Most private equity funds that are subject to the U.S. securities laws have relied on Rule 506(b), a safe harbor under Section 4(a)(2) of the Securities Act of 1933 (Securities Act), in forming funds and soliciting investors. In addition to other requirements, this exemption prohibits general solicitation and general advertising in reaching potential investors. These restrictions require sponsors of private equity funds to pay close attention to the mechanics of the offering (e.g., numbering and tracking offering memoranda), and to ensure that other activities of the sponsor (e.g., speaking at private equity conferences, sponsoring websites and participating in press interviews) do not fall within the essentially vague standard of general solicitation or general advertising. Given that all actual purchasers in a Rule 506(b) offering must generally qualify as “accredited investors” anyway (with limited exceptions)1, many commentators believed that the general solicitation and general advertising prohibitions were often difficult to comply with, and unnecessary.
In July 2013, the SEC amended Rule 506 and Rule 144A under the Securities Act to permit, in certain circumstances, an issuer to engage in general solicitation and general advertising in connection with private placements in Rule 506 and Rule 144A offerings (General Solicitation Rules).2 The SEC also proposed rules (Proposed Rules)3 to enhance the SEC’s ability to monitor how the General Solicitation Rules will affect the private offering market and to provide additional investor protection safeguards. The General Solicitation Rules became effective on September 23, 2013. The General Solicitation Rules and the Proposed Rules are discussed below.
Permitting General Solicitation and General Advertising in Rule 506 Offerings
Background: The Pre-Existing Rule 506(b) Safe Harbor Remains Available
Many U.S. private placements rely on Rule 506(b), a non-exclusive safe harbor under Section 4(a)(2) of the Securities Act, which exempts transactions by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act. The SEC has retained, in its current form, the existing Rule 506(b) safe harbor as a separate exemption that continues to prohibit general solicitation or general advertising. Rule 506(c) represents a separate, but related safe harbor under Rule 506 that permits an issuer to engage in general solicitation and general advertising, such as mass mailings, emails, public websites, social media, print media and broadcast media, subject to the conditions described further below.
Adopted Amendments to Rule 506: Creation of the Rule 506(c) Safe Harbor
The General Solicitation Rules create a new safe harbor that permits general solicitation and general advertising in connection with an offering of securities,4 subject to the following conditions:
The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors;
All purchasers of securities are accredited investors either because they come within one of the eight enumerated categories of persons that qualify as accredited investors or the issuer reasonably believes they qualify as such at the time of sale;5 and
The issuer meets all terms and conditions of Rule 501,6 Rule 502(a)7 and Rule 502(d)8.
Reasonable Steps to Verify Accredited Investor Status
For issuers seeking to engage in general solicitation and general advertising under new Rule 506(c), it will be critical for such issuers to establish appropriate policies and procedures to satisfy the requirement of taking reasonable steps to verify accredited investor status.9 In the General Solicitation Release, the SEC described two possible means of determining that such verification procedures are reasonable. First, an issuer (or those acting on its behalf) may make this determination using a principles-based approach, whereby the issuer makes an “objective determination,” based on the “particular facts and circumstances” of the applicable offering, in deciding what steps to take to verify a purchaser’s accredited investor status.10 The General Solicitation Release provides the following non-exhaustive and non-mandatory list of factors that may be appropriate for an issuer to consider:11
Nature of the purchaser and the type of accredited investor the purchaser claims to be;
Information that the issuer has about the purchaser; and
Nature and terms of the offering.
The guidance provided in the General Solicitation Release notes that, absent other information about the purchaser indicating accredited investor status, a questionnaire or executed form alone would not suffice for verification.12 This guidance also addresses the different categories of purchasers (e.g., natural persons versus registered broker-dealers), and the extent to which publicly available information regarding a purchaser, third-party verification services and minimum investment requirements, among other items, are relevant in connection with an issuer’s decision regarding what steps to take in verifying a purchaser’s accredited investor status.
