Most private companies that seek to raise capital through the sale of stock or other securities rely on the private placement safe harbor in Rule 506 of Regulation D under the Securities Act of 1933.  The Securities and Exchange Commission (SEC) recently approved changes to Rule 506 that will significantly impact the way companies raise capital, and proposed additional changes to Regulation D that would further alter the traditional fundraising paradigm. This article summarizes the new and proposed rules and provides you with a basic road map for conducting offerings under Rule 506, if and when these rules become effective.
As further described below, three important changes to Rule 506 take effect on September 23, 2013:
In addition, four other material changes to Regulation D have been proposed:
Private Placements With and Without General Solicitation
Despite its widespread use, in the past the utility of Rule 506 has been limited by the prohibition against the use of general solicitation to promote an offering. Historically, Rule 506 has required that a company be able to demonstrate it had a pre-existing, substantive relationship with all persons to whom it offered or sold securities, which necessarily limits the universe of potential investors. The JOBS Act, signed into law in April 2012, directed the SEC to revise Rule 506 to permit general solicitation in certain circumstances, and on July 10, 2013, the SEC approved final rules to implement this directive. In doing so, the SEC also left the existing Rule 506 framework in place, creating two separate safe harbors.
General Solicitation in Offerings Under Rule 506(c)
New Rule 506(c) permits companies to use general solicitation in a private placement provided two new conditions are satisfied. First, the issuer must take “reasonable steps” to verify each purchaser is an accredited investor. Second, all purchasers must meet the definition of “accredited investor,” meaning they must actually be accredited investors or the issuer must have a reasonable belief that they are all accredited investors. Unlike traditional Rule 506, Rule 506(c) permits offers to an unlimited number of non-accredited investors, but does not permit sales to any nonaccredited investors. It is important to note that a company conducting an offering under Rule 506(c) will lose the benefit of the safe harbor if it fails to take “reasonable steps” to verify that each investor is accredited, even if all investors turn out to be accredited.
In adopting Rule 506(c), the SEC elected not to specify any particular method a company must use to verify whether an investor is accredited. Instead, the SEC’s comments to the new rule provide that the reasonableness of the steps taken by an issuer will be an objective determination based on the facts and circumstances of the transaction. The SEC highlighted three factors that will be important in determining whether an investor is accredited:
1. The nature of the purchaser and the type of accredited investor the purchaser claims to be. For instance, reasonable steps taken to verify that the net worth of an individual satisfies the accredited investor threshold would likely differ from reasonable steps taken to verify that an entity is a registered broker or dealer pursuant to Section 15 of the Securities Exchange Act of 1934. This follows from the perception that verifying income and net worth standards of individuals requires more analysis than needed for a company professionally engaged in securities transactions.
2. The amount and type of information the issuer has about the purchaser. For instance, in some cases it may be reasonable for the issuer to rely on self-certification for a purchaser that is well-known to the issuer, but probably is not reasonable for the issuer to do so for purchasers where no pre-existing relationship exists.
3. The nature of the offering and the terms of the offering. For instance, verifying the status of investors solicited through a publicly accessible website, mass email or social media would necessitate greater care by the issuer than an offering made to a prescreened pool of high-net-worth individuals. Similarly, verifying the status of investors in an offering with a small minimum investment threshold would require greater care than one in which the minimum investment amount is high enough to make it likely the investor satisfies the income or net worth standards for accredited investors.
The new rule does, however, include four nonexclusive methods a company may use for determining whether a natural person is accredited:
1. The company may rely upon copies of IRS forms reporting an investor’s income for the past two years that show the necessary income level to qualify as an accredited investor, along with a written representation that he or she has a reasonable expectation of reaching the necessary income level in the current year.
2. The company may rely upon recent financial documents – such as bank statements, brokerage statements, appraisal reports and credit reports – showing the investor has sufficient net worth to qualify as an accredited investor, along with a written representation that all liabilities have been disclosed.
3. The company may rely upon a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney or certified public accountant that such person has determined, using reasonable steps within the past three months, that the investor is an accredited investor.
4. For any person who invested in the company as an accredited investor prior to the effective date of Rule 506(c) (i.e., prior to September 23, 2013) and who has since remained an investor in the company, the company may rely upon a certification by such person that he or she still qualifies as an accredited investor.
