Post-JOBS Act, fund managers have two options in offering interests to prospective investors: Rule 506(b), the traditional exemption allowing sales to accredited investors so long as the issuer refrains from “general solicitation;” and Rule 506(c), the exemption that allows an issuer to engage in general solicitation if certain conditions are met.
1. The Traditional Route: Rule 506(b)
The exemption that fund managers used prior to the passage of the JOBS Act is now designated as “Rule 506(b).” 506(b) allows sales to an unlimited number of accredited investors (and 35 non-accredited investors) so long as an issuer refrains from general solicitation. While the SEC has provided no comprehensive definition of general solicitation, it generally includes:
- advertisements published in newspapers and magazines;
- communications broadcast over television and radio;
- seminars where attendees have been invited via general solicitation; and
- other uses of publicly available media, such as unrestricted websites.
Rule 506(b) requires only that the issuer “reasonably believe” that the investors to whom it is selling interests are accredited. Fund managers have fulfilled this requirement in a number of ways, typically through actual knowledge of prospective investors in their network, cultivating relationships that support this reasonable belief and ultimately seeking representations from their investors on their subscription applications. With respect to non-accredited investors, the issuer must provide substantial information about the offering and have a reasonable belief that the investor (alone or with the assistance of a representative) has sufficient knowledge of financial matters that they can evaluate the prospective investment.
2. The New Exemption: Rule 506(c).
Rule 506(c) allows issuers to engage in general solicitation when offering their securities, provided that the issuer takes reasonable steps to verify that all investors to whom securities are actually sold are accredited. What are “reasonable steps”? The SEC provides a list of non-exclusive and non-mandatory verification methods:
- verification of investor’s income: reviewing a copy of an IRS form that reports income;
- verification of investor’s net worth: reviewing bank or brokerage statements, certificates of deposit, tax assessments and a credit report from at least one of the nationwide consumer reporting agencies, and obtaining a written representation from the investor (Note: these documents must be dated within the 3 months preceding the sale of interests);
- verification by a third party: a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, an attorney or CPA stating that such person or entity has taken reasonable steps to verify that the investor is accredited within the 3 months preceding the sale of interests and has determined that such investor is accredited; and
- verification via prior investment: persons who invested in the issuer’s Rule 506(b) offering as an accredited investor before September 23, 2013 and remain investors of the issuer.
Other methods of verification may be acceptable, including retaining an independent service provider that conducts this type of diligence. It should also be noted that an issuer who has taken reasonable steps to verify the accredited status of their investor will not lose their Rule 506(c) qualification because the investor is not, in fact, accredited. Thus, deception by investors should not result in the issuer losing the benefits of Rule 506(c).
3. Considerations Prior to the Use of 506(c)
Rule 506(c) is a radical departure from longstanding law. As such, there are a range of considerations for fund managers considering an offering under the new exemption:
- “Bad Actor” disqualification: Issuers are prohibited from relying on Regulation D exemptions in the case of offerings involving certain “bad actors.” We discuss this disqualification in more detail in our companion article.
- Antifraud rules: The SEC’s accompanying release specifically reminded private funds that they are subject to anti-fraud provisions of the Advisers Act;
- Conflict with non-U.S. laws: Other countries may have enacted securities laws that still include a ban on general solicitation;
- State law: While Rule 506(c) preempts many “blue sky” laws, state regulators concerned with potential fraud may create additional regulatory hurdles;
- Potential regulation by the CFTC: The CFTC has yet to issue guidance on whether general solicitation will preclude otherwise available exemptions. For example, fund managers who utilize derivative financial instruments for hedging and who rely on the “de minimis” exclusion from registration with the CFTC are currently prohibited from general solicitation in the U.S; and
- Election on Form D: Prior to utilizing a general solicitation, issuers must formally notify the SEC on its Form D, checking the box in Item 6, indicating that it is relying on 506(c).
While 506(c) appears to expand marketing opportunities for fund managers, additional regulatory and compliance requirements impose practical limitations on precisely how a fund manager should conduct its offering. Stated another way, what is the real value of a general solicitation when, even before actually engaging in it, the fund manager must take concrete and documented steps to determine the accredited status of the targeted investors. The bottom line is, the types of general solicitation described in Section 1, above are still largely off-limits for issuers relying on 506(c), except in the relatively rare cases in which there is a mechanism for pre-vetting seminar attendees, subscribers to a publication, users of a website, to name a few. Despite the hoopla to the contrary, we will not be hearing advertisements for private funds on the radio during our morning commutes any time soon.