This new Ropes & Gray podcast series, The PEP Talk, Ropes & Gray’s Private Equity Podcast, focuses on legal issues of interest to the private equity industry. In the first episode of the series, asset management partners Peter Laybourn and Debra Lussier are joined by Keith Higgins, chair of the firm’s securities and governance practice and former SEC director of corporation finance, to discuss the opportunity for private equity funds to engage in general solicitation during fundraising under Rule 506(c) of Regulation D of the Securities Act.
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Deb Lussier: Hello, everyone, and welcome to The PEP Talk, Ropes & Gray's Private Equity Podcast. I'm Deb Lussier. Peter Laybourn: And I'm Peter Laybourn. Deb and I are partners at Ropes & Gray and we are the co-leaders of fund formation for private equity buyout and growth funds in Ropes & Gray's asset management group.
Deb Lussier: On today's episode of The PEP Talk, we're going to discuss general solicitation during fundraising and specifically, Rule 506(c), under Regulation D of the Securities Act. The Jobs Act of 2012 required the Securities and Exchange Commission to adopt a rule to permit general solicitation in private offerings, and the Commission adopted Rule 506(c) in July 2013. The rule provides private equity fund sponsors with the ability to offer securities by means of general solicitation or general advertising.
Peter Laybourn: Deb and I are excited to be joined today by Keith Higgins. Keith is a member of Ropes & Gray's corporate department and he's the chair of the firm's securities and governance practice. Keith served as a director of corporation finance at the SEC from June of 2013 until January 2017. He rejoined Ropes & Gray in June of 2017. Keith's role with the SEC, which included overseeing the adoption and implementation of Rule 506(c), as well as his more than 35 years of practice as a securities lawyer, makes Keith uniquely qualified to help us understand the benefits and challenges of Rule 506(c). We're very happy to have him, not just for today's PEP Talk, but as chair of the firm's securities and governance practice. Keith, thanks for joining us on the podcast.
Keith Higgins: Thanks, Peter and Deb. Glad to be here.
Deb Lussier: Keith, when Rule 506(c) was proposed by the SEC, there was some buzz (among lawyers, at least) about the new rule. In fact, the industry trade press was writing stories asking whether a new day was dawning on how private equity sponsors were going to go about offering securities. As it turned out, there was no seismic shift in practice, and relatively few private equity fund sponsors took advantage of the new rule. Why do you think that was the case?
Keith Higgins: Deb, I think there were several reasons. First, no sponsors were really clamoring for a rule offensively to be able to use general solicitation. I think at best, most of them wanted some protection from the inevitable publicity footfalls that I know we'll talk about in a bit, rather than some new means of reaching investors. As such, it was really the question of, “Is there any downside to using the new rule?” The rule created a requirement that the issuer take reasonable steps to verify the accredited investor status of the purchasers – it was new and unfamiliar and some people didn't quite know what that meant. The rule was also controversial in some quarters and in an attempt to address some investor protection concerns, the Commission proposed a companion rule that would've imposed added requirements on generally solicited offerings, and even provided for the possible loss of the exemption altogether. This companion rule created some uncertainty and doubt, and as a result, I think there was not big take-up in the initial stages.
Peter Laybourn: Keith, perhaps the best way to understand what is required under Rule 506(c) might be to compare it to the most commonly used exemption from registration under Regulation D, and that's Rule 506(b). Can you explain the differences and similarities?
Keith Higgins: Sure, Peter. In Rule 506(c), you can offer to whomever you wish, so long as all sales are to accredited investors only. In Rule 506(b), you can sell to unlimited accredited investors, and up to 35, non-accredited, sophisticated investors, but you may not offer to anyone by means of a general solicitation. If you do, you've lost the entire exemption and it doesn't work just to boot out the people who you generally solicited – you've lost the exemption. For Rule 506(b), in addition, an accredited investor is someone who either is objectively an accredited investor or who the issuer reasonably believes to be an accredited investor. So, under 506(b), even if you don't do any diligence, if it turns out the investor is accredited, you're good to go. 506(c) is different – 506(c) says the definition is still the same, but you must take reasonable steps to verify the accredited investor status. So, if you don't take those steps, you don't have the exemption, even if it turns out that the person to whom you sold is an accredited investor.
Deb Lussier: What does it mean to take reasonable steps to verify the accredited investor status of a purchaser?
