President Obama signed the Jumpstart Our Business Startups Act, HR 3606 (the "JOBS Act") on Thursday, April 5, 2012, which contains significant amendments to the private capital raising provisions in the Securities Act of 1933, as amended (the "Securities Act"), the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and the Sarbanes-Oxley Act of 2002, as amended. The amendments most relevant to private investment funds and their investment advisers are contained in Title II, which lifts the ban on general solicitation and general advertising under Regulation D under the Securities Act ("Regulation D") in connection with private offerings, and Title V, which increases the holder-of-record threshold that triggers reporting company registration requirements under the Exchange Act. The JOBS Act also contains other changes to the Securities Act designed to promote the raising of capital through certain smaller-scale securities offerings without registering those securities,1 but this memo will only focus on Title II and Title V. Although the JOBS Act became effective as of the date of its signing, the Securities and Exchange Commission (the "SEC") has been charged with promulgating rules to flesh out further details relating to Title II.
Lifting the ban on general solicitation and general advertising in private placements Title II: Access to Capital for Job Creators
Section 201(a)(1) of the JOBS Act directs the SEC to revise Rule 506 ("Rule 506") of Regulation D within 90 days after the enactment of the JOBS Act (i.e., by July 4, 2012) to provide that the prohibition against "general solicitation or general advertising" imposed by Rule 502(c) of Regulation D will not apply to offers and sales of securities conducted under Rule 506, so long as all purchasers are "accredited investors" (as defined in Rule 501(a) of Regulation D). Rule 502(c) defines general solicitation or advertising to include, but not be limited to, "any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio," as well as any seminar where those attending have been invited by means of general solicitation or advertising. In various "no-action" letters, the SEC staff has deemed certain Internet websites to run afoul of Rule 502(c), as well as mailings to offerees with whom the issuer has no preexisting relationship. In a similar vein, Section 201(a)(2) of the JOBS Act also directs the SEC to amend subsection (d)(1) of Rule 144A under the Securities Act ("Rule 144A"), within 90 days after enactment, to provide that securities sold thereunder may be offered to persons other than qualified institutional buyers, as defined in Rule 144A ("QIBs"), including by means of general solicitation or general advertising, if the securities are ultimately sold only to persons reasonably believed by the seller to be QIBs.
Section 201(b)(2) of the JOBS Act amends Section 4 of the Securities Act and provides that offers and sales made pursuant to Rule 506, as amended, will not be deemed public offerings under the federal securities laws as a result of any general advertising or general solicitation. This amendment is relevant because many private investment funds take advantage of the exceptions from the definition of the term "investment company" in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, as amended (the "Investment Company Act"), each of which exceptions requires that the issuer not make a "public offering" of its securities. Section 201(b)(2) thus ensures that funds making an offering under Rule 506 using general advertising and solicitation will not be deemed public offerings for purposes of Sections 3(c)(1) and 3(c)(7).2
Another issue raised by the amendments to Rules 506 and 144A is whether the use of general solicitation or advertising would be deemed "directed selling efforts" in the United States within the meaning of Rule 902(c) of Regulation S under the Securities Act, thereby depriving the issuer or seller of the availability of Regulation S for offshore sales to non-U.S. persons. It is hoped that the SEC's rules under the JOBS Act will clarify that Regulation S will remain available for offerings complying with amended Rules 506 and 144A.
Furthermore, persons acting as "commodity pool operators" (as defined in Section 1a(5) of the Commodity Exchange Act, as amended) to private commodity pools generally rely upon exemptions from registration as such provided under Rules 4.13(a)(3) and 4.13(a)(4) promulgated by the Commodity Futures Trading Commission (the "CFTC").3 The exemptions provided by Rules 4.13(a)(3) and 4.13(a)(4) each require in part that interests in exempt pools "are offered and sold without marketing to the public in the United States." But, because the Section 201(b)(2) amendment of the JOBS Act only provides that offerings entailing general solicitation or advertising "shall not be deemed public offerings under the Federal securities laws," it is unlikely (without additional rulemaking by the CFTC), that fund advisers relying on the exemptions from registration under these CFTC rules would be permitted to take advantage of revised Rule 506 and engage in general advertising or general solicitation on behalf of the funds that they advise.
