JOBS Act and Other Securities Law Essentials for Growing Companies

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Jobs Act and Other Securities Law Essentials for Growing Companies

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JOBS ACT AND OTHER SECURITIES

LAW ESSENTIALSFOR GROWING COMPANIES

STEVE QUINLIVAN

JILL RADLOFF

ETHAN MARK

DAVID JENSON

STINSON LEONARD STREET LLP

SEPTEMBER 2014


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TABLE OF CONTENTS

I. BASIC PRINCIPLES ......................................................................................................... 1

General Rule ....................................................................................................................... 1

What is a public offering? ................................................................................................... 1What is a security? .............................................................................................................. 1

II. THE CLASSIC 4(A)(2) PRIVATE PLACEMENT ........................................................... 4

Do I Need a Private Placement Memorandum? .................................................................. 5

III. OTHER CONSIDERATIONS FOR PRIVATE PLACEMENTS ...................................... 5

Liability Standards .............................................................................................................. 5Pitfalls for Issuers ............................................................................................................... 8Pitfalls for Lawyers ............................................................................................................. 8

IV. PRIVATE OFFERINGS PURSUANT TO REGULATION D .......................................... 9

Overview ............................................................................................................................. 9Offerings Pursuant to Rule 504......................................................................................... 11Offerings Pursuant to Rule 505......................................................................................... 11

Offerings Pursuant to Rule 506(b) No General Solicitation Permitted ....................... 12Offerings Pursuant to Rule 506(c)General Solicitation Permitted ............................... 13Final SEC Rule Disqualifying Bad Actors From Rule 506 Offerings .............................. 20

V. PROPOSED REGULATION A+ ..................................................................................... 25

Investment Limitations ..................................................................................................... 25

Offering Statement ............................................................................................................ 25

Reporting Obligations ....................................................................................................... 26Relationship with State Securities Laws ........................................................................... 26

VI. PROPOSED CROWDFUNDING RULES....................................................................... 26

Limitation on Capital Raised ............................................................................................ 26Investment Limitation ....................................................................................................... 27Transactions Conducted Through an Intermediary ........................................................... 28

Ineligible Issuers ............................................................................................................... 28

Prohibitions Applicable to the Issuer ................................................................................ 28Form C and Filing Requirements ...................................................................................... 29

Required Disclosures of Offering Information ................................................................. 31Discussion of Financial Condition and Financial Disclosures ......................................... 33SEC Registration and FINRA Membership ...................................................................... 34Financial Interests ............................................................................................................. 35Fraud Reduction Measures ............................................................................................... 35


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Education Materials .......................................................................................................... 35Investor Limits .................................................................................................................. 36Investors Right to Cancel ................................................................................................ 36Communication Channels ................................................................................................. 36ATS/Secondary Market Transactions ............................................................................... 36

Registration ....................................................................................................................... 36

Exemption from Broker Dealer Registration .................................................................... 37Restrictions on Resales ..................................................................................................... 37Exemption from Section 12(g).......................................................................................... 37FINRA Proposes Rules for Crowdfunding Portals ........................................................... 38

VII. OTHER PENDING JOBS ACT CHANGES ................................................................... 38

VIII. INTEGRATION ............................................................................................................... 40

IX. RULE 701 ......................................................................................................................... 43

X.

EXCHANGE ACT REPORTING OBLIGATIONS ........................................................ 44

XI. USING FINDERS ............................................................................................................. 47

Who is a Broker? .............................................................................................................. 47Examples of SEC No-Action Letters ................................................................................ 50Examples of SEC Enforcement Action............................................................................. 51Consequences of Hiring an Unregistered Broker ............................................................. 52Blue Sky Issues ................................................................................................................. 53Direct Regulation of Finders in Minnesota ....................................................................... 54

XII.

TENDER OFFERS ........................................................................................................... 54

XIII. FOREIGN CORRUPT PRACTICES ACT ...................................................................... 55

XIV. WHISTLEBLOWERS ...................................................................................................... 56

XV. INVESTMENT COMPANIES ......................................................................................... 57

XVI. INVESTMENT ADVISERS ............................................................................................ 58


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Those characteristics usually associated with common stock, thereby indicating thatsuch stock is a security within the meaning of federal securities laws, are the right toreceive dividends, negotiability, ability to be pledged or hypothecated, voting rightsin proportion to the number of shares owned, and the capacity to appreciate in value.

The sale of all of the outstanding stock in a lumber business involved the sale of asecurity within the meaning of federal securities laws where, notwithstanding the factthat the sale amounted to a sale of the entire business, it was likely that the investorbelieved he or she was covered by federal securities laws.

Notes:

In Reeves et al. v. Ernst & Young,3 the Supreme Court held in determining whether aninstrument denominated a note is a security, within the meaning of the securities laws, courtsshould apply the family resemblance test. Under the family resemblance test, a note ispresumed to be a security, and the presumption may be rebutted only by showing that the notebears a strong resemblance, determined by examining four specified factors, to one of a

judicially crafted list of categories of instruments that are not securities. If an instrument is notsufficiently similar to a listed item, the court must decide whether another category should beadded by examining the same factors. The types of notes that the Court found were notsecurities were:

a note delivered in consumer financing,

a note secured by a mortgage on a home,

a short-term note secured by a lien on a small business or some of its assets,

a note evidencing a character loan to a bank customer,

short-term notes secured by an assignment of accounts receivable, or

a note which simply formalizes an open-account debt incurred in the ordinary courseof business.

The four factors a court will consider in determining whether other types of transactionsare not notes are:

Motivations for the Transaction. Courts will assess the motivations that prompt areasonable seller and buyer to enter into a transaction. If the sellers purpose is to

raise money for the general use of a business enterprise or to finance substantialinvestments and the buyer is interested primarily in the profit the note is expected togenerate, the instrument is likely to be a security. If the note is exchanged tofacilitate the purchase and sale of a minor asset or consumer good, to correct for the

3494 U.S. 56 (1990).


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sellers cash-flow difficulties, or to advance some other commercial or consumerpurpose, on the other hand, the note is less sensibly described as a security.

The Plan of Distribution. Courts will examine the plan of distribution of theinstrument to determine whether it is an instrument in which there is commontrading for speculation or investment.

Reasonable Expectations of the Investing Public. A court will consider instruments tobe securities on the basis of public expectations that the instruments are securities,even where an economic analysis of the circumstances of the particular transactionmight suggest that the instruments are not securities as used in that transaction.

Other Factors. A court will examine other factors render application of the SecuritiesAct unnecessary such as, for example, when an instruments risk is significantlyreduced because it is already subject to regulation pursuant to another regulatoryscheme.

Investment Contracts:

In SEC v. W.J. Howey Co.,4 the Supreme Court stated an investment contract forpurposes of the Securities Act means a contract, transaction or scheme whereby a person: (i)invests his money, (ii) in a common enterprise, and (iii) is led to expect profits solely from theefforts of the promoter or a third party.

It is immaterial whether the shares in the enterprise are evidenced by formal certificatesor by nominal interests in the physical assets employed in the enterprise. The Court stated thatthe test permits the fulfillment of the statutory purpose of compelling full and fair disclosurerelative to the issuance of the many types of instruments that in our commercial world fall

within the ordinary concept of a security. It embodies a flexible rather than a static principle,one that is capable of adaptation to meet the countless and variable schemes devised by thosewho seek the use of the money of others on the promise of profits.

Limited Liability Companies:

In some contexts, it is unclear whether interests in limited liability companies, or LLCs,will be treated as securities for purposes of federal securities laws. However,where money israised from passive investors, it will often be found that securities are involved.5

Under federal law, interests in limited liability companies are tested in the same manneras general partnerships the investment contract test set forth inHoweyis applied. One of the

4328 U.S. 293 (1946).

5 See Wheaton, Current Status of Securities and Bankruptcy Issues, American Law InstituteAmerican Bar

Association Continuing Legal Education (2003). See also C. Bishop and D. Kleinberger, Limited LiabilityCompaniesTax and Business Law, 11.01 et. seq. (1994 & Supp. 2006) for an extensive analysis of the topicsdiscussed herein.


