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Why We Don't See the SEC's New Rules Implementing the Jobs Act Altering the Way Hedge Funds Market in the Short Run

On September 23, 2013, SEC regulations adopted on July 10, 2013 to implement Section 201(a) of the JOBS Act will be effective. We are not seeing firms rush to generally solicit by marketing heavily or un-password protect their websites. In fact, what we are seeing is firms proceeding thoughtfully and cautiously. Most realize at this point that what initially was perceived as a new found freedom for private funds, is actually a maze of hurdles that must be carefully cleared before private funds can actually determine that they should in fact take advantage of new Rule 506(c) and “generally solicit”.

Specifically, under amended Rule 506, the SEC provides a new option for private placements to rely on new Rule 506(c), and make offerings through general solicitation and general advertising.

New Rule 506(c) permits a company to offer securities using general solicitation and general advertising, only if:

  • all purchasers of securities are accredited investors; and
  • the company takes reasonable steps to verify that purchasers of its securities are in fact accredited investors.

The term “general solicitation” is quite broad and could include, for example, open web sites (that don’t require passwords to access), media presentations, cold calls, television commercials, billboards and stadium advertisements. Don’t expect this marketing opportunity to take wind. To reiterate, this new option comes with several considerations that dilute its appeal.

Hurdle 1: Taking and Documenting Reasonable Steps

Some companies may choose not to use Rule 506(c) because the determination of whether the steps taken are “reasonable” is based on a facts and circumstances analysis conducted by each company. If a company conducting a private placement opts to do so under current Rule 506(b) as most currently do, the company does not need to engage in the verification process described below and can rely on its reasonable belief that the purchaser satisfies one or more accredited investor criteria set forth in Rule 501(a). Being able to rely on “reasonable belief ” without taking additional reasonable steps means that a fund may continue to rely on the questionnaires and representations found in its subscription documents.

For those interested in pursuing Rule 506(c), the SEC is using a principles-based method of verification and believes that a company should consider the following non-exclusive factors in its analysis:

  • 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 company has about the purchaser; and
  • the nature of the offering (e.g., the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount).

The SEC did provide some comfort by clarifying a few points:

  • issuers should consider the facts and circumstances of the purchaser and the transaction
  • the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify the accredited investor status.
  • a company may use a reliable third party verification of a person’s status as an accredited investor.

The SEC has provided the following examples of methods that a company may use to verify that a natural person purchasing its securities in a Rule 506(c) offering is an accredited investor if that company does not have knowledge that such person is not an accredited investor already:

  • Income Review: reviewing any IRS form that reports the purchaser’s income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser (or with the spouse) that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year; (Obtaining personal tax information may not be as easy as it sounds.)
  • Net Worth Review: reviewing documentation dated within the prior three months and obtaining a written representation from the purchaser (or with the purchaser’s spouse) that all liabilities necessary to make a determination of net worth have been disclosed. (Confirm assets through bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and verify liabilities using consumer reports from at least one of the nationwide consumer reporting agencies; or
  • Third Party Verification: obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:
  • a registered broker-dealer;
  • an investment adviser registered with the SEC;
  • a licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
  • a certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.

(Note: all of the above are registered with the government in some form or another and subject to corresponding oversight)

A company has the burden of proof that it meets the requirements of 506(c) with respect to each investor. It is important to note that if a company fails to meet the requirements of the rule, it cannot fall back on Section 4(a) (2) of the Securities Act. The company could do this when it relies on Rule 506(b) and does not engage in general solicitation. In other words, if a company fails to meet the requirements of Rule 506(b), it can always try to prove that the offering is still a private placement under Section 4(a)(2) (although it does not come under the safe harbor of Regulation D). This option is not available under new Rule 506(c). If a company fails to meet its requirements by, for instance, failing to take reasonable steps to verify investors, the company would have engaged in an unregistered public offering with all related consequences. Taking the right reasonable steps with respect to each investor as well as respecting the other requirements of Rule 506(c) is thus pivotal.

Even if a company determines that the analysis it has to perform in order to determine whether the purchaser of its securities in a Rule 506(c) offering is an accredited investor is not enough of a deterrent, the company will need to continue to consider the next hurdle.

Hurdle 2: CFTC

Are your funds relying on CFTC exemptions?

If not, congrats. You already passed hurdle 2 and can jump to hurdle 3!

