A private placement is an offering of securities by a company that is not offered to the public at large and is not registered with the SEC. Many of these offerings are made pursuant to Regulation D of the Securities Act of 1933. Generally, one must be an “accredited investor” to make an investment in a private placement. Institutions such as banks and insurance companies, and organizations or trusts with assets of $5 million or more, are accredited investors. For an individual to be an accredited investor, the person must have a net worth of $1 million or more, excluding the value of the person’s primary residence, or an income of more than $200,000 in the two most recent years.

Gerri Walsh, a senior executive at FINRA, warned that private placements are often issued by companies that have no requirement to file financial reports, and this can lead to difficulty for investors trying to evaluate the financial health of the company. Because of the issues with liquidity and risk, Walsh said that investors should carefully consider their options before investing in a private placement.

While private placements are not new, FINRA recently uncovered fraud and sales practice abuses related to private placements, including offering documents that contained inaccurate statements.

FINRA said that if an investor is presented with a private placement offering document, it should be reviewed carefully. According to the investor alert, people considering investing in a private placement should find out as much as possible about the company’s business and what the options are for liquidating one’s investment. The organization also said that any such investment should be discussed with one’s broker in detail beforehand.

A. Amendment to Rule 506

The SEC amended Rule 506 by adding subsection (c), which permits general solicitation and general advertising under the following conditions:

1. the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors; and
2. all of the purchasers of securities are accredited investors either because they fall within one of the categories of persons who are accredited investors under existing Rule 501 or the issuer reasonably believes that they do at the time of the sale of securities.

B. Verification Standards

To take advantage of the general solicitation and general advertising permitted under Rule 506(c), there is an affirmative requirement that the issuer take “reasonable steps to verify that the purchasers of the securities are accredited investors”. The specific steps required to be taken are not dictated by the new rules. Instead, the reasonableness of the steps taken turns on the objective assessment of the issuer. However, the final rules do set forth a non-exclusive and non-mandatory list of methods that are deemed to satisfy the verification requirement for purchasers who are natural persons, including:

1. documentation of net worth, such as through a review of bank and brokerage statements for assets and a credit report for liabilities;
2. documentation of income, such as through a review of the last two years’ income tax returns;
3. written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney or certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the past three months; and
4. reliance on written verification from an existing investor who previously purchased securities in the issuer’s Rule 506 private placement before the effectiveness of the new rules, where the investor continues to hold the previously purchased securities.

In addition to the foregoing, issuers may verify the accredited status of Rule 506(c) investors in any other reasonable manner that they select. The SEC discusses various other available methods, including a review of pay stubs or a review of an SEC or other governmental filing listing the investor’s annual compensation. Alternatively, if the amount of the investment is very high, such that only accredited investors would reasonably be expected to make such an investment, and the investor certifies that the investment is not being financed by a third party, this could be taken into account in determining that the investor is accredited. Conversely, merely having the investor check the “accredited investor” box on a questionnaire would not alone be a sufficient basis to demonstrate that the issuer has taken “reasonable steps” to verify the investor’s accredited status.

C. Proposed Form D Amendments

The SEC proposed amendments to Form D that would require additional information from issuers, such as the methods used to verify the accredited investor status of investors and the types of general solicitation and general advertising used. An issuer relying on new Rule 506(c) would also be required to file Form D with the SEC no later than fifteen days prior to commencing a Rule 506(c) offering and an amended Form D within thirty days following the completion of the offering. The SEC also proposed disqualifying issuers from relying on Regulation D for one year if they fail to file Form D and requiring additional legends and disclosures in all offering materials relying on Rule 506(c). Additionally, the SEC is proposing that for the first two years after the effective date of the rule an issuer relying on Rule 506(c) be required to file all general solicitation and general advertising materials with the SEC.

D. Bad Actor Disqualification

As mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), the SEC also approved final rules to disqualify securities offerings involving certain felons and other so-called “bad actors” from reliance on the exemption from Securities Act registration pursuant to Rule 506. If such “bad actors”, which now include investment managers and principals of private investment funds, are the subject to certain “disqualifying events”, then they will disqualify an issuer from relying on Rule 506. Disqualification will not arise as a result of triggering events that occurred before the effective date of the rule. However, matters that existed before the effective date of the rule and would otherwise be disqualifying are subject to a mandatory disclosure requirement to investors.

