Choosing a Type of Offering.
There are various exemptions from registration under which a company may offer its securities. Several exemptions available to companies engaged in general capital raising are discussed below.
Regulation A: The Small Public Offering Exemption
Before passage of the JOBS Act, former Regulation A, adopted under Section 3(b) of the Securities Act, granted an exemption from registration for offerings of securities of no more than $5 million in a 12-month period, including no more than $1.5 million in resales by parties other than the issuer. It was available to US and Canadian companies that are not:
• Reporting companies under the Exchange Act.
• Investment companies under the Investment Company Act of 1940, as amended.
• Development stage companies.
• Issuers of fractional undivided interests in oil or gas rights.
Regulation A was not available, however, to issuers deemed “unworthy” of the exemption because they engaged in some activity indicating that potential investors need the protection of a full registration under Section 5 of the Securities Act.
The issuer filed an offering statement with the SEC, which had to be “qualified” by the SEC, a process that could take up to 60 days. An issuer could obtain indications of interest before filing the offering statement, a practice known as “testing the waters,” and could offer securities after the offering statement is filed, but could not accept any offers for purchase until the offering statement is qualified. Once the offering statement was qualified, the issuer could sell its securities publicly, up to the Regulation A monetary limits. In this sense, former Regulation A offerings were not “private” offerings.
An offering under former Regulation A was attractive to issuers because it allowed for:
• Solicitations of indications of interest before the offering statement is filed.
• General solicitation of investors after the offering statement is qualified.
The primary offsetting disadvantages were the:
• $5 million limitation on the size of the offering.
• Waiting period for qualification of the offering statement.
Section 401(a) of the JOBS Act amended Section 3(b) of the Securities Act to add subsections (2) through (5). These provisions require the SEC to amend Regulation A or adopt a new, similar regulation exempting certain securities offerings of up to $50 million in any 12 month period from Securities Act registration.
On March 25, 2015, the SEC adopted final rules and forms amending Regulation A to implement the JOBS Act directive. These amendments became effective June 19, 2015. Amended Regulation A, referred to as Regulation “A+” to indicate it is an improved and modernized version of this long-standing exemption from SEC registration, allows non-reporting companies to raise up to $50 million in “mini-public offerings” qualified by the SEC.
Like former Regulation A, amended Regulation A provides for “mini-public offerings,” meaning offerings exempt from SEC registration, but sharing some key characteristics with SEC-registered offerings. Offerings under amended Regulation A are public offerings that can be made using general solicitation and general advertising. To offer securities under amended Regulation A, an issuer must file an offering statement on Form 1-A with the SEC, including an offering circular for distribution to investors and all required exhibits.
Form 1-A filings are subject to SEC review and comment. Before sales under Regulation A can be made, this filing and review process must culminate in the “qualification” of the Form 1-A. This is similar to a registration statement for a registered offering becoming effective. Subject to certain conditions, a Regulation A issuer is permitted to “test the waters,” or communicate with potential investors to see if they might be interested in an offering, before filing a Form 1-A. Amended Regulation A mandates ongoing reporting by certain issuers.
As under former Regulation A, securities sold in reliance on amended Regulation A are not restricted securities, meaning they generally can be freely resold by non-affiliates of the issuer. Certain Regulation A offerings benefit from federal preemption of the registration and qualification requirements of state securities laws.
Rule 147: The Intra-state Offering Exemption.
Rule 147, adopted under Section 3(a)(11) of the Securities Act, grants an exemption from registration to issuers conducting an intra-state offering that satisfy the following conditions:
• The issuer must be organized and doing business in the state where the securities are offered and sold.
• General advertising and general solicitation to market the securities are allowed only within the state and there is no limit on the amount of securities that may be sold.
• Resales are permitted to in-state residents. Resales by non-affiliates to out-of-state residents are only permitted beginning nine months after the last sale of securities by the issuer. The exemption is destroyed if offers or sales are made to out-of-state residents.
The in-state requirements of Rule 147 put significant constraints not only on the type of investors that companies may approach but also on the method of communication with those investors. As a result, Rule 147 may be of limited benefit to companies seeking to raise capital. It should also be noted that Rule 147’s requirements are absolute and that there is no “reasonable basis to believe” standard as in Regulation D.
Further, because Rule 506(c) permits general advertising and general solicitation with significantly fewer restraints on the geographical scope of communications, Rule 147 may now be of limited benefit. The continued utility of Rule 147 will depend, in part, on additional obligations proposed for Rule 506(c) issuers.
On October 30, 2015, the SEC proposed amendments to Rule 147. Among other things, the proposed amendments would eliminate the current intrastate restriction on offers, but not sales, to allow issuers to utilize a greater array of options to advertise their offerings, including the Internet and social media platforms. The proposed amendments would also ease the existing issuer residency and eligibility requirements and make the rule available to a greater number of businesses seeking intra-state financing. Comments on the proposed amendments were due in January 2016.
Regulation D: The Private Offering Exemption
For some companies, the best method of financing is an offering of securities under Regulation D, which provides for a limited offer and sale of a company’s securities without registration under the Securities Act. There are four categories of limited offerings available under Regulation D, which are discussed below. Regulation D is the most frequently used of the exemptions from registration under the Securities Act because:
• There are no SEC disclosure statement filing requirements with an associated waiting period.
• In offerings made under Rule 506(b) or 506(c) of Regulation D, there is no ceiling on the amount of money that can be raised.
• In offerings made under Rule 506(c), there is no prohibition on general advertising or general solicitation.
For offerings made under Rule 504, adopted under Section 3(b) of the Securities Act, the maximum aggregate offering price is $1 million in a 12-month period. Rule 504 is not available to any of the following:
• Companies subject to the reporting requirements of the Exchange Act.
• Investment companies.
• Blank check companies.
Rule 504 allows a company to use general advertising and general solicitation to market its securities if certain state registration requirements are met. Under Rule 504, an unlimited number of investors are permitted, and there are no sophistication or experience qualifications placed on investors. Finally, companies offering securities under Rule 504 are not obligated to provide investors any disclosure materials regarding the offering, but they frequently do.
