SEC Staff Issues Interpretive Guidance on Recently Adopted Amendments to Rule 506 Addressing General Solicitation and Bad Actors
Effective September 2013, the U.S. Securities and Exchange Commission (SEC) amended Rule 506 of Regulation D to (1) permit, in certain circumstances, an issuer to engage in general solicitation and general advertising in connection with Rule 506 offerings (General Solicitation Rules) and (2) disqualify issuers of securities offerings involving certain “felons” and other “bad actors” from relying on Rule 506 (Bad Actor Rules).1
To provide further clarification on the General Solicitation Rules and the Bad Actor Rules, the SEC Staff (Staff) recently updated its related Compliance and Disclosure Interpretations (Staff Interpretations), which are discussed and analyzed below.2
Staff Interpretations of the General Solicitation Rules
Background of the General Solicitation Rules
Many U.S. private placements have historically relied on Rule 506(b), a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act of 1933, as amended (Securities Act), which exempts transactions by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act. However, to rely on Rule 506(b), an issuer is prohibited from engaging in general solicitation and general advertising in connection with the offering. For various reasons set forth in the General Solicitation Release, and as directed by Section 201(a) of The Jumpstart Our Business Startups Act (JOBS Act), the SEC adopted the General Solicitation Rules, set forth in Rule 506(c) of Regulation D, to create a new exemption that permits an issuer to engage in general solicitation and general advertising in connection with a Rule 506(c) offering of securities, subject to the following conditions:
- The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors;
- All purchasers of securities are accredited investors either because they come within one of the eight enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes they qualify as such at the time of sale;3 and
- The issuer meets all terms and conditions of Rule 501,4 Rule 502(a)5 and Rule 502(d).6
Reasonable Steps to Verify Accredited Investor Status under the General Solicitation Rules
In the General Solicitation Release, the SEC described two possible means of determining that verification procedures are reasonable. First, an issuer (or those acting on its behalf) may use a principles-based approach, whereby the issuer makes an “objective determination,” based on the “particular facts and circumstances” of the applicable offering, in deciding what steps to take to verify a purchaser’s accredited investor status. The General Solicitation Release provides the following non-exhaustive and non-mandatory list of factors that may be appropriate for an issuer to consider:7 (i) nature of the purchaser and the type of accredited investor the purchaser claims to be; (ii) information that the issuer has about the purchaser; and (iii) nature and terms of the offering.
Second, as an alternative to the principles-based approach, the General Solicitation Rules contain four specific non-exclusive methods of verifying accredited investor status for a natural person that, if properly followed, are deemed to satisfy the “reasonableness” requirement of such verification: (i) income verification; (ii) net worth verification; (iii) third-party verification; and (iv) verification of current investors of an issuer. The requirements for each of these methods are set forth in the General Solicitation Rules. Issuers utilizing other accredited investor verification means will not be deemed or presumed to have acted unreasonably but, instead, must consider whether the method selected is reasonable based on the principles-based approach described above.8
Analysis of Staff Interpretations under the General Solicitation Rules
The Staff Interpretations provide clarification with respect to the application of various provisions of the General Solicitation Rules as set forth below.
- Conversion to Rule 506(c) Offering for Offerings Commenced Prior to September 23, 2013. The Staff Interpretations clarify that an issuer that commenced an offering prior to the effectiveness of the General Solicitation Rules may convert the offering to a Rule 506(c) offering and rely on the General Solicitation Rules, but must update its Form D to check the Rule 506(c) box to indicate its reliance on the General Solicitation Rules. No amendment is required if the issuer will continue to rely on Rule 506(b).
- Conversions between Rule 506(b) and Rule 506(c) Offerings. The Staff further clarified that that an issuer that commenced an initial offering intending to rely on Rule 506(c) may subsequently determine to rely on Rule 506(b) for the offering, if the issuer did not engage in any form of general solicitation, and as long as the conditions of Rule 506(b) are otherwise satisfied. If the issuer already filed a Form D indicating its reliance on Rule 506(c), it must amend the Form D. Conversely, if an issuer commences an offering relying on Rule 506(b), prior to any sales of securities, the issuer may instead choose to rely on Rule 506(c) for the offering as long as the conditions of Rule 506(c) are met. Again, the issuer must amend the Form D if it has already filed the Form D indicating the issuer’s reliance on Rule 506(c).
