On July 10, 2013, the SEC took the following actions that are likely to have a significant impact on hedge funds, private investment funds and other companies that raise capital through private offerings of securities:
(1) adopted rules to repeal the prohibition against general solicitation and advertising in securities offerings in which all purchasers are accredited investors under Rule 506 of Regulation D,
(2) adopted rules to disqualify offerings under Rule 506 that involve certain felons and other “bad actors,” and
(3) proposed rules that would:
- require additional filings at least 15 days before general solicitation begins and within 30 days after completion of the offering
- if filings are not made, disqualify future offerings from reliance on Rule 506.
The rules adopted should become effective in about two months. It is not clear when the proposed rules might become effective.
Repeal of ban on general solicitation:
By allowing advertising of private offerings, the new rules could give companies access to a much larger group of potential investors.
General solicitation will be allowed in Rule 506 offerings, if the issuer complies with the other applicable requirements of Regulation D, and:
- The issuer takes reasonable steps to verify that each investor is an accredited investor, and
- Either (1) each investor actually is an accredited investor, or (2) the issuer reasonably believes that each investor is an accredited investor.
“Reasonable steps to verify” is not defined, but the nature of each purchaser and transaction may determine what steps are reasonable. The SEC set out a non-exclusive list of steps that will satisfy the requirement, including:
- reviewing any IRS document that reports income and obtaining representations about expected income
- reviewing bank, brokerage or similar statements and obtaining representations that liabilities have been disclosed
- obtaining representations from registered broker-dealers or investment advisers, licensed attorneys or CPAs that they have confirmed accredited investor status
- for investors in an issuer’s previous offerings under Rule 506 who are natural persons and continue to hold securities, obtaining certifications from the investor.
Addressing a concern for private funds that rely on exclusions from the definition of “investment company” under the Investment Company Act that prohibit public offerings, the SEC confirmed that offerings conducted in compliance with the new rules will not jeopardize these exclusions.
Bad actor disqualification:
An issuer will not be able to rely on Rule 506 if certain persons involved with the company or the offering (including directors, executive officers, officers participating in the offering, general partners, managing members, 20% beneficial equity owners, promoters, placement agents and, for investment funds, their investment managers and controlling persons) have been subject to a “disqualifying event” since the effectiveness of the new rules. Disqualifying events occurring in the past might require disclosure to investors. A “disqualifying event” includes a conviction of securities fraud and other violations relating to securities offerings, investment activities and filings with the SEC.
If an issuer can show that it did not know and, with the exercise of reasonable care, could not have known of a disqualifying event, it can still rely on Rule 506.
Proposed rules:
The SEC proposed new requirements and limitations that, if adopted, would apply to offerings under Regulation D, including:
- A Form D must be filed with the SEC 15 at least days prior to any general solicitation.
- An amended Form D must be filed with the SEC within 30 days after the completion of the offering.
- The Form D must include information about the securities, the investors, the intended use of proceeds, the types of general solicitation and the methods of verification.
- Failure to file the required forms would disqualify the company from reliance on Rule 506 for one year after the delinquent filing is made.
- General solicitation materials must be submitted to the SEC on a confidential basis (this rule, intended to gather information, would expire after two years).
- Additional legends and disclosures, for all issuers, but for private funds in particular, would be required in materials distributed to investors.
The proposed rules have generated controversy within the SEC and among commentators, and the SEC has asked for input on several aspects of the proposed rules. As a result, it’s too early to predict when new rules might become effective or whether there will be changes to the rules as proposed.
Current rule still available:
The exemption under existing Rule 506, for offerings without general solicitation to accredited investors and up to 35 non-accredited investors, has not changed and can still be used.
To do now:
Hedge funds, private investment funds and other companies that foresee a need to raise additional capital should consider whether they already have a relationship with investors who can provide the needed capital. If not, and assuming rules similar to those proposed will be adopted, companies should consider whether the additional disclosure, advance filing and verification requirements are an acceptable price to pay for opening their offerings up to a broader group of investors.
