U.S. Private Placements: SEC Adopts Relaxed Marketing Rules and New “Bad Actor” Regime and Proposes New Investor Protection Measures

The U.S. Securities and Exchange Commission (SEC) has liberalized the rules governing the marketing of private placements in the United States. The new rules, which will become effective in mid-September 2013, were mandated by the Jumpstart Our Business Startups Act (JOBS Act) and will permit companies and funds to market U.S. private placements through general solicitation and general advertising—such as print advertisements, media broadcasts, website postings and public seminars—in connection with sales of securities to certain sophisticated investors. These rules will also be available to Canadian companies and other non-U.S. issuers conducting private placements in the United States.

Attempting to strike the right balance between facilitating capital-raising and protecting investors, the SEC has, in conjunction with liberalizing the marketing regime, also adopted the "bad actor" rules mandated by the Dodd-Frank Act. These rules, discussed further below, effectively impose new due diligence obligations on issuers and financial institutions conducting private placements.

The SEC is also proposing additional investor protection measures as well as new filing requirements in connection with private placements to enhance the SEC’s ability to monitor market practices in light of the elimination of the ban on general solicitation and advertising.

Private Placements to Accredited Investors

The SEC has amended Rule 506 of Regulation D under the Securities Act of 1933 ("Rule 506") to permit general solicitation and general advertising in private offerings, provided that the issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors.¹ The reasonableness of an issuer’s verification steps will depend on the facts and circumstances of the transaction, taking into account factors like the nature of the purchaser and the type of accredited investor the purchaser claims to be, the amount and type of information that the issuer has about the purchaser, the manner in which the purchaser was solicited, and the terms of the offering (for example, a minimum investment amount). In general, the more broadly marketed an offering is and the less information an issuer has about a potential investor, the more care the issuer must take to confirm accredited investor status. Appropriate sources of reliable information about an investor’s status may include, for example, publicly available documents filed with government agencies like the SEC or IRS, or information compiled by third parties, such as information about brokers on FINRA’s BrokerCheck website. For some institutional accredited investors, these sources may be the same as or similar to the sources noted in Rule 144A for verifying an investor’s status as a qualified institutional buyer. In all cases, issuers must retain adequate records of their verification procedures. The SEC expects the new marketing rules to encourage the development of innovative approaches to meeting the verification requirement, such as third-party development of databases of accredited investors.

For offerings that are marketed to investors who are natural persons, the SEC has provided a non-exclusive list of methods that an issuer may use to determine whether the person is an accredited investor. These methods include reviewing IRS forms, bank or brokerage statements, tax assessments, third-party appraisal reports, consumer credit reports or confirmations by certain licensed professionals such as broker-dealers, investment advisors, attorneys or accountants.

The obligation to verify accredited investor status is a key component of the new rules but, notably, an issuer may elect to conduct a Rule 506 offering without engaging in general solicitation or advertising, in which case the new verification obligation will not apply.

Rule 144A Offerings to Qualified Institutional Buyers

The new rules also permit general solicitation and general advertising in connection with Rule 144A offerings to qualified institutional buyers (QIBs),² and the verification requirements for Rule 506 offerings do not apply in this context. However, Rule 144A requires the issuer and anyone acting on its behalf, such as a dealer, to reasonably believe that all purchasers are QIBs, and there is an existing list of non-exclusive methods to establish that an entity meets the QIB threshold for ownership of and discretionary investments in securities.

Private Equity and Hedge Funds

Private equity funds, hedge funds and other privately offered funds will be able to take advantage of the liberalized marketing rules, and doing so will not jeopardize a fund’s exemption from regulation under the Investment Company Act. The SEC considered imposing special conditions on funds’ ability to engage in general solicitation and advertising, but ultimately decided against doing so. Instead, the SEC is encouraging private funds to carefully review and revise their policies and procedures to ensure that they are reasonably designed to prevent the use of fraudulent or materially misleading advertising.

The "Bad Actor" Disqualification

In adopting the liberalized marketing rules, the SEC stated that preserving the integrity of the private placement market and minimizing the incidence of fraud are critical regulatory objectives. To that end, the SEC has adopted a separate set of rules under which certain kinds of past wrongdoing are considered "disqualifying events" that will prevent an issuer from relying on a private placement exemption for an offering under Rule 506 (whether or not general solicitation or advertising is used). These "bad actor" rules, which are not applicable to Rule 144A offerings, cover wrongdoing by the issuer as well as by predecessors and affiliated issuers; directors, certain officers, general partners and managing members of the issuer; major shareholders and promoters of the issuer; investment managers and principals of pooled investment funds; and underwriters, placement agents and other persons compensated for soliciting investors, as well as their general partners, directors, certain officers and managing members. The list of disqualifying events includes numerous types of wrongdoing under securities laws and under regulations governing the financial and related industries, including the following:

