Rob Lando, Jason Comerford, James Lurie, Matthew Sadofsky
July 31, 2013
The Jumpstart Our Business Startups Act (JOBS Act) was intended to stimulate the growth of small businesses by relaxing a number of requirements and restrictions under U.S. federal securities laws. One of the most potentially significant changes called for by the JOBS Act was the requirement it imposed on the U.S. Securities Exchange Commission (SEC) to adopt rules eliminating the prohibition on general solicitation and general advertising in certain types of private placement offerings.
In response to that requirement, on July 10, 2013, the SEC did the following:
- Adopted rules amending Rule 144A under the U.S. Securities Act of 1933 (U.S. Securities Act) to allow offers to be made without restriction so long as all ultimate purchasers are reasonably believed to be qualified institutional buyers (Rule 144A Amendment).
- Created a new exemption (New Rule 506(c)) under Regulation D of the U.S. Securities Act that allows private placements to be made using general solicitation and general advertising, so long as all ultimate purchasers are reasonably believed to be accredited investors and reasonable steps are taken to verify the accredited investor status of those purchasers. This New Rule 506(c) will exist together with, and be available as an alternative to other existing exemptions under Regulation D, including Rule 506(b). That rule allows offers and sales to an unlimited number of accredited investors (and in some cases up to 35 non-accredited investors), but bans the use of general solicitation or general advertising.
- Introduced “bad actor” disqualifications, which will prohibit the use of Rule 506 under Regulation D, including New Rule 506(c), by persons who engaged in prescribed past conduct (Bad Actor Disqualification).
- Proposed new rules, which, if adopted, would require issuers to provide additional information to the SEC and investors for private placements made under Regulation D (the Regulation D Proposals), including some new requirements that would apply to all Regulation D offerings and some that would apply only to offerings under New Rule 506(c).
The Rule 144A Amendment, New Rule 506(c) and the Bad Actor Disqualifications all become effective on September 23, 2013, and the Regulation D Proposals remain open for comment until that date.
Offerings made under any provision of Regulation D other than New Rule 506(c), including the conventional Rule 506(b) exemption, are still prohibited from using general solicitation or general advertising. Private offerings may also still be made in reliance on the general Section 4(a)(2) private offering exemption under the U.S. Securities Act, which, by its terms, precludes any public offers or sales and so cannot employ general solicitation or general advertising. Finally, offerings made outside the United States in reliance on Regulation S under the U.S. Securities Act will still be subject to a prohibition against “directed selling efforts,” and some question remains about the interplay between this prohibition and the types of publicity activities that are now permitted under the Rule 144A Amendment and New Rule 506(c).
It was originally hoped that the JOBS Act requirement to ease the ban on general solicitation and general advertising in U.S. private placements would – by eliminating the need to impose U.S. publicity restrictions – simplify the offering process for Canadian issuers seeking to make private placements into the United States concurrently with public offerings or private placements in Canada. Unfortunately, for reasons we discuss further below, we do not believe that the steps taken by the SEC will have a significant impact on the U.S. publicity restrictions that will be imposed in Canada-U.S. cross-border offerings going forward. Further, Canadian issuers conducting a private placement using Rule 506 of Regulation D (even if they do not wish to take advantage of New Rule 506(c)) will now have to exercise “reasonable care” in determining whether or not a Bad Actor Disqualification has been triggered. Finally, if the Regulation D Proposals are adopted, Canadian issuers will have to provide more information to the SEC and investors than has previously been required. Ultimately, the rules adopted and proposed by the SEC may not only have a negligible impact on U.S. publicity restrictions for cross-border offerings by Canadian issuers but may even deter the use of Regulation D by Canadian issuers and increase reliance on the Rule 144A and Section 4(a)(2) offering exemptions.
Rule 144A Amendment
Previously, Rule 144A allowed only offers and sales of securities to persons reasonably believed to be qualified institutional buyers (QIBs), which resulted in the same practical effect as the ban on general solicitation or general advertising in Regulation D offerings because they would result in prohibited “offers” being made to the general public. The Rule 144A Amendment will permit offers to be made to persons other than QIBs, including by means of general solicitation, so long as the offered securities are actually sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs.
We recommend no change of practice in Canada-U.S. cross-border offerings when there is a Canadian prospectus offering or private placement and a concurrent U.S. offering under Rule 144A. The Canadian press release should continue to be restricted from dissemination in the United States in the absence of an available safe harbor for two reasons. First, the SEC has not clearly confirmed that such press releases would not constitute prohibited directed selling efforts under Regulation S in connection with the Canadian prospectus qualified offering, particularly if the press release issued in Canada does not specifically make reference to, or give sufficient prominence to, the concurrent Rule 144A offering in the United States.1 Second, offerings that are originally structured to only use the Rule 144A exemption for U.S. offers and sales are sometimes later modified to include the possibility of sales under other exemptions; we therefore believe it would generally be prudent to refrain from general solicitation or general advertising in the United States so as to preserve that flexibility.
