Private Offerings

The SEC’s Proposed Rules and Amendments to Allow General Solicitation and General Advertising in Private Offerings

by Vanessa Schoenthaler on September 3, 2012

In an open meeting last Wednesday the Securities and Exchange Commission voted to propose rules and amendments to implement Section 201(a) of the JOBS Act, which is responsible for eliminating the prohibition on general solicitation and general advertising in private offerings conducted pursuant to Rule 506 of Regulation D and private resales conducted pursuant to Rule 144A of the Securities Act of 1933; provided that, in the case of Rule 506, all purchasers are accredited investors and reasonable steps have been take to verify their status as such, and, in the case of Rule 144A, all purchasers are qualified institutional buyers.

In 2011 issuer’s raised an estimated $895 billion in offerings using Rule 506 and an estimated $168 billion in offerings using Rule 144A. In 2010 those numbers were even higher, with an estimated $902 billion raised in offerings using Rule 506 and an estimated $233 billion raised in offerings using Rule 144A. In reality the Rule 506 numbers may be higher still, as even the Commission acknowledges that not everyone who uses the exemption files a Form D (which is a requirement, but not a condition to the availability, of the exemption).

Offers and Sales that Involve General Solicitation and General Advertising Under Rule 506

Under the proposed rules and amendments a new subsection (c) would be added to Rule 506 which would permit general solicitation and general advertising in offers and sales of securities provided that:

  • the issuer of the securities–whether a company or a private investment fund, such as a hedge fund, venture capital fund or private equity fund–takes “reasonable steps to verify” that the purchasers are accredited investors;
  • all of the purchasers are accredited investors because at the time of the sale of the securities they either came within the definition of an accredited investor, as set forth in Rule 501(a) of Regulation D, or the issuer reasonably believed that they came within the definition; and
  • all of the terms and conditions of Rules 501 (Definitions), 502(a) (Integration) and 502(d) (Limitations on resale) of Regulation D are met.

Note: offers and sales of securities made pursuant new Rule 506(c) would not be subject to the information disclosure requirements of Rule 502(b), because all of the purchasers in such an offering would be accredited investors.

Reasonable Steps to Verify Accredited Investor Status

In an effort to provide flexibility to accommodate the various types of issuers, investors and methods of verification, the Commission declined to define what constitutes taking “reasonable steps to verify” that a purchaser is an accredited investor. Instead the proposing release indicates that reasonableness should be an objective determination, based on the facts and circumstances surrounding a given transaction. The proposing release also goes on to discuss in some detail three factors that an issuer might consider, among others, when assessing the reasonable likelihood that a purchaser is an accredited investor and the reasonable steps that would be necessary to verify a purchaser’s status as such.

The Nature of the Purchaser

The first factor to consider is the nature of the purchaser and the type of accredited investor that the purchaser claims to be. For example, verifying that a broker-dealer is an accredited investor by virtue of being registered under Section 15 of the Securities Exchange Act of 1934, can be accomplished by simply conducting a FINRA BrokerCheck search. Whereas verifying that an individual purchaser is an accredited investor under the annual income or net worth standards may require several steps and raise additional issues, such as privacy concerns regarding the type of personal financial information that a purchaser may need to provide to verify their status as an accredited investor.

Information About the Purchaser

The second factor to consider is the amount and type of information that an issuer has about a purchaser. For example, certain verifying information may already be in the public domain, such as information about a purchaser’s annual income garnered from a proxy statement or information found in a Form 990 about a non-profit organization’s total assets. Other third-party information that is not available publicly may also provide reasonably reliable evidence of a purchaser’s accredited investor status, such as copies of an individual’s Forms W-2 or 1099 to verify annual income. Additionally, a purchaser’s status as an accredited investor might be verified by a third-party service provider, such as a broker-dealer, attorney, accountant or other reasonably reliable third-party that offers verification services.

