On July 10, 2013, the Commissioners of the U.S. Securities and Exchange Commission ("SEC" or the "Commission") voted 4-1 to adopt a rule that will eliminate the prohibition against general solicitation and general advertising (together, "general solicitation") in private offeringsconducted pursuant to Rule 506 of Regulation D under the Securities Act of 1933 (the "Securities Act").1 Specifically, the Commission voted to amend Rule 506 to add a new paragraph (c), which will permit general solicitation so long as certain conditions are met by the issuer. Rule 506(c) was adopted to implement a requirement contained in Section 201(a) of the Jumpstart Our Business Startups Act (the "JOBS Act"). Rule 506(c) will become effective 60 days after the rule amendment is published in the Federal Register, or mid to late September 2013.2 Once Rule 506(c) becomes effective, private issuers--including hedge funds, private equity funds, venture capital funds and start-up companies--will be permitted to engage in general solicitation, so long as the issuer takes "reasonable steps" to verify that purchasers in the offering are accredited investors, and all purchasers of the securities are in fact accredited investors as defined in Rule 501(a). Alternatively, private issuers may forgo advertising to the general public and can continue to rely on Rule 506's legacy framework.
During the same open meeting in which Rule 506(c) was adopted, the Commission adopted final rules to disqualify securities offerings involving certain "felons and other 'bad actors'" from participating in Rule 506 offerings, as required by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, by a unanimous vote.3 In addition, the Commission proposed additional amendments to Regulation D, Form D, and Rule 156 under the Securities Act that are intended collectively to enhance the Commission's ability to evaluate changes in the private offering market and to address the development of practices in Rule 506 offerings.4 Gibson Dunn will be issuing a companion client alert in the near future containing additional information regarding these new rules.
Most hedge funds and private equity funds rely on the private placement exemption and the procedures of Rule 506 as a means to avoid the registration requirements of Section 5 of the Securities Act with respect to offerings in the United States. Rule 506 permits issuers to raise an unlimited amount of capital in private offerings sold to an unlimited number of accredited investors and up to 35 non-accredited investors. However, until Rule 506(c) was adopted, the exemption provided by Rule 506 was explicitly conditioned on issuers and other participants in the offering not engaging in any form of general solicitation or general advertising to attract investors. This prohibition has restricted the use of any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media shared or broadcastedover television, the radio, or the Internet to sell a private offering.
Title II of the JOBS Act, entitled "Access to Capital for Job Creators," was designed to broaden the pool of potential investors for private offerings and expand access to capital. Section 201(a) directed the Commission to eliminate the prohibition on general solicitation in securities offerings conducted pursuant to Rule 506, so long as all purchasers of the securities of such offerings are accredited investors. In addition, Section 201(a)(1) requires that the issuer "take reasonable steps to verify that purchasers of the securities are accredited investors," using such methods as determined by the Commission.
On August 29, 2012, the Commission proposed rules to implement Section 201(a) of the JOBS Act. On July 10, 2013, the Commission approved final rules, leaving the proposed rules largely unchanged, except for including a nonexclusive list of methods that issuers may use to satisfy the verification requirement with respect to investors who are natural persons, in addition to the principles-based approach that was described in the proposing release, as discussed below.
Summary of the Commission's New Rule
Revised Rule 506(c) will permit general solicitation so long as: (i) the issuer takes reasonable steps to verify that the purchasers are accredited investors; and (ii) all purchasers of the securities fall within one of the eight categories of persons who are accredited investors under Rule 501(a) of the Securities Act, or the issuer reasonably believes that the purchasers fall within one of those categories.5
The determination of whether the steps taken to verify that a purchaser is an accredited investor are reasonable will be an objective determination by an issuer based on the facts and circumstances of each purchaser and transaction.6 The adopting release enumerates a non-exclusive list of factors that an issuer should consider in making this determination, including: (1) the nature of the purchaser and type of accredited investor that the purchaser claims to be; (2) the amount and type of information that the issuer has about the purchaser; and (3) the nature/terms of the offering.
