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JOBS ACT AND OTHER SECURITIES

LAW ESSENTIALS

FOR GROWING COMPANIES

STEVE QUINLIVAN JILL RADLOFF ETHAN MARK DAVID JENSON

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TABLE OF CONTENTS

I. BASIC PRINCIPLES ... 1

General Rule ... 1

What is a public offering? ... 1

What 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 ... 5

Pitfalls for Issuers ... 8

Pitfalls for Lawyers ... 8

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

Overview ... 9

Offerings Pursuant to Rule 504... 11

Offerings Pursuant to Rule 505... 11

Offerings Pursuant to Rule 506(b) — No General Solicitation Permitted ... 12

Offerings Pursuant to Rule 506(c)—General Solicitation Permitted ... 13

Final SEC Rule Disqualifying Bad Actors From Rule 506 Offerings ... 20

V. PROPOSED REGULATION A+ ... 25

Investment Limitations ... 25

Offering Statement ... 25

Reporting Obligations ... 26

Relationship with State Securities Laws ... 26

VI. PROPOSED CROWDFUNDING RULES... 26

Limitation on Capital Raised ... 26

Investment Limitation ... 27

Transactions Conducted Through an Intermediary ... 28

Ineligible Issuers ... 28

Prohibitions Applicable to the Issuer ... 28

Form C and Filing Requirements ... 29

Required Disclosures of Offering Information ... 31

Discussion of Financial Condition and Financial Disclosures ... 33

SEC Registration and FINRA Membership ... 34

Financial Interests ... 35

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Education Materials ... 35

Investor Limits ... 36

Investor’s Right to Cancel ... 36

Communication Channels ... 36

ATS/Secondary Market Transactions ... 36

Registration ... 36

Exemption from Broker Dealer Registration ... 37

Restrictions on Resales ... 37

Exemption from Section 12(g)... 37

FINRA 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? ... 47

Examples of SEC No-Action Letters ... 50

Examples of SEC Enforcement Action... 51

Consequences of Hiring an Unregistered Broker ... 52

Blue Sky Issues ... 53

Direct Regulation of Finders in Minnesota ... 54

XII. TENDER OFFERS ... 54

XIII. FOREIGN CORRUPT PRACTICES ACT ... 55

XIV. WHISTLEBLOWERS ... 56

XV. INVESTMENT COMPANIES ... 57

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I. BASIC PRINCIPLES General Rule

Transactions in securities must either be registered with the SEC or exempt. A key determining factor is whether a “public offering” is involved. Another key determining factor is whether there is a sale of a “security.”

What is a public offering?

SEC v. Ralston Purina,1 involved a suit by the Securities and Exchange Commission (“SEC”) to enjoin a corporation from offering its common stock for sale to its employees without complying with registration requirements of the Securities Act of 1933 (the “Securities Act”). The Securities Act provides an exemption from its registration requirements for transactions by an issuer “not involving any public offering.” The court found that an offering need not be open to the whole world in order to qualify as a “public offering” for these purposes.

• The purpose of the Securities Act is to protect investors by promoting full disclosure of information that is necessary to making an informed investment decisions.

• An offering to persons who are shown to be able to fend for themselves is a transaction “not involving any public offering” within provision exempting such offerings by an issuer from the registration requirements of the Act.

• A private offering exemption is not dependent for its application on the number of persons to whom the offer is made, and a quantity limit cannot be imposed.

• Whether an issuance of corporate stock is exempt from registration requirements depends on whether offerees have knowledge obviating the need for protection of the Act and have access to the kind of information which registration would disclose.

What is a security?

The Securities Act provides “The term ‘security’ means any note, stock . . .bond . . . investment contract . . . [and] fractional undivided interest in oil, gas, or other mineral rights . . .”

Stock:

In Landreth Timber Co. v. Landreth,2 the purchasers of all of the outstanding stock in a lumber business brought a federal securities fraud action against the sellers. The court noted that:

• Most instruments bearing traditional title such as stock are likely to be covered by the definition of security contained in the federal securities laws.

