On July 10, 2013, the US Securities and Exchange Commission (SEC) adopted final rules pursuant to the Jumpstart Our Business Startups Act (JOBS Act) to permit general solicitation in Rule 506 offerings. New Rule 506(c) permits issuers to conduct a general solicitation to offer securities so long as the sales are limited to "accredited investors" and the issuer takes "reasonable steps" to verify that all purchasers of the securities are accredited investors.1These new rules will become effective on September 23, 2013.
This profound regulatory change will make it easier for private equity funds, venture capital funds, hedge funds and similar investment vehicles (collectively, Private Funds) to find investors and raise capital in the US Private Funds relying on Rule 506(c) will be able to advertise their offerings through the Internet (including via social media and email), newspapers, magazines, television, seminars and any other form of general solicitation without registering the offering as a public offering with the SEC, so long as the applicable requirements of Rule 506 and Regulation D are met.
Private Funds that choose not to engage in general solicitation will still be able to rely on the existing Rule 506(b) safe harbor and will not be subject to the new investor verification requirements of Rule 506(c).
Although Rule 506(c) will grant Private Funds access to a greater number of potential investors, it is generally expected that most Private Funds will continue to rely on Rule 506(b) and the existing private placement exemptions, including Section 4(a)(2) of the US Securities Act of 1933, as amended (Securities Act), until "market" practices regarding general solicitation are established.2
1. Rule 506 Offering Process
In an offering that qualifies for the Rule 506 exemption, a Private Fund may raise an unlimited amount of capital from an unlimited number of "accredited investors" and up to 35 non-accredited investors. Under SEC rules, accredited investors are individuals who meet certain minimum income or net worth levels, entities whose equity owners are themselves accredited investors and certain institutions such as trusts, corporations or charitable organizations that meet certain minimum asset levels.3
2. New Rule 506(c)
Once effective, new Rule 506(c) will permit Private Funds to advertise their offerings to the public provided that the following general requirements are met:4
- All purchasers of the securities are accredited investors;
- The issuer takes reasonable steps to verify that all investors are accredited investors; and
- All terms and conditions of Rule 501 and Rules 502(a) and 502(d) must be satisfied.
A Private Fund relying on Rule 506(c) will be required to take "reasonable" steps to check that each investor is actually an accredited investor no matter how certain it is that a particular investor qualifies as such. Whether the steps taken are "reasonable" will be determined by the Private Fund in the context of the particular facts and circumstances of each investor and transaction. Among the factors to be considered are (i) the nature of the investor and the type of accredited investor that the investor claims to be; (ii) the amount and type of information that the Private Fund has about the investor; and (iii) the nature of the offering (such as the manner in which the investor was solicited to participate in the offering) and the terms of the offering (such as a minimum investment amount). For example, the SEC indicated that an issuer who solicits investors through a website accessible to the general public, through a widely disseminated email or social media solicitation (e.g., Facebook), or through print media will likely be obligated to take greater measures to verify accredited investor status than an issuer who solicits new investors from a database of pre-screened accredited investors. However, the SEC stated that it does not believe that an issuer will have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, required only that the potential investor check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.
In addition to adopting the principles-based method of verification described above, the final text of Rule 506(c) will include the following non-exhaustive (and non-mandatory) verification methods that the SEC generally considers to be sufficient:
- When verifying whether the investor is an accredited investor on the basis of income, reviewing any IRS form that reports the investor’s income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the investor that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
When verifying whether the purchaser is an accredited investor on the basis of net worth, reviewing one or more of the following types of documentation 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:
- With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
- With respect to liabilities: a consumer report from at least one of the consumer reporting agencies that operate nationwide in the US;
Obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:
- A registered broker-dealer;
- An investment adviser registered with the SEC;
- 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 who is duly registered and in good standing under the laws of the place of his or her residence or principal office;
- In regard to any person who previously purchased securities in a Private Fund’s Rule 506 offering as an accredited investor and continues to hold such securities, obtaining a certification by such person at the time of sale that he or she still qualifies as an accredited investor.
3. Next Steps and Important Considerations
Rule 506(c) becomes effective on September 23, 2013. Before then, no general solicitation may be conducted when offering securities pursuant to Rule 506. However, before engaging in general solicitation, a Private Fund should consult with counsel in order to review the various considerations and procedures that general solicitation will require, including those described below. Although most Private Funds may chose to forego general solicitation and continue to rely on Rule 506(b) and past private placement practices, Rule 506(c) allows Private Funds to reach new sources of capital and benefit accredited investors seeking new investment opportunities.
- Using General Solicitation Limits the Availability of Other Private Placement Exemptions. The SEC’s amendments affect only Rule 506 and not Section 4(a)(2) offerings in general. A Private Fund that publicly advertises its offering runs the risk that inadvertent non-compliance with the Regulation D requirements could prevent it from "falling back" on the Section 4(a)(2) private placement exemption. Also, once general solicitation has occurred, an issuer is precluded from using the existing Rule 506(b) exemption for the same offering.