New Rule 506(c)
Under New Rule 506(c), issuers will be permitted to offer securities through means of general solicitation or general advertising if:
- all purchasers of securities are accredited investors, and
- the issuer takes “reasonable steps” to verify that the purchasers of the securities are accredited investors.
The SEC has not specifically defined what “reasonable steps” must actually be taken, but has provided a list of examples of the steps that might be appropriate and has said that what is necessary for any particular offering should be based on the facts and circumstances involved, including the nature of the offering and the subcategory of the accredited investor definition that the purchaser claims to satisfy. The more likely it appears to the issuer that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status.2 The SEC did, however, provide four specific methods for verifying the accredited investor status of a natural person that will always be considered satisfactory (for example, reviewing tax returns or bank statements).
Canadian issuers that intend to use New Rule 506(c) should first consult their U.S. counsel about whether the method they or their agents propose to use to verify the accredited investor status of prospective U.S. purchasers will satisfy the requirements of New Rule 506(c) before they engage in any general solicitation or general advertising in the United States. Additional verification procedures supplementing those historically used may be necessary or advisable, particularly when accredited investors that are natural persons are targeted as prospective investors. Canadian issuers conducting offerings should not issue any press releases or engage in any other publicity activities relating to the offering in the United States without first consulting their U.S. counsel about whether those activities could constitute prohibited directed selling efforts under Regulation S for the purposes of the non-U.S. portion of the offering.
Bad Actor Disqualification
The implications of the Bad Actor Disqualification will have to be considered by all issuers using Rule 506 under Regulation D to conduct a private placement, even if they do not wish to take advantage of New Rule 506(c) and its ability to engage in general solicitation and general advertising.
An issuer will be disqualified from using Rule 506 if it or any other person covered by the rule (Covered Person) has a “Disqualifying Event” that occurred on or after September 23, 2013. If a Covered Person had a Disqualifying Event before that date, Rule 506 will still be available to the issuer, but the prior Disqualifying Event must be disclosed to prospective investors.
Covered Persons subject to the Bad Actor Disqualification include the following:
- the issuer, any predecessor of the issuer or any affiliated issuer;
- any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
- any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
- any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;
- any promoter connected with the issuer in any capacity at the time of the sale; and
- any person that has been or will be paid (directly or indirectly) for solicitation of purchasers in connection with sales of securities in the offering and any director, executive officer, other officer participating in the offering, general partner, or managing member of any such solicitor, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member.
The list of Disqualifying Events is lengthy and includes being subject to a criminal conviction or court order for the purchase or sale of a security or making a false filing with the SEC. The list also includes other types of misconduct calling into question an individual’s trustworthiness to deal in securities, such as being subject a disciplinary order issued by the SEC or another regulatory authority.
However, even when a Covered Person has had a Disqualifying Event, an issuer will not be disqualified from using Rule 506 if it did not know and, in the exercise of reasonable care, could not have known of the involvement, presence or participation of a Covered Person subject to a Disqualifying Event.
Canadian issuers that intend to use Rule 506 for U.S. private placements (whether using conventional Rule 506(b) or New Rule 506(c)) will need to adopt a process to demonstrate that they have exercised reasonable care to identify Covered Persons for the purposes of the offering and to confirm that none of them was subject to a Disqualifying Event. Issuers should consider modifying their director and officer questionnaires to address Bad Actor Disqualification, and will also have to consider an appropriate means of soliciting the necessary information from their large shareholders. Placement agency agreements may also require modification to add appropriate representations and warranties for the benefit of each party. We expect that this new requirement for the use of Rule 506 and the potential for the loss of the exemption – if reasonable care to detect Disqualifying Events by Covered Persons is not exercised – could create a disincentive for Canadian issuers to use Rule 506 for their U.S. private placements, resulting in an increase in offerings that are limited exclusively to qualified institutional buyers under Rule 144A. For offerings in which Rule 144A is not an available option, the Bad Actor Disqualification may promote expanded reliance on the general private offering exemption under Section 4(a)(2) of the U.S. Securities Act; however, Canadian issuers will have to be mindful that the use of Section 4(a)(2) does not pre-empt the application of state “blue sky” securities laws.
