On July 10, 2013, the Securities and Exchange Commission (the “SEC”) adopted rules that repealed a long-standing ban on the use of general solicitation for private securities offerings. These changes will be effective in approximately 60 days and will allow companies to publicly offer their securities to any one provided these securities are sold only to investors a company reasonably believes are accredited1and a company has taken reasonable steps to verify this accreditation.2
New Requirement: Reasonable Steps to Verification
While the new rules open up a whole new avenue for companies and private funds, such as venture capital funds, private equity funds and hedge funds, to raise capital, the verification requirements in the new rules present significant risks if they are not performed properly. The SEC adopted two approaches it may use to determine whether or not a company’s steps to verify an investor’s accredited status are reasonable: a so-called objective, principles-based approach and a non-exclusive list of verification methods presumed to be reasonable for individual investors.
The Principles-Based Approach
In order to qualify under the principles-based approach, a company must use verification methods that are reasonable under the circumstances. For example, if a company has actual knowledge of an investor’s accredited status, then no further verification would be required. Absent actual knowledge, however, an issuer is required to use a method which is reasonable in light of the various factors surrounding the offering, including:
- The nature of the investor and the type of accredited investor the investor claims to be;
- The amount and type of information that a company has about an investor; and
- The nature of the offering, such as the type of solicitation used and the terms of the offering, such as the minimum investment amount.
It is important to note here that even if a company ultimately only issues securities to accredited investors, it may still violate the new rules if it does not also utilize reasonable verification procedures. Compliance with the new rules is critical because once a company uses general solicitation techniques such as print, internet or other media advertising for its offering, there will likely be no other exemption from the registration requirements of the 1933 Act and the offering may be deemed to be an unregistered public offering in violation of the 1933 Act resulting in significant potential penalties, including rescission rights on behalf of the investors.
Currently, many companies rely on the use of accredited investor questionnaires and accredited investor representations in transaction documents to determine if potential investors are accredited. The SEC now makes clear that self-accreditation by an investor by checking a box in a questionnaire is not sufficient if an issuer uses general solicitations. Rather, companies seeking to generally solicit must now take steps to independently verify items typically requested in a questionnaire.
Non-exclusive Documentation Methods
The SEC did provide in the new rules a non-exclusive list of acceptable documents which may be relied upon to satisfy the new verification requirement with respect to individuals. The list includes:
- Third Party Attestations: Written confirmation (dated no more than three months prior to investment) from a registered broker dealer, an SEC registered investment adviser, a licensed attorney, or certified public accountant that such person or entity has taken reasonable steps to verify that an investor is accredited;
- Income Verification Materials: Copies of tax return documents and W2’s for the most recent two years along with written representations from the investor stating a reasonable expectation of reaching the required income level in the year of investment; or
- Net Worth Verification Materials: Financial statements and/or appraisal reports by independent third parties dated within the prior three months to the investment along with a credit report from a credit reporting agency showing an investor’s assets and liabilities.
New Filing and Information Requirements
The SEC also proposed for comment a series of new rules imposing significant additional filing and information requirements with respect to Rule 506 offerings marketed through general solicitation. These proposals include:
- Amendments to Form D imposing additional information requirements;
- Restrictions on a company’s ability to use Rule 506 if it previously failed to file a Form D for a prior Rule 506 offering;
- Mandatory advanced filing of a Form D at least 15 days prior to engaging in any (written or oral) general solicitation and a new termination filing amendment that must be filed no later than 30 days after completing (or abandoning) the offering3;
- Temporary requirements that companies using general solicitation file copies of all written solicitation materials with the SEC for the next two years (however, these materials will not be disclosed by the SEC); and
- New legend requirements for written general solicitation materials regarding accreditation requirements and certain performance disclaimers.
Final Rules Regarding New Bad Actor Provisions
As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC also adopted new “bad actor” provisions restricting the ability of companies controlled by certain bad actors from using Rule 506. Actions which may subject a person to disqualification as a bad actor include certain felonies and regulatory violations concerning the offer and sale of securities.
The ability to use general solicitation to market a company’s securities to an unlimited number of accredited investors presents a landmark opportunity for companies seeking to raise capital in the private equity space, but companies should be mindful of the additional verification and specific filing requirements found in the new and proposed rules.
1 Regulation D of the Securities Act of 1933 (the “1933 Act”) specifies eight types of accredited investors. For individuals, the standard requires either a net worth of $1 million (excluding the value of any primary personal residence), or income exceeding $200,000 in each of the two most recent tax years or joint income with a spouse exceeding $300,000 for the previous two tax years and a reasonable expectation that an individual expects the same level of income in the current year.
2 Companies are currently permitted to issue an unlimited amount of securities in private offerings without the use of general solicitation to up to 35 unaccredited investors and an unlimited number of accredited investors under the previous version of Rule 506 of Regulation D of the 1933 Act (“Rule 506”). Issuers offering securities under the current version of Regulation D are required to file a “Form D” with the SEC within 15 days following the first sale in an offering. Under the new rules, issuers will still be permitted to conduct offerings under the current Rule 506 provisions without the use of general solicitation. These new verification requirements are for Rule 506 offerings that engage in general solicitations.
3 The date in which an issuer first generally solicits an offering is not always readily determinable. Given the new restrictions related to the failure to timely file a Form D, issuers may wish to consider filing a Form D prior to engaging in any activity that could be deemed a general solicitation. As a practical matter, issuers who have not already done so should consider adopting internal policies and procedures controlling and monitoring communications regarding prospective security offerings.