The staff (Staff) of the Division of Corporation Finance of the Securities and Exchange Commission (SEC) has recently issued frequently asked questions providing guidance on (1) the general solicitation provisions of Rule 144A and Rule 506(c) of the Securities Act of 1933 (Securities Act)¹ and (2) the Securities Act Rule 506(d) and (e) “bad actor” provisions.² 

Rule 506(c) allows the use of general solicitation and general advertising (referred to throughout this alert as general solicitation) in connection with unregistered offers and sales of securities by the issuer if:

• all purchasers of the securities are accredited investors;

• the issuer takes “reasonable steps” to verify that the purchasers are accredited investors; and

• all the terms and conditions of Securities Act Rules 501, 502(a) and 502(d) are satisfied.³

Rule 144A allows securities to be resold to qualified institutional buyers (QIBs) to be offered to persons other than QIBs, including by means of general solicitation, if the securities are sold only to QIBs or to persons that the seller and any person acting on its behalf reasonably believe are QIBs.

Under Rule 506(d), an issuer generally may not rely on the Rule 506 registration exemption in a private securities offering if the issuer or any other person covered by the rule (covered person)⁴ has committed specified prohibited acts with various look-back periods (disqualifying events)⁵ on or after September 23, 2013. Rule 506(e) requires an issuer to disclose to investors a covered person’s disqualifying events occurring prior to September 23, 2013 that do not lead to Rule 506 disqualification, but would have led to disqualification had Rule 506(d) been in effect.⁶

This client alert summarizes the Staff’s guidance, which will be of special interest to any issuer that seeks to rely on Rule 506, including public and private companies and investment funds.

Rule 506(c) General Solicitation Interpretations

Accredited investor verification requirement

• An issuer must satisfy Rule 506(c)’s accredited investor verification requirement even if all purchasers are 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.

• An issuer that chooses to use one of the non-exclusive verification methods must satisfy the specific requirements of that method. For example, to comply with the net worth verification method, the relevant documentation must be dated within 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 under the principles-based method of verification.

• The verification method for existing investors does not 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). This non-exclusive verification method is 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.

• An issuer that 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 would not lose the exemption if subsequent to the sale it is discovered that the purchaser is not an accredited investor so long as the other conditions of exemption are satisfied.

• The third-party verification method includes written confirmations from an attorney or certified public accountant licensed or duly registered, as the case may be, in good standing in a foreign jurisdiction.

Interaction with other offering exemptions

• An issuer that has commenced a Rule 506(c) offering, but has not engaged in any form of general solicitation in connection with the offering, may subsequently rely on Rule 506(b) as long as Rule 506(b)’s conditions are satisfied for the sale of allsecurities in the offering. If 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.

• An issuer that has commenced a Rule 506(b) offering may determine, prior to any sales of securities in the offering, to rely on Rule 506(c) as long as Rule 506(c)’s conditions are satisfied for the sale of all securities in the offering. If 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.

• If the conditions of Rule 506(c) are not met in a purported Rule 506(c) offering and the issuer has engaged in general solicitation, the issuer may not use Securities Act Section 4(a)(2) as a fallback exemption. The use of general solicitation remains incompatible with a claim of exemption under Section 4(a)(2). 

Form D filing matters

• A Form D amendment is required if an issuer commenced a Rule 506 offering before, and continued the offering as a Rule 506(c) offering after, September 23, 2013. The issuer must check the Rule 506(c) box in the filed amendment to indicate its reliance on this exemption. No amendment is required if the issuer decides to continue the offering in reliance on Rule 506(b).

Rule 144A General Solicitation Interpretations

• Issuers as well as the initial purchasers and other distribution participants may conduct general solicitation in Rule 144A offerings in which the securities were initially sold to financial intermediaries in transactions exempt under Securities Act Section 4(a)(2) or Regulation S.

