New Rule 506(c) and Unregistered Offerings in the U.S. Institutional Market: Flexibility to Use General Solicitation in the Internet-Enabled Market

Amendments adopted by the U.S. Securities and Exchange Commission (SEC) to Rule 506 of Regulation D became effective on Sept. 23, 2013. ¹See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. 33-9415 (Jul. 10, 2013), available at http://www.sec.gov/rules/final/2013/33-9415.pdf. Rule 506 provides a non-exclusive safe harbor exemption from the registration and prospectus delivery requirements of Section 5 of the Securities Act of 1933 (Securities Act). The SEC’s amendments, among other things, eliminated the prohibition against the use of general solicitation and advertising by issuers and their financial intermediaries in certain qualifying private offerings, as was mandated by the Jumpstart Our Business Startups Act of 2012 (JOBS Act). The amendments created new Rule 506(c) under which general solicitation and advertising now are permitted so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify their status as such. Rule 506(c) is targeted in particular to early stage and small issuers, allowing them easier access to a broader pool of potential investors in the unregistered securities market. But Rule 506(c) also provides large, well-established issuers—including foreign private issuers—with the opportunity to improve the efficiency of the offering process and pricing mechanisms in placing securities in the U.S. institutional market.

New Rule 506(c).

Under Section 5 of the Securities Act, all offers and sales of securities must be registered with the SEC and a Securities Act-compliant prospectus must be delivered to investors, unless the offering qualifies for an exemption. Section 4(a)(2) of the Securities Act provides an exemption from Section 5’s registration and prospectus delivery requirements for “transactions by an issuer not involving any public offering.” The term “public offering,” however, is not defined in the Securities Act, and so its meaning developed initially through judicial and administrative interpretations. In order to provide more objective criteria as to what is not considered a “public offering,” the SEC adopted Regulation D which provides specific non-exclusive safe harbor exemptions from Section 5’s registration and prospectus delivery requirements. Under Rule 506 of Regulation D, adopted in 1982, an issuer may sell securities, without any limitation on the offering size, to an unlimited number of accredited investors and to no more than 35 non-accredited but sophisticated investors. Prior to the SEC’s amendments, one of the conditions to reliance on Rule 506 was that the issuer (and any person acting on its behalf) must not offer or sell the securities through any form of general solicitation or general advertising–for example, by utilizing unrestricted websites or seminars open to investors generally. ²See Rule 502(c) of Regulation D, 17 C.F.R. § 230.502(c). While the terms “general solicitation” and “general advertising” are not defined in Regulation D, Rule 502(c) provides examples of general solicitation and general advertising.

With the objective of increasing job creation and economic growth by improving access to the capital markets for emerging growth companies, the U.S. Congress passed the JOBS Act and President Obama signed it into law on April 5, 2012. ³Jumpstart Our Business Startups Act, H.R. 3606, 112th Cong. (2012), available at http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf. Section 201(a)(1) of the JOBS Act directed the SEC to amend Rule 506 to permit general solicitation and advertising, provided that all purchasers of the securities are “accredited investors”—defined in Rule 501 to include individuals and entities meeting certain specified economic metrics, or reasonably believed by the issuer to meet such metrics. On July 10, 2013, the SEC adopted final amendments implementing Section 201(a)(1) of the JOBS Act. ⁴See supra note 1. The amendments created Rule 506(c) which permits an issuer to use general solicitation and advertising to offer and sell securities, provided that:

• all conditions of Rule 501 (defining, among other things, the term “accredited investor”), Rule 502(a) (relating to integration of multiple offerings), and Rule 502(d) (relating to restrictions on the resale of securities acquired in Regulation D offerings) are satisfied;

• all actual purchasers of the securities, as opposed to all those solicited, are accredited investors; and

• the issuer takes reasonable steps to verify that the actual purchasers of the securities are accredited investors.

The requirement that the issuer take “reasonable steps to verify” that actual purchasers are accredited investors must be independently satisfied even if it so happens that all purchasers in the offering are in fact accredited investors. The amendments also require an issuer conducting a Rule 506(c) offering to mark a new check box on Form D to indicate whether it is claiming the Rule 506(c) exemption, and other related amendments to Rule 506 disqualify offerings involving certain “bad actors” from reliance on the Rule 506 safe harbor exemptions. ⁵See Disqualification of Felons and Other “Bad Actors” From Rule 506 Offerings, SEC Release No. 33-9414 (Jul. 10, 2013), available at http://www.sec.gov/rules/final/2013/33-9414.pdf.

The amendments do not eliminate the existing Rule 506 safe harbor exemption where general solicitation and advertising are not utilized. Rather, the amendments re-designate the prior Rule 506 safe harbor exemption as Rule 506(b). Consequently, issuers retain the ability to rely on Rule 506(b) to conduct an offering without using general solicitation and advertising so that up to 35 non-accredited investors who are “sophisticated” can participate, and without being subject to the additional accredited investor verification requirement of Rule 506(c).

The Related Amendment to Rule 144A.