Moreover, certain non-U.S. investment advisers relying on the foreign private adviser exemption (the "Foreign Private Adviser Exemption") from registration contained in Section 203b(3) of the Investment Advisers Act of 1940, as amended (the "Advisers Act"),4 might not be able to benefit from revised Rule 506 in that they would be prevented from mentioning themselves in any general solicitation or advertising in the United States made on behalf of the funds that they advise. This is because one of the conditions of the Foreign Private Adviser Exemption prevents an investment adviser intending to rely on such exemption from holding itself out to the public generally in the United States as an investment adviser.5
Another challenge is how to reconcile Title II of the JOBS Act with certain state Blue Sky laws. In particular, many issuers who make non-public offerings under Rule 506 have in the past relied on self-executing exemptions in certain states, such as New York, in order to avoid filings and/or fees required by such state regulatory authorities under other statutory provisions or rules. These self executing exemptions often include, or have been interpreted to include, a prohibition on general solicitation or general advertising. Thus, issuers intending to rely on the new provisions in Article II of the JOBS Act permitting general solicitation and advertising need to consider if such solicitation and advertising runs afoul of exemptions previously relied on under the Blue Sky laws of the states where the securities are being offered and sold. However, such issuers may make "notice filings" with applicable states pursuant to Section 18 of the Securities Act (Rule 506 offerings are deemed "covered securities" under Section 18), or may rely on state exemptions from securities registration for offers and sales to certain institutional investors, which don't include a prohibition on general solicitation or advertising (although any such solicitation or advertising should make clear that offers and sales are restricted to institutional investors qualifying under applicable Blue Sky laws).
Currently the term "accredited investor" contained in Rule 501(a) of Regulation D applies to natural persons or entities who fit within certain prescribed classifications, or whom an issuer "reasonably believes" fits within those classifications. Section 201(a)(1) of the JOBS Act directs the SEC to promulgate rules to require issuers that use general solicitation or general advertising to offer and sell their securities to take "reasonable steps to verify" that the purchasers of securities are indeed accredited investors, using methods that are to be determined by the SEC.6 Given the SEC's strong objections to various aspects of the JOBS Act, including the lifting of the ban on general solicitation and advertising in Rule 506 offerings and Rule 144A resales,7 it is unclear as to how burdensome a verification process the SEC will ultimately devise. Additionally, while not specifically covered in the JOBS Act, it is unclear whether this enhanced verification process will or will not be extended to issuers who choose not to use general solicitation or general advertising when making a Rule 506 offering.
Increasing the threshold for registration under the Exchange Act
Title V : Private Company Flexibility and Growth
Prior to the enactment of the JOBS Act, private issuers were subject to a 499-equityholder of record limit without being required to register as a "reporting company" under Section 12(g) of the Exchange Act ("a 12(g) reporting company"). Section 501 of the JOBS Act amends Section 12(g)(1)(A) by increasing the threshold that a private issuer must pass to become a 12(g) reporting company, so that an issuer with total assets exceeding $10 million will be required to register and become subject to periodic reporting requirements under the Exchange Act and SEC rules if it has either: (a) 2,000 equityholders of record; or (b) 500 equityholders of record that are not accredited investors (the "New Threshold").8 This provision became effective as of April 5, 2012. Section 501 will thus give a measure of relief to private funds which may have been approaching the 500 equityholder threshold, and permit them to expand the number of equityholders further without becoming 12(g) reporting companies.
Pursuant to recent SEC FAQs posted on the SEC's website relating to the JOBS Act,9 the SEC has clarified that if an issuer (that is not a bank holding company) was required to become a 12(g) reporting company as of a fiscal year-end before April 5, 2012, but would no longer be required to comply with such registration due to the New Threshold, and such issuer has not yet registered that class of equity security and has not filed an Exchange Act registration statement, it is no longer required to do so. If such issuer has filed an Exchange Act registration statement, however, and the registration statement is not yet effective, then such issuer may withdraw the registration statement. If, on the other hand, the issuer has registered a class of equity security under Section 12(g), it would be required to continue that registration unless it is eligible to deregister under Section 12(g) or current rules.