Verifying the accredited investor status of natural persons using this principles-based approach may prove challenging for private fund issuers. Under Rule 501(a), natural persons may qualify as accredited investors under either a net worth test7 or income test.8 However, public information is not generally available on the personal finances of individuals, and there may be privacy concerns related to collecting this type of information. To address this issue, the Commission has identified certain categories of information that issuers could rely upon which, depending on the circumstances, may satisfy Rule 506(c)'s verification requirements. Examples of such information include publicly available information contained in filings with a federal, state or local regulatory body, or information available through a third party, such as a broker-dealer, accountant, or attorney.
In addition to the principles-based approach described above, Rule 506(c) provides a non-exclusive list of methods that an issuer may use to satisfy the verification requirement for a purchaser who is a natural person. These methods include: (1) reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser expects to continue to earn the necessary income in the current year; (2) reviewing copies of bank, brokerage and similar statements, certificates of deposit, tax assessments and appraisal reports as evidence of the purchaser's assets, and a consumer credit report as evidence of the purchaser's indebtedness, and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed; (3) receiving written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser's accredited status; and (4) with respect to a purchaser who invested in a Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c) and intends to invest in a Rule 506(c) offering by the same issuer, obtaining a certification from the purchaser that he or she qualifies as an accredited investor.
Private funds may choose to operate under the legacy Rule 506 regime, and thus forgo engaging in general solicitation, for a variety of reasons, including avoiding the more stringent accredited investor verification requirements applicable to Rule 506(c) offerings or in order to allow for sales to up to 35 non-accredited investors.
Interaction with Other Regulatory Frameworks
The adopting release for Rule 506(c) expressly confirms that an offering made pursuant to this rule will not constitute a public offering for purposes of Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the "Investment Company Act"). By way of background, Section 3(c)(1) of the Investment Company Act provides that an issuer will not be considered an investment company if its outstanding securities are beneficially owned by 100 or fewer persons and if it is not making and does not propose to make a public offering of its securities, and Section 3(c)(7) excludes from being an investment company any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of the acquisition of such securities, are "qualified purchasers" (as defined in the Investment Company Act), and which is not making and does not propose to make a public offering of such securities.
Notwithstanding the foregoing, it is important to note that other laws applicable to private funds can be impacted by a fund's use of general solicitation. For example, usage of Rule 506(c) may impact the availability of certain exemptions available under rules promulgated by the Commodity Futures Trading Commission ("CFTC"), including the de minimis exemption from registration as a commodity pool operator under CFTC Rule 4.13(a)(3). The de minimisexemption requires that interests in each applicable fund be "offered and sold without marketing to the public in the United States." Therefore, absent CFTC action, it appears that private funds seeking to engage in general solicitation may not be able to rely on the Rule 4.13(a)(3) exemption.
Additionally, marketing materials used to solicit prospective investors are subject to the antifraud provisions promulgated under the Securities Act, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940 (the "Advisers Act").9 Furthermore, for investment advisers that are registered with the SEC, certain advertisements may also trigger specific advertising rules and regulations. For example, an investment adviser is limited in its ability to utilize an advertisement that refers to any testimonial concerning the investment adviser or refers to its past specific investment recommendations. The Advisers Act also limits the ways in which an investment adviser can present its track record. Separately, entities registered with regulatory agencies besides the SEC, including the CFTC and/or the National Futures Association, may be subject to other agency-specific marketing rules and regulations. Finally, many states and non-U.S. jurisdictions have their own antifraud and market rules that must be considered before marketing materials can be disseminated.
Rule 506(c)'s elimination of the prohibition on general solicitation presents risks and opportunities for the private fund industry. On the one hand, the ability to engage in general solicitation will create new opportunities for private fund managers to expand their businesses. On the other hand, those managers that move aggressively without proper controls, policies and procedures face significant compliance risks that could result in reputational harm, regulatory scrutiny, and possible legal ramifications. So, with the liberalization of the private offering communication rules, private fund managers must reexamine their policies, procedures and form transaction documents, which up until now have generally not included provisions that contemplate general solicitation, so that they can ensure safe operation in this new legal environment.