1

346 U.S. 119 (1953).

2

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• Those characteristics usually associated with common stock, thereby indicating that such stock is a security within the meaning of federal securities laws, are the right to receive dividends, negotiability, ability to be pledged or hypothecated, voting rights in 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 a

security within the meaning of federal securities laws where, notwithstanding the fact that the sale amounted to a sale of the entire business, it was likely that the investor believed 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 an instrument denominated a “note” is a “security,” within the meaning of the securities laws, courts should apply the “family resemblance” test. Under the family resemblance test, a note is presumed to be a “security,” and the presumption may be rebutted only by showing that the note bears 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 not sufficiently similar to a listed item, the court must decide whether another category should be added by examining the same factors. The types of notes that the Court found were not securities 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 course of business.

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

• Motivations for the Transaction. Courts will assess the motivations that prompt a reasonable seller and buyer to enter into a transaction. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the

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seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, 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 the instrument to determine whether it is an instrument in which there is “common trading for speculation or investment.”

• Reasonable Expectations of the Investing Public. A court will consider instruments to be “securities” on the basis of public expectations that the instruments are securities, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction. • Other Factors. A court will examine other factors render application of the Securities

Act unnecessary – such as, for example, when an instrument’s risk is significantly reduced because it is already subject to regulation pursuant to another regulatory scheme.

Investment Contracts:

In SEC v. W.J. Howey Co.,4 the Supreme Court stated an investment contract for purposes 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 the efforts of the promoter or a third party.

It is immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise. The Court stated that the test permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative 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 those who 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 is raised 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 manner as general partnerships – the “investment contract” test set forth in Howey is applied. One of the

4

328 U.S. 293 (1946).

5

See Wheaton, Current Status of Securities and Bankruptcy Issues, American Law Institute—American Bar Association Continuing Legal Education (2003). See also C. Bishop and D. Kleinberger, Limited Liability

Companies—Tax and Business Law, ¶ 11.01 et. seq. (1994 & Supp. 2006) for an extensive analysis of the topics

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leading cases in this area is Williamson v. Tucker.6 In Williamson, the court recognized that although prior decisions had held that general partnership interests were generally not considered investment contracts for the purposes of the federal securities laws, “the mere fact that an investment takes the form of a general partnership or joint venture does not inevitably insulate it from 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 on a particular expertise of the promoter or managing partner that he or she has no reasonable alternative to reliance on the managing promoter or manager, then the investment in the partnership may be characterized as an investment contract. The court concluded that an investor who claims that a general partnership interest is a security must overcome a presumption that the general partnership interest is not an investment contract, but can establish the existence of a security by showing that (i) the partnership agreement leaves so little power in the investor that the arrangement is akin to a limited partnership, (ii) the investor is so inexperienced and unknowledgeable in business affairs that he or she cannot intelligently exercise partnership powers or (iii) the investor is so dependent on unique entrepreneurial or managerial abilities of the 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 a security, the organizational documents must be carefully drafted to provide investing members as much power as possible. Consider an effective right to remove management, effective veto rights, and majority and supermajority voting requirements. Also consider whether members can bind the LLC. Note also that the greater the number of passive investors, the greater the likelihood the investors are looking to the “efforts of others” under the Howey test, the case that set 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 in connection with a registered offering.

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

6 645 F. 2d 404 (5th Cir. 1981). 7 346 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 of certain 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 a good 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 or may 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, required that prior to making an offer, the issuer and any person acting on its behalf had to reasonably believe that the offeree either had such knowledge and experience in financial and business matters that he was capable of evaluating the merits and risks of the prospective investment or was 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 generated to perfect a common law private placement (compare Rule 506 where non-accredited investors are 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 a defensible choice. Where the number of offerees grows, providing a PPM is often a best practice. It is desirable to be able to demonstrate the issuer and its business and attendant risks were adequately explained.

III. OTHER CONSIDERATIONS FOR PRIVATE PLACEMENTS

Liability Standards

Valid Private Placements—Federal Law:

Gustafson, et al., v. Alloyd Company, Inc.,10 was an action brought by plaintiffs who purchased substantially all of the corporation’s stock from sellers pursuant to a private sale agreement. The plaintiffs sought rescission of the private sale agreement under Section 12(2) of the Securities Act on the ground that the written sale agreement was a “prospectus” and contained material misstatements. The Court held that although the term “prospectus” is defined in Section 2(a)(10) of the Securities Act, in part, as any “communication, written or by radio or television,” the term prospectus refers only to a document soliciting the public to acquire securities.