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leading cases in this area is Williamson v. Tucker.6 In Williamson, the court recognized thatalthough prior decisions had held that general partnership interests were generally not consideredinvestment contracts for the purposes of the federal securities laws, the mere fact that aninvestment takes the form of a general partnership or joint venture does not inevitably insulate itfrom the reach of the federal securities laws. The court found that if an investor general partner

irrevocably delegates his or her powers or is incapable of exercising them, or is so dependent ona particular expertise of the promoter or managing partner that he or she has no reasonablealternative to reliance on the managing promoter or manager, then the investment in thepartnership may be characterized as an investment contract. The court concluded that an investorwho claims that a general partnership interest is a security must overcome a presumption that thegeneral partnership interest is not an investment contract, but can establish the existence of asecurity by showing that (i) the partnership agreement leaves so little power in the investor thatthe arrangement is akin to a limited partnership, (ii) the investor is so inexperienced andunknowledgeable in business affairs that he or she cannot intelligently exercise partnershippowers or (iii) the investor is so dependent on unique entrepreneurial or managerial abilities ofthe promoter manager that he or she cannot replace the manager or exercise partnership powers.

If one wishes to avoid classification of an interest in a limited liability company as asecurity, the organizational documents must be carefully drafted to provide investing members asmuch power as possible. Consider an effective right to remove management, effective vetorights, and majority and supermajority voting requirements. Also consider whether members canbind the LLC. Note also that the greater the number of passive investors, the greater thelikelihood the investors are looking to the efforts of others under the Howeytest, the case thatset the standard for the definition of an investment contract.

II.

THE CLASSIC 4(A)(2) PRIVATE PLACEMENT

Ralston Purina7 sets forth the basic ground rules for private placements8 outside of a

statutory safe harbor:

The offering must be made to those able to fend for themselves; and

The offerees must have access to the kind of information required to be disclosed inconnection with a registered offering.

In addition to the sophistication and information requirements discussed in Ralston Purina, thefollowing are considered:

6645 F. 2d 404 (5th Cir. 1981).

7346 U.S. 119 (1953).

8 See Law of Private Placements (Non-Public Offerings) Not Entitled to Benefits of a Safe Harbors A Report

issued by the Committee of Federal Regulation of Securities, ABA Section of Business Law (the ABA Report),The Business Lawyer, Vol. 66, November 2010 for a useful guide to the history and law of private placements.


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Manner of Offering:

It is clear that advertising, seminars and the like are not permitted (with the exception ofcertain press releases by public companies meeting a safe harbor). It is often said that an issuer(or placement agent) must have a pre-existing relationship with the offerees. While this is agood rule to follow, it may not be necessary where institutional investors are involved. However,if an offering is made to an indeterminate number of previously unknown offerees who may ormay not be financially sophisticated, that would raise serious questions.9

Identity of Offerees:

The classical 4(a)(2) analysis, as stated by the SEC in now superseded Rule 146, requiredthat prior to making an offer, the issuer and any person acting on its behalf had to reasonablybelieve that the offeree either had such knowledge and experience in financial and businessmatters that he was capable of evaluating the merits and risks of the prospective investment orwas a person who was able to bear the economic risk of the investment.

Do I Need a Private Placement Memorandum?

There is no requirement that a private placement memorandum (a PPM) be generatedto perfect a common law private placement (compare Rule 506 where non-accredited investorsare included in an offering). Under Ralston Purina, it is access to information that matters.Where only a handful of sophisticated investors are involved, not producing a PPM is often adefensible choice. Where the number of offerees grows, providing a PPM is often a bestpractice. It is desirable to be able to demonstrate the issuer and its business and attendant riskswere adequately explained.

III.

OTHER CONSIDERATIONS FOR PRIVATE PLACEMENTS

Liability Standards

Valid Private PlacementsFederal Law:

Gustafson, et al., v. Alloyd Company, Inc.,10 was an action brought by plaintiffs whopurchased substantially all of the corporations stock from sellers pursuant to a private saleagreement. The plaintiffs sought rescission of the private sale agreement under Section 12(2) ofthe Securities Act on the ground that the written sale agreement was a prospectus andcontained material misstatements. The Court held that although the term prospectus is definedin Section 2(a)(10) of the Securities Act, in part, as any communication, written or by radio ortelevision, the term prospectus refers only to a document soliciting the public to acquire

securities.

9See ABA Report.

10513 U.S. 561 (1995).


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The effect ofGustafsonis to take private placements out of Section 12 of the SecuritiesAct leaving Rule 10b-5 of the Securities Exchange Act as the primary basis of liability. Theeffect is significant because an element of a Rule 10b-5 claim is scienter. Some of theelements of Rule 10b-5 action include:

the defendant made a material misrepresentation or omission;

the defendant acted with scienter, or a wrongful state of mind, which means thatthe defendant intended to make the material misrepresentation or omission, or actedrecklessly when making the misrepresentation or omission;

the material misrepresentation or omission was made in connection with thepurchase or sale of a security; and

the plaintiff relied upon the material misrepresentation or omission.

In Janus Capital Group, Inc., v. First Derivative Traders,11 the plaintiff alleged that

Janus Capital Group, or JCG, and its wholly owned subsidiary, Janus Capital Management LLC,or JCM, made false statements in mutual fund prospectuses filed by Janus Investment Fundforwhich JCM was the investment adviser. Although JCG created Janus Investment Fund, it was aseparate legal entity owned entirely by its mutual fund investors.

The case centered on whether JCG and JCM made the allegedly fraudulent statement inthe funds prospectus. The decision notes one makes a statement in connection with thepurchase or sale of securities by stating it. For purposes of Rule 10b-5, the maker of astatement is the person or entity with ultimate authority over the statement, including its contentand whether and how to communicate it. Without control, a person or entity can merely suggestwhat to say, and not make the statement in its own right. One who prepares or publishes a

statement on behalf of another is not its maker. This rule might best be exemplified by therelationship between a speechwriter and a speaker. Even when a speechwriter drafts a speech, thecontent is entirely within the control of the person who delivers it, and it is the speaker who takescreditor blamefor what is ultimately said.

This holding in the case follows from Central Bank of Denver, N.A. v. First InterstateBank of Denver, N. A.(1994), in which the Court held that Rule 10b5s private right of actiondoes not include suits against aiders and abettors. Such suitsagainst entities that contributesubstantial assistance to the making of a statement but do not actually make itmay bebrought by the SEC, but not by private parties. According to the Court, a broader reading ofmake, including persons or entities without ultimate control over the content of a statement,would substantially undermine Central Bank. If persons or entities without control over thecontent of a statement could be considered primary violators who made the statement, thenaiders and abettors would be almost nonexistent.

11131 S. Ct. 2296 (2011).


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Many believe the Janus case eliminates most Rule 10b-5 liability for non-issuers thathelp prepare disclosure documents. This includes investment banks, accountants and law firms.

Valid Private PlacementsState Law:

Minnesota law provides that a person is liable to the purchaser if the person sells asecurity . . . by means of an untrue statement of a material fact or an omission to state a materialfact necessary in order to make the statement made, in light of the circumstances under which itis made, not misleading, the purchaser not knowing the untruth or omission and the seller notsustaining the burden of proof that the seller did not know and, in the exercise of reasonablecare, could not have known of the untruth or omission (emphasis added).12 Note that theMinnesota statute appears to change the standard from reckless to negligently in manycircumstances.13

The same Minnesota statute provides for joint and several liability on the followingclasses of persons (other than those who with the exercise of reasonable care could not haveknown of the conduct):

direct or indirect controlling persons;

managing partners, executive officers, directors or individuals having a similar status;

individuals who are employees of or associated with persons who are liable and whomaterially aided the conduct; and

broker-dealers, agents, investment advisers, or investment adviser representatives thatmaterially aid the conduct.

