June 6, 2012
The Jumpstart Our Business Startups Act (JOBS Act) has significant
implications for managers of private funds. Some of the JOBS Act changes, such
as permitting publicity in fund offerings where the only purchasers are
accredited investors and a new broker-dealer exemption for ancillary services
related to private placements, may make fundraising easier.
Other JOBS Act changes of benefit to private fund managers are a new
confidential Securities and Exchange Commission (SEC) filing procedure that
could be used in the sale process for portfolio companies and Emerging Growth
Company (EMG) provisions that will make it easier to carry out primary and
secondary public offerings of portfolio company stock. These changes may improve
the ability of a fund to liquidate investments in portfolio companies.
Both C1 (less than 100 holders) and C7 (qualified purchaser) funds are
required to be offered in private placements, and by complying with Rule 506,
funds will meet the private placement standard. Because Rule 506 also preempts
state securities law regulation (other than notice filings), it is the preferred
alternative for funds looking to raise capital. Rule 506 currently prohibits the
use of ”general solicitation,” which includes communications in a newspaper,
magazine or similar documents or broadcasts over television or radio and any
seminar or meeting whose attendees have been invited by general solicitation or
The JOBS Act requires that the SEC revise Rule 506 to eliminate the current
“general solicitation” prohibition, so long as:
- all purchasers are “accredited” investors; and
- the issuer takes steps to verify the “accredited” status of the
This provision could result in a significant change in the way private funds
raise capital. This provision also involves a fundamentally different approach
to the “private placement” concept. Implementation of this new approach will
raise a number of legal and practical issues.
Verification of Accredited Investor Status
As noted earlier, the JOBS Act provides that only accredited investors can
participate in a Rule 506 offering in which general solicitation is used, and
that the SEC will establish by rule the procedure that an issuer needs to take
to “verify” that investors are accredited. These steps are to be specified by
the SEC in its rulemaking proceeding.
Currently, the most commonly used procedure to establish accredited status is
a questionnaire that is included as part of the subscription documents. The
degree of detail required by the questionnaire varies, as does the degree of
care that prospective investors use in completing the questionnaire. It is
possible that the SEC will require steps beyond review of an investor
questionnaire in the revised Rule 506.
The SEC has until early July to propose and adopt this change. Until Rule 506
is amended, the existing rules continue to apply. As of the writing of this
update, the SEC has not yet proposed the amended provision of Rule 506 in
response to this requirement of the JOBS Act. The SEC has established a page on
their website through which comments on JOBS Act changes can be submitted. As of
June 3, 2012, this site included 21 comments on the elimination of the general
solicitation restriction. These comments ranged from several very simple emails
using the SEC’s comment form to several relatively thorough comment letters.
Most of the comments received by the SEC have suggested the continuation of
current market practice: the use of a questionnaire to establish accredited
investor status. One commenter has suggested that the information supporting
accredited investor status should be given “under penalties of perjury.” Another
has suggested that the investor questionnaire require that a third party (such
as a lawyer or accountant) certify the status of the investor as accredited.
Another comment letter suggests that a private fund be required to obtain a
third party background check unless the fund uses a broker as a placement agent.
A few comment letters have suggested increasing the tests for accredited
investor status and/or imposing a minimum investment size for transactions where
general solicitation is used. One comment letter suggests that the SEC permit
the use of third-party service providers to verify accredited investor status
through the use of investor related information, which would be deposited with
the service provider on a confidential basis.
Issues Raised by General Solicitation
The elimination of the general solicitation restriction reverses a
long-standing administrative policy relating to the criteria for private
placements and raises a number of issues that the SEC and issuers will need to
The impact of this change on the application of the “integration” doctrine
remains unclear. This doctrine treats more than one offering as if it were only
one offering in determining compliance with the private placement provisions.
However, many funds are continuously raising capital. Some funds raise capital
for more than one fund at a time. As a result, general solicitation might be
considered to blur the line between offerings, such as when offerings are made
sequentially, or when more than one offering is being made at one time.
Integration can present an issue either under the Securities Act or the
Investment Company Act. In the Securities Act context, integration of offerings
is based on a fairly well-established five factor test (single plan of
financing, class of securities, timing, consideration received, and purpose of
the offering). Integration of offerings may lead to the loss of an exemption and
“puts” in the hands of investors. Regulation D provides that offerings conducted
more than six months apart are generally not integrated.
In the Investment Company Act context, integration treats two or more funds
as one fund for compliance purposes. This analysis is usually based on different
criteria than the Securities Act factors, but also can lead to the loss of an
Private funds especially can face integration issues in terms of the
Securities Act or the Investment Company Act. Both C1 and C7 funds are required
to be placed without engaging in a public offering, and many fund managers offer
side-by-side C1 and C7 funds. For the purposes of the Investment Company Act, C1
funds and C7 funds are not integrated. Therefore, a simultaneous offering of
these two types of funds should not present an issue under either the Securities
Act or the Investment Company Act. Nor should the integration of multiple C7
funds present an issue, because C7 funds can have an unlimited number of
investors, as long as they are all qualified purchases.
Accordingly, the main issue for private fund managers likely will be
simultaneous offerings of C1 funds or sequential offerings of C1 funds, where
the Regulation D six-month non integration period has not been satisfied.
In the case of offerings by issuers other than private funds, numerous other
integration issues may be present.
