After missing the congressional mandate to have rules promulgated by July 4, the U.S. Securities and Exchange Commission (SEC) proposal rules on August 29 that, if adopted as proposed, would eliminate the prohibition against general solicitation and general advertising in Rule 506 (so-called “Reg. D offerings”) and Rule 144A offerings. This alert focuses on the proposed addition of new Rule 506(c) to Reg. D.
The proposal is very friendly to all private funds. If adopted in its current form, it will eliminate the requirement that funds raise money without advertising or engaging in a general solicitation. Currently, a fund can only solicit investors with whom the fund (its managers, sponsors, etc.) has a “pre-existing substantive relationship.” Obviously, without the advertising prohibition, this would not apply. However, the proposal explicitly does not change any other aspect of Reg. D not specifically implicated by the general solicitation rule. Interestingly, the proposed rule specifically does not affect issuers who are relying on the statutory exemption contained in Section 4(a)(2) (formerly Section 4(2)) under the Securities Act of 1933, and who have not filed a Form D in reliance on that statutory language. Under the proposal, in order to be able to advertise and engage in a general solicitation, a private fund will need to file a Form D (as modified by the proposal) and indicate how the offering complies with the new safe harbor.
The SEC’s proposal tracks the congressional mandate, clearly stating that an issuer will still satisfy the new safe harbor even though its securities are offered using advertising and solicitation so long as only accredited investors are allowed to purchase the securities. No sales to non-accredited purchasers will be allowed if the issuer advertises or engages in a general solicitation of investors. The proposal would not change the definition of “accredited investor” or the current Reg. D exemption that allows sales to a limited number of non-accrediteds if there is no advertisement or solicitation and certain other conditions are met.
The SEC outlined three conditions to using the new rule: (1) the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors; (2) all purchasers must be accredited investors, either because they meet actually qualify as such or because the issuer reasonably believes they are accredited at the time of the sale of the securities; and (3) all the other terms of Reg. D must be satisfied.
Pepper Point: Upon adoption of the final rule and assuming it is not eroded from its current form, a private fund could post information about the fund on a non-password-protected Web site, in general circulation publications and in open e-mail provided it files a Form D.
But, along with this new-found freedom will be a heightened verification requirement. For funds, the manager or sponsor raising the fund must verify that the investors who buy interests in the fund are in fact accredited. The SEC’s proposal reviews the myriad comments suggesting various forms that that verification could take and solicits public comment on many of the suggestions (such as reliance on third parties engaged to manage the privacy issues if a fund demands a copy of a W-2 to verify compliance with the gross income test for accreditation; or an objective standard based on dollar amount of investment and self-certification by the investor). Reliance on the new rule, once adopted, is conditioned on the issuer’s reasonable belief that the purchaser is accredited and the issuer’s completion of the verification. The SEC acknowledges that funds may be able to meet verification requirements simply by following their current subscription practices; but there was also a warning that mere “click through” certification of status by the prospective investor is unlikely to be enough.
The SEC’s release also offers some comfort that the potential “gotchas” under the Investment Company Act and Regulation S will not be traps for the unwary. Compliant Reg. D. offerings will be viewed for Investment Company Act purposes as not involving a public offering and for Reg. S purposes as not improperly crossing offering borders even though they use general solicitation and advertising to reach investors.
Bottom line – the jury is still out on what constitutes reasonable verification of accredited investor status, what records need to be kept, and on whom a fund and its manager may rely to confirm such status.
Pepper Point: Assuming that an adviser is registered, and the adviser is taking carry/performance allocations or fees, the investors in the fund will still need to meet the qualified client requirement anyway, and the burden is on the fund and adviser to confirm eligibility for any available exemptions under the federal securities laws.
Pepper Point: Note that the JOBS Act only changed Reg. D. It did not change the rules applicable under the Advisers Act for advisers who are trying to avoid registration as advisers under federal or state law by not “holding themselves out” as advisers ready and willing to accept investment adviser clients. Limits on advertising still apply to advisers in that context.
There is a 30-day comment period and the rule is not self-executing, meaning it will require SEC action on a final rule.
Pepper Point: What should you be doing now?
Most importantly, don’t jump the gun – keep the publicly available Web sites under wraps, and don’t start advertising until the rule is final. In this instance patience is very important. Continue to follow the current requirements for Rule 506 under Reg. D.
For those funds currently fundraising, and for which the final rule may be promulgated prior to acceptance of the subscriptions at a closing, and for those funds about to approach the market: Consider modifying your current subscription materials to elicit more information and request confirmation of income and net worth. (This is not very different from when funds started demanding copies of passports and utility bills to meet custodians’ anti-money laundering requirements. There will be resistance at first until it becomes the norm.) The general solicitation/advertising prohibition and its related “pre-existing substantive relationship” requirement have always caused angst. So, plan for the final rule and put yourself in the best position to be compliant with the new rule and avoid issues created by “pushing the margins.” But there is a fair amount of controversy over the verification process and on what (and on whom) a fund may rely to verify accredited status, and records will undoubtedly have to be kept, so a fund should not implement wholesale change in its process just yet.
Finally, share with us your views about verification or consider submitting a comment. We are collecting comments and will submit a collective comment if the traffic warrants.