A New Way to Solicit Investment in Private Funds, 506(c) “Crowdfunding”
As of September 23, managers of hedge funds and other types of private funds can publicly solicit investment for their funds. As part of the JOBS Act, there’s a new way to conduct “private placements”.
Private placements are the offering of securities without the filing of a registration statement. Filing a registration statement, sometimes called “going public”, is an (often prohibitively) expensive process and requires annual and quarterly public disclosures, including information many funds would consider to be trade secrets.
Before the provisions of the JOBS Act were enacted, private funds could only offer interests in the fund to individuals with which the fund operators had an existing relationship. Now, if funds comply with all the provisions of the new rule, fund managers can offer their securities to anyone via conventional marketing methods like tv, radio, and web advertisements. It is important to note that only accredited investors may purchase securities offered under Rule 506(c). So 506(c) doesn’t increase the number of people eligible to invest in private funds, but it may provide fund managers with easier access to the eligible pool of retail investors.
New Red Tape Accompanies New Opportunity
The same legislation that creates the opportunity to generally solicit investment in private funds also creates some new burdens for those looking to take advantage of the chance to reach a greater pool of investors:
Enhanced verification of accredited investors
In order to publicly solicit investment under this new rule (Rule 506(c)), issuers, including fund managers, must “take reasonable steps to verify” that each purchaser is an accredited investor. The SEC has made it clear that the conventional verification practice of having investors self-certify, typically by signing a written representation, will no longer suffice. Thankfully, the SEC provided some safe harbors from the verification requirements, including an opinion from an attorney, CPA, or registered broker-dealer that an investor is accredited.
Notice to SEC and state regulators of an offering using general solicitation
Fund managers looking to take advantage of general solicitation will have to put the SEC and state regulators on notice of their efforts to generally solicit by checking a new box on Form D indicating whether or not the fund is offering securities under Rule 506(c).
Obligation to make sure no “bad actors” participate
Fund managers seeking investment pursuant to Rule 506 (either 506(c) or 506(b), the most commonly used private placement method) must now exercise reasonable care to make sure that no “bad actors” are involved in conducting the offering.
Bad actors include, among others, (a) individuals with securities-related criminal convictions, (b) individuals and entities that are subject to court orders, judgments, or decrees in connection with the purchase or sale of a security or false filing with the SEC, and (c) individuals and entities subject to final orders of state or federal securities regulators.
Individuals and entities that must not be bad actors include, among others, (a) the securities issuer and any predecessor or affiliated issuer, (b) any director, executive officer, general partner, or managing member of the issuer, (c) any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, and (d) any investment manager to an issuer that is a pooled fund.
Funds can utilize 506(c) and still rely on 3(c)(1) and 3(c)(7) exemptions to Investment Company Act of 1940
The JOBS Act states that offers and sales under 506(c) will not constitute public offerings under federal securities law. Accordingly, private funds can engage in general solicitation under Rule 506(c) and continue relying on the 3(c)(1) or 3(c)(7) exemptions to registration under the Investment Company Act of 1940. These are the most commonly used exemptions to the Investment Company Act—non exempt investment companies must complete the burdensome registration process and file ongoing disclosures. A fund is exempt from registration under the 3(c)(1) exemption if the fund (a) is not making a public offering of securities, and (b) is not owned by more than 100 investors. A fund is exempt from registration under 3(c)(7) if the fund (a) is not making a public offering of securities, (b) has only qualified purchasers as investors (individuals with net worth exceeding $5million), and (c) has less than 500 investors.
Commodity pool operators not able to rely on 506(c) yet without registering with CFTC
Under the Commodity Exchange Act, commodity pool operators (CPOs) are generally required to register with the Commodities Futures Trading Commission (CFTC). However, Rules 4.7(b), 4.13(a)(3) and Section 4(m) provide exemptions from registration so long as the investment opportunity is not marketed to the public. The CFTC has yet to harmonize its rules with the SEC’s rules. Therefore, it is unclear whether general solicitation under 506(c) would cause a registration exemption under the Commodity Exchange Act to fail. Until the CFTC resolves this ambiguity, CPOs should assume that 506(c) offerings would adversely impact their registration exemptions under the Commodity Exchange Act. CPOs and commodity trading advisors registered with the CFTC should keep in mind that the CFTC’s restrictions on advertising will apply regardless of the SEC’s rulemaking.
Funds utilizing 506(c) must be mindful of antifraud regulations
Fund managers must still be cognizant of antifraud regulations (imposed by the SEC and FINRA) which allow investors to recoup their original investment if a securities issuer (a) makes an incorrect or misleading statement about material information, or (b) fails to disclose material information. General solicitations that are inaccurate, incomplete, or exaggerated could result in an enforcement action against a fund or its manager.
Rule 506(c) and parallel offerings
Simultaneous Regulation S and Rule 506(c) offerings are permitted
An issuer may conduct a Rule 506(c) offering domestically and a concurrent offshore offering under Regulation S. Offerings made pursuant to Regulation S cannot include directed selling efforts (a similar restriction to the restriction against general solicitation) in the United States. Many private funds offer securities concurrently in the US and overseas. The SEC’s Rule 506(c) adopting release made it clear that Rule 506(c) and Regulation S offerings would not be integrated. Accordingly, an issuer can have concurrent Rule 506(c) and Regulation S offerings.
Simultaneous domestic offerings under 506(c) and 506(b) potentially troublesome
Theoretically, a securities issuer could be raising capital for parallel funds with one fund raising capital pursuant to a 506(c) offering and the other fund raising capital pursuant to a 506(b) offering. However, as a practical matter it may be difficult to solicit investment in the 506(c) offering without making substantive disclosures about the 506(b) offering. The risk of the 506(b) offering blowing a registration exemption will cause many well-advised fund managers to conduct both offerings as 506(c) offerings or both offerings as 506(b) offerings.
SEC Considering Additional Proposed Rules
The SEC is currently seeking comment on a number of proposed rules (we previously wrote about the proposed rules here) that would affect private fund offerings. The changes most relevant to fund offerings are:
- Proposed requirement to file Form D 15 days in advance of first offering
- Proposed requirement to file amended Form D upon closing
- Proposed requirement to file written solicitation materials
- Proposed requirement to include additional legends and disclosures on offering documents, including fund-specific requirements relating to performance data
- Proposed amendment to Rule 156 to apply guidance on misleading statements to marketing materials of private funds
When fund managers seek capital for their funds, they will now have an important decision to make in deciding whether or not the benefits of general solicitation will outweigh the administrative burdens that come with a Rule 506(c) offering. If you have any questions about how Rule 506(c) affects private funds, please feel free to give me a call at (206) 745-5229, or send me an email at email@example.com.
To view the rules in their entirety, see SEC Adopting Release No. 33-9415, “Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings” (July 10, 2013) at https://www.sec.gov/rules/final/2013/33-9415.pdf; SEC Adopting Release No. 33-9414, “Disqualification of Felons and Other ‘Bad Actors’ from Rule 506 Offerings” (July 10, 2013) at https://www.sec.gov/rules/final/2013/33-9414.pdf; and SEC Proposing Release No. 33-9416, “Amendments to Regulation D, Form D and Rule 156 under the Securities Act” (July 10, 2013) at https://www.sec.gov/rules/proposed/2013/33-9416.pdf.