Future of Traditional Rule 506 Offerings Without General Solicitation
While Rule 506(c) will allow issuers to reach more potential investors, offerings conducted under the traditional Rule 506 framework, now found in Rule 506(b), will continue to be an important avenue for raising capital because in many cases the costs of complying with the conditions of Rule 506(c) will not justify the potential benefits.
Offerings under Rule 506(b) will have two clear advantages over offerings under Rule 506(c). First, Rule 506(b) does not require that companies verify each purchaser is accredited, and in fact permits up to 35 non-accredited investors if certain conditions are satisfied. As noted above, a company conducting an offering under Rule 506(c) will lose the benefit of the safe harbor if it fails to take “reasonable steps” to verify that each investor is accredited, even if all investors turn out to be accredited. Second, because Rule 506(b) is a true “private offering,” it will still be possible for issuers who do not satisfy all of the requirements of Rule 506(b) to maintain that their financing is not a “public offering” under Section 4(2) of the Securities Act. By contrast, there is no fallback position available for an offering conducted using general solicitation under Rule 506(c). Both of these differences will make offerings under Rule 506(c), on average, more costly than offerings under Rule 506(b).
Bad Actor Disqualification
Along with approving a framework for offerings conducted with general solicitation, at its July 10 meeting the SEC also approved final rules, found in new Rule 506(d), that prevent a company from relying on the Rule 506 safe harbor if any felons or other “bad actors” are participants in the offering. In addition to the issuer, other “covered persons” include predecessors and affiliates of the issuer; any director, executive officer or other officer of the issuer participating in the offering; any beneficial owner of 20% or more of the issuer’s voting stock; and any person who has been or will be paid (directly or indirectly) remuneration for solicitation of investors.
Rule 506(d) includes a long list of securities-related transgressions that trigger the bad actor disqualification, including, among others, conviction within the past 10 years (five years for issuers, their predecessors and affiliates) of a felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the SEC; and becoming subject, at any time within the prior five years, to any order, judgment or decree of a court of competent jurisdiction that restrained or enjoined the person from engaging in any conduct or practice in connection with the purchase or sale of any security or involving the making of any false filing with the SEC. While the prohibition applies only where the trigger event occurs on or after September 23, 2013, companies are required to disclose to investors any event occurring prior to September 23 that otherwise would trigger disqualification.
Rule 506(d) does include an exception from disqualification if the issuer can establish it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed, but the burden will be on the issuer to prove the exception applies. As a result, it will be incredibly important for issuers to screen relevant persons prior to an offering to ensure it is not disqualified from relying on Rule 506.
At its July 10 meeting, the SEC also proposed a number of rules that would impact how offerings are conducted under Rule 506. These proposed rules have not been finalized so no immediate action is required; however, companies should keep them in mind as they plan for offerings in the near future.
Changes to Form D Filing Requirements
Several of the proposals relate to the Form D filing that issuers are currently supposed to make within 15 days following the first sale of securities in an offering relying on Rule 506. First and foremost, under proposed Rule 507, issuers failing to comply with the Form D filing requirements in Rule 503 would be prohibited from relying on Rule 506 for five years or until one year after the issuer has made all required Form D filings for offerings within the past five years, whichever comes first. If a company becomes subject to a court order, judgment or decree enjoining it for failure to comply with Rule 503, the company would be permanently disqualified from relying on Rule 506. Note that while a Form D filing is technically required under current law, it is not necessary to qualify for the Rule 506 safe harbor and therefore the requirement is often ignored.
In addition to making the Form D filing mandatory, the proposed rules would amend Rule 503 to require any issuer conducting an offering under Rule 506(c) to file a preliminary Form D at least 15 days prior to the first use of general solicitation. All issuers relying on Rule 506(b) or 506(c) would also be required to file a closing amendment to the Form D within 30 days following completion or termination of the offering. Under proposed Rule 507, failing to make these filings would result in loss of the safe harbor and disqualification from relying on Rule 506 in the future, as described above.
Finally, the proposed rules would require disclosure of additional information on the Form D, including general information on the intended use of the proceeds from the offering. Issuers conducting an offering under Rule 506(c) would also be required to provide information about the types of general solicitation the company intends to use in the offering and the methods the company uses to confirm all investors are accredited.
