by Genna Garver and Michael Homeier
On July 10, 2013, the U.S. Securities and Exchange Commission (“SEC”) adopted final rule amendments that eliminate the 80-year-old prohibition on general solicitation and general advertising in offerings under Rule 506 of Regulation D under the U.S. Securities Act of 1933, as amended (the “Securities Act”). Rule 506 offerings are widely used by sponsors of EB-5 securities offerings. The adoption of the amendments, which go into effect on September 23, 2013, implements Section 201(a) of the Jumpstart Our Business Startups Act (“JOBS Act”).
The SEC was under no legal obligation to do anything beyond eliminating the prohibition as directed by the JOBS Act, but it did. In connection with adopting the final rules, the SEC also voted to issue rule proposals (the “proposed rules”) that, if adopted, will require significant, additional investor protections to lessen the additional risks posed by the final rules and to better enable the SEC to monitor the market.
Regulation D generally provides a non-exclusive safe harbor from registration and prospectus delivery requirements under the Securities Act for offerings relying on Section 4(a)(2), which exempts transactions not involving any public offering. Historically, Rule 506(b)’s safe harbor has been available to issuers that do not engage in general solicitation and that raise unlimited capital from an unlimited number of “accredited investors” (generally, an individual with a net worth of $1 million or more, excluding the value of their primary residence, or with an annual income of $200,000 or $300,000 together with their spouse) and up to 35 non-accredited investors (never included in EB-5 transactions).
Under the new Rule 506(c), an issuer may engage in general solicitation, provided that all purchasers are accredited investors and the issuer takes “reasonable steps” to verify that the purchasers are, in fact, accredited. Once the new rules go into effect, EB-5 issuers relying on new Rule 506(c) will be permitted to solicit investors through newspapers, magazines, television, radio, seminars, websites, and email, so long as the EB-5 issuers take reasonable steps to verify that all purchasers are accredited investors and meet the other requirements discussed below.
“Reasonable Steps to Verify”
For Rule 506(c) offerings, issuers can no longer rely on the investor questionnaires, purchaser representations, and limited personal identification information that may suffice for Rule 506(b) offerings. Whether or not the steps taken to verify that an investor is accredited are reasonable is an objective determination depending on the specific facts and circumstances of each purchaser and transaction. Factors that issuers should consider include, (i) the nature of the purchaser and type of accredited investor the purchaser claims to be, (ii) the amount and type of information the issuer has about the purchaser, and (iii) the nature of the offering, such as the manner in which the purchaser was solicited and the terms of the offering (e.g., minimum investment amount).
Rule 506(c) enumerates certain non-exclusive methods of verifying accredited investor status for natural persons. For the income test, such methods include reviewing copies of any IRS form that reports income for the two past years and obtaining a written representation that the purchaser expects to reach the necessary income in the current year. However, such IRS forms will likely be unavailable for EB-5 investors, which means that issuers must take the principles-based method of verification discussed above when investors qualify as accredited investors by reason of annual income.
For the net worth test, issuers must review one or more written documents, dated within the last three months, demonstrating that the purchaser has disclosed all liabilities necessary to make the determination of net worth. For assets documents include: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisable reports issued by independent third parties. For liabilities documents include: a consumer report from at least one nationwide consumer reporting agency. However, such consumer reports may not be available for EB-5 investors, necessitating that issuers take the principles-based method of verification. Issuers should be prepared to encounter many obstacles to verifying that an EB-5 investor is accredited by reason of income or net worth (e.g., an investor’s aversion to providing information additional to the information provided to immigration counsel).
As an alternative to the non-exclusive methods described above, an issuer may satisfy the verification requirement by obtaining written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that it has taken reasonable steps to verify that the person is an accredited investor within the prior three months, including a specification as to what “reasonable steps” were actually used by the verifier. EB-5 issuers should discuss alternative methods for verifying accredited investor status with counsel. In all cases, records of accredited investor verification (including backup) need to be maintained by the issuer to meet any future challenge.
Additional Actions Required in Reliance on the Rule 506(c) Exemption
Rule 506(c) issuers must file a Form D, now amended to add a separate box to check for claiming the new exemption. Currently, an issuer is required to file Form D within 15 days of the first sale of securities. However, the SEC’s proposed rules may require an earlier filing depending on the form of the final rules to be adopted.