Section 201(a)(2) of the JOBS Act required that the SEC also amend Rule 144A to provide that securities resold pursuant to Rule 144A may be offered to persons other than qualified institutional buyers (QIBs), including by means of general solicitation and advertising, provided that securities are sold only to persons reasonably believed to be QIBs. Adopted in 1990, Rule 144A is a non-exclusive safe harbor under Section 4(a)(1) of the Securities Act that permits the resale of unregistered securities to QIBs. Rule 144A was intended to provide greater liquidity for unregistered securities in the U.S. institutional market and to make the market more accommodative to foreign private issuers. ⁶In the release adopting Rule 144A, Resale of Restricted Securities; Changes to Method of Determining Holding Period of Restricted Securities Under Rules 144 and 145, SEC Release No. 33-6862 (April 30, 1990), the SEC expressed its view that Rule 144A is “the first step toward achieving a more liquid and efficient institutional resale market for unregistered securities.” As Rule 144A applies only to the resale of securities, its safe harbor is not available to issuers.

QIBs, as defined in Rule 144A, consist of institutional investors considered to be the largest and most sophisticated, including specified institutions that own and invest on a discretionary basis at least $100 million in securities of unaffiliated issuers, banks and other specified financial institutions that have a net worth of at least $25 million, and registered broker-dealers that own and invest on a discretionary basis at least $10 million in securities of unaffiliated issuers. Except in rare cases, QIBs also qualify as accredited investors, given that the accredited investor criteria are generally less restrictive than the QIB criteria.

Prior to the SEC’s amendments to Rule 144A, offers to resell securities under Rule 144A could be made only to QIBs, which effectively foreclosed the use of general solicitation and advertising. The amendments, which became effective on Sept. 23, 2013 together with those to Rule 506, now expressly permit offers to sell unregistered securities under Rule144A to be made to persons other than QIBs, including by use of general solicitation or advertising, so long as the securities are actually sold only to investors which the seller, and any person acting on behalf of the seller, reasonably believe are QIBs.

Implications for Unregistered Offerings in the U.S. Institutional Market.

Industry professionals had long argued that the prohibition against general solicitation and advertising unnecessarily restricted the conduct of unregistered securities offerings. Issuers and financial intermediaries acting on their behalf—generally investment and commercial banks—were strictly limited in their marketing and sales efforts even where there was little if any risk that the securities would be sold to unqualified investors, particularly in the case of issuances in the U.S. institutional market. As the U.S. institutional market became broader, deeper and more diversified over the years, while the ability to widely and effectively disseminate business information on issuer performance advanced by reason of new information technologies and practices, the disconnect between the prohibition against general solicitation and the practical realities of the modernizing economy became more apparent. Reliance on well-trodden securities marketing and sales methods designed to avoid general solicitation and advertising—generally, relationship-based efforts utilizing financial intermediaries’ rosters of pre-existing buy-side relationships—has become particularly antiquated in the internet age and, in some circumstances, may no longer provide issuers with optimal market access and pricing.

Rule 506(c) and the amendment to Rule 144A should facilitate more efficient placement and trading of unregistered securities in the U.S. institutional market by reducing regulatory friction associated with the SEC’s prior approach of restricting the means of offering unregistered securities for sale. Rules 506(c) and 144A instead now focuses directly on assuring compliance with the ultimate objective—restricting sales to appropriately suitable investors—by placing greater responsibility on issuers, their intermediaries, and institutional resellers to know their purchasers and assure their suitability. But, regulatory reform represents only half of the equation needed to capture the opportunities provided by Rule 506(c) to make the U.S. institutional market for unregistered securities more efficient. The market practices followed by issuers, intermediaries and institutional buyers in the issuance of unregistered securities also need to evolve. New Rule 506(c) and the related amendment to Rule 144A relieve the regulatory burden imposed by the prohibition against general solicitation and advertising, but they also now open up a potentially more efficient transactional route by which unregistered securities can be sold in the U.S. institutional market.

Prior to the adoption of Rule 144A, there was no clear safe harbor for resale transactions except after a holding period. Consequently, private issuers generally sold unregistered securities directly to the market, with financial intermediaries serving as placement agents. In a number of no-action letters and staff guidance bulletins, the SEC has long held that if, at the time of an offering, the issuer or its agent has a pre-existing substantive relationship with a potential investor, the SEC will not find that the potential investor was reached through general solicitation. Issuers, therefore, could rely on the pre-existing relationships of their financial intermediaries to avoid general solicitation while reaching a broad investor base.

With the advent of Rule 144A, however, issuers of unregistered securities and their financial intermediaries no longer needed to concern themselves with whether a pre-existing substantive relationship existed with each investor. Offerings of unregistered securities—debt in particular—could be made to QIBs through a two-step transaction process commonly referred to as a “Rule 144A offering.” In a Rule 144A offering, there is an initial sale by the issuer to one or more financial intermediaries serving as initial purchasers—generally investment banks or commercial banks – in a transaction exempt from Section 5’s registration and prospectus delivery requirements under Section 4(a)(2). This is immediately followed by a resale of the securities by the initial purchasers to QIBs in transactions exempt from Section 5’s registration and prospectus delivery requirements under Rule 144A or, for sales outside the U.S., Regulation S under the Securities Act.