Because of the $1 million ceiling on the amount of capital that can be raised under Rule 504, and the availability of general advertising and general solicitation under Rule 506(c), this type of offering is not as frequently used as other types of Regulation D offerings. However, recently proposed amendments to Rule 504 may make it more attractive to issuers. On October 30, 2015, the SEC proposed amendments to Rule 504 that would increase the aggregate amount of securities that may be offered and sold in any 12-month period from $1 million to $5 million. The proposed amendments also include “bad actor” disqualification provisions. Comments on the proposed amendments were due in January 2016.
Rule 505, adopted under Section 3(b) of the Securities Act, provides for offerings with a maximum aggregate price of $5 million over a 12-month period. Rule 505 is not available to either of the following:
• Investment companies.
• Companies disqualified under Regulation A.
Rule 505 does not permit an issuer to use general advertising or general solicitation to market securities. Rule 505 is available to an unlimited number of accredited investors and up to 35 non-accredited investors. Non-accredited investors must receive a substantive disclosure document that includes financial statements.
Rule 505 contains a $5 million ceiling, limits the manner of offering and limits the number of non-accredited investors that may participate in an offering. As a result, many issuers choose to use Rule 506(b) or (c) instead of Rule 505 for their private offerings because neither contains a ceiling on the amount of capital that can be raised and Rule 506(c) permits the use of general advertising and general solicitation to market securities. In its October 30, 2015 rule proposal on Rule 504 (see above), the SEC seeks comment on whether Rule 505 should be retained in its current form or modified in light of the proposed Rule 504 increase in the aggregate amount of securities that may be offered in a 12-month period.
Rule 506(b), adopted under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act, contains no limit on the amount of capital that can be raised in an offering. In addition, aside from the bad actor disqualifications discussed below (see Rule 506(d): Bad Actor Disqualification), there are no restrictions on the types of issuers that can use Rule 506(b). An issuer using Rule 506(b) cannot engage in general advertising or general solicitation to market its securities. Rule 506(b) is available to an unlimited number of accredited investors and up to 35 non-accredited investors. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated, meaning that they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment. Non-accredited investors must receive a detailed disclosure document that includes financial statements.
In contrast to Rule 506(c), issuers are not required to take “reasonable steps” to verify the accredited investor status of purchasers. Instead, it is sufficient that investors actually be accredited, or that the issuer reasonably believes that they are accredited.
Similar to Rule 506(c), issuers are precluded from relying on the Rule 506(b) safe harbor if certain felons and other “bad actors” participate in an offering (see Rule 506(d): Bad Actor Disqualification).
Rule 506(c), which took effect on September 23, 2013, is similar to Rule 506(b) in that it:
• Contains no limit on the amount of capital that can be raised in an offering.
• Requires that certain investors receive a disclosure document that includes financial statements.
However, unlike Rule 506(b), Rule 506(c) permits issuers to communicate with investors and potential investors through general advertising and general solicitation, as long as:
• The issuer takes “reasonable steps” to verify that each purchaser is an accredited investor.
• At the time of the sale of the securities, all purchasers are accredited investors or the issuer reasonably believes they are accredited investors.
• All of the terms and conditions in Rule 501, Rule 502(a) and Rule 502(d) are satisfied.
The fact that an investor turns out to be accredited does not relieve the issuer from its obligation to take reasonable steps to verify this fact. However, an issuer that has taken reasonable steps to verify a purchaser’s accredited investor status does not forfeit reliance on Rule 506(c) if the purchaser turns out not to be an accredited investor, as long as the issuer had a reasonable belief that the investor was accredited at the time of sale. Rule 506(c) does not replace Rule 506(b) and issuers may conduct offerings under either safe harbor. However, many issuers will likely continue to rely on Rule 506(b), particularly where a placement agent or other broker is used to locate investors, given the additional burdens associated with Rule 506(c).
In connection with Rule 506(c), on July 10, 2013, the SEC proposed several new rules that would impose additional requirements on issuers conducting offerings under Rule 506(c).
Similar to Rule 506(b), issuers are precluded from relying on the Rule 506(c) safe harbor if certain felons and other “bad actors” participate in an offering (see Rule 506(d): Bad Actor Disqualification).
Rule 506(d): Bad Actor Disqualification.
Rule 506(d) is not an exemption from registration but a disqualification of that exemption under certain circumstances. Rule 506(d), which took effect on September 23, 2013, prohibits issuers from relying on Rules 506(b) and 506(c) if the offering involves certain felons or other bad actors. The rule, which was required by the Dodd-Frank Act, applies not only to the bad acts of the issuer, but also to those of certain related or affiliated parties, including:
• Significant (20% or more) beneficial owners.
• Placement agents (and their directors and officers).
The list of disqualifying events is similarly broad and includes, among other things, securities-related crimes and regulatory discipline, such as SEC cease-and-desist orders and certain disciplinary orders relating to brokers and dealers. Only disqualifying events that occur after the rule’s September 23, 2013 effective date will disqualify an issuer from relying on Rule 506. However, disqualifying events that occurred before this date must still be disclosed to prospective investors.
An issuer that is disqualified from relying on Rule 506 may seek a waiver from the SEC’s Division of Corporation Finance by showing good cause. The SEC has suggested that an example of good cause justifying a waiver would be a recent change of control of the issuer, where the persons responsible for the disqualifying event are no longer employed by, or no longer exercise influence over, the issuer. An exception to Rule 506(d) is also available if the issuer can show that it did not know and, in the exercise of reasonable care (which requires, at a minimum, a factual inquiry of the applicable persons), could not have known that a disqualification existed.
Section 4(5): The Exemption for Offerings Made Solely to Accredited Investors.
Section 4(5) of the Securities Act allows offerings of securities exclusively to accredited investors up to a maximum amount of $5 million. Under Section 4(5), an issuer cannot engage in general advertising or general solicitation to market its securities.
Section 4(5) is rarely relied on by issuers because of the parallels between it and Rule 505, which instead allows the offering of securities to non-accredited investors as well.
