On August 29, the United States Securities and Exchange Commission (SEC) proposed rules to eliminate the prohibition against general solicitation and general advertising in securities offerings under Rules 506 and 144A under the Securities Act of 1933 (the "Securities Act"). Under the proposed rules, which are mandated by Section 201 of the Jumpstart Our Business Startups Act (the "JOBS Act"), companies would be permitted to use general solicitation and general advertising to offer securities under Rule 506, which is part of Regulation D, and Rule 144A. These rules have important implications for:

  • private equity funds, venture capital funds, hedge funds, real estate funds, and other privately offered investment vehicles;
  • operating companies, including start-ups and pre-IPO stage companies, issuing equity in private placements; and
  • issuers of privately offered debt.

Specifically, these rules will allow these issuers to advertise offerings of their securities in media that are available to the general public, such as newspapers, magazines, television, radio, seminars, and the internet, and to make offers prior to ascertaining whether the offerees are eligible to participate in the placement.

Amendments to Rule 506

The proposed amendment would add a new paragraph (c) to Rule 506, which would permit the use of general solicitation to offer and sell securities under Rule 506, provided that:

  1. the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors;
  2. at the time of the sale of the securities either all purchasers are accredited investors or the issuer reasonably believes that they are; and
  3. all terms and conditions of Rule 501 and Rules 502(a) and (d) are satisfied, which primarily means that the securities will be subject to limitations on resale.

Verification of Purchaser Status

The SEC dedicated a significant portion of the proposing release to discussing the new requirement that an issuer take reasonable steps to verify that the purchasers of the securities are accredited investors. The SEC declined to specify the particular steps necessary to satisfy this requirement or provide a non-exclusive safe harbor, saying instead that it is an "objective determination, based on the particular facts and circumstances of each transaction." However, the SEC discussed examples of factors that would be taken into account in determining whether an issuer took reasonable steps, including:

  • The nature of the purchaser. What constitutes "reasonable steps" would differ depending on the type of accredited investor that the purchaser claims to be. For example, to verify whether a broker is an accredited investor, an issuer could check FINRA's BrokerCheck website, however tax or other financial information may be needed to verify the status of natural persons, which may give rise to privacy concerns.
  • The amount and type of information that the issuer has about the purchaser. The more information the issuer has about the purchaser, the fewer additional steps would be required to verify the purchaser's accredited investor status. Information could include publicly available regulatory filings (such as a proxy statement that discloses compensation of an executive or a Form 990 that reports a 501(c)(3) organization's total assets), W-2s, or third party verification of status.
  • The nature of the offering. Factors to consider include the manner in which the purchaser was solicited (e.g., investors solicited in a widely disseminated email would require more verification than investors solicited from a pre-screened database of accredited investors created and maintained by a broker-dealer or other reliable third party) and the terms of the offering (e.g., an offering with a minimum investment in excess of the net worth requirement in the accredited investor definition and a prohibition on third party financing would require less additional verification).

The SEC anticipates that many practices used by issuers in connection with existing Rule 506 offerings would satisfy the verification requirement proposed for offerings pursuant to Rule 506(c). The SEC notes that it will be important for issuers to retain adequate records that document the steps taken to verify that a purchaser is an accredited investor.

Regulation D Offerings Without General Solicitation

The SEC left in place Rule 506(b), pursuant to which issuers can conduct Rule 506 offerings without the use of general solicitation. There are two primary differences between Rule 506(b) and Rule 506(c). First, Rule 506(b) does not require issuers to take additional steps to verify the accredited investor status of purchasers. Second, Rule 506(b) allows securities to be sold to up to 35 non-accredited investors who are financially sophisticated, whereas Rule 506(c) only permits sales to accredited investors.

