Hedge fund general counsel and chief compliance officers have been pondering what their firms should make of the SEC’s new Rule 506(c).1 When it becomes effective next month, that provision will permit “general solicitation” by issuers making private placements of their securities, including— though the rule did not originate with this in mind—hedge funds selling limited partnership interests. Some hedge fund legal and compliance professionals are being pressed by firm principals and marketing staff to sign off on communications initiatives intended to take advantage of this new flexibility to raise their firms’ profiles and attract investor capital. How should one respond to this pressure?
The apparent advantages offered by Rule 506(c) are significant. However, any hedge fund contemplating the use of general solicitation should understand the downside of engaging in liberalized marketing and other communications under the rule. That downside boils down to two concerns.
The first relates to Rule 506(c) itself. Operating under the new provision will pose meaningful challenges. For example, an offering under Rule 506(c) will impose on the issuer a purchaser “verification” process that is difficult to know how to satisfy. General solicitation also will expand potential exposure to fraud claims, stress the issuer’s disclosure-control procedures, and possibly put CFTC or foreign securities law exemptions at risk.
The second concern—currently less concrete but ultimately more significant—arises outside the four corners of Rule 506(c). It relates to the SEC regulatory regime that will govern general solicitation in practice. That regime is both currently in flux and likely, whenever its final contours take shape, to subject the Rule 506(c) market to substantive regulation and intense enforcement scrutiny. The SEC’s intentions along these lines are evident in the agency’s proposals, released on the day Rule 506(c) was adopted, to amend Regulation D in a variety of ways, some relating specifically to private funds. At the same time, the SEC announced the formation of an interdivision working group to review and analyze general solicitation practices. Whatever the precise eventual content of the Regulation D revisions, it seems probable that a private fund entering the general solicitation arena will subject itself to significant regulatory risk.
For small hedge funds struggling to achieve market recognition and find investors, the prospective benefits of general solicitation perhaps will outweigh the attendant risks and costs. But in light of the compliance challenges posed by Rule 506(c) and the likelihood of an aggressive SEC posture toward private funds that use the rule, we think the prudent course for the wellestablished hedge fund manager is to wait and watch— to continue with historical marketing and publicity practices for the time being, while keeping an eye on peer activities, market developments and the progress of the SEC’s rulemaking proposals. At some point the uncertainties associated with general solicitation may subside enough for established managers to begin using Rule 506(c) with some confidence. For the moment, however, many private fund managers would be well advised to sit back rather than leap in.
We discuss these thoughts in greater detail below. We begin with a brief recap of the terms of Rule 506(c). We then examine the costs and burdens that a private fund manager will encounter in choosing to operate under the rule. Finally, we describe the SEC’s proposed amendments to Regulation D and announcement of a “Rule 506(c) Work Plan,” and consider the enhanced regulatory environment they presage for private funds engaging in general solicitation.
RULE 506(c): WHAT THE SEC HAS ADOPTED
The SEC adopted Rule 506(c) of Regulation D in July 2013. The rule implements Congress’ mandate under Section 201 of the JOBS Act by conditionally lifting the SEC’s historical ban on general solicitation and general advertising (general solicitation, for short) in private placements under Rule 506. The new rule will take effect on September 23, 2013.
The Terms of Rule 506(c)
The terms of Rule 506(c) are straightforward enough on their face. The rule allows an issuer (and persons acting on its behalf) to engage in general solicitation under the Rule 506 safe harbor on two conditions:
- All purchasers are accredited investors. Unlike in a traditional Rule 506(b) offering, an issuer electing to engage in general solicitation under Rule 506(c) must sell its securities exclusively to accredited investors.
- The issuer takes “reasonable steps to verify” that all purchasers are accredited investors. This procedural requirement is distinct from the requirement that the issuer sell its securities only to accredited investors. That is, an issuer that does not take reasonable steps to verify its purchasers’ accredited investor status—even if all purchasers in the offering do happen to have that status—cannot claim the Rule 506(c) registration exemption.
The SEC has suggested broad factors that an issuer might consider in determining what reasonable verification steps are necessary, including the type of accredited investor the purchaser claims to be, information the issuer already possesses about the purchaser, and the nature and terms of the offering. Rule 506(c), however, does not prescribe or endorse any particular process.
An issuer electing to conduct an offering under Rule 506(c) must so indicate by checking a box on Form D, which has been reformatted for this purpose.
Hedge Fund Managers Seem to Have Appealing New Opportunities
A hedge fund manager willing to use Rule 506(c) will be free to do things it probably has shied away from in the past. A manager now might allow the general public to access its website or third-party marketing platforms featuring the manager’s fund products and performance history; place advertisements in selected publications; liberalize communications with the press; allow firm personnel to speak at industry conferences or other semi-public events; develop a social media presence; publish tombstones; engage in event-sponsorship and other branding opportunities; and reach out to prospective investors with which the manager has no preexisting substantive relationship. These are certainly attractive possibilities.
