White Paper: Lifting the Ban on General Solicitation by Hedge Funds under the Jobs Act
Instituted in 1982, Rule 506 of Regulation D is a non-exclusive safe harbor promulgated under Section 4(a)(2) of the 1933 Securities Act. The rule exempts transactions by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act. Rule 506 allows issuers to offer and sell securities, without any limitation on the offering amount, to an unlimited number of “accredited investors,” as defined in the rule, and to no more than 35 non-accredited sophisticated investors. The current rule contains a number of conditions, including a requirement that the offering cannot involve any “general solicitation or general advertising.”
Prior to passage of the Jobs Act (the “Act”), for a communication to a potential investor to occur under Rule 506, the SEC required that a pre-existing, substantive business relationship between the issuer and the potential investor existed. In other words, an issuer could only contact prospective investors within its close ambit of contacts.
Enacted into law on April 5, 2012, Title II of the Jobs Act directs the SEC to eliminate the ban on general solicitation and advertising under Rule 506 provided the securities are sold only to accredited investors. As long an issuer takes reasonable steps to verify that purchasers of securities are accredited investors, such issuer may solicit investors and advertise its offering by virtually any means of communication, including the internet.
On August 29, 2012 the SEC proposed amendments that would effectuate the Act’s elimination of the ban on general solicitation under new Rule 506(c). In its release, the SEC specified that in order to take advantage of the proposed rule, an issuer must reasonably believe, and take “reasonable steps” to verify, that investors are accredited investors. Rather than enumerating specific steps an issuer would have to satisfy, the commission explained that an objective analysis based on the facts and circumstances of each transaction would be applied to determine whether reasonable steps were taken. Among the objective factors cited were the following:
- The nature of the purchaser and the type of accredited investor they claim to be;
- The amount and type of information that the issuer has about the purchaser;
- The nature of the offering, such as the manner in which the purchaser was solicited to participate and the terms of the offering, such as the minimum investment amount.
Rule 501(a) of the ‘33 Act sets forth various classes of accredited investors including natural persons with over $1 million in net worth (excluding the value of their primary residence), individuals with more than $200,000 in income over the previous two year, registered investment companies and 501(c)(3) organizations with $5 million in total assets, among others. The SEC pointed out that the reasonable steps needed to verify the status of a registered broker dealer (which can be done readily with an internet search on Edgar) will not be the same as those needed to verify the qualification of a natural person. When ready verification is more difficult, such as in the case of a natural person, the more information a issuer has indicating a prospective purchaser is accredited the fewer steps need to be taken, and vise versa. Publically available information, in federal or state securities filings, disclosing a prospective purchaser’s qualification, copies of W-2s or information regarding where a prospective purchaser works (such as an industry publication indicating that average annual salary for an employee of the purchaser’s type is information an issuer may reasonable rely on to determination qualification). Verification of accredited investor status by third parties such as a registered broker dealer, attorney or accountant, where the issuer has a reasonable basis to rely on such third party, would also be considered objective criteria by which to make a reasonable determination as to status.
The SEC indicated that the manner and terms of an offering is a further factor in evaluating whether reasonable steps were taken to verify qualification. If a solicitation was conducted on a website accessible to the general public or through a widely disseminated email, an issuer is likely to be required to take greater measures than if investors were culled from a pre-screened database of accredited investors compiled by a registered broker dealer, for example. In the event that solicitation was conducted on a broad scale basis having prospective investors simply check a box on the subscription document would not suffice to satisfy the reasonable verification standard, absent other information regarding such investor’s qualification. However, having a third party, upon which the issuer could reasonable rely, verify such investor’s status may be sufficient. Additionally, an investor’s ability to meet a high minimum initial investment would be relevant to making a reasonable assessment of a purchaser’s status – provided the investment is not financed by the issuer or any third party. Regardless of the factors involved in each individual determination, the Commission pointed out that it is important for issuers to retain adequate records that document the steps taken to verify that a purchaser was an AI.
The Road Ahead – Outstanding Questions
The amendments to Rule 506 are not yet effective. The proposed rules’ comment period has passed and the SEC is now considering those comments. It is unclear when the Commission will issue final rules, which could vary from the proposed rules, and provide the effective date for the rule changes. Until adopted, the SEC has indicated that market participants should continue to follow customary procedures with respect to Rule 506.
Additionally a number of questions remain unresolved. In the private fund space where the lifting of the ban on general solicitation has lead some to predict that hedge funds would begin buying naming rights for sports stadiums and advertising on prime time television, a variety of questions remain, including whether:
- An existing fund that has accepted non-accredited investors be allowed to take advantage of Rule 506(c)?
- Whether an existing fund be required to perform due diligence regarding the accredited investor status of its pre-existing investors in connection with its election to become a 506(c) issuer? In the event that the SEC requires due diligence, many private funds may discontinue their existing offerings under 506(b) and, after dormant period, commence new offerings under 506(c).
- Will the CFTC reconcile its existing prohibition on advertising by certain commodity pools with 506(c)? Given recent broadening of the definition of a commodity pool to include swaps and the removal of the qualified purchaser exemption, this is especially relevant to private funds today. Since the JOBS Act does not mention private funds in its text or the legislative history, the CFTC could conclude that commodity pool rules do not need to be addressed. While this seems unlikely, harmonization of the agencies rules may take an extended period and leave may CPOs and exempt pools in limbo.
- Will there be additional guidelines as to how private funds are to verify accredited investor status? One of the likely modifications to the private fund’s current legal documentation is that an adviser will ask each new investor to affirm that their subscription was funded without the use of financing.