The SEC Proposes to Update and Relax the Private and Limited Offering Exemptions Under Regulation D

by Alex Frutos

The SEC has been hard at work this summer trying to improve the effectiveness, cost efficiency, and flexibility of its rules and regulations, as demonstrated by its June and July releases relating to Section 404 compliance; adoption of the e-Proxy notice and access rules; proposed changes to Rule 144 and Rule 145; and proposed updates to Form D.  In this same vein, and as a sequel to the SEC’s 2005 Securities Offering Reform Rules in the public securities offerings arena, in August the SEC proposed rules to provide additional flexibility for private and limited offerings under Regulation D, which are exempt from the registration requirements of the Securities Act of 1933 (the Securities Act)1. The proposals are intended to clarify and modernize Regulation D in light of developments in market practice and communications technologies without compromising investor protection.

The SEC’s proposed changes to Regulation D (1) create a new exemption from the registration requirements of the Securities Act for offers and sales to “large accredited investors” in which a limited form of written announcement would be permitted; (2) update the definition of “accredited investor;” (3) shorten the integration safe harbor time period from six months to 90 days; and (4) impose uniform restrictions on certain “bad actors” from relying on any of the exemptions in Regulation D.

New Rule 507 Exemption for Large Accredited Investors

Currently, Regulation D provides three specific exemptions under the Securities Act for private and limited securities offerings. Rule 504 provides exemptions for issuers that are not subject to the reporting requirements of the Securities Exchange Act of 1934 for the offer and sale of up to $1 million of securities in a 12-month period. Rule 505 exempts offerings by issuers of up to $5 million of securities in a 12-month period. Rule 506 exempts offerings by issuers without any limit on the offering amount provided that the offering is made only to accredited investors and up to 35 non-accredited investors who satisfy an investment sophistication standard. All offers and sales made under Rules 505 and 506, and most offers and sales made under Rule 504, must be made without any general solicitation or advertising.

Proposed Rule 507 would be a new exemption from the registration requirements of the Securities Act for offers and sales of securities to a new category of “large accredited investors” in which a limited form of written announcement would be permitted.  The definition of a “large accredited investor” would be based on the current definition of an accredited investor but with higher dollar-amount thresholds as follows2:

	Accredited Investor	Large Accredited Investor
Legal Entities	> $5 million in assets	>$10 million in investments
Individuals	> $1 million net worth OR > $200,000 annual income ($300,000 with spouse)	> $2.5 million in investments OR > $400,000 annual income ($600,000 with spouse)

Certain entities that are subject to government regulation (such as banks), as well as directors and executive officers of the issuer, would qualify as large accredited investors without meeting any required dollar-amount threshold.

Proposed Rule 507 would be similar to Rule 506 in that (1) it would allow an issuer to sell an unlimited amount of securities to an unlimited number of investors who meet specified criteria; (2) it would place no restrictions on the payment of commissions; (3) the securities issued would be treated as “restricted securities” under the Securities Act; (4) the issuer would be required to exercise reasonable care to make sure purchasers are not underwriters; (5) the issuer must file a notice with the SEC on Form D; and (6) state regulation of the offering is preempted.  Unlike Rule 506 which does not allow any general solicitation or advertising but allows sales to up to 35 investors that are not accredited investors, a written limited announcement would be allowed under proposed Rule 507, but sales to investors who do not qualify as “large accredited investors” would not be allowed.  The announcement can include the issuer’s name and address, a brief description of the issuer’s business and certain terms of the securities offering.  The limited announcement must state prominently that sales will be made to large accredited investors only, that no consideration is being solicited or will be accepted through the announcement, and that the securities have not been registered with or approved by the SEC and are offered and sold pursuant to an exemption.  The announcement must be in a written medium, such as a newspaper or on the Internet, and may not be over the radio or television.3

Updates to Accredited Investor Definition

Currently, to qualify as an accredited investor, certain entities must have total assets in excess of $5 million and individuals must have either a net worth in excess of $1 million or annual income in excess of $200,000 ($300,000 with their spouse). Under the proposals, a new “investments-owned” alternative standard for determining accredited investor status would be added. For legal entities required to satisfy the $5 million assets test, the proposal would provide an alternate standard of $5 million in investments. For individuals and spouses, the proposals would provide an alternative standard of $750,000 in investments that could be used instead of the current net worth and annual income standards.

The SEC has recognized that inflation, along with the sustained growth in wealth and income in recent years, has resulted in a substantial number of investors surpassing the accredited investor standards.  Under the proposed rules, the dollar amount thresholds for both “accredited investors” and “large accredited investors” would be subject to periodic adjustment for inflation.

Shortened Integration Safe Harbor Waiting Period

Currently, Rule 502(a) of Regulation D contains an integration safe harbor that provides offers and sales made more than six months before a Regulation D offering or more than six months after a Regulation D offering will not be integrated and considered part of the same offering.  Multiple private placements are generally subject to the risk of being integrated by the SEC for purposes of determining the availability of certain exemptions from the registration requirements of the Securities Act and the Rule 502(a) safe harbor provides a bright line test for assessing this risk.  Recognizing that such a long delay inhibits companies, particularly smaller companies, from meeting their capital needs in today’s volatile capital markets, the SEC has proposed reducing the amount of time issuers are required to wait in order to rely on the integration safe harbor from six months to 90 days.

Disqualification Provisions

Currently, only Rule 505 imposes “bad actor” disqualification provisions, which prevent issuers from relying on the exemption if the issuer or certain affiliated persons have violated certain laws. Under proposed Rule 502(e), the disqualification provisions would apply to all offerings made under Regulation D, so that the issuer could not rely on any of the Regulation D exemptions if the issuer or certain related persons had committed certain bad acts.  “Bad actors” would include those convicted of criminal offenses related to the offer or sale of securities, those adjudicated to have violated the securities laws, and certain suspensions or expulsions from a national securities exchange or association.  The length of disqualification is generally five years and up to ten years for certain criminal convictions.

If you have questions concerning the proposed rules and the potential impact on your business, you can contact Alex Frutos at afrutos@jw.com, Jim Ryan at jryan@jw.com, or Jeff Sone at jsone@jw.com in our Dallas office; Mike Meskill at mmeskill@jw.com in Austin; Sabrina McTopy at smctopy@jw.com in Houston; or Steve Jacobs at sjacobs@jw.com in San Antonio for additional information.

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1. SEC Proposed Release No. 33-8828 (August 3, 2007).
2. Large accredited investors would be considered “qualified purchasers” under Section 18(b)(3) of the Securities Act, and thus securities sold in a Rule 507 offering would be “covered securities,” resulting in preemption from state securities regulation.
3. Hedge funds, private equity funds and other pooled investment vehicles relying on the exclusion from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 would not be able to rely on proposed Rule 507 in connection with a securities offering.

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