• criminal convictions, court injunctions and restraining orders under securities laws or arising out of the conduct of a financial intermediary such as an underwriter, broker-dealer or investment advisor;
   
• final orders of securities, banking, insurance and other regulators restricting a person’s business activities or arising out of fraudulent, manipulative or deceptive conduct;
   
• certain SEC disciplinary orders, cease-and-desist orders and stop orders; and
   
• suspension or expulsion from membership in a self-regulatory organization or from association with an SRO member.
  

The bad actor rules will not apply if an issuer can demonstrate that it did not know—and in the exercise of reasonable care, could not have known—that a covered person experienced a disqualifying event. This constitutes a due diligence obligation on the issuer to satisfy itself that its private placement exemption will not be jeopardized. Before proceeding with a Rule 506 private placement, issuers and financial institutions will need to employ reasonable procedures to uncover any disqualifying events by covered persons. Issuers should undertake an inquiry of covered persons, including modifying their D&O questionnaires and providing questionnaires to both shareholders owning 20% or more of the issuer’s voting securities and other potential covered persons. Financial institutions participating in a Rule 506 offering should also review and modify as appropriate their due diligence procedures to ensure that disqualifying events by covered persons are discovered. In addition, documentation associated with an offering, such as placement agent or subscription agreements, should be modified appropriately to cover disqualifying events.

Disqualifying events that occurred before the effective date of the bad actor rules in mid-September 2013 will not jeopardize an issuer’s private placement exemption, but such events must be disclosed to investors in transactions after the effective date.

Proposals to Protect Investors and Monitor Market Developments

In conjunction with adopting the rules permitting general solicitation and advertising, the SEC has proposed additional safeguards to protect investors in these offerings and enhance the SEC’s ability to monitor the effects of the rules on market practices. Under these proposals:

• a Form D would have to be filed with the SEC at least 15 days before general solicitation or advertising begins and again within 30 days following completion of the offering. The Form D would have to include information about the use of proceeds, the types of general solicitation or advertising that were engaged in, and the verification methods used to confirm purchasers’ accredited investor status;
   
• an issuer would be disqualified from relying on Rule 506 for one year if the issuer, or any predecessor or affiliate, did not comply, within the past five years, with any of the Form D filing requirements;
   
• general solicitation or advertising materials would have to contain prescribed cautionary legends. This would include, in the case of privately offered funds, a caution about relying on past fund performance data, if such data is contained in the solicitation materials; and
   
• the SEC’s guidance about materially misleading statements in sales literature, which is contained in Rule 156 under the Securities Act of 1933 and currently only applies to registered investment companies, would be extended to cover the sales literature of private funds making Rule 506 offerings.

Cross-Border Regulatory Trends

The liberalized U.S. marketing regime for private placements reflects a trend, partly in response to the recent financial crisis, towards easing restrictions in both the United States and Canada for issuers and underwriters conducting public and private securities offerings. Examples include the ability to "test the waters" before filing a preliminary prospectus in offerings by emerging growth companies (in the United States) and in initial public offerings (in Canada) and the potential adoption in both jurisdictions of new private placement exemptions, e.g., for small offerings and/or crowd-funded offerings. At the same time, the SEC and Canadian regulators want to ensure that the relaxed offering rules do not compromise investor protection, particularly in offerings marketed to less sophisticated investors. This concern is reflected in the SEC’s bad actor rules and in the OSC’s 2012 consultation paper on the exempt market. We expect continued change in the legal requirements in this area on both sides of the border as the SEC pursues its outstanding private placement proposals and the OSC pursues its comprehensive examination of the Canadian exempt market.

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¹ Accredited investors include banks and certain other financial institutions; broker-dealers; insurance companies; investment companies; corporations, partnerships and certain other entities with assets in excess of US$5 million; directors, executive officers and general partners of the issuer; natural persons whose net worth, or joint net worth with their spouse, exceeds US$1 million (excluding the value of the primary residence), and natural persons whose income exceeds certain thresholds.

² QIBs include investment companies, insurance companies, corporations, partnerships and certain other entities that own and invest on a discretionary basis at least US$100 million in securities of unaffiliated issuers; dealers that own and invest on a discretionary basis at least US$10 million in securities of unaffiliated issuers; and banks with a net worth of at least US$25 million and that own and invest on a discretionary basis at least US$100 million in securities of unaffiliated issuers. All QIBs also qualify as accredited investors.

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