On July 10, 2013, by a 4-1 vote, the Securities and Exchange Commission (the “SEC”) adopted amendments to Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”).1 These amendments, which were required by the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”),2 eliminate, subject to certain conditions, the prohibition on general solicitation and general advertising in Rule 506, one of the most commonly relied upon safe harbors from Securities Act registration by private fund issuers. The amendments adopted, which are substantially similar to those proposed by the SEC in its August 2012 release,3 could significantly change the environment in which privately offered funds, including hedge funds and private equity funds, raise investor capital without making a public offering registered under the Securities Act. These amendments will become effective 60 days after publication of the Adopting Release in the Federal Register.
At the same time, in a 3-2 vote, the SEC proposed an additional package of amendments to Regulation D, Form D and Rule 156 under the Securities Act.4 Among other things, for Rule 506 offerings involving general solicitation, the proposed amendments would change the timing, frequency and certain content of Form D filings, disqualify an issuer from relying on Rule 506 in certain circumstances, apply certain guidelines and requirements for the content of materials used in general solicitation, and temporarily require issuers engaging in general solicitation to submit their written solicitation materials to the SEC on a non-public basis.
Comments on the proposed additional amendments are due 60 days after publication of the Additional Amendments Proposing Release in the Federal Register.
The SEC also adopted amendments to Rule 144A under the Securities Act, clarifying that there is no prohibition on general solicitation in offerings made pursuant to that rule. This development is addressed in a separate Bingham alert. In addition, the SEC adopted a rule required under the Dodd-Frank Act that would disqualify certain “bad actors” from participating in securities offerings under Rule 506. This development will be addressed in a forthcoming Bingham alert.
General Solicitation Amendments
Eliminating General Solicitation Restrictions under Rule 506
Currently, it is a requirement of most private placement exemptions from the registration requirements of the Securities Act, including Rule 506, that issuers (including hedge funds, private equity funds and other private funds) may not use “any form of general solicitation or general advertising.”5 This restriction generally is 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/or public seminars or meetings as part of an issuer’s capital raising activities.
The amendments add to Rule 506 a new paragraph (c), which permits the use of general solicitation in connection with an offering of securities under Rule 506, provided that:
When Rule 506(c) becomes effective, a private fund (or its investment adviser on its behalf) will be able to engage in all forms of general solicitation without violating the Rule 506 safe harbor, so long as it complies with these conditions.
The SEC also is amending Form D 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 different accredited investor verification practices.
“Reasonable Steps to Verify” Accredited Investor Status — Principles-Based Approach
Rule 506(c)(2)(ii) requires an issuer that engages in general solicitation to take “reasonable steps to verify” that the purchasers of its securities are accredited investors. According to the Adopting Release, the verification condition is a principles-based condition that requires the issuer to make an “objective determination…in the context of the particular facts and circumstances of each purchaser and transaction” that the steps taken to verify a purchaser’s accredited investor status are reasonable.7
Under the principles-based approach, the SEC reiterated that issuers should consider a number of factors to determine the reasonableness of the steps to verify that a purchaser is an accredited investor, including:
In the Adopting Release, the SEC stated that these factors are interconnected, and the information gained by looking at these factors would help an issuer assess the reasonable likelihood that a purchaser is an accredited investor. In addition, the SEC observed that “[i]f an issuer has actual knowledge that the purchaser is an accredited investor, then the issuer will not have to take any steps at all.”8 Regardless of the particular steps taken, the SEC cautioned that it is important for issuers to retain adequate records that document the steps taken to verify that a purchaser is an accredited investor.
It is important to note that 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 only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.”9 Thus, the current common practice wherein each prospective investor completes a qualification questionnaire certifying its accredited investor status generally will not by itself satisfy the “reasonable steps” standard imposed by the SEC for Rule 506(c) offerings.