The Nature and the Terms of the Offering

The third factor to consider is really twofold: the nature of the offering and the terms of the offering. For example, the manner in which a purchaser is solicited, such as through a website accessible to the general public, a widely disseminated email or by social media, as compared to from a database of pre-screened accredited investors maintained by a reasonably reliable third-party, will require a greater or lesser number of steps to verify that the purchaser is an accredited investor. Likewise, the terms of the offering itself may bear on the number of steps required to verify that a purchaser is an accredited investor. For example, in the release the Commission notes that it tends to agree with the view that a purchaser’s ability to meet a high minimum investment amount could be relevant to an issuer’s evaluation of the steps necessary to verify the purchaser’s status as an accredited investor.

A Note on the Importance of Adequate Record Keeping

The proposing release also stresses the importance of an issuer retaining adequate records that document the steps taken to verify a purchaser’s status as an accredited investor because, in the event that a question should ever arise, the burden of demonstrating entitlement to an exemption from registration falls entirely on the issuer.

Offers and Sales that Do Not Involve General Solicitation and General Advertising Under Rule 506

In its current form, Rule 506 permits offers and sales of securities to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors, provided that when non-accredited investors participate in an offering the information disclosure requirements of Rule 502(b) are met. As proposed the rules and amendments would preserve Rule 506 in its existing form in amended subsection (b), maintaining the rule’s availability for those issuers who do not wish to engage in general solicitation and general advertising, and thus avoid becoming subject to the requirement that they take reasonable steps to verify purchasers’ accredited investor status, as well as those issuers who would like the option to include sophisticated non-accredited investors in their offerings.

General Solicitation and General Advertising Under Rule 144A

Under the proposed rules and amendments Rule 144A of the Securities Act would also be revised to permit offers of securities to persons other than qualified institutional buyers (QIBS), including by means of general solicitation and general advertising, provided that the securities are sold only to persons that the seller, or anyone acting on the seller’s behalf, reasonably believe to be a QIB.

Proposed Changes to Form D

Finally, the Commission is also proposing to revise Form D to add a separate box to be checked when an issuer uses general solicitation or general advertising in a Rule 506(c) offering. Such information would allow the Commission to get a general sense of the size of the market for offerings that use general solicitation and general advertising.

Comment Period

The Commission is soliciting comments on a number of aspects of the proposed rules and amendments, most notably on a variety of issues related to verification of accredited investor status. Comments are due 30 days from publication of the proposed rules and amendments in the Federal Register.

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The JOBS Act in a Nutshell – Part III General Solicitation and Private Offering Platforms

by Vanessa Schoenthaler on April 30, 2012

Jumpstart Our Business StartupsThe JOBS Act makes several significant changes to the rules surrounding private capital formation. One such change being the much-discussed elimination of the prohibition on general solicitation and general advertising in certain private securities offerings. Another being the addition of an exemption from broker-dealer registration for platforms that, to a certain extent, facilitate offers and sales of unregistered securities.

General Solicitation and General Advertising in Private Offerings

Section 201 of the JOBS Act requires that within 90 days of its enactment, or by July 4, 2012, the Securities and Exchange Commission revise Regulation D to eliminate the prohibition on general solicitation and general advertising in private offerings made in reliance on the safe harbor afforded by Rule 506, provided that only accredited investors participate in the offerings.

In its current form, Rule 506 allows an unlimited amount of capital to be raised from an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors, provided, however, that whenever non-accredited investors participate in an offering certain information disclosure requirements must be met. In its current form Rule 506 also explicitly prohibits general solicitation and general advertising, regardless of whether participating investors are accredited or non-accredited.

Section 201 of the JOBS Act also requires that the Commission, again by July 4, 2012, revise Rule 144A to provide that securities sold thereunder may be offered to persons other than qualified institutional buyers (QIBs), including by means of general solicitation or general advertising, provided that the securities are ultimately sold only to persons that the seller or anyone acting on the seller’s behalf reasonably believe to be QIBs.

