I. Background

As required by Section 201(a) of the Jumpstart Our Business Startups Act, enacted on April 5, 2012 (the “JOBS Act”)¹, the Securities and Exchange Commission (the “SEC”) has proposed a new rule 506(c) that would permit an issuer, including a private fund², to engage in general solicitation and general advertising in connection with offering its securities under Rule 506 of Regulation D of the Securities Act of 1933, as amended (the “Securities Act”) to accredited investors. Rule 506(c), which is expected to be adopted in the near future, will significantly expand the marketing opportunities that private funds may pursue by allowing them to engage in certain “public” advertising activities. This memorandum discusses Rule 506(c) and identifies certain business, regulatory and compliance issues that advisers to private funds should consider and address prior to pursuing these new marketing opportunities.

II. Rule 506(c)

Most private funds rely on Rule 506 to offer their securities to U.S. persons in transactions exempt from registration under the Securities Act and to avoid registering as investment companies under the Investment Company Act. Prior to the passage of the JOBS Act, Rule 506 prohibited a private fund, or any person acting on its behalf, from offering or selling securities through any form of “general solicitation or general advertising”. The SEC staff has historically interpreted these terms broadly to prohibit, among other activities, cold calling, advertisements published in newspapers and magazines, communications broadcast over television and radio, and seminars whose attendees have been invited through such general solicitation or general advertising. Further, the SEC staff has confirmed that other uses of publicly available media, such as unrestricted websites, also constitute general solicitation and general advertising.

Rule 506(c) will allow private funds to engage in general solicitation and general advertising, provided that the following conditions are met:

• the private fund takes reasonable steps to verify that the purchasers of its securities are accredited investors;
• all purchasers of the securities are accredited investors; and
• all terms and conditions of existing Rule 501 (definitions) and Rules 502(a) (integration restrictions) and 502(d) (resale limitations) are fulfilled.

Private funds and their advisers will need to carefully review, and amend as necessary, their existing marketing programs, offering documentation and related policies and procedures prior to engaging in any general solicitation or general advertising activities to ensure that they have in place appropriate policies and procedures to comply with Rule 506(c) and related securities laws.

III. Key Issues to Consider

General Solicitation and Advertising Policies and Procedures

Advisers to private funds intending to engage in public marketing activities under Rule 506(c) should first review, and amend as appropriate, their compliance policies and procedures governing marketing activities. Such policies and procedures were likely designed to prohibit general solicitation and advertising by requiring the fund (or adviser) to document a pre-existing relationship with each potential fund investor prior to discussing an investment in the fund with the investor. The policies also likely prohibited advisory personnel from discussing the private funds in public settings (e.g., in print or televised media, at open conferences, etc.).

Rule 506(c) would permit advisers relying on the Rule to remove these requirements and prohibitions from their policies and procedures. Such advisers should also consider adding internal policies, procedures and limitations addressing any new public marketing activities. For example, such advisers may want to (i) specify in their policies the types of public marketing activities in which they will engage, (ii) add procedures for authorizing such activities, and (iii) establish other parameters concerning the firm’s public marketing activities.

Advisers should also review their current marketing materials for compliance with SEC rules and guidance, particularly the disclosure requirements and related limitations the SEC staff has applied to performance advertising. Neither the JOBS Act nor Rule 506(c) places any new restrictions on advertising content; however, all marketing materials are subject to general anti-fraud provisions of the federal securities laws, including Rule 10b-5 under the Securities Exchange Act of 1934, as amended and Section 206 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). These anti-fraud provisions generally prohibit fraudulent, deceptive and manipulative activities³. Advisers should also note that much of the existing guidance regarding performance advertising was issued by the SEC staff through no action interpretive letters and based on particular facts and circumstances described in such letters⁴. For this reason, advisers should carefully consider the extent to which such guidance may or may not extend to materials disseminated more broadly under Rule 506(c) due to the change in context and scope of distribution.

Prohibition on Non-Accredited Investors

Currently, Rule 506 permits a private fund to admit up to 35 non-accredited sophisticated investors. In reliance on this rule, many private funds have non-accredited investors that are friends, family and employees. Significantly, Rule 506(c) requires all investors to be accredited investors and does not, absent further guidance from the SEC, provide a grandfathering provision for non-accredited investors in a fund. As a result, private funds that currently have non-accredited investors may have to redeem those non-accredited investors from the fund prior to engaging in public marketing under Rule 506(c). Further, going forward these private funds may be precluded from admitting non-accredited investors (even employees who are non-accredited).

