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August 29, 2013 | Posted in Law Alert

Law Alert: SEC Proposed Amendments to Rule 506 Raise Challenges for Private Issuers

On July 10, 2013 the Securities and Exchange Commission (SEC) proposed rules[1] (the “Proposed Rules”) that would:

- Require the filing of a Form D in Rule 506(c) offerings before the issuer engages in general solicitation;

- Require the filing of a closing amendment to Form D after the termination of any Rule 506 offering;

- Require written general solicitation materials used in Rule 506(c) offering to include certain legends and other disclosures;

- Require the submission to the SEC, on a temporary basis, of written general solicitation materials used in Rule 506(c) offerings; and

- Disqualify an issuer from relying on Rule 506 for one year for future offerings if the issuer, or any predecessor or affiliate of the issuer, did not comply within the last five years with Form D filing requirements in a Rule 506 offering.

These Proposed Rules were announced on the same day that the SEC issued final rules[2] (the “New Rules”) requiring issuers in private offerings under Regulation D to conduct due diligence on persons involved in representing the issuer to ensure that none of those insiders fall inside of defined “bad actor” categories.  The New Rules will take effect on September 23, 2013.  The Proposed Rules are open for comment until September 23, 2013.

This Law Alert summarizes the key elements of the Proposed Rules and the challenges they pose for issuers in private securities transactions under Regulation D. For an analysis of the New Rules please refer to our Law Alert on July 17, 2013: SEC Allows Public Advertising and Raises Due Diligence Bar on Private Securities Offerings.

PRE-SOLICITATION FILING OBLIGATION FOR 506(c) OFFERINGS

The Proposed Rules propose amending Rule 503 to require issuers that intend to engage in general solicitation for a Rule 506(c) offering to file an initial Form D before conducting any general solicitation activities.  Currently, Rule 503 requires an issue to file a Form D not later than 15 calendar days after the first sale of securities in a Regulation D offering.  Under the proposed amendment, if an issuer has not otherwise filed a filed a Form D for a Rule 506(c) offering, it would be required, at least 15 calendar days before commencing general solicitation for its offering, to file an initial Form D (an “Advance Form D”) that includes several key information items, including the issuer’s name and address, information on persons related to the issuer, the issuer’s industry classification, identification of the exemptions being claimed for the offering, identification of whether the filing is a new filing or an amendment, information on the type of security being offered, identification of whether the offering is related to a business combination, information on persons receiving sales compensation, and information on the use of proceeds from the offering.

After the filing of an Advance Form D, the issuer would then also be required to file an amendment providing the remaining information required by Form D within 15 calendar days after the date of first sale of securities in the offering, as is currently required by Rule 503.

POST-TERMINATION AMENDMENT TO FORM D

The Proposed Rules propose requiring the filing of a closing amendment to Form D within thirty calendar days after the termination of any Rule 506 offering.  When Regulation D was originally adopted, issuers were required to amend their Form D filings every six months so long as an offering was ongoing and were required to make a final Form D filing within 30 days after the final sale of securities in the offering.[3]  In 1986 the SEC eliminated these requirements.[4]

Unlike the pre-solicitation obligation that issuers have to file a Form D for an offering under Rule 506(c), the post-termination obligation to file an amendment to Form D would apply to offerings under both Rule 506(b) and 506(c).  The SEC explained in its release that this would be “in part, to enable more complete analysis and comparison of the use of long-standing Rule 506(b) and new Rule 506(c).”  The SEC also reasoned that because “these offerings account for substantially all of the capital reported as being raised under Regulation D, this approach should provide the Commission with substantially complete information about the Regulation D market without imposing additional compliance burdens on smaller offerings conducted in reliance on Rule 504 or Rule 505.”

MANDATORY LEGENDS AND DISCLOSURES

The Proposed Rules include a new Rule 509 that would require all issuers to include (i) certain legends in any written general solicitation materials used in a Rule 506(c) offering, and (ii) additional disclosures for private funds if such materials include performance data.  The SEC is also proposing to amend Rule 156 to extend the guidance contained in that rule to the sales literature of private funds.

