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SEC Proposes Revisions to Regulation D Limited Offering Exemptions

November 7, 2007

Proposals Intended to Clarify Rules and Provide Flexibility to Issuers and MFA Comments to Proposed Revisions

The Securities and Exchange Commission (SEC) has recently proposed a number of revisions to Regulation D, the series of eight rules that define certain conditions under which sales of securities are exempted from the registration requirements of Section 5 of the Securities Act of 1933.  These new revisions are intended to clarify and modernize Regulation D, bringing it into line with the realities of modern market practice and communications technologies, without compromising investor protection.

In response to the SEC’s invitation to submit comments on the proposed revisions, the Managed Funds Association (MFA) has commended the SEC for its efforts to modernize and streamline the filing process.  However, the MFA has also raised concerns about the creation of a new category of “large accredited investors,” updated financial eligibility and “bad actor” standards, coordination of information between federal and state agencies, and other elements of the proposed revisions.

Summary of Proposed Changes

These proposed changes include the following key provisions:

  • Creation of a new registration exemption for securities offers and sales to "large accredited investors." This new exemption would allow an issuer to engage in limited advertising.
  • A revised definition of "accredited investors."
  • An adjustment to account for inflation on the standard to meet the definitions of accredited investors and large accredited investors.
  • An expansion of the list of entities that would qualify as accredited investors or large accredited investors.
  • Revisions to the safe harbor requirements which will allow a new private offering to begin 90 days — rather than six months — after the close of a prior offering.
  • Providing uniform, updated "bad actor" disqualifications for all offerings under Regulation D.
  • A requirement that private companies file Form D electronically.

Description of Proposed Revisions

Permitting Limited Public Advertising in Exempt Offerings to Large Accredited Investors

Regulation D provides a number of exemptions from registration for securities offerings by issuers, subject to various restrictions on the number and type of purchasers and the number of offerees.  In its proposed new Rule 507, the SEC would allow issuers to sell their securities under Regulation D and engage in limited advertising so long as they sell only to a new category of investors called "large accredited investors."  The advertisements would be in the form of written announcements and could be published in any written medium, such as in a newspaper or on the internet, but excluding radio or television broadcast spots or infomercials.  Among other requirements, the announcement must state prominently that sales are to be made solely to "large accredited investors", and that the securities are not registered and will be sold pursuant to an exemption under the Securities Act of 1933.  The announcement may also include the name of the issuer, a 25-word-or-less description of the business of the issuer, and the name of a person to contact for additional information. 

Large Accredited Investors:  A New Category

Large accredited investors consist of the same categories of entities and individuals that currently qualify as accredited investors under the existing Rule 506, but with higher dollar-amount thresholds, and would include:

  • Legal entities with more than $10 million in investments, as compared to the $5 million in assets that currently qualify an entity as an accredited investor.
  • Natural persons with $2.5 million in investments (or joint investments with a spouse), subject to certain restrictions, as compared to the current accredited investor standard of $1 million in net worth, or with an individual income greater than $400,000 (or $600,000 with one's spouse) in each of the two most recent years and with a reasonable expectation of reaching that same income level in the current year.
  • Legal entities that qualify as accredited investors without being subject to dollar-amount thresholds, such as banks, registered investment companies, private business development companies and other regulated entities, would also qualify as large accredited investors without being subject to an income, assets or investment requirement.
  • Directors and executive officers of the issuer would be considered large accredited investors in addition to being considered accredited investors without being subject to an income, assets, or investment requirement.

For an offering under Rule 507, all purchasers must be large accredited investors.  This is a departure from the approach taken in Rule 506, which allows for offers and sales of securities to a limited number of non-accredited investors.

In addition, securities sold under the exemption proposed by Rule 507 would be "covered securities" under the Securities Act of 1933 because the purchasing large accredited investors would be defined as "qualified purchasers" under the Securities Act.  As such, securities sold in a Rule 507 exempt offering would be preempted from state securities registration requirements.

New Standards for Accredited Investors

The proposals broaden the existing definition of "accredited investor" by adding an alternative qualification basis relating to the total investments owned by a purchaser.  In particular, as an alternative to the $5 million asset standard (as noted above) that qualifies a legal entity as an accredited investor, the proposed rules provide a $5 million investments standard.  For individuals, the accredited investor definition would be expanded to include a $750,000 investments-owned test, as an alternative to the existing $1 million net worth.  The current method of qualification based on annual income remains intact.  (i.e. the $200,000 (or $300,000 with one's spouse) annual income tests).  The proposal adds a definition for "investments," which includes securities (other than those representing a control interest in an issuer), real estate held for investment purposes, commodity interests held for investment purposes, physical commodities held for investment purposes and cash and cash equivalents held for investment purposes, in each case including investments held in retirement plans and trusts.  The calculation for the value of investments excludes personal residences and places of businesses.

