Tag: Rule 506(c)

What’s Next For Private Funds Now that the SEC has Lifted the Ban on General Solicitation

SEC Seal 2

On Wednesday, the Securities and Exchange Commission adopted a new rule that will allow private funds to advertise. (Perhaps “private fund” is not the right label anymore.) Of course it’s not as simple as merely removing the word “not” and allowing public advertising of private placements.

The new rule creates a new option. It creates a public private placement. A fund manager or company can publicly advertise the offering so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors

The existing option is still viable that operates under the regulatory regime as it existed before 10:00 am yesterday. I suppose it’s a private private placement.

One concern I had was how a public private placement under the new Rule 506(c) would affect a private fund under its Section 3(c)1 or 3(c)7 exemption under the Investment Company Act. Private funds are precluded from relying on either of these two exemptions if they make a public offering of their securities. The SEC explicitly addressed this concern.

As we stated in the Proposing Release and reaffirm here, the effect of Section 201(b) is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.(page 48 of Release 33-9415)

Another concern was whether the SEC was eliminating the “reasonable belief” standard that an investor is accredited under the new Rule 506(c) offerings. The SEC specifically addressed this concern.

We note that the definition of accredited investor remains unchanged with the enactment of the JOBS Act and includes persons that come within any of the listed categories of accredited investors, as well as persons that the issuer reasonably believes come within any such category.

My last concern was what it meant to take “reasonable steps to verify” that investors are accredited. The SEC stuck with its principles-based approach, but did provide four non-exlusive methods for verifying accredited investor status for individuals.

The principles-based approach requires you to take an “objective determination … in the context of the particular facts and circumstances.” That’s a bit messy. I was hoping the SEC would explicitly state that a minimum investment of $1 million would be enough. If the investor has $1 million, then the investor has $1 million of net worth and meets the accredited investor threshold. The SEC states that the minimum investment is a highly relevant factor.

The SEC expresses some concern that the cash investment could be financed by the issuer or a third party. Those are legitimate concerns given the potential for fraud by shady operators who would hide behind such a bright line test. But it does cause me a headache.

Clearly there will need to be some additional recordkeeping when it comes to a public offering of a private placement.

The SEC also passed a rule banning “bad actors” from having a substantial role in a private placement, regardless of whether it is public or private. I’ll take a closer look at that one later.

Lastly, the SEC is proposing changes to the Form D required to filed with a private placement. There are many changes in that rule. More than I expected.

  • the filing of a Form D no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering;
  • the filing of a closing Form D amendment within 30 calendar days after the termination of a Rule 506 offering; and
  • additional information on Form D about the offering

In addition, the rule is proposing a new disclosure on advertising materials in public private placements. The new rule 509 will require all issuers to include: (i) legends in any written general solicitation materials used in a Rule 506(c) offering; and (ii) additional disclosures for private funds if such materials include performance data.

The SEC is also proposing amendments to Rule 156 under the Securities Act that would extend the guidance contained in the rule to the sales literature of private funds.

There is a lot to digest. Looks like my weekend will be spent reading SEC releases and rules.

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What Happens If You Violate the Ban on General Advertising and Solicitation?

compliance and advertising

I’m not planning to run late night ads for a latest security offering. But what could the Securities and Exchange Commission do about it? Keith Bishop asks: Can the SEC really create illegal actions by its own failures to comply with the law?

Last year’s JOBS Act contained an explicit mandate with an explicit time frame.

 Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors.

However, 90 days was never a feasible deadline to draft a rule, make it available for comment, respond to the comments, and publish a final rule. Congress could have made the change a statutory one, leaving the SEC rule explicitly out-of-date. But instead they mandated a regulatory change.

The first question is what would the SEC do to a violator? The SEC has published a JOBS Act page full of Frequently Asked Questions. Under Title III for crowdfunding the SEC published a statement warning would be entrepreneurs that securities crowdfunding is not legal until the regulations are finalized. The FAQ for Title II turns to the Broker-Dealer exemption for advertising. I don’t take the lack of a warning to mean that the SEC won’t prosecute. But given limited resources, you would have to wonder why the SEC would bother.