9

See ABA Report.

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The effect of Gustafson is to take private placements out of Section 12 of the Securities Act leaving Rule 10b-5 of the Securities Exchange Act as the primary basis of liability. The effect is significant because an element of a Rule 10b-5 claim is “scienter.” Some of the elements 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 that the defendant intended to make the material misrepresentation or omission, or acted recklessly when making the misrepresentation or omission;

• the material misrepresentation or omission was made “in connection with the purchase 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 Fund—for which JCM was the investment adviser. Although JCG created Janus Investment Fund, it was a separate legal entity owned entirely by its mutual fund investors.

The case centered on whether JCG and JCM “made” the allegedly fraudulent statement in the fund’s prospectus. The decision notes one “makes” a statement in connection with the purchase or sale of securities by stating it. For purposes of Rule 10b-5, the “maker” of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what 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 the relationship between a speechwriter and a speaker. Even when a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it, and it is the speaker who takes credit—or blame—for what is ultimately said.

This holding in the case follows from Central Bank of Denver, N.A. v. First Interstate

Bank of Denver, N. A. (1994), in which the Court held that Rule 10b–5’s private right of action

does not include suits against aiders and abettors. Such suits—against entities that contribute “substantial assistance” to the making of a statement but do not actually make it—may be brought by the SEC, but not by private parties. According to the Court, a broader reading of “make,” 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 the content of a statement could be considered primary violators who “made” the statement, then aiders and abettors would be almost nonexistent.

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

Valid Private Placements—State Law:

Minnesota law provides that “a person is liable to the purchaser if the person sells a security . . . by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statement made, in light of the circumstances under which it is made, not misleading, the purchaser not knowing the untruth or omission and the seller not sustaining the burden of proof that the seller did not know and, in the exercise of reasonable

care, could not have known of the untruth or omission” (emphasis added).12 Note that the Minnesota statute appears to change the standard from “reckless” to “negligently” in many circumstances.13

The same Minnesota statute provides for joint and several liability on the following classes of persons (other than those who with the exercise of reasonable care could not have known 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 who

materially aided the conduct; and

• broker-dealers, agents, investment advisers, or investment adviser representatives that materially aid the conduct.

As a result, the Minnesota statute potentially undermines the protections of Janus under Federal securities law.

Private Placements—Violation of Section 5:

Section 12(a)(1) of the Securities Act provides a private right of action for offerings of securities in violation of Section 5 of the Securities Act – i.e. an offering intended to be an exempt private offering that is invalid due to circumstances such as the purchase of securities by non-accredited investors or the “public offering” of the securities. Damages under Section 5 are a refund of the purchase price of the security in most circumstances. No causal connection to a loss is required.

Since no causal connection is required, everyone who purchases in a bad private placement can sue for a refund of the purchase price—i.e. everyone gets their money back.

12

MINN.STAT. § 80A.76(b).

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Issues can arise as to what constitutes the extent of the private placement. Prior sales may be integrated 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, especially where friends and family see lost value.

• Thinking It’s Easy: Raising money is difficult and many are unable to complete an offering.

• Failure to Raise Enough Money: Failure to fund foreseeable needs results in possible business failure, management distraction of continually raising money and increases the likelihood of a down round.

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

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

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

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

Pitfalls for Lawyers

• Failure to Recognize Risk: A high proportion of start-up businesses fail, leading in some cases for a search for deep pockets. Client acceptance procedures should recognize 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 the quality or nature of the investment. Lawyers should just collect checks and

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subscription agreements. Avoid the use of firm names on mailings and correspondence.