“Reasonable Steps to Verify” Accredited Investor Status of Natural Person Investors — Non-Exclusive List of Methods
In the Adopting Release, the SEC, acknowledging concerns that verification of accredited investor status with respect to natural persons poses greater practical difficulties compared to other types of investors, responded to commenters’ calls for specific guidance on what steps the SEC would consider reasonable. The SEC adopted four non-exclusive verification methods that are deemed to satisfy the required “reasonable steps” standard for natural persons (so long as the issuer or a person acting on its behalf does not have knowledge that a potential investor is not an accredited investor10):
Private funds (and their investment advisers) that wish to conduct a Rule 506(c) offering will need to consider how best to implement the verification methods described above, bearing in mind certain practical difficulties, including those acknowledged by the SEC. For example, natural person investors may be reluctant to provide the documentation that would satisfy the first two verification methods, as a result of concerns about privacy and the potential misuse of personal financial information. In addition, with respect to the net worth test, the SEC notes that even with the documents described above, it may be difficult for an issuer to determine whether it has a complete picture of a natural person’s liabilities. The SEC attempts to address this by also requiring a written representation from the potential investor that it has disclosed all liabilities necessary to form a determination of its net worth. Private funds and their investment advisers should note also that the existing relationship method of verification speaks only to follow on investments made by an existing investor in the same issuer where the investor had initially invested in an offering pursuant to Rule 506(b) prior to the effective date of Rule 506(c). The Adopting Release does not address whether self-certification might be appropriate when a pre-Rule 506(c) investor in one fund managed by an investment adviser seeks to invest in another fund managed by the same investment adviser, which is conducting a 506(c) offering. Similarly, the Adopting Release does not specify whether a private fund issuer would be required to obtain updated documentation for the income test or net worth test, or a fresh third-party confirmation for the third-party verification method, for each additional subscription made by an investor in a Rule 506(c) offering. However, it should be noted that to rely on these verification methods, the documentation required for the income test must be obtained for the prior two years while the documentation required for the net worth test must be dated within the prior three months, and any confirmation of verification from a third party must be based on steps taken within the prior three months.
As noted above, appropriate documentation and recordkeeping will be an important component to the verification process. Investment advisers that expect to conduct a private fund offering in reliance on Rule 506(c) should ensure they have policies and procedures that address compliance requirements with respect to this new layer of due diligence on investors. Similarly, the SEC expects that investment advisers will review the policies and procedures they have in place with respect to the nature and content of private fund literature, including general solicitation materials, to ensure they are reasonably designed to prevent the use of fraudulent or materially misleading communications, particularly if they intend to engage in general solicitation with respect to the private funds they advise.
Continued Availability of Rule 506(b) and Preservation of “Reasonable Belief” Standard
Private issuers that do not wish to engage in general solicitation may continue to offer their securities in reliance on the existing safe harbor under Rule 506(b). If an issuer does not engage in general solicitation, it will not be required to take reasonable steps to verify that all of its purchasers are accredited investors. However, once general solicitation has been made to potential investors in an offering, the issuer is precluded from making a claim of reliance on 506(b).
In addition, in the Adopting Release, the SEC reiterated its position that the “reasonable belief” standard in the definition of accredited investor is unchanged by the amendment to Rule 506. According to the SEC, 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 proposed Rule 506(c) if it is later discovered that the purchaser is not in fact an accredited investor.
3(c)(1) and 3(c)(7) Funds
The JOBS Act provides that offers and sales under Rule 506 “shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.” Accordingly, in the Adopting Release, the SEC made it clear that privately offered funds that rely on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”) will be able to engage in general solicitation in a Rule 506 offering without losing their ability to continue to rely on Section 3(c)(1) or 3(c)(7).
In the Adopting Release, the SEC also reminded investment advisers of the application of the antifraud provisions of Rule 206(4)-8 under the Investment Advisers Act of 1940 (the “Advisers Act”). The SEC did not indicate, however, whether the SEC 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 an important condition required in order to take advantage of certain limited exemptions from registration with the SEC as an investment adviser, such as the foreign private adviser exemption. In addition, advisers that are registered with the SEC must continue to comply with rules relating to advertising under the Advisers Act.
Because Title II of the JOBS Act only applies to federal securities laws, engaging in offerings under proposed Rule 506(c) will impact the availability of certain exemptions under the rules of the Commodity Futures Trading Commission (the “CFTC”), including the exemption from registration as a commodity pool operator under CFTC Rule 4.13(a)(3). This exemption requires that interests in each pool with respect to which the exemption is claimed be “offered and sold without marketing to the public in the United States.” Similarly, an investment adviser that is registered with the CFTC as a commodity pool operator or commodity trading adviser should bear in mind that irrespective of the SEC’s rulemaking, such advisers will be subject to the CFTC’s rules relating to advertising.
Rule 506 is a non-exclusive “safe harbor” from the registration requirements of the Securities Act under the exemption contained in Section 4(a)(2) (formerly Section 4(2)) of the Securities Act. However, the elimination of the prohibition on general solicitation applies only to private offerings made in reliance on the Rule 506 safe harbor, not to private offerings made under Section 4(a)(2) (the so-called “private resale exemption”), or any other registration exemptions (other than Rule 144A). Currently, many private offerings to institutional investors are made “side by side” to QIBs under Rule 144A and to institutional accredited investors under the private resale exemption. Issuers that wish to make similar side-by-side offerings and make use of general solicitation or advertising may need to structure the accredited institutional investor portion of their offerings to qualify for the safe harbor of Rule 506(c).