Regulation D Proposals
The SEC has stated that the purpose of the Regulation D Proposals is to help the SEC and state securities regulators to better monitor and evaluate (including for enforcement purposes) the development of market practices in Rule 506 offerings and to address issues that may arise in connection with permitting issuers to engage in general solicitation in Rule 506(c) offerings, including concerns that unlawful sales of securities to non-accredited investors may increase.
Two aspects of the Regulation D Proposals would apply to all offerings under Rule 506, even if the issuer does not wish to take advantage of New Rule 506(c) to engage in general solicitation or general advertising:
- More Information. A number of new disclosure items in all Form D (post-closing trade report) filings would be required – notably, the issuer’s website address; the names and addresses of any person who directly or indirectly controls the issuer; a table disclosing information on the number of accredited and non-accredited investors that have purchased in the offering, whether they are natural persons or legal entities and the amount raised from each category of investors; the name of any national securities exchange the issuer’s securities are listed on; additional details about the use of proceeds of the offering; the types of general solicitation used or to be used (for New Rule 506(c) offerings only); and the methods used or to be used to verify accredited investor status (for New Rule 506(c) offerings only).
- Disqualification for Failure to File Form D. An issuer would be disqualified from relying on the Rule 506 private placement exemption for one year if the issuer or any predecessor or affiliate of the issuer did not comply, within the last five years, with Form D filing requirements. The one-year disqualification period would commence once all required Form D filings have been made. The proposed disqualification would not affect Rule 506 offerings of an issuer that are ongoing at the time of the filing non-compliance, including the offering for which the issuer failed to make a required filing. The five-year look-back would not extend back past the effective date of the amendment. Under the proposal, there would be a 30-calendar day cure period for an issuer’s first late filing, and disqualification could be waived by the SEC for good cause.
Other aspects of the Regulation D Proposals would apply only to offerings under New Rule 506(c):
- Advance Form D Filing. The SEC would require the filing of a Form D in New Rule 506(c) offerings no later than 15 calendar days before the issuer engages in general solicitation – a marked departure from the traditional Form D filing deadline, which is 15 calendar days after the date of first sale of securities occurs. The advance notice Form D would include basic information about the issuer and its related persons, the type of securities to be offered (if then known), persons receiving sales compensation (if then known) and the use of proceeds of the offering. An issuer could also file an advance notice Form D without contemplating a specific offering in order to have the flexibility to conduct an offering using general solicitation under New Rule 506(c). After filing the advance notice Form D, the issuer would be required to file an amendment providing the remaining information required by Form D within 15 calendar days of the date of first sale of securities in the offering.
- Legend Requirement for General Solicitation Materials. Written general solicitation materials used in New Rule 506(c) offerings would be required to include certain legends and other disclosures. An issuer (or any of its predecessors or affiliates) that has been subject to any order, judgment or court decree for a failure to include the required legends would be ineligible to use the Rule 506 exemption.
- Temporary Mandatory Submission of Written General Solicitation Materials to SEC. An issuer conducting an offering using New Rule 506(c) would be required to submit to the SEC any written general solicitation materials prepared by or on behalf of the issuer and used for the New Rule 506(c) offering. The written materials would have to be submitted to the SEC no later than the date of first use, but the mandatory submission requirement would expire two years after the proposed rule’s effective date. The written general solicitation materials would not be made publicly available on the SEC’s EDGAR website and would not be considered “filed” or “furnished” for the purposes of the liability provisions of the U.S. Securities Act and the U.S. Securities Exchange Act of 1934. However, as with the proposed legend requirement for written general solicitation material, an issuer (or any of its predecessors or affiliates) that has been subject to any order, judgment or court decree for failure to submit written general solicitation materials to the SEC would be ineligible to use the Rule 506 exemption.
As previously noted, we expect that the Bad Actor Disqualification will create a disincentive for Canadian issuers to use the Rule 506 exemption when other U.S. private placement alternatives are available. If the Regulation D Proposals are adopted as proposed, the resulting added disclosure and filing obligations will be an even greater disincentive to use Rule 506, and Canadian issuers may be inclined to restrict the U.S. private placement component of their cross-border offerings to sales to QIBs under Rule 144A, if it is available, or to use the Section 4(a)(2) exemption under the U.S. Securities Act.
1 Issuers generally rely on Regulation S for securities offerings occurring outside the United States as the basis for not filing a registration statement with the SEC covering the offers and sales taking place in other countries. Regulation S prohibits directed selling efforts, which is generally regarded as equivalent to a prohibition on general solicitation.
2 For example, the SEC indicated that if the terms of the offering require a high minimum investment amount and a purchaser is sufficiently wealthy to be able to invest that amount, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take no additional steps other than to verify that the purchaser’s investment is not being financed by a third party.
Authored by Jason Comerford, Rob Lando, James Lurie, Matthew Sadofsky