Investment Fund Law Blog
Written by: Jay B. Gould, Michael Wu and Peter Chess
Note: Pillsbury and KPMG, along with the California Hedge Fund Association, will be sponsoring a “Managers Only” event on the JOBS Act and the new world of “general solicitation” for Funds on June 14.
The Jumpstart Our Business Startups Act (the “JOBS Act” or the “Act”), signed into law by President Obama on April 5, 2012, seeks to encourage economic growth through the easing of certain restrictions on capital formation and by improving access to capital. The JOBS Act contains a number of provisions that will directly impact private funds and their general partners, managers and sponsors. Below is a summary of the Act’s provisions that directly affect private funds, including ongoing requirements for funds that at this time do not appear to be affected by the Act.
Section 4 of the Securities Act. The JOBS Act amends Section 4 of the Securities Act of 1933, as amended (“Securities Act”), so that offers and sales exempt under Rule 506 of Regulation D will not be deemed public offerings as a result of general advertising or general solicitation. Private funds relying on the exception in Section 3(c)(1) (“3(c)(1) Fund”) of the Investment Company Act of 1940, as amended (“Investment Company Act”), will be able to continue to avail themselves of this exception so long as all of their investors are accredited investors, as defined in Rule 501 of Regulation D (“Accredited Investors”). We expect that private funds relying on the exception in 3(c)(7) (“3(c)(7) Fund”) of the Investment Company Act will obtain the greatest benefit from the JOBS Act, as these funds, which accept only “qualified purchasers,” as defined in Section 2(a)(51) of the Investment Company Act, may now have up to 2000 investors (as discussed below) before they would be required to register as a public reporting company under the Securities Exchange Act of 1934, as amended (“Exchange Act”). 3(c)(1) Funds will continue to be limited to 99 investors, although a fund manager may organize and offer both a 3(c)(1) Fund and a 3(c)(7) Fund with the same investment objective and strategies without the two funds being subject to “integration” under the Securities Act.
General Solicitation and General Advertising. The JOBS Act requires the Securities and Exchange Commission (“SEC”) to amend Regulation D under the Securities Act to eliminate the prohibition on general solicitation and general advertising for offerings under Rule 506, provided that all purchasers are Accredited Investors. The Act mandates that the SEC implement rule amendments ninety days after the enactment of the Act, or by July 4, 2012.
It is unlikely that the SEC will be able to meet this deadline given the requirement to provide public notice and comment prior to adopting any final rules; accordingly, these rule amendments are expected to be adopted by the fall with very little transition period. Although the Act leaves little in the way of discretion to the SEC in the rulemaking process there are two areas in which the SEC may seek to provide substantive guidance. The SEC is required to amend Regulation D such that any issuers relying on Rule 506 must take reasonable steps to verify that purchasers are Accredited Investors. Some observers believe that the SEC may require issuers that avail themselves of the general advertising provisions to obtain sufficient financial information from prospective purchasers so that the “accredited status” of such investors can be more precisely determined. This could take the form of requiring all such issuers to obtain an income statement or verified financial statement from investors. The other area in which the SEC may attempt to provide additional oversight is with respect to the offering of private fund interests through broker-dealers.
Brokers and Dealers. The JOBS Act provides that with regard to securities offered and sold under Rule 506 and subject to certain conditions, registration as a broker or dealer under Section 15(a)(1) of the Exchange Act will not be required for certain persons solely because of the performance of specific functions.[1] This exemption from registration is available only if such persons: (i) receive no compensation in connection with the purchase and sale of the securities; (ii) do not have possession of customer funds or securities in connection with the purchase and sale of securities; and (iii) are not subject to statutory disqualification (sometimes referred to as “bad boy” provisions). Although it is uncertain at this time, the SEC may take this opportunity to require private funds that avail themselves of the ability to advertise generally to conduct all offers and sales of their fund interests through a registered broker-dealer. The SEC realizes that as a result of the fast moving and innovative private funds industry, the regulator lost control of Regulation D as well as the “issuer’s exemption” in Rule 3a4-1 under the Exchange Act, the exemption that fund managers rely upon to offer their securities directly to purchasers. It is not clear that Rule 3a4-1 was ever intended for this purpose, and the SEC may take this opportunity to clarify how offers and sales are conducted generally by private fund managers.
