As anticipated in our previous blogs, the SEC yesterday proposed rules to permit general solicitation and general advertising in Rule 506 and Rule 144A offerings. The release proposes to create a new Rule 506(c), in which the prohibition against general solicitation would not apply to offers and sales of securities, provided that:
- The issuer takes reasonable steps to verify that the purchasers are accredited investors;
- All purchasers of the securities are accredited investors, either because they come within one of the enumerated categories 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 (definitions), Rule 502(a) (integration) and Rule 502(d) (limitations on resale) are satisfied.
Effectively, the SEC has proposed a new exemption that would permit sales of restricted securities to accredited investors, without any manner of sale limitations or specified information requirements.
The main issue in the proposal is what issuers must do to “take reasonable steps to verify” that purchasers are accredited investors. The model the SEC has proposed would neither mandate specific verification steps nor assure issuers and investors that adequate steps have been taken. The model will likely require issuers to obtain reliable third party information most of the time, rather than relying on questionnaires, contractual representations, or similar confirmations from a purchaser.
“Reasonable Steps to Verify” Accredited Investor Status
What issuers must do to “take reasonable steps to verify” that purchasers are accredited investors is probably the most controversial issue in the proposal. The proposing release says that what is “reasonable” would be an objective determination, based on the particular facts and circumstances of the transaction, and it sets out the following factors for issuers to consider:
- The nature of the purchaser. The type of accredited investor that the purchaser claims to be impacts the steps that are reasonable to take to verify accredited investor status. For instance, the steps to verify that an investor is a registered broker-dealer will be different than those to verify the accredited investor status of a nonprofit or natural person.
- The amount and type of information that the issuer has about the purchaser. Essentially, the more information the issuer has relevant to assessing the accredited investor status of a purchaser, the fewer steps it would have to take, and vice versa.
- The nature of the offering. The manner in which the purchaser was solicited to participate in the offering and the terms of the offering can be relevant to the reasonableness of steps taken to verify accredited investor status. For instance, if the offering involved solicitation of pre-screened accredited investors from a database maintained by a broker-dealer, issuers may be able to take fewer verification steps than in a broad public solicitation through a website or social media.
The release does not mandate specific verification steps – so there would be flexibility. But it does not present non-exclusive examples of what would constitute “reasonable steps to verify” accredited investor status – so there would be uncertainty. This uncertainty seems likely to create concern in the business community about using the exemption, given the significant exposure that comes with conducting an unregistered public offering.
Investor Questionnaires May not be Enough
In the case of a generally available website solicitation or a widely disseminated email or social media solicitation, the SEC said in the release:
we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.
(Emphasis added.) In other words, even if a purchaser gives a clear and unambiguous representation about its income or net worth to the issuer in such a transaction, the SEC would regard it as unreasonable for an issuer to rely on that representation alone as a verification of accredited investor status. Some businesses may regard this as unusual or counter-intuitive: Accepting the truth of promises from one party to another is a basic concept of contracting. Usually a party can reasonably assume that another party is not actively defrauding it in giving representations, at least absent red flags regarding the counterparty’s statements.
Obtaining Reliable Third Party Information
The proposing release suggests that issuers should usually obtain some reliable third party information to verify accredited investor status. For instance, the release presents examples of ways an issuer may demonstrate reasonable steps of verifying a natural person’s accredited investor status, which generally involve third party information:
- Reviewing public company proxy statements. If the purchaser is a named executive officer of a public company, the company’s proxy statement would discloses the purchaser’s compensation, which could help verify if the purchaser is accredited by virtue of his or her income.
- Reviewing copies of Forms W-2. An employer’s records demonstrating income would help verify if the purchaser is accredited by virtue of his or her income.
- Reviewing industry or trade publications. For a purchaser who works in a field where industry or trade publications disclose average annual compensation for certain levels of employees or partners, specific information about the average compensation earned at the purchaser’s workplace by persons at the level of the purchaser’s seniority may be publicly available.
- Receiving third-party verifications. Verification of a person’s status as an accredited investor by a third party, such as a broker-dealer, attorney or accountant, may be an adequate step, if the issuer has a reasonable basis to rely on such third-party verification.
