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SEC Adopts Rules Disqualifying “Bad Actors” from Participating in All Rule 506 Offerings and Allowing Advertising of Private Placement Offerings

SEC ADOPTS RULES DISQUALIFYING "BAD ACTORS" FROM PARTICIPATING IN ALL RULE 506 OFFERINGS AND ALLOWING ADVERTISING OF PRIVATE PLACEMENT OFFERINGS.

On July 11, 2013, the SEC released long awaited rules that permit advertising of some private placement transactions.  The SEC also adopted rules that prohibit "bad actors" from participating in private placements exempt under Rule 506 of Regulation D.  Both sets of rules will become effecctive September 23, 2013.

Disqualification of Felons and Other "Bad Actors" From All Rule 506 Offerings

Up until now, the "bad boy" disqualification rules have not applied to Rule 506 offerings.  Under new Rule 506(d), which applies to all Rule 506 offerings, the exemption from registration will not be available if the issuer or any of its promoters, directors, executive officers, other officers who participate in the offering, significant shareholders, underwriters, placement agents or other relevant persons have been convicted of, or are subject to court or administrative sanctions for securities fraud or other violations of specified laws.  The issuer must take "reasonable care" to determine that a disqualification does not exist.  The nature and scope of the required factual inquiry will vary based on the facts and circumstances.  The issuing release noted that "[f]actual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement."  If the issuer has any reason to question the accuracy of the response, then the issuer must make further inquiry.  If the offering continues beyond a limited period of time, periodic updating may be necessary.

As it may take some time to gather the required information, issuers who are contemplating a fall offering may want to begin the inquiry.

General Solicitation to be Allowed For Rule 506 Offerings Made Soley to Accredited Investors

Up until now, the “bad boy” disqualification rules have not applied to Rule 506 offerings.  Under new Rule 506(d), which applies to all Rule 506 offerings, the exemption from
registration will not be available if the issuer or any of its promoters, directors, executive officers, other officers who participate in the offering, significant shareholders, underwriters, placement agents or other relevant persons have been convicted of, or are subject to court or administrative sanctions for securities fraud or other violations of specified laws.  The issuer must take “reasonable care” to determine that a disqualification does not exist.  The nature and scope of the required factual inquiry will vary based on the facts and circumstances.  The issuing release noted that “[f]actual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.”  If the issuer has any reason to question the accuracy of the response, then the issuer must make further inquiry.  If the offering continues beyond a limited period of time, periodic updating of may be necessary.

As it may take some time to gather the required information, issuers who are contemplating a fall offering may want to begin the inquiry.

General Solicitation to be Allowed For Rule 506 Offerings Made Solely to Accredited Investors

Prior to the implementation of new Rule 506(c), issuers are still prohibited from engaging in “general solicitation” of investors.  This includes advertising the offering and can include other communications regarding the offering.  In determining whether a communication constitutes a general solicitation, one of the factors the SEC looks at is whether there is a pre-existing substantive relationship with the third party.

New Rule 506(c) allows advertising of offerings where sales are made only to persons who the issuer reasonably believes to be accredited investors.  Simply asking the investor to “check the box” that an investor is accredited is not sufficient.  The issuer is required to take “reasonable steps” to verify that all purchasers are, in fact, accredited, and should keep adequate records regarding the steps taken to verify accredited status.  In the issuing release, the SEC indicated that “the [verification] requirement 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.”

The SEC declined to specify what would constitute “reasonable steps,” noting that what is “reasonable” will be an objective determination based on the particular facts and circumstances of each purchaser and transaction.  In its issuing release, the SEC stated that “among the factors that issuers should consider under this facts and circumstances analysis are:

  • the nature of the purcahser 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; and
  • the nature of the offering, such as the manner in which the purchaser was solicited to particpate in the offering, and the terms of the offering, such as minimum investment amount."

The more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify status.  Some investors are accredited because of their status and verifying that status may be fairly easy.  For example, a broker dealer registered under Section 15 of the Securities Exchange Act of 1934 qualifies as an accredited investor and the issuer can check the status of the broker dealer by going to FINRA’s BrokerCheck Website.

The status of investors who are natural persons will likely pose greater practical difficulties as financial information for many natural persons is not publicly available unless the individual is an officer or director of a publicly traded entity.  In the issuing release, the SEC indicated that the types of information an issuer could rely upon to verify the accredited status of natural persons include:

  • For individuals who qualify as accredited investors based on the income test:  IRS forms that show income received including From W-2, Form 1099, Schedule K-1 filed Form 1040, or pay stubs for the most recent two years showing that the income requirement is met, along with a statement from the person that they are reasonably likely to meet the income requirement for the current year;
  • For individuals who qualify as ccredited investors based on the net worth test;  bank statements, brokerage statements, certificates of deposit, tax assessments and appraisal reports issued by third parties (all dated within the previous three months), together with a credit report from a nationwide consumer reporting agency;
  • For either test, written confirmation from a
    third party such as a registered broker-dealer, an SEC-registered investment advisor, a licensed attorney or a CPA that he or she has taken reasonable steps to verify that the purchaser is an accredited investors within the prior three months and that the purchaser is an accredited investor.

The methods listed above are not exclusive.

It remains to be seen how the new accredited status verification process will affect the use of Rule 506(c) for companies looking for early-stage financing.  Early stage financing is often provided by individual angel investors who may be reluctant to reveal the private financial information needed to verify their status to issuers, and their outside advisors may be reluctant to assume any risk by providing third party verification.

ADDITIONAL PROPOSED RULES

On July 11, 2013, the SEC also proposed rules that could significantly impact the private placement process.  The new rules, if adopted, could impose substantial additional requirements to using the Regulation D exemption.

Among the rules proposed are:

  • A Rule that would require issuers to file a Form D 15 calendar days before the first use of general solicitation in a Rule 506(c) offering, and the filing of a closing Form D amendment 30 calendar days after the termination of the offering;
  • A Rule that would amend Form D to require additional information including: identification of the issuer’s website; for a Rule 506(c) offering, the name and address of any person who directly or indirectly controls the issuer; clarification of the industry group of the issuer if  “other” is checked as the industry; information on the number of accredited and non-accredited investors who have purchase in the offering and whether they are natural persons or legal entities and the amount raised from each category of investors; more specific information on the use of the proceeds from the offering; the type of general solicitation used in a Rule 506(c) offering; and the methods used to verify accredited investor status;
  • A Rule that would amend Form D to disqualify an issuer from relying on Rule 506 for one year for future offerings is the issuer did not comply, within the past 5 years with all the Form D filing requirements; and
  • A Rule that would require prescribed legends in any written communication that constitutes a general offering under Rule 506 (c).

© Caulkins & Bruce PC, 2013.  The information presented in this blog is presented for informational purposes only.  You should not construe it as legal advice or a legal opinion on any specific fact or circumstances.

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