Ability to Rely on Investment Company Act Sections 3(c)(1) and 3(c)(7)

Private funds, such as private equity funds, venture capital funds, hedge funds, and many real estate funds, rely on one of the two exclusions from the definition of "investment company" set out under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, which enable these funds to be excluded from many of the Investment Company Act's regulatory provisions. Both of these exclusions prohibit a fund from making, or proposing to make, a public offering of its securities. At the time the JOBS Act was enacted, some practitioners questioned whether a Regulation D offering with a general solicitation would be considered a "public offering" under these sections. The SEC clarified in its proposing release that this would not be the case, relying on Section 201(b) of the JOBS Act, which provides that offers and sales exempt under Rule 506 (as revised pursuant to Section 201(a) of the JOBS Act) will not be deemed public offerings as a result of general advertising or general solicitation.

Continued Availability of Exemption from Registration as a Commodity Pool Operator

Many privately offered funds utilize swaps and futures, which are both regulated under the Commodity Exchange Act. The Commodity Exchange Act requires the general partner of a fund that trades swaps or futures to register as a commodity pool operator unless an exemption is available. There is a de minimis exemption, set out in Rule 4.13(a)(3) under the Commodity Exchange Act, which many general partners who engage in limited use of swaps (e.g., pursuant to a hedging program) will seek to rely upon. However, this exemption requires, among other things, that the interests in the relevant fund are offered and sold without marketing to the general public. It is not clear at the moment whether the general partner of a fund that engages in a general solicitation under Rule 506(c) would be able to rely on this exemption or would be required to register as a commodity pool operator.

It would be helpful for the Commodity Futures Trading Commission, which is responsible for rulemaking under the Commodity Exchange Act, to clarify this point. It seems contrary to Congress' intent in passing the JOBS Act (which is to facilitate investment and capital raising) that the general partner of a fund that engages in the limited use of swaps for hedging purposes should be subject to additional regulatory burdens solely by virtue of the fact that it engages in a general solicitation, as permitted under the JOBS Act.

Amendment to Rule 144A Rule 144A allows for resales to so-called qualified institutional buyers (QIBs) of securities that were issued in unregistered offerings under Section 4(2) of the Securities Act. Currently, Rule 144A securities can only be offered to QIBs. The proposed amendment to Rule 144A would eliminate this offering restriction by deleting the references to "offer" and "offeree" in Rule 144A(d)(1). The amended rule would prohibit sales of Rule 144A securities to anyone other than QIBs (or a purchaser that the seller reasonably believes is a QIB), but would allow offers to anyone, thereby permitting an issuer to engage in a general solicitation.

Integration with Offshore Offerings

Regulation S under the Securities Act provides safe harbors for offers, sales and resales of securities outside of the United States. In order for the safe harbors to apply, (i) the securities must be sold in an offshore transaction and (ii) there can be no directed selling efforts in the United States. In many instances, the U.S. portion of a global offering is conducted in accordance with Rule 144A or Rule 506 while the offshore portion relies on the safe harbors in Regulation S. Some commentators raised questions regarding the impact of a general solicitation on the availability of the Regulation S safe harbors. The SEC confirmed that offshore offerings that are conducted in compliance with Regulation S would "not be integrated with domestic unregistered offerings that are conducted in compliance with Rule 506 or Rule 144A as proposed to be amended." In simpler terms, the SEC confirmed that use of a general solicitation in compliance with Rule 506(c) or Rule 144A, as amended, will not impact an issuer's ability to rely on the safe harbors under Regulation S or constitute directed selling efforts into the United States.

Solicitation of Comments

The SEC solicited comments on several issues including the following:

  • whether the SEC should adopt a rule that specifies the methods that issuers must use or could use to verify accredited investor status;
  • whether an issuer should be deemed to have taken "reasonable steps to verify" qualified purchaser status if the only action taken is to request a representation from a purchaser that it is an accredited investor;
  • whether a high minimum investment amount is sufficient, in and of itself, to satisfy the requirement that the issuer has taken reasonable steps to verify a purchaser's status as an accredited investor; and
  • whether there are certain types of issuers (e.g., shell companies, blank check companies or issuers of penny stock) that would present heightened investor protection concerns as a result of the removal of the prohibition against general solicitation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.