United States: SEC Lifts Long-Time Ban On Advertising By Hedge Funds, Private Equity Funds, And Other Private Investment Vehicles

On July 10, the U.S. Securities and Exchange Commission ("SEC") adopted final rules under Section 201(a) of the Jumpstart Our Business Startups Act (the "JOBS Act") removing the ban against general solicitation and general advertising in private offerings made in reliance on Rule 144A and Rule 506 of Regulation D under the U.S. Securities Act of 1933 (the "Securities Act").1 The new rules went into effect on September 23.2 

The amendments to Rule 506 permit private issuers—including hedge funds, private equity funds, venture capital funds, and other private investment vehicles—to use general solicitation and general advertising in a Rule 506 private placement, as long as all purchasers are accredited investors and the issuer takes "reasonable steps" to verify that the purchasers are accredited investors. Under new Rule 506(c), private funds may now solicit investors through advertisements, articles, notices, or other communications published in any newspaper, magazine, or similar media broadcast over television, the radio, or the internet. 

In addition, the SEC adopted new Rules 506(d) and (e) and changes to Form D, which make all Rule 506 offerings subject to certain "bad actor" disqualification, disclosure, and certificate requirements.  

This Commentary focuses on the elimination of the long-time prohibition against general solicitation and general advertising on Rule 506 offerings by hedge funds, private equity funds, and other alternative investment funds. In short, although a much broader array of marketing tools is now available to be used by private fund issuers, before engaging in general solicitation in a Rule 506(c) offering, private funds and their investment advisers will need to reexamine their policies, procedures, and customary transaction documents to ensure compliance with the heightened due diligence requirements and consider whether engaging in general solicitation may conflict with other regulatory restrictions to which the fund is subject (such as CFTC regulations, the Investment Advisers Act, and any non-U.S. restrictions on advertising applicable to the fund).  

Overview of Rule 506 

Most private funds rely on the private placement exemption made available by Rule 506 to avoid the registration requirements of Section 5 of the Securities Act with respect to offerings in the United States. Rule 506 permits issuers to raise an unlimited amount of capital in private offerings sold to an unlimited number of accredited investors and up to 35 nonaccredited investors. Any form of general solicitation or general advertising was explicitly prohibited under the pre-amendment version of Rule 506 (the "Old Rule").3 This restriction had generally been interpreted broadly to prohibit, among other things, the use of publicly available websites, media broadcasts (such as radio and television advertisements), mass email campaigns, and public seminars or meetings as part of an issuer's capital-raising activities. 

Amendments to Rule 506 

The amendments add to Rule 506 a new paragraph (c), which permits the use of general solicitation and general advertising in connection with an offering of securities under Rule 506, provided that: 

  • The issuer takes "reasonable steps to verify" that the purchasers are accredited investors;
  • All purchasers of the securities are "accredited investors" (i.e., all of the purchasers fall into one of the categories set forth in Rule 501(a), or the issuer reasonably believes that all of the purchasers fall into one of such categories); and
  • All terms and conditions of Rule 501, 502(a), and 502(d), which set forth definitions, general conditions, and limitations on resale, are satisfied. 

Reasonable Steps to Verify Accredited Investor Status  

The verification requirement is a "principles-based" condition that requires the issuer to take reasonable steps to verify the accredited investor status of purchasers. Whether the steps taken were in fact reasonable is an "objective determination ... in the context of the particular facts and circumstances of each purchaser and transaction."4 

Under the principles-based approach, issuers should consider a number of interconnected factors. The more that the relevant facts and circumstances make it likely that a purchaser is an accredited investor, the fewer verification steps that will be required, and vice versa.5 The information gained by looking at the following factors would help an issuer assess the reasonable likelihood that a purchaser is an accredited investor and whether additional steps might be necessary: 

The Nature of the Purchaser and Type of Accredited Investor that the Purchaser Claims To Be. Taking reasonable steps to verify accredited investor status may differ with respect to different types of investors, such as corporations as compared to natural persons. The definition of "accredited investor" in Rule 501(a) includes eight enumerated categories of individuals or entities. Some purchasers may be accredited investors based on their status alone (e.g., an investment company registered under the U.S. Investment Company Act of 1940 (the "Investment Company Act") or a broker or dealer registered under the U.S. Securities Exchange Act of 1934 (the "Exchange Act")), while others satisfy the standard by virtue of their status and their total assets taken together (e.g., certain entities with total assets in excess of $5 million).

The Amount and Type of Information that the Issuer Has About the Purchaser. Examples of the types of information that issuers could review include publicly available information in filings with federal, state, or local regulatory bodies or information available through a third party, such as a broker-dealer, accountant, or attorney.  

The Nature and Terms of the Offering. The issuer should consider the manner in which the purchaser was solicited to participate in the offering. The more public the method (e.g., a publicly available website, social media, or mass email), the more likely additional verification steps will be required. 