Like Rule 506, Rule 144A is a safe harbor for sales of unregistered securities. Where they differ is that Rule 506 addresses sales of securities by an issuer (akin to a primary offering), whereas Rule 144A addresses resales by persons other than an issuer (akin to a secondary offering). Very generally, the safe harbor afforded by Rule 144A allows for resales of a limited category of qualifying securities to QIBs. Rule 144A resales often follow in close proximity to the private offering in which the securities being resold were originally issued.

So how are these changes going to impact the market for private securities offerings?

Insofar as Rule 506 offerings are concerned, over time we may see a shift from other types of Regulation D offerings to Rule 506 offerings, but lifting the ban on general solicitation and general advertising is not likely to have a significant impact on the type of investors participating in Rule 506 offerings.

Based on a recent report by the Commission’s Division of Risk, Strategy and Financial Innovation (FSHI), Rule 506 is already by far the most popular private offering exemption; used in over half of all the private offerings examined in FSHI’s report. And, even though Rule 506 allows for participation by up to 35 non-accredited investor, almost 90% of all Regulation D offerings (Rules 504, 505 and 506 combined) are made up entirely of accredited investors. So, while we may ultimately see even more Rule 506 offerings, there’s not much room for a shift in the ratio of non-accredited to accredited investors.

As for transactions set up to take advantage of the Rule 144A resale exemption, they only make up a small number of the private offerings conducted each year and they generally involve larger companies that already are, or immediately become, subject to the Exchange Act’s reporting requirements. Compared to Rule 506 offerings, Rule 144A transactions are fairly niche and, while I don’t have anything in the way of stats to back it up, I don’t think that we’re going to see any great shift toward Rule 144A offerings just because general solicitation and general advertising is permitted.

Where lifting the ban on general solicitation and general advertising will undoubtedly have the greatest impact is in the amount of information about private offerings that becomes publicly available. Hopefully this will result in a better understanding of how private capital formation works, as opposed to an overload of information that is of diminishing value or quality.

One other item of note here is that, despite the JOBS Act having taken effect, the current prohibition on general solicitation and general advertising remains in place until the Commission adopts amended or new implementing rules and those rules themselves take effect.

The Platform Exemption to Broker-Dealer Registration

Finally, Section 201 the JOBS Act creates an entirely new exemption from the broker-dealer registration requirements for anyone that maintains a platform or other mechanism that permits offers, sales, purchases or negotiations of securities, or permits general solicitation, general advertising or related activities by an issuer that is offering securities, regardless of whether those activities take place online, in person or by some other means.

What’s more, the exemption is available even if the person maintaining the platform invests in or provides “ancillary services” related to the securities that are made available through the platform. Ancillary services are defined to include due diligence services, provided no compensated investment advice is given, and the provision of standardized documents, provided there is no involvement in the negotiation process and the parties are free to use their own transaction documents if they choose to.

Lastly, the exemption is contingent on there being no transaction related compensation, no possession of securities or customer funds and no involvement by persons subject to statutory disqualification under Section 3(a)(39) of the Exchange Act.

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The SEC’s Final Rules For Calculating Net Worth Under the Definition of Accredited Investor

by Vanessa Schoenthaler on December 22, 2011

Yesterday the Securities and Exchange Commission adopted final rules and amendments conforming the net worth standard under the definition of accredited investor to the requirements of Section 413(a) of the Dodd-Frank Act. The Commission’s rules and amendments are effective as of February 27, 2012, but the amended net worth standard has been in effect since the Dodd Frank Act was enacted on July 21, 2010.

The General Rule

To qualify as an accredited investor under the amended net worth standard, an individual investor must have a net worth, alone or jointly with their spouse, in excess of $1,000,000 excluding the estimated fair market value of their primary residence.

Subject to certain exceptions, any indebtedness secured by an investor’s primary residence, up to its estimated fair market value at the time of the sale of the securities, should be excluded from the liability side of the net worth equation. Meaning that you only need to exclude the positive equity in an investor’s primary residence when calculating their net worth.