IV. PRIVATE OFFERINGS PURSUANT TO REGULATION D

Overview

Generally, sales of securities must be registered under the Securities Act, unless an exemption from registration applies. Rules 501 through 508 under the Securities Act, which are known as Regulation D, contain requirements relating to several different methods of conducting sales of exempt securities. Compliance with Regulation D is not a requirement for a valid private 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 not prevent an issuer from also claiming that the offering is exempt under Section 4(a)(2) of the Securities Act, which contains a general exemption for transactions “not involving any public offering.” However, compliance with Regulation D is attractive to issuers because it provides specific steps the issuer can take to ensure a valid exemption.

Much of Regulation D is premised on the notion that certain individuals, termed “accredited 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 the loss of their investment. An “accredited investor” is an investor that falls into one of eight categories set forth in Rule 501(a), including a bank, a private business development company under the Investment Advisers Act of 1940, a tax exempt organization with at least $5 million in assets, and certain natural persons who have a net worth of at least $1 million, or who had an annual income of at least $200,000 individually, or at least $300,000 together with a spouse, in each of the last two years. In the past, a person could count the value of a primary residence towards the $1 million net worth threshold. However, Section 413(a) of the Dodd-Frank Act provided that the value of a person’s primary residence can no longer be included as an asset for purposes of calculating net worth, and debt secured by a primary residence must be counted as a liability 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 in Rule 504, Rule 505, or Rule 506(b), and Rule 506(c). Regulation D imposes different requirements on the issuer with respect to each type of offering, but there are several issues that are common to Regulation D offerings in general.

Integration:

With respect to a Regulation D offering, there is a window of six months prior to the commencement of the offering and six months after the conclusion of the offering during which other sales of securities may be considered “integrated” with the offering for purposes of Regulation D. In other words, a sale of securities not in compliance with Regulation D three months after the completion of an otherwise valid Regulation D offering could jeopardize the entire offering if the subsequent sale is considered integrated. The SEC uses a five factor test to determine whether offerings should be integrated: (i) whether the sales are part of a single plan of 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 consideration is 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 under Regulation 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 disclosures it makes to accredited investors (provided it complies with anti-fraud provisions), the materials that it must provide to non-accredited investors are generally equivalent to materials that must be provided 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 issuer than 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 any other media that is distributed to an un-screened audience. Likewise, the offering cannot include seminars or presentations that are open to the public at large.

Restrictions on Resale:

Securities purchased in a Regulation D offering are restricted securities within the meaning of the Securities Act, which means that they may not be resold other than pursuant to registration under the Securities Act or an exemption from such registration. The issuer is also obligated to take reasonable steps to ensure that purchasers in a Regulation D offering are not underwriters. 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 or for others; (ii) providing disclosure to investors that the securities are restricted securities and cannot be resold other than pursuant to registration, or an exemption from registration, under the Securities Act; and (iii) placing a legend on each certificate representing the securities that sets forth the restrictions on transferability.

Filing Form D:

Rule 503 of Regulation D requires that in connection with an offering in reliance on Rule 504, Rule 505, or Rule 506, the issuer must complete and file a notice of sales on Form D with the SEC within 15 days of the first sale of securities in the offering.15 Form D may only be filed online through the SEC’s EDGAR system, which requires issuers to apply for and obtain access codes prior to making a Form D filing. Questions often arise as to the manner of calculating the date 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 solicitation with respect to Rule 506(c) offerings.

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subscription is accepted until a minimum level of aggregate proceeds is achieved. The SEC’s view is that the date of first sale is the date the first investor is “irrevocably contractually committed to invest,” which could vary depending on the terms of the subscription agreement utilized in the offering.16 With respect to an offering in which proceeds are held in escrow until a 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 filing requirements. As a result of adoption of the National Securities Markets Improvement Act of 1996, Rule 506 offerings are not subject to state registration requirements. However, this federal preemption does not apply to Rule 504 or Rule 505 offerings, or to offerings exempt from federal 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 still allowed to impose notice filing requirements and require filing fees in connection with Rule 506 offerings, 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 applicable state a copy of the Form D for the offering and a cover letter that may require disclosure of other offering information, such as the number of purchasers in the offering residing in the applicable state. Blue sky filings add to the administrative expense of an offering, because each state has its own approach to the filings. In Minnesota, a combination of statutes, administrative rules, and interpretive materials provide that an issuer must file a copy of Form D with the Minnesota Department of Commerce, pay a $300 filing fee, and indicate by letter the number of purchasers in 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 million in securities in any 12 month period, provided that the issuer is not a reporting company under the Exchange Act, an investment company, or a blank check company. In addition, in certain circumstances (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 general advertising 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 investment companies) 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 of Regulation A. The bad actor disqualifications in Rule 262 are quite complicated and apply to a number of different types of actors with respect to a number of different types of events with varying look-back periods. Generally speaking, with respect to issuers, disqualifying events include 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 having filed a registration statement that is subject to an ongoing examination under Section 8 of the Securities Act.