As a result, the Minnesota statute potentially undermines the protections of Janusunder Federalsecurities law.

Private PlacementsViolation of Section 5:

Section 12(a)(1) of the Securities Act provides a private right of action for offerings ofsecurities in violation of Section 5 of the Securities Act i.e. an offering intended to be anexempt private offering that is invalid due to circumstances such as the purchase of securities bynon-accredited investors or the public offering of the securities. Damages under Section 5 are arefund of the purchase price of the security in most circumstances. No causal connection to aloss is required.

Since no causal connection is required, everyone who purchases in a bad privateplacement can sue for a refund of the purchase pricei.e. everyone gets their money back.

12MINN.STAT. 80A.76(b).

13SeeTrooien v. Mansour, 608 F. 3d 1020 (8thCir. 2010).


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Issues can arise as to what constitutes the extent of theprivate placement. Prior sales may beintegrated into one deemed offering increasing liability.14

Pitfalls for Issuers

Some common pitfalls for issuers encountered in private placements are:

Selling Securities for Too High of a Value: Down rounds are emotional, especiallywhere friends and family see lost value.

Thinking Its Easy: Raising money is difficult and many are unable to complete anoffering.

Failure to Raise Enough Money: Failure to fund foreseeable needs results in possiblebusiness failure, management distraction of continually raising money and increasesthe likelihood of a down round.

Too Many Shareholders: Most small businesses do not have the resources or desire toperform an investor relations function for numerous shareholders. In addition, asplintered shareholder base may make it difficult to complete major corporatetransactions such as a merger or a sale of the business.

Failure to Keep Records: Complete and accurate shareholder records are essential forthe sale of a business. All transfers must be documented with hopefully evidence ofcancelled stock certificates. In addition, issuers will have to prove that all issuanceswere exempt under the securities act.

Failure to Maintain D&O Insurance: Directors and officers liability insurance cansoften the blow if securities issuances are challenged.

Failure to Have Audited Financial Statements: The absence of audited financialstatements can cause difficulty in later rounds.

Pitfalls for Lawyers

Failure to Recognize Risk: A high proportion of start-up businesses fail, leading insome cases for a search for deep pockets. Client acceptance procedures shouldrecognize this.

Unachievable Business Plans and Inexperienced Management: Unrealistic business

plans and inexperienced management leads to increased risks.

Participation in Offering: Ideally, lawyers should not make any statements about thequality or nature of the investment. Lawyers should just collect checks and

14SeeRule 502(a) for SEC guidance on the integration analysis.


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subscription agreements. Avoid the use of firm names on mailings andcorrespondence.

IV.

PRIVATE OFFERINGS PURSUANT TO REGULATION D

Overview

Generally, sales of securities must be registered under the Securities Act, unless anexemption from registration applies. Rules 501 through 508 under the Securities Act, which areknown as Regulation D, contain requirements relating to several different methods of conductingsales of exempt securities. Compliance with Regulation D is not a requirement for a validprivate offering, nor is the election to attempt to comply with Regulation D an exclusive election;for example, an issuer that attempts to comply with Rule 506(b) in a private offering does notprevent an issuer from also claiming that the offering is exempt under Section 4(a)(2) of theSecurities Act, which contains a general exemption for transactions not involving any publicoffering. However, compliance with Regulation D is attractive to issuers because it providesspecific steps the issuer can take to ensure a valid exemption.

Much of Regulation D is premised on the notion that certain individuals, termedaccredited investors, possess enough business sophistication, and have enough financial assets,that they do not require the full protections of the securities laws and are able to withstand theloss of their investment. An accredited investor is an investor that falls into one of eightcategories set forth in Rule 501(a), including a bank, a private business development companyunder the Investment Advisers Act of 1940, a tax exempt organization with at least $5 million inassets, and certain natural persons who have a net worth of at least $1 million, or who had anannual income of at least $200,000 individually, or at least $300,000 together with a spouse, ineach of the last two years. In the past, a person could count the value of a primary residencetowards the $1 million net worth threshold. However, Section 413(a) of the Dodd-Frank Act

provided that the value of a persons primary residence can no longer be included as an asset forpurposes of calculating net worth, and debt secured by a primary residence must be counted as aliability to the extent it exceeds the current fair market value of the residence.

There are four main types of offerings that are exempt under Regulation D, described inRule 504, Rule 505, or Rule 506(b), and Rule 506(c). Regulation D imposes differentrequirements on the issuer with respect to each type of offering, but there are several issues thatare common to Regulation D offerings in general.

Integration:

With respect to a Regulation D offering, there is a window of six months prior to thecommencement of the offering and six months after the conclusion of the offering during whichother sales of securities may be considered integrated with the offering for purposes ofRegulation D. In other words, a sale of securities not in compliance with Regulation D threemonths after the completion of an otherwise valid Regulation D offering could jeopardize theentire offering if the subsequent sale is considered integrated. The SEC uses a five factor test todetermine whether offerings should be integrated: (i) whether the sales are part of a single planof financing; (ii) whether the sales involve issuance of the same class of securities; (iii) whether


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the sales have been made at or about the same time; (iv) whether the same type of considerationis being received; and (v) whether the sales are made for the same general purpose.

Disclosures to Non-Accredited Investors:

If securities are offered or sold to non-accredited investors where permitted underRegulation D, additional disclosure requirements apply to the materials provided to the non-accredited investors. While the issuer can exercise a fair degree of control over the disclosuresit makes to accredited investors (provided it complies with anti-fraud provisions), the materialsthat it must provide to non-accredited investors are generally equivalent to materials that must beprovided in connection with a public offering. As a result, an offering that includes non-accredited investors can often be more expensive, time consuming, and burdensome to the issuerthan an offering solely to accredited investors.

Ban on Advertising and General Solicitation:

Except with respect to offerings under Rule 506(c), the offering cannot utilize any

advertising or general solicitation, including advertisements in newspapers, magazines, or anyother media that is distributed to an un-screened audience. Likewise, the offering cannot includeseminars or presentations that are open to the public at large.

Restrictions on Resale:

Securities purchased in a Regulation D offering are restricted securities within themeaning of the Securities Act, which means that they may not be resold other than pursuant toregistration under the Securities Act or an exemption from such registration. The issuer is alsoobligated to take reasonable steps to ensure that purchasers in a Regulation D offering are notunderwriters. An issuer can demonstrate it has taken reasonable steps to this end by: (i)

conducting a reasonably inquiry into whether a purchaser is purchasing for his own account orfor others; (ii) providing disclosure to investors that the securities are restricted securities andcannot be resold other than pursuant to registration, or an exemption from registration, under theSecurities Act; and (iii) placing a legend on each certificate representing the securities that setsforth the restrictions on transferability.

Filing Form D:

Rule 503 of Regulation D requires that in connection with an offering in reliance on Rule504, Rule 505, or Rule 506, the issuer must complete and file a notice of sales on Form D withthe SEC within 15 days of the first sale of securities in the offering.15 Form D may only be filedonline through the SECs EDGAR system, which requires issuers to apply for and obtain accesscodes prior to making a Form D filing. Questions often arise as to the manner of calculating thedate of first sale with respect to an offering in which proceeds are held in escrow and no

15 In connection with the adoption of new Rule 506(c), discussed below, the SEC has proposed amendments to

Form D that would require the document to be filed at least 15 days in advance of the date of a general solicitationwith respect to Rule 506(c) offerings.


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subscription is accepted until a minimum level of aggregate proceeds is achieved. The SECsview is that the date of first sale is the date the first investor is irrevocably contractuallycommitted to invest, which could vary depending on the terms of the subscription agreementutilized in the offering.16 With respect to an offering in which proceeds are held in escrow untila minimum level of aggregate proceeds is achieved, the SEC interprets the date of first sale as

the date proceeds are first received into escrow.