In addition to the changes to the Form D filing requirements, the proposed rules would add two other conditions to offerings conducted under Rule 506(c). First, proposed Rule 509 would require all general solicitation materials used in a Rule 506(c) offering to contain legends alerting potential investors to various conditions of the offering, including that the securities may only be sold to accredited investors and that the securities are subject to legal restrictions on transfer and resale. Second, proposed Rule 510T would require that for a period of two years issuers relying on Rule 506(c) must submit to the SEC any written general solicitation materials. As with the Form D filing requirements described above, proposed Rule 507 provides that an issuer would be permanently disqualified from relying on Rule 506 if it or any of its predecessors or affiliates becomes subject to a court order, judgment or decree enjoining it for failure to comply with the foregoing requirements.
The changes to Rule 506 effective September 23 and, if they are eventually approved, the additional changes proposed by the SEC will alter the way companies need to approach fundraising transactions in several respects. In particular, companies will need to do more planning in advance of commencing an offering. This section lays out the steps companies will need to take under the new rules and the additional steps they will need to take if the proposed rules are approved. It is important to keep in mind that the proposed rules are not effective unless and until approved by the SEC following a public comment period (which is currently ongoing) and that they may be modified prior to approval. Thus, beginning September 23, companies may engage in general solicitation in connection with an offering of securities simply by complying with the conditions of 506(c).
The introduction of disqualification rules mean the first thing the issuer must do is determine if it is eligible to rely on Rule 506. For the time being this simply means confirming that no “covered person” under Rule 506(d) is a felon or bad actor. Because Rule 506(d) includes an exception from disqualification if the issuer can establish it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed, issuers should at least require each covered person to confirm, in writing, that such person has not been the subject of an event that would lead to disqualification. It may also be appropriate for the issuer to do additional diligence, particularly on any covered person with whom the issuer does not have a long-standing relationship. If proposed Rule 507 is approved, the issuer will also have to confirm it has properly complied with the new requirements of Rules 503 (Form D filings), 509 (legends on general solicitation materials) and 510T (delivery to the SEC of general solicitation materials) for offerings on or after September 23, 2013, to ensure it is not disqualified from relying on Rule 506.
Once the issuer confirms it is eligible to conduct an offering under Rule 506, it must then decide whether it may want to use general solicitation to promote its offering. If the issuer knows it will not be using general solicitation, it can avoid the additional complexities and cost associated with Rule 506(c). However, if the issuer knows it will use general solicitation, or wants to leave open the possibility, it must comply with Rule 506(c) from the outset. Once an issuer begins to use general solicitation in an offering, it will not be possible to transition back to a “private” offering under Rule 506(b), so the issuer must be prepared to incur the additional costs for the duration of the offering.
Even if the issuer elects to proceed under Rule 506(b), it still needs to think carefully about how it conducts the offering. Going forward, the SEC will likely be monitoring solicitation activities in Rule 506 offerings more carefully (as evidenced by the proposed rules discussed above). In particular, look for the SEC to take a more strict stance on what constitutes a “pre-existing, substantive relationship” between a company and a potential investor. As a result, an issuer should not assume all activities that previously were considered acceptable forms of solicitation under traditional Rule 506 continue to be permitted under Rule 506(b). Until the SEC provides clearer guidance on what constitutes general solicitation, an issuer should carefully document the nature of its relationship with potential investors and be cautious about extending the offering too far beyond its immediate circle of contacts.
If the issuer elects to proceed under Rule 506(c), it will need to carefully consider at the outset the type of general solicitation it plans to use and the method or methods it will use to confirm each investor in the offering is an accredited investor. While the preliminary steps required by the proposed rules will not apply when Rule 506(c) goes into effect on September 23, it would be prudent for the issuer to include the legends prescribed by proposed Rule 509 in all of its general solicitation materials. If the proposed rule requiring a pre-solicitation Form D filing is approved, the issuer will need to be careful not to commence general solicitation before the Form D filing is made. Similarly, if the proposed rule requiring delivery to the SEC of all general solicitation materials is approved, the issuer will need to ensure copies of such materials are submitted through the SEC’s website before being used. Regardless of whether the proposed rules are adopted, any issuer conducting an offering pursuant to Rule 506(c) should maintain careful records of all general solicitation materials used in the offering, the types of general solicitation used and the steps taken to verify that each purchaser of securities in the offering qualifies as an accredited investor.