Offshore Offerings/Regulation S
The JOBS Act does not change the rules for offshore offerings conducted under
Regulation S. Regulation S provides a non-exclusive safe harbor exemption from
the registration requirements of the Securities Act for offerings that take
place outside the United States. Regulation S is not available if there are
“directed selling efforts” in the United States, however. As a result, the
prohibition on directed selling efforts continues to apply.
For funds that have used Regulation S for the offshore component of a
simultaneous private placement and offshore offering, there may be a need to use
Rule 506 for both the domestic and offshore components. Hopefully the SEC will
provide guidance on this issue in the proposing and adopting releases for the
change in 506 required by the JOBS Act, as several comments from the public have
focused on this issue.
Private Offerings Generally
The elimination of the general solicitation provision in Regulation D may not
result in a similar change for private offerings that do not rely on Rule 506.
If there is general solicitation, but the offering fails to qualify under Rule
506, it may not be feasible to rely on the general private placement concepts.
One commenter has suggested that the general solicitation restriction be
eliminated in the context of private placements altogether.
Prior Substantive Relationship
The SEC has developed the concept of a “prior substantive relationship” to
deal with the restriction on general solicitation. This concept, in effect,
requires that the issuer have a relationship with the investor that provides the
issuer with a reasonable basis to conclude that the investor is accredited.
A number of SEC no-action letters have dealt with the concept of the prior
substantive relationship, and the ways in which this type of relationship can be
established, including the use of third parties (such as brokers) to establish
this relationship. The SEC has also provided guidance on the ways in which a
password-protected website can be used without engaging in general solicitation.
The elimination of the prohibition on general solicitation should result in
the elimination of the "prior substantive relationship” requirement in these
types of offerings.
Content of Solicitation Material
Mutual Fund-Type Regulation?
The Investment Company Institute has suggested, in effect, that solicitation
materials be subject to the same type of regulation as mutual fund
Blackrock’s comment letter suggests the opposite approach.
Impact of Investment Adviser Registration
Many fund managers have been required to register as investment advisers as a
result of the Dodd-Frank Act. Since registered investment advisers are subject
to various limitations on “advertising” materials, fund managers that are now
registered as investment advisers will need to consider these advertising rules
in connection with any solicitation materials.
Impact of CFTC Provisions
Many hedge fund managers rely on CFTC Rule 4.13(a)(4), which provides an
exemption from registration for a commodity pool offered only to specified
investors (certain “qualified eligible” persons and accredited investors). The
CFTC has rescinded Rule 4.13(a)(4) effective in April 2012 for new funds, though
existing funds can continue to rely on Rule 4.13(a)(4) through the end of this
The CFTC left in place Rule 4.13(a)(3), which provides a registration
exemption for pool operators that use commodity interests on a limited basis, if
the pool is offered only to accredited investors, knowledgeable employees and
certain “qualified eligible” persons. However, Rule 4.13(a)(3) contains a
restriction on “marketing to the public.”
The elimination of Rule 4.13(a)(4) is a significant change in the regulatory
landscape for hedge fund managers. It is unclear whether, as a practical matter,
Rule 4.13(a)(3) is a viable alternative.
For hedge funds (and funds of funds) that have commodities interests in their
portfolio, the changes in these CFTC provisions may impact the ability to take
advantage of the elimination of the general solicitation provisions of Rule 506.
Absent further guidance, it is unclear whether general solicitation (even if
limited to accredited investors as required by the JOBS Act) would be permitted
under the CFTC Rule 4.13(a)(3).
New Broker-Dealer Exemption
The JOBS Act also provides a new exemption from broker-dealer status for
- maintain a “platform or mechanism” to facilitate 506 offerings, or
- engage in general solicitation, advertising, co-invest or provide
ancillary services in 506 offerings.
This exemption is available to persons who do not receive compensation in
connection with the purchase or sale of securities and do not have possession of
customer funds or securities.
Impact of JOBS Act on Sale of Portfolio Companies
Confidential SEC Filings
The JOBS Act allows confidential stock offering filings with the SEC, which
could be useful to managers of private equity funds in the sale of portfolio
companies. The confidential filing could be used as a backup in an auction
process. This procedure would include the confidential filing of a registration
statement relating to the portfolio company, which could be reviewed by the SEC
on a confidential basis while the fund seeks to market the portfolio company in
a private M&A transaction. By employing this method, the fund would have an
alternative exit in place with the added possible benefit of creating more
leverage with potential buyers of the portfolio company. A private fund could
also use these new provisions to obtain liquidity with respect to some or all of
its ownership position in a portfolio company.
For additional guidance on the procedure to be used for these confidential
filings, please consult the SEC website or contact one of the authors.
To qualify, an EMG needs to have annual gross revenue of less than $1 billion. The
JOBS Act makes a number of changes in the registration process for an EMG such
as reduced financial statements burdens and exemption from auditor certification
of internal controls. In addition, the JOBS Act also reduces the cost of being a
public company for an EMG by, among other things, eliminating the need for say
on pay votes.
‘34 Act Registration
Historically, C7 funds have been allowed an unlimited number of qualified
purchasers as investors, and ‘34 Act registration has been required for these
funds when they reached 500 investors. As with public companies, ‘34 Act
registration involves the filing of periodic and current reports (10-Ks, 10-Qs,
8-K), which would be burdensome for most private funds.
The JOBS Act raises the 500-investor trigger to 2,000, allowing C7 funds to
have significantly more investors before being required to register under the
‘34 Act. (The JOBS Act also requires ‘34 Act registration if an issuer has more
than 499 shareholders who are not accredited. Because C7 funds are required to
be composed of qualified purchasers, this provision should not impact C7 funds.)