As an alternative to the principles-based approach described above, the General Solicitation Rules contain four specific non-exclusive methods of verifying accredited investor status for a natural person13 that, if properly followed, are deemed to satisfy the reasonableness requirement of such verification:14
Income – (1) reviewing copies of various Internal Revenue Service forms (e.g., Form W-2, Form 1099, Schedule K-1 of Form 1065 and a filed Form 1040) for the two previous years that report the income of the purchaser and (2) obtaining a written representation from the purchaser to the effect that he or she has a reasonable expectation, in the current year, of reaching the income level necessary to qualify as an accredited investor;
Net Worth – (1) reviewing various types of documentation relating to the purchaser’s net worth (e.g., bank statements, brokerage statements, certificates of deposit, tax assessments and appraisal reports), dated within the prior three months, (2) reviewing a credit or consumer report regarding the purchaser from at least one nationwide consumer reporting agency and (3) obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed;
Third-Party – obtaining written confirmation from certain third-parties (e.g., a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant) that (1) such third-party has taken reasonable steps to verify the purchaser’s accredited investor status within the prior three months and (2) such third-party has made a determination that the purchaser is an accredited investor;15 and
Prior Investors – with respect to a purchaser who has previously invested in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of the General Solicitation Rules (and is currently an investor of the issuer), obtaining a certification by the purchaser at the time of the Rule 506(c) sale that he or she continues to qualify as an accredited investor.16
These methods are a non-exclusive safe harbor. Issuers utilizing other accredited investor verification means will not be deemed or presumed to have acted unreasonably but, instead, must consider whether the verification method selected is reasonable based on the principles-based approach described above.
Regardless of which verification procedure is employed by an issuer, it should be noted that any issuer claiming an exemption from the registration requirements of Section 5 of the Securities Act bears the burden of proving that such exemption was properly relied upon. Accordingly, it is important for issuers to maintain adequate records that document the steps they have taken to verify that a purchaser was an accredited investor at the time of purchase and to determine, to the extent that Rule 506(c) is being relied on, that their chosen verification method was appropriate.
Amendment to Form D
To help the SEC gather data on the use of general solicitation and general advertising in offerings relying on Rule 506(c), the SEC also adopted an amendment to Form D, which issuers are currently required to file with the SEC when they sell securities pursuant to Regulation D. The revised Form D adds a separate box for an issuer to check if it is claiming the new Rule 506(c) exemption. In addition, the Proposed Rules include certain proposed amendments to Form D, as well as other requirements applicable to the use of general solicitation in private offerings.
Permitting General Solicitation and General Advertising in Rule 144A Offerings
Prior to the adoption of the General Solicitation Rules, Rule 144A served as a non-exclusive safe harbor that provided an exemption from the registration requirements of the Securities Act for offers and sales of securities by persons, other than the issuer, to Qualified Institutional Buyers (QIBs)17 or persons reasonably believed to be QIBs. Prior to the adoption of the General Solicitation Rules, although Rule 144A did not explicitly prohibit general solicitation, offers were only permitted to be made to QIBs or persons reasonably believed to be QIBs.
Under the General Solicitation Rules, Rule 144A has been amended so that offers of securities to persons who are not QIBs would be permitted, including by means of general solicitation and general advertising, so long as the securities are sold only to QIBs or persons reasonably believed to be QIBs.18 The General Solicitation Rules do not address what would constitute “reasonable belief” of QIB status. However, Rule 144A already contains a list of non-exclusive methods by which an issuer can establish whether a prospective purchaser is a QIB.
Implications of Rule 506(c) for Private Funds and their Investment Advisers
Exclusions under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act
Private funds generally rely on the exclusions from the definition of an “investment company” available under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act (a Section 3(c)(1) Fund or Section 3(c)(7) Fund, as applicable). However, these exclusions are not available if a fund makes or proposes to make “a public offering of its securities.” In the General Solicitation Release, the SEC confirmed that a private fund engaged in general solicitation and general advertising under Rule 506(c) would not be making a “public offering” for purposes of the Investment Company Act and, thus, would not forfeit its exclusion from registration under the Investment Company Act. In taking this view, the SEC reminded investment advisers to private funds that they are subject to Rule 206(4)-8 under the Investment Advisers Act of 1940 (Advisers Act) and that the SEC “may bring enforcement actions under the Advisers Act against advisers who defraud investors or prospective investors in those pooled vehicles.” It should be noted, however, that the General Solicitation Release did not explicitly extend this confirmation to the new Rule 144A offerings, although many members of the private offering industry are of the view that such guidance should equally apply to Rule 144A offerings.
The General Solicitation Release confirms that if an issuer’s ongoing Rule 506(b) offering commenced prior to the effective date of the new Rule 506(c), the issuer may proceed with the offering as either a Rule 506(b) offering or a Rule 506(c) offering. If the issuer opts to continue under Rule 506(c), any general solicitation that occurs after the effective date will not affect the exempt status of offers and sales of securities that occurred prior to the effective date in reliance on Rule 506(b).
Integration of Domestic and Offshore Offerings
The General Solicitation Release provides that private domestic Rule 506(c) or Rule 144A offerings would not be integrated with Regulation S offshore offerings. Accordingly, issuers would be able to conduct a Rule 506(c) or Rule 144A offering concurrently with a Regulation S offering while employing general solicitation and general advertising in the United States, without violating the prohibition in Regulation S on “directed selling efforts” in the United States.
