The overwhelming majority of hedge funds and private equity funds rely on an exemption from registration found in Rule 506 under Regulation D of the Securities Act. Prior to September 2013, Rule 506 was restrictive in that it required hedge fund managers to establish a pre-existing relationship with investors and placed a firm prohibition on general solicitation and advertising practices.
As we have previously written regarding hedge fund advertising rules, in September 2013 the SEC expanded Rule 506 to include an alternative exempt offering framework. Under new Rule 506(c), issuers may engage in general solicitation and advertising practices when offering securities, provided that all purchasers of the securities are verified (more below) accredited investors. Under the expanded Rule 506 framework, issuers have the option to continue to rely on the original Rule 506 exemption—now found under Rule 506(b)—which still prohibits general solicitation and advertising practices.
Although the establishment of Rule 506(c) removed the general solicitation and advertising prohibition—effectively freeing fund managers to advertise hedge fund offerings through television, newspapers, websites, etc.—relatively few issuers have opted to take advantage of it. In January 2016, SEC Chair Mary Jo White stated that from September 2013 through late 2015, 506(c) offerings only had a $71 billion market as opposed to the $2.8 trillion market for 506(b) offerings. This is likely due in part to the heightened verification requirement of Rule 506(c); whereas Rule 506(b) allows potential investors to self-certify their accredited status, Rule 506(c) requires that issuers take “reasonable steps” to verify the accredited status of each investor. Rule 506(c) sets out three primary methods of verification:
Income: Issuers can review any I.R.S. form that reports the investor’s income for the two most recent years. This includes, but is not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040. In addition to I.R.S. forms stating the investor’s income for the two most recent years, an investor must make written representation that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor.
Net Worth: Issuers can review documentation dated within the prior three months to determine whether an investor meets the requisite net worth to qualify as an accredited investor. For assets, issuers can review bank statements, brokerage statements, certificates of deposits, tax assessments, and other appraisal reports by third parties. With respect to liabilities, issuers can utilize a consumer report from a nationwide consumer reporting agency.
Professional Verification: Issuers can obtain written confirmation from persons or entities that have taken reasonable steps to verify the investor is an accredited investor within the prior three months and has determined that the investor is an accredited investor. This includes a registered broker-dealer; an investment adviser in good standing with the SEC; a licensed attorney in good standing under his or his jurisdiction; or a CPA who is registered and in good standing under the laws of the place of his or her residence or principal office.
Although the above-listed safeguards will apply to most new purchasers, the SEC also included a safeguard for issuers that obtain a written certification from an accredited investor who purchased securities pursuant to 506(b) from the issuer prior to September 23, 2013, if that same issuer conducts a Rule 506(c) offering at a later date.
While the heightened verification requirement of Rule 506(c) does require more effort and due diligence on behalf of the issuer, the ability to publicly advertise may help issuers raise additional capital. Rule 506(c) provides the above-listed safe harbors, but the SEC has indicated issuers may be able to satisfy verification obligations through other means. In addition, there has been a rise in independent, third-party verifiers that are willing to conduct accredited investor status verification and certification for issuers in accordance with the Rules.
Please feel free to contact us if you have any questions regarding exempt offerings under Rule 506(c) or other aspects of Regulation D.