The proposed rules also contain slightly revised definitions of various terms, including replacing the term “prospective accredited natural person” with the term “purchaser,” and refining the terms “related person,” “investment purposes,” “valuation” and “deductions” — all of which is intended to create greater clarity and consistency across the various rules.

New Entities Added to List of Accredited and Large Accredited Investors

The proposed rules add entities to the list of accredited and large accredited investors, which list currently includes organizations described in Section 501(c)(3) of the Internal Revenue Code, corporations, Massachusetts or similar business trusts and partnerships. The proposed rules add limited liability companies, Indian tribes, labor unions, governmental bodies or other legal entities with substantially similar legal attributes.

Inflation Adjustment

The proposed rules impose an adjustment for inflation on the standards to meet the accredited investor and Rule 507 large accredited investor definition.  This adjustment would not be made until July 1, 2012, and only every five years thereafter.

Revisions to Safe Harbor

The integration doctrine of Regulation D is intended to prevent an issuer from improperly avoiding registration requirements by artificially dividing a single offering into multiple offerings.  A safe harbor was created to provide issuers with a clear test upon which they could rely to avoid integration of multiple offerings; offers and sales that closed more than six months before the initiation of subsequent offering, or began more than six months after the close of the prior offering.

Under the proposed rules, this window between offerings has been shortened to 90 days.  The change is intended to address the increased volatility of capital markets and to enable smaller companies, in particular, to meet their capital needs.

Prohibiting "Bad Actors" from Using Regulation D

Currently, issuers may rely on the Rule 506 exemption of Regulation D even if the sponsor, its management team or its owners have committed violations of securities laws.  The proposed rules would provide uniform bad actor disqualification for all offerings under Regulation D.  The uniform rule would apply to any issuer, any predecessor of the issuer and any affiliated issuer; any director, executive officer, general partner or managing member of the issuer; any promoter connected with the issuer; and any beneficial owner of 20% or more of any class of the issuer's equity securities.

Electronic Filing of Form D

The SEC has also recently proposed revising the requirements of Form D.  Form D serves as the official notice of an offering of securities that relies on an exemption provided by Regulation D.  To streamline the filing process and to make the information more easily available to, and searchable by, the public, the SEC is proposing a revised, simplified Form D with updated information requirements.

The proposed Form D must be filed electronically through a new online filing system.  No special software would be required to file Form D online, and no filing fee has been proposed.  However, private companies wishing to use one of the Regulation D exemptions would be required to obtain an EDGAR filing code in order to use the new system.

The proposed changes to Form D include elimination of the current requirement to identify 10% holders of a class of equity securities and the requirement to estimate the use of the proceeds of the offering.  New questions would include the issuer’s revenue range (with a “decline to disclose” option), whether or not the transaction represented a business combination, and identification of the broker’s CRD number, if a broker is used for the transaction.

MFA Raises Concerns

In two letters to the SEC, submitted in October 2007, the Managed Funds Association has generally applauded the SEC for its efforts to modernize and streamline the process.  However, the MFA also has raised specific concerns about certain elements contained in the proposed changes.  These comments include opinions on the following points, among others:

Large Accredited Investors

The MFA has recommended that the Commission not adopt the large accredited investors and accredited natural persons proposals noted above.  Instead, the MFA suggests that the SEC take a tiered approach to the accredited investor standard based on the type of offering.

Accredited Investors

The MFA has noted that the financial eligibility standard for natural persons in the current definition of accredited investors has not changed since 1982, and that inflation and sustained economic growth have pushed a number of investors beyond the “accredited investor” standard.  The MFA suggests that an increase in the financial eligibility standards for investors in 3(c)(1) funds will address the SEC’s concerns regarding investor participation in these funds, while taking into consideration the effects of inflation on financial eligibility. 

With regard to the categories of legal entities on the list of permitted accredited investors, the MFA recommends that the definition of such investors be expanded to include qualified purchasers, knowledgeable employees, trust grantors, trustees and beneficiaries.  The association also recommends that the SEC reevaluate Rule 502(c), which prohibits general solicitation and advertising.  The MFA is concerned that this prohibition does not promote the Commission’s goal of investor protection, and prevents issuers (hedge funds, in particular) from providing greater transparency to their prospective investors.

Safe Harbors and Bad Actors

The MFA supports the SEC’s shortening of the length of time required by the integration safe harbor from 6 months to 90 days.  However, the association also feels that the disqualification provisions, as described in the proposed rule, are overly broad and imprecise, and recommends that these provisions be limited to Rule 505 only.

Federal and State Coordination

The MFA acknowledges the advantages of a coordinated, uniform electronic filing system for Form D.  However, until state securities regulators agree to permit “one-stop” filing and a central filing system is created, it is likely that the proposed system would increase, rather than decrease, the costs and burdens associated with preparing and filing Form D.  It is conceivable that issuers may be required to file up to 50 separate amendments to the states, and pay associated state filing fees, if states do not agree to the uniform system.  The MFA is encouraging the SEC to take a leadership role in obtaining buy-in from the states before implementing the proposed electronic filing system.