On August 29, 2012, the Securities and Exchange Commission voted 4-1 to propose rule amendments to Regulation D under the Securities Act of 1933 (the “Securities Act”) that, if adopted, will significantly change the environment in which privately offered funds, including hedge funds and private equity funds, raise investor capital. The proposed amendments were mandated by the Jumpstart Our Business Startups Act (the “JOBS Act”), enacted earlier this year. In particular, the proposed amendments to Rule 506 of Regulation D under the Securities Act, one of the most commonly relied upon safe harbors from Securities Act registration by private fund issuers, would eliminate, subject to certain conditions, the existing prohibitions on general solicitation and general advertising in Rule 506. The SEC’s release describing the proposed amendments (the “Release”) can be found at http://www.sec.gov/rules/proposed/2012/33-9354.pdf.
Eliminating General Solicitation Restrictions
Currently, issuers relying on the Rule 506 safe harbor (including many private funds) are not permitted to use “any form of general solicitation or general advertising”1 when conducting an unregistered offering of their securities. This restriction is interpreted broadly and prohibits, 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.
To implement the requirements of the JOBS Act, the SEC’s proposal would amend Rule 506 by adding Rule 506(c), which will permit the use of general solicitation in connection with an offering of securities, provided that (i) all purchasers of securities in such offering are “accredited investors”, as defined in Rule 501(a) of Regulation D, (ii) the issuer in such offering takes reasonable steps to verify that all purchasers of the securities are accredited investors and (iii) all terms and conditions of Rule 501 and Rules 502(a) and 502(d) are satisfied.2
“Reasonable Steps to Verify”
Proposed Rule 506(c) requires that an issuer that engages in general solicitation must take “reasonable steps” to verify that the purchasers of its securities are accredited investors. Although the Release contains some guidance about the “reasonable steps” that an issuer should take to verify that the purchasers of its securities are accredited investors, the SEC expressly declined to propose specific methods of verification that it would deem reasonable. The Release states that whether the steps actually taken by an issuer in this regard are reasonable would be “an objective determination, based on the particular facts and circumstances of each transaction.” The Release provides 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:
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 potential purchaser is an accredited investor. Regardless of the particular steps taken, it would be important for issuers to retain adequate records that document the steps taken to verify that a purchaser is an accredited investor. The SEC declined to provide uniform verification methods, in part because doing so might be ill-suited or unnecessary to a particular offering or purchaser. Instead, the SEC expects that issuers and market participants will have the flexibility to adopt different approaches to verification depending on their particular circumstances and to adapt to changing market practices and implement innovative ways to meet the verification requirements, such as the development of third party databases of accredited investors.
Currently, it is common practice for many private funds to have each prospective investor complete a qualification questionnaire in which the investor certifies, among other things, that it is an accredited investor. Private funds that wish to rely on proposed Rule 506(c) if and when it is adopted should note that, depending on all the facts and circumstances of an offering, this practice by itself may not constitute sufficient reasonable steps toward verifying the investor’s accredited status for purposes of proposed Rule 506(c).
Preservation of “Reasonable Belief” Standard and Continued Availability of Rule 506(b)
In the Release, the SEC attempted to alleviate the concerns expressed by some commenters that language in Title II of the JOBS Act could be interpreted as precluding the use of a “reasonable belief” standard in the definition of accredited investor for purposes of the new Rule 506(c). The SEC confirmed that the definition of accredited investor is unchanged by the amendment to Rule 506, and that so long as an issuer takes reasonable steps to verify that a purchaser is an accredited investor and has a reasonable belief that such purchaser is an accredited investor, the issuer would not lose the ability to rely on proposed Rule 506(c) if it was later discovered that the purchaser was not in fact an accredited investor.
