The challenge is verifying annual income or net worth of “natural person” investors. Natural persons are accredited if they meet either an annual income test or a net worth test. The SEC has listed four non-exclusive “safe harbors” for determining that a natural person is accredited. If a fund manager fits within any of these safe harbors, it will have satisfied the SEC’s standard of verification unless it has actual knowledge that an investor is not accredited. It is not necessary to fit within one of the safe harbors, but the fund manager will then have the burden of demonstrating, if asked by the SEC, that it used reasonable steps to verify that the investor was accredited.
The four safe harbors involve:
1.Reviewing copies of IRS forms that report an investor’s income and getting the investor’s representation that he or she expects to meet the income requirement for the current year;
2. Reviewing recent financial documents that report an investor’s net worth (such as bank/brokerage statements and a credit report) and getting the investor’s representation that all liabilities have been disclosed;
3. Obtaining a written confirmation from a registered broker-dealer, SEC registered investment adviser, licensed attorney or certified public accountant that such person has determined the investor is accredited; or
4. For existing investors in a fund when the new rule becomes effective, obtaining a certification that he or she still qualifies as an accredited investor.
Downsides to using the New Rule 506(c)
As discussed more fully below, while Rule 506(c) may open the door for advertising, each manager must still determine if the benefits of advertising outweigh the costs. Additionally, while most funds rely on Rule 506 of Reg D, a fund may have the fallback option of relying on the statutory exemption in Section 4(a)(2) of the Securities Act of 1933 for “transactions by an issuer not involving any public offering.” Reg D is safe harbor for complying with the statutory exemption in Section 4(a)(2). Previously, if a fund made an offering that failed to meet the requirements of the Rule 506 safe harbor, the fund could potentially still fall back on the statutory exemption because there was no public offering. This remains the case for funds who do not publicly solicit or advertise. However, if a fund advertises its offering in reliance on new Rule 506(c), the fallback option of Section 4(a)(2) will not be available if the requirements of Rule 506(c) are not met.
The Proposed Rules
As mentioned earlier, the SEC also proposed various new rules under Reg D and asked for public comments. Specifically, the Proposed Rules would have the following effects if enacted as proposed:
1. Written general solicitation materials used in a Rule 506(c) offering would temporarily need to be filed with the SEC.
2. Form D would have to be pre-filed in any Rule 506(c) offerings 15 days before the first advertisement and an amended Form D would be required 15 days after the first investor buys an interest in the fund. Currently, Form D filings are only required within 15 days after the first sale.
3. All funds (even those not advertising) would have to file a closing amendment to Form D at the end of the offering.
About the Author
David M. Matteson (pictured) is a partner and Andrew C. Raby is a senior associate at Drinker Biddle & Reath. They practice in the firm’s Investment Management Group, assisting alternative investment clients, including many CPOs and CTAs