United States: U.S. JOBS Act Remakes The Standards For Offerings Of Hedge Funds And Private Equity Funds

President Obama on April 5, 2012 signed into law the Jumpstart Our Business Startups Act ("JOBS Act" or "Act"). The JOBS Act seeks to eliminate certain restrictions on capital formation and to encourage economic growth in the United States by "improving access to the public capital markets for emerging growth companies," a new category of issuers created by the Act.

The JOBS Act also includes provisions that significantly ease the restrictions on general solicitation and general advertising for all issuers making private offerings of securities in accordance with Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933, as amended ("Securities Act").

This DechertOnPoint focuses on those sections of the JOBS Act that will affect how private funds, such as hedge funds and private equity funds, can market to potential investors.

Background

Section 5 of the Securities Act prohibits offers and sales of securities by means of the U.S. mails or interstate commerce unless such securities are registered with the U.S. Securities and Exchange Commission ("SEC"), except if an exemption from registration applies. Since limited partnership interests, limited liability company interests, shares and other interests offered to investors by a private fund (i.e., a fund relying on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940, as amended ("Investment Company Act")), are within the definition of the term "securities" for purposes of Section 5, the sponsor of a private fund must either register those securities or rely on an exemption from registration.

Rule 506 of Regulation D, adopted pursuant to Section 4(2) of the Securities Act, provides a non-exclusive safe harbor for private offerings of securities (i.e., private placements) that intend to qualify for the exemption from registration for non-public offering of securities provided in Section 4(2).¹ If an offering of securities falls within the safe harbor provided by Rule 506, registration of the securities under Section 5 is not required.

The safe harbor found in Rule 506 of Regulation D permits the private placement of securities to an unlimited number of "accredited investors" (as defined in Regulation D)² and up to 35 non-accredited investors, provided certain conditions are met. One such condition is that the issuer of the securities or a person acting on behalf of an issuer may not engage in any general solicitation or general advertising in connection with the offer of the issuer's securities.³

JOBS Act Revisions to Rule 506

Section 201(a) of the JOBS Act requires the SEC to revise Rule 506, no later than 90 days after the enactment of the Act, to provide that the prohibition against general solicitation and general advertising for offerings, contained in Rule 502(c), shall not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers of such securities are accredited investors.⁴ The Act requires that any such rules adopted by the SEC must "require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the [SEC]."⁵

The JOBS Act further states that Rule 506, as revised by Section 201(a)(1) of the Act, "shall continue to be treated as a regulation issued under Section 4(2) of the Securities Act."⁶ As a result, offerings made in accor-dance with Rule 506 will continue to benefit from federal preemption under Section 18 of the Securities Act. In addition, Section 201(b) of the JOBS Act amends Section 4 of the Securities Act to provide that "offers and sales exempt under [Rule] 506 . . . shall not be deemed public offerings under the [f]ederal securi-ties laws as a result of general advertising or general solicitation."⁷ Notably, however, the Act does not state that Section 4(2) is itself amended or that general solicitations made in connection with an offering purporting to be made in reliance on Section 4(2) (rather than under Rule 506) will not be deemed to be public offerings.

Until Rule 506 is amended by the SEC, as directed by the JOBS Act, Rule 506 remains unchanged. Once the SEC completes its rulemaking, an issuer or a person acting on behalf of an issuer will be able to promote the sale of a security through a general solicitation or general advertising without registering the security under the Securities Act, provided the other require-ments of Rule 506, as amended, are satisfied. In addition, since Section 4 of the Securities Act specifies that offerings made pursuant to Rule 506 will not be deemed to be public offerings under the full range of the federal securities laws, reliance on the revised Rule 506 would satisfy the restrictions on public offerings found in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act.⁸

JOBS Act Revisions to the Securities Exchange Act of 1934

Section 201(c) of the JOBS Act also amends Section 4 of the Securities Act to provide a limited exemption from registration as a broker or dealer with respect to securities offered or sold in compliance with Rule 506. Under the amendments, a person will not be required to register as a broker or dealer solely because such person: (i) "maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities" offered and sold in com-pliance with revised Rule 506 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;" (ii) co-invests or is associated with a person who co-invests in securities offered and sold in compliance with Rule 506; or (iii) itself provides (or an associated person provides) "ancillary services" with respect to securities offered and sold in compliance with Rule 506.⁹

In order to qualify for one of the foregoing exemptions, the person (and each person associated with that person) must (a) not receive any compensation in connection with the purchase or sale of such securities; (b) not have possession of customer funds or securities in connection with the purchase or sale of such securities; and (c) not be disqualified from membership in a self-regulatory organization under Section 3(a)(39) of the Securities Exchange Act of 1934, as amended ("Exchange Act").¹⁰

The JOBS Act also amends Section 12(g) of the Exchange Act to increase from 500 to 2,000 the permissible number of stockholders of record a company may have before it must register with the SEC, so long as no more than 499 of such stockholders are non-accredited investors.¹¹ The amendment to Section 12(g) exempts such companies from reporting requirements under the Exchange Act. The changes in the JOBS Act also exclude from the 2,000 stockholder limit those stockholders who received their interests under employee compensation plans in transactions exempted from the registration requirements of Section 5 of the Securities Act.

Practical Implications for Private Funds

The amendments to the Securities Act and the required revisions to Rule 506, contained in or directed by the JOBS Act, should allow sponsors of a private fund to reach out to potential investors through general solicitations and advertising without jeopardizing the fund's ability to rely on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act and Rule 506 of Regulation D as a safe harbor under Section 4(2) of the Securities Act, respectively, to avoid registration of the fund and its securities. However, until the amendments to Rule 506 are finalized following SEC rulemaking, private fund sponsors and placement agents should continue to follow their current practices, policies and procedures for their private offerings.

