On July 10, 2013, the SEC eliminated the longstanding prohibition against general solicitation in certain private offerings of securities in response to Congress's mandate under the Jumpstart Our Business Startups Act (the "JOBS Act"). The new SEC rules allow an issuer to engage in general solicitation in the private offer and sale of securities as long as (i) all purchasers of the securities are "accredited investors" and (ii) the issuer takes reasonable steps to verify each purchaser's status as such. The SEC provided a non-exclusive list of specific verification methods which an issuer may use to determine whether or not a purchaser qualifies as an accredited investor. If an issuer relies upon one of these methods, it will generally be deemed to have taken reasonable steps to verify a purchaser's accredited investor status.
The SEC also amended its rules concerning the resale of private securities to qualified institutional buyers ("QIBs") in order to permit the use of general solicitation by the seller as long as such securities are sold only to persons that the seller reasonably believes are QIBs. Concurrently, the SEC adopted rules which disqualify bad actors from relying on the private placement exemptions afforded by Regulation D under the Securities Act of 1933 (the "Securities Act"). Finally, the SEC proposed amendments to the Form D information requirements applicable to private offerings under Regulation D.
I. Rule 506 Amendments
The JOBS Act directed the SEC to amend Rule 506—the most widely relied upon private offering exemption under Regulation D. Generally, Rule 506 permits sales of an unlimited dollar amount of securities to be made without Securities Act registration, subject to certain requirements. In general, private funds account for the vast majority of the capital raised in Rule 506 offerings under Regulation D. For example, in 2012 the SEC estimated that the amount of capital (including both equity and debt) raised by private funds, such as venture capital funds, private equity funds and hedge funds, accounted for approximately $725 billion, representing approximately 81% of the total amount of capital raised in Rule 506 offerings.
Previously, Rule 506 permitted sales to an unlimited number of accredited investors and up to 35 non-accredited investors, provided that (i) there was no general solicitation; (ii) appropriate resale limitations were imposed; (iii) any applicable information requirements were satisfied; and (iv) the other conditions of the rule were met (e.g., notice of sale filed with the SEC on Form D). In practice, most private funds only made offers and sales of securities to accredited investors in order to avoid the cumbersome additional disclosure requirements for non-accredited investors under Rule 506. The SEC has now amended Rule 506 to add a new subsection (c), which permits an issuer to engage in general solicitation for a Rule 506 offering, provided that (i) all purchasers of securities are accredited investors and (ii) the issuer takes reasonable steps to verify the purchasers' accredited investor status.
Verifying Accredited Investor Status under New Rule 506(c)
Under Regulation D, a natural person qualifies as an accredited investor if he or she has either (i) an individual net worth or joint net worth with a spouse that exceeds $1 million at the time of purchase, excluding the value of a primary residence (and any related indebtedness); or (ii) an individual annual income that exceeded $200,000 in each of the two most recent years or a joint annual income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
In determining what constitutes reasonable verification measures, the SEC has adopted a principles-based approach pursuant to which an issuer should consider the facts and circumstances surrounding each purchaser and the relevant transaction, including (i) the nature of the purchaser and the type of accredited investor the purchaser claims to be; (ii) the amount and type of information that the issuer has regarding the purchaser; and (iii) the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as the minimum investment amount.
The SEC has provided a non-exclusive list of methods (in effect, safe harbors) by which an issuer may verify a natural person's accredited investor status. These methods include:
- reviewing IRS forms that report the purchaser's income for the two most recent years (e.g., Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040), and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
- reviewing bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, third-party appraisal reports, and/or consumer reports from a nationwide consumer reporting agency, provided that such documentation is dated within the prior three months, and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed; and
- obtaining a written confirmation of accredited investor status from either an SEC-registered broker-dealer, an SEC-registered investment adviser, a licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law, or a certified public accountant. Such persons or entities would have to confirm that they have taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and have determined that such purchaser is an accredited investor. An issuer may rely on other third parties for investor verification, provided that the issuer has conducted appropriate due diligence and has a "reasonable basis" for relying on such third-party verification.
An issuer cannot rely any of the foregoing verification safe harbors if the issuer has actual knowledge that a person is not an accredited investor.
With respect to existing investors who previously qualified as accredited investors and who make additional investments as part of an ongoing offering (e.g., a continuously offered hedge fund), an issuer may satisfy Rule 506(c)'s verification requirement by obtaining a self-certification of accredited investor status from such investor at the time of each new investment.
Rule 506 Offerings Without General Solicitation
As noted above, Rule 506 currently conditions the availability of the safe harbor for private placements on the issuer, or any person acting on its behalf, not offering or selling securities through any form of general solicitation. This existing safe harbor—now renumbered as Rule 506(b)—is substantively unaffected by the new SEC rules. Accordingly, issuers not wishing to engage in general solicitation may continue to rely on the Rule 506(b) safe harbor and will not be subject to the new requirements to take reasonable steps to verify a purchaser's accredited investor status.
Investment Company Act Implications for Private Funds
The SEC clarified that the elimination of the prohibition against general solicitation for private offerings will not prevent private fund issuers from relying on the exemptions from registration as an "investment company" under the Investment Company Act of 1940 (the "Investment Company Act"). In the SEC's view, the use of general solicitation by private funds will not be considered a public offering—a determination which would disqualify the private funds from relying upon the registration exemptions in the Investment Company Act.
II. Rule 144A Amendments
The SEC amended Rule 144A, which governs institutional resales of private securities, to permit offers of private securities to persons other than QIBs, including by means of general solicitation. However, the offered securities may only be sold to persons whom the seller and any person acting on behalf of the seller reasonably believe to be QIBs. Unlike new Rule 506(c), amended Rule 144A does not contain a separate requirement that the seller take reasonable steps to verify a person's status as a QIB.