Once a company chooses the exemption it will use to conduct its offering, it must go about structuring the offering and obtaining investors. Rule 502(c) of Regulation D, applicable in all offerings conducted in reliance on Rules 505 and 506(b), prohibits issuers from engaging in general advertising and general solicitation to find investors. However, Rule 502(c) does not apply to offerings conducted in reliance on Rule 506(c).
A company and its agents may not engage in general advertising designed to attract investors to an offering under Rule 505 or Rule 506(b). However, a company can still make generic advertisements and reports wholly unrelated to the offering. Companies should pay careful attention to and review all of their promotional materials and reports when conducting an offering.
One way for an issuer to demonstrate that the sale of a security in a private placement is not the result of general advertising or general solicitation is to document that a substantive and pre-existing relationship between the issuer and the prospective investor exists. To be substantive, the relationship should involve a discussion of the prospective investor’s financial goals and objectives, and the nature and quality of the relationship should be examined. To be pre-existing, a relationship should be in place before the terms of the offering are developed and the offering commences.
The extent of an issuer’s pre-existing relationships with prospective investors may influence whether it chooses to rely on Rule 506(b) or Rule 506(c) when conducting a private offering. For example, if an issuer has substantial existing relationships with prospective investors, it may prefer to rely on Rule 506(b), which, unlike Rule 506(c), does not require the issuer to take reasonable steps to verify that all purchasers are accredited investors. Under Rule 506(b), the issuer would also be permitted to sell to up to 35 non-accredited investors. In addition, if the proposed rules are adopted, under Rule 506(b) the issuer would not be subject to some of the additional obligations (such as legending and filing of solicitation materials).
Having a substantive and pre-existing relationship is not the exclusive means of demonstrating the absence of general advertising or general solicitation. An issuer may sell a security to a prospective investor without violating Rule 502(c) where:
• The investor, unsolicited, expresses interest in the sale of that specific security.
• The issuer has not engaged in general advertising or general solicitation that is related to an investment.
However, in practice, companies should exercise caution in the absence of a substantive and pre-existing relationship, unless they are relying on Rule 506(c).
Under appropriate circumstances, a “sister” issuer, firm or company may have a sufficient relationship with a prospective investor to enable the issuer to “tack” on to the sister’s substantive and pre-existing relationship with the potential investor to demonstrate the absence of general advertising or general solicitation.
Using Intermediaries to Find Investors.
Issuers often engage intermediaries to act on their behalf to locate prospective investors. Again, if it is necessary to avoid general solicitation, the consideration is whether the intermediary has a substantive and pre-existing relationship with the prospective investor that will enable it to be aware of the financial circumstances or sophistication of the prospective investor or that is otherwise of some substance and duration. The relationship need not arise in a business context. It may arise in a social context if in the course of the relationship the intermediary and the prospective investor communicated regarding the prospective investor’s investment goals and objectives.
On the other hand, for an offering under Rule 506(c), because intermediaries are permitted to use general advertising and general solicitation, they are not required to have a substantive or pre-existing relationship with prospective investors. When engaging an intermediary in connection with a Rule 506(c) offering, issuers should consider the intermediary’s experience with that particular exemption (particularly in the period immediately following effectiveness of the exemption) and its related resources. An intermediary with substantial pre-existing relationships with potential investors may still be advantageous in helping to ensure that the offering is fully subscribed.
In either case, there are several types of intermediaries available to an issuer to assist it in locating prospective investors:
• Associated persons.
• Unregistered finders.
• Registered broker-dealers.
Using “Associated Persons” of the Issuer to Find Investors.
Generally, issuers act through their officers, directors and employees, and an issuer can demonstrate a substantive and pre-existing relationship with a prospective investor through any of these persons. Rule 3a4-1 under the Exchange Act provides a non-exclusive safe harbor from the definition of a broker for persons associated with an issuer who:
• Are engaged in securities-related activities incident to their duties on behalf of the issuer.
• Do not receive compensation related to the sale of the issuer’s securities, whether by commission or other remuneration based directly or indirectly on securities transactions.
Employees and possibly individual affiliates of an issuer who are not registered representatives of broker-dealers may be considered “associated persons” for purposes of Rule 3a4-1. In this case, they may be exempt from registration and then would be permitted to engage in limited sales activities as intermediaries under the safe harbor.
Using Unregistered Finders to Find Investors.
A finder is a person who identifies prospective investors for an issuer but has no active role in negotiations and does not bind either party to a transaction. Finders generally do not register with the SEC as broker-dealers if their activities are so limited. A “broker” under the Exchange Act is any person engaged in the business of effecting transactions in securities for the account of others. The SEC staff has found the following types of activities trigger the obligation to register as a broker-dealer:
• Actively soliciting investors.
• Advising investors on the merits of an investment.
• Analyzing the financial needs of an issuer.
• Participation in presentations or negotiations.
• Prior dealings in securities transactions.
• Receiving transaction-based compensation.
• Structuring a transaction or making recommendations regarding the nature of securities, whether to issue securities or the value of securities sold.
Therefore, an unregistered finder should avoid these types of activities. If the finder’s activities extend beyond uniting issuers and prospective investors, and especially if they fall in a gray area, these types of activities may jeopardize a private offering and could result in purchasers having a rescission right with respect to the offering.
At the same time the SEC is increasing its focus on the activities of unregistered finders, support within the securities industry for a form of “broker-dealer lite” registration has emerged. The American Bar Association Task Force on Private Placement Broker-Dealers (Task Force) issued a report in May 2005, which was re-issued in April 2010, recommending that the SEC adopt a form of broker-dealer lite registration to cover these activities. In March 2012, the Task Force again recommended a broker-dealer lite solution, which included exempting from federal registration any “securities intermediaries” registered with the states. The proposed exemption would apply to parties that:
• Introduce investors either to the issuer or to registered brokers.
• Conduct due diligence.
• Structure a transaction.
• Recommend or negotiate the offering.
The exemption would apply even if the parties receive transaction-based compensation. The proposal would:
• Require both the entity and the operating individuals to register with the SEC.
• Not contain any net capital requirements.
• Include certain “bad boy” restrictions.
However, the proposal leaves open the scope of permissible transactions, including whether there should be an aggregate or transaction-based dollar limitation.
