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 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:
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:
© 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.