Section 201 of the recently passed Jumpstart Our Business Startups Act will change the advertising limits on private funds and any other company that raises capital through the private placement safe harbor in Rule 506 of Regulation D. That rule has historically prevented the use of general solicitation and advertising in selling private fund interests. Section 201 requires the SEC to lift the ban through a new rulemaking and gave the SEC 90 days (July 4) to do so.
I still find it strange that Congress did not just create revise the underlying statutes to allow solicitation and advertising in private offerings not registered with the SEC. Instead, Congress took the convoluted route of requiring the SEC to change a rule that interprets a statutory provision of the Securities Act. That injects some uncertainty into what limitations, if any, the SEC will continue to require after July 4 (or whenever the new rule goes into effect).
There are a few other points in Section 201 that concern me and make me worry about fundraising in the post JOBS Act regulatory world.
First, Section 201 limits sales only to accredited investors when using general advertising or solicitation. Currently, a Rule 506 offering can have up to 35 non-accredited investors. That would typically include friends and family investors. It would also include employees.
Second, Section 201 requires the SEC to include a requirement that the issuer take reasonable steps to determine accredited investor status using methods determined by the SEC. That could radically change the current practice and safeguards in the fundraising process.
Third, I’m concerned what the effect will be for a fund or other issuer that ends up selling to a non-accredited investor. A fund can take reasonable steps to determine if a potential investor is accredited. But the investor could be deceptive. That would leave the fund in violation even though it reasonably believed the investor was accredited.
Fourth, Section 201 purports to lift the ban across all federal securities law. In particular, I’d prefer clarification that the advertising and solicitation applies to the Section 3(c)(1) and 3(c)(7) of the Investment Company Act that permits most private funds to avoid regulation under that law.
In looking through the comments letters to Section 201, I see that I am not alone in these concerns.
The American Bar Association’s Federal Regulation of Securities Committee does a a great job of focusing on my fourth concern and asks for a clear statement that “an offering of fund shares pursuant to Rule 506 or Rule 144A utilizing general solicitation or general advertising will not be a ‘public offering’ for the purposes of Section 3(c)(1) or 3(c)(7) of the Investment Company Act.”
The letter also requests clarification of the reasonable belief standard in the Rule 501 definition of accredited investor.
“any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person…”
The letter falls short in its comments to the verification practice. It merely asks the SEC to have the rule reflect “current custom and practice” without letting the SEC what the customs and practice is. (It’s asking the investor to fill out a questionnaire.)
In it’s comment letter, the Managed Fund Association focuses on reasonable steps for the verification process.
In general, each potential hedge fund investor must complete a subscription document provided by the fund’s manager that provides a detailed description of, among other things, the qualification standards that a purchaser must meet under the federal securities laws. In completing the subscription materials, each investor must identify which applicable qualification standard it meets. In addition to these procedures, many hedge funds managed by MFA members obtain further assurance of the qualification of their investors by virtue of minimum investment thresholds that meet or exceed the net worth requirement in the definition of accredited investor.
The Managed Fund Association also asks that the knowledgeable employee exemption be extended to Rule 506. With private funds, investors prefer (demand?) that senior management have a significant investment in the fund. This aligns interests among the investors and management. When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employee when it’s unlikely that your key employees will have the $5 million in investments needed to qualify as a Qualified Purchaser. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. The Managed Fund Association recommends
that as part of the implementation of Section 201, the SEC amend the definition of “accredited investor” to include those individuals who meet the definition of “knowledgeable employee” in Rule 3c-5 under the Investment Company Act.
The New York City Bar splits the verification process by asking for a principle-based approach with a non-exclusive safe harbor. Their comment letter points out the body of existing practice and asks the SEC to build on it, rather than replace it.
The clock is ticking and the SEC has very little time to produce a proposed rule for comment. I wouldn’t be surprised to see the SEC miss the deadline given all of the other rule making piled up in front of them. That means the advertising may have to wait that much longer.
Sources – Comment letter from:
- Stuart J. Kaswell, Executive Vice President & Managing Director, General Counsel, Managed Funds Association
- Robert E. Buckholz, Chair, Committee on Securities Regulation, New York City Bar Association
- Jeffrey W. Rubin, Chair, Federal Regulation of Securities Committee, Business Law Section, American Bar Association, New York, New York