On July 10, 2013, the Securities and Exchange Commission adopted the long-awaited amendments to Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”), which will allow issuers to engage in general solicitation and general advertising in connection with offers and sales of securities in private placements conducted in accordance with Rule 506(c). Rule 506(c) has the potential to completely transform private fundraising by opening offerings to investors that otherwise would not have access and providing investment funds and other private issuers sources of capital that previously have been unavailable. These amendments, which will become effective 60 days after publication in the Federal Register, have come at a time when fundraising opportunities in Europe may be diminishing for some private fund managers due to changes in private placement rules mandated by the Alternative Investment Fund Managers Directive.
Rule 506(c) of Regulation D under the Securities Act, which implements Section 201(a) of the Jumpstart Our Business Startups Act (JOBS Act), will permit sponsors of private investment funds and other issuers to engage in general solicitation and general advertising in connection with offers and sales of securities in private placements conducted pursuant to Rule 506(c). As a consequence of the significant liberalization of rules governing the marketing of private placements, issuers will be able to conduct private placements of securities in increasingly broad and creative ways. Media interviews, television, radio and internet advertisements and other mass marketing of private placements likely will become standard practice for some issuers. Although the amendments effect a significant change in the rules of the road for private placements, they do not completely eradicate prohibitions against general solicitation and general advertising. Fund sponsors and other issuers should take careful note of the conditions that must be satisfied in order to take advantage of general advertising and general solicitation in connection with Rule 506(c) offerings. They also should stay tuned for future rule making which potentially could impose further restrictions on private placements that are conducted using general advertising and general solicitation.
Conditions to be Satisfied under Rule 506(c)
In order to use general solicitation and general advertising in connection with a private placement of securities pursuant to Rule 506(c), all of the following conditions must be satisfied:
- The offering must comply with the provisions of (i) Rule 501 that define “accredited investor” and other terms used in Regulation D, (ii) Rule 502(a) that establish rules regarding the integration of offerings and (iii) Rule 502(d) that establish limitations on the resale of securities acquired in Regulation D offerings.
- Item 6 of the Form D filed in connection with the offering must indicate that the issuer is relying on the exemption contained in Rule 506(c).
- All purchasers of securities in the offering must be accredited investors.
- The issuer or its agent must take reasonable steps to verify the purchasers’ accredited investor status.
Reasonable Steps to Verify Accredited Investor Status
In connection with a Rule 506(c) offering, an issuer or its agent must take reasonable steps to verify the accredited investor status of all purchasers. The SEC has indicated that the reasonableness of any verification process will be determined in light of the nature of the investor, the way in which investors are solicited, the minimum investment amount and other terms of the offering, the amount and type of information already obtained about the investor and other relevant facts and circumstances surrounding the investment transaction. This test of reasonableness arguably has always applied to Regulation D offerings, but there has been a general recognition that most issuers have relied to some extent on “self-certification” of accreditation and have relied solely on an investor’s representation that he or it is accredited. The SEC has provided the following nonexclusive list of methods to verify the accredited investor status of a purchaser who is a natural person, which will be deemed to satisfy the requirements of Rule 506(c), so long as the issuer or its agent does not have knowledge that the purchaser is not an accredited investor:
- For income verification, reviewing copies of any Internal Revenue Service form that reports income for the two most recent years, along with a written representation from the investor regarding the investor’s reasonable expectation of reaching the requisite level of income in the current year;
- For net worth verification, reviewing (i) bank, brokerage or other securities account statements, certificates of deposit, tax assessments and appraisal reports issued by independent third parties, in each case, dated within the preceding three months, to determine the value of assets owned, (ii) a credit report from at least one nationwide reporting agency and (iii) a representation of the investor that all liabilities necessary to determine net worth have been disclosed;
- Obtaining written confirmation from a registered broker-dealer, a federally-registered investment advisor, a licensed attorney in good standing in the jurisdiction in which he practices, or a certified public accountant in good standing in the jurisdiction in which he practices that, within the preceding three months, the professional has taken reasonable steps to verify and has determined that the purchaser is an accredited investor; and
- Obtaining a certification as to its status as an accredited investor from a natural person who (i) was an accredited investor in a Rule 506(b) offering conducted by the issuer prior to the effective date of Rule 506(c) and (ii) remains an accredited investor of the issuer at the time of the sale of the securities. The SEC has indicated in the adopting release that in circumstances where an investor was not an accredited investor at the time it purchased securities in a prior Rule 506(b) offering of the issuer, a certificate from that investor will not be sufficient to verify its status as an accredited investor for purposes of the Rule 506(c) offering. It is unclear whether a successor fund will be permitted to rely upon self-certification where its investors also are investors in an affiliated predecessor fund that offered interests pursuant to Rule 506(b) before the effective date of Rule 506(c).