The SEC staff has hinted for several years that it intends to propose a regulation requiring placement agent/finders that are currently unregistered with the SEC and not members of the Financial Industry Regulatory Authority (FINRA) to register with the SEC and join FINRA, but reform has stalled. In April 2012, the SEC met with the Task Force on this issue, and the American Bar Association suggested that the SEC may be receptive to the Task Force’s proposal for a federal exemption for finders. In September 2015, the SEC’s Advisory Committee on Small and Emerging Companies recommended rules similar to the ones presented by the Task Force and also included a recommendation that a person that receives transaction-based compensation solely for providing names of or introductions to prospective investors not be subject to registration as a broker. However, these recommendations remain a work in process and adoption in any form is not certain.
Using Registered Broker-Dealers to Find Investor.
Issuers frequently engage in targeted inquiries to selected broker-dealers to seek their assistance in a proposed offering. The activities of a registered broker-dealer are not nearly as restricted as those of an unregistered finder. Broker-dealers may, among other things, actively participate in the negotiation and structuring of an offering and receive transaction-based compensation.
JOBS Act Safe Harbor.
The JOBS Act amended Section 4 of the Securities Act to allow third parties to provide various services in Rule 506 offerings through websites, social media and other means without being required to register as broker-dealers, provided they:
• Do not (and none of their associated persons) receive compensation in connection with the purchase or sale of a security. The SEC has interpreted this broadly to include any direct or indirect economic benefit to a person or any of its associated persons (other than co-investing in an offered security) (Question 5, Frequently Asked Questions about Exemption from Broker-dealer Registration in Title II of the JOBS Act (February 5, 2013)).
• Do not hold investor funds or securities.
• Are not subject to certain “bad actor” disqualifications under Section 3(a)(37) of the Exchange Act.
The safe harbor covers the following activities:
• Maintaining a platform or mechanism that permits:
• the offer, sale, purchase or negotiation of, or with respect to, securities; or
• general solicitations, general advertisements, or similar or related activities by issuers of the securities, whether online, in person or through any other means.
• Co-investing in the securities (including by any associated person).
• Providing ancillary services with respect to the securities (including by any associated person).
"Ancillary services" means:
• Providing due diligence services in connection with the offer, sale, purchase or negotiation of a security, provided the services do not include, for separate compensation, investment advice or recommendations to issuers or investors.
• Providing standardized documents to issuers and investors, as long as:
• the person or entity does not negotiate the terms of the issuance for and on behalf of third parties; and
• issuers are not required to use the standardized documents as a condition to using the service.
The activities covered by the safe harbor do not appear to include broader participation in transaction negotiation and, therefore, this type of participation may continue to subject a person to broker-dealer registration requirements. The SEC staff has indicated that in their view it is unlikely that anyone outside the venture capital area will be able to rely on the exemption from broker-dealer registration (Question 6, Frequently Asked Questions about Exemption from Broker-dealer Registration in Title II of the JOBS Act).
Using Placement Agents to Assist in Finding Investors.
An issuer also may wish to enlist the assistance of a placement agent registered as a broker-dealer under applicable federal laws. The ability of a placement agent to locate suitable and willing purchasers of the issuer’s securities is a key criterion for issuers. It is also very important for the issuer to evaluate the placement agent’s experience and compliance history in conducting private placements, particularly if conducting an offering under Rule 506(c) using general advertising and general solicitation.
Considerations in Selecting a Placement Agent.
The principal factors that an issuer should consider and review when selecting a placement agent, and conversely, what the placement agent should be prepared to demonstrate to a prospective client, are:
• The number and nature of successful placements.
• The size range and average size of these offerings.
• The time taken to complete each offering.
• The placement agent’s success record.
• The placement agent’s experience in the issuer’s industry.
• Whether the placement agent and its officers have a history of complying with regulatory standards for private offerings specifically and securities laws in general (including confirming that the placement agent and its agents are not subject to the bad actor disqualifications under Rule 506(d)).
• The identity and qualifications of management and supervisory personnel responsible for compliance with the Regulation D requirements specifically and securities laws in general.
• The existence of written policies and procedures intended to assure Regulation D compliance.
• The thoroughness of the firm’s record keeping procedures.
An issuer may consider requiring the development of written policies and procedures for conducting private offerings as a condition of engaging the placement agent or, at least, contractually requiring the placement agent’s adoption of acceptable policies and procedures regarding its proposed private offering.
Requirements for Sales Personnel.
Even in the smallest firms, only those sales personnel with established records of success in these types of offerings, appropriate clientele, experience in private offerings and exemplary compliance histories should be allowed to participate in an offering. Each approved broker should be required to sign a compliance certification that he will follow the general and specific conditions of the offering and only then should each broker receive private offering documents. A complete information packet should contain, in draft or in definitive form, a copy of the private placement memorandum, subscription documents, other sales material intended for distribution to investors and any internal analyses approved by the issuer and placement agent describing the securities and the offering. At this point, each of these documents should be marked “Internal Use Only” and none should be copied or provided to any prospective investor.
Qualifying Prospective Investors.
In a private offering conducted under Rule 505 or Rule 506(b) of Regulation D, an unlimited number of accredited investors may participate in the offering, but only 35 non-accredited investors may participate. In contrast, in a private offering conducted using general advertising or general solicitation under Rule 506(c), only accredited investors may participate. Under Rule 506(b), all non-accredited investors, either alone or with a purchaser representative, must be sophisticated, meaning that they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment. For these reasons, issuers and placement agents acting on their behalf should review the qualifications of the prospective investors in the offering.
The definition of accredited investor includes any person who comes within, or who the issuer reasonably believes comes within, one of eight enumerated categories at the time of the sale of the securities to that person. What constitutes reasonable belief depends on the facts of each particular case.
Generally, an accredited investor is any one of the following:
• A bank, insurance company, registered investment company, business development company or small business company.
• An employee benefit plan if a bank, insurance company or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5,000,000.
• A charitable organization, corporation or partnership with assets exceeding $5,000,000.
• A director, executive officer or general partner of the company selling the securities.
