A new frontier in private capital raising within the United States?
February 2014 | PROFESSIONAL INSIGHT | PRIVATE EQUITY
Financier Worldwide Magazine
Until recently, sponsors of private investment funds, such as private equity funds and hedge funds (collectively, ‘private funds’), could not solicit capital from the general public in the United States by advertising a specific private fund product (e.g., in financial publications or on their websites), without complying with the registration requirements of the US federal securities laws. Instead, most sponsors of private funds have raised capital by relying on Regulation D, promulgated under the US Securities Act of 1933, as amended, which provides certain statutory exemptions from the registration requirements if certain rules are adhered to. Among other things, the rules limit participation in most such offerings to investors meeting certain financial thresholds, so-called ‘accredited investors’, and, for issuers relying on a Rule 506 exemption (the most commonly used exemption) a prohibition against any form of ‘general solicitation’ or ‘general advertising’ as a means of raising capital. This all changed on 10 July 2013 when the US Securities and Exchange Commission (SEC), pursuant to a mandate in the Jumpstart Our Business Startups Act, as amended (the so-called ‘JOBS Act’), relaxed the US private placement rules by adopting new Rule 506(c) under Regulation D, thereby allowing issuers of securities, including private funds, to raise capital in the US by means of ‘general solicitation’ and ‘general advertising’. While the existing exemptions continue to be available to private funds, the JOBS Act has provided sponsors more options for raising capital in the US.
To date, private fund sponsors appear to be approaching Rule 506(c) cautiously, with most sponsors choosing to continue to raise capital under the existing regime without the use of ‘general solicitation’ or ‘general advertising’. While sponsors may be hesitant to use the new rules for a number of reasons, including reputational concerns, there are significant issues, including regulatory impediments, which sponsors should analyse carefully before engaging in ‘general solicitation’ and ‘general advertising’. Below, we explore just a few of those issues, but any sponsor considering availing itself of the new rules, should carefully consider the full spectrum of issues and requirements particular to the fundraising process.
Verification of accredited investor status
Similar to the existing exemptions, purchasers of securities in offerings made in accordance with new Rule 506(c) must be ‘accredited investors’, but the new rules also require sponsors that want to rely on Rule 506(c) to take ‘reasonable steps’ to verify that purchasers of securities are ‘accredited investors’. (Curiously, according to recent statements from the SEC staff, an offering will fail to satisfy the exemption if the sponsor fails to take ‘reasonable steps’ even if all purchasers are, in fact, ‘accredited investors’.) The SEC has suggested two general approaches to the new verification rules. The first is a principles-based, facts and circumstances approach, in which the sponsor would calibrate its verification efforts to the nature of the purchaser and the type of ‘accredited investor’ the purchaser claims to be, the amount and type of information regarding the purchaser that is available to the sponsor, and the nature of the offering, including the manner in which the purchaser was solicited and certain terms of the offering, such as the minimum investment amount. Second, bowing to public comment on the original proposing release, the SEC articulated the following non-exclusive methods for verifying the ‘accredited investor’ status of natural persons that, if used, would satisfy the verification requirement: (i) review of income verification information (e.g., based on recent tax returns); (ii) review of recent net worth verification information (e.g., bank statements, brokerage statements, and credit reports); and (iii) written confirmation by a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant that such person has recently taken reasonable steps to verify that an investor is an accredited investor. (There is a fourth method, expected to have a limited application, allowing certifications from purchasers who invested in a private fund relying on the existing rules if that same private fund subsequently conducts a Rule 506(c) offering under the new rules.)
Although the foregoing non-exclusive verification methods have provided helpful guidance regarding the verification steps that sponsors relying on new Rule 506(c) must take, the existence of multiple, non-exclusive verification methods, along with the SEC’s expectation that, in many cases, a private fund sponsor should tailor its verification methods to the specific circumstances of the offering, make it challenging for sponsors to implement a standardised verification program that will be sufficient to meet the requirements of Rule 506(c). In an 11 November 2013 article in New York Times DealBook, titled Private Equity’s Online Courtship, William Alden noted that, around the time of the adoption of Rule 506(c), certain businesses began to offer ‘matchmaking services’, which locate, and in some cases even vet, potential private fund investors from a broader-than-usual investor pool. Appropriately structured, such services could help connect sponsors with a broader set of investors, while also potentially helping to establish an industry-standard approach to vetting under Rule 506(c).
Interaction with certain CFTC Rules
Many private funds avoid registration with the Commodity Futures Trading Commission (CFTC) by relying on certain exemptions under CFTC rules and, it is not clear if private funds relying on one such commonly used exemption can engage in ‘general solicitation’ or ‘general advertising’ if they want to continue to rely on such exemption.Specifically, CFTC Rule 4.13(a)(3), which provides a registration exemption to certain commodity pool operators (CPOs) with respect to private funds that trade only a de minimis amount of commodity interests (many private funds fall under this category), prohibits marketing of such private funds to the public in the US. Therefore, a private fund whose CPO relies on Rule 4.13(a)(3) likely cannot also engage in ‘general solicitation’ and ‘general advertising’ under Rule 506(c). There are also open questions regarding whether private funds can engage in ‘general solicitation’ and ‘general advertising’ if the funds’ CPOs rely on CFTC Rule 4.7, which exempts registered CPOs from certain CFTC disclosure requirements, with respect to such funds. It is expected that the CFTC may take steps to conform CFTC rules to Rule 506(c), but, unless and until it does, significant uncertainty remains with respect to the interaction of these rules.
Interaction with non-US regulatory regimes
Finally, it is not clear whether private funds that also offer interests to non-US investors will be able to engage in ‘general solicitation’ or ‘general advertising’ directed at US investors if related solicitation and advertising materials are made available to or accessible by investors in non-US jurisdictions that prohibit ‘general solicitation’ and ‘general advertising’.
While many jurisdictions have been following a trend of liberalising private placement rules over recent years, many continue to impose limitations on ‘general solicitation’ and ‘general advertising’. In certain cases, US private fund sponsors relying on the new rules could still comply with private placement rules in such jurisdictions even if certain advertising or solicitation materials meant for US investors were viewed by or accessible to prospective investors in such jurisdictions (so long as private placement rules in such jurisdictions are otherwise satisfied), whereas such conduct could be problematic in many other jurisdictions. Therefore, private fund sponsors planning to use ‘general solicitation’ or ‘general advertising’ materials that are, or may become, accessible to non-US investors will need to carefully consider whether such activities may inadvertently violate private placement laws in any non-US jurisdictions where such sponsors are hoping to attract capital. The extent to which US ‘general solicitation’ and ‘general advertising’ may jeopardise private fund offerings outside the US is likely to continue to be an area of focus for private fund sponsors.
While the new rules have provided greater flexibility for sponsors offering private funds in the US, many questions remain, and sponsors are well-advised to consider both the US and multi-jurisdictional implications of engaging in ‘general solicitation’ and ‘general advertising’ prior to doing so. While a new frontier may have opened to private funds, it should be approached with caution.
Peter Laybourn is a partner and Michael Doore is an associate at Ropes & Gray LLP. Mr Laybourn can be contacted on +1 (617) 951 7558 or by email: firstname.lastname@example.org. Mr Doore can be contacted on +1 (617) 951 7149 or by email: email@example.com.
© Financier Worldwide
Peter Laybourn and Michael Doore
Ropes & Gray LLP