On July 10, the U.S. Securities and Exchange Commission ("SEC") adopted final rules under Section 201(a) of the Jumpstart Our Business Startups Act (the "JOBS Act") removing the ban against general solicitation and general advertising in private offerings made in reliance on Rule 144A and Rule 506 of Regulation D under the U.S. Securities Act of 1933 (the "Securities Act").1 The new rules went into effect on September 23.2
The amendments to Rule 506 permit private issuers—including hedge funds, private equity funds, venture capital funds, and other private investment vehicles—to use general solicitation and general advertising in a Rule 506 private placement, as long as all purchasers are accredited investors and the issuer takes "reasonable steps" to verify that the purchasers are accredited investors. Under new Rule 506(c), private funds may now solicit investors through advertisements, articles, notices, or other communications published in any newspaper, magazine, or similar media broadcast over television, the radio, or the internet.
In addition, the SEC adopted new Rules 506(d) and (e) and changes to Form D, which make all Rule 506 offerings subject to certain "bad actor" disqualification, disclosure, and certificate requirements.
This Commentary focuses on the elimination of the long-time prohibition against general solicitation and general advertising on Rule 506 offerings by hedge funds, private equity funds, and other alternative investment funds. In short, although a much broader array of marketing tools is now available to be used by private fund issuers, before engaging in general solicitation in a Rule 506(c) offering, private funds and their investment advisers will need to reexamine their policies, procedures, and customary transaction documents to ensure compliance with the heightened due diligence requirements and consider whether engaging in general solicitation may conflict with other regulatory restrictions to which the fund is subject (such as CFTC regulations, the Investment Advisers Act, and any non-U.S. restrictions on advertising applicable to the fund).
Overview of Rule 506
Most private funds rely on the private placement exemption made available by Rule 506 to avoid the registration requirements of Section 5 of the Securities Act with respect to offerings in the United States. Rule 506 permits issuers to raise an unlimited amount of capital in private offerings sold to an unlimited number of accredited investors and up to 35 nonaccredited investors. Any form of general solicitation or general advertising was explicitly prohibited under the pre-amendment version of Rule 506 (the "Old Rule").3 This restriction had generally been interpreted broadly to prohibit, among other things, the use of publicly available websites, media broadcasts (such as radio and television advertisements), mass email campaigns, and public seminars or meetings as part of an issuer's capital-raising activities.
Amendments to Rule 506
The amendments add to Rule 506 a new paragraph (c), which permits the use of general solicitation and general advertising in connection with an offering of securities under Rule 506, provided that:
- The issuer takes "reasonable steps to verify" that the purchasers are accredited investors;
- All purchasers of the securities are "accredited investors" (i.e., all of the purchasers fall into one of the categories set forth in Rule 501(a), or the issuer reasonably believes that all of the purchasers fall into one of such categories); and
- All terms and conditions of Rule 501, 502(a), and 502(d), which set forth definitions, general conditions, and limitations on resale, are satisfied.
Reasonable Steps to Verify Accredited Investor Status
The verification requirement is a "principles-based" condition that requires the issuer to take reasonable steps to verify the accredited investor status of purchasers. Whether the steps taken were in fact reasonable is an "objective determination ... in the context of the particular facts and circumstances of each purchaser and transaction."4
Under the principles-based approach, issuers should consider a number of interconnected factors. The more that the relevant facts and circumstances make it likely that a purchaser is an accredited investor, the fewer verification steps that will be required, and vice versa.5 The information gained by looking at the following factors would help an issuer assess the reasonable likelihood that a purchaser is an accredited investor and whether additional steps might be necessary:
The Nature of the Purchaser and Type of Accredited Investor that the Purchaser Claims To Be. Taking reasonable steps to verify accredited investor status may differ with respect to different types of investors, such as corporations as compared to natural persons. The definition of "accredited investor" in Rule 501(a) includes eight enumerated categories of individuals or entities. Some purchasers may be accredited investors based on their status alone (e.g., an investment company registered under the U.S. Investment Company Act of 1940 (the "Investment Company Act") or a broker or dealer registered under the U.S. Securities Exchange Act of 1934 (the "Exchange Act")), while others satisfy the standard by virtue of their status and their total assets taken together (e.g., certain entities with total assets in excess of $5 million).
The Amount and Type of Information that the Issuer Has About the Purchaser. Examples of the types of information that issuers could review include publicly available information in filings with federal, state, or local regulatory bodies or information available through a third party, such as a broker-dealer, accountant, or attorney.
The Nature and Terms of the Offering. The issuer should consider the manner in which the purchaser was solicited to participate in the offering. The more public the method (e.g., a publicly available website, social media, or mass email), the more likely additional verification steps will be required.
