Summary of Reg. D, Rule 506(c) Final Rules
 
Abstract – The SEC’s final rules to eliminate the prohibition against general solicitation and general advertising in certain Regulation D, Rule 506 offerings are effective as of September 23, 2013.
 
By John W. Cones
 
            On July 10th, 2013, the federal Securities and Exchange Commission (“SEC”) adopted final rules to implement the Congressionally mandated Jumpstart Our Business Startups Act (“JOBS Act”) provision [Section 201(a)(1)] that eliminates the prohibition against general solicitation and general advertising in certain Regulation D, Rule 506 offerings. The amendment permits a securities issuer to engage in general solicitation or general advertising in offering and selling securities pursuant to Rule 506, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors. The amendment also includes a non-exclusive list of methods that issuers may use to satisfy the verification requirement for purchasers who are natural persons. The amendment also revises Form D to require issuers to indicate whether they are relying on the provision that permits general solicitation or general advertising in a Rule 506 offering. At the same time, the SEC adopted amendments to disqualify issuers and other market participants from relying on Rule 506 if “felons and other ‘bad actors’” are participating in the Rule 506 offering (the so-called “bad boy” rule).
 
            Effective Date – The final rule and form amendments are effective 60 days after publication in the Federal Register, which turned out to be September 22, 2013, since the final rules were published in the Federal Register on July 24, 2013.
 
            Prior to the implementation of this new SEC rule, the Regulation D, Rule 506 exemption from securities registration was conditioned on the issuer, or any person acting on its behalf, not offering or selling securities through any form of “general solicitation or general advertising”.  Through its own interpretations, the SEC has confirmed that uses of publicly available media, such as unrestricted websites constitute general solicitation and general advertising.
 
            To implement Section 201(a) of the JOBS Act, the SEC amended Rule 506 to add new paragraph (c), under which the prohibition against general solicitation contained in Rule 502(c) would not apply, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors. For the notice filing Form D, the SEC added a check box to indicate whether an issuer is claiming an exemption under Rule 506(c).
 
            The new rule affects only Rule 506, and not Section 4(a)(2) offerings in general, meaning that even after the effective date of Rule 506(c), an issuer relying on Section 4(a)(2) outside of the Rule 506(c) exemption will be restricted in its ability to make public communications to solicit investors for its offerings because public advertising will continue to be incompatible with a claim of exemption under Section 4(a)(2) of the 1933 Securities Act.
 
            The new rule 506(c) permits the use of general solicitation to offer and sell securities under Rule 506 provided the following conditions are satisfied:
 
Ø all terms and conditions of Rule 501 (definitions) and Rules 502(a) (integration) and
502(d) (limitations on resale) must be satisfied;
 
Ø all purchasers of securities must be accredited investors; and
 
Ø the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors.
 
            Note that the requirement that issuers take reasonable steps to verify that purchasers of the offering’s securities are accredited investors is separate from and independent of the requirement that sales be limited to accredited investors, and must be satisfied even if all purchasers happen to be accredited investors.
 
            Offerings under Rule 506(c) are not subject to the requirement to comply with Rule 502(c), which contains the prohibition against general solicitation. While the SEC’s new rule 506(c) enables issuers to use general solicitation in Rule 506 offerings, the SEC also preserved, in the existing Rule 506(b), the ability of issuers to conduct a Rule 506 offering that is subject to the prohibition against general solicitation. So, issuers actually now have two Rule 506 options:
 
Ø conduct a traditional Regulation D, Rule 506(b) offering to accredited and non-accredited investors with whom the issuer, its upper level management and employees have a pre-existing relationship, or
 
Ø conduct an offering pursuant to the new Regulation D, Rule 506(c) to accredited investors only.
 
            As noted above, the SEC also included a non-exclusive list of methods that issuers may use to verify the accredited investors status of natural persons.
 
            Disclosure – Offerings under Rule 506(c) are not subject to the specific information (disclosure) requirements of Rule 502(b) for non-accredited investors, since all purchasers in the Rule 506(c) offerings are required to be accredited investors. However, as noted in Preliminary Note 1 of Regulation D, the anti-fraud rule (a general underlying disclosure requirement) still applies, and according to the SEC General Counsel’s Office, the document used to promote such offerings must be a securities disclosure document. A business plan is not adequate.
 
