On April 5, 2012, President Obama signed the Jumpstart Our Business Startups Act (JOBS Act) into law. Among other provisions intended to facilitate job creation and capital formation, the JOBS Act substantially liberalizes the regulation of securities offerings under the Securities Act of 1933 (1933 Act).1 In particular, Section 201(a) of the JOBS Act directs the U.S. Securities and Exchange Commission (SEC) to amend Rule 506 of Regulation D under the 1933 Act to permit general solicitation or general advertising in connection with private offerings of securities, provided all purchasers of the securities are accredited investors (because either they fall within the definition of an "accredited investor" as set forth in Rule 501 of Regulation D or the issuer reasonably believes the purchaser satisfies such definition at the time of sale) and the issuer has taken reasonable steps to verify that all purchasers of the securities are accredited investors. Similarly, the JOBS Act directs the SEC to revise Rule 144A under the 1933 Act to allow securities to be offered to persons other than qualified institutional buyers (QIBs), including offers made using general solicitation, so long as the securities are sold only to persons the seller reasonably believes are QIBs.
On August 29, 2012 the SEC proposed rules and rule amendments consistent with the directives in the JOBS Act (Proposing Release).2 Rather than issue final rulemaking as contemplated in the JOBS Act, the Proposing Release merely offers rule proposals and solicits public comments on the proposals. Nonetheless, given that many private investment funds, including hedge funds and private equity funds, rely on the exemption from registration under the 1933 Act provided by Regulation D in connection with their capital-raising efforts, the proposed revisions to Regulation D, if adopted substantially in the form proposed in the Proposing Release, have the potential to provide such issuers with greater flexibility in conducting their offerings.
Proposed Amendments to Rule 506 and Form D
As described in the Proposing Release, a private investment fund relying on Rule 506 under Regulation D will be able to engage in general solicitation and marketing activities in connection with its capital-raising activities. Rule 506 provides a safe harbor exemption from the registration requirements of the 1933 Act, which is conditioned on multiple requirements, including a prohibition against selling or offering securities by means of general solicitation or advertising. "General solicitation," though not defined under Regulation D, is broadly construed to include newspaper and magazine advertisements such as tombstone advertisements, radio and television communication, and solicitation of seminar attendance.
The Proposing Release includes a proposal to adopt new Rule 506(c) under Regulation D, which would permit the use of general solicitation so long as the following three conditions are satisfied:
- The issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors.
- All purchasers of securities must be accredited investors, either because they fall within one of the enumerated categories of persons who qualify as accredited investors or the issuer reasonably believes they do, at the time of the sale of the securities.
- All terms and conditions of Rule 501 and Rules 502(a) and 502(d) must be satisfied.
Thus, in order to rely on Rule 506(c) and engage in a general solicitation, a general partner or sponsor of a private investment fund will be required to exercise a greater degree of diligence in determining whether a prospective purchaser of investment fund securities satisfies the definition of an accredited investor.3 More specifically, the sponsor or general partner must "take reasonable steps to verify" that a purchaser is an accredited investor. The Proposing Release indicates that this "reasonableness" determination is meant to be an "objective determination, based on the particular facts and circumstances of each transaction." To that end, the SEC notes that the following factors may be considered in determining what sort of verification would be reasonable:
- The nature of the purchaser and type of accredited investor he/she claims to be.
- The amount and type of information the issuer has about the purchaser.
- The nature of the offering, such as the manner used to solicit the purchaser, and the terms of the offering, such as a minimum investment amount.
Furthermore, the Proposing Release indicates that the SEC generally does not believe that an issuer relying on Rule 506(c) under Regulation D would have taken reasonable steps to verify accredited investor status if, absent additional information supporting the prospective investor's claim of accredited investor status, the issuer merely requires the proposed investor to complete an accredited investor questionnaire. While the Proposing Release provides some guidance by way of several general examples, the SEC did not suggest a uniform procedure or otherwise specify a method for verifying a prospective purchaser's accredited investor status. In the SEC's view, imposing a single, uniform requirement may be ill-suited or superfluous in a particular situation. Rather, it notes that the "objectively reasonable" standard proposed provides flexibility for varied circumstance, permits the ability to adapt to market changes, and allows for both innovation and the continued utilization of existing practices that satisfy the verification requirements. The steps necessary to determine an investor's status as an accredited investor essentially may be measured on a sliding scale, with fewer additional steps required where the issuer has sufficient information about a prospective purchaser or where the investor was solicited though a database of pre-screened accredited investors, and a greater burden where less information is known or available or the solicitation was made through a publicly accessible website. However, as is currently the case under Regulation D, the burden of complying with the safe harbor provisions of Regulation D falls on the issuer, not the prospective investor.
As the Proposing Release notes, the verification obligation required in connection with Rule 506(c) does not replace or otherwise supplant the "reasonable belief" standard set forth in Rule 501 under Regulation D. Thus, because the determination is largely based on the issuer's objective assessment, it is important to retain all pertinent records that lead to or support the determination. Good record-keeping will be helpful if, despite the reasonable efforts of the issuer, a purchaser later turns out not to be an accredited investor. So long as the issuer took reasonable steps to verify and had a reasonable belief that the purchaser was an accredited investor, the SEC opines that the issuer would not lose the ability to rely on the exemption.
