Advisors to private funds engage in the solicitation of the private placement of interests in a fund. Interests in private funds are not registered under U.S. or foreign securities laws because of the exemption offered by Rule 506 of Regulation D. Previously, private funds were prohibited by Rule 506 from publicly offering and conducting general advertising or general solicitation in offering and selling the private fund’s securities. In 2014 the JOBS Act directed the SEC to remove the prohibition on general solicitation provided that sales are limited to “accredited investors” that issuers have taken reasonable steps to verify.
Investment advisors are permitted to engage in private or general solicitation with respect to private placement of interests in a fund. The type of solicitation used should be determined and maintained throughout the capital raise process.
Under the private solicitation rules, investment advisors are prohibited from soliciting investors by any of the following means:
- any advertisement or notice in print or electronic media;
- unsolicited telephone solicitations or mailings to prospective investors with whom the Firm has no pre-existing, substantive relationship;
- seminars or other meetings or presentations open to the public; or
- publication of solicitation materials over the internet.
A “pre-existing” relationship is one that the issuer has formed with a prospective investor or, alternatively, one that was established through an intermediary prior to sending the prospective investor any offering materials. As a general matter, the SEC clarified that there is no minimum waiting period required to establish a pre-existing, substantive relationship with a prospective investor. A “substantive” relationship is one in which the issuer (or its agent) has sufficient information to evaluate, and does in fact, evaluate a prospective investor’s financial circumstances and sophistication in determining its status as an accredited or sophisticated investor. Self-certification alone (i.e., by checking a box) is not sufficient. The quality of the relationship between an issuer (or its agent) and a prospective investor is the most important factor. Under the private solicitation rules, no offering material may be sent to a prospective investor unless a pre-existing, substantive relationship has been established.
Should an Advisor choose to engage in public solicitation, advertising to the public is permissible provided the Advisor takes “reasonable steps” to ensure that all investors are “accredited” prior to signing a subscription agreement. Reasonable steps include reviewing one or more of the following types of documentation dated within the prior three-month period:
- With respect to institutions: Annual financial report or quarterly financial statement;
- With respect to individuals: Bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third-parties; and a consumer report from at least one of the nationwide consumer reporting agencies;
- With respect to a person who qualifies as an accredited investor based on joint income or joint net worth with that person’s spouse: Copies of IRS forms for the two most recent years and obtaining written representations from the person and the spouse;
- For a person who qualifies as an accredited investor based on joint net worth with that person’s spouse: Documentation and written representations from both the person and the spouse; or
- Obtaining a written confirmation from a Broker-Dealer, Investment Adviser, attorney or Certified Public Accountant that such person has determined that such purchaser is an accredited investor.
An Advisor should rely on its outside counsel to review the documentation provided by each new investor prior to receipt of funds to confirm that reasonable steps have been taken to ensure that all investors are accredited. Self-accreditation by an investor (e.g., a check-the-box representation in a subscription agreement) will not meet the Rule 506 verification requirement.
The Dodd-Frank Act prohibits the use of the Rule 506 exemption for any securities offering in which certain felons and other bad actors are involved (the “Disqualification Rule”). Under the Disqualification Rule, an issuer cannot rely on the Rule 506 exemption if the Advisor or any other person soliciting on behalf of the Advisor had a “disqualifying event”.
The Disqualification Rule covers the Advisor as well as its:
- Directors and certain officers, general partners, and managing members.
- 20% beneficial owners (calculated based on total voting power).
- Persons compensated for soliciting investors, including their directors, general partners and managing members.
Under the Disqualification Rule, a “disqualifying event” includes:
- Criminal convictions in connection with the purchase or sale of a security;
- Court injunctions and restraining orders;
- Final orders from the CFTC, or state regulators of securities, insurance or banking;
- Certain SEC disciplinary orders;
- SEC cease-and-desist orders; or
- Suspension or expulsion from membership in a self-regulatory organization (SRO).
For a complete list of “disqualifying events” refer to Rule 506 Securities Act of 1933, as amended (the “Securities Act”).
Disqualification applies only for disqualifying events that occur on or after September 23, 2013, the effective date of the Disqualification Rule. Matters that existed before September 23, 2013 and would otherwise be disqualifying are subject to a mandatory disclosure requirement to investors.
To comply with the Disqualification Rule, Advisors must obtain certifications from “Covered Persons” to determine if such persons have been the subject of a Rule 506 “disqualifying event” or an event that must be disclosed on the Firm’s Form ADV. The “Bad Actor Questionnaire” shall be completed by each person engaged in the solicitation and private offering process prior to the Fund’s closing. In addition, all solicitation agreements must contain representations on the part of the solicitor stating that the solicitor has not had a “disqualifying event.”
The Advisor’s CCO should ensure that the appropriate information is obtained from Covered Persons and consultants, if any, using a “Bad Actor Questionnaire”. If the CCO should discover that a “bad actor” was used in the sale of private placement of Regulation D securities, proper disclosure should be made to its investors.
Payments to Third-Party Solicitors
The SEC has established guidelines through Rule 206(4)-3 for Advisers to pay cash referral fees to third-parties that solicit investors on behalf of the Advisor as long as certain basic requirements are met:
- There must be a written agreement between the Advisor and the solicitor, a copy of which the Adviser must retain detailing the referral arrangement.
- At the time of any solicitation activities, the solicitor must provide the prospective investor with a copy of the Advisor’s brochure and a separate written disclosure document that discloses among other things that the solicitor is being compensated (including any additional amounts the client will be charged by the adviser as a result of the referral arrangement – or that there will be no additional charge).
- The Advisor receives from the client, prior to or at the time of entering into any written or oral investment advisory agreement with the client, a signed and dated acknowledgement that the client received the Advisor’s brochure and the solicitor’s written disclosure document.
- The Advisor must make a bona fide effort to ascertain whether the solicitor is in compliance with the terms of the agreement and to have a reasonable basis for believing that the solicitor is in compliance.
- The Advisor must ensure that solicitor registration requirements, if any, are met.
- The Advisor must ensure Form ADV Part 1 Item 8.F and Part 2 Item 13.B accurately disclose the use of solicitors.
Advisors should provide the solicitor with written instructions on the requirements and expectations. The solicitor should be made aware that if the prospective investor refuses to sign the acknowledgement that they have received the brochure and written disclosure document or any other requirement that has not been met, the solicitor will not be paid the solicitor fee.
Because each state has its own set of rules, advisors should know whether a solicitor needs to be registered as an investment advisor and if they are registered.
If the solicitor will be soliciting prospective government clients (i.e. public pension plans) be sure to conduct a two-year look back on political contributions so that fees are not impacted by the Pay-to-Play Rule.
Books and Records Retention Requirements
Books and records related to solicitors include:
- The name and business address of each regulated person to whom the Firm provides or agrees to provide, directly or indirectly, payment to solicit a government entity for investment advisory services on its behalf, in accordance with Rule 206(4)-5(a)(2).
- Records of all payments made to solicitors.
- All written acknowledgments of receipt obtained from investors.
- Copies of the disclosure documents delivered to investors by solicitors.
All required books and records must be maintained for 5 years and on-site for the first 2 years.
We hope you find this information helpful. Please contact us with any questions.