It is important to note that the issuer must take reasonable steps to verify accredited investor status; an issuer will not be deemed to have complied with Rule 506(c) simply on the grounds that the purchasers ultimately were all accredited investors. In the context of a Rule 506(c) offering, the practice of accepting self-certification by an investor (i.e., a checked box on an investor questionnaire or subscription agreement) will not be sufficient on its own to demonstrate that reasonable steps have been taken to verify accredited investor status.6
A Nonexclusive List of Methods to Verify Accredited Investor Status of Natural Persons
In order to address industry requests that Rule 506(c) include some element of certainty with respect to verification methodologies, the SEC provided a nonexclusive list of methods that an issuer may use to satisfy the verification requirement for a purchaser who is a natural person. These methods include:
- Verification by Net Income. Reviewing copies of any IRS form that reports the income of the purchaser together with a written representation that the purchaser expects to continue to earn the necessary income in the current year;
- Verification by Net Worth. Reviewing copies of bank and brokerage, certificate of deposit, tax assessment, and appraisal reports issued by independent third parties as evidence of the purchaser's assets, and a consumer credit report as evidence of the purchaser's indebtedness in each case dated within the prior three months, together with a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed;
- Third-Party Verification. Receiving written confirmation from an SEC-registered broker–dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant7 that such entity or person has taken reasonable steps to verify the purchaser's accredited status; and
- Verification by Existing Relationship. With respect to a purchaser who invested in a Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c), remains an investor, and intends to invest in a Rule 506(c) offering by the same issuer, receiving a certification from the purchaser that he or she qualifies as an accredited investor.
Issuers and investment advisers that intend to conduct a private fund offering in reliance on Rule 506(c) should make certain that they have due diligence and recordkeeping policies and procedures in place that ensure compliance with the verification required under the new rule.
Reasonable Belief Standard
The "reasonable belief" standard in the definition of accredited investor (i.e., that an accredited investor is a person who meets one of the enumerated categories, or who the issuer reasonably believes meets one of the enumerated categories) is unchanged by the amendment to Rule 506. As long as an issuer takes reasonable steps to verify that a purchaser is an accredited investor and has a reasonable belief that the purchaser is an accredited investor, the issuer would not lose the ability to rely on Rule 506(c) if it is later discovered that the purchaser is not in fact an accredited investor. On the other hand, an issuer that fails to take reasonable steps to verify accredited investor status will lose the benefit of Rule 506(c) even if all purchasers are accredited investors.8
"Bad Actor" Disqualification and Revised Form D
The SEC adopted new Rules 506(d) and (e) and changes to Form D, which make all Rule 506 offerings subject to certain "bad actor" disqualification, disclosure, and certificate requirements. Generally, where issuers are associated with events specified by Congress as indicators of financial or disclosure fraud or misconduct, the use of Rule 506 will be prohibited (or, with respect to pre-September 23 "bad actor" events, permitted only with disclosure of such bad acts). Form D was amended to add a check box for issuers to indicate whether they are relying on Rule 506(c). The SEC noted that this would give it an opportunity to monitor the use of general solicitation in private offerings and would assist it in evaluating the effectiveness of various accredited investor verification practices.
The Impact of Rule 506(c) on Private Funds
Amended Rule 506 substantially increases the types of permitted fundraising activities of private funds. Under Rule 506(c), funds are now permitted to engage in all forms of communication with prospective investors, including forms of communication traditionally viewed as general solicitation, as long as (i) the only investors actually admitted into the fund qualify as "accredited investors" or who the fund reasonably believes would so qualify, and (ii) the fund takes reasonable steps to verify the accredited investor status of each of the investors admitted to the fund.
Most private funds rely on the Section 3(c)(1) or 3(c)(7)9 exclusions under the Investment Company Act to avoid being deemed investment companies. Both Section 3(c)(1) and 3(c)(7) require that the fund is not making and does not propose to make a "public offering" of its securities. The SEC has expressly confirmed that an offering made pursuant to Rule 506(c) will not constitute a public offering for purposes of Sections 3(c)(1) and 3(c)(7).10
However, private funds and their investment advisers will need to consider whether engaging in general solicitation may conflict with other regulatory restrictions to which the fund is subject. Outlined below are several of the key factors to be considered in making such a determination.
Investment Advisers Act
Investment advisers that are registered with the SEC must continue to comply with rules relating to advertising under the U.S. Investment Advisers Act of 1940 (the "Advisers Act"). For example, a registered investment adviser is limited in its ability to use marketing materials that refer to any testimonial concerning the investment adviser or that refer to its past specific investment recommendations. Investment advisers are also limited in the way that they may present a track record. Adequate disclosures are typically required in order to ensure that information will not be deemed to be misleading, inaccurate, or incomplete.
For investment advisers that take advantage of certain exemptions from Advisers Act registration, such as the foreign private adviser exemption, it is important to note that the SEC did not indicate whether it would view an investment adviser to a private fund that conducts an offering under Rule 506(c) as not "holding itself out" as an investment adviser, which is a key condition required in order to take advantage of the exemption.
