On August 29, 2012, the Securities and Exchange Commission (“SEC”) proposed new rules (“Proposed Rules”) to implement the Jumpstart Our Business Startups Act (“JOBS Act“), which was signed into law on April 5, 2012. Under the Proposed Rules, which are mandated by the JOBS Act, hedge funds would be permitted to use means of general solicitation and general advertising to offer securities under Rule 506 of Regulation D and Rule 144A of the Securities Act of 1933 (“Securities Act”). Although the SEC is expected to modify the Proposed Rules to some degree in the final rules release, the new Rule 506 and Rule 144A regimes should appear substantially as they are outlined in the Proposed Rules.
General Solicitation and Advertising Permitted in Certain Regulation D Offerings
Rule 506 offerings have long been used by hedge funds to raise capital from prospective investors without the need to register the offering under the Securities Act, a process that involves a prolonged review by the SEC staff. Traditionally, Rule 506 has provided that an issuer (i) may accept as purchasers an unlimited number of “accredited investors” (as defined in Rule 501(a)) and up to 35 non-accredited investors; and (ii) must not use any means of solicitation which could be deemed to be a “general solicitation” or “general advertisement.” Rule 502(c) defines general advertising to include, “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”
The JOBS Act directed the SEC to amend Rule 506 to enable issuers relying upon the Rule 506 “safe harbor” to utilize means of “general solicitation” and “general advertising”, without the offering being deemed a “public offering,” which would necessitate registration under the Securities Act. Under the “new” Rule 506(c), the SEC will eliminate the prohibition against “general solicitation” and “general advertising” for issuers that otherwise comply with the “old” Rule 506 and who accept as purchasers only those persons and entities that meet the definition of “accredited investor” contained in Rule 501(a) of Regulation D.
The Proposed Rules provide that issuers claiming the new Rule 506(c) exemption must check a box on a revised Form D indicating this intent. This expansion of the “check the box” Regulation D “check the box” regime will allow the SEC to monitor the use of the new safe harbor and potentially adopt additional rules or modify existing rules to fill gaps. For those issuers who wish to accept “non-accredited” investors or otherwise do not wish to use “general solicitation” or “general advertising” in their offerings, the “old” Rule 506 will continue to be available. Prior to utilizing the new Rule 506(c) exemption, issuers must take “reasonable steps” to verify that purchasers are in fact “accredited investors”.
The Proposed Rules suggest that the SEC will not provide a great deal of guidance on what verification process will be required for issuers utilizing the new Rule 506(c) to have met the “reasonable steps” requirement, opting instead for an “objective” analysis based on the “facts and circumstances” involved. However, the SEC identified in the Proposed Rules several factors that issuers should consider to determine what verification process to undertake. These factors include: the nature of the purchaser and the type of accredited investor that the purchaser claims to be; the amount and type of information that the issuer has about the purchase; and the nature of the offering (i.e., the manner in which the purchaser was solicited to participate in the offering and the terms of the offering).
The SEC also clarified in the Proposed Rules that although there are new verification requirements associated with the new Rule 506(c), issuers will still only be required to form a “reasonable belief” that purchasers are “accredited investors.” The SEC has said specifically in the Proposed Rules that hedge funds relying upon the exclusions from the definition of “investment company” under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”) will be able to use the new Rule 506(c) and will not be deemed to be making a “public offering” of securities as that term is used in Sections 3(c)(1) and 3(c)(7). That is to say, that a private fund utilizing the new Rule 506(c) will not violate its exclusion under the Investment Company Act by virtue of soliciting prospective investors via means of “general solicitation” or “general advertising.”
General Solicitation and Advertising Permitted in Rule 144A Transactions
The Proposed Rules also lift the prohibition on general solicitation and general advertising for the resale of securities under Rule 144A. Rule 144A provides a safe harbor exemption for resales of restricted securities to “qualified institutional buyers” (“QIBs”) without registration under the Securities Act.
A person wishing to rely on Rule 144A in connection with the resale of securities has traditionally not been able to use “general solicitation” or “general advertising” to offer Rule 144A securities. As amended, Rule 144A would require that the exempted securities be sold only to QIBs or to a person that the seller, and any person acting on behalf of the seller, reasonably believes is a QIB.
As a result, Rule 144A offerings could be made to persons other than QIBs, including by means of “general solicitation” or “general advertising,” as long as the seller, and any person acting on behalf of the seller, reasonably believes the purchaser is a QIB.
Public Comments on the Proposed Rules
The SEC received public comments from a variety of different constituencies, each with somewhat different views on how the final rules should look. The state securities regulators that submitted comments uniformly requested greater guidance from the SEC as to what would constitute “reasonable steps” in verifying that an individual is an accredited investor. The regulators from South Carolina, Montana, Hawaii, Indiana, Ohio, Virginia, Massachusetts, and Missouri all advocated for the SEC to clarify what would be sufficient verification steps. The North American Securities Administrators Association also advocated for a more detailed definition of “reasonable steps” and noted that a lack of guidance from the SEC would lead to costly litigation and inconsistent interpretations of the rule. In particular, the Ohio Division of Securities suggested a more objective verification process such as “a review of tax returns or financial records, a review of certification letters or certificates from regulatory agencies confirming that an entity falls into a category of accredited investor, or where appropriate, third-party verification by registered broker-dealers.”
However, some comments, such as the one from the Business Law Section of the American Bar Association, agreed with the SEC’s flexible facts and circumstances approach to verifying an individual’s accredited investor status. Other commenters requested guidance on any transitional period once the final rules are adopted by the SEC. One commenter noted that, at the time the final rules become effective, there will undoubtedly be issuers conducting securities offerings in reliance on the existing Rule 506. The commenter advocated that such issuers should be allowed, upon effectiveness of the final rule, to use the new Rule 506 exemption and use general solicitation for the remaining portion of their offerings, provided that they satisfy the requirements of the rule going forward.
The Managed Funds Association, the industry group representing hedge funds and other private funds, encouraged the SEC to provide issuers with additional legal certainty when an investment amount is sufficiently high and the purchaser certifies that it is in fact an accredited investor. The Managed Funds Association urged the SEC “to adopt a safe harbor in the final version of Rule 506(c) that would deem an issuer to have complied with the verification requirement if a purchaser, in addition to providing certifications that it is an accredited investor and has not obtained financing for the transaction, meets a certain minimum investment level that the SEC determines based on these thresholds.”
As of October 5, 2012, the SEC is no longer accepting public comments on the Proposed Rules. In accordance with their normal procedures, we expect that the SEC will take some time to review the public comments received prior to implementing any changes to the Proposed Rules and adopting final rules.
Interested in Learning More?
If you are interested in learning more about the SEC’s Proposed Rules or are looking to develop a marketing program for your hedge fund to take advantage of the increased flexibility provided by the JOBS Act, please contact us for a complimentary consultation.