Regulation S is a safe harbor for offers and sales of securities made outside the United States. One requirement of a Regulation S offering is that there can be no “directed selling efforts” in the United States, a concept that is similar to general solicitation. Many private fund offerings are made side-by-side to the U.S. domestic market under Rule 506 and offshore in reliance on Regulation S. In the Adopting Release, the SEC reiterated its view that concurrent Regulation S and Rule 506 offerings would not be integrated so that the use of general solicitation in the Rule 506 component of such an offering would not preclude reliance on Regulation S for the offshore component of the transaction.
New Marketing Tools, Greater Certainty of Permitted Communications
The prohibition on general solicitation in Rule 506 offerings has restricted the use of advertising, newspaper or magazine articles, public Internet websites, media broadcasts, mass email campaigns, and public seminars or meetings to sell the offering. By eliminating the prohibition on general solicitation in Rule 506, the amendments will permit the use of a much broader array of marketing tools to be used by private fund issuers. As discussed above, however, private funds and their investment advisers will need to consider whether, and to what extent, engaging in general solicitation pursuant to Rule 506(c) may conflict with other regulatory constraints to which a private fund or its investment adviser may be subject (including CFTC regulations, Advisers Act requirements, as well as any applicable non-U.S. regulatory frameworks, such as under the Alternative Investment Fund Managers Directive). In addition, when assessing whether to conduct a Rule 506(c) offering, private fund issuers should bear in mind that the regulatory consequences of doing so remain uncertain, particularly given the SEC’s proposal of related amendments to Regulation D, Form D and Rule 156 under the Securities Act.
Proposed Amendments to Regulation D, Form D and Rule 156
In her opening statement, at the SEC's July 10th open meeting, SEC Chair Mary Jo White indicated that she believes the SEC should “take steps to pursue additional investor safeguards if and where such measures become necessary once the ban on general solicitation is lifted.”12 Accordingly, over the strong dissent of SEC Commissioners Troy A. Paredes and Daniel M. Gallagher, each of whom expressed the belief that the proposals would undermine the goals of the JOBS Act and impede capital formation, the SEC proposed a package of related amendments to Regulation D, Form D and Rule 156 under the Securities Act. If adopted, the proposed amendments would:
Timing and Content of Form D Filings
In order to facilitate efforts to evaluate the use of Rule 506(c), the SEC has proposed to amend Rule 503 to require any issuer that seeks to rely on Rule 506(c) to file a Form D at least 15 calendar days prior to beginning any general solicitation with respect to the offering (an “Advance Form D”). The information required in an Advance Form D would be a subset of the information generally required on Form D, including identifying information about the issuer and its related persons, information on the type of security to be offered, information about persons receiving sales compensation, and information on the use of proceeds from the offering. An issuer would not need to have a specific offering in mind to file an Advance Form D if it simply wishes to retain the flexibility to conduct an offering and engage in general solicitation. The issuer would be required to file an amendment providing the remaining information required by Form D within 15 calendar days after the first sale of the securities, as is currently required by Rule 503, unless the Advance Form D contained complete information.
For Rule 506(b) offerings, the requirement to file a Form D within 15 calendar days after the first sale of the securities would remain unchanged.
In addition, the proposed amendments would require the filing of a final amendment to Form D within 30 calendar days after the termination (i.e. after the final sale in the offering or upon the issuer’s determination to abandon the offering) of any Rule 506 offering, whether conducted under Rule 506(b) or Rule 506(c). The SEC’s stated objective for this proposed filing requirement is to gather more complete information about the size and characteristics of the Rule 506 offering market. The SEC notes that until a closing Form D amendment is filed, the offering will be deemed to be ongoing and the issuer will be subject to the existing requirements to file amendments to Form D at least annually and otherwise as needed to reflect changes in previously filed information and to correct material mistakes and errors. A separate closing Form D amendment will not be required if the issuer included all information required by Form D in an earlier Form D filing and checked the “closing filing” box.
The SEC also proposes to amend Form D to expand the information it requires. The additional information that would be required under the proposed amendments to the Form includes:
In addition, the current option to “Decline to Disclose” issuer size (in terms of revenues for an operating company, or net asset value for a private fund) would be revised to “Not Available to Public.” Therefore, an issuer would only be permitted to select this option if it does not otherwise make this information public (e.g., in its general solicitation materials). As amended, Form D would also include separate fields for indicating if a filing is an Advance Form D or closing Form D amendment.