• A business in which all the equity owners are accredited investors.
• A natural person with a net worth, or joint net worth with a spouse, of at least $1,000,000. On December 21, 2011, the SEC adopted final rules amending the definition of accredited investor under Rule 501(a) of Regulation D and other Securities Act provisions to conform it to changes implemented by Section 413(a) of the Dodd-Frank Act. Under amended Rule 501(a), in calculating a person’s net worth (the amount of assets in excess of liabilities):
• The value of the person’s primary residence is not included as an asset. This exclusion of the value of a person’s primary residence has been in effect since July 22, 2010, the date the Dodd-Frank Act became effective.
• The amount of debt secured by the primary residence, up to its estimated fair market value, is not included as a liability, unless the person incurred debt within 60 days before buying securities in the unregistered offering for the purpose of buying those securities and not for buying the residence. In that situation, the amount of debt borrowed during that 60-day period must be included as a liability.
• Any debt secured by the primary residence in excess of the estimated fair market value of the home is included as a liability.
• These additions and subtractions to the definition of net worth do not apply to a person exercising a right to buy securities if the person held that right to buy those securities, as well as other securities of the same issuer, on July 20, 2010, and met the net worth test in effect at the time the person acquired the right.
• For more information on the net worth test, see Net Worth Standard for Accredited Investors, SEC Release No. 33-9287 (Dec. 21, 2011).
• A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
• A trust with assets of at least $5,000,000, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.
In the SEC’s proposed rules relating to Rule 506(c), the SEC staff solicited comments on the definition of accredited investor for natural persons. In addition, under Section 413(b) of the Dodd-Frank Act, the SEC must review this definition after July 2014 and every four years after that.
Confirming the Accredited Investor Definition.
For an offering under Rule 506(b), the issuer must reasonably believe that the prospective investor is accredited (see Accredited Investors) and must reasonably believe that the potential investor has enough knowledge and sophistication to properly evaluate the investment opportunity. Generally, this standard is met by the prospective investor’s self-certification and a further review of the prospective investor by the issuer. Although the SEC staff has suggested that issuers exercise greater diligence in their review of the sophistication of prospective investors, this does not appear to be standard practice.
If the issuer is using a placement agent to attract investors, it can also rely on a placement agent’s relationship with a potential investor. If the issuer is using a placement agent, an investor questionnaire (also known as an accredited investor questionnaire) should be compiled by the participating broker based on existing records and the broker’s familiarity with the size and nature of the prospective investor’s accounts at his or her firm and elsewhere and with the prospective investor’s financial resources, knowledge and sophistication and investment interests. Each investor questionnaire should be reviewed by the placement agent’s compliance personnel.
Usually, the participating broker’s supervisor will review the documents and undertake a follow-up review, including conversations with the participating broker and a review of client account opening cards, monthly statements and other account records and additional internal and external sources of information. Supervisory and compliance personnel should not approve an investor questionnaire with any incomplete responses or uncertainties regarding the existing relationship with the prospective investor, the prospective investor’s suitability or accredited investor status or the appropriateness of the investment for the individual.
If the issuer has not engaged a placement agent, the issuer should require prospective investors to complete an investor questionnaire and undertake a follow-up review, which may include seeking additional documents or back-up information from any prospective investor.
For an offering under Rule 506(c), the issuer is not required to make any inquiry, or have any reasonable belief, that the prospective investor is accredited. Instead, issuers may conduct broad based advertising and solicitation to non-accredited investors. However, issuers must take “reasonable steps” to verify that the actual purchasers of securities are all accredited investors. Whether steps taken to verify accredited investor status are reasonable is an objective, principles-based determination by the issuer. In making this determination, the issuer should consider the following factors:
• Type of purchaser and type of accredited investor that the purchaser claims to be.
• Amount and type of information that the issuer has about the purchaser.
• Nature of the offering, including the manner of the solicitation and the terms of the offering.
Type of Purchaser.
What constitutes “reasonable steps” in a Rule 506(c) offering varies depending on the type of accredited investor that the purchaser claims to be. An investor claiming to be a registered broker-dealer, for example, may be verified by checking FINRA’s BrokerCheck website, while a natural person would need to provide information relating to his or her income or assets. The SEC has acknowledged that information about a natural person’s income or assets may be difficult to obtain due to privacy concerns. Therefore, the reasonableness of the verification steps will depend on specific facts and circumstances.
Amount and Type of Information that the Issuer Has About the Purchaser.
The amount and type of information that an issuer has about a purchaser can be a significant factor in determining whether an issuer took “reasonable steps” in verifying that all purchasers were accredited investors. 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 available to an issuer may include:
• Information available through public filings, such as compensation data in a public company’s proxy statement.
• Information provided by third parties, such as a trade publication that discloses average annual compensation earned at the investor’s workplace for a person at the level of the investor’s seniority.
• Other information provided by a third party engaged by the issuer specifically for the purpose of verifying a purchaser’s accredited investor status.
Nature and Terms of the Offering.
The nature of the offering, such as the means through which an issuer publicly solicits investors, may also be relevant in determining whether reasonable steps were taken to verify accredited investor status. As the solicitation becomes broader, greater measures are required to verify investor status. For example, where an issuer solicits investors through a website accessible to the general public, or through a mass mailing or social media, greater measures are required than where the solicitation is limited to a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer.
Notably, the SEC has said that it would not consider the checking of a box on an investor questionnaire (absent other information about the purchaser) to qualify as reasonable steps in verifying accredited investor status under Rule 506(c). The SEC has also said that the terms of an offering may be a factor influencing the reasonableness of an issuer’s verification steps. For example, an investor’s ability to meet a high minimum subscription amount may sufficiently establish the investor’s accredited investor status, if the minimum is so high that only accredited investors could reasonably be expected to meet it (and the issuer is reasonably satisfied that the investment is not being funded by third-party financing).
Despite this principles-based approach, the SEC has identified four non-exclusive methods for verifying the accredited investor status of natural persons:
• On the basis of income, by reviewing any IRS form that indicates the requisite level of income for accreditation, along with a written representation regarding the purchaser’s expected income in the current year.
