Publications

SEC Adopts Final Rules Lifting General Solicitation Ban and Disqualifying Bad Actors; Proposes New Requirements for Rule 506 Offerings

September 6, 2013
Harter Secrest & Emery LLP

Recently, the Securities and Exchange Commission (the “SEC”) adopted final rules (the “New Rules”), which lift the ban on general solicitation and disqualify “bad actors” from participating in securities offerings that rely on Rule 506 of Regulation D (“Rule 506”) under the Securities Act of 1933, as amended (the “Securities Act”). Rule 506 provides a “safe harbor” for private offerings utilizing the exemption under Section 4(a)(2) of the Securities Act. Currently, Rule 506 prohibits general solicitations in the offer and sale of securities.

Under the New Rules, the SEC created a new Rule 506 private offering safe harbor designated as Rule 506(c) that permits general solicitation – under certain conditions. The current Rule 506 private offering safe harbor that prohibits general solicitation has been designated as Rule 506(b) and it is still available for issuers not interested in engaging in general solicitation. Also, under the New Rules, issuers are prohibited from relying on any of the Rule 506 safe harbors if certain individuals participating in the offering have been subject to any “disqualifying events,” such as criminal convictions in connection with the purchase or sale of securities. The SEC also proposed amendments to Regulation D, Form D, and Rule 156 that would impose new _ling requirements and penalties for Rule 506 offerings, if adopted. The New Rules will be effective on September 23, 2013.

Ban on General Solicitation Lifted

Section 201(a) of the Jumpstart Our Business Startups Act (the “JOBS Act”) required the SEC to issue rules eliminating the prohibition against general solicitation for the offer and sale of securities that rely on Rule 506 and Rule 144A of the Securities Act. Previously, the Rule 506 safe harbor was conditioned upon an issuer not offering or selling securities through any form of general solicitation, such as general advertising including, but not limited to, advertisements in newspapers, magazines, websites, television, and radio. The New Rules eliminate the prohibition on general solicitation by creating a new Rule 506(c). The prohibition continues to apply to offerings made under Rules 504, 505 and 506(b) of Regulation D. The New Rules permit the use of general solicitation under Rule 506(c) if:

  • All of the purchasers of securities are “accredited investors”; and
  • The issuer takes “reasonable steps” to verify that the purchasers of the securities are “accredited investors.”

The New Rules also contain a non-exclusive list of methods that issuers may use to verify “accredited investor” status in Rule 506(c) offerings. In summary, the methods include (i) reviewing Internal Revenue Service forms to confirm income, (ii) reviewing account statements from banks, brokerages or other statements of securities holdings to confirm net worth, and (iii) a written confirmation from the purchasers broker-dealer, investment adviser, certified public accountant or licensed attorney. Existing investors who purchased securities prior to September 23, 2013, may provide the issuer with a certification of their continued accredited investor status in lieu of the methods described above. The SEC emphasized that the issuer has the burden of demonstrating that its offering is entitled to an exemption from registration and therefore it should retain adequate records documenting the steps it has taken to verify the accredited investor status of the purchasers in the offering.

The SEC also warned issuers engaging in general solicitation in reliance on Rule 506(c) that if they failed to comply with all of the conditions of Rule 506(c) they will be unable to rely on any of the other exemptions in Regulation D, and that they may not claim the private offering exemption set forth in Section 4(a)(2) of the Securities Act, essentially leaving the issuer without an exemption from Securities Act registration.

Issuers not interested in engaging in general solicitation may continue to rely on the existing Rule 506 safe harbor that is now designated as Rule 506(b). Such issuers may continue to sell securities to up to 35 non-accredited investors in compliance with Rule 506(b).

Final Disqualification Rules Prohibit “Bad Actors” in Rule 506 Offerings

Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) required the SEC to adopt rules disqualifying certain “felons and other ‘bad actors’” from participating in securities offerings that rely on Rule 506. The New Rules disqualify issuers from reliance on Rule 506 if certain individuals or entities (including directors, certain officers, and other affiliated companies or persons) involved in the offering, referred to as a “covered person”, have been subject to a “disqualifying event.”1 Disqualification events that occurred before the New Rules become effective will not result in disqualification from Rule 506, but issuers will be required to disclose the existence of such events to potential investors.

The New Rules create a ‘reasonable care’ exception, which permits an issuer to establish that it did not know, and could not have reasonably known, that a disqualification existed. An issuer wishing to establish reasonable care must demonstrate that it made a factual inquiry into whether any disqualifications existed. The SEC did not set forth specific steps that are necessary or sufficient to establish reasonable care, but in most cases, obtaining certifications from the issuer’s covered persons should be sufficient. Finally, the New Rules also amend Form D, which will include in the signature block a certification where issuers claiming a Rule 506 exemption will confirm that the offering is not disqualified from reliance on Rule 506 for one of the disqualifying events described in the footnote below.

Proposed Rules to Amend Regulation D Filing Requirements

The SEC also proposed rules to amend Regulation D, Form D, and Rule 156 to allow the SEC to respond to changes in the Rule 506 market practices as required by the New Rules. Under the proposed rules:

  • If an issuer is going to engage in general solicitation in a Rule 506(c) offering, it must submit its Form D to the SEC prior to commencing general solicitation and must amend its Form D after the termination of any Rule 506(c) offering;
  • Written general solicitation materials used in Rule 506(c) offerings must include certain legends and other disclosures;
  • Written general solicitation materials used in Rule 506(c) offerings must be submitted to the Commission no later than the date of first use of such materials;
  • Issuers are disqualified 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, subject to a cure period for late filings;
  • Issuers filing Form D are required to include additional information about offerings conducted in reliance on Regulation D; and
  • Amendments to Rule 156 would extend the antifraud guidance contained in the rule to the sales literature of private funds.

What to Do Now

Issuers that are interested in engaging in a general solicitation and relying on Rule 506(c) to conduct an offering should begin putting together policies and procedures now that will enable verification of the status of purchasers. Issuers will need to determine what type of information they will request of purchasers and consider the privacy issues raised by requesting some of the information needed to verify accredited investor status. Issuers should consider supplementing this information with representations and warranties as to accredited investor status in subscription documents if such representations and warranties are not already contained in such documents. Further, issuers will need to evaluate, or consider adopting, document retention policies to ensure that they maintain proper documentation regarding how they verified the accredited investor status of purchasers.

All issuers engaged in Rule 506 offerings will need to develop due diligence procedures to determine that no covered persons have any disqualifying events. We would recommend that all issuers engaging in a Rule 506 offering receive written certifications from each covered person to confirm compliance with Rule 506. For offerings expected to last more than one year, issuers will need to adopt policies to ensure that they receive annual certifications from all covered persons. In the acquisition context, if an issuer anticipates relying on Rule 506 in the future it should complete adequate due diligence of the target and its officers, directors and employees to ensure that the target is not subject to any events that could disqualify the issuer from reliance on Rule 506 post-acquisition.

If you have any questions regarding this LEGALcurrents®, or require assistance in preparing for the implementation of the New Rules, please do not hesitate to contact any member of our firm’s Securities Practice Area at 585-232-6500.

1 “Disqualifying events” include, among other things, criminal convictions, court injunctions, and restraining orders related to U.S. securities laws and final orders of certain U.S. federal and state regulators that bar engaging in securities, banking, and similar activities or are based on violations of certain antifraud laws and regulations. In general, such conduct must have occurred, depending on the applicable event, between 5 and 10 years prior to the covered sale in order to constitute a “disqualifying event.”