Advertising Permitted with Strings Attached: Significant New Offering Rules for Private Funds and Their Managers

by Holland & Knight LLP
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On July 10, 2013, the Securities and Exchange Commission (the SEC) approved a final rule making changes to Rule 506 of the Securities Act of 1933 (the most widely used and important exemption from federal and state registration of offerings) to permit issuers (including funds) to use general solicitation and general advertising to offer their securities provided both that:

  • all purchasers of the securities are accredited investors or the issuer reasonably believes that the investors so qualify
  • the issuer takes reasonable steps to verify that the investors are accredited investors

The SEC requires an issuer relying on this new exemption in Rule 506(c) to consider the facts and circumstances of each purchaser and the transaction. Nevertheless, in response to commenters' requests, the final rule provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement for individual investors.

The methods described in the final rule include the following:

  • reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year
  • receiving a 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
  • 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 deposits, tax assessments and appraisal reports issued by independent third parties
    • with respect to liabilities: a consumer credit report from at least one nationwide consumer credit reporting agencies  
  • if the purchaser purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of the new Rule 506(c) and continues to hold such securities, receiving a certification by such purchaser at the time of the new sale of securities pursuant to Rule 506(c) that such purchaser qualifies as an accredited investor

These verification methods represent an enormous operational change for funds and requires new procedures and due diligence for funds that choose to advertise. Other than as described above, mere self-verification by a prospective investor (e.g., checking a box on a subscription agreement to represent that the investor is accredited) will not be sufficient. It is likely that third-party service providers will offer verification services.

Issuers conducting Rule 506 offerings without the use of general solicitation or general advertising (now called Rule 506(b) offerings) can continue to conduct securities offerings in the same manner and are not subject to the new verification rule.

Form D

The final rule amends Form D, which is the notice that issuers must file with the SEC and state regulators when they sell securities under Regulation D. The revised form adds a separate box for issuers to check if they intend to engage in general solicitation or advertising under this new Rule 506(c) exemption.

Timing

The rule amendments become effective 60 days after publication in the Federal Register, which should mean they are effective by the end of September 2013.

Not So Fast

Many private fund managers rely upon exemptions from regulation by the Commodities Futures Trading Commission (CFTC) (such as the de minimis exemptions available to fund managers with limited trading in commodity interests). These exemptions currently prohibit general solicitation or advertising. Absent further guidance from the CFTC, you should assume that such important exemptions are not available to fund managers who conduct general solicitations.

The new rule also does not override the private placement regimes of other countries, and it is possible that various types of federal solicitations conducted within or from the United States (such as the use of unrestricted websites) may be deemed a violation of the private placement rules in another country.

Further, sponsors of private funds should be aware that if they broadly advertise as they are now allowed, they may not be allowed to fall back on the exemption from registration under Section 4(a)(2) of the Securities Act of 1933 if they fail to satisfy the exemption under Rule 506(c). Moreover, alternative state blue sky exemptions for private offerings that avoid federal Form D filings and state investment adviser or foreign private adviser exemptions based on "not holding out" may be unavailable for offerings that engage in general solicitation.

Finally, issues of integration may remain if an issuer conducts multiple concurrent offerings (although according to the new rule release Regulation S offshore offers should not be integrated with a U.S. 506(c) offering). Antifraud rules and specific advertisement content rules, especially for registered advisers, may be a trap for the unwary advertiser.

Registered investment advisers need to remember they can only charge incentive compensation to investors meeting the higher "qualified client" standards.

2. Disqualification of Felons and Other "Bad Actors" from Rule 506 Offerings

The SEC also approved a final rule on July 10, 2013 that prohibits an issuer from relying on the vital Rule 506 exemption if the issuer or any related person covered by the rule has a "disqualifying event." This new disqualification rule is Rule 506(d).

Covered Persons

The final disqualification rule covers a much narrower list than had been proposed and includes the fund itself, including its predecessors and affiliated funds, as well as:

  • directors, executive officers, general partners, and managing members of the fund as well as other officers participating in the offering
  • beneficial owners of 20 percent or more of the fund
  • promoters
  • investment managers and principals of the fund
  • persons compensated for soliciting investors as well as the general partners, directors, officers and managing members of any compensated solicitor

Disqualifying Events

Under the final rule, a "disqualifying event" includes:

  • Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction must have occurred within 10 years of the proposed sale of securities (or five years in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order must have occurred within five years of the proposed sale of securities.
  • Final orders from the CFTC, federal banking agencies, the National Credit Union Administration or state regulators of securities, insurance, banking, savings associations or credit unions that either:
    • bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities
    • are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years of the proposed sale of securities
  • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons.
  • SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws.
  • SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities.
  • Suspension or expulsion from membership in a self-regulatory organization (SRO) or from association with an SRO member.
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

Reasonable Care Exception

The final 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 (e.g., a factual inquiry) before they may rely on this defense.

Rule Not Retroactive; Disclosure of Pre-Existing Disqualifying Events

Importantly, unlike in the proposed rule, disqualification applies only for disqualifying events that occur after the effective date of this rule. However, issuers must disclose to investors prior to the sale all matters existing before the rule's effective date that would otherwise be disqualifying under new Rule 506(e). If an issuer does not make this mandatory disclosure, it may not rely on Rule 506 with limited exception..

Waivers

Rule 506(d) also includes a waiver provision, under which a waiver of disqualification may be granted upon a showing of good cause. The final rule also permits any court or regulatory authority that enters an order, judgment or decree that would cause an actor to be disqualified under the rule to advise the SEC that, in its view, disqualification under Rule 506 should not arise as a consequence of such order, judgment or decree, and in such circumstances disqualification will not arise.

Form D

The final rule amends the signature block in the Form D to contain a certification whereby issuers relying on Rule 506 confirm that the offering is not disqualified based on Rule 506(d).

Timing

This rule amendment also will become effective in 60 days after publication in the Federal Register.

3. Proposed Amendments to Private Offering Rules

On July 10, 2013, the SEC also proposed additional amendments to Rule 506 and Form D that would:

  • require issuers to file an advance notice of sale 15 days before and at the conclusion of an offering
  • require issuers to provide additional information about the issuer and the offering, including:
    • identification of the issuer's website
    • expanded information on the issuer
    • the offered securities
    • the types of investors in the offering
    • the use of proceeds from the offering
    • information on the types of general solicitation used
    • the methods used to verify the accredited investor status of investors
  • disqualify issuers who fail to file Form D
  • require issuers to include legends and disclosures in written general solicitation materials
  • require issuers to submit written general solicitation materials to the SEC
  • extend to private funds guidance contained in Rule 156 under the Securities Act about misleading statements in advertising materials

Timing

The proposal is subject to a 60-day public comment period.
 

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