It is important to note that the issuer must take reasonable steps to verify accredited investor status; an issuer will not be deemed to have complied with Rule 506(c) simply on the grounds that the purchasers ultimately were all accredited investors. In the context of a Rule 506(c) offering, the practice of accepting self-certification by an investor (i.e., a checked box on an investor questionnaire or subscription agreement) will not be sufficient on its own to demonstrate that reasonable steps have been taken to verify accredited investor status.6 

A Nonexclusive List of Methods to Verify Accredited Investor Status of Natural Persons 

In order to address industry requests that Rule 506(c) include some element of certainty with respect to verification methodologies, the SEC provided a nonexclusive list of methods that an issuer may use to satisfy the verification requirement for a purchaser who is a natural person. These methods include:  

  • Verification by Net Income. Reviewing copies of any IRS form that reports the income of the purchaser together with a written representation that the purchaser expects to continue to earn the necessary income in the current year;
  • Verification by Net Worth. Reviewing copies of bank and brokerage, certificate of deposit, tax assessment, and appraisal reports issued by independent third parties as evidence of the purchaser's assets, and a consumer credit report as evidence of the purchaser's indebtedness in each case dated within the prior three months, together with a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed;
  • Third-Party Verification. Receiving written confirmation from an SEC-registered broker–dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant7 that such entity or person has taken reasonable steps to verify the purchaser's accredited status; and
  • Verification by Existing Relationship. With respect to a purchaser who invested in a Rule 506(b) offering as an accredited investor prior to the effective date of Rule 506(c), remains an investor, and intends to invest in a Rule 506(c) offering by the same issuer, receiving a certification from the purchaser that he or she qualifies as an accredited investor. 

Issuers and investment advisers that intend to conduct a private fund offering in reliance on Rule 506(c) should make certain that they have due diligence and recordkeeping policies and procedures in place that ensure compliance with the verification required under the new rule. 

Reasonable Belief Standard 

The "reasonable belief" standard in the definition of accredited investor (i.e., that an accredited investor is a person who meets one of the enumerated categories, or who the issuer reasonably believes meets one of the enumerated categories) is unchanged by the amendment to Rule 506. As long as an issuer takes reasonable steps to verify that a purchaser is an accredited investor and has a reasonable belief that the purchaser is an accredited investor, the issuer would not lose the ability to rely on Rule 506(c) if it is later discovered that the purchaser is not in fact an accredited investor. On the other hand, an issuer that fails to take reasonable steps to verify accredited investor status will lose the benefit of Rule 506(c) even if all purchasers are accredited investors.  

"Bad Actor" Disqualification and Revised Form D 

The SEC adopted new Rules 506(d) and (e) and changes to Form D, which make all Rule 506 offerings subject to certain "bad actor" disqualification, disclosure, and certificate requirements. Generally, where issuers are associated with events specified by Congress as indicators of financial or disclosure fraud or misconduct, the use of Rule 506 will be prohibited (or, with respect to pre-September 23 "bad actor" events, permitted only with disclosure of such bad acts). Form D was amended to add a check box for issuers to indicate whether they are relying on Rule 506(c). The SEC noted that this would give it an opportunity to monitor the use of general solicitation in private offerings and would assist it in evaluating the effectiveness of various accredited investor verification practices. 

The Impact of Rule 506(c) on Private Funds 

Amended Rule 506 substantially increases the types of permitted fundraising activities of private funds. Under Rule 506(c), funds are now permitted to engage in all forms of communication with prospective investors, including forms of communication traditionally viewed as general solicitation, as long as (i) the only investors actually admitted into the fund qualify as "accredited investors" or who the fund reasonably believes would so qualify, and (ii) the fund takes reasonable steps to verify the accredited investor status of each of the investors admitted to the fund. 

Most private funds rely on the Section 3(c)(1) or 3(c)(7)9 exclusions under the Investment Company Act to avoid being deemed investment companies. Both Section 3(c)(1) and 3(c)(7) require that the fund is not making and does not propose to make a "public offering" of its securities. The SEC has expressly confirmed that an offering made pursuant to Rule 506(c) will not constitute a public offering for purposes of Sections 3(c)(1) and 3(c)(7).10

However, private funds and their investment advisers will need to consider whether engaging in general solicitation may conflict with other regulatory restrictions to which the fund is subject. Outlined below are several of the key factors to be considered in making such a determination. 

Investment Advisers Act 

Investment advisers that are registered with the SEC must continue to comply with rules relating to advertising under the U.S. Investment Advisers Act of 1940 (the "Advisers Act"). For example, a registered investment adviser is limited in its ability to use marketing materials that refer to any testimonial concerning the investment adviser or that refer to its past specific investment recommendations. Investment advisers are also limited in the way that they may present a track record. Adequate disclosures are typically required in order to ensure that information will not be deemed to be misleading, inaccurate, or incomplete.  

For investment advisers that take advantage of certain exemptions from Advisers Act registration, such as the foreign private adviser exemption, it is important to note that the SEC did not indicate whether it would view an investment adviser to a private fund that conducts an offering under Rule 506(c) as not "holding itself out" as an investment adviser, which is a key condition required in order to take advantage of the exemption. 