17

State Blue Sky Filings:

Offerings conducted pursuant to Rule 506 implicate state blue sky law notice filingrequirements. As a result of adoption of the National Securities Markets Improvement Act of1996, Rule 506 offerings are not subject to state registration requirements. However, this federalpreemption does not apply to Rule 504 or Rule 505 offerings, or to offerings exempt fromfederal registration under Section 4(a)(2) of the Securities Act that do not comply with Rule 506.While state registration requirements are preempted for Rule 506 offerings, states are stillallowed to impose notice filing requirements and require filing fees in connection with Rule 506offerings, and most states have adopted such requirements, known as blue sky laws. State blue

sky laws typically require the issuer to pay an administrative fee and to file with the applicablestate a copy of the Form D for the offering and a cover letter that may require disclosure of otheroffering information, such as the number of purchasers in the offering residing in the applicablestate. Blue sky filings add to the administrative expense of an offering, because each state has itsown approach to the filings. In Minnesota, a combination of statutes, administrative rules, andinterpretive materials provide that an issuer must file a copy of Form D with the MinnesotaDepartment of Commerce, pay a $300 filing fee, and indicate by letter the number of purchasersin the offering and the aggregate amount of securities sold.

Offerings Pursuant to Rule 504

Rule 504 provides an exemption from registration for offers and sales of up to $1 millionin securities in any 12 month period, provided that the issuer is not a reporting company underthe Exchange Act, an investment company, or a blank check company. In addition, in certaincircumstances (generally if an issuer complies with state law public-offering type requirements)the securities sold in a Rule 504 offering will not be restricted securities and the ban on generaladvertising and solicitation in Rule 502(c) will not apply to the offering.

Offerings Pursuant to Rule 505

Rule 505 provides an exemption from registration for issuers (other than investmentcompanies) that offer and sell up to $5 million in securities in any 12 month period. Sales may

be made to an unlimited number of accredited investors and up to 35 non-accredited investors.In addition to the typical Regulation D requirements described above, this exemption is not

16 See Securities Act Rules, Compliance and Disclosure Interpretations, 257.02, available at

http://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm.17

See Securities Act Rules, Compliance and Disclosure Interpretations, 257.05, available at

http://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm.


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available for issuers who are subject to the bad actor disqualifications set forth in Rule 262 ofRegulation A. The bad actor disqualifications in Rule 262 are quite complicated and apply to anumber of different types of actors with respect to a number of different types of events withvarying look-back periods. Generally speaking, with respect to issuers, disqualifying eventsinclude having been convicted of during the last five years, or being the subject of orders or

investigations within the last five years relating to, securities fraud (broadly defined), or havingfiled a registration statement that is subject to an ongoing examination under Section 8 of theSecurities Act.

Offerings Pursuant to Rule 506(b) No General Solicitation Permitted

Historically, Rule 506 presented one type of offering exemption which required, amongother things, that there be no general solicitation and advertising in connection with the offering.As we discuss in the next section, the SEC has recently bifurcated Rule 506 into two separateexemptions. New Rule 506(c) now permits the use of general solicitation and advertising inconnection with private offerings (discussed in more detail below). Traditional Rule 506offerings that do not make use of general solicitation and advertising can still be conducted as

before in reliance on Rule 506(b).

Rule 506(b) allows an issuer to sell an unlimited aggregate amount of securities to anunlimited number of purchasers who are accredited investors and up to 35 purchasers who arenot accredited investors but who meet a certain threshold of investment sophistication. Rule 506offerings accounted for an estimated $895 billion in capital raised in the U.S. in 2011, comparedwith $984 billion raised through registered offerings.18

If non-accredited investors are included in the offering, disclosures similar to thoserequired in public offerings must be made to the non-accredited investors, increasing the expenseand administrative burden of conducting the offering. While Rule 505 places no additional

requirements on non-accredited investors who participate in the offering, non-accreditedinvestors in a Rule 506(b) offering must, either alone or with a purchaser representative, havesuch knowledge and experience in financial and business matters that he is capable ofevaluating the merits and risks of the prospective investment. In other words, some level of duediligence on the part of the issuer is required with respect to non-accredited investors in Rule 506offerings. This could take the form of a questionnaire that the investor fills out describing theirfinancial position and business sophistication.

The continued availability of existing Rule 506(b) will be important for those issuers thateither do not wish to engage in general solicitation in their Rule 506 offerings (and becomesubject to the requirement to take reasonable steps to verify the accredited investor status of

purchasers) or wish to sell privately to non-accredited investors who meet Rule 506(b)ssophistication requirements. For example, while offerings under Rule 506(c) will may requireissuers to engage in a range of steps to verify accredited investor status, the traditional method of

18 Securities Act Release No. 9354, Eliminating the Prohibition Against General Solicitation and General

Advertising in Rule 506 and Rule 144A Offerings, August 29, 2012.


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asking investors to self-certify that they meet the accredited investor definition by checking abox will continue to satisfy the requirements of Rule 506(b). Traditional Rule 506(b) offeringsare also beneficial to investors with whom an issuer has a pre-existing substantive relationship.

One way in which Rule 506(b) offerings will change as a result of recent SEC rulemaking is that offerings under Rule 506(b) are now subject to disqualification or disclosure rulesunder the bad actor provisions discussed below.

Offerings Pursuant to Rule 506(c)General Solicitation Permitted

The SEC has adopted final rules eliminating the ban on general solicitation andadvertising in Rule 506 offerings as required by the JOBS Act. The changes are mostlyembodied in new Rule 506(c). The relationship between Rule 506(b) and new Rule 506(c) issuch that an issuer could conceivably transition an ongoing Rule 506(b) offering to a Rule 506(c)offering to take advantage of general solicitation. The key question is whether all of therequirements of Rule 506(c) are met with respect to all sales in the offering including salesmade prior to the determination to transition to a Rule 506(c) offering. This same concept

applies in the case of an issuer that began a Rule 506 offering before new Rule 506(c) wenteffective in September and wants to transition to a generally solicited offering. On the otherhand, if an issuer has begun a Rule 506(c) offering and has engaged in advertising or generalsolicitation, the issuer is unable to transition the offering to a Rule 506(b) offering; the use ofadvertising or general solicitation would make compliance with the requirements of Rule 506(b)impossible. Compliance with state blue sky laws must also be considered in connection withRule 506(c) offerings. Blue sky notice filings are typically required with respect to any sales oroffers of sales made in a particular state. If general solicitation and advertising is being utilized,it may be difficult to track when offers have made their way into a particular state.

Definition of General Solicitation and Advertising:

Rule 506(c) does not itself change the existing definition of what constitutes generalsolicitation and general advertising. Although those terms are not defined in Regulation D,Rule 502(c) does provide examples of general solicitation and general advertising, includingadvertisements published in newspapers and magazines, communications broadcast overtelevision and radio, and seminars where attendees have been invited by general solicitation orgeneral advertising. By interpretation, the SEC has confirmed that other uses of publiclyavailable media, such as unrestricted websites, also constitute general solicitation and generaladvertising, but that presentations commonly known as venture fairs or demo days do notconstitute general solicitation or advertising..

General Requirements:

Under new Rule 506(c), issuers can offer securities through means of general solicitation,provided that they satisfy all of the conditions of the exemption. These conditions are:

all terms and conditions of Rule 501, Rule 502(a), and Rule 502(d) must be satisfied.Rule 501 consists mostly of definitions, Rule 502(a) addresses integration with otherofferings and Rule 502(d) requires issuers to take reasonable steps to prevent


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purchasers from further distributions of securities so that they are not classified asunderwriters;

all purchasers of securities must be accredited investors; and

the issuer must take reasonable steps to verify that the purchasers of the securities areaccredited investors.

