In April 2012, we wrote here about the potential future impact of the Jumpstart Our Business Startups Act (“JOBS Act”) on M&A transactions in which an acquirer seeks to issue its privately placed equity securities as consideration in an acquisition. Our discussion at the time focused on the conditions of Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”) and, in particular, the tension faced by issuers that are required to determine the offerees’ status as “accredited investors” or as otherwise suitable to evaluate the potential investment. We noted that such issuers have historically been prohibited from using any form of “general solicitation” when offering securities in such transactions. Subsequently, in July 2013, the SEC adopted final rules (effective September 23, 2013) to eliminate the absolute prohibition against general solicitation in securities offerings conducted pursuant to Rule 506, as required by Section 201(a) of the JOBS Act (Gibson Dunn’s summary and analysis of the rules may be found here). The following discussion updates our earlier post to address the legal and practical effects of these new rules for M&A transactions that include a private placement component.
As we wrote previously, under the former version of Rule 506, an issuer-acquirer could:
sell an unlimited amount of its securities in a private placement to an unlimited number of “accredited investors” (as defined in Rule 501) and up to 35 non-accredited investors. Under [this rule], each investor that is not an accredited investor, either alone or with his purchaser representative(s), must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment. As a result, to confirm satisfaction of the investor suitability standards of Regulation D, the acquirer must determine whether the sellers are accredited investors or meet the financial and business sophistication requirements. The acquirer can make such determination by contacting each seller and requesting that each seller complete and return an investment questionnaire. If any seller is not an accredited investor, the acquirer can arrange for the appointment of a purchaser representative for such seller.
Importantly, the traditional Rule 506 safe harbor described above has been preserved intact as Rule 506(b), and issuers may continue to comply with its conditions, the most significant of which is the complete prohibition on the use of any form of general solicitation in the offering or sale of securities. As previously noted, when acquirers reach out to potential sellers to determine their sophistication they may risk violating the prohibition against general solicitation, unless the issuer or its agent has a pre-existing substantive relationship with the offerees.
The newly adopted rules create a new subsection (c) of Rule 506, which permits Rule 506 offerings that employ general solicitation methods if: (i) each purchaser in the offering is an accredited investor, or the issuer reasonably believes that each purchaser is an accredited investor at the time of the sale of the securities, and (ii) the issuer takes reasonable steps to verify that each purchaser is an accredited investor. This represents a seismic shift in the nature of allowable advertising and outreach in private offerings—including transactions in which unregistered equity securities may be offered as consideration in an acquisition, but the usefulness of the new Rule 506(c) will be constrained by the requirement that each offeree receiving unregistered equity securities must in fact be an accredited investor. Therefore, while an issuer-acquirer may now choose to engage freely in any “solicitation” or other efforts directed toward potential sellers to determine investor suitability, once the issuer has begun such a general solicitation, it may not then rely on Rule 506(c) to issue the equity securities to sellers that are not verified accredited investors. Furthermore, once a general solicitation has commenced, the issuer will no longer have the flexibility to go back and rely on Rule 506(b) or the traditional Securities Act Section 4(a)(2) private placement exemption as an alternative to the Regulation D safe harbor (given that the changes to Rule 506 specifically do not apply to Section 4(a)(2)). As a practical matter, if an acquirer chooses to engage in a general solicitation and cannot verify that each seller is accredited, then the acquirer should be prepared to pay cash consideration to any non-accredited investors. If so desired, the acquirer could also attempt to register the entire issuance of equity securities with the SEC, but of course the SEC may view the prior general solicitation as an “offer” in violation of the gun-jumping provisions of Section 5 of the Securities Act.
If the acquirer suspects that some of the sellers may not be accredited, but it still wants to use its privately-placed equity securities as acquisition currency, then it will need to follow the traditional model for engaging in such private placements—under Rule 506(b)—and avoid any type of general solicitation. This means that the issuer will need to have a pre-existing substantive relationship with each seller and the offering can include no more than 35 non-accredited investors. A purchaser representative may be used in order to establish the required pre-existing relationship or to validate the sophistication of any non-accredited sellers.