SEC Issues New Rule 506 Guidance

 Securities Lawyer 101 Blog

On January 3, 2014, the Securities and Exchange Commission (the “SEC”) released Compliance and Disclosure Interpretations.  The release provided useful information about several topics including the JOBS Act’s recently enacted Rule 506 (c) of Regulation D.

Under the federal securities laws, the purchase or sale of a security must be subject to a registration statement under the Securities Act of 1933 (the “Securities Act”) or exempt from registration. Section 4(a)(2) provides an exemption from securities registration for transactions by an issuer not involving a public offering. Rule 506 of Regulation D under the Securities Act provides an exemption for private placement offerings that do not to involve a public offering under Section 4(a)(2). The JOBS Act amended Rule 506(c) to allow general solicitation and advertising in offerings so long as sales are made only to accredited investors.  Rule 506(c) streamlines the going public process and provides a method for issuers to raise capital both before and after their transaction is complete.

The SEC’s new Compliance and Disclosure Interpretations related to Rule 506 of Regulation D are summarized below.

Question:  An issuer commenced an offering in reliance on Rule 506 before September 23, 2013, the effective date of the new Rule 506(c) exemption, and filed a Form D notice for the offering.  If, pursuant to the transition guidance in Securities Act Release No. 9415 (July 10, 2013), the issuer decides to continue that offering after September 23, 2013 in accordance with Rule 506(c), is the issuer required to file an amendment to the previously-filed Form D to indicate that the issuer is now relying on the Rule 506(c) exemption?

Answer:  Yes.  As the decision to continue the offering in reliance on Rule 506(c) represents a change in the information provided in the previously-filed Form D, the issuer must file an amendment to the Form D and check the Rule 506(c) box to indicate its reliance on this exemption.  If the issuer decides to continue the offering in reliance on Rule 506(b), no amendment to the previously-filed Form D is required solely to reflect this decision.

Question:  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.  Subsequent to the sale, it becomes known that the purchaser did not meet the financial or other criteria in the definition of “accredited investor” at the time of sale.  Assuming that the other conditions of Rule 506(c) were met, is the exemption available to the issuer for the offer and sale to the purchaser?

Answer:  Yes.  An issuer does not lose the ability to rely on Rule 506(c) for an offering if a person who does not meet the criteria for any category of accredited investor purchases securities in the offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of the sale of securities.

Question:  An issuer intends to conduct an offering under Rule 506(c).  If all of the purchasers in the offering met the financial and other criteria to be accredited investors but the issuer did not take reasonable steps to verify the accredited investor status of these purchasers, may the issuer rely on the Rule 506(c) exemption?

Answer:  No.  The verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors.  The verification requirement must be satisfied even if all purchasers happen to be accredited investors.  Under the principles-based method of verification, however, the determination of what constitutes reasonable steps to verify is an objective determination based on the particular facts and circumstances of each purchaser and transaction.

Question:  An issuer chooses to verify the accredited investor status of a purchaser in a Rule 506(c) offering by using the net worth verification method provided in the rule and, as required under this method, reviews the relevant documentation dated within the prior three months.  If, at the time the purchaser decides to purchase securities in the offering, the previously submitted documentation is not dated within the prior three months of the time of the sale of securities, may the issuer continue to rely on the net worth verification method provided in the rule?

Answer:  No.  An issuer may satisfy the verification requirement of Rule 506(c) by either using the principles-based method of verification or relying upon one of the specific, non-exclusive verification methods listed in the rule.  Although use of the non-exclusive verification methods is not required, an issuer that chooses to use one of the methods must satisfy the specific requirements of that method.  In order to comply with the net worth verification method provided in the rule’s non-exclusive list, the relevant documentation must be dated within the prior three months of the sale of securities.  If the documentation is older than three months, the issuer may not rely on the net worth verification method, but may instead determine whether it has taken reasonable steps to verify the purchaser’s accredited investor status under the principles-based method of verification.

