Background
When enacted on April 5, 2012, Title II of the Jumpstart Our Business Startups Act of 2012 (JOBS Act) endeavored to lift the long-standing ban on general solicitation and advertising for private securities offerings under Rule 506 and Rule 144A, so long as the securities are sold only to accredited investors under Rule 506 or qualified institutional buyers (QIBs) under Rule 144A.
To implement this change for issuers relying on the Rule 506 safe harbor, the JOBS Act directs the Securities and Exchange Commission (SEC) to revise Rule 506 to require issuers engaging in general solicitation or advertising to “take reasonable steps to verify” that the purchasers of the securities are accredited investors, “using such methods as determined by the [SEC].” For Rule 144A, the JOBS Act simply directs that the revised rules permit general solicitation and advertising of offerings to investors who are not QIBs, provided that the ultimate sales of securities under Rule 144A are made only to investors who are, or who the seller reasonably believes are, QIBs.
For the past 15 months, the private securities world has eagerly awaited the SEC’s articulation of the “reasonable steps” and “methods” for qualification under the revised Rule 506 exemption and adoption of the rule amendments mandated by Title II of the JOBS Act. On August 29, 2012, the SEC issued proposed rules that, to many, left the Rule 506 “reasonable steps” and “methods” too vague to provide a reliable safe harbor. In the proposed rule release, the SEC stated its belief that promulgating specific methods for determining accredited investor status would be impractical and potentially ineffective in light of the wide range of verification issues that may arise in connection with a particular offering. Instead, the SEC set out a more flexible and adaptable facts-and-circumstances approach to determine whether, in a particular case, reasonable steps had been taken by an issuer to verify the purchaser’s accredited investor status. Although the SEC received a substantial number of comments on the proposed rules, including the recommendations of the SEC’s Investor Advisory Committee on October 12, 2012, it did not take further action on the matter until yesterday.
Final Rules for Private Offerings under Rule 506 and Rule 144A
Yesterday, the SEC adopted final rules adopting the originally proposed facts-and-circumstances approach to assessing whether an issuer has taken appropriate steps to ascertain that a purchaser is an accredited investor, but with one important modification responding to comments calling for more clearly defined methods of determining accredited investors status: The final rules include a list of four specific and detailed non-exclusive, non-mandatory methods for verifying accredited investor status of purchasers who are natural persons. In summary, they include the following:
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Meeting the Income Requirement: IRS Forms: Reviewing any Internal Revenue Service form—including Forms W-2, 1099, K-1, and 1040—that reports the purchaser’s income for the two most recent years and obtaining a 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;
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Meeting the Net Worth Requirement: Financial Institution and Other Third Party Statements: Reviewing certain documents—including, for assets, bank, brokerage and other statements of securities holdings, certificates of deposit, tax assessment and appraisal reports, and, for liabilities, a report from a nationwide credit reporting agency. The report must be dated within the prior three months that show the purchaser’s assets and liabilities, and the issuer must obtain a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed;
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Third Party Confirmation: Obtaining a written confirmation from certain third parties, including registered broker-dealers, SEC-registered investment advisers and licensed attorneys and certified public accountants in good standing, that such person or entity has taken reasonable steps within the prior three months to verify that the purchaser is an accredited investor and has determined that such purchaser is an accredited investor; and
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Accredited Investors who are Prior Purchasers: Regarding any person who purchased securities in an issuer’s Rule 506 offering as an accredited investor prior to the effective date of the final rules and who continues to hold such securities, obtaining a certification by such person at the time of sale that he or she remains qualified as an accredited investor.
An issuer using any of these methods with respect to individual purchasers of its securities will be deemed to have taken reasonable steps to verify that those purchasers are accredited investors, and may confidently rely on the Rule 506 safe harbor. None of the listed methods will satisfy the verification requirement if the issuer or its agent had actual knowledge that the purchaser is not an accredited investor.
In other respects, the amendments to Rule 506 and related rules under the Regulation D remain substantially as set forth in the SEC’s August 29, 2012 proposed rule release:
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New Rule 506(c) for Offerings Involving General Solicitation and Advertising. The amendments add a new subsection (c) to existing Rule 506 that permits general solicitation and advertising for private offerings of securities under Rule 506 if:
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the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors; and
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all purchasers of the securities are accredited investors.
