After missing its initial deadline, earlier this week the SEC finally released its long-awaited proposed rules to eliminate the general solicitation and advertising ban.
Under the proposed rules, fund managers conducting Rule 506 offerings would be permitted to use general solicitation and general advertising to market the underlying securities, provided that: (1) the issuer takes reasonable steps to verify that the investors are accredited investors; and (2) all investors are accredited investors, because either (i) they come within one of the categories of persons who are accredited investors under existing Rule 501 or (ii) the issuer reasonably believes that they meet the categories at the time of the sale of the securities.
In determining the reasonableness of the steps that an issuer has taken to verify that a purchaser is an accredited investor, the proposing release somewhat vaguely explains that issuers are to consider the facts and circumstances of the transactions. This includes, among other things, the following factors:
The type of purchaser and the type of accredited investor that the purchaser claims to be.
The amount and type of information that the issuer has about the purchaser.
The nature of the offering, meaning:
The manner in which the purchaser was solicited to participate in the offering.
The terms of the offering, such as a minimum investment amount.
The SEC's proposing release rationalizes that adopting specific verification methods that an issuer might use "would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor."
The SEC further notes that proposing such methods could be overly burdensome in some cases and ineffective in others. However, fund managers and other interested parties will likely find this approach lacking; there has been considerable speculation leading up to the proposed rules as to how the SEC would address the verification process, as well as the impact the change would have on investor certification practices, but the SEC appears to have effectively punted here.
This leaves issuers in a state of limbo regarding what constitutes "reasonable steps" to verify accredited investors. As such, until the SEC provides further clarification, managers relying on the new exemption are advised to err on the side of caution by requiring as much information from qualifying investors as the issuer can reasonably request. It will be interesting to see if the SEC provides any further guidance regarding verification methods in the final rules.
It also remains to be seen whether the SEC will restrict certain types of advertising with respect to issuers relying on the new exemption; it is likely that, as issuers begin to engage in general solicitation and general advertising activities, the rules and surrounding interpretations will be further refined in response to common practices.
Notably, the proposed rules would preserve the existing portions of Rule 506 as a separate available exemption, allowing issuers who elect to conduct Rule 506 offerings without the use of general solicitation and general advertising to avoid becoming subject to the new verification rules.
It is also important to note that fund managers cannot rely on the new rules yet; this week's released rules are proposed rules only and will not take effect until the SEC takes comments and releases final rules, which may differ materially from the proposed rules outlined above.
Please feel free to contact us if you have any questions regarding the status of the JOBS Act or its potential impact on hedge fund marketing activities.