This summer, the SEC at last amended Rule 506 of Regulation D to enact the directive given the SEC in the JOBS Act. (Previous blogs have addressed the provisions of the JOBS Act, which became law in April 2012).
At the same time, the SEC in a separate release added "bad boy" conditions for the use of Rule 506. This blog post addresses only the topic of the new general solicitation rule under Rule 506.
Basically Rule 506 is now bifurcated into two rules.
"Old Rule 506" [found at Rule 506(b)] is the prior rule, with no changes (except for the addition of the "bad boys" qualification, which I will blog about later).
"New Rule 506" [found at Rule Rule 506 ( c )] is the version of 506 that eliminates the prohibition against general solicitation (and includes the "bad boys" qualification) BUT replaces it with a new set of conditions to be met by an issuer.
New Rule 506 took effect September 23. Any issuer which prior to that date wanted to avail itself of Rule 506 to carry out its private placement had to comply with all of the conditions of Old Rule 506, including the requirement that the offering be made privately, meaning not by way of any form of "general solicitation" or "general advertising."
The terms "general solicitation" and "general advertising" (lumped together under the rubric "general solicitation") aren't so much defined for purposes of Regulation D as described in Rule 502 ( c ) as including "but not limited to" ads, notices and articles published in newspapers or magazines or broadcast over TV or radio, or meetings or seminars if the persons attending were invited by general advertising or solicitation. That rule goes back to the original version of Regulation D adopted in 1982 (31 years ago) and was based upon established judicial principles in the field of federal securities regulation dating back to the 1930s. The SEC, observing the changes in communication over the last three decades, previously declared that general solicitation also encompasses communications and ads carried over the internet by mass emails or websites with unrestricted access.
So the JOBS Act's order to the SEC to eliminate the general solicitation prohibition obviously upends a primary and long-settled condition for private placement offerings.
But Congress did NOT direct the SEC to discard that proscription in whole, but rather in part, by limiting the change exclusively to persons that are "accredited investors" as defined in Rule 502 (a).
The first difference between Old and New Rule 506, then, is the scope of purchasers: Old Rule 506 allows the sale of securities to an unlimited number of accredited investors PLUS a maximum of 35 non-accredited investors; New Rule 506 allows the sale EXCLUSIVELY to an unlimited number of accredited investors; no non-accredited investors allowed.
The second difference between Old and New Rule 506 is how the issuer must go about determining whether or not a purchaser is an "accredited investor." Old Rule 506 stays unchanged: the purchaser either must come within any of the 8 categories enumerated in Rule 502 (a)'s definition of "accredited investor" OR the issuer must "reasonably believe" the purchaser comes within any of those 8 categories. Old Rule 506 makes the accredited investor test largely self-proofing: an issuer may accept at face value a purchaser's representation that is an accredited investor PROVIDED the issuer is unaware of information that makes reliance upon the purchaser's statement unreasonable.
New Rule 506 does NOT use the identical "reasonable belief" alternative for evaluating who is an accredited investor. Instead, it flatly requires that all purchasers be accredited investors. Nevertheless, in the adopting release, the SEC contends that the reasonable belief alternative abides for both Old Rule 506 and New Rule 506 offerings; it says that the different formulation in New Rule 506 "reflects only the differing manner in which the reasonable belief standard" is expressed due to the difference in times between the adoption date of Regulation D and the adoption date of New Rule 506, concluding that "an issuer will not lose the ability to rely on Rule 506 ( c ) [if a purchaser fails to come within at least one of the categories for an accredited investor] 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."
New Rule 506 places a due diligence burden on the issuer to investigate and verify whether or not the purchaser is in fact an accredited investor by taking "reasonable steps to verify that purchasers … are accredited investors." These steps must be taken REGARDLESS of the issuer's knowledge of a purchaser's status as an accredited investor. And this new duty of affirmative due diligence applies to both natural person purchasers and to entity purchasers. In this way, New Rule 506 differs in a third way from Old Rule 506: under the Old Rule, an issuer's 506 offering would satisfy the "accredited investor" test if the purchasers were in fact accredited investors, whether or not the issuer had any knowledge or belief that they were accredited investors.
According to the adopting release, whether or not an issuer has taken "reasonable steps" for verification of a purchaser's status depends upon "the context of the particular facts and circumstances of each purchaser and transaction." Among the factors an issuer should take into account in analyzing each purchaser's qualification as an accredited investor are (1) the nature of the purchaser and category of accredited investor that he claims to be, (2) the amount and type of information in the issuer's possession regarding the purchaser, and (3) the nature of the offering, including the manner in which the purchaser was solicited, and the terms of the offering, particularly the minimum investment amount. No single factor is dispositive and the weight given to each item should fluctuate depending upon the outcome of the other factors. For example, if the information relevant to the third factor strongly supports an individual purchaser's representation that he satisfies the individual net worth or net income category for an accredited investor — because, for example, the offering's minimum investment is high and the individual demonstrates that he can hurdle that bar easily without third party financing assistance — then the issuer may be less rigorous in examining how the purchaser satisfies the other two factors: "… 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…."
But then the SEC raises practical problems for issuers and attorneys by NOT writing into the language of New Rule 506 what it has said in the adopting release, but instead creating a new "safe harbor within the safe harbor" of Reg D by enumerating specific steps an issuer may — but is not obligated — to take for the purpose of verifying accredited investor status of natural persons and which steps, if taken, "shall be deemed" to satisfy the reasonable steps duty (so long as the issuer has no knowledge that would contradict the conclusion that the purchaser is an accredited investor). (The amended Rule provides NO such safe harbor relief in evaluating entity purchasers.)
These "non-exclusive and non-mandatory methods" for verifying that a natural person is an accredited investor (this inventory of precise steps do NOT apply in evaluating whether an entity is an accredited investor) include: reviewing his IRS filings to determine whether or not he meets the income test for accredited investor eligibility; reviewing third party generated documents (bank statements, brokerage statements, property tax assessments and independent appraiser reports as to assets; and consumer reporting agency reports as to liabilities) to determine whether or not he meets the net worth test for accredited investor eligibility; or obtaining written opinion as to his eligibility from a registered broker dealer or investment advisor, or a licensed CPA or licensed attorney.
Finally, the SEC updated Form D to require an issuer to identify whether a Rule 506 offering covered by that Form D relies upon the registration exemption of Old Rule 506 or New Rule 506; in adopting the new Form D, the SEC stated clearly that each 506 issuer must specify EITHER Old Rule 506 or New Rule 506 as the exemption used, and that it cannot elect both.
In Part 2 of this bog, I will comment on some of the possible consequences, opportunities, and pitfalls that may arise from this amendment.