In a Rule 144A offering, it is generally unquestioned that the sale by the issuer to the initial purchasers is not the product of general solicitation or advertising by the issuer and so complies with Section 4(a)(2) without the need to rely on a safe harbor exemption such as Regulation D, there clearly being no “public offering” involved. As to the second step, provided the financial intermediaries which act as initial purchasers limit their sales to known QIBs, and the issuer complies with the information disclosure and other requirements for Rule 144A eligibility, the initial purchasers’ resales to QIBs come within Rule 144A’s safe harbor. Because the SEC does not consider the first and second transactional steps to be integrated, the issuer in the first step is not considered to be engaged in general solicitation by reason of the initial purchaser’s marketing to QIBs in the second step. ⁷Rule 144A(e) provides that “[o]ffers and sales of securities pursuant to this section shall be deemed not to affect the availability of any exemption or safe harbor relating to any previous or subsequent offer or sale of such securities by the issuer or any prior or subsequent holder thereof.”

Now, however, with the advent of Rule 506(c), issuers are free to engage in general solicitation and advertising in selling their securities directly to institutions qualifying as accredited investors, including QIBs. Issuers need not rely on financial intermediaries’ pre-existing substantive relationships as a means of establishing that they are not engaged in general solicitation, as was the case prior to Rule 144A. And, issuers need not be limited to selling unregistered securities through financial intermediaries in a two-step process under Rule 144A.

While the prevailing two-step approach employed in 144A offerings likely will remain the dominant method for selling unregistered securities in the U.S. institutional market given its established market acceptance, Rule 506(c) offers an alternative approach: issuers’ solicitation of and direct sales to institutions qualifying as accredited investors (including QIBs) exempted from Section 5’s registration and prospectus delivery requirements under the new safe harbor provided by Rule 506(c), with financial intermediaries acting as solicitation and placement agents, and secondary market trades then occurring under Rule 144A. In this alternative approach, the role and responsibility of a financial intermediary in an offering of unregistered securities in the U.S. institutional market again can be limited to that of a placement agent, now free to engage in general solicitation and advertising on behalf of the issuer. The intermediary need not serve in the role of initial purchaser and reseller of the securities. A financial intermediary, of course, may itself still purchase a part of the offering or, by agreement with the issuer, backstop the offering with a commitment to purchase some or all of the securities as may be necessary to clear the offered volume at a particular price or spread.

Facilitation of Emerging Offering and Pricing Mechanisms.

The ability of an issuer to directly solicit and sell to institutional investors potentially facilitates broader market access and more transparent and competitive pricing. As an initial matter, Rule 506(c) enables issuers more easily to test the market to assess the availability of capital by, for example, soliciting interest at investor conferences or by informal outreach to buy-side market participants. In conducting an offering, rather than relying primarily on a financial intermediary to build an order book based on pre-issuance indications of interest and price talk with the intermediary’s buy-side accounts, an issuer may prefer to engage in an auction to price its securities. Such an approach would be particularly suited to circumstances where the issuer, or a credit support provider, is well known in the market and where the securities are rated by one or more of the credit rating agencies. In those cases, a financial intermediary’s active engagement with the market may be more limited than currently is typical. Pricing and allocation can be determined, for example, by Dutch auction conducted online under pre-established bidding rules. Where the credit quality and capacity of the issuer is less well known, or where the structure or terms of the securities are more complex, the pre-auction sale and marketing efforts of the issuer and its placement agent can be calibrated to the market’s greater information requirements.

In all likelihood, except perhaps in the case of highly rated issuers routinely in the market, the role of financial intermediaries in the issuance process will remain essential to success, as intermediaries bring credibility and market knowledge to the process, and will be relied upon by investors to negotiate the terms of the securities and diligence the creditworthiness of the issuer. Nonetheless, Rule 506(c) can unleash the power of the internet—particularly when harnessed to financial intermediaries’ proprietary databases and communications networks—to reach the widest possible investor base with all needed sales and disclosure materials in short timeframes. These same technologies can be deployed to facilitate the qualification of purchasers as eligible accredited investors. And, integrated internet-based auction platforms can optimize price competition and transparency. While a formal auction is possible under the currently prevailing two-step transactional process, and was not foreclosed by the prior regulatory prohibition against general solicitation and advertising, internet-based auction platforms for new securities issuances generally have not met with great success. The elimination of both the initial purchase of new securities by a financial intermediary and the prohibition against general solicitation and advertising now better align the offering process with the potential power and efficiency of internet-based marketing efforts and auction pricing.

Conclusion.

The optimal balance between direct to market internet-based auction processes, at one extreme, and relationship-based book building efforts by financial intermediaries, at the other end of the spectrum, likely will depend on the particular issuer and security and will evolve over time in response to market demands and the development of new business technologies. While new Rule 506(c) does not necessarily represent a tipping point in this progression, it can facilitate continued change in the direction of greater efficiency in the sale of unregistered securities in the U.S. institutional market.