Verification Policies and Procedures

Private funds intending to rely on Rule 506(c) should review and revise as necessary their offering and subscription documentation and procedures to ensure they will be able to comply with Rule 506(c)’s verification requirements. This represents a significant departure from current practice that generally permits a private fund to rely on the representations in the subscription agreement unless it has specific reason to know they are untrue. Under Rule 506(c), relying solely on the investor’s representation that it is accredited may not be sufficient in all cases. The SEC has not identified specific procedures that issuers must follow to satisfy the verification requirements and instead stated that applicable procedures will depend on the facts and circumstances of each case. As a result, we expect industry practices regarding verification to evolve over time as Rule 506(c) goes into effect and to the extent the SEC provides further guidance.

Commodity Futures Trading Commission (“CFTC”) Regulations

Advisers to private funds frequently rely on certain exemptions under the Commodities Exchange Act, as amended (the “CEA”) that also prohibit “marketing to the public.” CFTC Section 4.13(a)(3) provides an exemption from commodity pool operator registration where commodity interest trading is limited, pool participants are sophisticated and pool interests are not marketed to the public in the U.S. Similarly, certain advisers that trade commodity interests for managed account clients (i.e., commodity trading advisors (“CTAs”)) rely on an exemption from CTA registration pursuant to CEA Section 4m(1) and CFTC Rule 4.14(a)(10) conditioned on their providing trading advice to no more than 15 persons, as long as they do not hold themselves out to the public as CTAs. Rule 506(c) will not alter these CFTC exemptions. Advisers relying on these exemptions may not be able to take advantage of Rule 506(c), unless the CFTC issues new rules removing the prohibition on “marketing to the public” or otherwise harmonizes its exemptions with Rule 506(c).

State Investment Adviser Registration and Blue Sky Laws

The Advisers Act generally prohibits the states from applying their investment adviser registration requirements to SEC registered investment advisers, and the Securities Act generally prohibits the states from applying their securities registration requirements to securities issued under Rule 506. In both cases, however, state securities regulators may require the investment adviser or the issuer, as the case may be, to submit certain notice filings and pay applicable filing fees. In addition, exempt reporting advisers⁵ may have to register with the state securities authorities in the states in which they operate absent an available exemption at the state level.

Advisers and private funds often seek to rely on specific exemptions from these potential notice filing and registration requirements available under the applicable state blue sky laws. In many cases these state exemptions from investment adviser notice filings/registration are conditioned on the adviser not holding itself out generally to the public as an investment adviser. Advisers to private funds that offer securities under Rule 506(c) may be deemed to be holding themselves out publicly as investment advisers for purposes of these exemptions. Accordingly, SEC registered advisers should review any applicable state exemptions that they rely on to determine whether a Rule 506(c) offering could trigger state notice filing requirements, and exempt reporting advisers should determine whether such activities could trigger a state registration obligation.

Similarly, many exemptions from the state notice filing requirements for private securities offerings are available only for securities offered without any general solicitation or advertising. Securities offered under Rule 506(c) through public marketing activities may no longer qualify for the exemptions from notice filings that are conditioned on the prohibition of general solicitation or advertising. Private funds relying on Rule 506(c) will need to review their notice filing policies to determine whether any additional notice filings will now be required for their offerings.

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We will update you upon adoption of the proposed amendments. If you have any questions concerning this memorandum or the rule proposals, please contact an attorney in the Investment Management Group at Seward & Kissel LLP.

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¹ Please see our memorandum dated March 30, 2012 which outlines the passage of the JOBS Act.

² Private funds typically avoid registration under the Investment Company Act of 1940, as amended (the “Investment Company Act”) by relying on exclusions from the definition of an “investment company”, such as Sections 3(c)(1) or 3(c)(7) of the Investment Company Act. Section 3(c)(1) excludes from the definition of “investment company” any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 beneficial owners, and which is not making and does not presently propose to make a public offering of its securities. Section 3(c)(7) excludes from the definition of “investment company” any issuer whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are “qualified purchasers,” and which is not making and does not at that time propose to make a public offering of its securities.

³ In particular, they prohibit the making of untrue statements of material facts or omissions to state material facts required to make the statements that are made not misleading in connection with the offer and sale of securities.

⁴ For example, SEC no action interpretive letters have allowed advisers more flexibility to present performance information in materials used in face-to-face meetings with a limited number of sophisticated investors than it has in other contexts.

⁵ An “Exempt Reporting Adviser” is an investment adviser that qualifies for the exemption from registration under Section 203(l) of the Advisers Act because it is an adviser solely to one or more venture capital funds, or under Rule 203(m)-1 of the Advisers Act because it is an adviser solely to private funds and has assets under management in the United States of less than $150 million.