By Peter Tyson and Simon Riveles
Following the SEC’s adoption of amended Rule 506, the SEC has proposed amendments to Rule 156 of the Securities Act of 1933 to extend the rule’s interpretive guidance on sales literature to private funds. The proposed amendments to Rule 156 reflect the SEC’s concerns regarding fraudulent and misleading sales literature, the incidence of which could increase given the adoption of Rule 506(c), which allows private funds to use general solicitation as a means for capital formation.
Background to Rule 156
Rule 156 provides guidance on the types of information in investment company sales literature that could be misleading for purposes of federal securities laws pertaining to anti-fraud, including Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Section 10b-5 thereunder. “Sales literature” under Rule 156 includes any communication in writing, by radio, or by television, used by any person to sell or induce the sale of securities of any investment company. Communications between issuers, underwriters and dealers are included in the definition of sales literature if the communication (or the information it contains) can be “reasonably expected” to be communicated to prospective investors in the offer or sale of securities, or are designed to be employed in written or oral form in the offer or sale of securities.
Essentially, Rule 156 prohibits any person who directly or indirectly uses sales literature that is materially misleading in connection with the offer or sale of securities issued by an investment company. Sales literature is materially misleading if it: (a) contains an untrue statement of material fact, or (b) omits to state a material fact that is necessary in order to make a particular statement not misleading in light of the circumstances in which that statement was made. Rule 156 does not prohibit or permit any particular statements or representations. Ultimately, whether or not a particular statement is materially misleading depends on an evaluation of the context in which it is made.
Rule 156 provides a few examples of general factors that could cause a statement to be misleading, including:
1. Statements made in connection with the offer or sale of the securities in question;
2. The absence of explanations, qualifications, limitations, or other statements necessary or appropriate to make a given statement not misleading; or
3. General economic or financial conditions or circumstances.
Rule 156 also provides a non-exhaustive list of circumstances where representations about past or future performance could be misleading, including:
1. Representations, as to security of capital, possible future gains or income, or expenses associated with an investment;
2. Representations implying that future gain or income may be inferred from or predicted based on past investment performance; or
3. Portrayals of past performance, made in a manner that would imply that gains or income realized in the past would be repeated in the future.
Finally, Rule 156 provides a few examples of where a statement involving a material fact about the characteristics or attributes of an investment company could be misleading, including:
1. Statements about possible benefits connected with, or resulting from, services to be provided or methods of operation that do not devote an equal amount of time discussing the risks or limitations associated therewith;
2. Exaggerated or unsubstantiated claims about management skill or techniques, characteristics of the investment company or an investment in securities issued by the company, services, security of investment or funds, effects of government supervision, or other attributes; and
3. Unwarranted or incompletely explained comparisons to other investment vehicles or to indexes.
SEC’s Proposed Amendments to Rule 156
Currently, Rule 156 only applies to sales literature of registered investment companies. The proposed amendments will extend the application of the rule’s guidelines to private funds making general solicitations under Rule 506 in order to address concerns about: (i) advertising performance without providing adequate disclosure of unusual circumstances that have contributed to fund performance; (ii) advertising performance without providing adequate disclosure of the performance period, or that more current information about performance is available; and (iii) advertising performance based on selective time periods without providing disclosure that would permit an investor to evaluate the significance of performance that is based on selective time periods.
The SEC has requested comment on the proposed amendments to Rule 156, and has specifically requested comment on potential form and content restrictions for private funds. Some commentators have expressed concern that general solicitation materials for private funds raise a substantial risk of investor confusion, and may cause investors to draw unwarranted conclusions when comparing the performance of private funds, which are not subject to standardized performance calculations and reporting requirements, to the performance of other funds. It has also been noted that private fund portfolios tend to be more illiquid and difficult to value than registered investment companies, which may also result in misleading performance data due to faulty valuations. Such comments ultimately raise the suggestion that either the SEC develops standardized performance methodologies, or private funds should be entirely prohibited from including performance data in general solicitation materials. However, other comments have suggested that the limitation of general solicitations to accredited investors will limit the risk of investor harm.
In light of the adoption of Rule 506(c) and the proposed amendments to Rule 156, private fund managers intending to use general solicitation should carefully consider the guidelines provided under Rule 156 and ensure that all general solicitation materials abide by such guidelines. Additionally, private fund managers should pay further attention to the development of Rule 156 in case certain form and content restrictions are included in the final rules.
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