These methods are not required, and almost certainly represent a greater amount of inquiry than many issuers or broker-dealers will find reasonable or appropriate. We will likely see a period of uncertainty in the private placement market as issuers and broker-dealers attempt to determine what level of inquiry into accreditation will be generally accepted as “reasonable.”
Maintaining Documentary Evidence
For issuers that intend to rely upon the exemption from registration contained in Rule 506(c), it is particularly important to maintain records evidencing the steps taken to verify that purchasers of the issuer’s securities are accredited investors. If an issuer uses general advertising and general solicitation in connection with an invalid Rule 506(c) offering, other exemptions from registration under Section 4(a)(2) of the Securities Act would be unavailable, as well, and a violation of Section 5 of the Securities Act would be the likely result. The SEC has indicated that it will monitor verification practices with a view to determining the effect of verification processes on investor protection and capital raising.
Issuers that conduct offerings in reliance upon the exemptions from Securities Act registration under Section 4(a)(2), including those contained in Rule 506(b), also should give consideration to the methods used to formulate a reasonable basis to believe that certain purchasers are accredited investors. Because the issuer has the onus of proving that an exemption from registration under the Securities Act is available, maintenance of tangible objective evidence of an investor’s status as an accredited investor is important.
Implications for Rule 506(b) Offerings
Some issuers may choose to continue to conduct offerings subject to the prohibition against general advertising and general solicitation pursuant to Rule 506(b), which was not changed by the amendments. They may elect not to engage in general advertising and general solicitation for reasons relating to liability, a desire to include up to 35 sophisticated non-accredited investors in the offering, concerns about additional regulation that may accompany general solicitation, or for other reasons. If a Rule 506(b) offering is underway at the time the amendments become effective, an issuer may continue the offering in accordance with Rule 506(b) or Rule 506(c). Any general solicitation or general advertising pursuant to a Rule 506(c) offering that occurs after the effective date of the amendments will not taint the offers and sales of securities previously conducted pursuant to Rule 506(b).
Effect of General Solicitation on Investment Company Act Exemptions
In the adopting release, the SEC reaffirmed that private investment funds that use general advertising and general solicitation in accordance with Rule 506(c) will not be deemed to be engaged in a public offering for purposes of Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”). Consequently, use of general advertising and general solicitation in accordance with the provisions of Rule 506(c) will not cause a fund to lose its exclusions from the definition of investment company under the Investment Company Act.
Anti-fraud Implications for Fund Managers
Litigation and enforcement risks will almost certainly be heightened with the use of general advertising and general solicitation. It is important, therefore, for fund managers to develop and implement policies and procedures to ensure that advertising and solicitation materials do not contain incomplete, untrue or misleading statements. Investment advisors to private funds are subject to prohibitions against fraudulent, deceptive and manipulative conduct pursuant to Rule 206(4)-8 under the Investment Advisers Act of 1940 (the “Advisers Act”) and the SEC has reiterated that it will enforce the anti-fraud provisions of Rule 206(4)-8 vigorously, pursuant to the authority granted to it in Section 206(4) of the Advisers Act. In addition, the SEC has proposed amendments to Rule 156 under the Securities Act which would extend to all private funds the anti-fraud guidance regarding sales literature which currently is applicable only to investment companies.
Corresponding Amendment to Rule 144A
As required by Section 201(a)(2) of the JOBS Act, Rule 144A(d)(1) will be revised to provide that resales of securities pursuant to Rule 144A may be conducted using general solicitation, provided that all purchasers of the securities are qualified institutional buyers or persons that the seller or its agent reasonably believes are qualified institutional buyers. As a result of the amendment, offers (but not sales) under Rule 144A may be made to persons that are not qualified institutional buyers. Rule 144A offerings that begin before the effective date of the amendment to Rule 144A(d)(1) may be bifurcated so that the portion of the offering occurring after the effective date of the amendment may be conducted using general solicitation and general advertising without jeopardizing the availability of Rule 144A for the portion of the offering that occurred before the effective date of the amendment, which is 60 days after publication in the Federal Register.
No Integration with Offshore Offerings
The SEC reaffirmed the view that offshore offerings conducted pursuant to Regulation S under the Securities Act will not be integrated with concurrent onshore offerings conducted using general advertising and general solicitation pursuant to the amendments to Rule 506 or Rule 144A. Offerings conducted outside the U.S. are subject to local securities laws, which may prohibit general advertising and general solicitation. Therefore, issuers will need to make sure that any advertising conducted in the U.S. does not taint any concurrent offshore offering under the laws of any non-U.S. jurisdictions in which the issuer is conducting an offering.