Assuming the SEC did prosecute, what would the courts do? …

I think I’ve gone on long enough. At this point, your offering is tied up in expensive legal roadblocks and your burning through cash to pay your lawyers. Whatever advantage you thought you might gain from advertising is gone.

Some brave soul may step up and be willing to test the advertising waters out of principle. But it would be a test rooted in sensible economic analysis.

506(c) and General Solicitation and Advertising in Securities Offerings

Section 201(a)(1) of the Jumpstart Our Business Startups Act (the “JOBS Act”) directs the Securities and Exchange Commission to amend Rule 506 of Regulation D. Congress wants to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors. With one caveat: the issuer must take reasonable steps to verify that purchasers of the securities are accredited investors. After some delays, the SEC has finally published a proposed rule to implement the Congressional mandate.

After waiting all summer for a proposed rule, the SEC decided to finally take action during my vacation. And on the day I promised to take my kids to Story Land. My review of the rule and commentary would have to wait until my kids had their fill of Cinderella and the Bamboo Chutes.

Thanks to William Carleton’s live blog and a review of speeches, I could see that the five commissioners were not in full agreement about the rule or the procedure for adopting the rule. Commissioner Gallagher was in favor of the proposed rules, but wanted it to be an interim final rule. Commissioner Aguilar thought the proposed rules did not go far enough in protecting investors. In the end, that may not mean much.

As expected, the removal of the general solicitation and public offering prohibitions, comes with a few caveats.

Does Not Remove Ban

I found it interesting that the SEC chose to create a new regulatory scheme, rather than merely eliminate the ban. The proposed rule includes a new Rule 506(c) that permits general solicitation and advertising provided all investors are accredited and the issuer takes reasonable steps to verify that they are accredited. 506(b) stays in place allowing an issuer to have up to 35 sophisticated, but non-accredited investors, provided there is not general solicitation or advertising, but does not have to take reasonable steps to verify the investors’ status.

“Take reasonable steps to verify”

The SEC did not do what many feared would be the worst result under the JOBS Act. The proposed rule does not impose any specific requirement to verify that an investor meets the standard of an accredited investor. “Whether the steps taken are “reasonable” would be an objective determination, based on the particular facts and circumstances of each transaction.”

To some extent that seems okay. In the private equity fund model we have a particular concern that a potential investor will be able meet a capital call. It should just mean having to document the diligence process.

However, the SEC did strike one common aspect of fundraising practice.

[W]e do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.

Offering documents will need to be changed.

A Non-Accredited Investor Sneaks In

The language of the JOBS Act made some, including me, nervous that if a non-accredited investor could sneak into an offering and blow up the exemption. A person of limited means really wanted to be an investor, lied on the questionnaire, but passed through the reasonable steps taken by the issuer to verify status. Fortunately, the SEC took that position that the issuer would not lose the ability to rely on the Rule 506(c) exemption, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.

Changes to Form D

In addition, to the new 506(c) the SEC is proposing to amend Form D. The notice filing with the SEC would have a check box to indicate whether an offering is being conducted pursuant to the proposed Rule 506(c) that would permit general solicitation.

Blessing for Private Funds

Private funds typically rely on the Rule 506 safe harbor to raise funds without having to register under the Securities Act. Private funds were also restricted under Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act from making a public offering of securities. Historically, the SEC has considered rule 506 transactions to be non-public offerings. But would the SEC change that position given its hostility towards the JOBS Act?

Thankfully, the answer is no.

We believe the effect of Section 201(b) is to permit privately offered funds to make a general solicitation under amended Rule 506 without losing either of the exclusions under the Investment Company Act.

Comments

Now there is 30 comment period. I’m just guessing, but I’d be surprised to see changes to the proposed rule. I think the benefit of the comment period will be to add some additional commentary around the “reasonable steps to verify” standard.

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