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

Historically, Rule 506 presented one type of offering exemption which required, among other 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 separate exemptions. New Rule 506(c) now permits the use of general solicitation and advertising in connection with private offerings (discussed in more detail below). Traditional Rule 506 offerings 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 an unlimited number of purchasers who are accredited investors and up to 35 purchasers who are not accredited investors but who meet a certain threshold of investment sophistication. Rule 506 offerings accounted for an estimated $895 billion in capital raised in the U.S. in 2011, compared with $984 billion raised through registered offerings.18

If non-accredited investors are included in the offering, disclosures similar to those required in public offerings must be made to the non-accredited investors, increasing the expense and administrative burden of conducting the offering. While Rule 505 places no additional requirements on non-accredited investors who participate in the offering, non-accredited investors in a Rule 506(b) offering must, either alone or with a purchaser representative, have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” In other words, some level of due diligence on the part of the issuer is required with respect to non-accredited investors in Rule 506 offerings. This could take the form of a questionnaire that the investor fills out describing their financial position and business sophistication.

The continued availability of existing Rule 506(b) will be important for those issuers that either do not wish to engage in general solicitation in their Rule 506 offerings (and become subject 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)’s sophistication requirements. For example, while offerings under Rule 506(c) will may require issuers 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

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asking investors to self-certify that they meet the accredited investor definition by checking a box will continue to satisfy the requirements of Rule 506(b). Traditional Rule 506(b) offerings are 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 rule making is that offerings under Rule 506(b) are now subject to disqualification or disclosure rules under 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 and advertising in Rule 506 offerings as required by the JOBS Act. The changes are mostly embodied in new Rule 506(c). The relationship between Rule 506(b) and new Rule 506(c) is such 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 the requirements of Rule 506(c) are met with respect to all sales in the offering – including sales made 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) went effective in September and wants to transition to a generally solicited offering. On the other hand, if an issuer has begun a Rule 506(c) offering and has engaged in advertising or general solicitation, the issuer is unable to transition the offering to a Rule 506(b) offering; the use of advertising 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 with Rule 506(c) offerings. Blue sky notice filings are typically required with respect to any sales or offers 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 “general solicitation” and “general advertising.” Although those terms are not defined in Regulation D, Rule 502(c) does provide examples of general solicitation and general advertising, including advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars where attendees have been invited by general solicitation or general advertising. By interpretation, the SEC has confirmed that other uses of publicly available media, such as unrestricted websites, also constitute general solicitation and general advertising, but that presentations commonly known as “venture fairs” or “demo days” do not constitute 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 other offerings 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 as underwriters;

• all purchasers of securities must be accredited investors; and

• the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors.

Principles-Based Approach to Verifying Accredited Investor Status:

Under Rule 506(c), issuers are required to take reasonable steps to verify the accredited investor status of purchasers. Whether the steps taken are “reasonable” will be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction. The SEC calls this a principles-based approach, and has indicated that it does not intend to provide guidance or approval on a case by case basis for issuers. The SEC is unconcerned with the actual circumstances of a purchaser; the rule 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 purchaser turns out to not, in fact, be an accredited investor, the Rule 506(c) exemption is still valid as long as the issuer made a reasonable inquiry and formed a reasonable belief as to the purchaser’s accredited status within the meaning of Rule 506(c). Conversely, if an issuer fails to make the necessary inquiry, the Rule 506(c) exemption will not be available to the issuer, even if it turns out that each purchaser is in fact an accredited investor.

