FEATURE: Some strings attached

Since President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law on April 5, 2012, various segments of the private funds industry have been waiting for the day that the US Securities and Exchange Commission (SEC) would implement the provision of that law eliminating the prohibition on general solicitation for private offerings. After a multitude of delays, that day finally arrived on July 10, with the SEC voting to adopt a previously proposed rule lifting the ban for many types of private investment funds, including real estate. 

Known as Rule 506(c), the new rule substantially increases the scope of permitted activities during fundraising, allowing fund managers to engage in all forms of communication with prospective investors. In particular, it is likely to facilitate the use of the Internet and the press as means to communicate information about fund offerings. Even for those managers that do not intend to conduct a general solicitation, the rule may serve as a ‘safety net’ against accidental disclosures of offerings otherwise intended to comply with existing rules.

Of course, just because the ban on general solicitation has been lifted doesn’t mean that every firm will rush to abandon the status quo. Clearly, the new rule most benefits those firms that are struggling with their fundraising, managers that are looking to expand their investor pool and newer emerging firms as opposed to large established firms with many existing LP relationships. In addition, it does create a couple of new compliance hurdles for firms to clear in order to participate, and some believe that the benefits do not outweigh the costs.

Weighing the benefits

Within the private investment industry, there’s a camp that believes Rule 506(c) will usher in a new era of alternative asset managers regularly using the Internet and other media to bolster brands and generate more interest from investors, perhaps even taking out television advertisements. Even if it’s not to market specific fundraisings but to generally raise a firm’s profile, that can only be beneficial in the long term, they argue.

So, too, is the fact that alternative investment professionals will now be able to speak more freely in public, with the press and in front of peers at conferences and industry events. While those individuals still will need to meet various SEC requirements – such as refraining from making claims about future returns they are unable to substantiate – they no longer have to worry about whether the SEC will consider their comments to be ‘marketing’ and halt a fundraise in progress.

According to Jonathan Axelrad, partner in the private investment funds practice at Goodwin Procter, there are basically two things that the market is focused on regarding the flexibility provided by Rule 506(c). “The first is to increase exposure to investors by making a general solicitation, and the second is to gain more effective control over a firm’s general public persona, for example by speaking more freely with the press,” he says.

Indeed, most law firms traditionally have counseled against speaking with the press during fundraising, but that restriction could go away for those that opt in. In addition, the new rule frees up a firm’s public relations function, making sure the corporate message gets out accurately.

Lawrence Hass, partner and head of the private investment funds practice at Paul Hastings, notes that, under the current regime of Rule 506(b), which strictly limits a firm’s activities, it was difficult to reach out to new investors where the fund sponsor had no prior substantial relationship. According to Hass, a firm first had to go out and establish a relationship through meetings and dialogue about investment objectives without mention of a fund, then it had to wait a period of time before going back to that investor for a second meeting where it could discuss its fund. 

“Often, it can be hard to get those two meetings,” Hass says. “The ability to opt into 506(c) makes it easier to fundraise in that many of the communication obstacles are gone and it allows firms to reach out to new investors without first having a substantial relationship.”

A number of considerations

For those firms that do elect to take advantage of Rule 506(c), the requirements can be a bit more burdensome. Indeed, to benefit from the new rule, all investors admitted to a fund must qualify as ‘accredited’ investors and the manager must take reasonable steps to verify the accredited status of each investor. In addition, the GP must meet all other applicable requirements of Rule 506.

The new rule offers a non-exclusive list of verification methods deemed sufficient. They include: reviewing copies of any tax form that reports the income of the investor and obtaining a written representation that the investor has a reasonable expectation to earn a qualifying level of income in the current year; reviewing specified documents for assets, such as bank or investment account statements, and reviewing a report from a consumer reporting agency; or receiving written confirmation from a registered broker-dealer or investment advisor, licensed attorney or certified public accountant that the firm has taken reasonable steps to verify the investor’s accredited status. Unlike under the existing regime, self-verification by the investor is not among them, unless the investor in question is an existing investor with the firm.

A number of legal experts have identified this requirement as one potential hindrance to widespread implementation. For firms whose target investors are primarily institutions, verification is likely to be nothing more complex than filing out a form once. For those targeting high-net-worth individuals and offshore investors, however, the process could be a little more involved. Indeed, the industry already is discussing whether high-net-worth individuals would be willing to provide their tax returns as part of the verification process, which currently is not required. 

Costs also are an area of concern. “The mere fact that Rule 506c requires verification of accredited investor status presumably imposes some level of incremental cost, although for many funds that cost will be modest,” adds Axelrad. 

Meanwhile, state regulators are less than happy about Rule 506(c) because they believe it will result in more fraud. Although the SEC also voted to adopt rules that prohibit private offerings by ‘bad actors’, as well as proposing a variety of other rules to limit abuse under the new rule, state entities may look for additional ways to make general solicitation tougher. Furthermore, if a firm is fundraising outside the US, it will need to analyze the implications of the new rule in those markets as well, since solicitation and disclosure policies vary widely from country to country.

“Right now, we don’t really know how a foreign securities regulator will react to a general solicitation if a US-based fund manager tries to accept an investment from an investor located in that foreign jurisdiction,” Axelrad says, noting that it has never been tried before. “Securities regulators in all foreign jurisdictions will need to reach their own view on the impact of general solicitations in the US upon issuance of securities to their citizens.”