The Commission illustrates this general rule with the example of an investor that has:

  • a net worth of $2,000,000 (calculated by using the commonly accepted definition of net worth, i.e., the difference between the value of the investor’s total assets, including their primary residence, and the value of their total liabilities, including any indebtedness secured by their primary residence);
  • a primary residence with an estimated fair market value of $1,200,000 at the time of the sale of the securities; and
  • indebtedness secured by the primary residence (a mortgage) in the amount of $800,000.

How do you calculate the investor’s net worth under the amended standard? First you have to calculate the positive equity in their primary residence:

Then you can determine their net worth under the amended standard:

The 60-Day Look-Back — The Refinancing Scenario

The liability side of the net worth equation should generally include any incremental increase in the amount of indebtedness secured by an investor’s primary residence (e.g., a refinancing, second mortgage or home equity loan, etc.) that is incurred during the 60-day period prior to the sale of the securities, even if the estimated fair market value of the investor’s primary residence exceeds the total amount of the indebtedness incurred.

The one exception to this requirement is for indebtedness incurred during the 60-day look-back period as part of an investor’s acquisition of a new primary residence. 

Negative Equity — The Underwater Mortgage Scenario

The liability side of the net worth equation should also include any excess of indebtedness secured by an investor’s primary residence over its fair market value (e.g., an underwater mortgage). Meaning that you need to reduce an investor’s net worth by the amount of any negative equity in their primary residence.

Limited Grandfathering of Certain Formerly Accredited Investors

The final rule provides for limited grandfathering under which the former accredited investor net worth standard will apply to certain purchases of securities by an investor that would not otherwise qualify under the new accredited investor net worth standard, provided that:

  • the right to purchase those securities was held on or before July 20, 2010 (the day before enactment of the Dodd-Frank Act);
  • at the time the investor acquired the right they qualified as an accredited investor under the former net worth standard; and
  • the investor held securities of the same issuer, other than the right, on July 20, 2010.

The grandfathering provision applies to the exercise of:

  • statutory rights, such as pre-emptive rights arising under state law;
  • rights derived from an issuer’s constituent documents, such as its certificate of incorporation; and
  • contractual rights, such as rights to acquire securities upon exercise of an option or warrant or conversion of a convertible instrument, rights of first offer or refusal and contractual pre-emptive rights.

Interesting Asides

Some interesting statistics from the final rule’s adopting release:

For the Commission’s fiscal year ended September 30, 2010:

  • 22,941 issuers filed a Notice of Exempt Offering of Securities on Form D;
  • 17,593 of those were initial Form D filings (filings for new offerings);
  • only 66, or 0.4%, of the initial Form D filings relied on an exemption from registration afforded by Section 4(5) (formerly Section 4(6)) of the Securities Act;
  • it’s interesting how the Commission presents this and the next data point, it might not make sense at first (the numbers don’t immediately add up), but if you think it through, it works: 16,856, or 96%, of the initial Form D filings relied on an exemption from registration afforded by one of the rules promulgated under Regulation D;
  • 834 of the initial Form D filings relied on an exemption from registration afforded by both Section 4(5) and one of the rules promulgated under Regulation D; and
  • finally, the median size of an offering relying on an exemption from registration afforded by one of the rules promulgated under Regulation D was approximately $1,000,000.

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The SEC Releases its 29th Annual Forum on Small Business Capital Formation Report

by Vanessa Schoenthaler on June 14, 2011

Earlier today the Securities and Exchange Commission released its Final Report from the 29th Annual Forum on Small Business Capital Formation held in November 2010.

This year’s forum yielded 36 recommendations from three working groups and a number of written recommendations submitted by organizations concerned with small business capital formation.

Participation was down slightly, with a total of 60 participants in the three working groups, as compared to 72 last year, and with 37% voting to rank each of the final recommendations, as compared to 44% last year.

