Private Equity Newsletter - Autumn 2013 Edition: SEC Permits General Solicitation and General Advertising in Private Placement Offerings

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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. 

Transitional Matters

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:

  1. 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
  2. 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

Broker-Dealer Registration

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.

Footnotes

1 Under the Rule 506(b) safe harbor, an issuer may offer and sell securities, without any limitation on the offering amount, to an unlimited number of “accredited investors,” as defined in Rule 501(a) of Regulation D, and to no more than 35 non-accredited investors who meet certain “sophistication” requirements. The availability of the Rule 506(b) safe harbor is subject to a number of requirements and, pursuant to Rule 502(c), is conditioned on the issuer, or any person acting on its behalf, not offering or selling securities through any form of general solicitation or general advertising.

2 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44771 (July 24, 2013) (General Solicitation Release). 

3 Release No. 33-9416, Amendments to Regulation D, Form D and Rule 156 under the Securities Act, July 10, 2013 (Proposing Release). 

4 The General Solicitation Release reaffirms previous guidance by the SEC regarding what constitutes general solicitation or general advertising, but does not provide further discussion. See General Solicitation Release at 44773.

5 In the General Solicitation Release, the SEC confirmed that Section 201(a)(1) of the JOBS Act does not alter the existing “reasonable belief” standard. The General Solicitation Release notes that if a prospective investor were to provide an issuer with false information as to its accredited investor status within one of any of the eight enumerated categories in Rule 501(a), the issuer would not lose its ability to rely on Rule 506(c) for that offering, provided the issuer “took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.” See General Solicitation Release at 44782-783.

6 Rule 501 provides the definitions used in Regulation D, including the multiple categories of accredited investors.

7 Rule 502(a) outlines the factors to be considered in determining whether a Rule 506 offering should be integrated with another offering.

8 Rule 502(d) provides that securities sold under Regulation D are restricted securities under the Securities Act and cannot be resold without registration under the Securities Act or an exemption therefrom.

9 It should be noted that, with respect to a Rule 506(c) issuer relying on the exclusion from the definition of an “investment company” available under Section 3(c)(7) of the Investment Company Act of 1940 (Investment Company Act), the General Solicitation Rules do not increase existing diligence expectations in connection with such issuer’s determination as to whether a prospective investor is a “qualified purchaser” as defined under the Investment Company Act.

10 See General Solicitation Release at 44778.

11 The General Solicitation Release notes that “these factors are interconnected” and the more the “facts and circumstances” analysis of a purchaser indicates that the purchaser likely qualifies as an accredited investor, the fewer steps would be needed to verify accredited investor status. See Id.

12 See General Solicitation Release at 44778-782.

13 The General Solicitation Proposing Release did not include a specific list of verification methods. In response to commenters seeking greater certainty regarding how to properly satisfy the verification requirement, the SEC included a non-exclusive list of methods in the General Solicitation Release. See General Solicitation Release at 44780-782.

14 The General Solicitation Release states, however, that actual knowledge of a purchaser’s non-accredited investor status precludes an issuer or its agent from relying on these verification methods. See General Solicitation Release at 44780.

15 The General Solicitation Release states that an issuer may also be entitled to rely on third-party verification of accredited investor status by a person or entity other than those listed in the General Solicitation Release, provided that any such third-party takes reasonable steps to verify that purchasers are accredited investors, and the issuer has a reasonable basis to rely on such verification. See General Solicitation Release at 44781-782.

16 The General Solicitation Release does not clarify whether this fourth method would be applicable to a purchaser of a sponsor’s private fund (i.e., the issuer) that seeks to invest in that sponsor’s successor private fund (i.e., the successor issuer). However, some members of the private fund industry are of the view that this fourth method should be available to a sponsor that is offering interests in a successor private fund under Rule 506(c). 

17 QIB is defined in Rule 144A(a)(1) and includes specified institutions that, in the aggregate, own and invest on a discretionary basis at least $100 million in securities of issuers that are not affiliated with such institutions. Banks and other specified financial institutions must also have a net worth of at least $25 million. A registered broker-dealer qualifies as a QIB if it, in the aggregate, owns and invests on a discretionary basis at least $10 million in securities of issuers that are not affiliated with the broker-dealer. 

18 The General Solicitation Release confirms that, with respect to ongoing Rule 144A offerings that commenced prior to the effective date of the General Solicitation Rule, the issuer may proceed with the offering after such effective date in accordance with the amended Rule 144A, without affecting the availability of Rule 144A for the portion of the offering that occurred prior to such effective date. See General Solicitation Release at 44786.

19 In addition, it may be appropriate for the CFTC to provide guidance as to the effect that such use of general solicitation and general advertising by a CPO and/or a commodity trading advisor (CTA) may have on certain other exemptive provisions of  the CEA and CFTC regulations, including: (1) with respect to CPOs, CFTC Rules 4.8, 4.13(a)(1), 4.13(a)(2) and 30.4(c); and (2) with respect to CTAs, CEA Sections 4m(1) and 4m(3) and CFTC Rules 4.14(a)(5), 4.14(a)(8)(i)(C), 4.14(a)(8)(ii)(B) and 4.14(a)(10).

20 Interestingly, the General Solicitation Release does not discuss Rule 206(4)-1 under the Advisers Act, which many people in the private offering industry believe is not applicable to a private fund’s sales materials.

21 See "Recent SEC Actions Focus on Broker-Dealer Activity of Private Funds, Highlight Perils, and Generate Controversy," DechertOnPoint (April 22, 2013), regarding such recent SEC staff comments and increased SEC enforcement activity. 

22 See "Investment Portals Addressed in SEC Staff Guidance Under JOBS Act; No-Action Letters Also Issued," DechertOnPoint (May 14, 2013), regarding this exemption from broker-dealer registration for investment portal operators. 

23 Rule 501(b) of Regulation D defines an “affiliate” as a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified.

 

Topics:  General Solicitation, JOBS Act, Private Equity, Rule 144A, Rule 506 Offerings, Safe Harbors, SEC, Securities Act of 1933

Published In: Communications & Media Updates, Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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