In addition, the Release confirms the continued availability of the existing safe harbor under Rule 506(b), whereby an issuer may offer and sell securities, without any limitation on the offering amount to an unlimited number of accredited investors and up to 35 non-accredited investors who meet certain “sophistication requirements.” The availability of this safe harbor is subject to a number of requirements and is conditioned on the issuer or any person acting on its behalf not offering or selling securities through any form of general solicitation. Even if proposed Rule 506(c) is adopted, issuers may nevertheless continue to rely on Rule 506(b), and in doing so they will not become subject to the new requirement under Rule 506(c) to take reasonable steps to verify that all of their purchasers are accredited investors, assuming they do not engage in general solicitation and they otherwise comply with the requirements of Regulation D. The SEC indicated in the Release that it did not wish to deprive issuers that (i) do not want to engage in general solicitation in connection with their offerings of securities, and/or (ii) want to sell their securities privately to purchasers that are not accredited investors, but who meet Rule 506(b)’s sophistication requirements, of this important source of capital.
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 Release the SEC makes it clear that privately offered funds that rely on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 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). The SEC does not indicate, however, whether the SEC will 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 Investment Advisers Act of 1940 (the “Advisers Act”).
It should be noted that because Title II of the JOBS Act only applies to “Federal securities laws,” it is unclear how 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 exemptions from registration as a commodity pool operator under CFTC Rules 4.13(a)(3) and 4.13(a)(4).3 These exemptions require that interests in each applicable fund be “offered and sold without marketing to the public in the United States.” Similarly, an investment adviser that is or will be registered with the CFTC as a commodity pool operator and/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.
Amendment to Form D
The SEC is also proposing a revision to Form D, which is a notice filing made in connection with an offering of securities that is not registered under the Securities Act in reliance on an exemption provided by Regulation D. The SEC has proposed to add a check box to Form D where issuers will indicate whether they are claiming an exemption under Rule 506(c). The SEC noted that this would give the SEC an opportunity to monitor the use of general solicitation in private offerings and would assist the SEC in evaluating the effectiveness of different accredited investor verification practices.
Amendments to Rule 144A
The SEC also proposes to amend Rule 144A under the Securities Act, which is similarly mandated by the JOBS Act. Rule 144A currently provides a safe harbor exemption from registration under the Securities Act for resales of certain restricted securities, if they are offered and sold solely to “qualified institutional buyers” (“QIBs”), as defined in Rule 144A(a)(1) under the Securities Act. Because the Rule 144A safe harbor is conditioned in part on the restricted securities being offered solely to QIBs, the Staff of the SEC has historically interpreted this safe harbor to prohibit general solicitation in the sale of 144A securities. The SEC’s proposed amendment to Rule 144A would eliminate references to “offer” and “offeree,” so that 144A securities may be offered to persons other than 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 believes is a QIB.
The proposed elimination of the restrictions on general solicitation in offerings relying on the exemption in Rule 506(c) is expected to have a significant impact on the way that hedge funds, private equity funds and other private funds can raise capital. The proposed Rule presents the opportunity for private funds and their sponsors to reach potential investors beyond their traditional networks and to increase their name recognition and prominence on a broader scale. Sponsors should bear in mind, however, that the opportunity comes with increased responsibilities for due diligence with respect to verification of the accredited investor status of potential investors, as well as continued compliance with other regulations, including under the Advisers Act and the rules promulgated by the CFTC.
Comments on the proposed amendments must be submitted within 30 days of their publication in the Federal Register, which is expected imminently. While one of the Commissioners expressed a desire for the amendments will become effective before the end of the year, it is not certain exactly when that will happen. Until final rules are adopted, issuers and persons acting on their behalf should not engage in any general solicitation in connection with Rule 506 or Rule 144A offerings.
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:Joseph-Roger
1 In this Alert, we refer to both general solicitation and general advertising as “general solicitation.”
2 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.
3 The CFTC recently repealed CFTC Rule 4.13(a)(4), effective December 31, 2012.
This article was originally published by Bingham McCutchen LLP.