The SEC has indicated that the steps required to be taken by an issuer should be appropriately 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 prospective purchaser is an accredited investor are:

• the nature of the purchaser and the type of accredited investor that the purchaser claims 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 to participate in the offering, and the terms of the offering, such as a minimum investment amount.

These factors are interconnected and are intended to help guide an issuer in assessing the reasonable 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 purchaser’s accredited investor status. After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer 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 to verifying 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 Markets Association (SIFMA) released a memo on June 23, 2014, outlining several specific methods for verifying accredited investor status that SIFMA believes would satisfy the principles-based approach. For registered broker-dealers and investment advisers seeking to verify the accredited investor 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 the offering – that SIFMA believes would satisfy the principles-based approach. Of course, the SIFMA memo does not constitute SEC guidance, but it does have the support of a number of major law firms and may be a useful tool in seeking to satisfy an issuer’s obligation to take reasonable steps to verify accredited investor status outside of the Rule 506(c) safe harbors. The SIFMA memo also contains an example questionnaire for use in verifying accredited investor status of natural persons and an example of a written verification that could be provided to an issuer by a broker-dealer, investment adviser, or law firm certifying that a purchaser is an accredited investor for purposes of the written third party confirmation safe harbor.

Nature of the Purchaser: Rule 501(a) sets forth different categories of

accredited investors, such as broker-dealers, investment companies, employee benefit plans established by state governmental entities, and tax exempt organizations. Issuers should recognize that the steps that will be reasonable to verify whether a purchaser is an accredited investor 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 by virtue of being a registered broker-dealer – such as by going to FINRA’s BrokerCheck website – will necessarily differ from the steps that may be reasonable to verify whether a natural person is an accredited investor.

Information about the Purchaser: The amount and type of information that

an issuer has about a purchaser can also be a significant factor in determining what additional steps would be reasonable to take to verify the purchaser’s accredited investor status. The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it may have to take, and vice versa. Examples of the types of information that issuers could review or rely upon – any of which might, depending on the circumstances, in and of themselves constitute reasonable steps to verify a purchaser’s 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) organization with $5 million in assets, and the organization’s Form 990 series return filed with the Internal Revenue Service discloses the organization’s total assets;

• third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories in the accredited investor definition – for example, 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 person’s status as an accredited investor by a third party, provided that the issuer has a reasonable basis to rely on such third-party verification.

Nature and Terms of the Offering: The nature of the offering – such as the

means through which the issuer publicly solicits purchasers – may be relevant in determining the reasonableness of the steps taken to verify accredited investor status. An issuer that solicits new investors through a website accessible to the general public, through a widely disseminated email or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party. The SEC believes that an issuer will be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification. The SEC does not believe that an issuer will have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, required that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.

The terms of the offering will also affect whether the verification methods used by the issuer are reasonable. The SEC continues to believe that there is merit to the view that a purchaser’s ability to meet a high minimum investment amount could be a relevant factor to the issuer’s evaluation of the types of steps that would be reasonable to take in order to verify that purchaser’s status as an accredited investor. By way of example, the ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any third party, could be taken into consideration in verifying accredited 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 verifying accredited investor status for natural persons that, if used, are deemed to satisfy the verification requirement in Rule 506(c). Issuers are not required to use any of these methods, but each of these methods is an alternative to the general principles-based approach. The SEC has indicated that these four safe harbors will be narrowly construed. However, even if an issuer is unable to comply with one of the safe harbors, the types of steps that are outlined in the safe harbors can be a basis for satisfying the reasonable verification requirement on the principles-based approach described above.

Income: Review of Tax Returns With a Current Certification. In verifying

whether a natural person is an accredited investor on the basis of income, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies of any Internal Revenue Service (“IRS”) form that reports income, including, but not limited to, a Form W-2 (“Wage and Tax Statement”), Form 1099 (report of various types of income), Schedule K-1 of Form 1065 (“Partner’s 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 the income level necessary to qualify as an accredited investor during the current year. In the case of a person who qualifies as an accredited investor based on joint income with that person’s spouse, an issuer would be deemed to satisfy the verification requirement in Rule 506(c) by reviewing copies 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 not available with respect to prospective investors who file tax returns in foreign jurisdictions but not in the U.S., and it is not available if, due to the timing of the offering in the tax year, the prospective investor’s 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. In

