Best Practices for Ensuring That Only Accredited Investors Participate in Publicly Advertised Private Offerings by Hedge Funds (Part Two of Two)

In June 2013, under authority delegated to it by Congress in the JOBS Act, the SEC adopted Rule 506(c) under the Securities Act.  See “A Compilation of Important Insights from Leading Law Firm Memoranda on the Implications of the JOBS Act Rulemaking for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).  Rule 506(c) generally permits hedge fund managers to advertise a private offering while maintaining the offering’s Securities Act Section 4(a)(2) exemption from registration, so long as they, among other things, take reasonable steps to verify that investors in the offering are “accredited.”  See “SEC Provides Guidance on When the Bad Actor Rule Disqualifies Hedge Fund Managers from Generally Soliciting or Advertising,” Hedge Fund Law Report, Vol. 7, No. 9 (Mar. 7, 2014).  Recently, the CFTC issued guidance harmonizing its general solicitation rules with the SEC’s.  See “The Odyssey of Private Fund Advertising: From Great Expectations to Much Ado about Nothing,” Hedge Fund Law Report, Vol. 7, No. 36 (Sep. 25, 2014).  Hedge fund managers have been slow to access the expanded marketing rights under the JOBS Act rules.  See, e.g., “Dan Darchuck of Topturn Capital Discusses the Mechanics and Consequences of Video Advertising by Hedge Fund Managers,” Hedge Fund Law Report, Vol. 7, No 13 (Apr. 4, 2014).  One of the more frequently cited reasons for the industry-wide reluctance is the challenge of verifying the accredited status of investors.  Specifically, Rule 506(c)(2)(ii) contains four safe harbors pursuant to which a hedge fund issuer will be deemed to have taken reasonable steps to verify accredited investor status.  But those safe harbors entail practical obstacles.  To help the broker-dealer and investment management industries overcome those obstacles, the SEC and SIFMA issued guidance on complying with the safe harbors.  See “SEC and SIFMA Offer Additional Guidance on Rule 506(c) Accredited Investor Status,” Hedge Fund Law Report, Vol. 7, No. 30 (Aug. 7, 2014).  At PLI’s recent Hedge Fund Management 2014 program, Sidley Austin partner Thomas J. Kim and Davis Polk partner Nora M. Jordan – both principal drafters of the SIFMA guidance – explained the thinking behind the SIFMA guidance, how the guidance interacts with the Rule 506(c) safe harbors (in particular, the account method test and the investment amount test), how the guidance addresses privacy concerns, the rationale for the guidance’s focus on assets rather than liabilities and the utility of disclaimers in connection with 506(c) offerings.  This article summarizes the main points made by Kim and Jordan.  For the first article in our series covering the same PLI event, see “Davis Polk and Sidley Partners and MFA GC Address the Maze of Hedge Fund Marketing Regulation in the U.S. and E.U. (Part One of Two),” Hedge Fund Law Report, Vol. 7, No. 38 (Oct. 10, 2014).

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