Impact on Regulation S Offshore Offerings
Most EB-5 program issuers rely on the dual protections provided by Securities Act Regulation D and Regulation S. Regulation S provides a safe harbor for any offer or sale of securities made outside the United States, provided that no directed selling efforts are made in the United States. The SEC has confirmed that any general solicitation in compliance with a Rule 506(c) should not make Regulation S unavailable for a concurrent offshore offering. EB-5 issuers should consult with counsel to ensure concurrent offerings each comply with their respective safe harbors.
Securities Act Section 4(a)(2) Alternative Unavailable
Unlike for offerings under Rule 506(b), there is no safety outside the safe harbor for Rule 506(c) offerings. An issuer disqualified from relying on Rule 506(c) for a failure of accredited investor verification, that has engaged in general solicitation, may not alternatively rely on Section 4(a)(2) or Rule 506(b) because general solicitation is irreconcilable with a claim of exemption for transactions not involving any public offering.
Impact on Foreign and State “Blue Sky” Exemptions
Securities issued in Rule 506(c) offerings are “covered securities” under state Blue Sky regulations and, therefore, states are preempted by federal law from requiring registration of such offerings. However, as with Rule 506(b) offerings, Rule 506(c) offerings are still subject to state notice filing requirements. Although some states exempt issuers from such notice filings, the exemptions are often available only for securities offered without general solicitation and, therefore, will not be available for 506(c) offerings. Further, a number of countries accessed in the search for EB-5 investors may not permit general solicitation of their citizens by foreign investment opportunities. Counsel should be engaged to confirm whether general solicitation poses any problems with relying on foreign and state exemptions.
Special Concerns for EB-5 Fund Structures
To avoid being regulated like a mutual fund under the Investment Company Act of 1940, as amended (“Investment Company Act”), EB-5 programs using a “pooled” private investment fund structure often rely on Investment Company Act Section 3(c)(1) or 3(c)(7)’s exclusion from the definition of “investment company,” each of which require that the securities being offered not be part of a “public offering.” The JOBS Act specifically provides that issuers relying on these exclusions may engage in general solicitation without losing either exclusion.
Changes to Form D
The proposed rules amend Rule 503 by expanding and adding content requirements in Form D and also by increasing the frequency of the Form D filing requirements. Expanded information required includes, without limitation, control person and promoter information, disclosure of whether the Form D filing itself is an "advance-notice" or a "termination" Form D (detailed below), specification of the number of accredited and non-accredited investors and the amount raised from each, and details as to intended use of proceeds. Newly-required information includes number and types of participating accredited investors, specifics as to the form(s) of general solicitation used or to be used (mass mailings, emails, public websites, social media, print media, broadcast), and identification of the method(s) used or to be used to verify accredited investor status in a Rule 506(c) offering.
The frequency of the Form D filing obligation is proposed to be increased from one time to three or more times. Generally, a new "Advance Notice" Form D is due 15 days prior to use of general solicitation in a 506(c) offering, disclosing less information than the full amount of information required by Form D. Subsequently, an amended Form D would be required to amend the advance-notice Form D, due (a) no later than 15 days after the first sale to provide all the information required by Form D that could not be included in the advance-notice; (b) as soon as practicable to disclose a material mistake, error, or material change; (c) annually, for continuing offerings, on or before the first anniversary of the most recent previously filed notice; and (d) a termination amendment within 30 days after termination of the offering (for all offerings). Form D amendments are required to include information about the remaining disclosure items not applicable to an advance-notice Form D, including offering amount, total amount of securities sold, types of general solicitation used, and the methods used to verify purchasers' accredited investor status.
Expanded Issuer Disqualification
Currently, Rule 507 disqualifies an issuer from relying on Regulation D if the issuer has been enjoined by a court for violating the Rule 503 (Form D) filing requirements. The proposed rules would amend Rule 507 to further disqualify an issuer, for one year, from conducting any follow-up on Rule 506 offerings if the issuer, its predecessor, or affiliate did not comply at any time in the preceding five-year period with the Form D filing requirements.