But, Rule 506(c) Comes with Significant Baggage
The apparent new freedom offered by Rule 506(c) is accompanied, however, by several risks and burdens.
The Purchaser Verification Process May Be Difficult
The requirement that the issuer take reasonable steps to verify its purchasers are accredited investors is “principles-based’; it is up to the issuer to decide what steps are adequate.7 The issuer must think about the objective facts and circumstances of an offering, including what the issuer already knows about each potential investor, what representations the investor has made, how the investor has been solicited and the terms of the offering itself.
Given the inherent imprecision of the required analysis, we expect that determining the verification processes to implement for different types of investors will be a challenging and time-consuming task for fund managers, at least until market practice has had time to develop.8 Fund managers can expect to encounter new compliance issues and costs as they implement their purchaser verification processes, perhaps in part because prospective investors may be reluctant to provide requested information they consider sensitive or unnecessary.
The “Reasonable Steps” Determination May Be Vulnerable to Hindsight Attack
In addition to the internal challenges a hedge fund manager may face in defining and implementing reasonable purchaser-verification processes, the manager’s determination may be subject to hindsight questioning by the SEC. The Rule 506(c) adopting release distils the issuer’s position this way: “After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears likely that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa.” The analysis therefore consists of two steps, each of which calls for a subjective determination by the issuer in order ultimately to satisfy the ostensibly “objective” reasonable verification standard. The unavoidable subjectivity of the manager’s task makes us wonder whether the verification process may be vulnerable to SEC second-guessing. That is not a comforting possibility when compliance with Section 5 of the Securities Act is at stake.9
The Fund Manager May Have Heightened Exposure to Fraud Claims
The very nature of a general solicitation will subject a fund manager to heightened exposure under Exchange Act Rule 10b-5 and Investment Advisers Act Rule 206(4)-8.10 Using Rule 506(c) therefore can be expected to put significant stress on the manager’s internal compliance and legal professionals, who will need to ensure that the communications comprising the general solicitation—written, oral, online, social mediabased, etc.—are factually correct and consistent with other fund disclosure and marketing materials. The need to ensure coordinated disclosure is especially acute for hedge funds, that—unlike other issuers that might rely on Rule 506(b)—are more or less constantly open to new investors and thus in quasi-permanent “offering” mode. Moreover, when the SEC staff examines a fund manager’s books and records (which must include marketing materials distributed to ten or more persons), the staff can be expected to review with special interest the content of general solicitation materials, documentation supporting the claims they make, and records of how the materials were disseminated.
Attention to the Investment Adviser’s Act Advertising Rules Will Become Especially Important
In addition to anti-fraud concerns in general, a hedge fund manager that is a registered investment adviser must comply with the prohibition on deceptive “advertising” set forth in Rule 206(4)-1 under the Investment Advisers Act. As interpreted by the SEC, this provision regulates the presentation of a wide range of information that might be used in a general solicitation, including information about the past performance of the fund and the investment professionals who manage it. To the extent a general solicitation involves wide dissemination of performance claims and other advertising, the opportunity to run afoul of Rule 206(4)-1 naturally expands. In the Rule 506(c) adopting release, the SEC specifically warns private fund advisers to “carefully review any [advertising-related] policies and procedures that have been implemented to determine whether they are reasonably designed to prevent the use of fraudulent or materially misleading private fund advertising and make appropriate amendments to those policies and procedures, particularly if the private funds intend to engage in general solicitation activity.”
Managers Will Lose an Opportunity to Incentivize Manager Personnel Who Are Not Accredited Investors
Hedge funds relying on the exemption from investment company status under Section 3(c)(1) of the Investment Company Act may issue fund securities to their “knowledgeable employees” without counting those employees toward the 100-beneficial-owners limit. Similarly, a Section 3(c)(7) fund may issue securities to knowledgeable employees whether or not they are “qualified purchasers.” It is possible that a knowledgeable employee is not an accredited investor. In that case, a fund manager that chooses to engage in a general solicitation under Rule 506(c) will foreclose the opportunity to incentivize those employees with fund securities.
General Solicitation Could Put a CFTC Registration Exemption at Risk
The Dodd-Frank Act has brought some hedge fund managers within the definition of “commodity pool operator” under the Commodity Exchange Act. Rule 4.13(a)(3) under that statute provides an exemption from CFTC registration for commodity pool operators that trade commodity interests (including many types of swaps) on only a de minimis basis, as long as the pool— i.e., the fund—is offered only to accredited investors and other eligible persons without “marketing to the public.” The CFTC has not issued guidance about whether general solicitation under Rule 506(c) would constitute impermissible public marketing. Unless and until the CFTC provides commentary on that topic, hedge funds with commodity interest assets may be placing their Rule 4.13(a)(3) exemption in jeopardy if they conduct general solicitations under Rule 506(c).
