This Client Update is the third segment in a three-part series on the new or proposed Securities and Exchange Commission rules governing private placements, mandated under the JOBS Act and the Dodd-Frank Act. This update focuses on the SEC's proposed changes to Form D. Form D is the notice filing made with the SEC in connection with private placements seeking the benefit of the Regulation D safe harbor. Part 1, available here, covered the new rules lifting the ban on general solicitation and general advertising in certain private placements of securities. Part 2, available here, covered the new rules governing offerings that are associated with "bad actors."
After proposing rules permitting general solicitation in certain private placements, the SEC received many comments voicing concern that allowing general solicitation could lead to increased instances of fraud. New Rule 506(c) will allow general solicitation in connection with offerings in which sales are made exclusively to accredited investors, subject to certain other conditions. The traditional Rule 506 safe harbor, which prohibits general solicitation and allows sales to up to 35 non-accredited investors, will be maintained basically unchanged as Rule 506(b). In response to concerns about increased fraud, the SEC proposed extensive amendments to Form D, some of which would apply only to new Rule 506(c) offerings and some of which would apply to all Rule 506 offerings. The proposed changes may be so burdensome, however, that, if adopted as proposed, they could discourage issuers from relying on Rule 506.
The SEC has proposed to require issuers to file a Form D at several different points during a Rule 506 offering. Under the proposed rules, issuers seeking to engage in a Rule 506 offering would need to file a Form D:
- Fifteen days in advance of any general solicitation in a Rule 506(c) offering. This would theoretically provide the SEC and state regulators with additional information about any future offerings that will involve general solicitation. Note that this would preclude issuers relying on Rule 506(b) from switching to an offering relying on Rule 506(c) in the event the issuer inadvertently engaged in general solicitation.
- Fifteen days after the first sale in a Rule 506 offering.
- Thirty days after terminating a Rule 506 offering. This filing would be required whether the offering closed, or whether it was terminated as "unsuccessful." Given that issuers may be reluctant to disclose publicly that an offering was not successful, the proposed rule requiring a closing Form D could operate to discourage issuers from undertaking Rule 506 offerings.
The most expansive of the proposed amendments involves additional required disclosure on Form D. Proposed Item 3 on Form D, for example, would require an issuer conducting an offering in reliance on Rule 506(c) to disclose the name and address of any person who directly or indirectly controls the issuer. This is broader and more subjective than the required disclosure of "control persons" in public offerings.
As a further example, proposed Item 5 broadens disclosure for Rule 506(c) offerings in another potentially significant way. Currently, an issuer can "Decline to Disclose" in its Form D information about its revenues or, in the case of a fund, its net asset value. The proposed rule would change this option to "Not Available to the Public." According to the proposing release, issuers who disclose revenue or net asset value information in general solicitation materials are not eligible to select the "Not Available to the Public" option. Because general solicitation has historically been interpreted to include communications to a large number of prospective investors with which the issuer or its agent does not have any "substantive pre-existing relationship," issuers who conduct a general solicitation in this manner would be required disclose their revenues or net asset value on a Form D. It appears that this would be the case even if they only transmit the information after potential investors have signed a confidentiality agreement.
It is also notable that the use of proceeds disclosure in proposed Item 16, which is extremely detailed, requires more information than Item 504 of Regulation S-K, which governs disclosure of the use of proceeds in connection with registered public offerings. Proposed Item 16 would require issuers other than pooled investment funds to disclose the percentage of offering proceeds that will be used to:
- repurchase or retire the issuer's existing securities;
- pay offering expenses;
- acquire assets, other than in the ordinary course of business;
- finance acquisitions of other businesses;
- pay for working capital needs; or
- discharge indebtedness.
In total, there are 22 disclosure requirements on the proposed Form D, six of which are new. These include the number and type of accredited investors, and the number of natural persons; the amount of money raised from accredited and non-accredited investors; the types of general solicitation used or to be used, if applicable; and, for Rule 506(c) offerings, the methods of verification the issuer used to confirm accredited investor status.