• On the basis of net worth, by reviewing any of a number of financial documents for assets (such as bank statements) and liabilities (such as a consumer credit report) dated within the prior three months, along with a written representation that all of the purchaser’s liabilities have been disclosed.
• On the basis of a written verification from a qualified third party, which includes registered broker-dealers, SEC-registered investment advisers, licensed attorneys and certified public accountants, a statement that the third party has taken reasonable steps to verify the purchaser’s accredited investor status within the prior three months and has determined that the purchaser is an accredited investor.
• In the case of a natural person who invested in a Rule 506(b) offering by the issuer before the enactment of Rule 506(c), and who remains a security holder, on the basis of a written certification by the person that he is still an accredited investor.
While these methods are not mandatory, they are considered safe harbors as long as the issuer does not have actual knowledge that a particular investor is not accredited.
For a form of accredited investor representation letter for a Rule 506(c) offering designed to help the issuer satisfy the requirement that it take reasonable steps to verify that each purchaser is an accredited investor (including a template third-party verification letter that can be used by broker-dealers, licensed attorneys, investment advisers and certified public accountants to confirm a purchaser’s status).
Issuers continue to have the burden of demonstrating compliance with any exemption under the Securities Act. Therefore, issuers relying on Rule 506, and particularly Rule 506(c), should ensure that they maintain adequate records that verify compliance with the exemption (including, in the case of Rule 506(c) offerings, the reasonable steps taken by the issuer to verify each purchaser’s accredited investor status). Issuers that have not engaged a placement agent should maintain these records, including investor questionnaires and any follow-up correspondence with or additional documents from prospective purchasers.
Negotiating the Terms of the Offering.
While terms vary from transaction to transaction, the following is a list of those that are frequently negotiated in a private offering:
• Type of security.
• Price of security.
• Voting rights.
• Registration rights.
• Right to designate board members.
• Conversion rights.
• Anti-dilution protections.
• Dividend preference.
• Liquidation preference.
• Redemption rights.
Generally, negotiated terms will be summarized in a term sheet that is circulated to prospective investors. The term sheet often forms the basis of a more substantive disclosure document, the private placement memorandum (PPM).
Preparing the Private Placement Memorandum.
The antifraud provisions of the federal securities laws require issuers to provide investors with full, fair and complete disclosure of all material facts about the issuer, its management, business, operations and finances. If an issuer’s offering will be sold to any non-accredited investors under Rule 505 or 506(b), the issuer must provide the narrative and financial disclosures required by Rule 502(b)(2).
Although not required, most investors, non-accredited or otherwise, expect to receive some form of a disclosure document. If prepared, this disclosure document should be provided to both accredited and non-accredited investors.
A PPM is designed to fulfill the disclosure requirements of Rule 502(b)(2). Generally, the issuer’s management, with assistance from its counsel and accountants, prepares the PPM, which should contain fair and balanced disclosures regarding the issuer and the prospective offering. The PPM is designed to simultaneously satisfy the issuer’s disclosure requirements while serving as a shield against any future charges of violating the antifraud provisions of the federal securities laws.
The value of the disclosure documents can be destroyed if the issuer, its placement agent or a broker makes oral or written representations that are different from or inconsistent with those in the PPM. Accordingly, all sales presentations and correspondence and, in the case of offerings under Rule 506(c), all general advertising and general solicitation materials, should be governed by the general content of the PPM. In addition, if new material information occurs relating to the issuer or its business or financial condition before the sale of the securities, the PPM must be updated to reflect those changes.
While there are no SEC filing requirements for the PPM, FINRA Rule 5123 requires FINRA members and any associated persons participating in a private placement to either:
• File the PPM, term sheet or other offering documents with FINRA within 15 days of the first sale of securities, together with certain information about the members, the issuer and the offering.
• If no offering documents were used, include a statement to this effect together with the other information required by Rule 5123.
FINRA Rule 5123 defines a private placement as a non-public offering in reliance on an available exemption from registration under the Securities Act, subject to certain exception. Filings are not subject to review and are treated confidentially by FINRA.
Offering the Securities.
Offers in a Rule 506(b) private placement should be made only to prospective investors who are pre-qualified and determined to be eligible and with whom the issuer, placement agent or participating broker has a substantive and pre-existing relationship. Offers should be made only through the PPM and other materials prepared by the issuer and the placement agent, if applicable.
“Internal Use Only” materials relating to the private offering (including materials prepared by the issuer, a placement agent or compliance personnel) should not be duplicated, extracted or summarized and then provided to prospective investors (see above).
Offers in a Rule 506(c) private placement, on the other hand, may be made through general advertising and general solicitation. Acceptable forms of general advertising and general solicitation under Rule 506(c) include advertisements, articles, e-mail solicitations and other communications made by means of television, radio, print or online media (including a website accessible to the general public or through a social media platform). Issuers should note, however, that advertisements and other solicitations by issuers remain subject to the general anti-fraud provisions of the federal securities laws, including Rule 10b-5 under the Exchange Act, Section 17(a) of the Securities Act and, for investment advisers, Section 206 of the Investment Advisers Act of 1940, as amended, which all prohibit false or misleading statements or other fraudulent conduct in connection with the offer or sale of securities.
Delivery of PPMs to Investors.
In an offering under Rule 506(b), the PPM and accompanying subscription documents, approved sales materials and summaries should be sent only to pre-qualified prospective investors who have given the issuer or participating broker an affirmative indication of interest. Copies of the PPM package are generally numbered and logged, so that there is a record of recipients.
In an offering under Rule 506(c), the PPM and related documents may be sent to any prospective investor, whether or not pre-qualified as an accredited investor or party to a pre-existing relationship.
In either case, “Internal Use Only” summaries or documents should not be provided to investors. Written documents other than those prepared by the issuer and approved by the placement agent, if applicable, should not be sent to prospective investors.
Delivering Copies of PPMs to Advisors.