The release does provide two examples that do not involve reviewing third party information. First, the release observes (in a footnote) that if an issuer has “actual knowledge” that the purchaser is an accredited investor, then “the issuer would not have to take any steps at all” to verify accredited investor status in the context of the offering. Presumably this addresses situations in which such knowledge is obtained prior to the offering, perhaps based on pre-existing substantive relationships with family members, friends, existing investors or business acquaintances.
Second, when the terms of the offering require a high minimum investment amount, the release states that “it may be reasonable for the issuer to take no steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by the issuer or by a third party, absent any facts that may indicate that the purchaser is not an accredited investor.” While the issuer should know whether it is financing the purchaser’s investment, in most situations confirmations directly from the purchaser might be the only way an issuer can reasonably try to confirm the absence of third party financing.
Existing “Private” Rule 506 Deal Structures Remain Available
Proposed Rule 506(c) effectively functions as a new exemption that does not impact the ability of issuers to conduct offerings under current Rule 506(a) and (b) (without the use of general solicitation). The ability to continue current Rule 506 practices will be useful for many deal structures, such as when general solicitation is unnecessary or when a deal will include non-accredited investors who meet Rule 506 “sophistication” requirements.
New Form D Check Box
The proposed rules would add a check box to Form D to indicate whether an offering is being conducted pursuant to proposed Rule 506(c) with general solicitation. However, the proposal expressly does not condition the availability of Rule 506 on the filing of the (revised) Form D.
Private Funds May Generally Solicit
As readers of this blog already know, most private funds are structured to be excluded from the definition of “investment company” under Rule 3(c)(1) or 3(c)(7) under the Investment Company Act of 1940. Neither of these exclusions are available for “public offerings,” so private funds generally raise money in private offerings, typically under Rule 506. Noting the apparent intent of the JOBS Act, the release proposes that privately offered funds may raise money through general solicitation under Rule 506(c) without losing either of the exclusions under the Investment Company Act.
Proposed Rule 144A Amendments
Rule 144A currently provides a resale exemption for securities that, among other conditions, are “offered or sold only to a qualified institutional buyer or to an offeree or purchaser that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer.” Rule 144A is often used by US institutional investors to acquire securities from other institutions who participate in foreign public offerings. In response to the JOBS Act mandate to permit general solicitation in Rule 144A offerings, the SEC proposed to eliminate references to “offer” and “offeree” in Rule 144A. This would effectively permit Rule 144A resales using general solicitation, so long as the purchasers are QIBs or persons the seller or any person acting on its behalf reasonably believes are QIBs.
Safe Harbor for Concurrent Reg S Offerings
Many companies will raise money not only in the US in compliance with US Securities Act of 1933, but also outside of the US in transactions that do not trigger the jurisdictional reach of the Securities Act. To avoid these offerings being “integrated” and considered as one offering, the release proposes an integration safe harbor for concurrent offshore offerings made under Regulation S and offerings in compliance with revised Rules 506(c) and 144A. This is useful if, for example, an issuer conducts an offering in the US using general solicitation under new Rule 506(c), and simultaneously conducts an offering in, say, Canada to sophisticated investors who might not meet the accredited investor test.
What do you think?!
The SEC is soliciting comments on its proposed rules. The 30-day comment period is relatively short. Hopefully this means the SEC is committed to adopting final rules rapidly. At its open meeting yesterday, two of the SEC’s five Commissioners emphasized their disappointment that the SEC missed the JOBS Act’s 90-day deadline for permitting general solicitation in Rule 506 offerings where all purchasers are accredited investors. In any event, the time to comment is now, as this may move quickly.
I think proposed Rule 506(c) would be more effective if it were to provide greater certainty that issuers have taken “reasonable” steps to verify accredited investor status. It seems fairly clear that some regard it as reasonable for issuers to rely on purchaser representations in contracts and questionnaires, while others believe reasonable verification should involve issuers reviewing personal financial information. Regardless of where one comes out on the “reasonable steps” debate, I suspect most reasonable people agree that there is little purpose in having issuers essentially guess as to whether they have done enough. I think it would be highly useful for the SEC to present a list of non-exclusive examples of what would constitute “reasonable steps to verify” accredited investor status. Of course, it would be nice if those steps were not unduly burdensome or impractical in the context of often quick-moving financings.