Question:  Does the third-party verification method in the non-exclusive list of verification methods in Rule 506(c) include written confirmations from an attorney or certified public accountant who is licensed or duly registered, as the case may be, in good standing in a foreign jurisdiction?

Answer:  Yes.  This method of verification is not limited to written confirmations from attorneys and certified public accountants who are licensed or registered in a jurisdiction within the United States.

Question:  Does the verification method for existing investors in the non-exclusive list of verification methods apply to new issuers that have the same sponsor as the issuer in which the investor purchased securities in a prior Rule 506(b) offering (for example, a new limited partnership organized by a general partner where the investor purchased securities of a prior limited partnership sponsored by the same general partner)?

Answer:  No.  This non-exclusive method of verification is, by its terms, limited to verification of existing investors who purchased securities in the same issuer’s Rule 506(b) offering as accredited investors prior to September 23, 2013 and continue to hold such securities.

Question:  If an issuer commenced an offering intending to rely on Rule 506(c) but did not engage in any form of general solicitation in connection with the offering, may the issuer subsequently determine to rely on Rule 506(b) for the offering?

Answer:  Yes, as long as the conditions of Rule 506(b) have been satisfied with respect to all sales of securities that have occurred in the offering.  To the extent the issuer already filed a Form D indicating its reliance on Rule 506(c), it must amend the Form D to indicate its reliance on Rule 506(b) instead, as that decision represents a change in the information provided in the previously-filed Form D.

Question:  If an issuer commenced an offering in reliance on Rule 506(b), may the issuer determine, prior to any sales of securities in the offering, to rely on Rule 506(c) for the offering?

Answer:  Yes, as long as the conditions of Rule 506(c) are satisfied with respect to all sales of securities in the offering.  To the extent the issuer already filed a Form D indicating its reliance on Rule 506(b), it must amend the Form D to indicate its reliance on Rule 506(c) instead, as that decision represents a change in the information provided in the previously-filed Form D.

Question:  If the conditions of Rule 506(c) are not met in a purported Rule 506(c) offering, could the Securities Act Section 4(a)(2) private offering exemption be available to the issuer?

Answer:  If the issuer has engaged in general solicitation, no.  As stated in Securities Act Release No. 9415 (July 10, 2013), the mandate in the JOBS Act to permit general solicitation for a subset of Rule 506 offerings affects only Rule 506 and not Section 4(a)(2) offerings in general.  The use of general solicitation continues to be incompatible with a claim of exemption under Section 4(a)(2).

Question: When is an issuer required to determine whether bad actor disqualification under Rule 506(d) applies?

Answer: Rule 506(d) disqualifies an offering of securities from reliance on a Rule 506 exemption from Securities Act registration. Issuers must therefore determine if they are subject to bad actor disqualification any time they are offering or selling securities in reliance on Rule 506. An issuer that is not offering securities, such as a fund that is winding down and is closed to investment, need not determine whether Rule 506(d) applies unless and until it commences a Rule 506 offering. 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.

Question: If a placement agent or one of its covered control persons, such as an executive officer or managing member, becomes subject to a disqualifying event while an offering is still ongoing, could the issuer continue to rely on Rule 506 for that offering?

Answer: Yes, the issuer could rely on Rule 506 for future sales in that offering if the engagement with the placement agent was terminated and the placement agent did not receive compensation for the future sales. Alternatively, if the triggering 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 no longer performed roles with respect to the placement agent that would cause them to be covered persons for purposes of Rule 506(d).

Question: For purposes of Rule 506(d), does an “affiliated issuer” mean every affiliate of the issuer that has issued securities?

Answer: No. Under Rule 506(d), an “affiliated issuer” of the issuer is an affiliate (as defined in Rule 501(b) of Regulation D) of the issuer that is issuing securities in the same offering, including offerings subject to integration pursuant to Rule 502(a) of Regulation D. Securities Act Forms C&DIs 130.01 and 130.02 provide examples of co-issuer or multiple issuer offerings.