- Reliance on Section 4(a)(2). The Staff confirmed that if an issuer fails to meet the conditions of Rule 506(c) in a purported Rule 506(c) offering and has engaged in general solicitation, then the issuer cannot rely instead on the private offering exemption provided in Section 4(a)(2).
- General Guidance on Verification of Accredited Investor Status. The Staff Interpretations note that the accredited investor verification requirement is separate from and independent of the requirement that sales be must be limited to accredited investors. Thus, the verification requirement must be satisfied even if all purchasers happen to be accredited investors, such that an issuer will not be able to rely on the General Solicitation Rules if the issuer did not take reasonable steps to verify the accredited investor status of purchasers who, in fact, are accredited investors. In contrast, if an issuer takes reasonable steps to verify the accredited investor status of a purchaser and forms a reasonable belief that the purchaser is an accredited investor at the time of the sale of securities, the issuer does not lose its ability to rely on Rule 506(c) if a person who does not, in fact, meet the criteria for any category of accredited investor purchases securities in the offering.
- Net Worth Verification Method. One manner in which an issuer can verify the accredited investor status for a natural person is to obtain documents that evidence such person’s assets (bank statements, brokerage statements, etc.) and liabilities (i.e., through a consumer report from at least one nationwide consumer reporting agency) and a written acknowledgment from the purchaser that all liabilities necessary to determine the purchaser’s net worth have been obtained. The Staff Interpretations confirm that, if an issuer elects to rely on the net worth verification method, the relevant verification documentation must be dated within the prior three months of the time the purchaser decides to purchase securities in the offering. To continue to rely on the net worth verification method, the issuer would need to obtain updated verification documents that are within such three-month period. Alternatively, the issuer may determine whether it has taken reasonable steps to verify the accredited investor status of the purchaser under the principles-based method of verification.
- Third-Party Verification Method. An issuer can satisfy its verification obligations by obtaining written confirmation from certain third parties (including registered broker-dealers, SEC-registered investment advisers, licensed attorneys in good standing under the laws of the jurisdiction where they are admitted to practice, and certified public accountants who are duly registered and in good standing under the laws of the place where they reside or have a principal office) that such third party has taken reasonable steps to verify (within the last three months) and has determined that the investor is an accredited investor. The Staff Interpretations clarify that such third-party confirmations may include written confirmations from an attorney or certified public account licensed, duly registered and in good standing in the United States or in a foreign jurisdiction.
- Current Investor Verification Method. With respect to any person who purchased an issuer’s Rule 506(b) offering as an accredited investor prior to Septembers 23, 2013, and who continues to hold such securities for the same issuer’s Rule 506(c) offering, the issuer can satisfy its verification requirements by obtaining a certification by such person at the time of sale that the investor qualifies as an accredited investor. The Staff Interpretations indicate that this method does not apply in the context of an investor seeking to invest in an issuer that has the same sponsor as the issuer in which the investor purchased securities in a prior Rule 506(b) offering. In other words, if an existing accredited investor in a private fund offered pursuant to Rule 506(b) prior to September 23, 2013 makes a follow-on investment in the same fund that is subsequently offered pursuant to Rule 506(c), the issuer can rely on a certification from the accredited investor, but if the same investor seeks to make an investment in a new fund offered by the same manager pursuant to Rule 506(c), the issuer cannot rely on the current investor certification method.
Staff Interpretations of the Bad Actor Rules
Background of the Bad Actor Rules
Pursuant to the mandate in Section 926(1) of the Dodd-Frank Act, the SEC adopted disqualification rules “substantially similar” to those in Rule 262 of Regulation A under the Securities Act. The amendments to Rule 506, set forth in the Bad Actor Rules (Rule 506(d) and Rule 506(e)), disqualify issuers of securities offerings involving certain “felons” and other “bad actors” from relying on Rule 506 of Regulation D where an issuer or certain “covered persons” have had a “disqualifying event.”
Covered Persons under the Bad Actor Rules
The disqualification provisions in the Bad Actor Rules generally apply to the following categories of “covered persons”:
- Investment managers of private fund issuers;
- The directors, executive officers, other officers participating in the offering, and general partners and managing members of such investment managers;
- The directors and executive officers of such general partners and managing members and their other officers participating in the offering;
- The issuer and any predecessor of the issuer or affiliated issuer;
- The directors, executive officers, other officers participating in the offering, and general partners or managing members of the issuer;
- Any 20% beneficial owner of an issuer’s outstanding voting equity securities, calculated on the basis of voting power;
- Certain promoters; and
- Persons compensated for soliciting investors as well as the general partners, directors, executive officers, other officers participating in the offering and managing members of any compensated solicitor.