Proposed Rule 509 would require all issuers to include prominent legends in all written general solicitation materials to the effect that:

- The securities may be sold only to accredited investors, which for natural persons are investors who meet certain minimum annual income or net worth thresholds; [5]

- The securities are being offered in reliance on an exemption from the registration requirements of the Securities Act of 1933 (the “Securities Act”) and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act;

- The Commission has not passed upon the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials;

- The securities are subject to legal restrictions on transfer and resale, and investors should not assume they will be able to resell their securities; and

- Investing in securities involves risk, and investors should be able to bear the loss of their investment.

In its proposing release the SEC stated that it believed these new mandatory legends “would better inform potential investors as to whether they are qualified to participate in Rule 506(c) offerings and certain potential risks that may be associated with such offerings.”

Importantly, the failure to include these mandatory legends would not cause the offering to cease to be exempt from registration under Rule 506(c).   However, as part of its proposal, the SEC would amend Rule 507(a) so that Rule 506 would be unavailable for an issuer if that issuer, or any of its predecessors or affiliates, has been subject to any order, judgment or court decree enjoining such person for failure to comply with Rule 509.  Consequently, the “penalty” for failing to include the mandatory legends is the loss of the ability to utilize Rule 506 for up to five years.

REAL-TIME SUBMISSION OF GENERAL SOLICITATION MATERIALS

As part of the Proposed Rules, the SEC would create a new Rule 510T that would require an issuer conducting an offering in reliance on Rule 506(c) to submit to the SEC any written general solicitation materials prepared by or on behalf of the issuer and used in connection with the Rule 506(c) offering.  Under the proposed rule, written general solicitation materials must be submitted no later than the date of first use of such materials in the offering.  The rule would expire two years after its effective date.

The SEC’s purpose in proposing this two-year rule is not clear.  In its proposing release, the SEC stated, “The Commission will need to understand developments in the Rule 506 market after the effectiveness of Rule 506(c).  One of these developments would be the market practices through which issuers would solicit potential purchasers of securities offered in reliance on Rule 506(c).  . . . Proposed Rule 510T would facilitate this assessment  . . . .”

Importantly, written general solicitation materials will not be filed through the EDGAR system.  Rather, written general solicitation materials submitted to the SEC pursuant to proposed Rule 510T would not be treated as being “filed” or “furnished” for purposes of the Securities Act or the Securities Exchange Act of 1934, including the liability provisions of those Acts.  As proposed, the SEC would not make publicly available the materials submitted on the SEC’s website, and the SEC does not anticipate that the materials would be reviewed in the manner in which the SEC staff reviews registration materials.

Compliance with proposed Rule 510T would not be a condition of Rule 506(c).  As with the proposed Rule 509 requirement that issuers include legends and other disclosures in written general solicitation materials, the SEC would amend existing Rule 507(a) so that Rule 506 would be unavailable for an issuer if such issuer, or any of its predecessors or affiliates, has been subject to any order, judgment or court decree enjoining such person for failure to comply with Rule 510T.

ONE YEAR DISQUALIFICATION FOR NON-COMPLIANCE

The SEC also proposed to amend Rule 507 of Regulation D to expand the ways in which an issuer may be disqualified from using Rule 506.  Currently, Rule 507 only disqualifies an issuer from using Regulation D if the issuer or a predecessor or affiliate, has been enjoined by a court for violating the filing requirements in Rule 503.  The SEC’s Proposed Rule would amend Rule 507 so that, in addition to the existing disqualification rules, an issuer would be disqualified automatically (without the requirement of any court action) for a period of one year if the issuer or any predecessor or affiliate of the issuer did not comply, within the past five years, with Form D filing requirements in a Rule 506 offering.  The one-year disqualification period would begin following the filing of all required Form D filings or, if the prior offering has been terminated, following the filing of a closing amendment.