Keith Higgins: It's a good question, Deb. The rule's been described as principles-based, meaning the Commission didn't specifically define what reasonable steps to verify accredited investor status would be. Instead, they said it would depend on the facts and circumstances of each case. But commenters who commented on the rule said, “Gee, we could really use a safe harbor – we need to have something that we can point to.” So, in the “be careful what you wish for” type of category, the Commission gave a safe harbor that provided specific examples of things that you had to do for individuals or things that would make you in the safe harbor for individuals.
For institutions, there isn't any safe harbor. Institutions have to have at least $5 million of total assets, so it's going to depend on the facts and circumstances, how you verify that the investor has that. For individuals, the safe harbor is for the $200,000 of income, you have to provide tax returns or tax forms (W-2's, etc.) that show you had that for the last two years and a certification that you reasonably expect it in the future. For the net worth, $1 million net worth requirement, you have to provide a list of assets that gets you there, as well as a credit report from a nationally recognized credit agency showing the liability side of the balance sheet in order to establish that. That was one of the controversial things, people said, at least as to individuals, “Gee, that's going to be awfully hard, people do not want to give up their tax returns. You know, it's just going to be difficult.” For institutions, it shouldn't be as difficult. You've just got to get the $5 million in total assets bogey – and what are reasonable steps to verify that? You know, I would submit that if CalPERS is one of your investors, you don't need to get them to turn over a list of their assets or something like that – you can read publications that give you a high degree of comfort that you're going to meet that, and then of course, they're going to make the representations. I think the point about reasonable steps to verify is you can't rely on what we call a “naked self-certification” – someone just coming in who you have no relationship with, whom you don't know, and that institution certifies, “Yes, I'm an accredited investor” – and with nothing else, that's a problem. But that something else, again, the Commission said it's a facts-and-circumstances situation – that something else will be very different when you're dealing with a CalPERS versus someone else. But simple things like a letter from a custodian saying this investor has at least $5 million of assets under my custody, perfect – that would work fine in every instance.
Peter Laybourn: I'm sure that every fund formation lawyer out there has had instances where a client calls them up with a particular general solicitation question. I certainly know that I have had that happen multiple times.
Keith Higgins: We've talked about it before.
Peter Laybourn: Exactly, many times. For example, one called me up very recently and said, “Hey, we've just been approached by a reporter and we'd like to respond to him or her and share the details about our fund. Can we do that?” And I then have to be the bad guy and say, “No, you can't because you're relying on 506(b).” So Keith, do you have any advice for sponsors that find themselves in that position and who want to talk to the press?
Keith Higgins: Sure. You want to talk to the press about that specific offering and about that fund, you can flip the offering to a 506(c). In fact, unless you've made your first sale, you haven't filed your Form D anyway, so you haven't had to check the box as to whether you're doing it under B or C, you just decide you're going to move forward on 506(c). And the Commission staff did provide guidance that said it's okay to flip from a B to a C – that's good to go. The other piece of advice on that, if you want to talk to reporters, is you have to engage in that “fencing on an electronic tightrope” where you're talking about the general strategies of the fund complex, etc., without trying to focus in on a specific offering that you're doing – that's what we've been doing all along and it sometimes works, sometimes doesn't. So, the surefire way to do it is to decide you're going to do a 506(c), and particularly, if you're selling to institutions, I think the verification shouldn't be a big problem.
Deb Lussier: Keith, is there any waiting period if one wants to flip from a 506(b) to a 506(c)?
Keith Higgins: There is not, no – you can just do it. And remember, once you've moved to 506(c), though, you can't sell to those unaccredited investors the 506(b) allows you to, but that's not what the situation is going to be with funds anyway.
Deb Lussier: Any last thoughts before we let you go?
Keith Higgins: Well, as I hope I've tried to make clear during the course of our discussion, I don't think 506(c) needs to be as hard as people think it might be, and particularly where the offering is limited to institutional accredited investors. We at Ropes have helped many sponsors navigate through this and it really ought to be a tool that each sponsor at least considers in the fundraising.
Deb Lussier: Thanks so much for joining us, Keith.
Peter Laybourn: Yes, thanks, Keith, and thanks to our listeners. We hope you enjoyed the first episode of The PEP Talk and that you will join us again for future podcasts on the latest developments in the private equity space. For more information on the topics that we discussed today, and other topics of interest to the private equity community, please visit our website at www.ropesgray.com. And of course, if we can help you navigate a 506(c) fundraising, please don't hesitate to get in touch.