CFTC 

The use of general solicitation or general advertising may affect the availability of certain exemptions under rules promulgated by the Commodity Futures Trading Commission ("CFTC"), including the de minimis exemption from registration as a commodity pool operator under CFTC Rule 4.13(a)(3). The de minimis exemption requires that interests in each applicable fund be "offered and sold without marketing to the public in the United States." Without a contrary holding by the CFTC, it appears that private funds using general solicitation may not be able to rely on the Rule 4.13(a)(3) exemption. CFTC Rule 4.7, which provides relief from certain regulatory requirements for CFTC-registered commodity pool operators, also includes a restriction against general solicitation.           

Anti-Fraud Rules and Foreign Publicity Restrictions 

Marketing materials used to solicit prospective investors remain subject to the anti-fraud rules under the U.S. federal securities laws, including Rule 10b-5 under the Exchange Act and Rule 206(4)-8 under the Advisers Act. In addition, many non-U.S. jurisdictions have their own publicity rules and restrictions in connection with an offering that must be observed if the fund is marketed in those jurisdictions. 

State Registration as an Investment Adviser           

By lifting the ban on general solicitation, Rule 506(c) will allow contact with potential investors through unblocked internet websites, which means that private funds could potentially solicit investors in many different states within the United States. Commonly referred to as the "de minimis" exemption, most states have a maximum number of clients an investment adviser (who does not have an office in the state or is not otherwise registered with the SEC) may have without being required to register in that state. The number varies from state to state. In many states the number is five or fewer, in other states the number is six, while a few state statutes have no de minimis exemption and require firms to register in the state if they have just one client in the state. Furthermore, there are some states with more stringent rules requiring that the adviser not "hold itself out to the public" as an investment adviser to qualify for the de minimis exemption.  

Given the varying rules and regulations across the states, investment advisers that plan to use Rule 506(c) to engage in general solicitation of investors should consult with counsel with respect to the laws in the states in which they will solicit potential investors to determine whether they must register as an investment adviser. This is particularly important if the investment adviser intends to solicit investors on the internet, where the adviser may be deemed to be holding itself out to the public as an investment adviser. 

Conclusion 

By lifting the long-time ban on general solicitation and general advertising under Rule 506, the SEC has opened up opportunities for participants in the private fund industry to expand their investor base and grow their businesses. However, before moving forward aggressively, fund managers should ensure that appropriate controls, policies, and procedures are in place to mitigate the potential compliance risks involved. Private funds intending to engage in general solicitation will need to reexamine their due diligence procedures and customary transaction documents, which, for many, up until now have generally not included provisions that contemplate general solicitation or the robust verification procedures required under the new rule. Fund managers must also consider any applicable compliance obligations under other laws and regulations, including the Advisers Act, the rules promulgated by the CFTC, and state and non-U.S. laws, which may prohibit advertising under relevant exemptions.

Footnotes

1 Available at http://www.sec.gov/rules/final/2013/33-9415.pdf (the "Adopting Release").

2 Revised Rule 144A permits a seller to rely on Rule 144A even if the securities are offered to non-Qualified Institutional Buyers ("QIBs"), including by means of general solicitation, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a QIB. The amendments to Rule 144A are addressed in a separate Jones Day Commentary, available at http://www.jonesday.com/general-solicitation-now-permitted-in-rule-144a-offerings-are-foreign-private-issuers-free-to-talk-10-07-2013/.


3 Under the Old Rule, the prohibition on general solicitation applied to all Rule 506 offerings. As revised, that limitation is applied only to offerings under Rule 506(b).


4 Adopting Release, at 27.


5 Adopting Release, at 28.


6 Adopting Release, at 34.


7 See SEC New C&DIs Re Rule 144A and Rule 506(c), November 13, 2013, question 260.09.


8 Adopting Release, at 26.


9 In general, Section 3(c)(1) excludes from the definition of an "investment company" any issuer whose interests are beneficially owned by not more than 100 persons. Section 3(c)(7), which excludes from the definition of an "investment company" any issuer whose outstanding securities are owned exclusively by "qualified purchasers" (e.g., individuals who own at least $5 million in investments, or certain entities that have at least $25 million in investments). In the case of non-U.S. funds, Section 3(c)(1) operates so that the fund is permitted to have an unlimited number of non-U.S. resident holders and to conduct a U.S. offering that results in the fund having no more than 100 beneficial owners resident in the United States. Similarly, in the context of Section 3(c)(7), for non-U.S. funds, issuers are permitted to offer and sell their securities in the United States to an unlimited number of qualified purchasers, and the non-U.S. resident investors in the fund do not have to be qualified purchasers. See No-Action Letters, Touche Remnant & Co. (8/27/84) and Investment Funds Institute of Canada (3/4/96).


10 Adopting Release, at 48.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Joseph E. Bauerschmidt
Similar Articles
Relevancy Powered by MondaqAI
Morrison & Foerster LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Morrison & Foerster LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions