Proposed Amendments to Rule 506 of Regulation D

To: Our Clients and Friends
From: Geraldine M. Cunningham
Re: Proposed Amendments to Rule 506 of Regulation D
Date: September 4, 2012

Overview of Proposed Rule 506 Amendments.  On August 29, 2012, the Securities and Exchange Commission (the “SEC”) issued much-awaited proposed amendments to Rule 506 of Regulation D under the Securities Act of 1933 (SEC Release No. 33-9354 (the “Proposal”)).  The amended rule, as proposed, would permit an issuer to offer and sell securities under Rule 506 by means of general solicitation and general advertising, as long as the issuer takes reasonable steps to verify purchasers’ accredited investor status and all purchasers are accredited investors, either because they fall within the definition of an accredited investor or the issuer reasonably believes that the purchaser meets the accredited investor definition at the time of sale.  The SEC would also revise Form D (Notice of Exempt Offering of Securities), the notice filing that issuers relying on Regulation D must file with the SEC, to include a check box indicating whether the issuer is conducting its offering under revised Rule 506.

Background.   Issuers who comply with the various conditions of Rule 506 have the benefit of a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act (i.e., the non-public offering exemption and formerly Section 4(2) of the Securities Act), can offer and sell their securities, without prior registration of the offering, to an unlimited number of accredited investors (subject to limitations that may be imposed by other applicable securities laws) and up to 35 non-accredited investors who meet certain sophistication requirements, and are not restricted in the monetary amount of the offering.  Given the considerable benefits and flexibility of Rule 506, it has become an important capital raising tool for issuers of all types, including start-up companies and private funds.  Indeed, in its Proposal, the SEC noted that an estimated $895 billion and $902 billion in capital was raised in Rule 506 offerings in 2011 and 2010, respectively.  Issuers conducting Rule 506 offerings, however, have been, and until the SEC’s adoption of the amendments to Rule 506, continue to be, subject to an absolute ban on offering or selling the securities through any form of “general solicitation and general advertising” (e.g., advertisements and communications in newspapers, magazines, television, radio, and unrestricted websites, and marketing through seminars whose attendees have been invited by general solicitation or advertising).  The recently enacted Jumpstart Our Business Startups Act (the “JOBS Act”) requires the SEC to amend Rule 506 to permit general solicitation in these offerings provided that all purchasers are accredited investors and directs the SEC to adopt rules regarding how a purchaser’s accredited investor status should be verified under amended Rule 506.  The Proposal was issued in response to this legislative mandate.

No Effect on Current Rule 506 or Section 4(a)(2) Offerings.    In the Proposal, the SEC states that general solicitation will be permitted only under amended Rule 506 and will not affect offerings that rely on the non-public offering exemption under Section 4(a)(2) of the Securities Act.  Thus, issuers who do not comply with all applicable Rule 506 conditions, such as filing Form D, will not be permitted to market using general solicitation.  Similarly, the SEC notes that amended Rule 506 (to be codified as Rule 506(c)) will supplement, but not replace, current Rule 506 (to be codified as Rule 506(b)).  Current Rule 506 will remain intact and will be available to issuers who do not want to engage in general solicitation and be subject to the resultant accredited investor verification requirements or who wish to sell privately to sophisticated non-accredited investors.

How to Verify Accredited Investor Status.  As proposed, new Rule 506(c) would not dictate or give examples of adequate verification steps.  Rather, the facts and circumstances of each transaction would determine whether the issuer’s accredited investor verification steps are reasonable.  The SEC advises issuers to base the extent of their verification steps on factors such as the nature of the purchaser, the amount and type of information that the issuer has about the purchaser, and the nature of the offering, such as the manner in which the purchaser was solicited and the offering’s minimum investment amount.

In its discussion of these factors, the SEC acknowledged that verification for some types of purchasers will be relatively simple (e.g., entities that qualify as accredited investors because they are registered broker-dealers) while verifying whether a natural person is an accredited investor will present difficulties since natural persons must meet either a minimum net worth or annual income test to qualify as an accredited investor and may be unwilling to disclose personal financial information evidencing their accredited investor status.  The SEC would also permit issuers to use third-parties, such as attorneys, broker-dealers and accountants, for accredited investor verification. The nature of the offering would also affect the extent to which an issuer must verify an investor’s accredited investor qualifications.  For example, an issuer that markets its offering through an unrestricted website or an electronic communication disseminated widely to the public would need to take more verification steps than an issuer who marketed to investors listed on a database of pre-screened accredited investors created and maintained by a reliable third party.  The offering’s minimum investment amount also would affect the degree of accredited investor status verification.  According to the SEC, “if an issuer knows little about the potential purchaser who seeks to qualify under the natural person tests for accredited investor status, but the terms of the offering require a high minimum investment amount, then it may be reasonable for the issuer to take no steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by the issuer or a third party, absent any facts that may indicate that the purchaser is not an accredited investor.”  The SEC also indicated that an issuer’s determination as to whether a purchaser is an accredited investor will not be subject to an absolute standard.  Rather, if a purchaser is not an accredited investor, this fact will not cause an amended Rule 506 offering to lose the benefit of the exemption so long as the issuer undertook reasonable verification steps and had a reasonable belief that the purchaser was an accredited investor.

Recordkeeping will be Critical.  The SEC’s Proposal warns that issuers who conduct offerings under amended Rule 506 must keep good records documenting their accredited investor verification steps since these issuers will have the burden of proving that they are entitled to the new exemption.

Conclusion.  Proposed Rule 506(c) sheds light on how the SEC will likely implement its mandate to permit general solicitation in connection with Rule 506 offerings.  However, the SEC has solicited comment on the verification procedures and other aspects of the proposed rule.  Until the SEC’s adoption of final Rule 506 amendments, Rule 506 issuers must continue to operate under the rule’s current requirements, including the general solicitation ban.

If you would like additional information about anything discussed in this memorandum, please contact Geraldine Cunningham (GCunningham@kmollp.com; 212-906-8310).    

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