III. Form D Amendments
In connection with the other amendments to Regulation D, the SEC also amended Form D, which is the notice that issuers file with the SEC to indicate they have sold securities under Regulation D. As revised, Form D will now require an issuer to disclose whether it has engaged in general solicitation activities during its private offering.
Private funds and other issuers who engage in general solicitation in reliance on the Rule 506(c) exemption may not later switch to the Rule 506(b) exemption. In essence, once the "cat is out of the bag" for a general solicitation offering, an issuer is precluded from relying on Rule 506(b) which prohibits such activities. However, the reverse is possible, so that private funds and other issuers that are unsure whether they want to adopt the additional compliance measures associated with a Rule 506(c) offering should be able to select the Rule 506(b) exemption at the outset of their offering and subsequently switch to a Rule 506(c) offering if they later determine to engage in general solicitation activities.
IV. Fund Integration Issues
The SEC reaffirmed that it will not integrate simultaneous domestic and offshore private offerings even if the issuer engages in general solicitation. However, private fund advisers seeking to sell interests in concurrent offshore and domestic offerings (e.g., the sale of interests in an onshore/offshore master-feeder structure) should be careful to comply with the requirements of Regulation S with respect to the offshore offering and Rule 506 with respect to the domestic offering in order for both offerings to be exempt from registration under the Securities Act.
V. Disqualification of Felons and Other "Bad Actors" from Rule 506 Offerings
The SEC adopted amendments that disqualify issuers and marketing participants from relying on Rule 506 if "felons and other 'bad actors'" participate in the private offering. "Bad actor" disqualification requirements, commonly called "bad boy" provisions, disqualify securities offerings from the Regulation D safe harbor if the issuer or other relevant persons ("Covered Persons") have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws.
Importantly, the SEC has included within the definition of Covered Persons: (i) any beneficial owner of 20% or more of the issuer's outstanding voting securities; (ii) placement agents and finders; (iii) investment managers to pooled investment funds; and (iv) any general partner, managing member, executive officer and director of any such placement agent or investment manager. The foregoing provisions should be of interest to private fund managers and warrant enhanced due diligence procedures (and possibly additional contractual representations) with respect to new management personnel and placement agents retained by a private fund so as not to render such fund ineligible for the Regulation D exemption.
VI. Proposed Amendments to Regulation D
The SEC proposed rules which would require issuers to provide additional information about Rule 506 offerings. The proposed amendments to Regulation D would (i) require the filing of a Form D with the SEC in Rule 506(c) offerings before the issuer engages in general solicitation; (ii) require the filing of a closing amendment to Form D within 30 days after the termination of any Rule 506 offering; (iii) require written general solicitation materials used in Rule 506(c) offerings to include certain legends and other disclosures; (iv) require the submission, on a temporary basis, of written general solicitation materials used in Rule 506(c) offerings to the SEC; and (v) disqualify an issuer from relying on Rule 506 for one year for future offerings if the issuer, or any predecessor or affiliate of the issuer, did not comply, within the last five years, with the Form D filing requirements in a Rule 506 offering.
Finally, the proposed rules would also amend Form D to require additional information with respect to Rule 506 offerings, including additional information on the types of general solicitation and investor verification methods. In addition, the proposed rules would extend the SEC's antifraud guidance on investment company sales literature to the sales literature of private funds. The SEC's proposed rules are open for comment for 60 days from publication in the Federal Register.
Implications of New Rules for Private Funds
The SEC's final rules and the corresponding amendments to Regulation D have a number of practical implications for private fund managers:
- New Rule 506(c) will be effective 60 days after publication in the Federal Register (which has not yet occurred). Thus, a manager cannot engage in any general solicitation activity for at least two months.
- New Rule 506(c) does not contain any restrictions on the forms of general solicitation in which a fund manager can engage. Thus, internet, social media, TV, email, blogs, seminars, press releases and interviews, etc. are all permitted subject to the SEC's general antifraud rules. Once a manager elects to engage in general solicitation activity with respect to an existing fund, it will need to amend the fund's existing Form D to indicate that it is relying on the new Rule 506(c) exemption.
- Once a manager elects to engage in general solicitation activity in reliance on the new Rule 506(c) exemption, it will need to implement enhanced compliance policies and recordkeeping to document that it is taking "reasonable steps" to ensure that each new investor is an accredited investor. (By contrast existing investors that reinvest only need to self-certify as to their accredited investor status.)
- Some broker-dealers and investment advisers are developing online accredited investor screening platforms which will collect and review required documentation and take other measures to develop a database of pre-screened accredited investors. Fund managers choosing to utilize such a third-party service must obtain a written confirmation of such verification measures from the broker-dealer or investment adviser in accordance with the rule.
- Due to the SEC's heightened focus on the risks and consequences of the new rule, fund managers should carefully review their compliance policies and procedures to ensure that they are designed to prevent the use of fraudulent or materially misleading private fund advertising, particularly if the funds intend to engage in general solicitation activity.
- Many funds that trade commodities rely on the de minimis trading exemption from CFTC registration as a commodity pool operator under CFTC Rule 4.13(a)(3), which contains a requirement that the fund not be publicly offered. The CFTC is considering harmonizing Rule 4.13(a)(3) with the SEC's new rules to clarify that general solicitation, as permitted by new Rule 506(c), will not cause a fund to be in violation of the private offering requirement of CFTC Rule 4.13(a)(3). Because the CFTC has not yet issued any guidance or clarification on this issue, it would be prudent for fund managers who rely on the Rule 4.13(a)(3) exemption to wait for CFTC clarification of this issue before engaging in any general solicitation activity with respect to their funds.