verifying whether a natural person is an accredited investor on the basis of net worth, an issuer is deemed to satisfy the verification requirement in Rule 506(c) by reviewing the documentation described below, dated within the prior three months, and by obtaining a written representation from such person that all liabilities necessary to make a determination of net worth have been disclosed. In the case of a person who qualifies as an accredited investor based on joint net worth with that person’s spouse, an issuer would be deemed to satisfy the verification requirement in Rule 506(c) by reviewing such documentation in regard to, and obtaining representations from, both the person and the spouse. The documentation that must be reviewed by an issuer to comply with this method of satisfying Rule 506(c) consists of (i) a credit report from at least one of the nationwide consumer reporting agencies; and (ii) one or more of the following: 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 agencies will not satisfy the safe harbor. The reviewed documents must be dated within three months of the date of the sale of securities, which limits the utility of this safe harbor. If an issuer reviews documents and makes a determination that the purchaser is an accredited investor at the outset of an offering, or at the time a subscription is accepted into escrow, but does not close on the transaction for three months or more, the issuer would have failed to satisfy this method of verification. A tax assessment that is older than three months, even if it is the most recent tax assessment 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 the

verification requirement in Rule 506(c) by obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited 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-party confirmation by one of these parties will be deemed to satisfy the verification requirement in Rule 506(c), depending on the circumstances, an issuer may be entitled to rely on the verification of accredited investor status by a person or entity other than one of these parties, provided that any such third party takes reasonable steps to verify that purchasers are accredited investors and has determined that such purchasers are accredited investors, and the issuer has a reasonable basis to rely on such verification.

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Safe Harbor for Accredited Investors in a Prior Offering. An issuer will

be deemed to satisfy the requirements of Rule 506(c) with respect to a prospective purchaser if that purchaser (i) previously invested in the issuer’s Rule 506(b) offering as an accredited investor, and (ii) certifies in writing that such prospective purchaser is still an accredited investor at 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 common sponsors; if NewCo and OldCo are both sponsored by Investment Fund, a purchaser of NewCo securities will not fall within the existing investor safe harbor by reason of being an existing investor in OldCo.

Amendment to Form D:

Form D is the notice of an offering of securities conducted without registration under the Securities Act in reliance on Regulation D. Under Rule 503 of Regulation D, an issuer offering or selling securities in reliance on Rule 504, 505 or 506 must file a notice of sales on Form D with the SEC for each new offering of securities no later than 15 calendar days after the first sale of 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 “Rule 506” has been renamed “Rule 506(b).”

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

If an issuer begins a Rule 506(b) offering and files a Form D, and then later decides to transition to a Rule 506(c) offering to make use of advertising or general solicitation, the issuer will 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 registration under the Securities Act. In addition, private funds generally rely on one of two exclusions from the definition of “investment company” under the Investment Company Act – Section 3(c)(1)144 and Section 3(c)(7) – which enables them to be excluded from substantially all of the regulatory provisions of that Act. Those exclusions are only available to private funds that are not making or propose to make public offerings. The SEC has historically regarded Rule 506 transactions as non-public offerings for purposes of Sections 3(c)(1) and 3(c)(7). The SEC reaffirmed that the effect of Section 201(b) of the JOBS Act is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.

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Many hedge funds have been reluctant to use general solicitation to offer securities because of the possibility it would be inconsistent with exemptions related to CPO (commodity pool 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 CPO may claim exemptive relief if it is a registered CPO who offers or sells participations in a pool solely to qualified eligible persons, or QEPs, in an offering which qualifies for exemption from the registration requirements of the Securities Act pursuant to section 4(2) (now section 4(a)(2), as amended by the JOBS Act) of that Act or pursuant 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 each pool for which the CPO claims the exemption be exempt from registration under the 33 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 place securities 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 solicitation would not permit reliance on the foregoing exemptions but then granted no-action relief that permits the use of general solicitation if the terms of the no action letter are complied with. The conditions are:

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

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

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

Advertising and general solicitation are permitted only in offerings conducted pursuant to Rule 506(c), and not in Section 4(a)(2) offerings in general. Section 4(a)(2) is the traditional statutory exemption for private offerings. This means that even after the effective date of Rule 506(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 because public advertising will continue to be incompatible with a claim of exemption under Section 4(a)(2).