Disqualifying Events under the Bad Actor Rules
If an issuer or a covered person of an issuer has been involved in any of the “disqualifying events” in the Bad Actor Rules, absent an exemption or waiver, the issuer will be disqualified from relying on Rule 506 as the basis for its exemption from registration under the Securities Act. The disqualifying events include being subject to:
- SEC cease-and-desist orders barring or limiting such persons from engaging in certain enumerated activities under the federal securities laws;
- SEC cease-and-desist orders, entered into within the last five years, in connection with violations of anti-fraud provisions of the federal securities laws;
- Criminal convictions, entered within ten years before such sale (or five years in the case of issuers, their predecessors and affiliated issuers), in connection with the purchase or sale of any security, involving the making of any false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries such as underwriters and broker-dealers;
- Court restraining orders and injunctions, entered within five years before such sale, in connection with the purchase or sale of any security, involving the making of any false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries such as underwriters and broker-dealers;
- Suspension or expulsion from membership in, or restrictions on a covered person’s ability to associate with members of, a securities self-regulatory organization; and
- Final orders of certain enumerated state and federal regulators (including the CFTC, federal banking agencies, state securities regulators and insurance, banking and savings associations) that (1) bar the covered person from associating with the above-referenced regulated entities, or (2) find a violation of any law or regulation prohibiting fraudulent, manipulative or deceptive conduct and that were entered into within ten years before such sale.
Additional Aspects of the Bad Actor Rules
It is important to note the following additional aspects of the Bad Actor Rules:
- Only disqualifying events occurring on or following September 23, 2013 will trigger disqualification, although disqualifying events occurring before that date must be disclosed to investors;
- The Bad Actor Rules provide an exception from disqualification where the issuer can demonstrate that it did not know and, using reasonable care, could not have known that a disqualification existed because of the presence or participation of another covered person in the offering; and
- The SEC may grant a waiver of disqualification where an issuer has shown good cause that it is not necessary, under the circumstances, that the registration exemption be denied. In addition, disqualification of a covered person subject to a disqualifying event will not occur if, before the relevant sale is made pursuant to Rule 506, the court or regulatory authority that entered the relevant order, judgment or decree advises the SEC, in writing, that disqualification is inappropriate.
Analysis of Staff Interpretations under the Bad Actor Rules
The Staff Interpretations provide clarification with respect to the application of various provisions of the Bad Actor Rules, as set forth below.
Timing of Determination and Re-Certification of Bad Actor Status. An issuer must determine if it is subject to a bad actor disqualification (i.e., it must exercise reasonable care, including making factual inquiry that is reasonable in light of the circumstances, into whether any covered person is subject to a bad actor disqualification) any time the issuer is offering or selling securities in reliance on Rule 506. The Staff Interpretations clarify that an issuer that is not offering securities (such as a fund that is winding down and is closed to investment) does not need to make such inquiry unless and until it commences a Rule 506 offering. In addition, the Staff Interpretations provide as follows:
An issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to, for example, contractual covenants, bylaw requirements, or an undertaking in a questionnaire or certification. However, if an offering is continuous, delayed or long-lived, the issuer must update its factual inquiry periodically through bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.
Thus, the Staff has made clear its expectation that, in connection with ongoing offerings made pursuant to Rule 506 (e.g., hedge fund offerings), the issuer has an obligation to obtain periodic re-certifications or conduct other updated factual inquiry of the bad actor status of covered persons of the issuer. The Staff does not specify how frequently such re-certification should occur. In addition, it is important to note that the Staff has suggested that negative consent may be a viable means of satisfying an issuer’s duty to periodically make such factual inquiry into the bad actor status of its covered persons. This may be a favorable approach for many issuers, given the administrative burden associated with obtaining affirmative responses to questionnaires from the many covered persons of an issuer.