If so, read on.

Although the SEC is lifting the restriction on general solicitation, it is still unknown whether the CFTC would follow suit. (Some are hopeful that this will happen) Exempt commodity pool operators (“CPOs”) (relying on the Rule 4.13(a)(3) de minimis exemption) and registered CPOs relying on the Rule 4.7 exemption still face restrictions. Rule 4.13(a)(3) contains a general restriction on marketing to the public. Rule 4.7 is only available if a fund is offered or sold “solely to qualified eligible persons.”

Therefore any funds relying on these exemptions may not be able to take advantage of Rule 506(c) without losing these exemptions.

Hurdle 3: AIFMD

Are you a private funds adviser marketing to European investors?

If not, congrats. You already passed hurdle 3 and can jump to hurdle 4!

If so, read on.

Those selling private fund within the European Union should consider how any efforts to generally solicit could affect the reverse solicitation provision under the new Alternative Investment Fund Managers Directive (“AIFMD”). In general, US managers that market funds to EU investors must meet certain requirements of the AIFMD. Reverse solicitation permits non-E.U. managers to avoid the directive if the investor comes unsolicited. The question here is whether or not access to information through an open website or other forms of general solicitation could exclude a U.S. manager from relying on reverse solicitation because the manager “markets” to EU investors. Note that EU investors can be located in the US and not only in Europe. The definition of a European investor covers an investor which is domiciled or “with a registered office” in the European Union.

Hurdle 4: Only Accredited Investors Permitted

Some companies may decide not to use the new Rule 506(c) in order to make private placements to non-accredited investors who meet the sophistication requirements of Rule 506(b) (and, yes, in a 506 (c) offer knowledgeable employees must be accredited) Of course, you can continue to function under the existing rule 506(b) authority, which bans general solicitation. That provision does permit private offerings to be sold to up to 35 non-accredited investors which can be friends and family or employees of a fund.

Hurdle 5: 506(b) and 506(c) offerings close in proximity

The consensus seems to be that its most conservative to pursue a 506 (b) or (c) offering. Issuers should stick with one or the other and, if offering both, the issuer should adopt appropriate precautions including detailed policies and procedures. Here are some concerns:

  • You can’t rely on 506(b), then break your exemption (inadvertantly or advertantly), and automatically use 506(c). Or you cannot attempt to conduct a 506(c) offering but fail to do so (for instance by not taking “reasonable steps”) and then rely on a 506(b) offering You can only use 506 (b) or (c) and must state so in your Form D.
  • Funds can conduct a 506(c) offering and continue with a 506(b) offering but they need to separate offerings by 6 months to avoid integration. The safe harbor runs from last sale to first offer and issuers need to document (with appropriate Form D filings and internal policies and procedures).

Hurdle 6: SEC Proposed Rules

When the SEC adopted these final rules governing general solicitation and advertising, the SEC also proposed new rules and rule amendments to address concerns that may arise in connection with permitting issuers to engage in general solicitation. (of course we could not expect a relaxation of the regulations without more regulations to counteract the newfound freedom being made available.)

New Proposals and amendments include:

Form D Filings

  • Pre-sale: Currently, Rule 503 requires that the Form D be filed within 15 after the first sale. For issuers that intend to engage in general solicitation pursuant to Rule 506(c), the filing of a Form D no later than 15 calendar days in advance of the first use of general solicitation (“Advance Form D”). The Advance Form D will not request all the types of information currently requested by Form D. After the filing of an Advance Form D, the issuer would be required to file an amendment providing the remaining information required by Form D within 15 calendar days after the date of first sale of securities in the offering, as is currently required.
  • Closing: Currently, Rule 503 does not require filing a Form D after termination. Amended Rule 503 would require firms to file a Form D amendment within 30 calendar days after the termination of a Rule 506 offering.
  • Amend Form D to Require Additional Information

For offerings conducted under Rule 506(c) Form D will require;

  • The name and address of any person directly or indirectly controlling the issuer;
  • Information about the size of the issuer where such information is otherwise publicly disclosed;
  • Additional information about the number and types of accredited investors investing.
  • Additional information about the use of proceeds from offerings conducted under Rule 506.
  • If a registered broker-dealer was used in connection with the offering, whether any general solicitation materials were filed with FINRA.
  • The name and SEC file number for each investment adviser who supports the issuer (for pooled investment funds advised by registered investment advisers and exempt reporting advisers)
  • The methods used to verify accredited investor status and the types of general solicitation/advertising used (For Rule 506(c) offerings).

