On March 27, 2012, Congress approved the so-called JOBS Act1 and President Obama is expected to sign it in the coming days. Once in effect, the JOBS Act will, among other things, (1) eliminate the prohibition against general solicitation and general advertising in connection with private offerings to accredited investors conducted in reliance on Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”), (2) apply the elimination of the prohibition against general solicitation to other federal securities laws, and (3) raise the investor threshold for registration under the Securities Exchange Act of 1934 (the “Exchange Act”) from 500 to 2,000 “holders of record” for most issuers.
These provisions will significantly impact the manner in which private funds are offered and sold in the United States.
Elimination of Prohibition Against General Solicitation
The JOBS Act directs the Securities and Exchange Commission (“SEC”) to revise Rule 5062 of Regulation D to provide that the prohibition against general solicitation in Rule 502(c) will not apply to offers and sales of securities conducted under the rule, so long as all purchasers are accredited investors.3 The SEC’s amended rules must require issuers to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the SEC. The SEC’s rules may also include limitations or other requirements with respect to general solicitation and advertising. The SEC will have 90 days to adopt final rules.4
The JOBS Act also provides that offers and sales made pursuant to Rule 506 will not be deemed public offerings under the federal securities laws as a result of general advertising or general solicitation. Sections 3(c)(1) and 3(c)(7) of the Investment Company Act, the exclusions from the definition of “investment company” under which most private investment funds that trade securities are operated, each require that the issuer not make, and not propose to make, a public offering. Under the JOBS Act, an offering under the revised Rule 506 would be considered a non-public offering for purposes of these Investment Company Act exclusions. Note, however, that a similar requirement imposed under CFTC Rule 4.13(a) for exempt commodity pools would not be impacted by this provision of the JOBS Act.
The elimination of the ban on general solicitation and general advertising represents a fundamental change in the nature of private fund offerings. Depending to some extent on the forthcoming SEC rules, managers of private funds may be able to advertise in the media, solicit through open websites, conduct general investment seminars, and the like, so long as the ultimate investors are all accredited investors.5
Increases in Exchange Act Registration Threshold
Section 12(g) of the Exchange Act requires issuers of securities to register with the SEC and thereby become public reporting companies within 120 days of the end of any fiscal year in which they first have total assets exceeding $1 million and any class of equity securities held of record by 500 or more persons. Rule 12g-1 under the Exchange Act, which was adopted in 1983, raised the $1 million threshold to $10 million, but the 500 shareholder threshold has remained unchanged since it was adopted in 1964. The JOBS Act will raise the $1 million statutory threshold to $10 million and the 500-holder of record threshold to 2,000, or 500 shareholders who are not accredited investors, for most issuers.6
The amendments will mean that private funds previously subject to a 499-holder of record cap to avoid being required to become public reporting companies will now be allowed to have up to 1,999 holders of record without the requirement of Exchange Act registration. The threshold for terminating Exchange Act registration of any class of equity security will be raised from 300 to 1,200 holders of record for banks and bank holding companies, but will remain at 300 holders of record for other issuers. Note that notwithstanding that the Exchange Act will effectively allow an issuer to have up to 499 non-accredited holders of a class of equity securities, the 35 person limit under Rule 506 of Regulation D on investors that are not accredited investors has not been increased.
The JOBS Act also includes substantial amendments loosening restrictions on initial public offerings and providing for a new capital raising regime through so-called crowdfunding, as well as other substantial securities law amendments. These provisions will be discussed in one or more future Sidley updates.
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1 The Jumpstart our Business Startups Act, H.R. 3606.
2 Rule 506 is the primary rule under which private funds conduct offers and sales of securities in the United States. It allows offerings in unlimited dollar amounts to an unlimited number of investors, provided that no more than 35 of the purchasers are not “accredited investors.” However, the elimination of the restriction on general solicitation only applies if all investors are “accredited investors.” Note that the prohibition on general solicitation will continue to apply to offerings made under Rule 504 and 505 of Regulation D.
3 For any private fund that is also a “commodity pool” for purposes of the Commodity Exchange Act and Commodity Futures Trading Commission (“CFTC”) rules and is subject to CFTC Rule 4.21, the commodity pool operator will need to comply with the disclosure document delivery requirements under CFTC rules and should carefully consider the interplay of those requirements with whatever means of publicity is utilized in connection with the offering of the pool.
4 The term “accredited investor” as currently set forth in Rule 501(a) of Regulation D means anyone who comes within certain categories, or who the issuer reasonably believes to come within those categories, effectively establishing a “reasonable care” defense to an allegation that a non-accredited investor has slipped through the screen. A similar “reasonable belief” standard appears in Rule 2a51-1(h) under the Investment Company Act of 1940 (the “Investment Company Act”) regarding the term “qualified purchaser” as used in Section 3(c)(7) of the Investment Company Act. The proposing and adopting releases of Rule 2a51-1 indicate the SEC intended the reasonable belief standard in Rule 2a51-1(h) to reflect the same approach taken in Rule 501(a) of Regulation D and Rule 144A(d)(i). The SEC has previously stated, in relation to Regulation D and Rule 501(a), that “What constitutes a ‘reasonable’ belief will depend on the facts of each particular case. For this reason, the staff generally will not be in a position to express views or otherwise endorse any one method of ascertaining whether an investor is accredited.” However, Rule 144A(d)(i) contains a list of non-exclusive methods of establishing a reasonable belief as to a person’s status as a “qualified institutional buyer.” In light of the congressional instruction in the JOBS Act, the SEC may amend Rule 501(a) to include a list of non-exclusive methods of establishing a reasonable belief as to a person’s status as an “accredited investor.”
5 Any advertisements for a private fund must comply with applicable advertising restrictions under SEC rules applicable to investment advisers, as well as any Financial Industry Regulatory Authority rules to the extent that a broker-dealer is involved in the offering. If the private fund is also a “commodity pool,” the commodity pool operator will need to comply with applicable CFTC and National Futures Association rules.
6 Banks and Bank Holding Companies will be subject to a 2,000 holder of record threshold, without regard to investors’ accreditation. Note, however, the increase in the holders of record threshold will not impact the Rule 506 “safe harbor” under Regulation D, which allows an issuer to sell to up to 35 persons who are not accredited investors.
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