Amendments Relating to Content of Written General Solicitation Materials
Proposed Rule 509 would require private funds and all other issuers conducting a Rule 506(c) offering to include certain legends in any written general solicitation materials. Certain additional disclosure requirements would also apply to private funds, as described below. Legends may be (but are not required to be) combined into a single sentence and modified as long as the wording used clearly communicates the required information. The legends proposed by the SEC are that:
In addition, private funds also would be required to include a legend that the securities offered are not subject to the protections of the Investment Company Act. Additional disclosures required to be included in a private fund’s solicitation materials that includes performance data are that:
The SEC stated that it was proposing the additional disclosure requirements for private funds in response to some commenters’ concerns that private funds’ ability to engage in general solicitation and advertising could result in confusion among investors who may not be able to distinguish between private funds, which are not subject to the restrictions and requirements of the Investment Company Act, and mutual funds, which are. In particular, with respect to the performance disclosures, the SEC stated that it believes “that the proposed disclosures are a meaningful way to highlight that there are limitations on the usefulness of past performance data, as well as the inherent difficulty of comparing performance of a private fund with other private funds and with registered products, such as mutual funds.”13
The SEC also proposes to amend existing Rule 156. Rule 156 is an interpretative rule that provides guidance to certain investment companies (such as mutual funds) with respect to application of the antifraud provisions of the federal securities act in connection with the use of sales literature. The SEC proposes to amend Rule 156 to apply to private funds, so that these funds will consider the principles underlying Rule 156 in their communications with, and solicitations of, investors.
Finally, and again with a view toward a comprehensive analysis of the impact of lifting the prohibition on general solicitation the SEC has proposed a temporary rule requiring issuers relying on Rule 506(c) to submit their general solicitation materials to the SEC. These materials would be submitted via a website link and would not be publicly available. This temporary rule would expire two years after its effective date.
While the filing of Form D is required for Rule 506 offerings, and the failure to file subjects the issuer to possible SEC enforcement action, it does not result in the loss of the exemption. Rule 507 under Regulation D currently provides for the disqualification of an issuer from relying on Regulation D only if the issuer (or a predecessor or affiliate) has been enjoined by a court for violating the filing requirements in Rule 503. In an effort to improve Form D filing compliance, the SEC has proposed to add much more stringent disqualification provisions to Regulation D.
The SEC proposes to automatically disqualify an issuer from relying on Rule 506 if the issuer (or a predecessor or affiliate) did not comply, within the past five years, with the Form D filing requirements for any Rule 506 offering by the issuer (or by its predecessor or affiliate). The disqualification would apply automatically to any new offering and would last for a period of one year from the date that all required Form D filings of the issuer have been made, or if the offering for which the issuer was delinquent has terminated, following the filing of a closing amendment. The disqualification provision would apply only to new offerings, so the offering in which the failure to comply occurs would not lose its exemption. In addition, issuers would not be required to look back beyond the effective date of new Rule 507(b). Amended Rule 507 would also include a 30 day cure period for an issuer’s first failure to make a Form D filing on a timely basis with respect to a particular offering, and would allow the SEC to grant waivers upon a showing of good cause.
According to the SEC, this disqualification provision should provide issuers and their related persons with the incentive to comply with Rule 503 and make timely and complete Form D filings, without imposing the type of disproportionate penalty that could arise if compliance with Rule 503 were made a condition to reliance on Rule 506. Private funds and their investment advisers should note that for purposes of determining who an affiliate of an issuer is under Rule 507, the SEC cites the definition contained in Rule 501(b): “a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified.” Typically, this would include a private fund’s general partner, investment adviser and any other private fund who shares a general partner and/or investment adviser with that private fund. The SEC requested comment on whether, in response to one private fund’s failure to comply with Rule 503, it is disproportionate to prohibit any private funds affiliated with that private fund from relying on Rule 506, and if Rule 507(b) should contain an express provision that excludes affiliated private funds from such consequences.