Funds Will Be Subject to Blue Sky Notice Filing and Fee Requirements
As is the case with Rule 506(b) offerings, state securities regulators will be preempted under the National Securities Markets Improvement Act of 1996 (“NSMIA”) from requiring registration of Rule 506(c) offerings. However, NSMIA does allow the states to require Form D notice filings and associated fees when an issuer makes an offering under Rule 506. Many state blue sky regulations offer exemptions from such notice filing requirements, but only on the condition that the issuer makes no general solicitation. A hedge fund that opts to use Rule 506(c) therefore may be courting exposure to state notice and fee requirements that would not apply in a traditional Rule 506(b) transaction.
Funds Must Consider Private Offering Rules in Foreign Jurisdictions
Many hedge funds offer their securities to investors outside the United States under Regulation S at the same time they solicit U.S. investors under Rule 506. The SEC has confirmed that a Regulation S offering will not be integrated with a Rule 506(c) offering, but most foreign jurisdictions have their own internal regulatory schemes concerning private offerings of securities. A hedge fund that takes advantage of Rule 506(c) therefore will need to evaluate the extent to which its U.S. publicity conceivably might conflict with the privateoffering regimes of relevant foreign jurisdictions, i.e., whether the public accessibility in a foreign jurisdiction of the fund’s U.S. general solicitation materials would be subject to (and need to satisfy) any publicity limitations the foreign jurisdiction imposes under its own private offering rules.11
Some of the above points are significant risks. Others are more in the headache category. Together, though, they illustrate that the terms of Rule 506(c) have costs and the potential to cause difficulties for managers that choose the general solicitation route.
AMENDMENTS TO REGULATION D: WHAT THE SEC HAS PROPOSED
Simultaneous with its promulgation of Rule 506(c), the SEC released proposed rules concerning the regulation of private offerings under Regulation D, including proposed amendments to Form D’s disclosure requirements and filing deadlines (the “Reg. D Proposals”).12 Unlike Rule 506(c), the Reg. D Proposals are not a response to a Congressional mandate. They are of the SEC’s own devising and are “intended to enhance the Commission’s ability to evaluate the development of market practices in Rule 506 offerings and to address concerns that may arise in connection with permitting . . . general solicitation.”
Understanding the Background
Before discussing the content of the Reg. D proposals, it is useful to note the circumstances in which they arose. Appreciating this background is helpful in understanding both the impetus for the Reg. D Proposals and the overall regulatory perspective the SEC will bring to the general solicitation space.
The first point to recognize is that neither Congress nor the SEC had a policy goal of enabling private funds to engage in general solicitation. When writing the JOBS Act, Congress had small corporate issuers in mind and did not grasp that the freedom to engage in general solicitation would apply equally to private funds. Nor was general solicitation—for private funds or any other type of issuer— the SEC’s idea. Section 201 of the JOBS Act instructed the SEC to draft and adopt Rule 506(c). Congress thus disrupted by fiat a private offering regulatory regime developed through years of agency rulemaking, staff guidance and input from the securities bar. In this light, the Reg. D Proposals may be seen as a re-assertion of SEC authority over the regulation of private offerings, with a particular focus on the behavior of private funds as a class of issuer to which Congress accidentally made general solicitation available.
The Reg. D Proposals also may be seen as the SEC’s acknowledgment of concerns voiced from certain quarters about potential investor exploitation under Rule 506(c). Following its proposal of Rule 506(c) in 2012, the SEC received numerous alarmed comments from consumer groups, state securities regulators, investor advocates and others urging the SEC either to drop the proposal (not an option, given the Congressional mandate) or to couple the new rule with special investor safeguards. The Reg. D Proposals indicate a degree of SEC sympathy toward those commenters.
Content of the Reg. D Proposals
The potential burdens and risks that hedge fund managers might expect under Rule 506(c) have been anticipated, more or less, during the year spent awaiting the rule’s adoption. The Reg. D Proposals, on the other hand, are quite new and fund managers will need to watch their progress closely.13 They evince an SEC mindset suggesting that a private fund manager choosing to employ general solicitation will be placing itself under agency scrutiny.
Timing and Content of Form D
The Reg. D Proposals would require an issuer to file an “Advance Form D” at least 15 calendar days before initiating any general solicitation under Rule 506(c), and a “closing” Form D amendment within 30 calendar days after terminating any Rule 506 offering. Form D itself also would be amended to contain a variety of new disclosure line items for Rule 506 offerings; for Rule 506(c) offerings in particular, revised Form D would call for information about the types of general solicitation used, the issuer’s methods for verifying accredited investor status and the identity of persons controlling the issuer. An issuer that failed to comply with its Form D filing obligations effectively would be barred for one year from further use of Rule 506.