Record Holders. The JOBS Act increases from 500 to 2,000 the number of record holders of equity securities an issuer may have before the issuer is required to register under Section 12(g) of the Exchange Act, so long as the number of non-Accredited Investors does not exceed 499. 3(c)(1) Funds will be unable to have any non-Accredited Investors if they want to employ general advertising even though, under Regulation D rules that predate the JOBS Act, sales could be made to up to 35 non-Accredited Investors (with no general solicitation). There is an outstanding question as to whether the SEC will “grandfather” in existing non-Accredited Investors in 3(c)(1) Funds, or if perhaps some form of Rule 506 will survive whereby sales to non-Accredited Investors will be permissible if no general solicitation takes place.
Continuing Restrictions and Obligations. Although the JOBS Act will potentially ease the burdens presented by capital raising for private funds, the following should be noted:
- Private fund offerings pursuant to Rule 506 will continue to be subject to the anti-fraud provisions of federal and state securities laws and the restrictions on advertising found in the Investment Advisers Act of 1940, as amended (“Advisers Act”). For example, Rule 206(4)-1 of the Advisers Act (the advertising rule) and its general prohibition against advertisements that are false and misleading still necessitates compliance. Managers of private funds that advertise generally must understand the advertising rules against “testimonials” in their public marketing materials. To be “liked” on Facebook or similarly endorsed on other social networking sites would likely be considered to be an illegal testimonial by the SEC which could result in and administrative action accompanied by fines and penalties.
- Private funds should continue to rely on the guidance provided in the Clover Capital Management, Inc. SEC no-action letter and the subsequent line of letters when contemplating activities such as performance presentations by following practices so as not to present misleading performance results. Further, private funds should continue to comply with Rule 206(4)-8 of the Advisers Act and its prohibition on making untrue statements or omitting material facts or otherwise engaging in fraudulent, deceptive or manipulative conduct regarding interactions with investors in pooled investment vehicles. To the extent a private fund manager avails itself of the ability to advertise past performance, special care will need to be taken to ensure that all documents are consistent and performance information is presented in a manner that is complete and accurate.
- Private funds should consider and continue to comply with advertising and disclosure rules as applicable to registered advisers and members of the Financial Industry Regulatory Authority (“FINRA”). FINRA rules also apply to broker-dealers acting as placement agents or intermediaries in Rule 506 transactions. Private funds making use of exemptions from registration under the Advisers Act and/or the Investment Company Act must continue to comply with the restrictions set forth in such exemptions. For example, although the JOBS Act provides that offers and sales exempt from registration under Rule 506 will not be deemed public offerings by virtue of the use of general advertising and general solicitation, 3(c)(1) Funds must not exceed the one hundred beneficial owner limit.
Foreign Private Advisers. A “foreign private adviser” that qualifies for the exemption from registration under the Advisers Act is an adviser that has no place of business in the U.S., fewer than 15 U.S. clients, less than $25 million attributable to U.S. clients and does not hold itself out generally to the public in the U.S. as an investment adviser. The SEC in the past has construed certain types of advertising, including information available on websites, as an example of an adviser holding itself out to the public in the U.S. as an investment adviser. Given the increased freedom for advertising under the JOBS Act, the SEC may look more closely at advisers taking advantage of the foreign private adviser exemption and whether any activities that could be construed as advertising may violate the terms of the exemption.
Regulation S. Regulation S under the Securities Act, the safe harbor from registration for offshore sales of securities to non-U.S. persons, does not allow for “directed selling efforts” in the U.S. It remains to be seen if general solicitation or advertising in connection with the amendments to Regulation D will be seen as “directed selling efforts” under Regulation S and whether the SEC will clarify how this will affect the potential use of Regulation S in connection with offerings under Rule 506.
State Blue Sky Laws. Many private funds have relied on self-executing exemptions in certain states in order to avoid filings and/or fees required under applicable state statutes or rules. These self-executing exemptions are commonly conditioned on a prohibition on general solicitation or general advertising. Private funds employing general solicitation and/or advertising in reliance on the amended Rule 506 should note the mechanics of such Blue Sky laws of the states where securities are being offered and sold and comply accordingly.
[1] This applies to persons that: (a) maintain a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means; (b) co-invest in such securities; or (c) provide ancillary services with respect to such securities.