Principles-Based Approach to Verifying Accredited Investor Status:

Under Rule 506(c), issuers are required to take reasonable steps to verify the accreditedinvestor status of purchasers. Whether the steps taken are reasonable will be an objectivedetermination by the issuer (or those acting on its behalf), in the context of the particular factsand circumstances of each purchaser and transaction. The SEC calls this a principles-basedapproach, and has indicated that it does not intend to provide guidance or approval on a case bycase basis for issuers. The SEC is unconcerned with the actual circumstances of a purchaser; therule relates only to the steps taken by an issuer, the conclusion reached by the issuer, and

whether the steps taken and conclusion reached were reasonable. For example, if a purchaserturns out to not, in fact, be an accredited investor, the Rule 506(c) exemption is still valid as longas the issuer made a reasonable inquiry and formed a reasonable belief as to the purchasersaccredited status within the meaning of Rule 506(c). Conversely, if an issuer fails to make thenecessary inquiry, the Rule 506(c) exemption will not be available to the issuer, even if it turnsout that each purchaser is in fact an accredited investor.

The SEC has indicated that the steps required to be taken by an issuer should beappropriately scaled depending on the likelihood that a purchaser is an accredited investor.Among the factors that issuers should consider relating to the likelihood that a prospectivepurchaser is an accredited investor are:

the nature of the purchaser and the type of accredited investor that the purchaserclaims to be;

the amount and type of information that the issuer has about the purchaser; and

the nature of the offering, such as the manner in which the purchaser was solicited toparticipate in the offering, and the terms of the offering, such as a minimuminvestment amount.

These factors are interconnected and are intended to help guide an issuer in assessing thereasonable likelihood that a purchaser is an accredited investor which would, in turn, affect the

types of steps that would be reasonable to take to verify a purchasers accredited investor status.After consideration of the facts and circumstances of the purchaser and of the transaction, themore likely it appears that a purchaser qualifies as an accredited investor, the fewer steps theissuer would have to take to verify accredited investor status, and vice versa.

While intended by the SEC to be flexible and adaptable, the principles-based approach toverifying accredited investor status is also a source of uncertainty for issuers. In an attempt to


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provide some additional guidance to issuers, the Securities Industry and Financial MarketsAssociation (SIFMA) released a memo on June 23, 2014, outlining several specific methods forverifying accredited investor status that SIFMA believes would satisfy the principles-basedapproach. For registered broker-dealers and investment advisers seeking to verify the accreditedinvestor status of a natural person the SIFMA memo provides two proposed methods one based

on the account balance of the investor and one based on the amount being invested in theoffering that SIFMA believes would satisfy the principles-based approach. Of course, theSIFMA memo does not constitute SEC guidance, but it does have the support of a number ofmajor law firms and may be a useful tool in seeking to satisfy an issuers obligation to takereasonable steps to verify accredited investor status outside of the Rule 506(c) safe harbors. TheSIFMA memo also contains an example questionnaire for use in verifying accredited investorstatus of natural persons and an example of a written verification that could be provided to anissuer by a broker-dealer, investment adviser, or law firm certifying that a purchaser is anaccredited investor for purposes of the written third party confirmation safe harbor.

Nature of the Purchaser: Rule 501(a) sets forth different categories ofaccredited investors, such as broker-dealers, investment companies, employee benefit plansestablished by state governmental entities, and tax exempt organizations. Issuers shouldrecognize that the steps that will be reasonable to verify whether a purchaser is an accreditedinvestor will vary depending on the type of accredited investor that the purchaser claims to be.For example, the steps that may be reasonable to verify that an entity is an accredited investor byvirtue of being a registered broker-dealer such as by going to FINRAs BrokerCheck website will necessarily differ from the steps that may be reasonable to verify whether a natural person isan accredited investor.

Information about the Purchaser: The amount and type of information thatan issuer has about a purchaser can also be a significant factor in determining what additionalsteps would be reasonable to take to verify the purchasers accredited investor status. The more

information an issuer has indicating that a prospective purchaser is an accredited investor, thefewer steps it may have to take, and vice versa. Examples of the types of information that issuerscould review or rely upon any of which might, depending on the circumstances, in and ofthemselves constitute reasonable steps to verify a purchasers accredited investor status include, without limitation:

publicly available information in filings with a federal, state or local regulatory body for example, if the purchaser claims to be an IRC Section 501(c)(3) organizationwith $5 million in assets, and the organizations Form 990 series return filed with theInternal Revenue Service discloses the organizations total assets;

third-party information that provides reasonably reliable evidence that a person fallswithin one of the enumerated categories in the accredited investor definition forexample, without limitation:o the purchaser is a natural person and provides copies of pay stubs for the two

most recent years and the current year; or


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o verification of a persons status as an accredited investor by a third party,provided that the issuer has a reasonable basis to rely on such third-partyverification.

Nature and Terms of the Offering: The nature of the offering such as themeans through which the issuer publicly solicits purchasers may be relevant in determining thereasonableness of the steps taken to verify accredited investor status. An issuer that solicits newinvestors through a website accessible to the general public, through a widely disseminated emailor social media solicitation, or through print media, such as a newspaper, will likely be obligatedto take greater measures to verify accredited investor status than an issuer that solicits newinvestors from a database of pre-screened accredited investors created and maintained by areasonably reliable third party. The SEC believes that an issuer will be entitled to rely on a thirdparty that has verified a persons status as an accredited investor, provided that the issuer has areasonable basis to rely on such third-party verification. The SEC does not believe that an issuerwill have taken reasonable steps to verify accredited investor status if it, or those acting on itsbehalf, required that a person check a box in a questionnaire or sign a form, absent otherinformation about the purchaser indicating accredited investor status.

The terms of the offering will also affect whether the verification methods used by theissuer are reasonable. The SEC continues to believe that there is merit to the view that apurchasers ability to meet a high minimum investment amount could be a relevant factor to theissuers evaluation of the types of steps that would be reasonable to take in order to verify thatpurchasers status as an accredited investor. By way of example, the ability of a purchaser tosatisfy a minimum investment amount requirement that is sufficiently high such that onlyaccredited investors could reasonably be expected to meet it, with a direct cash investment that isnot financed by the issuer or by any third party, could be taken into consideration in verifyingaccredited investor status.

Safe Harbors: Non-Exclusive Methods of Verifying Accredited Investor Status:

The SEC has included in Rule 506(c) four specific non-exclusive methods of verifyingaccredited investor status for natural persons that, if used, are deemed to satisfy the verificationrequirement in Rule 506(c). Issuers are not required to use any of these methods, but each ofthese methods is an alternative to the general principles-based approach. The SEC has indicatedthat these four safe harbors will be narrowly construed. However, even if an issuer is unable tocomply with one of the safe harbors, the types of steps that are outlined in the safe harbors can bea basis for satisfying the reasonable verification requirement on the principles-based approachdescribed above.

Income: Review of Tax Returns With a Current Certification. In verifyingwhether a natural person is an accredited investor on the basis of income, an issuer is deemed tosatisfy the verification requirement in Rule 506(c) by reviewing copies of any Internal RevenueService (IRS) form that reports income, including, but not limited to, a Form W-2 (Wage andTax Statement), Form 1099 (report of various types of income), Schedule K-1 of Form 1065(Partners Share of Income, Deductions, Credits, etc.), and a copy of a filed Form 1040 (U.S.Individual Income Tax Return), for the two most recent years, along with obtaining a written


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representation from such person that he or she has a reasonable expectation of reaching theincome level necessary to qualify as an accredited investor during the current year. In the case ofa person who qualifies as an accredited investor based on joint income with that persons spouse,an issuer would be deemed to satisfy the verification requirement in Rule 506(c) by reviewingcopies of these forms for the two most recent years in regard to, and obtaining written

representations from, both the person and the spouse. This safe harbor verification method is notavailable with respect to prospective investors who file tax returns in foreign jurisdictions but notin the U.S., and it is not available if, due to the timing of the offering in the tax year, theprospective investors tax returns for the two prior years are not available at the time of sale.