There are a few proposals that show up each year, but many of this year’s recommendations focus on Regulation A, the requirements of Exchange Act Section 12(g) and scaled reporting/eligibility requirements for smaller issuers.  The top 5 recommendations include proposals that the Commission:

  • specifically consider the impact of Dodd-Frank Act rulemaking on small business investing;
  • adopt a private offering exemption that does not prohibit the general solicitation of, or advertising to, purchasers that do not need the protections afforded by Securities Act registration;
  • provide better scaling of reporting requirements for smaller companies;
  • exempt companies with a market capitalizations of less $250 million from Section 404(b) of the Sarbanes-Oxley Act (we already know that this one was rejected in April); and
  • increase the permissible offering amount under Regulation A and the number of shareholders that trigger registration under Section 12(g) of the Exchange Act (As an aside: both Fortune and PeHUB are reporting today that there’s a bill in the works that may actually take care of the latter portion of this proposal, by increasing Section 12(g)’s shareholder trigger requirement from its current level of 500 holders of record to 1,000 holders of record exclusive of accredited investors and employees holding stock options.).

(Download File)

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The SEC Proposes Rules for Disqualification of Felons and Other Bad Actors from Rule 506 Offerings

by Vanessa Schoenthaler on May 26, 2011

In addition to final rules and forms implementing the whistleblower program, yesterday the Securities and Exchange Commission also voted, by a margin of 3-2, to propose a series of rule amendments designed to implement Section 926 of the Dodd-Frank Act.

Section 926 requires the adoption of rules disqualifying an offering from reliance on Rule 506 of Regulation D when certain felons or other “bad actors” are involved in the offering. Rule 506 is by far the most widely claimed exemption under Regulation D. For the 12 month period ended September 30, 2010 the Commission received 17,292 initial filings for offerings under Regulation D, of those 16,027 claimed a Rule 506 exemption.

The Actors

As proposed the rule amendments would add a new subsection (c) to Rule 506 entitled “Bad Actor Disqualification”, and would apply to bad acts committed by:

  • the company or any predecessor or affiliated company;
  • the company’s officers, directors, general partners or managing members;
  • beneficial owners of 10% or more of a company’s equity securities;
  • any promoter connected to the company in any capacity at the time of sale;
  • any person that has been or will be paid, directly or indirectly, for the solicitation of purchasers in connection with an offering; and
  • any officers, directors, general partners or managing members of a compensated solicitor.

The Bad Acts

The bad acts triggering disqualification would include:

  • criminal convictions in connection with: the purchase or sale of securities; the making of false filings with the Commission; or the business of an underwriter, broker-dealer, municipal securities advisor or paid solicitor of securities, that have occurred within 10 years of the offering (or 5 years in the case of the company, or a predecessor or affiliated company);
  • being subject to a court injunction or restraining order within 5 years of the offering that, at the time of the offering, prohibits a person from engaging in: conduct in connection with the purchase or sale of securities; the making of false filings with the Commission; or the business of an underwriter, broker-dealer, municipal securities advisor or paid solicitor of securities;
  • being subject to a final order by certain state or federal regulators that, at the time of the offering, bars a person from: association with an entity regulated by the Commission; engaging in the business of securities, insurance or banking; engaging in savings association or credit union activities; or is based on a violation of law or regulation that prohibits fraudulent, manipulative or deceptive conduct entered within 10 years of the offering;
  • certain Commission disciplinary orders related to broker-dealers, municipal securities dealers, investment advisers and investment companies and their associated persons;
  • suspension or expulsion from membership in, or suspension or bar from associating with, a member of a securities self-regulatory organization;
  • being subject to a refusal order, stop order or order suspending a Regulation A exemption within 5 years of the offering; and
  • being subject to a U.S. Postal Service false representation order within 5 years of the offering.

One Exception

The proposed rule amendments contain a reasonable care exception which provides that a company would not lose the benefit of the Rule 506 exemption, regardless of the existence of a disqualifying bad act, if the company can show that it did not know and, in the exercise of reasonable care, could not have know of the disqualification. Establishing reasonable care requires doing your diligence, i.e., conducting a factual inquiry into whether any disqualification exists; the nature and scope of the inquiry will depend on the facts and circumstances of the offering.