            Further, an ongoing offering under the traditional Rule 506 that commenced before the effective date of Rule 506(c), the issuer may choose to continue the offering after the effective date in accordance with the requirements of either Rule 506(b) or Rule 506(c). If an issuer chooses to continue the offering in accordance with the requirements of Rule 506(c), any general solicitation that occurs after the effective date will not affect the exempt status of offers and sales of securities that occurred prior to the effective date in reliance on Rule 506(b).
 
Reasonable Steps to Verify Accredited Investor Status   
 
            Section 201(a)(1) of the JOBS Act mandated that the SEC’s amendment to Rule 506 require issuers using general solicitation in Rule 506 offerings to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the SEC.
 
            Principles-Based Approach – On the one hand, the SEC has chosen to take a fairly flexible so-called “principles-based” approach, in which issuers would consider a number of factors when determining the reasonableness of the steps to verify that a purchaser is an accredited investor, such as:
 
• the nature of the purchaser and the type of accredited investors that the purchaser claims to be;
 
            • the amount and type of information that the issuer has about the purchasers; and
 
• 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.
 
            In the alternative, the SEC has provided a non-exclusive list of verification methods that would function as a safe harbor for compliance with the verification requirement.
 
            Generally speaking it is the SEC’s position that after consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investors, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa.
 
            As an example, the SEC says that if the terms of the offering require a high minimum investment amount and a purchaser is able to meet those terms, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party.
 
            Regardless of the particular steps taken, because the issuer has the burden of demonstrating that its offering is entitled to an exemption from the registration requirements of Section 5 of the Securities Act, it will be important for issuers and their verification service providers (if used) to retain adequate records regarding the steps taken to verify that each purchaser was an accredited investor.
 
            As noted above, in determining the reasonableness of the steps to verify accredited investor status, an issuer may consider three categories of information:
 
            • the nature of the purchaser,
           
            • information about the purchaser and
           
            • the nature and terms of the offering.
 
            Nature of the Purchaser – The definition of “accredited investor” in Rule 501(a) includes natural persons and entities that come within any of 8 enumerated categories in the rule, or that the issuer reasonably believes come within one of those categories, at the time of the sale of securities to that natural person or entity.
 
Some persons may be accredited investors based on their status, such as:
 
            • a registered broker or dealer, or
 
            • a registered investment company.
 
Some purchasers may be accredited investors based on a combination of their status and the amount of their total assets, such as:
 
• a plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5 million, or
 
            • a 501(c)(3) organization, corporation, business trust or partnership not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million.
 
            Natural persons may be accredited investors based on either their net worth or their annual incomes:
 
• a natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1 million, excluding the value of the person’s primary residence; or
 
• a natural person who had an individual income in excess of $200,000 in each of the two most recent years, or joint income with that person’s spouse in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same income level in the current year. 
 
            Since Rule 501(a) sets forth different categories of accredited investors, an issuer should recognize that the steps that will be reasonable to verify whether a purchaser is an accredited investor will vary depending on the type of accredited investor that the purchaser claims to be. For example, the steps that may be reasonable to verify that an entity is an accredited investor by virtue of being a registered broker-dealer, such as by going to FINRA’s BrokerCheck website, will necessarily differ from the steps that may be reasonable to verify whether a natural person is an accredited investor.
 
            Information About the Purchaser – Again, as a general rule, the more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it may have to take, and vice versa. Examples of the types of information that issuers could review or rely upon – any of which might, depending on the circumstances, in and of themselves constitute reasonable steps to verify a purchaser’s accredited investor status – include without limitation:
 
 
•  publicly available information in filings with a federal, state or local regulatory body; (for example, the purchaser is a named executive officer of an Exchange Act registrant, and the registrant’s proxy statement discloses the purchaser’s compensation; or the purchaser claims to be a 501(c)(3) organization with $5 million in assets, and the organizations’ Form 990 series return filed with the IRS discloses the organization’s total assets);
 
•  third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories in the accredited investor definition (for example, a purchaser who is a natural person and provides copies of pay stubs for the two most recent years and the current year; or specific information about the average compensation earned at the purchaser’s workplace by persons at the level of the purchaser’s seniority; or verification of a person’s status as an accredited investor by a third party, provided that the issuer has a reasonable basis to rely on such third-party verification).
 
