On July 10, 2013, the Securities and Exchange Commission (SEC) adopted final rules implementing provisions of the JOBS Act, which remove the ban against the use of general solicitation and general advertising in private offerings made in reliance on Rule 506 of Regulation D or Rule 144A. Rule 506 is the primary “safe harbor” relied on by private funds to offer securities to accredited investors in a private offering.
The SEC also adopted final rules disqualifying issuers from relying on Rule 506 with respect to offerings that involve certain felons or other “bad actors.” Finally, the SEC proposed rules requiring issuers to provide the SEC additional information to enable it to monitor Rule 506 offerings involving general solicitation.
Impact on Private Fund Offerings
The SEC actions will greatly expand the way in which private funds may access potential investors. However, before seeking to raise capital through general solicitation or general advertising, private funds must consider the application of the final rules and other factors.
The effective date of the final rules is 60 days after their publication in the Federal Register, which is expected to occur soon. Until that time, private funds should not engage in any general solicitation or general advertising.
Elimination of the Ban on General Solicitation and General Advertising
While the final rules amend Rule 506 to remove the ban on general solicitation and general advertising, Rule 506(c) now requires funds to (i) take “reasonable steps” to verify that investors are accredited investors and (ii) reasonably believe all of their investors are accredited investors. In the release adopting the final rules and in response to public comments, the SEC included a list of nonexclusive methods an issuer may use to verify an investor’s accredited investor status.
- Review copies of any IRS form that reports income (e.g., W-2, Form 1099 or a copy of a filed Form 1040), along with a written representation that the investor will likely continue to earn the necessary income in the current year;
- Review copies of bank statements, brokerage or other statements of securities holdings, or CDs for evidence of sufficient net worth, along with a credit report for evidence of total liabilities; or
- Obtain a written confirmation from a broker-dealer, an investment adviser, a licensed attorney or a certified public accountant that such entity or person has taken reasonable steps to verify the investor’s accredited investor status.
There may be a number of additional verification methods available that funds relying on Rule 506 can utilize beyond those described above, including methods to verify the accredited investor status of partnerships, LLCs, corporations and other entities. Whether or not a fund took “reasonable steps” to verify the investor’s status is an objective determination based on the particular facts and circumstances of each investor and the offering. In the adopting release, the SEC noted that the determination on reasonableness would include the following:
- “the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- the amount and type of information that the issuer has about the purchaser; and
- 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 a minimum investment amount.”
Regardless of the particular steps taken, because the fund has the burden of demonstrating its compliance with the requirements of Rule 506, it will be important for each fund to retain adequate records of its verification process and documents supporting its determinations. Funds that intend to engage in general solicitation in reliance on the amended Rule 506 should review, and consider whether to alter, their investor intake process. Please contact your Vedder Price attorney for assistance.
We note a fund may rely on the original Rule 506 (now Rule 506(b)) to the extent the fund does not wish to engage in a general solicitation. Funds will be required to note on Form D whether they are using general solicitation or general advertising to solicit investors.
Disqualifying Bad Actors
The SEC also amended Rule 506 to disqualify issuers from relying on Rule 506 with respect to an offering if felons and other “bad actors” who are covered persons (i.e., directors and certain officers, large investors, placement agents and underwriters, among others) participate in the offering. Disqualification will apply for disqualifying events that occur after the effective date of the final rules. To the extent a fund was subject to a disqualifying event prior to the effective date, the fund will be required to disclose the disqualifying event but will not be prohibited from relying on Rule 506. The SEC has issued a fact sheet on covered persons and disqualifying events. View the fact sheet here.
Proposed Enhanced Monitoring of Rule 506 Offerings by the SEC
The SEC proposed amendments to Regulation D and Form D that would enable the SEC to collect additional data to understand market practices surrounding Rule 506 offerings and address concerns related to the removal of the general solicitation ban. Below is a summary of the proposed requirements:
- File Form D 15 days before any general solicitation occurs and within 30 days after the conclusion of the offering.
- Require certain specified legends on offering materials and materials used by private funds that contain performance data.
- Submit to the SEC any written general solicitation materials on a temporary and nonpublic basis.
- With limited exceptions, prohibit an issuer for one year from relying on Rule 506 if the issuer or any predecessor or affiliate of the issuer failed to comply with the Form D filing requirement within the last five years.
The SEC also proposed amending Rule 156 under the Securities Act of 1933, which interprets the anti-fraud provisions of the federal securities laws to apply to the sales literature used by private investment funds relying on Rule 506(c). Comments on the proposed rules are due 60 days after publication in the Federal Register.