The Controversial Provision

At the Commission’s open meeting, one of the more controversial aspects of the proposed rule amendments was the inclusion of disqualifying events that pre-date enactment of the Dodd-Frank Act in the look-back period for bad acts under the rule.

In other words, as currently proposed, if an actor covered by the new rule amendments entered into a negotiated settlement agreement with a federal or state regulator prior to enactment of the Dodd-Frank Act that settlement agreement will still disqualify the actor from participating in Rule 506 offerings, even if they might not have settled had they known at the time that it would have resulted in disqualification.  For a complete discussion of the issue take a look at pages 44-49 of the Commission’s proposing release.

Both Commissioners Casey and Paredes took issue with this provision and ultimately voted against the proposed rules and amendments.

The Commission is soliciting public comments on the proposed rules and amendments, which are due on or before July 14, 2011.

 

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Dodd-Frank Act Amends the Definition of Accredited Investor

by Vanessa Schoenthaler on August 2, 2010

On July 21, 2010 President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law.  The Dodd-Frank Act focuses primarily on financial institutions; however, there are several provisions that affect non-financial institutions, like Section 413(a)’s adjustment to the definition of “accredited investor”.

Prior to enactment of the Dodd-Frank Act a person was considered an accredited investor under both Rules 215 and 501(a)(5) of the Securities Act if:

  • in each of the two most recent years they had income in excess of $200,000, or in excess of $300,000 jointly with a spouse, and had a reasonable expectation of reaching that same income level in the current year; or
  • they had a net worth, individually or jointly with a spouse, in excess of $1,000,000.

Section 413(a) adjusts this second standard by requiring that any calculation of net worth exclude the value of a person’s primary residence.  This adjustment is effective immediately.

The Securities and Exchange Commission, in responding to inquiries on how to determine the value of a primary residence, has updated its Compliance and Disclosure Interpretations (here and here) with the following guidance:

Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth.

So, until the Commission completes its rulemaking process and amends Rules 215 and 501(a)(5) of the Securities Act (which you can comment on here):

  • If you’re an investor trying to determine whether you’re accredited under the new net worth standard you have to exclude the value of your primary residence from the calculation and, if you have any negative equity (if you’re underwater on your mortgage), you have to further reduce your net worth by that amount of negative equity.
  • If you’re a company or fund trying to raise money you should revise your subscription documents to include language that reflects the adjusted net worth standard for individual accredited investors.

(h/t to Kevin for some of the research on this first post)

On July 21, 2010 President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The Dodd-Frank Act focuses primarily on financial institutions; however, there are several provisions that affect non-financial institutions, like Section 413(a)’s adjustment to the definition of “accredited investor”.

Prior to enactment of the Dodd-Frank Act a person was considered an accredited investor under both Rules 215 and 501(a)(5) of the Securities Act if:

· in each of the two most recent years they had income in excess of $200,000, or in excess of $300,000 jointly with a spouse, and had a reasonable expectation of reaching that same income level in the current year; or

· they had a net worth, individually or jointly with a spouse, in excess of $1,000,000.

Section 413(a) adjusts the latter category by requiring that any calculation of net worth exclude the value of a person’s primary residence. This adjustment is effective immediately.

The SEC, in responding to inquiries on how to determine the value of a primary residence, has updated its Compliance and Disclosure Interpretations (here and here) with the following guidance:

Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth.

So, until the SEC completes its rulemaking process and amends Rules 215 and 501(a)(5) of the Securities Act:

· if you’re an investor trying to determine whether you’re accredited under the net worth category then you have to exclude the value of your primary residence from your calculation, and if you have any negative equity (if you’re underwater on your mortgage) then you also have to reduce your net worth by an equal amount.

· if you’re a company or a fund trying to raise money then you have to revise your offering documents

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