Legends in Written General Solicitation Materials
The Reg. D Proposals contemplate the adoption of new Rule 509. This rule would apply specifically to Rule 506(c) offerings. It would require any written general solicitation materials to contain legends warning investors that: the offering materials are not subject to the disclosure rules applicable to registered offerings; the SEC has not passed upon the merits of the offering or the securities; the securities are subject to transfer restrictions; and an investment in the securities involves risk of loss.16 Private funds using written general solicitation materials would have to include an additional legend cautioning investors that the offered securities are not subject to the protections of the Investment Company Act; and would be required to include a series of prescribed warnings concerning any fund performance data contained in the materials.17 An issuer that became subject to an order, judgment or court decree enjoining the issuer from violation of the Rule 509 disclosure mandates would be barred from future use of Rule 506.18
Extending Rule 156 Sales Literature Guidance to Private Funds
Rule 156 under the Securities Act provides guidance to investment companies (e.g., mutual funds) about the type of statements in their sales literature that could, depending on context, be misleading for purposes of the federal securities laws. Among the types of statements addressed by Rule 156 are those concerning an investment company’s past or future investment performance, the nature of its portfolio and the qualifications of its personnel. The Reg. D Proposals would subject private funds’ sales literature, including written general solicitation materials used in Rule 506(c) offerings, to Rule 156. In explaining this proposal, the SEC stated that “[b]ased on enforcement and regulatory experience regarding private funds, we believe that the areas identified in Rule 156 as being vulnerable to misleading statements in investment company sales literature are similarly vulnerable with respect to private fund sales literature.”
Advance Submission to SEC of Written General Solicitation Materials
Finally, the Reg. D Proposals include a stark new provision, Rule 510T, which would have effect for two years following its adoption. Rule 510T would obligate any issuer making a Rule 506(c) offering to submit to the SEC on a nonpublic basis all written general solicitation materials prepared by or on behalf of the issuer. A Rule 510T submission to the SEC would be due no later than the date the written general solicitation materials relating to an offering were first used in the offering.
Rule 510T is so broad that it appears fraught with opportunities for unintentional non-compliance. In fact, the SEC implicitly anticipates non-compliance by proposing that an issuer that becomes subject to an order, judgment or court decree enjoining the issuer for violation of Rule 510T should be disqualified from future use of Rule 506.19
In total, the Reg. D Proposals illustrate the SEC’s desire to police general solicitation activity vigilantly, to maintain a degree of control over the content of general solicitations, and to arm itself with tools to bar the use of Rule 506 by issuers found to have abused their new freedom.
THE RULE 506(C) WORK PLAN: WHAT THE SEC HAS ANNOUNCED
The perception that the SEC will be especially watchful in overseeing the development of general solicitation practices is reinforced by the SEC’s announcement in the Reg. D Proposals release that its staff will execute a comprehensive “Rule 506(c) Work Plan.” While the announcement appears with the Reg. D Proposals, it is not itself a proposal—according to the SEC, the Rule 506(c) Work Plan is already under development. The plan will bring together staff from the Divisions of Corporation Finance, Economic and Risk Analysis, Investment Management, Trading and Markets, and Enforcement, as well as staff from the Office of Compliance Inspections and Examinations, to review and analyze issuers’ use of Rule 506(c).
The SEC states that its staff executing the Work Plan will, among other things: evaluate the range of purchaser verification practices used by issuers and other offering participants; examine the information that issuers submit to the SEC in connection with Rule 506(c) offerings, including Form D line item responses and written general solicitation materials; submitted under Rule 510T; monitor the Rule 506(c) market for increased incidence of fraud and develop risk characteristics for the types of issuers and offerees involved in general solicitation offerings; incorporate an evaluation of Rule 506(c) offering practices in the staff’s examinations of registered investment advisers; and coordinate with state securities regulators on sharing information about Rule 506(c) offerings.
Coupled in particular with the virtually real-time data gathering contemplated by Advance Form D and Rule 510T, the Work Plan seems apt—if not explicitly intended—to provide grist for the SEC enforcement mill.
Rule 506(c) seems to open wide vistas for hedge fund marketing and publicity. It is not surprising that some fund principals and marketing staff are pressing their general counsel and compliance officers to bless novel communication initiatives designed to capitalize on the new freedom. But given the practical burdens and compliance challenges posed by Rule 506(c), the prospect of an aggressive SEC posture toward private funds that use the rule and the unsettled regulatory landscape, it seems prudent to discourage a premature embrace of general solicitation. Hedge fund legal and compliance professionals certainly will want to monitor market developments and the SEC’s rulemaking process, with an eye to determining when general solicitation may become appropriate for their firms. For most private funds, though, the moment to leap in has not yet arrived.