On July 10, 2013, the Securities and Exchange Commission (“SEC”) approved final rules pursuant to the Jumpstart our Business Startups Act (“JOBS Act”) that remove the ban on general solicitation and advertising practices for certain private offerings made in reliance on Rule 506 under Regulation D of the Securities Act. After taking nearly a year to implement the originally proposed rule amendments, the SEC’s final rules will become effective on September 23, 2013. As previously discussed (see here, here, here and here), the removal of the general solicitation and advertising ban is a watershed event that will significantly alter the capital-raising landscape for private fund managers going forward.
Amendments to Rule 506 and Rule 144A to Eliminate the General Solicitation and Advertising Ban
Under new Rule 506(c), issuers may engage in general solicitation and general advertising practices when offering securities, provided that:
1) All purchasers of the securities are accredited investors; and
2) The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.
Defining what constitutes “reasonable steps to verify” accredited investors will be the crux of the new rules. In response to heavy criticism to the proposed rule amendments, the SEC included the following verification methods in Rule 506(c) (though not exclusive, the list provides a helpful guideline to managers relying on the new rules):
1) Documentation of income, such as a review of the investor’s income tax returns for the previous two years;
2) Documentation of net worth, such as a review of the investor’s bank or brokerage statements;
3) Third-party verification from a broker-dealer, certified public accountant, licensed attorney, etc.; and
4) Reliance on written verification from an existing investor who invested in the underlying Rule 506 offering prior to the new rules taking effect.
Note that issuers also have the option to continue to rely on the original Rule 506 exemption instead (now found under Rule 506(b)), which still prohibits general solicitation and advertising practices. However, in contrast to Rule 506(c), Rule 506(b) allows issuers to accept up to thirty-five (35) non-accredited investors in the offering. For many start-up and emerging managers, the decision whether to launch as a Rule 506(b) or a Rule 506(c) offering will ultimately hinge on the tradeoff between utilizing general solicitation and advertising practices versus retaining the flexibility to accept investments from certain non-accredited family members and friends.
The SEC also adopted amendments to Rule 144A under the Securities Act which will allow issuers to offer securities to persons other than qualified institutional buyers (“QIBs”), including by means of general solicitation and advertising practices, provided the securities are only sold to investors the issuer reasonably believes are QIBs.
“Bad Actor” Disqualification
The SEC also approved final rules that disqualify issuers from utilizing the Rule 506 exemption if certain felons and other “bad actors” are involved in the offering. In contrast to the originally proposed rules, disqualifications will apply only for triggering events that occur after the effective date of the new rule (subject to mandatory disclosures).
Proposed Form D Amendments
Finally, the SEC proposed rules for comment regarding changes to Form D filing requirements and additional content distributed pursuant to Rule 506 offerings. Form D will be revised to require issuers to check a box indicating whether they are relying on Rule 506(c) for the underlying offering. The proposed rules would also require issuers that intend to rely on Rule 506(c) to file Form D no later than 15 days before engaging in general solicitation or advertising practices (currently an issuer must file a Form D within 15 days after the first sale of securities in the offering).
Conclusion
Issuers will only be able to opt-in to Rule 506(c) and utilize general solicitation and advertising practices if they take reasonable steps to verify that all investors are accredited. Note that fund managers may choose to continue an offering that commenced prior to the effective date of the final rules as either a Rule 506(b) or a Rule 506(c) offering, despite the offering not previously having been in compliance with Rule 506(c). However, fund managers electing to opt-in to Rule 506(c) will need to take appropriate action to confirm compliance with the new rules going forward, including modifying existing offering documents, updating record-keeping and due diligence procedures, etc., as well as amending Form D filings accordingly.
Please feel free to contact us if you have any questions regarding the status of the JOBS Act or its potential impact on hedge fund marketing activities.