Once an offering under Rule 506(b) or 506(c) begins, the issuer must take care to comply with applicable federal and state notice filing requirements. At present this only requires a Form D filing and state “blue sky” filings within 15 days after the first sale of securities, but the proposed changes to Rule 503 would also require a closing amendment within 30 days of the end of the offering. If proposed Rule 507 is adopted it will be imperative that the issuer make the necessary Form D filings on time so as to avoid being disqualified from relying on Rule 506 in the future.
The new and proposed changes to Regulation D will significantly impact how companies raise capital in the future. While companies will be permitted to use general solicitation in connection with unregistered offerings, they will also lose the right to rely on the Regulation D safe harbors if the specific conditions of those safe harbors are not satisfied. Until the SEC provides more guidance on what activities constitute general solicitation, companies will need to be particularly careful about how they conduct their offerings.
 In 2011, Rule 506 private placements accounted for approximately $895 billion raised, which was more than public offerings during the same period.
Jonathan Guest, Partner, firstname.lastname@example.org
Jonathan Guest concentrates his practice in corporate and securities law including debt and equity finance (public and private offerings including shelf regulations, registered direct offerings, PIPEs and rights offerings), corporate governance (Sarbanes-Oxley compliance), and domestic and cross-border mergers and acquisitions. He has also advised early-stage companies concerning matters of entity selection, capital structure, "angel" and venture capital finance, secured loans, executive compensation, intellectual property protection, and technology licensing. Jonathan's clients include publicly-traded U.S., Canadian, U.K. and Australian companies involved in pharmaceuticals and drug development, oil and gas as well as natural resource exploration and production, and commercial real estate. He has also advised companies engaged in telecommunications, e-commerce, and software. Jonathan has extensive experience with federal and state securities law matters encountered by foreign companies seeking to raise capital and have their securities traded in the United States. Prior to joining McCarter & English, Jonathan was a partner at one of the largest international law firms.
Mr. Guest has been selected as one of Massachusetts Super Lawyers for 2004-2011.
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Benjamin M. Hron, Special Counsel, email@example.com
Ben Hron is a business law attorney whose practice focuses on advising private companies, most in the life sciences and information technology industries, on general corporate matters, angel and venture capital financing, mergers and acquisitions, securities law compliance and strategic collaborations. He also represents investors in connection with the financing of private companies. Ben has extensive experience working with entrepreneurs and emerging companies, often getting involved when a business is still in its infancy and helping guide the founders through the formative early stages of their company's development. Ben also co-chairs the McCarter & English seminar series for entrepreneurs at the Cambridge Innovation Center.
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James F. Coffey, Partner, firstname.lastname@example.org
James F. Coffey is a partner in McCarter's Corporate, Securities and Financial Institutions Practice Group. He has extensive experience providing strategic counsel to companies in critical phases of transition, including start-ups and early stage development companies seeking angel funding as well as fully mature businesses seeking insight on exit strategies. Mr. Coffey represents emerging companies in several business sectors. Some of his early stage development clients include companies in social networking, carbon credit technology, alternative energy, information technology, e-commerce, life sciences and consumer products, among others.
Full Bio (http://www.mccarter.com/James-F-Coffey/)
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
Joseph W. Bartlett is special counsel in the Corporate, Securities and Financial Institutions practice. A recognized pioneer of the national private equity and venture capital bar, Mr. Bartlett contributed to the original models for private equity and fund of fund partnerships. His experience extends to alternative investments, venture capital, emerging companies, corporate restructurings, private equity and buyouts. Mr. Bartlett's practice includes serving as counsel to asset managers, including those of major public and private equity funds, with a focus on technology companies, and he has also served as trustee of a series of public mutual funds and chair of a public REIT. His venture fund work began with the first Greylock fund, and he has drafted documents for several of the largest and most successful LBO funds.
Full Bio (http://www.mccarter.com/Joseph-W-Bartlett/)
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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from McCarter & English, LLP. This work reflects the law at the time of writing in October 2013.