Net Worth: Review of Specified Documents Within 3 Month Window. Inverifying whether a natural person is an accredited investor on the basis of net worth, an issuer isdeemed to satisfy the verification requirement in Rule 506(c) by reviewing the documentationdescribed below, dated within the prior three months, and by obtaining a written representationfrom such person that all liabilities necessary to make a determination of net worth have beendisclosed. In the case of a person who qualifies as an accredited investor based on joint networth with that persons spouse, an issuer would be deemed to satisfy the verificationrequirement in Rule 506(c) by reviewing such documentation in regard to, and obtainingrepresentations from, both the person and the spouse. The documentation that must be reviewedby an issuer to comply with this method of satisfying Rule 506(c) consists of (i) a credit reportfrom at least one of the nationwide consumer reporting agencies; and (ii) one or more of thefollowing: bank statements, brokerage statements and other statements of securities holdings,certificates of deposit, tax assessments and appraisal reports issued by independent third parties.Credit reports from foreign reporting agencies analogous to the three U.S. nationwide agencieswill not satisfy the safe harbor. The reviewed documents must be dated within three months ofthe date of the sale of securities, which limits the utility of this safe harbor. If an issuer reviewsdocuments and makes a determination that the purchaser is an accredited investor at the outset ofan offering, or at the time a subscription is accepted into escrow, but does not close on thetransaction for three months or more, the issuer would have failed to satisfy this method ofverification. A tax assessment that is older than three months, even if it is the most recent taxassessment and even though tax assessments are typically performed only on an annual basis,will not satisfy this safe harbor.

Written Third Party Confirmation. An issuer is deemed to satisfy theverification requirement in Rule 506(c) by obtaining a written confirmation from a registeredbroker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified publicaccountant that such person or entity has taken reasonable steps to verify that the purchaser is anaccredited investor within the prior three months and has determined that such purchaser is anaccredited investor. There is no requirement that an attorney or certified public accountant be

licensed or registered in the U.S. in order to provide the certification. While third-partyconfirmation by one of these parties will be deemed to satisfy the verification requirement inRule 506(c), depending on the circumstances, an issuer may be entitled to rely on the verificationof accredited investor status by a person or entity other than one of these parties, provided thatany such third party takes reasonable steps to verify that purchasers are accredited investors andhas determined that such purchasers are accredited investors, and the issuer has a reasonablebasis to rely on such verification.


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Safe Harbor for Accredited Investors in a Prior Offering. An issuer willbe deemed to satisfy the requirements of Rule 506(c) with respect to a prospective purchaser ifthat purchaser (i) previously invested in the issuers Rule 506(b) offering as an accreditedinvestor, and (ii) certifies in writing that such prospective purchaser is still an accredited investorat the time of the Rule 506(c) sale. The requirement that the prospective purchaser be an

investor in the issuer in a prior offering does not extend to affiliates of the issuer or commonsponsors; if NewCo and OldCo are both sponsored by Investment Fund, a purchaser of NewCosecurities will not fall within the existing investor safe harbor by reason of being an existinginvestor in OldCo.

Amendment to Form D:

Form D is the notice of an offering of securities conducted without registration under theSecurities Act in reliance on Regulation D. Under Rule 503 of Regulation D, an issuer offeringor selling securities in reliance on Rule 504, 505 or 506 must file a notice of sales on Form Dwith the SEC for each new offering of securities no later than 15 calendar days after the first saleof securities in the offering.

The SEC adopted revisions to Form D in connection with the adoption of Rule 506(c).Issuers conducting Rule 506(c) offerings must indicate that they are relying on the Rule 506(c)exemption by marking the new check box in Item 6 of Form D. The prior check box for Rule506 has been renamed Rule 506(b).

The SEC is of the view that an issuer will not be permitted to check both boxes at thesame time for the same offering. According to the SECs long-held views, once a generalsolicitation has been made to the purchasers in the offering, an issuer is precluded from making aclaim of reliance on Rule 506(b), which remains subject to the prohibition against generalsolicitation, for that same offering.

If an issuer begins a Rule 506(b) offering and files a Form D, and then later decides totransition to a Rule 506(c) offering to make use of advertising or general solicitation, the issuerwill need to file an amendment to the Form D to indicate its reliance on Rule 506(c).

Hedge Funds, Private Equity Groups and Venture Capital Funds:

Private funds, such as hedge funds, venture capital funds and private equity funds,typically rely on Section 4(a)(2) and Rule 506 to offer and sell their interests without registrationunder the Securities Act. In addition, private funds generally rely on one of two exclusions fromthe definition of investment company under the Investment Company Act Section 3(c)(1)144and Section 3(c)(7) which enables them to be excluded from substantially all of the regulatoryprovisions of that Act. Those exclusions are only available to private funds that are not makingor propose to make public offerings. The SEC has historically regarded Rule 506 transactions asnon-public offerings for purposes of Sections 3(c)(1) and 3(c)(7). The SEC reaffirmed that theeffect of Section 201(b) of the JOBS Act is to permit private funds to engage in generalsolicitation in compliance with new Rule 506(c) without losing either of the exclusions under theInvestment Company Act.


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Many hedge funds have been reluctant to use general solicitation to offer securitiesbecause of the possibility it would be inconsistent with exemptions related to CPO (commoditypool operator) regulations administered by the CFTC. More specifically:

CFTC Regulation 4.7 provides relief from certain of the disclosure, periodic and

annual reporting, and recordkeeping requirements. Regulation 4.7(b) provides a CPOmay claim exemptive relief if it is a registered CPO who offers or sells participationsin a pool solely to qualified eligible persons, or QEPs, in an offering which qualifiesfor exemption from the registration requirements of the Securities Act pursuant tosection 4(2) (now section 4(a)(2), as amended by the JOBS Act) of that Act orpursuant to Regulation S.

CFTC Regulation 4.13(a)(3) provides a registration exemption for CPOs who operate

pools meeting the conditions enumerated in the regulation, including interests in eachpool for which the CPO claims the exemption be exempt from registration under the33 Act and offered and sold without marketing to the public in the United States.

Obviously, hedge fund sponsors were concerned that use of general solicitation to placesecurities would be inconsistent with the requirement to comply with the Section 4(a)(2)exemption or the CFTC restriction on marketing to the public.

In a no-action letter the CFTC confirmed its view that the use of general solicitationwould not permit reliance on the foregoing exemptions but then granted no-action relief thatpermits the use of general solicitation if the terms of the no action letter are complied with. Theconditions are:

The issuer musty comply with the requirements of Rule 506(c) regarding generalsolicitation or if resellers comply with related Rule 144A requirements.

The relief is not self-executing. A notice filing must be made with the CFTC thatcontains the information specified in the no-action letter and is filed in the mannerspecified.

No General Solicitations in Section 4(a)(2) Private Placements:

Advertising and general solicitation are permitted only in offerings conducted pursuant toRule 506(c), and not in Section 4(a)(2) offerings in general. Section 4(a)(2) is the traditionalstatutory exemption for private offerings. This means that even after the effective date of Rule506(c), an issuer relying on Section 4(a)(2) outside of the Rule 506(c) exemption will be

restricted in its ability to make public communications to solicit investors for its offering becausepublic advertising will continue to be incompatible with a claim of exemption under Section4(a)(2).

In a traditional Rule 506 offering (now a Rule 506(b) offering), the exemption in Section4(a)(2) of the Securities Act provided a safety net of sorts; even if an issuer failed to meet all ofthe requirements of the Rule 506 exemption, the issuer could always fall back on the exemption


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provided in Section 4(a)(2). In a Rule 506(c) offering, this may not be the case. If an issuerattempts to comply with Rule 506(c) but fails to fulfill the requirements of the rule, the Section4(a)(2) exemption will not be available to the issuer if the issuer has engaged in advertising orgeneral solicitation in connection with the offering.