In addition, it should be noted that, since the JOBS Act does not state that Section 4(2) itself is amended by the JOBS Act, issuers relying on the provisions of Section 4(2), but not Rule 506, should not assume that general solicitations thereunder will be permitted. It seems unlikely that the SEC or the SEC staff initially will agree that Section 4(2) itself has been amended by the Act. Further, the JOBS Act impacts the Commodity Futures Trading Commission's rules and regulations for certain exemptions from registration under the Commodity Exchange Act, as amended ("CEA"), as a commodity pool operator (such as Rule 4.7 under the CEA), which require that the offering be made in reliance on Section 4(2) of the Securities Act or Regulation S. Presumably because Rule 506 remains a rule under Section 4(2), those exemptions should still be available with regard to pools offered under the revised rule.

The new broker-dealer registration exemptions could facilitate a private fund sponsor's use of third-party websites and other marketing platforms to conduct its general solicitations and advertising. Such a change could open up new marketing channels previously unavailable to private funds, including advertisements in newspapers and magazines, broadcasts on television and radio, communications on a publicly accessible internet and platform, public seminars, and mass public mailings.

Fund sponsors should note that the JOBS Act requires that persons engaging in any general solicitation under Rule 506, as it is directed to be amended, must take "reasonable steps to verify" that the purchasers of the private fund's securities are accredited investors. What may constitute "reasonable steps" and verification for this purpose is expected to be addressed in rulemaking by the SEC. Such rulemaking might affect the ability of fund sponsors to engage in general solicitations and general advertising to market interests in such funds. Moreover, the SEC staff may actively seek to challenge fund sponsors whose verification procedures are lax.

In addition, fund sponsors should keep in mind that all other laws governing solicitations and advertisements, such as the anti-fraud provisions of the federal securi-ties laws and advertising restrictions issued by the SEC and FINRA, would continue to apply to communications made to potential investors in reliance on revised Rule 506. Sponsors may also be able to increase the number of investors in their private funds as a result of the revisions to Section 12(g) of the Exchange Act.

The rulemaking by the SEC is required to be in place no later than 90 days after enactment of the JOBS Act.12 Dechert will monitor and alert you regarding further developments.

Footnotes

1 Section 4(2) of the Securities Act states that the provisions of Section 5 "shall not apply to [t]ransactions by an issuer not involving any public offering." An issuer that conducts a pri-vate offering of its securities would be exempt from the registration requirements of Section 5. Compliance with the requirements of Rule 506 of Regulation D under the Securities Act permits an issuer to claim the Section 4(2) exemption from registration.

2 The term "accredited investor" is defined in Rule 501 under the Securities Act. The term includes (but is not limited to): natural persons with individual or joint net worth with a spouse of more than $1,000,000 excluding the value of their primary residence; natural persons with incomes of more than $200,000 (or joint incomes of $300,000 for married couples) per year for the past two years, with a reasonable expectation that such income levels will be attained in the current year; and certain banks, business development companies, trusts and other entities.

3 Rule 506(b)(1) and Rule 502(c). "General solicitation or general advertising" has been interpreted broadly to in-clude actions such as (i) advertisements in newspapers and magazines, broadcasts over the television and radio, and communications on a publicly accessible Internet website; (ii) seminars open to the general public; and (iii) cold calls, mass postal mailings and bulk email mes-sages. See Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge Funds (September 2003).

4 In addition, the JOBS Act requires the SEC (no later than 90 days after the date of enactment of the Act) to revise subsection (d)(1) of Rule 144A under the Securities Act to provide that securities sold under Rule 144A may be of-fered to persons other than qualified institutional buyers ("QIBs"), including by means of general solicitations and general advertising, provided that such securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe to be QIBs.

5 Section 201(a)(1) of the JOBS Act.

6 Id.

7 Section 201(b)(2) of the JOBS Act.

8 Private funds rely on either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act to avoid registra-tion of the fund as an investment company thereunder. Sections 3(c)(1) and 3(c)(7) prohibit a private fund that wishes to rely on such exceptions from registration, from publicly offering its securities for sale. In certain SEC no-action letters, the SEC staff has expressed the position that the SEC interprets the non-public offering require-ment of Section 3(c)(1) (and presumably Section 3(c)(7)) in a manner that is consistent with the non-public offering exemption under Section 4(2) of the Securities Act and Rule 506 of Regulation D under the Securities Act. See C. Evans Patterson, SEC No-Action Letter (pub. avail. Mar. 9, 1988); and Santa Barbara Securities, SEC No-Action Letter (pub. avail. Apr. 8, 1983).

9 Section 201(c) of the JOBS Act.

10 Section 3(a)(39) of the Exchange Act sets forth certain activities that would subject a person to a "statutory dis-qualification" with respect to membership or participation in, or association with a member of, a self-regulatory organization ("SRO"). These activities generally include expulsion from an SRO, suspension or revocation of regis-tration with the SEC, the Commodity Futures Trading Commission or a foreign equivalent of either of the fore-going, association with persons subject to a statutory disqualification and felony convictions.

11 Section 501 of the JOBS Act.

12 On April 11, 2012, the SEC announced that it is accepting public comments with respect to the rulemakings re-quired by the JOBS Act. Under a process used with the Dodd-Frank Act, comments will be accepted prior to the SEC release of its rule proposals. The announcement is available at http://www.sec.gov/news/press/2012/ 2012-60.htm.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.