The proposed disqualification rule would not affect offerings of an issuer or an affiliate that are ongoing at the time of the filing non-compliance, including the offering for which the issuer failed to make a required filing, and these offerings could continue to rely on Rule 506 for as long as the conditions of Rule 506 continue to be met.  Disqualification would apply only to future offerings.

CHALLENGES FOR ISSUERS

The Proposed Rule is open for public comment until September 23, 2013. As a result, it is unknown whether the Proposed Rule will be adopted and, if so, whether there will be any changes in response to comments.  If adopted in its current form, however, the Proposed Rule would pose several challenges to issuers.

First, while entrepreneurs historically have often prepared private offering documents purporting to rely on Rule 506 without legal advice, such efforts will be extremely difficult, if not impossible, under the Proposed Rule.  The Form D filing requirement and the requirement that written general solicitation materials be provided to the SEC prior to use will certainly require an attorney’s advice if an issuer is to comply properly with the rules.

Second, with respect to the real-time filing requirement, issuers will need to take care to consider what documents should be included in written general solicitation materials.  In the past, entrepreneurs often solicited legal advice only on their private placement documents, determining that other documents (such as a “pitch deck” or “business plan”) were only “business documents” that did not need legal review.  Under the Proposed Rule, documents like a “teaser”, a “pitch deck” or a business plan would almost certainly constitute written general solicitation materials that must be filed prior to use.  If such documents will be filed, their legal importance would recommend that they receive a lawyer’s review.

Third, because the written general solicitation documents will be provided to the SEC, and presumably archived at the SEC, issuers will want to take greater care in the preparation of such documents.  Conscientious issuers have always taken care to ensure that their general solicitation documents are accurate. Many have assumed that such documents would have a short lifespan. While the SEC probably does not intend to become an archive for such materials, it will necessarily become so. As a consequence, it would not be unexpected for plaintiffs to resort to legal process in future litigation to compel the SEC to produce written general solicitation documents previously filed by issuers who are defending cases.

Fourth, while the SEC’s proposed rule changes are not explicitly intended to create a standard of care, or a standard that would raise an inference of wrongdoing for private litigation, the SEC’s rule changes could become so.  For example, in litigation between an aggrieved investor and an issuer relating to an offering under Rule 506, if the plaintiff investor could demonstrate that it had received written general solicitation materials that the defendant issuer had not properly filed under proposed Rule 510T, would that plaintiff be entitled to an inference that the defendant had acted improperly?  Would the defendant’s failure to file, in and of itself, create a private cause of action?

Concerns like these underscore the need for issuers to take great care in private offerings of securities under Rule 506, especially in light of the Proposed Rules.

 


[1] Release No. 33-9416 (File No. S7-06-13) Amendments to Regulation D, Form D and Rule 156 under the Securities Act (July 10, 2013).

[2] Release No. 33-9415 (File No. S7-07-01) Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings (July 10, 2013), and Release No. 33-9414 (File No. S7-21-11) Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings (July 10, 2013).

[3] See Release No. 33-6389.

[4] See Form D and Regulation D, Release No. 33-6663 (Oct. 2, 1986, 51 Fed. Reg. 36385, 36386 (Oct. 10, 1986).  The SEC noted at the time that “[t]he information contained in the original notification has proved sufficient for the Commission’s enforcement surveillance for compliance with the requirements of Regulation D.”

[5] The term “accredited investor” is defined in Rule 501 under the Securities Act, in general terms, as a natural person with either (a) a net worth of $1 million or more, excluding the person’s primary residence, or (b) adjusted gross income of $200,000 or more ($300,000 if married filing jointly) in each of the past two years and with the reasonable expectation of earning at least such amount in the current year.  The term may also include partnerships, all of whose individual partners are accredited investors, corporations with net assets of $5 million or more and other entities.