E. Retention of the Existing Rule 506 Safe Harbor

The SEC is retaining the existing ability of issuers to conduct Rule 506(b) offerings without engaging in a general solicitation or general advertising.

F. Amendment to Rule 144A

The SEC also adopted an amendment to Rule 144A to permit securities sold under Rule 144A to be offered to investors other than qualified institutional buyers (“QIBs”), including by general solicitation or advertising, so long as the securities are only sold to investors that the issuer reasonably believes to be QIBs at the time of sale.

The final rules will go into effect sixty days after their publication in the Federal Register (mid-September 2013). The proposed Form D amendments are currently open for comment for sixty days.

G. Noteworthy Considerations
Rule 506 Offerings

• An issuer can rely on traditional means of confirming that investors are accredited investors in connection with Rule 506(b) offerings.

• A press release announcing a Rule 506(c) offering does not need to comply with Rule 135c.

• An issuer conducting a Rule 506(c) offering must establish a reasonable belief that the investors in the offering are accredited investors. Thus, if an issuer relies on a third-party verification service, the issuer must conduct due diligence on the third-party service and seek to understand the process that will be used by the third-party verification service for verification of accredited investor status.

• An issuer can rely on the Section 4(a)(2) exemption in conjunction with or as an alternative to a Rule 506(b) offering because the Rule 506(b) offering does not involve general solicitation or general advertising. However, an issuer cannot rely on the Section 4(a)(2) exemption in connection with a Rule 506(c) offering because general solicitation of investors is not consistent with an exempt offering under Section 4(a)(2), which is a transaction “by an issuer not involving any public offering”.

• An issuer can likely begin a private offering as a Rule 506(b) offering and then decide to rely on Rule 506(c) for the offering. However, it is unlikely that an issuer would be able to change course from a Rule 506(c) offering to a Rule 506(b) offering given the presence of general solicitation or general advertising in connection with the Rule 506(c) offering.

• Generally, an issuer cannot conduct a contemporaneous Rule 506(b) offering and Rule 506(c) offering. If the issuer offers the same security, it would not be possible to prevent the general solicitation and general advertising used in connection with Rule 506(c) from tainting the contemporaneous Rule 506(b) offering. However, it may be possible to conduct contemporaneous offerings if the issuer offered different securities and if the investors in the two offerings were different. Rule 502(a) of Regulation D sets forth the traditional “five factor” test that issuers should consider in determining whether offers and sales should be integrated for the purposes of the exemptions under Regulation D.

• Once a Rule 506(c) offering has been completed, the issuer can conduct a Rule 506(b) offering. Given that the Rule 506(c) offering involved general solicitation and general advertising, it is judicious to let time elapse between the two offerings. Rule 502(a) of Regulation D provides a safe harbor from integration of Regulation D offerings made six months before or six months after an offering. A Rule 506(c) offering can follow a completed Rule 506(b) offering.

Secondary Market Transactions

• General solicitation and general advertising should not be used in connection with resales made in reliance on Rule 4(a)(1-1/2) because this exemption relies on the interplay of the Section 4(a)(1) and the Section 4(a)(2) exemptions and the JOBS Act did not amend Section 4(a)(2).
• The changes to Rule 506(c) do not affect resales because Rule 506 is available only to issuers.