The Proposing Release does not impact the existing safe harbor available to issuers under Regulation D. Thus, the existing safe harbor remains available to those issuers not seeking to engage in any general solicitation or general advertising. As the SEC notes in the Proposing Release, reliance on the existing provisions of Regulation D may be of particular interest to those issuers who, for example, do not wish to become subject to the verification requirements of Rule 506(c), or who may wish to sell to nonaccredited investors who otherwise meet the Rule 506 sophistication requirements.4
In addition to the amendments to Rule 506, the Proposing Release also proposes an amendment to Form D, a notice filing required by each issuer claiming a registration exemption under Regulation D, to include a "check box" specifically requiring an issuer to indicate whether an offering is being made in reliance on the proposed amendment to Rule 506.
Impact on Sections 3(c)(1) and 3(c)(7) of the 1940 Act
Private Funds. In order to avoid registration as an "investment company" under the Investment Company Act of 1940, as amended (1940 Act), most private investment funds rely on the exclusion from the definition of an investment company provided in either Section 3(c)(1) ("accredited investor funds") or Section 3(c)(7) ("qualified purchaser funds") of the 1940 Act. Reliance on either is conditioned, in part, on the issuer not engaging in any form of public offering or solicitation in connection with the offering of its securities. Significantly, the Proposing Release confirms the SEC's view that private investment funds will be able to engage in general solicitations and use general advertisements in accordance with Rule 506(c) under Regulation D without having to register as an investment company under the 1940 Act.
It is important for general partners and other sponsors of private investment funds to note, however, that the Proposing Release does not include any amendments to Sections 3(c)(1) or 3(c)(7). Therefore, issuers seeking to rely on either must still comply with the remaining conditions of the applicable exclusion. For example, to rely on Section 3(c)(1), the offering must be limited to no more than 100 investors in a fund.
Commodity Pools. Although the Proposing Release clarifies the implications of Rule 506(c) to private investment funds under the 1940 Act, the extent to which commodity pool operators and commodity trading advisers will be able to rely on Rule 506(c) remains uncertain. In the wake of recent rulemaking under the Dodd-Frank Act, many private investment funds that utilize swaps and other commodity interests rely on Rule 4.13(a)(3) under the Commodity Exchange Act of 1936, which provides a registration exemption for commodity pool operators that use commodity interests on a limited basis, provided the pool is offered only to accredited investors, knowledgeable employees and certain "qualified eligible" persons. Among other requirements, Rule 4.13(a)(3) includes a restriction against engaging in general solicitations. Thus, absent guidance to the contrary from the Commodity Futures Trading Commission, private investment funds that utilize commodities interests (including most swaps not related to a specific security) in pursuing their investment objectives may not be able to rely on Rule 506(c) if and when it is adopted by the SEC without registering as a commodity pool operator and/or commodity trading adviser.
Content Standards. Interestingly, the Proposing Release does not propose any content standards or other requirements with respect to solicitation or advertisements of private investment funds in reliance on Rule 506(c) under Regulation D. However, issuers that intend to engage in general solicitation and general advertising activities in reliance on Rule 506(c) under Regulation D should note that any such advertisement is subject to the various anti-fraud provisions of the federal securities laws, including, but not limited to Rule 10b-5 under the Securities Exchange Act of 1934, as amended, and Rule 206(4)-8 under the Investment Advisers Act of 1940, as amended (Advisers Act). In addition, registered investment advisers will have to comply with other requirements of the Advisers Act, including Rule 206(4)-7. For example, before engaging in any general solicitation or advertisement in connection with a private investment fund, a registered investment adviser should review its policies and procedures to ensure that the compliance risks presented by such expanded marketing activities are appropriately addressed in the written policies and procedures adopted by the investment adviser.
Given that the Proposing Release merely offers rule proposals, it is conceivable that the SEC could be swayed by various commentators who have argued that advertisements by private investment funds should be subject to the same content standards applicable to registered funds such as mutual funds. For instance, in a comment letter filed with the SEC in anticipation of rulemaking related to the JOBS Act, the Investment Company Institute (ICI) argues that it is "critically important for the ... [SEC] to consider carefully the best and most appropriate ways to protect potential investors from misleading advertisements by private funds."5 In the ICI's view, the SEC should, at a minimum, "impose content restrictions on private fund advertising at least as extensive as those currently applicable to mutual funds."6 The extent to which the final rulemaking by the SEC may be influenced by comments made by the ICI or other commentators remains to be seen.
Proposed Amendment to Rule 144A
Like Rule 506 under Regulation D, Rule 144A is a non-exclusive safe harbor that provides an exemption from registration under the 1933 Act for resales of "restricted securities" to QIBs. Under the proposed amendment to Rule 144A, "restricted securities" may be offered to persons other than QIBs, including offers made by general solicitation, so long as the securities are sold only to persons whom the seller or any person acting on behalf of the seller reasonably believes is a QIB.
Solicitation of Comments
As noted above, the Proposing Release is soliciting comment on the proposed rulemaking. Persons wishing to comment have 30 days from the date the Proposing Release is published in the Federal Register; comments must be received by the SEC on or before October 5.