On July 10, 2013, the Securities and Exchange Commission (SEC) issued long-anticipated rules eliminating the prohibition against general solicitation and advertising in connection with offerings under Rules 506 and 144A under the Securities Act of 1933.
The rules were mandated by Section 201(a) of the 2012 Jumpstart Our Business Startups (JOBS) Act. The JOBS Act required the SEC to issue the rules over a year ago, and potential issuers, investors and market intermediaries have been anxiously waiting for the SEC to take action.
Although the "crowd funding" provisions of the JOBS Act have received the most media attention, the new rules on general solicitation are likely to have a larger impact on capital formation.
Changes to Rule 506 of Regulation D
Private placements under Rule 506 of Regulation D constitute an unheralded but extremely large source of capital for growing companies. Indeed, four times as much capital was raised in private placements under Regulation D as was raised in IPOs in 2012.
Under Rule 506, a company may sell securities, without any limitation on the offering amount, to an unlimited number of "accredited investors," as defined in Regulation D under the Securities Act of 1933, and to no more than 35 non-accredited investors who meet certain sophistication requirements. However, under the current law, which has been in place for the past 80 years, companies that want to issue securities under Rule 506 are prohibited from general solicitation or advertising, including digital media campaigns, advertisements published in newspapers and magazines, communications broadcast over television and radio, blast emails or websites offering securities, and seminars where attendees have been invited by general solicitation.
The final rule promises to change all that. Under new Rule 506(c), issuers may use general solicitation or advertising to offer and sell securities under Rule 506. Market participants will soon be able to use the Internet, send broad-based email advertisements, run newspaper and magazine ads, and place commercials on the television and radio to advertise offerings. General solicitation or advertising may be used if the following conditions are satisfied:
- All terms and conditions of Rules 502(a) (relating to integration with other offerings) and 502(d) (relating to limitations on resales) are met.
- All purchasers of securities are accredited investors.
- The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.
Therefore, issuers taking advantage of the new rule will be limited to selling securities to individual investors who have a net worth of at least $1 million, excluding their primary residence, or annual income of more than $200,000 in each of the previous two years, and certain institutional investors.
Under the new rule, issuers are required to take reasonable steps to verify the accredited investor status of potential investors. Whether the steps taken are "reasonable" is an objective determination by the issuer (or those acting on its behalf), based on the particular facts and circumstances of each investor and transaction. Among the factors that issuers should consider are:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be.
- The amount and type of information that the issuer has about the purchaser.
- 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 SEC enacted four non-exclusive methods for verifying the accredited investor status for individuals that are deemed per se "reasonable." These include:
- Reviewing copies of any IRS form that reports income for the two most recent years, along with obtaining a written representation that the investor has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
- Reviewing documentation of assets and liabilities, dated within the prior three months, along with written representation that all liabilities necessary to make a determination of net worth have been disclosed. Approved documentation includes:
o 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.
o For liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.
- Obtaining written confirmation from a registered broker-dealer, an SEC-registered investment advisor, a licensed attorney, or a certified public accountant that the purchaser's accredited investor status was verified within the past three months.
- Investors in Rule 506(b) offerings who remain investors of the issuer are considered accredited for any Rule 506(c) offering conducted by the same issuer if the investor certifies that his or her status has not changed.
Issuers should note that the new rule does not apply to private placements under the other sections of Regulation D—only offerings to accredited investors under Rule 506.
Changes to Rule 144A
The new rules also include an amendment to Rule 144A. Rule 144A is typically used to offer and sell debt securities to large institutional investors. Amended Rule 144A(d)(1) will permit general solicitation in connection with 144A offerings if the seller or its representative reasonably believes the purchaser is a Qualified Institutional Buyer as defined in Rule 144A.
Effects of the New Rules
The rules will be effective 60 days after publication in the Federal Register.
While the rules change the manner in which market participants solicit investments, all offerings, no matter how they are conducted, remain subject to antifraud rules.
The new rules will allow greater transparency into the private placement market. They have the potential to expose issuers to hundreds of thousands of potential investors. And they will enable investors to see a much broader array of potential deals. After 80 years, these changes were long overdue.