As widely reported, the Securities and Exchange Commission (SEC) approved a final rule effective Sept. 23, 2013, that prohibits a fund relying on the vital Regulation D/Rule 506 exemption from SEC registration if the issuer or any related person covered by the rule has a "disqualifying event." (See Holland & Knight alert, "Advertising Permitted with Strings Attached: Significant New Offering Rules for Private Funds and Their Managers," July 17, 2013.) Rule 506 is important because it essentially grants a 50-state exemption from registration to a qualifying offering upon making simple notice filings and offers the only way for a fund to advertise.

To comply with this new "bad actor" rule and rely on Rule 506, fund sponsors must establish new procedures and diligence materials designed to reveal disqualifying events for covered persons, which includes certain employees, affiliates and placement agents. Importantly, disqualification applies only for disqualifying events that occur after the effective date of this rule. However, issuers must disclose to investors prior to any sale all matters existing before the rule's effective date that would otherwise be disqualifying under new Rule 506(d). If an issuer does not make this mandatory disclosure, it cannot rely on Rule 506 (whether or not it advertises). Further, the SEC has amended Form D to require an issuer to certify that the offering is not disqualified from relying on Rule 506.

The rule provides an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. This exception will require additional due diligence procedures and questions for funds to ask and document (i.e., a factual inquiry) before they may rely on this defense. Depending on the circumstances, "covered persons" include:

  • executive officers or general partners or managing members of the fund
  • the adviser
  • adviser employees
  • placement agents and their personnel
  • entities affiliated with the investment manager (even with no involvement in the business of the investment manager or the fund)
  • investors holding 20 percent or more voting securities in a fund

As a result, fund sponsors relying on Regulation D should determine the full range of persons that could subject them to the new disclosure or disqualification rule and must adopt procedures to monitor for bad actors because new disqualifying events by such persons would prohibit use of Regulation D with potentially devastating consequences.

Accordingly, for a fund to make new sales after Sept. 23, in compliance with the all-important Regulation D, the fund must be in a position to know and must disclose certain past disqualifying events of certain covered persons.

By Sept. 23, fund sponsors should distribute and receive back completed questionnaires or certifications from, among others, officers, investment manager personnel and placement agents. Fund sponsors should also amend placement agent and subscription agreements to add representations and covenants addressing disqualifying events. Funds engaged in ongoing offerings must update their compliance and due diligence procedures to monitor for changes in covered persons or such persons’ disciplinary status.

You may feel confident that no such events exist, but the SEC will want to see documentation of this conclusion.

Additionally, investment managers should be careful when hiring or inheriting new employees to ensure any such employees who are covered persons are not subject to any disqualifications under Rule 506(d). It is not yet clear how broadly some aspects of the rule, including the definition of covered persons, will be interpreted.

Update on General Solicitation

Another new rule also effective Sept. 23, 2013, will permit issuers (including funds) to use general solicitation and general advertising to offer their securities under certain conditions. This liberalization currently is of very limited use for hedge funds since many private fund managers rely upon exemptions from registration or regulation by the Commodities Futures Trading Commission (CFTC) which prohibit general solicitation or advertising. The CFTC is aware of this disconnect and purports to be addressing it, but until it does, as a practical matter for many if not most funds, the ability to advertise will not be available on Sept. 23.