The use of general solicitation or general advertising may affect the availability of certain exemptions under rules promulgated by the Commodity Futures Trading Commission ("CFTC"), including the de minimis exemption from registration as a commodity pool operator under CFTC Rule 4.13(a)(3). The de minimis exemption requires that interests in each applicable fund be "offered and sold without marketing to the public in the United States." Without a contrary holding by the CFTC, it appears that private funds using general solicitation may not be able to rely on the Rule 4.13(a)(3) exemption. CFTC Rule 4.7, which provides relief from certain regulatory requirements for CFTC-registered commodity pool operators, also includes a restriction against general solicitation.
Anti-Fraud Rules and Foreign Publicity Restrictions
Marketing materials used to solicit prospective investors remain subject to the anti-fraud rules under the U.S. federal securities laws, including Rule 10b-5 under the Exchange Act and Rule 206(4)-8 under the Advisers Act. In addition, many non-U.S. jurisdictions have their own publicity rules and restrictions in connection with an offering that must be observed if the fund is marketed in those jurisdictions.
State Registration as an Investment Adviser
By lifting the ban on general solicitation, Rule 506(c) will allow contact with potential investors through unblocked internet websites, which means that private funds could potentially solicit investors in many different states within the United States. Commonly referred to as the "de minimis" exemption, most states have a maximum number of clients an investment adviser (who does not have an office in the state or is not otherwise registered with the SEC) may have without being required to register in that state. The number varies from state to state. In many states the number is five or fewer, in other states the number is six, while a few state statutes have no de minimis exemption and require firms to register in the state if they have just one client in the state. Furthermore, there are some states with more stringent rules requiring that the adviser not "hold itself out to the public" as an investment adviser to qualify for the de minimis exemption.
Given the varying rules and regulations across the states, investment advisers that plan to use Rule 506(c) to engage in general solicitation of investors should consult with counsel with respect to the laws in the states in which they will solicit potential investors to determine whether they must register as an investment adviser. This is particularly important if the investment adviser intends to solicit investors on the internet, where the adviser may be deemed to be holding itself out to the public as an investment adviser.
By lifting the long-time ban on general solicitation and general advertising under Rule 506, the SEC has opened up opportunities for participants in the private fund industry to expand their investor base and grow their businesses. However, before moving forward aggressively, fund managers should ensure that appropriate controls, policies, and procedures are in place to mitigate the potential compliance risks involved. Private funds intending to engage in general solicitation will need to reexamine their due diligence procedures and customary transaction documents, which, for many, up until now have generally not included provisions that contemplate general solicitation or the robust verification procedures required under the new rule. Fund managers must also consider any applicable compliance obligations under other laws and regulations, including the Advisers Act, the rules promulgated by the CFTC, and state and non-U.S. laws, which may prohibit advertising under relevant exemptions.
1 Available at http://www.sec.gov/rules/final/2013/33-9415.pdf (the "Adopting Release").
2 Revised Rule 144A permits a seller to rely on Rule 144A even if the securities are offered to non-Qualified Institutional Buyers ("QIBs"), including by means of general solicitation, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a QIB. The amendments to Rule 144A are addressed in a separate Jones Day Commentary, available at http://www.jonesday.com/general-solicitation-now-permitted-in-rule-144a-offerings-are-foreign-private-issuers-free-to-talk-10-07-2013/.
3 Under the Old Rule, the prohibition on general solicitation applied to all Rule 506 offerings. As revised, that limitation is applied only to offerings under Rule 506(b).
4 Adopting Release, at 27.
5 Adopting Release, at 28.
6 Adopting Release, at 34.
7 See SEC New C&DIs Re Rule 144A and Rule 506(c), November 13, 2013, question 260.09.
8 Adopting Release, at 26.
9 In general, Section 3(c)(1) excludes from the definition of an "investment company" any issuer whose interests are beneficially owned by not more than 100 persons. Section 3(c)(7), which excludes from the definition of an "investment company" any issuer whose outstanding securities are owned exclusively by "qualified purchasers" (e.g., individuals who own at least $5 million in investments, or certain entities that have at least $25 million in investments). In the case of non-U.S. funds, Section 3(c)(1) operates so that the fund is permitted to have an unlimited number of non-U.S. resident holders and to conduct a U.S. offering that results in the fund having no more than 100 beneficial owners resident in the United States. Similarly, in the context of Section 3(c)(7), for non-U.S. funds, issuers are permitted to offer and sell their securities in the United States to an unlimited number of qualified purchasers, and the non-U.S. resident investors in the fund do not have to be qualified purchasers. See No-Action Letters, Touche Remnant & Co. (8/27/84) and Investment Funds Institute of Canada (3/4/96).
10 Adopting Release, at 48.
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