The legend requirements for general solicitation materials, and the temporary SEC submission requirements for such materials, would likewise not be a condition of the Rule 506(c) exemption from registration. Instead, Rule 507 would be amended so that Rule 506 in its entirety would be unavailable to an issuer if it (or a predecessor or affiliate) is subject to any order, judgment or court decree enjoining such person for failure to comply with these requirements. The SEC noted that its proposals treat noncompliance with the Form D filing requirements (which would result in automatic disqualification) differently from noncompliance with the disclosure and content requirements under proposed Rule 509 (which would result in disqualification only if the noncompliance ultimately leads to an order, judgment or court decree). The SEC stated that it believes an automatic disqualification provision could result in disproportionate consequences for inadvertent errors or omissions, particularly given the large volume of written communications that issuers may be expected to use during the course of a Rule 506(c) offering. The SEC did not, however, foreclose the possibility that it may reconsider this position after assessing the level of compliance with Rule 509 once it is in effect.
Additional Requests for Comment
In addition to these proposals, the SEC has also requested comment on a wide variety of related matters, including whether additional content restrictions should be imposed on general solicitation materials used by private funds, and whether amendments to the existing accredited investor standards should be made. The SEC has requested comment, for example, on whether private funds should be subject to standardized performance reporting and whether being audited by an independent public accountant should be a condition to a private fund’s ability to make performance claims in general solicitation materials. In addition, the SEC asked whether the SEC should draw a distinction between the general solicitation activity of a 3(c)(1) fund and that of a 3(c)(7) fund. While noting that its ability to amend the definition of the “accredited investor” standard for natural persons is in some ways constrained by statute, the SEC agreed with commenters who suggested that the definition should be reviewed. The SEC requested comment on whether the net worth and annual income tests are appropriate for ascertaining that an investor has sufficient knowledge and experience in business and financial matters, and if so, whether the current fixed thresholds are appropriate or whether percentage-based thresholds would be more appropriate.
The elimination of the prohibition against general solicitation in Rule 506(c) offerings could have a significant impact on the way that hedge funds, private equity funds and other private funds can raise capital. Issuers and their advisers should bear in mind that the opportunity comes with increased responsibilities for due diligence with respect to verification of the accredited investor status of potential investors, and must also be considered in light of any applicable compliance obligations under other laws and regulations, including under the Advisers Act and the rules promulgated by the CFTC. The SEC clearly intends to closely monitor the impact that lifting the prohibition against general solicitation will have on the private placement market. The proposed additional amendments could significantly increase the regulatory burden associated with Rule 506(c) offerings. Issuers will need to assess these potential costs as they consider their alternatives under this new private placement regime.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Giordano-Steven
1 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Rel. Nos. 33-9415, 34-69959, available at http://www.sec.gov/rules/final/2013/33-9415.pdf (the "Adopting Release”).
2 The JOBS Act is available at http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf. Our client alert regarding the JOBS Act is available at http://www.bingham.com/Alerts/2012/04/JOBS-Act-Congress-Attempts-to-Reduce-Regulatory-Burdens-on-IPOS-and-Private-Offerings.
3 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Rel. No. 33-9354, 77 Fed. Reg. 54464 (Sept. 5, 2012), available at http://www.gpo.gov/fdsys/pkg/FR-2012-09-05/html/2012-21681.htm. Our alert discussing the proposing release is available at http://www.bingham.com/Alerts/2012/08/SEC-Proposed-Amendments-to-Rule-506-to-Permit-General-Solicitation-and-General-Advertising.
4 Amendments to Regulation D, Form D and Rule 156 under the Securities Act, SEC Rel. Nos. 33-9416, 34-69960, available at http://www.sec.gov/rules/proposed/2013/33-9416.pdf (the “Additional Amendments Proposing Release”).
5 In this alert, we refer to both general solicitation and general advertising as “general solicitation.”
6 Rule 501 contains definitions of the terms used throughout Regulation D, including the term, “accredited investor.” For purposes of determining whether the conditions of a Regulation D safe harbor are met, Rule 502(a) requires the integration of all offerings by an issuer that occur within six months of each other. Rule 502(d) imposes limitations on the resale of securities acquired in a transaction under Regulation D.
7 Adopting Release, at 27.
8 Adopting Release at 31, n. 111.
9 Adopting Release, at 33-34.
10 The SEC noted that “[b]ecause an issuer must have a reasonable belief that the purchaser is an accredited investor, the issuer could not form such reasonable belief if it has knowledge that the purchaser is not an accredited investor.” Adopting Release at 36, n. 116.
11To the extent a natural person qualifies as an accredited investor based on his or her joint income or joint net worth with his or her spouse, the relevant documentation relating to, and the requisite representations from, both the person and his or her spouse would be required to satisfy these verification methods.
12Statement of Chairman Mary Jo White on July 10, 2013, available at htp://www.sec.gov/news/speech/2013/spch071013mjw.htm.
13 Additional Amendments Proposing Release at 68.
This article was originally published by Bingham McCutchen LLP.