General Solicitation Under Regulation D – Recent Trends and Enforcement Activity
Rule 506(b) offerings under Regulation D (the traditional approach to Regulation D private placements) very much continue to be the primary avenue for private markets fund offerings. However, over the past few years, we have seen a noticeable uptick in 506(c) general solicitation offerings in the private markets space. There are multiple factors driving this change.
Firstly, in contrast to the SEC administration tasked with implementing the 506(c) regime over a decade ago (with the goal of facilitating increased capital inflows into private markets), more recent SEC administrations have been increasingly receptive to fund managers engaging in such offerings. In fact, in certain recent exams where SEC examiners took the position that private markets fund managers had engaged in prohibited general solicitation in connection with their respective 506(b) offerings, these examiners recommended these firms switch their offerings to 506(c). This shift in the SEC’s mindset, at least in part, has incentivized private fund managers to more seriously consider engaging in general solicitation than in the past. As more fund managers embrace the 506(c) regime, the practical challenges associated with such offerings have started to appear less insurmountable and managers have found comfort in numbers and easier to benchmark approaches in the greyer areas of 506(c) compliance.
Secondly, as the SEC has started to vigorously enforce the older 506(b) regime, and an increasing number of private markets fund managers have been cited for have engaged in improper general solicitation, certain fund managers have sought to rely on 506(c) to insulate themselves from such deficiency findings. Here, 506(c) effectively serves as a safe harbor for these managers, even though they do not intend to market their funds publicly (e.g., via a television ad or banners at a sporting event).
Thirdly, in recent years we have seen high net worth investors increasingly become interested in private markets investments – historically the exclusive domain of large and sophisticated institutional investors. Driven by this trend, certain private markets fund managers have chosen to switch their offerings to the 506(c) regime to more effectively source capital from this historically untapped market.
Recent Regulatory Trends
Enforcement activity and SEC deficiency findings relating to improper 506(b) offerings are no longer new trends. Over the past few years, we have seen a steady uptick in the SEC’s efforts to aggressively regulate 506(b) offerings – particularly to ensure managers are not cherry picking by seeking to simultaneously take advantage of the benefits of both 506(b) and 506(c) offerings without addressing the associated administrative burdens. Our Q3 2022 Private Markets Update analyzes recent enforcement activity in this space and presents key takeaways for private markets fund managers. Additionally, with the slow-but-steady proliferation of 506(c) offerings, we have seen SEC examiners increasingly examine whether fund managers are independently verifying the accredited investor status of prospective investors. However, until very recently, we did not see enforcement activity in this area.
In what may well be the first 506(c)-related enforcement activity, the SEC recently sanctioned an unregistered private real estate fund manager for allegedly conducting an unregistered offering - by failing to take reasonable steps to independently verify the accredited investor status of investors it sourced through a 506(c) offering conducted via multiple channels (including an unrestricted website, YouTube videos and a press release). Consequently, multiple investors who did not qualify for accredited investor status were admitted to a fund managed by the foregoing manager. More specifically, the SEC alleged that the fund manager:
- Failed to adopt written policies and procedures, controls or compliance measures relating to accreditation verification and failed to provide training to employees involved in soliciting investments to ensure that the manager only sold fund interests to accredited investors;
- Inappropriately sought to rely on subscription document self-certifications sought from investors (and even there failed to follow-up with investors who had not completed these certifications);
- Accepted investments from some investors after receiving documentation that on its face indicated these investors did not qualify for accredited investor status; and
- In the case of entities that did not meet accredited investor status at the entity-level, failed to undertake entity look-thru analysis to ensure all beneficial owners of these entities were themselves accredited investors.
- The foregoing enforcement action provides a detailed action-oriented road-map for managers engaging in (or considering engaging in) 506(c) offerings. As noted in the enforcement action, managers engaging in such offerings should have detailed policies and procedures to address how they intend to verify prospective investors’ accredited investor status and periodically train applicable employees on implementing these policies and procedures. The enforcement action explicitly clarifies that relying on self-representations in subscription documents is not sufficient on its own.
- Since the 506(c) regime takes a principles-based approach for verification (and provides a non-exclusive list of verification procedures in relation to natural person investors to ensure greater certainty that such persons qualify for accredited investor status), fund managers may want to consider a bi-furcated approach. This would involve a more flexible approach for vetting institutional investors and a less open-ended approach for natural person investors (leveraging the various non-exclusive verification approaches alluded to above). Managers seeking more flexibility in vetting institutional investors should nevertheless maintain sufficient granular policies and procedures here to ensure a relatively high level of consistency in approach.
- To the extent a fund manager is engaging in verification in-house, compliance should have a process for ensuring the verification processes are being properly implemented – e.g., engaging in spot-testing to ensure that documentation evidencing an investor’s net-worth and/or income adequately demonstrates the investor’s qualification for accredited investor status.
- An increasing number of fund managers are outsourcing the verification process (particularly in the case of prospective high net worth investors) to third parties for a variety of reasons (e.g., where investors are uncomfortable sharing financial information with their managers or to ease the administrative burden on in-house staff). In such instances, as demonstrated in multiple SEC exams, the SEC expects such managers to engage in adequate due-diligence (initially and on an ongoing basis) to ensure such third parties have robust verification policies and procedures and are consistently following them.
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