            Nature and Terms of the Offering – The nature of the offering, such as the means through which the issuer publicly solicits purchasers, may be relevant in determining the reasonableness of the steps taken to verify accredited investor status. An issuer that solicits new investors through a website accessible to the general public, through a widely disseminated e-mail or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party. The SEC goes on to say that an issuer will be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification. The SEC takes the position that an issuer will not have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, require only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.
 
Non-Exclusive Methods of Verifying Accredited Investor Status
 
            In addition to the principles-based method of verification, the SEC included in its new Rule 506(c), four specific non-exclusive methods of verifying accredited investor status for natural persons that, if used, are deemed to satisfy the verification requirement of Rule 506(c), except that none of these methods will be deemed to satisfy the verification requirement if the issuer or its agent has knowledge that the purchaser is not an accredited investor.
 
            1. Income – In verifying whether a naturel person is an accredited investor on the basis of income, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies of any IRS form that reports income for the individual and/or spouse from the two most recent years, along with obtaining a written representation from such person(s) that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
 
            2. Net Worth – In verifying whether a natural person is an accredited investor on the basis of net worth, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing one or more of the following types of documentation, dated within the prior three months, and by obtaining a written representation from such person and/or spouse that all liabilities
 
necessary to make a determination of net worth have been disclosed.
 
• For assets, that documentation may include bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties; 
 
• For liabilities, that documentation may include a credit report from at least one of the nationwide reporting agencies.
 
            3. Third-Party Confirmation – An issuer is deemed to satisfy the verification requirement in Rule 506(c) by obtaining a written confirmation at the time of the sale from any of the following:
 
            • a registered broker-dealer;
 
            • an SEC-registered investment adviser;
• a licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or 
 
• a certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office
 
that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor.
 
            The SEC goes on to say in its July 10 Release 33-9415 that while third-party confirmation by one of these parties will be deemed to satisfy the verification requirement in Rule 506(c), depending on the circumstances, an issuer may be entitled to rely on the verification of accredited investor status by a person or entity other than one of these parties, provided that any such third party takes reasonable steps to verify that purchasers are accredited investors and has determined that such purchasers are accredited investors, and the issuer has a reasonable basis to rely on such verification.
 
            4. Existing Investors – For existing investors who were accredited investors in a traditional Rule 506(b) offering prior to the effective date of the new Rule 506(c), a self-certification at the time of sale that he or she is an accredited investor will be deemed to satisfy the verification requirement of Rule 506(c).
 
            The SEC recognizes that a person could provide false information or documentation to an issuer in order to purchase securities in an offering made under the new Rule 506(c). Thus, even if an issuer has taken reasonable steps to verify that a purchaser is an accredited investor, it is possible that a person nevertheless could circumvent those measures. If a person who does not meet the criteria for any category of accredited investor purchases securities in a rule 506(c) offering, the SEC takes the position that the issuer will not lose the ability to rely on Rule 506(c) for that offering, 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 at the time of sale. [Source: SEC Release No. 33-9415, July 10, 2013, 116 pages]
 
            Proposed Rules – In addition to adopting the new final rule for Reg. D, Rule 506(c), the SEC also voted to approved a rule proposal requiring issuers to provide additional information about such offerings to better enable the SEC to monitor the market with the general solicitation ban now lifted. The proposal also provides for additional safeguards as this market changes and new practices develop. This proposal, subject to a 60 day comment period, would require issuers using the new rule 506(c) to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. In addition, this proposed rule would require that the issuer update the information contained in the Form D and indicate that the offering has ended within 30 days of completing such an offering.
 
            Further, under this proposed rule, issuers would be required to provide additional information to the SEC including:
 
            • Identification of the issuer’s website;
            • Expanded information on the issuer;
            • The offered securities;
            • The types of investors in the offering;
            • The use of proceeds from the offering;
            • Information on the types of general solicitation used;
            • The methods used to verify the accredited investor status of investors.
 
            In addition, under the proposal, issuers would be disqualified from using the new Rule 506(c) exemption in any new offering if the issuer or its affiliates do not comply with the Form D filing requirements. Also, the proposal would require issuers to include certain legends and specific disclosures in any written general solicitation materials and to submit any written general solicitation materials to the SEC.  [SEC “Fact Sheet – Proposing Amendments to Private Offering Rules”, SEC Open Meeting, July 10, 2013; www.sec.gov/news/press/2013-124-item3.htm]
 
Copyright 2011 by John W. Cones
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