On July 10, 2013, by a 4-1 vote, the SEC eliminated the prohibition of general solicitations and advertisings for securities offerings exempt from the SEC’s registration requirement. The new rules become final 60 days after publication in the federal register. The change is significant because the majority of private equity and hedge funds raise money through offerings that are exempt from the SEC’s costly and time consuming registration requirements. Previously, if a fund wanted to advertise the offering, they would have to register the offering or face an enforcement action by the SEC.
While the new rule lifts the 80-year old ban and permits private equity and hedge funds to raise capital by advertising offerings without incurring the wrath of the SEC, both investors and funds should proceed with extreme caution. For investors, lifting the ban provides a new avenue for unscrupulous actors to raise money through false and misleading advertisements putting investors at risk. Investors should engage in extensive due diligence before making an investment based on an advertisement or general solicitation.
Private equity and hedge funds also face substantial risks. Smaller, legitimate funds struggling for capital in this competitive market may be tempted to advertise without paying attention to the fine line between advocacy and exaggeration. These funds will undoubtedly find themselves the target of lawsuits brought by disgruntled investors and pursued by an aggressive plaintiff’s bar. More established, larger funds also face significant pitfalls if they advertise. Funds should exercise restraint. If a fund decides to advertise or solicit, it is critical to examine all statements to be sure they are completely accurate and can be substantiated by evidence. The statements should be examined with the same scrutiny afforded the SEC filings of publicly traded companies. For most funds, however, there is little to be gained through general solicitations or advertisements and much to be lost in fending off litigation.
Previously, private equity funds, hedge funds or any company seeking to raise money by selling securities had to either register the offering with the SEC or rely on an exemption from the registration requirement. Most exemptions from registration prohibited companies from engaging in general solicitation or general advertising such as advertising the offering in newspapers or on the Internet.
Rule 506 of Regulation D under the Securities Act is the most commonly used exemption from registration. Before the new rules were approved, in an exempt offering under Rule 506, the issuer could raise an unlimited amount of money from an unlimited number of “accredited investors” and up to 35 non-accredited investors. Under Rule 501 of Regulation D, there are several types of accredited investors, including individuals (or couples) with a net worth that exceeds $1 million (excluding the value of the person’s or couples primary residence), individuals with an income exceeding $200,000 in each of the two most recent years, and spouses with a joint income exceeding $300,000 for each of the two most recent years and with a reasonable expectation of the same income in the current year. Certain institutions such as trusts, corporations, or charitable organizations that meet certain minimum asset requirements are also accredited investors.
In April 2012, Congress passed the Jumpstart Our Business Startups Act (“JOBS Act”). One provision of the JOBS Act directed the SEC to lift the prohibition on general solicitation or general advertising for Rule 506 exempt offerings provided the sales are limited to accredited investors and the issuer takes reasonable steps to verify that all purchasers are truly accredited investors.
The JOBS Act also directed the SEC to amend Rule 144A under the Securities Act, an exemption from registration that applies to the resale of securities to larger institutional investors known as qualified institutional buyers (“QIBs”). Under current Rule 144A, offers of securities can only be made to QIBs. Under the new rule, Rule 144A is amended so that offers of securities can be made to investors who are not QIBs as long as the securities are sold only to persons whom the seller reasonably believes are QIBs.
New Rule 506
The final rule approved by the SEC on July 10, 2013 changes to Rule 506 to permit issuers to use general solicitation and general advertising to offer their securities provided that:
- The issuer takes reasonable steps to verify that the investors are accredited investors.
- All purchasers of the securities fall within one of the categories of persons who are accredited investors under existing Rule 501 of Regulation D or the issuer reasonably believes that the investors fall within one of the categories at the time of the sale of the securities.
The determination of the reasonableness of the steps taken to verify an accredited investor is an objective assessment by an issuer. An issuer is required to consider the facts and circumstances of each purchaser and the transaction. The SEC has provided a non-exclusive list of methods that issuers may use to satisfy the verification requirement for individual investors:
- Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.
- Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser’s accredited status.
The existing provisions of Rule 506 as a separate exemption are not affected by the new rule. In other words, issuers conducting Rule 506 offerings without the use of general solicitation or general advertising can continue to conduct securities offerings in the same manner as before and are not subject to the new verification rule.
New Rule 144A
Under the new rule, securities sold pursuant to Rule 144A can be offered to persons other than QIBs, including by means of general solicitation, provided that the securities are sold only to persons whom the seller and any person acting on behalf of the seller reasonably believe to be QIBs.
New Form D
The new rule also amends Form D, which is the notice that issuers must file with the SEC when they sell securities under Regulation D. The revised form adds a separate box for issuers to check if they are claiming the new Rule 506 exemption that would permit general solicitation or general advertising.
Disqualification for Bad Actors
On July 10, 2013, the SEC also adopted a disqualification rule for so-called “bad actors,” meaning that certain issuers or individuals cannot rely in the Rule 506 exemption. The potential disqualification applies to:
- Directors and certain officers, general partners, and managing members of the issuer.
- 20 percent beneficial owners of the issuer.
- Investment managers and principals of pooled investment funds.
- Persons compensated for soliciting investors as well as the general partners, directors, officers, and managing members of any compensated solicitor.
The events that will disqualify individuals or issuers from relying on the Rule 506 exemption include:
- Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction must have occurred within 10 years of the proposed sale of securities (or five years in the case of the issuer and its predecessors and affiliated issuers).
- Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order must have occurred within five years of the proposed sale of securities.
- Final orders from the Commodity Futures Trading Commission, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations, or credit unions that:
- Bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or
- Are based on fraudulent, manipulative, or deceptive conduct and are issued within 10 years of the proposed sale of securities.
- Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons.
- SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws.
- SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities.
- Suspension or expulsion from membership in a self-regulatory organization (SRO) or from association with an SRO member.
- U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.