Final SEC Rule Disqualifying Bad Actors From Rule 506 Offerings

The SEC has adopted final rules to implement Section 926 of the Dodd-Frank Wall StreetReform and Consumer Protection Act. Section 926 required the SEC to adopt rules thatdisqualify securities offerings involving certain felons and other bad actors from reliance onRule 506 of Regulation D.

Covered Persons:

The disqualification provisions of Rule 506(d) will cover the following persons, whichthe SEC refers to as covered persons:

the issuer and any predecessor of the issuer or affiliated issuer;

any director, executive officer, other officer participating in the offering, generalpartner or managing member of the issuer;

any beneficial owner of 20% or more of the issuers outstanding voting equitysecurities, calculated on the basis of voting power;

any investment manager to an issuer that is a pooled investment fund and anydirector, executive officer, other officer participating in the offering, general partneror managing member of any such investment manager, as well as any director,

executive officer or officer participating in the offering of any such general partner ormanaging member;

any promoter connected with the issuer in any capacity at the time of the sale;

any person that has been or will be paid (directly or indirectly) remuneration forsolicitation of purchasers in connection with sales of securities in the offering (whichwe refer to as a compensated solicitor); and

any director, executive officer, other officer participating in the offering, generalpartner, or managing member of any such compensated solicitor.

The final rules include a provision under which events relating to certain affiliated issuers are notdisqualifying if they pre-date the affiliate relationship.

Determining who an issuers covered persons are can be tricky in certain circumstances.For example, if a shareholder becomes a covered person as a result of a purchase of securitiesin an ongoing private offering, if the covered person is subject to a disqualifying event, the issuerwill be disqualified from relying on Rule 506 for all future sales in the offering. For this reason,


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issuers should conduct due diligence on any person who will become a 20% owner in anoffering. Voting agreements and shared voting power over shares can also create difficulties inidentifying covered persons. All shares that are subject to a voting agreement may beconsidered, as a group, to constitute a covered person. If a group of owners designates oneperson to hold voting power with respect to pooled shares, the person holding the voting power

is considered to be the covered person.

The SEC has also indicated that in some cases, officers of a compensated solicitor will bedeemed to be participating in the offering and therefore subject to the bad actordisqualifications. While an officer of a compensated solicitor that performs mainlyadministrative tasks in connection with the offering will not be considered a covered person, anofficer who actively solicits investors in the offering will be considered a covered person.Between those clear cases, there are likely many gray areas for which the SEC has not providedguidance.

In some cases, an issuer can take action to terminate a covered persons involvement withthe company or in the offering when a disqualifying event occurs. If a placement agent becomes

subject to a disqualification while an offering is ongoing, the issuer can continue to rely on Rule506 as long as it terminates the engagement with the placement agent and pays no compensationto the agent for future sales. A similar concept applies when only one or a subset of coveredpersons associated with the placement agent are affected by a disqualification event (i.e., theoffering can continue as long as the persons subject to the disqualifying event are terminated bythe placement agent or reduced to roles that do not make them covered persons for purposes ofRule 506(d)). Its unclear how soon after the disqualifying event the termination of coveredperson status must occur in order to allow the issuer to continue to rely on Rule 506, or how salesof securities in the offering after the disqualifying event but before termination of the coveredperson will be treated.

Disqualifying Events:

Under Rule 506(d), a covered person is subject to a disqualifying event if the coveredperson:

Has been convicted, within ten years before such sale (or five years, in the case ofissuers, their predecessors and affiliated issuers), of any felony or misdemeanor:o In connection with the purchase or sale of any security;o Involving the making of any false filing with the SEC; oro 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; or

Is subject to any order, judgment or decree of any court of competent jurisdiction,entered within five years before such sale, that, at the time of such sale, restrains orenjoins such person from engaging or continuing to engage in any conduct orpractice:o In connection with the purchase or sale of any security;


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o Involving the making of any false filing with the SEC; oro Arising out of the conduct of the business of an underwriter, broker, dealer,

municipal securities dealer, investment adviser or paid solicitor of purchasers ofsecurities; or

Is subject to a final order of a state securities commission (or an agency or officer of astate performing like functions); a state authority that supervises or examines banks,savings associations, or credit unions; a state insurance commission (or an agency orofficer of a state performing like functions); an appropriate federal banking agency;the U.S. Commodity Futures Trading Commission; or the National Credit UnionAdministration that:o At the time of such sale, bars the person from:

Association with an entity regulated by such commission, authority, agency,

or officer; Engaging in the business of securities, insurance or banking; or Engaging in savings association or credit union activities; or

o

Constitutes a final order based on a violation of any law or regulation thatprohibits fraudulent, manipulative, or deceptive conduct entered within ten yearsbefore such sale; or

Is subject to an order of the SEC entered pursuant to section 15(b) or 15B(c) of theSecurities Exchange Act of 1934 (15 U.S.C. 78o(b) or 78o-4(c)) or section 203(e) or(f) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(e) or (f)) that, at the timeof such sale:o Suspends or revokes such persons registration as a broker, dealer, municipal

securities dealer or investment adviser;o Places limitations on the activities, functions or operations of such person; oro

Bars such person from being associated with any entity or from participating inthe offering of any penny stock; or

Is subject to any order of the SEC entered within five years before such sale that, at

the time of such sale, orders the person to cease and desist from committing orcausing a violation or future violation of:o Any scienter-based anti-fraud provision of the federal securities laws, including

without limitation section 17(a)(1) of the Securities Act of 1933 (15 U.S.C.77q(a)(1)), section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C.78j(b)) and 17 CFR 240.10b-5, section 15(c)(1) of the Securities Exchange Act of1934 (15 U.S.C. 78o(c)(1)) and section 206(1) of the Investment Advisers Act of

1940 (15 U.S.C. 80b-6(1)), or any other rule or regulation thereunder; oro Section 5 of the Securities Act of 1933 (15 U.S.C. 77e); or

Is suspended or expelled from membership in, or suspended or barred fromassociation with a member of, a registered national securities exchange or a registerednational or affiliated securities association for any act or omission to act constitutingconduct inconsistent with just and equitable principles of trade; or


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Has filed (as a registrant or issuer), or was or was named as an underwriter in, anyregistration statement or Regulation A offering statement filed with the SEC that,within five years before such sale, was the subject of a refusal order, stop order, ororder suspending the Regulation A exemption, or is, at the time of such sale, the

subject of an investigation or proceeding to determine whether a stop order orsuspension order should be issued; or

Is subject to a United States Postal Service false representation order entered withinfive years before such sale, or is, at the time of such sale, subject to a temporaryrestraining order or preliminary injunction with respect to conduct alleged by theUnited States Postal Service to constitute a scheme or device for obtaining money orproperty through the mail by means of false representations.

Reasonable Care Exception:

The Rule 506 exemption is still available if the issuer establishes that it did not know and,in the exercise of reasonable care, could not have known that a disqualification existed under thebad actor provision. The SEC believes the steps an issuer should take to exercise reasonable carewill vary according to the particular facts and circumstances. For example, the SEC anticipatesthat issuers will have an in-depth knowledge of their own executive officers and other officersparticipating in securities offerings gained through the hiring process and in the course of theemployment relationship, and in such circumstances, further steps may not be required inconnection with a particular offering. Factual inquiry by means of questionnaires orcertifications, perhaps accompanied by contractual representations, covenants and undertakings,may be sufficient in some circumstances, particularly if there is no information or otherindicators suggesting bad actor involvement.