Currently, although issuers are required to file a Form D in conjunction with a Rule 506 offering, there is no real penalty for failure to file. The proposed rules seek to change this, imposing a one-year disqualification period if an issuer, its predecessor, or an affiliate failed at any time within the past five years to comply with the Form D filing requirement in a Rule 506 offering and did not remedy such failure within 30 days. The issuer could only again rely on Rule 506 for a subsequent private placement one year after a corrective Form D was filed. As proposed, although failure to file would not disqualify that particular offering from relying on Rule 506, even an inadvertent or immaterial failure to file, if not cured within 30 days, would result in prospective disqualification.
The SEC also proposed content and legend requirements for general solicitation materials. As proposed, issuers using general solicitation would need to include the legends substantially similar to the following on all written materials:
- The securities may be sold only to accredited investors, which for natural persons, are investors who meet certain minimum annual income or net worth thresholds.
- The securities are being offered in reliance on an exemption from the registration requirements of the Securities Act and are not required to comply with specific disclosure requirements that apply to registration under the Securities Act.
- The Commission has not passed upon the merits of or given its approval to the securities, the terms of the offering, or the accuracy or completeness of any offering materials.
- The securities are subject to legal restrictions on transfer and resale, and investors should not assume they will be able to resell their securities.
- Investing in securities involves risk, and investors should be able to bear the loss of their investment.
Private funds will also need to include a legend disclosing that the securities being offered are not subject to the protections of the 1940 Act, as well as other detailed disclosures about the usefulness and accuracy of any historical performance data, if disclosed.
While these legend requirements are fairly standard, they do implicate an issuer's ability to use general solicitation in a forum with limited available space, such as certain forms of social media. It is not clear whether providing a link to these legends in written materials available online, rather than including the legends themselves, would satisfy the proposed rule.
The SEC, to facilitate monitoring the use of general solicitation, has also proposed a temporary, two-year rule, Rule 510T, requiring issuers to submit all general solicitation material to the SEC on or before the date of its first use. This material will not be made public by the SEC through, for example, publication on EDGAR. However, it is not clear whether an individual could obtain access to this information via the Freedom of Information Act.
The proposed rules would change Rule 156 under the Securities Act to extend the prohibition on materially misleading sales literature to include private funds. Currently, Rule 156 only addresses the use of such literature by registered investment funds. Fraud in sales literature by private funds is already unlawful under the Securities Act, and the proposed amendment neither expands nor alters this, but rather codifies something that is already understood.
It remains to be seen how comments to the SEC may affect the final rule. As proposed, however, the new rules would at a minimum increase compliance costs for the majority of issuers conducting an offering relying on Rule 506.
Implications and Interpretations
- If the SEC mandates filing a Form D in advance of general solicitation, as proposed, it could create an artificial delay in many offerings. Issuers, once deciding to engage in general solicitation, would file a Form D stating this fact, and then would need to wait for 15 days before actually commencing the general solicitation. This would also make it difficult for issuers to change an offering from Rule 506(b) to Rule 506(c) without delaying the offering, and would make it impossible for issuers to carry out such a change in the event that an issuer has inadvertently engaged in general solicitation.
- It is unlikely that issuers will want to publicize that they plan to conduct an offering by filing a Form D in advance of the offering, even if the advance Form D does not include specific offering details. Issuers are also unlikely to want to file a Closing Form D – which would become publicly available on EDGAR – after an unsuccessful offering, disclosing that the offering was unsuccessful.
- Issuers will likely consider the one-year disqualification from relying on Rule 506 for failure to comply with the Form D filing requirements burdensome and disproportionately harsh as a penalty for failure to comply with a notice filing originally intended only for informational purposes.
The full text of the SEC release proposing the changes to Regulation D, Form D, and Rule 156 is available here. We expect that the SEC will receive many comments on the proposed rules. Comments are due on September 23, 2013, and can be submitted to the SEC here.
This Client Update is intended to provide general information to our clients and should not be construed as legal advice. If you have questions regarding this client update, please contact your principal attorney at Tonkon Torp LLP, or Tom Palmer (503.802.2018; firstname.lastname@example.org), Drea Schmidt (503.802.5703; email@example.com) or Claire Brown (503.802.5731; firstname.lastname@example.org) of our Corporate Finance Practice Group.