Integration of Domestic Offerings
While the General Solicitation Rules do not integrate private domestic Rule 506(c) or Rule 144A offerings with an offshore Regulation S offering, the General Solicitation Rules do not address whether an adviser’s domestic Section 3(c)(7) Fund offering, using general solicitation and general advertising in accordance with Rule 506(c), would be integrated with the adviser’s domestic Section 3(c)(1) Fund offering that is relying on Rule 506(b) and not using general solicitation and general advertising. If the SEC were to integrate the two offerings, the Section 3(c)(1) Fund would be held to the accredited investor verification standards of Rule 506(c) (regardless of whether the Section 3(c)(1) Fund was promoted through the use of general solicitation or general advertising).
Commodity Futures Trading Commission (CFTC) Regulation
Many private funds are also deemed to constitute commodity pools that are subject to the Commodity Exchange Act (CEA) and the CFTC regulations thereunder, as well as the rules of the National Futures Association, the designated derivatives self-regulatory organization. Certain operators or advisors to such commodity pools currently qualify for an exemption from registration as a commodity pool operator (CPO) pursuant to CFTC Rule 4.13(a)(3), or are registered as a CPO but qualify for operational exemptions pursuant to CFTC Rule 4.7 or 4.12(b) (e.g., disclosure, reporting, record keeping and advertising), provided that certain conditions are met (including with regard to the nature of the offering of interests in the pools and the pool participants). The CFTC has not yet provided guidance as to the extent to which the above exemptions may continue to be relied on by operators or advisors to private funds that are conducting Rule 506(c) offerings using general solicitation and general advertising.19
Rule 206(4)-8 under the Advisers Act
The General Solicitation Release reminds investment advisers to private funds that they are subject to Rule 206(4)-8 under the Advisers Act, which prohibits them from:
making any untrue statement of a material fact or omitting to state a material fact necessary to make the statements made, in the light of the circumstances in which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle, or
otherwise engaging in any fraudulent, deceptive or manipulative act with respect to any such investor or prospective investor. Accordingly, investment advisers seeking to employ general solicitation and general advertising in a Rule 506(c) offering should, in particular, ensure that they have properly implemented policies and procedures that are reasonably designed to prevent violations of Rule 206(4)-8.20
While the General Solicitation Rules constitute a significant easing of the restrictions on the manner in which certain private funds are offered and sold, they do not ease the licensing requirements for those who engage in selling interests of such private funds. Recent public comments by the SEC staff, along with increased SEC enforcement activity, emphasize the need for those engaged in the sale of private funds to be registered as broker-dealers or to be associated with broker-dealers, unless an appropriate exemption is available.21
In addition, while Section 201(c) of the JOBS Act created an exemption from broker-dealer registration for investment portal operators,22 reliance on that exemption when marketing private funds may be of limited use, as active marketing and transaction-based compensation, among other factors common in private fund distributions, would eliminate the availability of that exemption from broker-dealer registration.
SEC Rule Proposals
The SEC also proposed additional rules to help it monitor the impact of the General Solicitation Rules and to address various investor protection concerns.
If adopted, the Proposed Rules would:
Amend Rule 503 of Regulation D to require an issuer to: (i) file Form D no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering; and (ii) file a closing Form D amendment within 30 calendar days after the termination of a Rule 506 offering;
Amend Form D to require additional information, primarily with respect to Rule 506 offerings;
Amend Rule 507 of Regulation D to disqualify an issuer from relying on Rule 506 for one year in connection with future offerings if the issuer, or any predecessor or affiliate,23 did not comply within the last five years with Form D filing requirements as part of a Rule 506 offering;
Adopt Rule 509 of Regulation D to mandate certain legends and other disclosures on written general solicitation materials used in Rule 506(c) offerings;
Adopt Rule 510T of Regulation D to require that written general solicitation materials used in Rule 506(c) offerings be submitted to the SEC on a temporary basis; and
Amend Rule 156 under the Securities Act (currently applicable to registered funds, including mutual funds) to apply to sales literature of private funds.
According to the Proposing Release, the SEC anticipates that the elimination of the ban against general solicitation vastly impacts the private issuer market and will potentially increase the types of issuers that raise capital using Rule 506, the types of investors who are solicited and the amount of capital that will be raised in reliance on Regulation D. The stated purpose of the Proposed Rules is to enhance the SEC’s ability to evaluate market practices in Rule 506 offerings and to address issues that are expected to arise in connection with general solicitations and general advertising.