The Securities and Exchange Commission (“SEC”) voted yesterday to eliminate the ban on general solicitation and advertising for offerings conducted under Rule 506 of Regulation D. Private investment funds can now offer their securities freely and solicit investors with no restriction provided that they:
- take reasonable steps to verify that the investors are accredited investors; and
- all purchasers of their securities fall within one of the categories of persons who are accredited investors under an existing rule (Rule 501 of Regulation D) or the fund reasonably believes that the investors fall within one of the categories at the time of the sale of the securities.
This means that although offers of fund interests will be unrestricted by private funds that will engage in general solicitation, sales of those interests will be restricted to accredited investors only and will be subject to the new verification requirement regarding accreditation.
Note that the verification requirement is separate and independent from the requirement that all sales be limited to accredited investors. In other words, the verification requirement must be satisfied even if all investors happen to be accredited. The new verification requirement was the subject of several comment letters addressed to the SEC. Commenters requested that the SEC give more guidance related to what funds should do to verify the status of their investors. Although the SEC reiterated that the appropriate steps depend on the particular circumstances of the offering, it did provide a non-exclusive list of four verification methods that would be deemed sufficient for checking the status of natural persons (no list was given for entity investors). The four verification methods are:
- Review of IRS tax forms reporting income such as W-2s, Form 1040 and Schedule K-1s;
- Review of assets and liabilities. For asset review, a fund can use bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties. For liabilities, a fund should review a consumer report (also known as a credit report) from at least one of the nation-wide consumer reporting agencies and also obtain a written representation from the investor that all liabilities necessary to make a determination of net worth have been disclosed;
- Written confirmation from a registered broker-dealer, a SEC-registered investment adviser, a licensed attorney, or a certified public accountant that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor;
- With respect to pre-existing investors in the fund (i.e. for natural persons who invested prior to the recent amendments), a self-certification by the person at the time of sale that he or she qualifies as an accredited investor.
It is important to note that the ability of issuers to conduct Rule 506 offerings under the existing regime has been preserved under the final rule. Accordingly, funds that opt to offer their interests without recourse to general solicitation or advertising need not comply with the requirement to take “reasonable steps” to verify the financial status of purchasers as accredited investors and can continue to privately offer securities to up to 35 non-accredited investors (in addition to an unlimited number of accredited investors). Funds may wish, for instance, to avoid general solicitation and retain the ability to offer to 35 non-accredited investors in order to offer their interests to their own employees who do not meet the accredited investor standard. Retaining the ability to offer without general solicitation may also be beneficial for funds that offer their interests to investors with whom they have a pre-existing relationship. Another reason fund managers may wish to offer securities without general solicitation would be in order to continue relying on CFTC exemption 4.13(a)(3) which allows commodity pool operators to avoid registration if they trade a de minimis amount of commodity interests provided that the “interests in the pool are offered and sold without marketing to the public in the United States” (which requirement appears to preclude general solicitation).
When filing their Form D, funds should from now on indicate whether they wish to engage in general solicitation and conduct an offering under new Rule 506(c) or conduct an offering without general solicitation pursuant to the old regime under Rule 506(b). Funds already in existence should amend their Form D to report their chosen manner of offering and should also adopt promptly new policies and procedures in their compliance manuals to reflect the new rules.
Please note that the amended Rule 506 affects only Rule 506 offerings and not Section 4(a)(2) offerings in general. Thus, even after the effective date of amended Rule 506, a fund relying on Section 4(a)(2) outside of the Rule 506 exemption will be restricted in its ability to make public communications to solicit investors for its offering because public advertising will continue to be incompatible with a claim of exemption under Section 4(a)(2).
Note also that the SEC adopted yesterday a second rule that disqualifies funds from participating in a rule 506 offering if felons and other “bad actors” participate in the offering. In addition, the SEC adopted yesterday a rule proposal which aims at improving the information provided by issuers engaging in general solicitation in order to avoid fraudulent activity and manipulation of investors.
The two new rules can be found here (Final Rule — Lifting General Solicitation Ban & Final Rule — Disqualification of Bad Actors) and the new proposal can be found here (Rule Proposal — Regulation D Amendments). The new rules will become effective 60 days after their publication in the Federal Register. We will analyze the rules and the proposal further, but please contact us if you have with any questions in the meantime.