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Reasonable Belief as to Accredited Investor Status. The amended rules will continue to employ the same reasonable belief standard currently applied to Rule 506 offerings, meaning that, as long as an issuer takes reasonable steps to verify that a purchaser is an accredited investor and reasonably believes that the purchaser is accredited at the time of sale, the fact that a purchaser ultimately turns out not to have been accredited at the time of sale will not cause the issuer to lose its ability to rely on Rule 506(c) and engage in general solicitation and advertising.
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Current Rule 506 Safe Harbor Exemption Remains. The SEC's amendments leave intact the existing safe harbor exemption (under new Rule 506(b)) for issuers conducting an offering without engaging in general solicitation or advertising.
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Amended Form D. The amended rules include modest changes to Form D. Among the changes, a new box titled "Rule 506(c)" will be added for issuers relying on the new exemption and the existing box currently titled "Rule 506" will be renamed "Rule 506(b).”
Amendments to Rule 144A Adopted as Proposed
As originally proposed in August 2012, the amendments to Rule 144A permit securities sold pursuant to Rule 144A to be offered by means of general solicitation and advertising to investors who are not qualified institutional buyers (QIBs) if the ultimate sales of securities under Rule 144A are made only to investors that are, or which the seller reasonably believes are, QIBs. Prior to the JOBS Act, sellers could not offer securities under Rule 144A to investors who were not QIBs, which effectively prohibited the use of general solicitation and advertising.
Denial of the Rule 506 Safe Harbor for Prospective Bad Actors
With its adoption of the Rule 506 and related Regulation D amendments pursuant to the JOBS Act, the SEC also adopted a long-awaited amendment to Rule 506 to prohibit the use of the safe harbor exemption by certain “bad actors” (violators of securities laws) pursuant to the Section 926 of the Dodd–Frank Wall Street Reform and Consumer Protection Act. Among the modifications to the proposed rule changes originally released by the SEC in May 2011, the most notable is that the denial of the Rule 506 exemption will apply only to persons who are found to have violated securities laws after the rule amendment becomes effective. Consequently, any persons who engaged in prohibited activities prior to the amendment will be able to publicly solicit investments using the Rule 506 safe harbor.
Effective Date of Final Rules
The above-described final rules will be effective 60 days after the date they are published in the Federal Register.
No Fallback Exemption if Rule 506(c) Requirements Are Not Met
As noted in our prior Updates addressing the changes to Rule 506, the JOBS Act’s mandate to lift the ban on general solicitation and advertising affects only offerings meeting the requirements of Rule 506(c), and not offerings in general under Section 4(a)(2) of the Securities Act, from which the Rule 506 safe harbor exemption is derived.
Issuers engaging in general solicitation and advertising of an offering face significant consequences if they rely on the new Rule 506(c) exemption but fail to meet the "reasonable steps" accredited investor verification standard, as they cannot rely on the statutory exemption provided by Section 4(a)(2) of the Securities Act and would be left without any exemption from the Securities Act registration requirements. The SEC included language in the final rules to make this point absolutely clear.
New Proposed Rules for Tracking the Rule 506 Market and Additional Investor Safeguards
Simultaneously to its adoption of these significant amendments, the SEC proposed new rules and amendments to Regulation D designed to enable the SEC to better monitor the Rule 506 market to address concerns that may arise in connection with the general solicitation and advertising of private offerings under Rule 506(c). These proposed rules would:
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Require issuers to file a Form D within 15 days before engaging in general solicitation or advertising of a private offering under Rule 506(c);
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Require issuers to file an amended Form D within 30 days after the completion of a Rule 506(c) offering;
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Revise Form D to require the disclosure of additional information about the issuer, the securities offering, the purchasers and the use of proceeds from the offering;
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Disqualify an issuer from the use of Rule 506 for future offerings if the issuer has failed to file a Form D for a Rule 506 exemption within the five preceding years (only applicable to failures to file a Form D after the effective date of the proposed rules);
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Require inclusion of certain legends on all written general solicitations and advertisements for Rule 506(c) offerings;
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Extend the current Rule 156 of the Securities Act to apply to sales literature used by private funds; and
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Require issuers engaging in general solicitation and advertising under Rule 506(c) to privately submit copies of all written general solicitations and advertisements to the SEC via an online drop box. This is a temporary rule expected to last two years.
Additional Information
The full texts of the final rules under the JOBS Act can be found here, the rule amendments under the Dodd-Frank Act can be found here, and the new proposed rules can be found here. For more information and analysis regarding the JOBS Act, please see our March 30, 2012 JOBS Act Update and our September 10, 2012 JOBS Act Update.