Furthermore, Private Funds rely on one or both of the exemptions in Section 3(c)(1) and Section 3(c)(7) of the US Investment Company Act of 1940, as amended (the "Investment Company Act"), in order to avoid registration with the SEC as an "investment company." Section 4(b) of the Securities Act provides that "[o]ffers and sales exempt under [Rule 506(c)] shall not be deemed public offerings under the Federal securities laws as a result of general solicitation." Consequently, the amendments to Rule 506 permit Private Funds to engage in general solicitation in compliance with new Rule 506(c) without losing their eligibility to rely on the exemptions under Section 3(c)(1) or 3(c)(7) of the Investment Company Act. However, if general solicitation occurs but the requirements of Rule 506(c) and Regulation D are ultimately not met, the Private Fund will be ineligible to rely on Section 3(c)(1) and Section 3(c)(7).
Finally, caution will be required to ensure that general solicitation in the US does not violate the securities laws of other jurisdictions where investors are sought.
- Ensure That a Timely and Correct Form D Notice Filing Is Made. The SEC is simultaneously amending Form D, which is the notice that issuers must file with the SEC within 15 calendar days after the first sale of securities sold in each offering under Regulation D. The revised form will add a separate box for issuers to check if they are claiming the new Rule 506(c) exemption that permits general solicitation.
On July 10, 2013, the SEC also proposed amendments to Regulation D that, if finalized, will require an issuer that intends to offer or sell securities using general solicitation to file a Form D notice of such intended offering no later than 15 calendar days to the first use of general solicitation in a Rule 506(c) offering (and subsequently amend the filing when the offering concludes). The SEC’s proposed amendments would disqualify issuers from using Rule 506(c) (and Rule 506(b)) for future offerings until one year has elapsed after the required Form D filings are made if they (or their predecessors or affiliates) failed to comply, within the past five years, with the Form D filing requirements for any Rule 506 offering. Additionally, the SEC proposed that all written materials used in general solicitation would bear specific legends and that an issuer be required to submit to the SEC any written communication that constitutes a general solicitation or general advertising in any offering conducted in reliance on Rule 506(c) no later than the date of first use. 5The SEC is currently accepting comments from the public regarding these proposed amendments.
- The JOBS Act Only Affects Federal Securities Laws. Private Funds may be subject to other laws prohibiting the use of general solicitation in their offerings despite the JOBS Act and Rule 506(c). For example, some Private Funds are regulated by the US Commodity Futures Trading Commission (CFTC) pursuant to the US Commodity Exchange Act, which governs the trading of commodity futures and swaps in the US Absent further guidance from the CFTC, several key exemptions used by Private Funds, including the CFTC Rule 4.13(a)(3) "de minimis" exemption (which is a widely-used exemption that "commodity pool operators" of certain Private Funds use to avoid registration with the CFTC) and the CFTC Rule 4.7 "registration lite" exemption (which provides certain relief for CFTC-registered entities), will continue to prohibit the use of general solicitation by affected Private Funds.
- Advertising Content and Procedures Must Be Carefully Reviewed. All investment advisers remain subject to the anti-fraud rules contained in SEC Rule 10b-5 under the US Securities Exchange Act of 1934 and SEC Rule 206(4)-8 under the US Investment Advisers Act of 1940 (Advisers Act). These rules require Private Funds and their investment advisers to refrain from fraudulent conduct in connection with their offerings. 6 Furthermore, registered investment advisers are subject to additional rules under the Advisers Act concerning advertisements of their services. In light of the SEC’s recent enforcement actions against Private Fund advisers and others for material misrepresentations to investors and prospective investors regarding fund performance, strategy, and investments, among other things, 7investment advisers to Private Funds should carefully review their policies and procedures to make sure that they are reasonably designed to prevent the use of fraudulent or materially misleading advertising.
- Recordkeeping Is Essential. It will be important for Private Funds and their verification service providers to retain adequate records regarding the steps taken to verify that a purchaser was an accredited investor when it made its investment. As discussed above, a Private Fund cannot "fall back" on the Section 4(a)(2) private placement exemption (or another exemption from registration as an "investment company" under the Investment Company Act) if it generally solicits investors, so proper diligence and maintenance of records will be crucial in case an investor turns out not actually to be an accredited investor after investing in a Private Fund. The SEC made clear in its guidance that a Private Fund will not lose the ability to rely on Rule 506(c) if an investor turns out not to be an accredited investor after the fact, so long as the Private Fund took reasonable steps to verify that the investor was an accredited investor and had a reasonable belief that such investor was an accredited investor at the time of sale. Without proper records to evidence the requisite diligence, Private Funds will not be able to demonstrate their compliance with Rule 506(c).
- Private Funds Need to Comply with Privacy Laws. Private Funds are subject to various privacy laws, including those enforced by the US Federal Trade Commission. These laws generally concern how Private Funds and their service providers maintain the privacy of non-public personal information provided by natural persons in connection with their investment. Given the wide range of methods that Private Funds can use to raise capital through general solicitation, Private Funds and their verification service providers will need to ensure that they comply with applicable privacy laws and that their compliance procedures adequately maintain the confidentiality of information used to verify natural persons as accredited investors.