Rule 506 “Bad Actor” Interpretations

Rule 506(d) covered persons

• For purposes of Rule 506(d), an “affiliated issuer” is an affiliate (as defined in Securities Act Rule 501(b)) of the issuer that is issuing securities in the same offering, including offerings subject to integration pursuant to Securities Act Rule 502(a), not every affiliate of the issuer that has issued securities. This is the most significant bad actor interpretation as it narrows the scope of the rule and will ease the diligence burden on issuers, especially private investment funds which no longer need to conduct bad actor diligence on controlled portfolio companies.

• “Compensated solicitors” are not limited to brokers subject to registration pursuant to Section 15(a)(1) of the Securities Exchange Act of 1934 (Exchange Act) and their associated persons. All persons who have been or will be paid, directly or indirectly, remuneration for solicitation of purchasers are covered persons, 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.

• “Participation” in an offering is not limited to solicitation of investors, but to constitute participation activities must be more than transitory or incidental. Examples of activities constituting participation 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. Examples of activities that generally would not constitute participation include administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities. Interestingly enough, the Staff only provided this guidance with respect to officers of compensated solicitors. It is unclear if this was unintentional or if they did not intend the guidance to apply to directors and officers of an issuer, a general partner and an investment manager.

• The term “participating” does not include a person whose sole involvement is as a member of a compensated solicitor’s deal or transaction committee that is responsible for approving such solicitor’s participation in the offering.

Rule 506(d) disqualification

• An issuer must determine if it is subject to bad actor disqualification any time it offers or sells securities in reliance on Rule 506. An issuer may reasonably rely on a covered person’s agreement to provide notice of a disqualifying 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. Although a helpful interpretation, it raises other unanswered questions such as the meaning of “long-lived” offering, the meaning of “periodically” and the recommended frequency of such updates.

• 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.

• 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. This may occur when, despite the exercise of reasonable care, the issuer:

  Issuers will still need to consider what steps are appropriate upon discovery of 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 disqualification.

• was unable to determine the existence of a disqualifying event;

• was unable to determine that a particular person was a covered person; or

• reasonably determined that the person was not a covered person, but subsequently learned that determination was incorrect.

• An issuer could continue to rely on Rule 506 for future sales in an offering where a placement agent or one of its covered control persons becomes subject to a disqualifying event during the offering if the placement agent engagement is terminated and the placement agent does not receive compensation for future sales. Alternatively, if the triggering disqualifying event affected only the placement agent’s covered control persons, 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.

• An issuer need not seek an SEC waiver or take any other action to confirm that bad actor disqualification will not apply where a court or regulator order provides, in accordance with Rule 506(d)(2)(iii), that Rule 506 disqualification should not arise as a result of the order.

• An SEC order to cease and desist from violations of a non-scienter based rule, such as Exchange Act Rule 105, would not trigger disqualification, even if the rule is promulgated under a scienter-based provision of law such as Exchange Act Section 10(b).

• Rule 506(d) disqualification is not triggered by actions taken in jurisdictions other than the United States.

Rule 506(e) disclosure

• An issuer must provide all investors with Rule 506(e) disclosure for all compensated solicitors who are involved with the offering at the time of sale and their covered control persons. In an offering in which the issuer uses multiple placement agents or other compensated solicitors, the issuer cannot provide investors with disclosure only with respect to the particular compensated solicitor or placement agent that solicited those investors and its covered control persons.

• In a continuous offering, the issuer is not required to provide Rule 506(e) disclosure for all solicitors that were ever involved during the course of the offering. A reasonable time prior to the sale of securities, the issuer must provide the required disclosure with respect to all compensated solicitors that are involved at the time of sale. Disclosure is not required for compensated solicitors who are no longer involved with the offering. The interpretation leaves unanswered when a solicitor is deemed “no longer involved with the offering.” For example, would tail payments keep a solicitor involved even if it no longer is doing any work on the offering?

• Rule 506(e) only requires disclosure of events that would have triggered disqualification at the time of the offering had Rule 506(d) been applicable. Disclosure is not required of events outside the applicable look-back period and orders that do not have continuing effect.

• The Rule 506(e) disclosure obligation is not subject to waiver.