Offerings in Close Proximity

• A private placement made pursuant to Section 4(a)(2) and/or Rule 506(b) shortly before the filing of an initial public offering (“IPO”) would not likely be viewed as “gun jumping” because such an offering does not involve general solicitation and general advertising. However, a Rule 506(c) offering conducted in close proximity to the filing of an IPO may be viewed as “gun jumping” because of the general solicitation and general advertising associated with the offering, especially if the Rule 506(c) offering involves the sale of the same security as that offered in the IPO. In the case of emerging growth companies, the JOBS Act specifically permits test-the-waters communications with institutional accredited investors and QIBs prior to or after the filing of a registration statement. However, the general solicitation and general advertising used in a Rule 506(c) offering may also raise concerns for any test-the-waters discussions.
• The SEC and its staff has clarified that an issuer that is conducting a public offering may conduct a concurrent private placement as long as, among other things, the issuer has not solicited the offerees in the private placement using the registration statement. Presumably, this analysis is made simpler now that general solicitation may be used in connection with a Rule 506(c) offering. The longstanding principle still applies that an offering that commences as a private offering must be completed as a private offering and an offering that commences as a public offering must be completed as a public offering except in the circumstances specified in Rule 155.
• It is unlikely that Rule 506(c) will be used in connection with a private investment in public equity (“PIPE”) transaction. An already public company will likely be reluctant to use general solicitation in connection with a PIPE transaction, because announcing the potential private offering may have an effect on its stock price. Also, once an announcement is made, an issuer may be more reluctant to terminate a deal if the pricing is not favorable.
• Rule 152 clarifies that a completed private offering will not be integrated with a subsequent public offering. Generally, issuers that conduct a PIPE transaction, or private offering wherein resale registration rights are offered to the private investors, rely on Rule 152 in connection with the filing of a resale registration statement. When Rule 152 was adopted, the private offering would not have involved a general solicitation. Thus, it is unclear whether Rule 152 would be available in connection with an offering in which general solicitation is permitted.

Please contact Mitchell C. Littman, Esq. at mlittman@littmankrooks.com, Steven D. Uslaner, Esq. at suslaner@littmankrooks.com or Lesley DeCasseres, Esq. at ldecasseres@littmankrooks.com if you have questions concerning the Rule.

* General solicitation and general advertising include advertisements published in newspapers and magazines, website postings, press releases, communications broadcast over television and radio, and seminars or meetings where attendees have been invited by general solicitation or general advertising.

The required offering documents must be filed electronically with FINRA through the FINRA Firm Gateway (the “Firm Gateway System”). All broker-dealers have authorized users to this system. FINRA has indicated that it will afford confidential treatment to all documents and information filed pursuant to Rule 5123, and will use the offering materials only for the purpose of determining compliance with FINRA rules or other appropriate regulatory purposes.

The following private placements are exempt from the Rule 5123 filing requirement:

Exemptions Based on the Type of Offerings

• offerings made pursuant to Rule 144A or Regulation S promulgated under the Securities Act of 1933 (the “Securities Act”);
• offerings of debt securities sold under Section 4(2) of the Securities Act, so long the maturity is below 397 days and the minimum denomination is $150,000 (or the equivalent in other currencies);
• offerings of exempted securities, as defined in Section 3(a)(12) of the Securities Exchange Act of 1934 (the “Securities Exchange Act”);
• offerings of exempt securities with short-term maturities under Section 3(a)(3) of the Securities Act (i.e., commercial paper);
• offerings of non-convertible debt or preferred securities by issuers that meet the eligibility criteria for registering primary offerings of non-convertible securities on SEC Forms S-3 and F-3;
• offerings of securities in business combination transactions, such as exchange offers and transactions covered by Rule 145 promulgated under the Securities Act (statutory mergers and consolidations, reclassifications and asset transfers);
• offerings of securities issued in conversions, stock splits and restructuring transactions to existing investors without the need for additional consideration or investments on the part of the investors;
• offerings subject to FINRA filing requirements under its suitability rule (Rule 2310), corporate financing rule (Rule 5110) or conflicts of interest rule (Rule 5121); and
• private placements by members (which are subject to Rule 5122).

Exemptions Based on the Type of Purchaser

• investment companies, as defined in Section 3 of the Investment Company Act of 1940 (the “Investment Company Act”);
• qualified institutional buyers (“QIBs”), as defined in Rule 144A promulgated under the Securities Act (“Rule 144A”), or an entity owned exclusively by QIBs;
• qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;
• institutional accounts, as defined in FINRA Rule 4512(c);
• banks, as defined in Section 3(a)(2) of the Securities Act;
• accredited investors, as described in Rule 501(a)(1), (2), (3), or (7) promulgated under the Securities Act; and
• issuer employees and affiliates.

Additionally, FINRA member firms may apply for exemptions from the provisions of the Rule for “good cause.”

Please contact Mitchell C. Littman, Esq. at mlittman@littmankrooks.com or Steven D. Uslaner, Esq. at suslaner@littmankrooks.com if you have questions concerning the Rule.