This additional disqualification would apply to future offerings, beginning on the date a missed filing was due, with only a single 30-day cure period to file a missed Form D or to amend an erroneous Form D permitted per offering. Finally, proposed amended Rule 507 would make Rule 506 unavailable if a court took injunctive action against the issuer or a failure to comply with either Rule 509 or Rule 510T (discussed below).
Additional Legends Required for Sales Materials
Proposed new Rule 509 would require that legends be included in written solicitation materials for offerings made in reliance on 506(c), disclosing that only accredited investors are permitted; the offering is exempt from registration and need not comply with the disclosure requirements; the SEC has not approved the offering or the materials; the securities purchased are restricted; and purchasing the securities involves risk, and that investors should be able to bear the loss of the investment.
Requirement to Submit Marketing Materials to SEC
Proposed new Rule 510T, to be effective for two years following adoption, would compel the submission by a 506(c) issuer of its written general solicitation materials to the SEC no later than the date of first use of the materials. The failure to submit the materials would disqualify the issuer from relying on Rule 506 in the future. This rule echoes FINRA’s new Rule 5123 requiring broker-dealers to report and upload offering materials when engaging a placement agent for a private placement.
"Bad Actor" Disqualification
The proposed rules also include "bad actor" disqualifications, requiring an issuer to use reasonable care to ensure that no "covered person" (including any director, officer, manager, significant owner, selling agent, underwriter, or placement agent) with a "disqualifying event" (a conviction of, or subject to court or administrative sanction for, securities fraud or other violations) participated in the offering. An issuer that fails this standard will lose its securities law exemption.
Practical Effect if Proposed Rules Become Final: What Steps to Take?
The proposed rules cloud, with significant regulatory ambiguity, the easing of Regulation D by the final rules. Along with the new marketing freedom come several potential compliance and liability dangers. Although Chairman White indicated there may be a transition period for 506(c) offerings commenced prior to the finalization of the proposed rules, there is no guarantee that the proposed rules will be finalized as proposed, or that they will not be retroactively applied. Assuming the proposed rules are finalized substantially as proposed, to determine whether to rely on new Rule 506(c) issuers must also carefully consider the following issues:
Implement Timing and Disclosure Due Diligence Procedures for Revised Form D: To avoid the one-year prohibition of relying on Rule 506, issuers need to implement policies and procedures to ensure Form D filings are timely and completely made. The additional information required by the proposed rules could subject an issuer to expanded SEC inquiry and potential disclosure liability, particularly if the Form D conflicted with information in the offering documents (a real danger, given the participation of differing persons in accomplishing different steps).
Impact on Solicitation Materials: Under the proposed rules, issuers must (i) include the disclosure legend requirements in all written general solicitation materials used under 506(c), and (ii) at least for the next two years, submit those materials to the SEC no later than the date of first use. The SEC's access to the materials could expand the risk of regulatory inquiry or action.
Implement "Bad Actor" Due Diligence Process: To verify that none of an issuer's covered persons is subject to disqualification, the issuer must identify those covered persons, and undertake an active investigation as to disqualified status. If a covered person with a disqualifying event participated in the offering, the issuer can avoid loss of the exemption only if it can show that it did not know and, in exercise of reasonable care, could not have known of the disqualifying event. In drafting both its selling agreements with its underwriters and placement agents, and its employment agreements or D&O questionnaires with directors, officers, managers, and significant owners, an issuer should include mutual representations as to the affirmative absence of a bad actor disqualification.
The bottom line linking both the final rules and the proposed rules: each issuer needs to determine if the benefits of general solicitation outweigh the cost of compliance for both the accredited investor verification and the proposed rule’s additional filing and disclosure requirements—not to mention any additional regulatory scrutiny that the SEC may add. It is perhaps not at all surprising that many issuers are reported to have concluded that the benefits of general solicitation are offset by the complexity, costs, and risks involved with Rule 506(c), leading them to choose, instead, continued reliance on Rule 506(b). Those who conclude the opposite would be well advised to temper their marketing enthusiasm with a wary eye on the shadow cast by the proposed rules.
 This article refers to general solicitation and general advertising generally as “general solicitation.”