales of certain “restricted securities” to qualified institutional buyers (“QIBs”). Currently, Rule 144A provides offers of securities only to QIBs, which has the practical effect of a prohibition against general solicitation.
The estimated capital raised in 2011, based off of debt and equity Form D filings, through Rule 506 and Rule 144A offerings was $895 billion and $168 billion, respectively (or approximately $1,063 billion combined), compared to $984 billion raised in registered offerings.
B. Section 201(a) of the JOBS Act
The Jumpstart Our Business Startups Act (the “JOBS Act”) was enacted on April 5, 2012. Section 201(a) thereof directed the SEC to modify certain rules within 90 days of its enactment.
Section 201(a)(1) of the Jumpstart Our Business Startups Act (the “JOBS Act”) directed the SEC to amend Rule 506 of Regulation D to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors, and that the issuer shall be required “to take reasonable steps to verify that purchasers of the securities are accredited investors[.]”
Section 201(a)(2) of the JOBS Act directed the SEC to revise Rule 144A(d)(1)11 under the Securities Act to permit offers of securities pursuant to Rule 144A to persons other than QIBs, including by means of general solicitation or general advertising, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs.
II. Proposed Amendments to Rule 506 and Related Issues
A. Proposed New Rule 506(c)
Proposed Rule 506(c) would permit the use of general solicitation, and not be subject to compliance with Rule 502(c), to offer and sell securities under Rule 506, provided the following conditions are satisfied:
- the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors;
- all purchasers of securities must be accredited investors, either by way of one of the enumerated categories in Rule 501(a) or the issuer reasonably believes that they do, at the time of the sale of the securities;
- and all terms and conditions of Rule 501 and Rules 502(a) and 502(d) must be satisfied.
NOTE: Broker-dealers participating in offerings relying on proposed Rule 506(c) would continue to be subject to the rules of FINRA regarding communications with the public. See FINRA Rule 2210.
B. Reasonable Steps to Verify Accredited Investor Status
The SEC proposes an objective standard, based on the particular facts and circumstances, that issuers are required to “take reasonable steps to verify” that the purchasers are accredited investors. Examples of the non-exclusive and interconnected factors include:
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- Verification varies depending on type of accredited investor – e.g. a broker-dealer’s status could be checked on FINRA’s BrokerCheck website
- the amount and type of information that the issuer has about the purchaser; and
- The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa
- Examples of information include: publicly available information in filings with a federal, state or local regulatory body; W-2, personal bank and brokerage account statements; average annual compensation as provided in industry/trade publications; and reasonable reliance on verification by broker-dealer, attorney or accountant.
- 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 a minimum investment amount.
- The more public the offering (e.g. website or media versus pre-screened database by reasonably reliable third-party), the more information to verify
- Ability to meet high minimum investment, not through financing
In addition, the SEC provides the following additional guidance for compliance: (i) issuers should retain adequate records that document the steps taken to verify that a purchaser was an accredited investor and (ii) many practices currently used by issuers in connection with existing Rule 506 offerings are anticipated to satisfy the proposed verification requirements.
C. Reasonable Belief that All Purchasers Are Accredited Investors
The proposal clarifies the intent that the reasonable belief standard will continue to apply to Rule 506(c). If a person purchases securities who does not meet the criteria for any category of an accredited investor in a Rule 506(c) offering, the SEC believes that the issuer would not lose the ability to rely on the proposed Rule 506(c) exemption, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.
D. Form D Check Box for Rule 506(c) Offerings
SEC proposal only adds or amends check boxes on Form D relating to the type of federal exemptions and exclusions claimed, including Rule 506(c) under Item 6 of Form D.
E. Specific Issues for Privately Offered Funds
The SEC interprets the directive contained in the JOBS Act to apply to the two common exemptions claimed by hedge funds from the provisions of the Investment Company Act of 1940. Section 3(c)(1) excepts from the definition of investment company a fund that meets two requirements: (i) it must be beneficially owned by less than 100 persons and (ii) “which is not making and does not presently propose to make a public offering of its securities.” Section 3(c)(7) applies to any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are “qualified purchasers,” and which is not making and does not at the time propose to make a public offering of such securities. As the SEC has historically regarded Rule 506 transactions as non-public offerings for the purposes of Sections 3(c)(1) and 3(c)(7), they believe the effect of the JOBS act is to permit such privately offered funds to make a general solicitation under the proposed Rule 506(c) without losing the exclusions under the Investment Company Act.
IV. Proposed Amendment to Rule 144A – Offers to Persons Other Than Qualified Institutional Buyers
SEC proposes to amend Rule 144A(d)(1) to eliminate the references to “offer” and “offeree,” which would allow for general solicitation, but the limitation as to the purchasers remain – securities must be sold to a QIB or a purchaser that the seller and any person acting on behalf of the seller reasonably believe is a QIB.
IV. Integration with Offshore Offerings
The SEC clarifies that, consistent with historical treatment, concurrent offshore offerings that are conducted in compliance with Regulation S would not be integrated with domestic unregistered offerings that are conducted in compliance with Rule 506 or Rule 144A, as proposed to be amended. Therefore, in a global offering where the United States portion is conducted in accordance with proposed rule 506(c) or proposed amended Rule 144A, it would not run afoul of the second of the two general conditions for safe harbor under Regulation S – no directed selling effort in the United States.
The SEC requests comments within 30 days of publication on the proposal, including its operation, procedure and alternatives.
Full Text of Proposal: Release No. 33-9354
 Rule 501(a) of Regulation D
 Rule 506(b)(2)(ii) requires non-accredited investors, up to 35, to have “such knowledge and experience in financial and business matters that he [or she] is capable of evaluating the merits and risks of the prospective investment.”
 E.F. Hutton & Company Incorporated, SEC No Action Letter, December 3, 1985.
 “Restricted securities” include, in part, “[s]ecurities acquired directly or indirectly from the issuer, or from an affiliate of the issuer, in a chain of transactions not involving a public offering.” Rule 144(a)(3) of the Securities Act.
 Existing Rule 506(b) would be preserved for issuers not interested in general solicitation or that wish to sell privately up to 35 non-accredited investors meeting its sophistication requirements.
 The SEC specifically avoided any exclusive or non-exclusive list and further provides that the factors are interconnected – the information gained by looking at factors would help assess likelihood of being an accredited investor and thus, affect the types of steps required to verify.
 An issuer claiming an exemption from the registration requirements of Section 5 of the Securities Act has the burden of showing that it is entitled to that exemption.
 Section 3(a)(1) of the Investment Company Act of 1940 defines an investment company as any issuer of securities which “is or holds itself out as being engaged primarily or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.”
 Rule 902(c)(1) “directed selling effort” is broadly defined as “conditioning the market” in the U.S. for any of the securities offered in reliance on Regulation S, which includes placing an advertisement in a publication “with a general circulation in the United States” referring to the Regulation S offering.