- Covered Persons – Meaning of “Affiliated Issuer”. One category of covered person whose bad actor status must be determined is any of the issuer’s “affiliated issuers”. However, the Bad Actor Rules do not provide specific guidance as to how an “affiliated issuer” is defined for purposes of the Bad Actor Rules. The Staff Interpretations clarify that, for purposes of the Bad Actor Rules, an “affiliated issuer” is an affiliate that issues securities in the same offering, including offerings subject to integration with such offering under Rule 502(a) of Regulation D, such as co-issuer or multiple issuer offerings. The Staff has thus alleviated concerns that the intended scope of the definition could, for example, include as a covered person of a Rule 506 issuer any other issuer that was under common control with the issuer relying on Rule thereby triggering, especially in the case of very large organizations with a multitude of issuers under common control, onerous diligence requirements to ascertain the bad actor status of each such issuer irrespective of the circumstances of such affiliation.
- Covered Persons – Compensated Solicitors. Another category of covered persons whose bad acts could result in disqualifying an issuer from relying on Rule 506 are compensated solicitors. The Staff Interpretations confirm that this term is not limited to brokers, as defined in Section 3(a)(4) of the Securities Exchange Act of 1934, as amended (Exchange Act), who are subject to registration pursuant to Section 15(a)(1) of the Exchange Act, and their associated persons. Rather, “compensated solicitors” include all persons who have been or will be paid, directly or indirectly, remuneration for solicitation of purchasers, regardless of whether they are required to register under the Exchange Act or are associated persons of registered brokers.
- Meaning of “Participating” in the Offering. The Staff provided further guidance as to whether certain relevant persons are covered persons who, by their activities, are deemed to be “participating” in the offering made by the issuer. The Staff Interpretations specifically provide as follows:
- Any person whose sole involvement with a Rule 506 offering is that of a member of a compensated solicitor’s deal or transaction committee responsible for approving the compensated solicitor’s participation in the offering, is not “participating” in the offering, and thus, is not a covered person of the issuer;
- Participating in an offering includes: participation or involvement in due diligence activities or the preparation of offering materials (including analysts’ reports used to solicit investors); providing structuring or other advice to the issuer in connection with the offering; and communicating with the issuer, prospective investors or other offering participants about the offering;
- To constitute participation, activities must be more than transitory or incidental; and
- Administrative functions, such as opening brokerage accounts, wiring funds and bookkeeping activities, would not generally be deemed to be participation in the offering.
- Covered Persons and “Beneficial Ownership”. The Staff provided clarification with respect to the meaning and application of beneficial ownership in the context of Rule 506(d), explaining that:
- A shareholder that becomes a 20% beneficial owner upon completion of a sale of securities is not a 20% beneficial owner at the time of that sale but would be a covered person with respect to any sales of securities in the offering that were made while it was a 20% beneficial owner. Rule 506(d) looks to the time of each sale of securities.
- The term “beneficial owner” is interpreted in the same manner under Rule 506(d) as under Exchange Act Rule 13d-3. Thus, a beneficial owner under Rule 506(d), means “any person who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, under Exchange Act Rule 13d-1 has or shares or is deemed to have or share: (1) voting power, which includes the power to vote, or direct the voting of, such security; and/or (2) investment power, which includes the power to dispose, or to direct the disposition of, such security.”
- Beneficial ownership includes both direct and indirect interests, determined under Rule 13d-3. It may be necessary to “look through” entities to their controlling persons to make this determination.
- In the context of voting agreements whereby some of the shareholders of a Rule 506 offering have entered into a voting agreement under which each shareholder agrees to vote its shares of voting equity securities in favor of director candidates designated by one or more of the other parties, whether the parties to a voting agreement are required to aggregate their holdings for purposes of determining whether they as a group, or any single party thereto, is a 20% beneficial owner of a Rule 506 issuer, and therefore a covered person, is analyzed in the same manner as under Exchange Act Rules 13d-3 and 13d-5(b). In that regard, the Staff noted the following:
Under that analysis, the shareholders have formed a group, and the group beneficially owns the shares beneficially owned by its members. In addition, the parties to the voting agreement that have or share the power to vote or direct the vote of shares beneficially owned by other parties to the agreement (through, for example, the receipt of an irrevocable proxy or the right to designate director nominees for whom the other parties have agreed to vote) will beneficially own such shares. Parties that do not have or share the power to vote or direct the vote of other parties’ shares would not beneficially own such shares solely as a result of entering into the voting agreement . . . . If the group is a 20% beneficial owner, then disqualification or disclosure obligations would arise from court orders, injunctions, regulatory orders or other triggering events against the group itself. If a party to the voting agreement becomes a 20% beneficial owner because shares of other parties are added to its beneficial ownership, disqualification or disclosure obligations would arise from triggering events against that party.