Issuers to Submit General Solicitation Materials to the SEC

New Rule 510T would require issuers to submit to the SEC any written general solicitation materials used in a Rule 506(c) offering no later than the date the materials are first used in connection with the offering. The rule would expire two years after its effective date and appears to be an effort by the SEC to better understand the efforts issuers would use to solicit purchasers in Rule 506(c) offerings. The SEC will make available an intake page on the SEC’s website to allow issuers, investors, and other market participants to voluntarily submit any written general solicitation materials used in connection with a Rule 506(c) offering prior to the effectiveness of Rule 510T in the event a company is enthusiastic to share.

Disqualification Provisions

Currently, issuers are only precluded from relying on Rule 506 in connection with a failure to file a Form D if the issuer (or any of its predecessors or affiliates) have been subject to a court order enjoining such person for failure to comply with Rule 503, which requires the filing of a Form D.

If the issuer (or any predecessor or affiliate of the issuer) has not complied, within the last five years, with all of the Form D filing requirements in a Rule 506 offering, amended Rule 507 rules would automatically disqualify an issuer from using Rule 506 in any new offering for one year. The five year look-back period would not extend back beyond the effective date of amended Rule 507. The rule would also provide a cure period so that it would not be considered late if a required Form D or amendment is filed within 30 days after its due date. The cure period will not be available if the issuer previously failed to comply with a Form D filing deadline related to the same offering.

Legends in Offering Materials

New Rule 509 would require issuers to include certain legends in any written communication that is general solicitation related to an offering relying on Rule 506(c). Additional disclosures would be needed for private funds, such as private equity, venture capital, and hedge funds.

The general legends include, for example, disclosure that the offer is sold only to accredited investors, the reliance on an exemption from the registration requirements of the Securities Act, and transfer restrictions under applicable securities laws. Private funds would be required to include additional legends that the securities are not subject to the Investment Company Act of 1940.

Rule 156 Amendments

  • Rule 156 provides guidance on the types of information that could be misleading in investment company sales literature. The SEC proposed to amend Rule 156 to apply the guidance in that rule to the sales literature of private funds. If adopted, the proposed advertising rules for private funds will be so similar to those of mutual funds that certain private funds may consider moving to open or closed end funds since the two regimes are coming closer.

Hurdle 7: Bad Actor Disqualification Rules

On the infamous day in July when the SEC loosened the reins on general solicitation and proposed related new rules and rule amendments, the SEC also finalized the “bad actor” disqualification rules (as required by the 2010 Dodd-Frank Act). This applies to most private placements, not just 506 (c) offerings.

Essentially, pursuant to new Rule 506(d), if a “covered person” under the rule engages in a bad act after the effective date, a fund in any offering will not be able to engage under Rule 506. If the bad act happened prior to the effective date, the bad act will need to be disclosed to investors in order for the private fund to be offered under Rule 506. In a notable addition to the definition of “covered persons” found in the proposed rules, such persons now include the directors, executive officers, other officers participating in the offering, and general partners and managing members of investment managers of pooled investment funds.

Due diligence will be necessary in order to avoid potential disqualification. Here are some suggestions to consider:

  • Be sure to include a pre-screening process where new employees make written representations that they have not had any disqualifying event. Have them fill out a questionnaire with relevant certifications.
  • Circulate questionnaires to existing employees asking whether they participated in a disqualifying event in the past. As mentioned above, if such employees committed a “bad act” as defined in the new rule, this fact should be disclosed to investors (but the offering can continue).
  • Review selling agreements and placement agent agreements and be sure to include necessary assertions.
  • Use extra care and diligence during corporate mergers.
  • Implement strong policies and procedures illustrating the firm’s reasonable care and related controls to avoid hiring persons with disqualifying events.

These compliance measures should be completed prior to September 23 when the rules will become effective. Policies and procedures must be drafted and put in place before that date. As discussed, it may seem simple at the surface level to determine you want to pursue a 506(c) offering, but you have to be sure not to get tripped up with the various roadblocks that make it a bit more challenging. Not only is the SEC going to be monitoring compliance with 506(c) offerings, but the states will be too!

© National Society of Compliance Professionals, Inc. Reprinted with permission. www.nscp.org

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