It is not unusual for investors in sizable private placements to ask that a copy of the PPM be sent to their financial advisors, accountants or counsel. In some instances, prospective investors will identify a “purchaser representative.” It is understandable that an investor would request this and it is permissible for a copy of the PPM to be forwarded to these advisors. Because of the solicitation restrictions applicable to Rule 506(b) offerings, many placement agents follow the practice of not including subscription documents with copies of the PPM sent to advisors. They forward the materials accompanied by a transmittal letter indicating that the delivery of the PPM does not constitute an offer to the advisor and confirming the agreement of the advisor not to furnish the PPM to any other person. However, for offerings under Rule 506(c), issuers and placement agents can take a less conservative approach when conducting offerings using general advertising and general solicitation.
Completing the Subscription Documents.
All subscription documents should be completed in the form delivered to the prospective investor. A purchaser suitability questionnaire (investor questionnaire or accredited investor questionnaire) may be included in the subscription documents. This questionnaire should be completed by investors in as much detail as possible because the information in the investor questionnaire will be relied on by the issuer, placement agent and counsel in determining whether investors meet applicable suitability requirements. For offerings conducted under Rule 506(c), subscription agreements should contain additional representations, and the subscription documents should include questionnaires and requests for supporting documents that are designed to show “reasonable steps” in verifying accredited investor status. These should be tailored to the amount and type of information available about the prospective investors and the nature and terms of the offering.
Although participating brokers may assist their clients in completing the subscription documents, a participating broker should not complete any portion of any subscription document except in conformity with the client’s response to a question contained in that document or in response to the client’s specific instruction. A participating broker should review the subscription documents completed and delivered by a client. Any subscription document that is incomplete or has been incorrectly completed should be returned to the client for completion or revision. For offerings using general advertising and general solicitation, the participating broker is required to conduct additional research and request supplemental documents to comply with the requirement of taking “reasonable steps” to verify the investor’s accredited investor status (see above). After the participating broker is satisfied that each subscription document is correctly completed, the documents should be forwarded to the supervisory or compliance personnel responsible for coordinating the offering.
Each prospective investor’s subscription documents should be reviewed by compliance personnel to assure, among other things, that the:
• Subscription documents are correctly completed and executed.
• Information in the subscription documents is consistent with the investor questionnaire or other documents used to verify investor status.
• Investor meets the requirements for the offering.
• Investor is an accredited investor.
For offerings conducted under Rule 506(c), compliance personnel must also ensure that the documents satisfy the “reasonable steps” requirement to verify the purchaser’s accredited investor status and provide a written certification to the issuer to this effect.
The placement agent should forward an investor’s subscription documents to the issuer only if:
• The subscription documents appear to be in order.
• The placement agent’s compliance personnel have a reasonable basis for believing that the prospective investor satisfies the applicable suitability and accreditation standards (including through verification of the “reasonable steps” required for Rule 506(c) offerings).
• An investment in a private offering appears to be within the risk parameters of the investor’s portfolio.
An issuer that has not engaged a placement agent should undergo its own review process for completed subscription documents and accept subscriptions only if the subscription documents appear to be in order, the issuer has a reasonable basis for believing that the prospective investor satisfies the applicable suitability and accreditation standards and, if applicable, the issuer has taken reasonable steps to verify the investor’s accredited investor status.
Many private placements of securities, particularly those in which a placement agent is engaged, require a legal opinion from the issuer’s counsel. This type of legal opinion is especially difficult because many Regulation D requirements, including the requirements relating to the verification of accredited investors in a Rule 506(c) offering, are fact-based and would require counsel to undertake substantial due diligence to render a meaningful opinion. For this reason, many private placement legal opinions are narrowly drawn and offer limited comfort beyond the standard representations relating to issuer capitalization and the validity of the issuance of the securities in the private offering.
Closing the Offering and Post-closing Procedures.
The closing of the offering generally occurs when the issuer accepts an investor’s subscription documents. An offering may have one, orchestrated closing, or there may be multiple closings for a single offering. In the case of a contingent offering (an offering requiring some minimum amount of sales), issuers and their counsel must keep in mind Rules 10b-9 and 15c2-4 under the Exchange Act:
• Rule 10b-9 requires that, in a contingent offering, the purchase price must be returned to investors if the minimum amount of securities is not sold within a specified period of time.
• Rule 15c2-4 requires that, in a contingent offering, the purchase price paid by investors must be deposited into an escrow account until the minimum conditions have been satisfied. If the conditions are satisfied, the money must be paid to the issuer. If the conditions are not satisfied, the money must be returned to the investors.
Before structuring, drafting and closing a contingent offering, issuers should ensure that they and their counsel are well acquainted with the intricacies of Rules 10b-9 and 15c2-4.
In addition to written policies and procedures governing private placements, placement agents should maintain appropriate files reflecting compliance with these procedures. Promptly after the closing of the private offering, copies of these compliance materials, in addition to materials maintained in client files, should be collected, reviewed for completeness and accuracy and filed in a single location. Ideally, compliance files for the private offering will include:
• Copies of the PPM, additional selling materials and all other documents provided by the issuer and prepared or approved by the placement agent, including, if applicable, general advertising or general solicitation materials.
• Lists or notations reflecting the selection of participating brokers, the basis for their selection and their compliance certifications.
• Copies of investor questionnaires completed by participating brokers and indicating review, any necessary follow-up and approval by supervisory personnel, including, for offerings under Rule 506(c), documentation of the “reasonable steps” taken to verify that all purchasers are accredited investors.
• Weekly or other reports from participating brokers reflecting contacts with prospective offerees and identifying to whom (including advisors) copies of the PPM were delivered.
• Copies of completed subscription documents.
• Certification from the participating broker regarding review of subscription documents and their consistency with the investor questionnaire and the participating broker’s knowledge and understanding about the client, reflecting any additional confirmatory steps taken and the basis for the participating broker’s reasonable belief regarding the offeree’s suitability and accreditation, including, for offerings under Rule 506(c), certification of the “reasonable steps” taken to verify that all purchasers are accredited investors.
• A checklist or other notations made by supervisory personnel reflecting review of the subscription documents, consistency with the investor questionnaire, other information regarding the client available to the firm, additional confirmatory steps undertaken and any other relevant notations.
• A log accounting for all distributed copies of the PPM.