Disqualification of Bad Actors from Rule 506 Offerings
To implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC adopted Rule 506(d), disqualifying offerings from exemption in reliance on Rule 506 where certain “covered persons” have been involved with any of the enumerated disqualifying events. Disqualification will not occur as a result of disqualifying events that occurred before the effective date of Rule 506(d); however, disqualifying events occurring prior to the effective date of Rule 506(d) must be disclosed to prospective investors in writing a reasonable time prior to sale pursuant to Rule 506(e). Rule 506(d) will become effective 60 days after publication in the Federal Register.
For purposes of Rule 506(d), “covered persons” include:
- the issuer, any of its predecessors or affiliates;
- any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
- any beneficial owner of at least 20% of the issuer’s voting equity securities, calculated on the basis of voting power;
- any investment manager to an issuer that is a fund and any director, executive officer, other officer participating in the offering, general partner or managing member of the investment manager and the same category of officers of the investment manager’s general partner or managing member;
- any promoter connected in any capacity with the issuer at the time of sale;
- any person that has been or will be compensated, directly or indirectly, for soliciting purchasers in connection with the sale of securities in the offering; and
- any director, executive officer, other officer, general partner or managing member of any such paid solicitor.
Disqualifying events include, among others,
- felony and misdemeanor criminal convictions entered within the most recent five years for issuers, and within the most recent ten years for other covered persons, (i) in connection with the purchase or sale of a security, (ii) involving making false filings with the SEC, or (iii) arising out of the business of an underwriter, broker, dealer, investment advisor, paid solicitor or certain other financial professionals;
- final orders issued by banking, insurance or other regulators that (i) at the time of sale bars a covered person from (A) associating with an entity regulated by those authorities, (B) engaging in the securities, insurance or certain other regulated businesses or (ii) are based on the violation of any law or regulation prohibiting fraudulent, manipulative or deceptive conduct within the ten years prior to the sale;
- any order, judgment or decree of any court of competent jurisdiction, within five years before any sale in the offering that, at the time of sale, enjoins or restrains a covered person from engaging in conduct in connection with the purchase or sale of a security; involving making a false filing with the SEC; or arising out of the business of an underwriter, broker, dealer, investment advisor, paid solicitor or certain other financial professionals; and
- suspension or expulsion from membership in, or suspension or a bar from, association with a member of a self-regulatory organization.
Where an issuer is able to demonstrate that it did not know and, using reasonable care, could not have known that a disqualification existed, the offering may qualify for an exception from disqualification. The SEC has made clear its view that, in order for an issuer to take advantage of the exception, it must have made a factual inquiry into relevant facts in order to determine whether a disqualification existed. The nature and scope of the inquiry will depend on the particular circumstances. For prolonged or continuous offerings, reasonable care will require the issuer to update the inquiry at reasonable intervals. The signature block of Form D will be amended to include a certification by the issuer confirming that the offering is not disqualified from reliance on Rule 506 for any of the reasons set forth in Rule 506(d).
Certain Proposed Amendments Potentially Affecting Private Placements
The SEC has proposed several amendments which, if adopted, would impose additional requirements and restrictions on private placements, potentially offsetting many of the benefits derived from the adoption of Rule 506(c) and Rule 144A(d)(1). Some of the proposals include:
- amending Rule 503 of Regulation D under the Securities Act (“Regulation D”) to require a Form D to be filed at least 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering and filing a closing Form D amendment within 30 calendar days after the termination of the offering;
- amending Form D to require additional information regarding offerings, including information about the issuer and affiliated persons, offering terms and use of proceeds and, for Rule 506(c) offerings, information regarding the methods used to verify the purchasers’ accredited investor status;
- amending Rule 507 of Regulation D to disqualify an issuer from relying upon Rule 506 for one year for future offerings if the issuer or any predecessor or affiliate of the issuer did not comply with all Form D filing requirements in any Rule 506 offering within the last five years, subject to a 30-day cure period for the first late filing;
- requiring issuers to include prescribed legends in any written communication constituting general solicitation in a Rule 506(c) offering, including, for private investment funds, a legend disclosing that the securities offered are not subject to the protections of the Investment Company Act and disclosures relating to performance data, fees and expenses; and
- requiring an issuer conducting a Rule 506(c) offering to submit to the SEC, no later than the date of first use, any written general solicitation materials prepared by or on behalf of the issuer and used in connection with the offering.
The SEC has requested comments on the proposed rules. Comments on whether to revise the definition of “accredited investor”, as it relates to natural persons, also have been requested. The comment period extends for 60 days after the proposed rules are published in the Federal Register.