- Actions Not Triggering Disqualification – Foreign Bad Acts and Certain Commission Orders. According to the Staff Interpretations, actions taken in jurisdictions other than the United States, including convictions, court orders or injunctions in a foreign court, or regulatory orders issues by a foreign regulatory authority, do not trigger disqualification under the Bad Actor Rules. Additionally, not all cease and desist orders by the SEC trigger disqualification; only those orders to cease and desist from violations of scienter-based provisions of the federal securities laws (including scienter-based rules such as violations of Rule 105 under the Exchange Act) trigger disqualification under Rule 506(d)(1)(v).
- Exemption from Disqualification. If an order issued by a court or regulator provides that it should not result in disqualification under Rule 506(d)(2)(iii), disqualification is not triggered, and there is no need to seek a waiver, as the provision is self-executing.
- Reliance on Rule 506 Where Disqualifying Event Has Occurred – Compensated Solicitors. The Staff noted that when a placement agent or one of its covered control persons becomes subject to a disqualifying event while an offering is ongoing, the issuer may continue to rely on Rule 506 for future sales in the offering, if the placement agent is terminated and does not receive compensation for the future sales. In addition, if the disqualifying event affected only the covered control persons of the placement agent, the issuer could continue to rely on Rule 506 for that offering if such persons were terminated or were no longer covered persons for purposes of Rule 506(d).
- Application of the Reasonable Care Exception. The reasonable care exception applies whenever the issuer can establish that it did not know and, despite the exercise of reasonable care, could not have known that a disqualification existed. Examples of situations where this may occur include when the issuer, despite the exercise of reasonable care: could not determine the existence of a disqualifying event; was unable to determine that a particular person was a covered person; or initially reasonably determined that a person was not a covered person but subsequently learned that determination was incorrect. The Staff noted that an issuer must take appropriate steps upon the discovery of disqualifying events or becoming aware that a person is a covered person throughout the course of an ongoing offering. These steps may include seeking waivers of disqualification, termination of the relationship with covered persons, providing Rule 506(e) disclosures, or other remedial actions.
- General Guidance on Rule 506(e) Disclosures. Rule 506(e) of the Bad Actor Rules generally provides that an issuer must disclose to each purchaser, within a reasonable time prior to sale, a written description of bad acts of covered persons that would have triggered disqualification of the issuer from relying on Rule 506 had such acts occurred on or after September 23, 2013. In addressing Rule 506(e), the Staff confirmed that:
- The disclosure obligation under Rule 506(e) is not subject to waiver, even where disqualifying events occurred before September 23, 2013.
- An order under Rule 506(d)(2)(iii), which permits issuers to rely on the self-executing statement of a regulatory authority to avoid Rule 506 disqualification, does not waive the disclosure obligation set forth in Rule 506(e). However, a regulatory authority may determine that an order entered before September 23, 2013 would not have triggered disqualification under Rule 506(d)(1), because the violation was not a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale.
- Rule 506(e) does not require disclosure of events that would no longer trigger disqualification under Rule 506(d), such as a criminal conviction that occurred more than ten years before the offering or an order or a bar that is no longer in effect at the time of the offering.
- Where an issuer uses multiple placement agents or other compensated solicitors in an offering, Rule 506(e) requires disclosure of disqualifying events with respect to all compensated solicitors who are involved at the time of sale and their covered control persons. Thus, the disclosure obligation to an investor is not limited to the disqualifying events of the particular compensated solicitor or placement agent and its covered control persons that solicited that investor. However, the issuer need not provide disclosure for all solicitors that were ever involved during the course of the offering. Rather, at a reasonable time prior to the sale, the issuer must disclose to an investor all compensated solicitors that are involved at the time of sale.
The Staff Interpretations provide much needed guidance regarding the General Solicitation Rules and the Bad Actor Rules. While this is a helpful effort by the Staff to give practical guidance on the interpretation of these rules, we anticipate that many other open questions will need to be addressed, as issuers and other industry participants continue to refine their practices and policies surrounding these rules and seek to ensure that they are able to rely on the General Solicitation Rules and to otherwise ensure that they are not disqualified from relying on Rule 506 due to the bad acts of their covered persons.