^{1. See SEC Div. of Corp. Fin., Securities Act Rules Compliance and Disclosure Interpretations (C&DIs), Questions 138.03 - 138.04 and 260.05 - 260.13 (Nov. 13, 2013), available at http://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm#138-03.}

^{2. See SEC Div. of Corp. Fin., Securities Act Rules C&DIs, Questions 260.14 - 260.27 (Dec. 4, 2013), available at http://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm#260-14.}

^{3. For more information on Rule 144A’s and Rule 506(c)’s general solicitation provisions, please see our client alert dated July 22, 2013, General Solicitation Permitted in Certain Rule 506 and Rule 144A Offerings; “Bad Actors” Disqualified from Rule 506 Offerings; Other Significant Amendments Proposed to Regulation D.}

^{4. Covered persons are: (a) the issuer, any predecessor of the issuer or an affiliated issuer; (b) a director of the issuer, an executive officer (as defined in Securities Act Rule 405) of the issuer or an officer of the issuer who is not an executive officer but who is participating in the offering; (c) a general partner or managing member of the issuer; (d) a beneficial owner of 20% or more of the issuer’s outstanding voting equity securities; (e) a promoter connected with the issuer in any capacity at the time of a sale in the offering; (f) any person that has been or will be paid (directly or indirectly) remuneration for the solicitation of purchasers in connection with the sale of securities in the offering or any general partner, managing member, director or executive officer of such solicitor or other officer of such solicitor participating in the offering or a general partner or managing members of such solicitor; or (g) any investment manager of an issuer that is a pooled investment fund or any general partner, managing member, director or executive officer of such investment manager or other officer of such investment manager participating in the offering or a general partner or managing members of such investment manager.}

^{5. The following are disqualifying events for an issuer when a covered person:}

• ^{(i) has been convicted within ten years (five years in the case of issuers, their predecessor and affiliated issuers) prior to any sale of securities in the offering of any felony or misdemeanor or (ii) is subject to any order, judgment or decree of any court of competent jurisdiction entered within five years before the time of a sale in that offering and that, at such time, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice, in the case of either (i) or (ii):}

• ^{in connection with the purchase or sale of any security;}

• ^{involving the making of a false filing with the SEC; or}

• ^{arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;}

• ^{is subject to a final order of a state securities commission, a state regulator of banks, savings associations, credit unions or insurance companies, a federal banking agency, the Commodity Futures Trading Commission or the National Credit Union Administration entered (i) that, at the time of a sale in the offering, bars such person from association with an entity regulated by one of those authorities or from engaging in the business of securities, insurance, banking, or savings association or credit union activities or (ii) is a final order (as now defined in Securities Act Rule 501) based on a violation of a law or regulation prohibiting fraudulent, manipulative or deceptive conduct and the final order was entered within ten years before the time of a sale in the offering}

• ^{is subject to certain orders of the SEC entered pursuant to the sections of the Exchange Act governing brokers and dealers and municipal securities dealers or pursuant to the Investment Advisers Act of 1940 that at the time of a sale in the offering suspends or revokes a person’s registration as a broker, dealer, municipal securities dealer or investment adviser, limits such person’s activities as such or bars such person from association with an entity or from participating in the offer of penny stock offerings;}

• ^{is subject to any SEC order entered within five years before the sale that, at the time of a sale in the offering, orders the person to cease and desist from committing or causing a future violation of specified scienter-based anti-fraud laws and rules or Securities Act Section 5;}

• ^{is suspended or expelled from membership in, or suspended or barred from association with members of, a registered national securities exchange or national or affiliated securities association for an act or omission to act constituting conduct inconsistent with just and equitable principles of trade;}

• ^{has filed, or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the SEC that, within five years before the time of a sale in the offering, was the subject of a refusal order, stop order or order suspending the Regulation A exemption or is, at the time of such sale, the subject of an investigation or proceeding to determine if such an order should be issued; or}

• ^{is subject to a United States Postal Service (USPS) false representation order entered within five years before the time of a sale in the offering or, at such time, is subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the USPS to constitute a scheme or device for obtaining money or property through the mail by means of false representations.}

^{6. For more information on Rule 506’s bad actor provisions, please see the client alert referenced in note 3.}