Issuers that have not engaged a placement agent should undergo a similar post-closing review of materials and evaluation of procedures.
Filing Form D.
If the issuer is making a private offering under Rule 504, 505 or 506 of Regulation D, it must file a Form D with the SEC within fifteen days after the first sale of securities, although failure to timely file is no longer a condition of the availability of the exemption. The acceptance of subscription funds into an escrow account pending receipt of minimum subscriptions triggers the filing requirements, even though in a technical sense the issuer has not yet “sold” the security.
Form D includes separate check boxes for the issuer to indicate whether it is conducting an offering under Rule 506(b) or Rule 506(c). In addition, the Form D signature block includes a certification by the issuer that it is not barred from relying on Rule 506 due to the “bad actor” disqualifications under Rule 506(d).
The failure to timely file a Form D is currently not a condition to the availability of an exemption under Regulation D, although the SEC has proposed to change this and other elements of the form.
Liability for Non-compliance with an Exemption.
Both the Securities Act and the Exchange Act impose liability for violations of registration requirements, disclosure obligations and broker-dealer regulations.
Under the Securities Act, liability for directors and officers arises under Sections 11 and 12. Section 11 applies only to registered securities, rather than securities that are exempt from registration, but its framework has been followed in private litigation. Section 11 prohibits an issuer, its officers and directors from misrepresenting or omitting to state material facts in any registration statement filed with the SEC in connection with the sale of securities. Section 11 specifically creates a private right of action by purchasers of securities against the issuer’s directors and others who violate this section. However, a director may escape liability if:
• He or she reasonably relied on an expert such as an attorney or accountant in approving expertized portions of the registration statement.
• He or she reasonably believed, based on a reasonable investigation, that the disclosure was true.
Section 12 of the Securities Act imposes civil liability on any person who offers or sells a security by means of a false or misleading prospectus or other communication. Although not specifically referring to directors, this provision has been successfully used by injured purchasers to impose civil liability for damages on the selling issuer’s directors for aiding and abetting the improper sales. Section 12 also provides that any person who sells a security by means of a false or misleading prospectus or other communication or in violation of Section 5 of the Securities Act (meaning the security is not registered and was not sold under a valid exemption from registration) is liable to repay the consideration paid for the security.
Under the Exchange Act, the primary sections that give rise to civil liabilities against officers and directors are Section 10(b) and Rule 10b-5. Both provisions impose personal liability on corporate officers and directors. These antifraud provisions prohibit any person from using any manipulative or deceptive device, prohibit any misrepresentation or omission of a material fact and prohibit any person from engaging in any act or practice which operates as a fraud or deceit on any other person in connection with the purchase or sale of any security. The section applies to the purchase or sale of any security, even though the issuer may not be an SEC reporting company.
Both provisions have traditionally been interpreted to impose personal liability on corporate officers and directors. These provisions impose personal liability on persons deemed to have “made” the relevant misstatements or omissions, which means those persons with “control” over these statements (see Janus Capital Group, Inc. v. First Derivative Traders, 131 S.Ct. 2296, 2011 WL 2297762 (2011)). While the case did not address the issue of directors and officers assisting in the preparation of an offering document, these individuals may be deemed control persons under the standard set out by the court.
For placement agents and finders, the failure to register with the SEC as a broker-dealer according to the requirements of the Exchange Act exposes the unregistered broker-dealer to considerable liability unless an exemption exists in each case. An unregistered securities broker faces serious possible liabilities, including injunctions, criminal sanctions, damage suits and contract rescissions, through actions instituted by the SEC, the US Department of Justice and by private parties to the transactions. Using an unregistered broker-dealer may also give purchasers a rescission right with respect to the offering.
Section 29(b) of the Exchange Act provides that every contract made in violation of the Exchange Act, including contracts for which performance under the contract is a violation of any of the Exchange Act provisions, is void as to “any persons who, in violation of any such provision, rule or regulation, shall have made or engaged in the performance of any such contract.” While Section 29(b) certainly creates risk for the finder, the language is broad enough that it can also be interpreted to void the contract for the sale of the securities to investors located through the use of the finder. Under federal law, this potential rescission right can be exercised until the later of three years from the date of issuance of the securities or one year from the date of discovery of the violation. Certain states, such as California, also provide a rescission right to purchasers of securities from unregistered broker-dealers, which can be exercised even if the purchaser no longer owns the securities.
Proposed Amendments to Regulation D
Rules 509 and 510T
On July 10, 2013, the SEC proposed the following rules that would impose additional requirements on issuers conducting offerings under Rule 506(c) (Amendments to Regulation D, Form D and Rule 156, SEC Release No. 33-9416 (July 10, 2013)):
• Proposed Rule 509 would require prescribed legends in any written general solicitation materials used in a Rule 506(c) offering.
• Proposed Temporary Rule 510T would, for a period of two years after effectiveness of the rule, require issuers to submit any written general solicitation materials used in a Rule 506(c) offering to the SEC no later than the date of first use (although the materials would not be publicly available).
The purpose of the proposed rules is to enhance the ability of the SEC and state regulators to evaluate market developments in Rule 506(c) offerings and to address investor protection concerns. However, these additional rules, along with the amendments to Form D discussed below, if adopted in their proposed forms, would likely constitute a substantial burden on issuers wishing to conduct an offering under Rule 506(c) and could therefore have a chilling effect on its utilization.
Changes to Form D.
On July 10, 2013, the SEC also proposed changes to Form D that would require issuers to, among other things:
• File a Form D no later than 15 calendar days prior to commencement of general advertising or general solicitation in a Rule 506(c) offering.
• File a new closing Form D amendment within 30 calendar days after the termination of any Rule 506 offering.
• Provide significantly more information in Form D filings, including, with respect to Rule 506(c) offerings, the type of general solicitation used and the methods utilized to verify the accredited investor status of investors.
(SEC Release No. 33-9416.)
The SEC also proposed new Rule 507, which would disqualify an issuer from relying on any provision of Rule 506 for one year following a corrective filing if the issuer or its affiliates had failed to file any Form D reports for a Rule 506 offering within the previous five years (but not extending before effectiveness of the new rule).
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