Question: Are compensated solicitors limited to brokers, as defined in Exchange Act Section 3(a)(4), who are subject to registration pursuant to Exchange Act Section 15(a)(1), and their associated persons?

Answer: No. All persons who have been or will be paid, directly or indirectly, remuneration for solicitation of purchasers are covered by Rule 506(d), regardless of whether they are, or are required to be, registered under Exchange Act Section 15(a)(1) or are associated persons of registered broker-dealers. The disclosure required in Item 12 of Form D expressly contemplates that compensated solicitors may not appear in FINRA’s Central Registration Depository (CRD) of brokers and brokerage firms.

Question: Does the term “participating” include persons whose sole involvement with a Rule 506 offering is as members of a compensated solicitor’s deal or transaction committee that is responsible for approving such compensated solicitor’s participation in the offering?

Answer: No.

Question: Are officers of a compensated solicitor deemed to be “participating” in a Rule 506 offering only if they are involved with the solicitation of investors for that offering?

Answer: No. Participation in an offering is not limited to solicitation of investors. Examples of participation in an offering include participation or involvement in due diligence activities or the preparation of offering materials (including analyst 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 for purposes of the rule, such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering.

Question: Is disqualification under Rule 506(d) triggered by actions taken in jurisdictions other than the United States, such as convictions, court orders, or injunctions in a foreign court, or regulatory orders issued by foreign regulatory authorities?

Answer: No.

Question: Is disqualification under Rule 506(d)(1)(v) triggered by all Commission orders to cease and desist from violations of Commission rules promulgated under Exchange Act Section 10(b)?

Answer: No. Disqualification is triggered only by orders to cease and desist from violations of scienter-based provisions of the federal securities laws, including scienter-based rules. An order to cease and desist from violations of a non-scienter based rule would not trigger disqualification, even if the rule is promulgated under a scienter-based provision of law. For example, an order to cease and desist from violations of Exchange Act Rule 105 would not trigger disqualification, even though Rule 105 is promulgated under Exchange Act Section 10(b).

Question: If an order issued by a court or regulator provides, in accordance with Rule 506(d)(2)(iii), that disqualification from Rule 506 should not arise as a result of the order, is it necessary to seek a waiver from the Commission or to take any other action to confirm that bad actor disqualification will not apply as a result of the order?

Answer: No. The provisions of Rule 506(d)(2)(iii) are self-executing.

Question: Does the reasonable care exception only cover circumstances where the issuer has identified all covered persons but, despite the exercise of reasonable care, was unable to discover the existence of a disqualifying event? Or could it also apply where, despite the exercise of reasonable care, the issuer (i) was unable to determine that a particular person was a covered person (for example, an officer of a financial intermediary that the issuer did not know was participating in the offering, despite the exercise of reasonable care) or (ii) initially determined that the person was not a covered person but subsequently determined that the person should have been deemed a covered person?

Answer: 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 under Rule 506(d)(1). This may occur when, despite the exercise of reasonable care, the issuer was unable to determine the existence of a disqualifying event, was unable to determine that a particular person was a covered person, or initially reasonably determined that the person was not a covered person but subsequently learned that determination was incorrect. Issuers will still need to consider what steps are appropriate upon discovery of Rule 506(d) disqualifying events and covered persons throughout the course of an ongoing Rule 506 offering. An issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide Rule 506(e) disclosure, or take such other remedial steps to address the Rule 506(d) disqualification.

Question: Is there a procedure provided in Rule 506(e) for issuers to seek a waiver of the obligation to disclose past events that would have been disqualifying, except that they occurred before September 23, 2013 (the effective date of Rule 506(d))?

Answer: No. The disclosure obligation is not subject to waiver.

Question: Does Rule 506(e) require disclosure of past 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 bar that is no longer in effect at the time of the offering?