The SEC also believes the time frame for inquiry should also be reasonable in relation tothe circumstances of the offering and the participants. Consistent with this standard, the SECstated the objective should be for the issuer to gather information that is complete and accurate asof the time of the relevant transactions, without imposing an unreasonable burden on the issueror the other participants in the offering. However, with respect to offerings that are continuous,delayed, or long-lived, the SEC anticipates that an issuer will need to periodically update itsfactual inquiry into its covered persons in order to continue meeting the reasonable careexception. Its unclear how frequently an issuer must update its inquiry or how long an offeringmust be ongoing in order to require an update to the inquiry. The SEC expects that issuers willdetermine the appropriate dates to make a factual inquiry, based upon the particular facts andcircumstances of the offering and the participants involved, to determine whether any covered

persons are subject to disqualification before seeking to rely on the Rule 506 exemption.

The SEC noted issuers should make factual inquiry of the covered persons, but in somecasesfor example, in the case of a registered broker-dealer acting as placement agentit maybe sufficient to make inquiry of an entity concerning the relevant set of covered officers andcontrolling persons, and to consult publicly available databases concerning the past disciplinaryhistory of the relevant persons.


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Waivers:

The rules provide the SEC can provide a waiver from the bad actor disqualification upona showing of good cause and without prejudice to any other action by the SEC, if the SECdetermines that it is not necessary under the circumstances that an exemption be denied.

A waiver can also be granted by the court or regulatory authority that enters the relevantorder, judgment or decree advising in writing that the bad actor disqualification should not ariseas a consequence of such order, judgment or decree. However, the SEC has indicated thatwaivers are not possible with respect to the requirement, under Rule 506(e) (discussed below),that issuers disclose certain past conduct of covered persons.

As of August 22, 2014, the SEC had granted five waivers of the Rule 506 bad actordisqualification. The SEC has indicated that past waiver requests that have been granted may bea source of guidance for determining what factors will lead the SEC to grant a waiver. Thecommon elements in the five waivers that have been granted thus far appear to be: (i) thedisqualifying conduct was not directly related to the offering and sale of securities, (ii) the

company seeking the waiver has fully cooperated with the SEC in carrying out its obligationspursuant to settlement agreements and orders, and (iii) third parties who do business with thecompany would be harmed as a result of the companys disqualification from relying on Rule596. The SECs adopting release for the bad actor disqualification from Rule 506 also notes thatthe following factors may be relevant for determining whether a waiver is appropriate: (i) changeof control of the company, (ii) change of supervisory personnel, (iii) absence of notice andopportunity for hearing, and (iv) relief from a permanent bar for a person who does not intend toapply to re-associate with a regulated entity.

Disqualifying Events Prior to the Effective Date; Disclosure:

The final rule includes a provision specifying that disqualification will not arise as aresult of triggering events that occurred before the effective date of the rule amendments whichwas September 23, 2013. Although no disqualification results, Rule 506(e) requires disclosure toinvestors regarding such events. Issuers will be required to provide disclosure a reasonabletime prior to sale.

If disclosure is required and not adequately provided to an investor, the SEC does notbelieve that relief will be available under Rule 508, under which insignificant deviations fromRegulation D requirements do not necessarily result in loss of the Securities Act exemption withregard to an offer or sale of securities to a particular individual or entity. The reason is for Rule508 to apply to an offer or sale of securities, the failure to comply with a Regulation D

requirement must not pertain to a term, condition or requirement directly intended to protect thatofferee or purchaser.

New Rule 506(e) does, however, provide that the failure to furnish required disclosure ona timely basis will not prevent an issuer from relying on Rule 506 if the issuer establishes that itdid not know, and in the exercise of reasonable care could not have known, of the existence ofthe undisclosed matter or matters. This reasonable care exception to the disclosure requirementis similar to the reasonable care exception to disqualification described above, and will


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preserve an issuers claim to reliance on Rule 506 if disclosure is required but the issuer canestablish that it did not know and in the exercise of reasonable care could not have known of thematters required to be disclosed. The provision also includes an instruction, clarifying thatreasonable care requires factual inquiry.

New Form D:

Form D has also been revised. As revised the signature block of the Form D contains acertification, whereby issuers claiming a Rule 506 exemption confirm that the offering is notdisqualified from reliance on Rule 506 as a result of the bad actor disqualification provisions.

V.

PROPOSED REGULATION A+

On December 18, 2013, the SEC published its proposal to modify Regulation A. TheSEC is proposing to expand Regulation A into two tiers: Tier 1, for offerings of up to $5 million;and Tier 2, for offerings of up to $50 million. The proposed rules also seek to modernize theRegulation A filing process to create additional flexibility and streamline compliance for

Regulation A issuers.

Advantages of Regulation A+ include:

The ability to publicly offer securities without a full registration process

Securities sold are not restricted securities and can be transferred freely

Available to issuers that do not qualify as emerging growth companies underthe JOBS Act

There is no strict liability for public offerings under Section 11 of the SecuritiesAct

Investment Limitations

The proposed rules contain new investment limitations. For a Tier 2 offering an investoris limited to purchasing securities with a purchase price of no more than 10% of the greater ofthe investors annual income and net worth. Issuers would not be required to verify individualincome and net worth and could rely on investor representations of compliance. No similarlimitation applies to Tier 1 offerings.

Offering Statement

The proposed rules update Regulation A to require electronic filing of offering statementson the EDGAR System. A From 1-A would be developed that is a fill-in-the-blank form similarto Form D and then other disclosure documents and exhibits would be attached. Ongoing reportswould also be filed electronically. The SEC is also proposing an access-equals-delivery modelfor Regulation A final offering circulars. The SEC also proposes to allow the non-publicsubmission of draft offering statements by issuers of Regulation A securities.


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The SEC believes that an offering made in reliance on Section 4(a)(6) should not beintegrated with another exempt offering made by the issuer, provided that each offering complieswith the requirements of the applicable exemption that is being relied upon for the particularoffering. An issuer could complete an offering made in reliance on Section 4(a)(6) that occurssimultaneously with, or is preceded or followed by, another exempt offering. An issuer

conducting a concurrent exempt offering for which general solicitation is not permitted,however, would need to be satisfied that purchasers in that offering were not solicited by meansof the offering made in reliance on Section 4(a)(6). Similarly, any concurrent exempt offeringfor which general solicitation is permitted could not include an advertisement of the terms of anoffering made in reliance on Section 4(a)(6) that would not be permitted under Section 4(a)(6)and the proposed rules.

Investment Limitation

Under Section 4(a)(6)(B), the aggregate amount sold to any investor by an issuer,including any amount sold in reliance on the exemption during the 12-month period precedingthe date of such transaction, cannot exceed:

the greater of $2,000 or 5 percent of the annual income or net worth of such investor,as applicable, if either the annual income or the net worth of the investor is less than$100,000; and

10 percent of the annual income or net worth of such investor, as applicable, not toexceed a maximum aggregate amount sold of $100,000, if either the annual income ornet worth of the investor is equal to or more than $100,000.

There is a glitch in the drafting of the statute because the language if either the annual incomeor net worth of the investor is equal to or more than $100,000 can cause both limitations to be

applicable. The SEC believes that the appropriate approach to the investment limit provision isto provide for an overall investment limit of $100,000, but within that overall limit, to providefor a greater of limitation based on annual income and net worth. Under the proposed rules,therefore, if both annual income and net worth are less than $100,000, then a limit of $2,000 or 5percent of annual income or net worth, whichever is greater, would apply. If either annualincome or net worth exceeds $100,000, then a limit of 10 percent of annual income or net worth,whichever is greater, but not to exceed $100,000, would apply.

The proposed rules require a natural persons annual income and net worth to becalculated in accordance with the SECs rules for determining accredited investor status. Theproposed rules would clarify that an investors annual income and net worth may be calculated

jointly with the income and net worth of the investors spouse.

The proposal allows an issuer to rely on efforts that an intermediary takes in order todetermine that the aggregate amount of securities purchased by an investor will not cause theinvestor to exceed the investor limits, provided that the issuer does not have knowledge that theinvestor had exceeded, or would exceed, the investor limits as a result of purchasing securities inthe issuers offering.

7/22/2019 JOBS Act and Other Securities Law