Parsing the proposals

Beyond the primary rules included with the adoption of Rule 506(c) on July 10, the SEC proposed a number of additional compliance rules that currently are out for public comment. Under those proposed rules, firms that wish to participate under 506(c) would need to make a pre-offering filing at least 15 days before engaging in solicitation, as well as file again within 30 days of final closing. The firm also would need to supply additional information about itself and the offering, including the identification of its website, the use of proceeds, potential methods of solicitation to be used and methods used to verify accredited investor status.
Currently, the traditional Form D is filed prior to the first closing and provides very little information. 

“The proposed rules really relate to filing requirements and whether a firm will need to pre-file to let the government know it will seek to utilize the new rule,” says Hass. “We don’t view that a major expense or even an obstacle, but it has yet to be seen what the government may do with that information.”

In addition, the proposed compliance rules also include a special two-year provision requiring the filing of all written marketing materials, which could include the private placement memorandum (PPM). While this temporary rule is designed to help the SEC gain a better understanding of what is happening in the marketplace, firms are fearful that someone at the SEC will look at the marketing materials, misunderstand its content and potentially take action on the mis-understanding. 

“This has the potential to change the way many firms prepare their marketing materials,” says Axelrad. “If it comes to pass, firms will hate that requirement with a white-hot passion.”

Hass, however, doesn’t see a major issue if new filings require inclusion of the PPM. The issue arises if the rule ends up requiring large amounts of additional information presented in a different way or format, he says.

As a matter of law, a firm is not required to have a PPM, Hass stresses, noting that it is a concept that has evolved over the years in order for sponsors to have comfort that the information provided to investors is complete and accurate. Because conversations with potential investors frequently take place before there is a PPM, if a rule requires filing one as part of the pre-filing, the effect is that a firm could not speak to investors about a fund until there is a PPM, he explains.

The proposed compliance rules currently are in a public comment period, which will stay open until September 23. Presumably, those rules will receive comments and the SEC will take those comments into consideration. Given the current pace of action, experts say it could be some time before the SEC makes a decision regarding the proposed rules.

Of course, the SEC is under no mandate to do anything with the proposed compliance rules, and two of the five commissioners already voted against even proposing the rules. Therefore, there is a meaningful chance that the proposed rules will be substantially revised before adoption, if they ever are adopted.

Final analysis

With Rule 506(c) scheduled to go into effect on September 23, firms can begin opting in and taking advantage of general solicitation within a few weeks, although the opposing camp argues that none of this is going to shift the status quo. In terms of general advertising to increase awareness and attract more investors, many in this group believe that the bulk of the private real estate industry will remain resolutely relationship-based, targeting accredited investors by way of personal, tailored outreach. 

Likewise, this group doesn’t expect previously tight-lipped GPs to suddenly start giving out firm or fund information to journalists. Rather, they anticipate the majority of private real estate firms will not tick the general solicitation box when filing Form D, meaning they will be just as careful with their words as they’ve always been.   

On compliance, the ‘nay-sayers’ also believe there’s more risk for those who go down the general solicitation route. They point out that any advertisement still is subject to anti-fraud rules and, without best practices or precedent to rely upon, it can be perilous for a fund manager to be the first one out of the gates. Some also dislike the SEC’s proposed temporary requirement for all GPs using general solicitation to submit their marketing materials for monitoring purposes – a level of regulatory attention some firms simply are not comfortable with. 

Of course, the trade-off is the ability to communicate more freely and access many more investors more easily and potentially with less expense. “Anyone is going to conclude that, if you need to build your investor list, the trade-off is worth it,” says Hass.

Axelrad agrees. “It seems likely that firms having difficulty meeting their fundraising targets will be aggressive early adopters of 506(c),” he says. “Other firms are more likely to take a wait-and-see attitude, but it does seem likely that, over time, the enhanced communication opportunities will lead many firms to take advantage of Rule 506(c), even if they don’t need it for fundraising purposes.” 


Read between the lines

With the dawn of general solicitation, the SEC is tightening up rules for all 506 offerings

Back when there was no alternative path, many people and firms were engaging in technical violations of the solicitation ban, which the SEC largely ignored because it had greater priorities. Now, with the advent of Rule 506(c), which allows general solicitation, the agency can say it has given the industry recourse via compliance with the new rule. Therefore, if a firm chooses to ignore this clear path by pursuing a 506(b) offering, not verifying investors and still communicating publicly, that firm is a violator that ignored the rules as opposed to one that just had a slip. 

“The risks of technical violations under 506(b) just went up,” says Jonathan Axelrad, partner in the private investment funds practice at Goodwin Procter. “The mere existence of 506(c) increases the risks of using 506(b) as far as technical violations are concerned.”

No one at the SEC has come out to say anything like that yet, but it is worth noting that the ‘bad actors’ rule is not limited to 506(c) offerings and applies to 506(b) offerings as well. So, the SEC already has made it clear that it is prepared to tighten up 506(b) as part of the overall process of implemented 506(c). In other words, if a manager continues to use 506(b), the SEC is going to hold that firm to those rules more rigorously.