Answer: No. Rule 506(e) requires only disclosure of events that would have triggered disqualification at the time of the offering had Rule 506(d) been applicable. Because events outside the applicable look-back period and orders that do not have continuing effect would not trigger disqualification, Rule 506(e) does not mandate disclosure of such matters in order for the issuer to be able to rely on Rule 506.

Question: In an offering in which the issuer uses multiple placement agents or other compensated solicitors, is the issuer required to provide investors with disclosure under Rule 506(e) only with respect to the particular compensated solicitor or placement agent that solicited those investors and its covered control persons (i.e., general partners, managing members, directors, executive officers, and other officers participating in the offering)?

Answer: No. Issuers are required to provide all investors with the Rule 506(e) disclosure for all compensated solicitors who are involved with the offering at the time of sale and their covered control persons.

Question: In a continuous offering, is the issuer required to provide disclosure under Rule 506(e) for all solicitors that were ever involved during the course of the offering?

Answer: No. A reasonable time prior to the sale of securities in reliance on Rule 506, the issuer must provide the required disclosure with respect to all compensated solicitors that are involved at the time of sale. Disclosure with respect to compensated solicitors who are no longer involved with the offering need not be provided under Rule 506(e) in order for the issuer to be able to rely on Rule 506.

Question: Is a shareholder that becomes a 20% beneficial owner by purchasing securities in an offering a covered person with respect to that offering?

Answer: Rule 506(d) looks to the time of each sale of securities, and provides that no exemption will be available for the sale if any covered person is subject to a bad actor triggering event at that time.  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 the sale.  However, it 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.

Question: Is the term “beneficial owner” in Rule 506(d) interpreted the same way as under Exchange Act Rule 13d-3?

Answer: Yes, “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-3 has or shares, or is deemed to have or share:  (1) voting power, which includes the power to vote, or to 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.

Question: For purposes of determining 20% beneficial owners under Rule 506(d), is it necessary to “look through” entities to their controlling persons?

Answer: Beneficial ownership includes both direct and indirect interests, determined as under Exchange Act Rule 13d-3.

Question: Some of the shareholders of a Rule 506 issuer 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.  Are the parties to the agreement required to aggregate their holdings for purposes of determining whether they as a group are, or any single party is, a 20% beneficial owner of the issuer and, therefore, a covered person under Rule 506(d)?

Answer: Beneficial ownership of group members and groups should be analyzed the same as under Exchange Act Rules 13d-3 and 13d-5(b).  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.  See Exchange Act Sections 13(d) and 13(g) and Regulation 13D-G Beneficial Ownership Reporting CDI 105.06.  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.

Question: Does an order issued by a court or regulator, in accordance with Rule 506(d)(2)(iii), waive the disclosure obligation set forth in Rule 506(e)?

Answer: No. The disclosure obligation in Rule 506(e) pertains to an issuer’s obligation to provide investors disclosure of disqualifying events that would have triggered disqualification, except that these events occurred before September 23, 2013.  Rule 506(d)(2)(iii) permits issuers to rely on the self-executing statement of a regulatory authority to avoid Rule 506 disqualification when that regulatory authority advises the Commission in writing or in its order, decree or judgment, that Rule 506 disqualification should not arise a consequence of a disqualifying event that occurred on or after September 23, 2013.

A regulatory authority such as a state securities commission may, however, 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.

For further information about this blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, or visit www.securitieslawyer101.com

This information is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. For more information concerning the JOBS Act, crowdfunding, emerging growth companies, Rule 144, Form 8K, FINRA Rule 6490, Rule 506 private placement offerings, Regulation A, Rule 504 offerings, SEC reporting requirements, SEC registration on Form S-1 and Form 10, Pink Sheet listing, OTCBB and OTCMarkets disclosure requirements, DTC Chills, Global Locks, reverse mergers, public shells, go public direct transactions and direct public offerings please contact Hamilton & Associates at (561) 416-8956 or by email at info@securitieslawyer101.com. Please note that the prior results discussed herein do not guarantee similar outcomes.

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Brenda Hamilton, Securities Attorney
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