In a traditional Rule 506 offering (now a Rule 506(b) offering), the exemption in Section 4(a)(2) of the Securities Act provided a safety net of sorts; even if an issuer failed to meet all of the 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 issuer attempts to comply with Rule 506(c) but fails to fulfill the requirements of the rule, the Section 4(a)(2) exemption will not be available to the issuer if the issuer has engaged in advertising or general 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 Street Reform and Consumer Protection Act. Section 926 required the SEC to adopt rules that disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on Rule 506 of Regulation D.

Covered Persons:

The disqualification provisions of Rule 506(d) will cover the following persons, which the 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, general partner or managing member of the issuer;

• any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;

• any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or 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 or managing 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 for solicitation of purchasers in connection with sales of securities in the offering (which we refer to as a “compensated solicitor”); and

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

The final rules include a provision under which events relating to certain affiliated issuers are not disqualifying if they pre-date the affiliate relationship.

Determining who an issuer’s 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 securities in an ongoing private offering, if the covered person is subject to a disqualifying event, the issuer will 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 an offering. Voting agreements and shared voting power over shares can also create difficulties in identifying covered persons. All shares that are subject to a voting agreement may be considered, as a group, to constitute a “covered person.” If a group of owners designates one person 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 be deemed to be “participating in the offering” and therefore subject to the bad actor disqualifications. While an officer of a compensated solicitor that performs mainly administrative tasks in connection with the offering will not be considered a covered person, an officer 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 provided guidance.

In some cases, an issuer can take action to terminate a covered person’s involvement with the 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 Rule 506 as long as it terminates the engagement with the placement agent and pays no compensation to the agent for future sales. A similar concept applies when only one or a subset of covered persons associated with the placement agent are affected by a disqualification event (i.e., the offering can continue as long as the persons subject to the disqualifying event are terminated by the placement agent or reduced to roles that do not make them “covered persons” for purposes of Rule 506(d)). It’s unclear how soon after the disqualifying event the termination of covered person status must occur in order to allow the issuer to continue to rely on Rule 506, or how sales of securities in the offering after the disqualifying event but before termination of the covered person will be treated.

Disqualifying Events:

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

• Has been convicted, within ten years before such sale (or five years, in the case of issuers, 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; or

o 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 or enjoins such person from engaging or continuing to engage in any conduct or practice:

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o Involving the making of any false filing with the SEC; or

o 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 a final order of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration 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 that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale; or

• Is subject to an order of the SEC entered pursuant to section 15(b) or 15B(c) of the Securities 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 time of such sale:

o Suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment adviser;

o Places limitations on the activities, functions or operations of such person; or o Bars such person from being associated with any entity or from participating in

the 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 or causing 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 of 1934 (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; or

o 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 from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct 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, any registration 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, or order 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 or suspension order should be issued; or

• Is subject to a United States Postal Service false representation order entered within five years before such sale, or is, at the time of such sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money or property 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 the bad actor provision. The SEC believes the steps an issuer should take to exercise reasonable care will vary according to the particular facts and circumstances. For example, the SEC anticipates that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering. Factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.

The SEC also believes the time frame for inquiry should also be reasonable in relation to the circumstances of the offering and the participants. Consistent with this standard, the SEC stated the objective should be for the issuer to gather information that is complete and accurate as of the time of the relevant transactions, without imposing an unreasonable burden on the issuer or 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 its factual inquiry into its covered persons in order to continue meeting the reasonable care exception. It’s unclear how frequently an issuer must update its inquiry or how long an offering must be ongoing in order to require an update to the inquiry. The SEC expects that issuers will determine the appropriate dates to make a factual inquiry, based upon the particular facts and circumstances 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 some cases—for example, in the case of a registered broker-dealer acting as placement agent—it may be sufficient to make inquiry of an entity concerning the relevant set of covered officers and controlling persons, and to consult publicly available databases concerning the past disciplinary history of the relevant persons.

References

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