For private funds with investors, most or all of whom are believed to be accredited investors, Title V of the JOBS Act should reduce the burdens associated with compliance with the SEC registration and periodic and current disclosure requirements under Section 12(g).
1. See (i) Title III of the JOBS Act, also known as the "Capital Raising Online While Deterring Fraud and Unethical Non- Disclosure Act of 2012,'' or the "CROWDFUND Act," which provides a limited exemption from registration under the Securities Act for "crowdfunding," or certain securities issuances that cannot raise more than $1 million and where individual investors have strict ownership percentage restrictions, and (ii) Title IV, entitled "Small Company Capital Formation," which provides for an exemption under Section 3(b) of the Securities Act for a class of securities issued by companies that seek to raise not more than $50 million in the preceding 12-month period. However, neither of such exemptions is operative until the SEC adopts rules governing transactions thereunder; the rules under Title III must be adopted by December 31, 2012, while no deadline is set for rulemaking under Title IV.
2 It is noteworthy, however, that issuers relying on these exceptions would be prevented from issuing interests to "knowledgeable employees" (as defined in Rule 3c-5 under the Investment Company Act) if the interests are offered by means of general advertising or general solicitation, to the extent that such knowledgeable employees are not also accredited investors.
3 The exemption provided by CFTC Rule 4.13(a)(4) has been rescinded effective as of April 24, 2012, but any adviser that has filed an exemption prior to that date for any existing funds it advises will be permitted to use it until December 31, 2012.
4 An investment adviser intending on relying on the Foreign Private Adviser Exemption must ensure that it (i) has no place of business in the United States; (ii) has, in total, fewer than 15 clients in the United States and investors in the United States in private funds advised by the investment adviser; (iii) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million; and (iv) does not hold itself out generally to the public in the United States as an investment adviser.
5 Holding oneself out as an "investment adviser" would include maintaining a listing as an investment adviser in a telephone, business, building or other directory; using letterhead indicating any investment advisory activity; or letting it be known, through word of mouth or otherwise, that it is willing to provide investment advisory services. (See SEC Division of Investment Management no-action letter, DZP Associates (November 19, 1976) and SEC Division of Investment Management Staff Legal Bulletin No. 11, "Applicability of the Advisers Act to Financial Advisors of Municipal Securities Issuers" (September 19, 2000).
6 By contrast, offerors using general solicitation or general advertising in a Rule 144A offering need only "reasonably believe" that the purchasers of the securities are QIBs.
7 See, for example, the comments by SEC Commissioner Luis A. Aguilar in "Public Statement by Commissioner: Investor Protection is Needed for True Capital Formation" (March 16, 2012), available at http://www.sec.gov/news/speech/2012/spch031612laa.htm:
I share the concerns expressed by many that this provision of H.R. 3606 would be a boon to boiler room operators, Ponzi schemers, bucket shops, and garden variety fraudsters, by enabling them to cast a wider net, and making securities law enforcement much more difficult. Currently, the SEC and other regulators may be put on notice of potential frauds by advertisements and Internet sites promoting "investment opportunities." H.R. 3606 would put an end to that tool. Moreover, since it is easier to establish a violation of the registration and prospectus requirements of the Securities Act than it is to prove fraud, such scams can often be shut down relatively quickly. H.R. 3606 would make it almost impossible to do so before the damage has been done and the money lost.
8 It will be difficult for certain issuers to determine whether current holders of their equity securities are, in fact, accredited investors, particularly those issuers whose securities have been traded in the secondary market in reliance on Rule 144 under the Securities Act or otherwise.
9 "Jumpstart Our Business Startups Act Frequently Asked Questions – Changes to the Requirements for Exchange Act Registration and Deregistration" (April 11, 2012), available at http://sec.gov/divisions/corpfin/guidance/cfjjobsactfaq- 12g.htm
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