The JOBS Act: Impact on Investment Funds
Investment Management Update
Date: April 12, 2012
On April 5, 2012, President Obama signed the Jumpstart Our Business Startups Act (JOBS Act) into law.1 The JOBS Act will bring about a number of significant changes to the federal securities laws and is primarily intended to drive job creation by facilitating capital-raising by startups and other emerging growth companies (collectively, EGCs). The act will, among other things, ease certain restrictions on private offerings conducted pursuant to various exemptions provided under the Securities Act of 1933 (1933 Act) and allow EGCs to avoid the registration and disclosure obligations under the Securities Exchange Act of 1934 (Exchange Act) as their shareholder bases grow.
Although aimed primarily at EGCs, the JOBS Act also has significant implications to managers and sponsors of private investment funds, including hedge funds, private equity funds, venture capital funds and other such vehicles that rely on Sections 3(c)(1) and 3(c)(7) under the Investment Company Act of 1940 (1940 Act) to avoid registration as investment companies (each, a Private Fund, and together, Private Funds). Among other provisions that may be applicable to Private Funds and as described more fully below, the JOBS Act:
- Removes the prohibition on general solicitation in connection with transactions effected pursuant to Rule 506 under Regulation D of the 1933 Act (Regulation D) or Rule 144A under the 1933 Act (Rule 144A), provided sales are limited to qualifying investors.
- Allows sponsors of exchange platforms where securities are offered and sold pursuant to Regulation D to avoid registration as brokers or dealers under the Exchange Act, provided certain conditions are satisfied.
- Alters the thresholds that trigger registration of an issuer's securities under Section 12(g) of the Exchange Act, including a different threshold for banks and bank holding companies.
Although subject to final rulemaking by the Securities and Exchange Commission (SEC), the changes contemplated by the JOBS Act are likely to have a significant impact on the manner in which Private Funds attract investment capital.
General Solicitation Restrictions Lifted
Private Funds, in conducting their offerings, rely on certain exemptions provided under the 1940 Act and the 1933 Act. In particular, they typically rely on Section 3(c)(1) (3(c)(1) Funds) or Section 3(c)(7) (3(c)(7) Funds) under the 1940 Act to avoid registration as investment companies and Rule 506 under Regulation D (Rule 506) to avoid the registration requirements of the 1933 Act. Among other conditions of relying on the exemptions set forth in both the 1940 Act and the 1933 Act, Private Funds are currently limited in the manner in which their securities may be offered. Both Sections 3(c)(1) and 3(c)(7) of the 1940 Act prohibit a Private Fund from making a "public offering of its securities," while Rule 506 prohibits Private Funds from conducting offerings through means of a "general solicitation." Thus, Private Funds largely have been prohibited from advertising or contacting potential investors other than those with whom either the manager of the fund or any third-party placement agent has a preexisting relationship.
The JOBS Act directs the SEC to, within 90 days of the date the Act is signed into law, amend Rule 506 and Rule 144A to eliminate the prohibition on general solicitation in transactions effected under the following circumstances:
- Pursuant to Rule 506, where all purchasers of such securities are "accredited investors" as defined in Rule 501(a) under Regulation D.2
- Pursuant to Rule 144A, where all purchasers of such securities are "qualified institutional buyers" as defined in Rule 144A.
In each case, the issuer must have a reasonable basis for believing that the purchaser is either an accredited investor or qualified institutional buyer, as applicable.
Although the JOBS Act does not specifically amend the 1940 Act, it is unlikely that either 3(c)(1) Funds or 3(c)(7) Funds will be required to register as investment companies as a consequence of conducting offerings by means of general solicitations. The JOBS Act specifically provides that an offering under Rule 506 made by means of general advertising or solicitation, which otherwise complies with the requirements of Rule 506, shall not be deemed to be a public offering. The SEC staff previously has taken the position that offerings by 3(c)(1) Funds and 3(c)(7) Funds that satisfy the requirements of Rule 506 would not constitute "public offerings" for purposes of the 1940 Act.3 Thus, although the JOBS Act does not amend either Section 3(c)(1) or 3(c)(7) under the 1940 Act, it would seem to afford both 3(c)(1) Funds and 3(c)(7) Funds the ability to use general solicitation and general advertising to offer securities without running afoul of the prohibition on public offerings contained in the 1940 Act.
It is unclear whether or not Private Funds relying on the exemption from registration provided under Section 4(2) of the 1933 Act will be permitted to engage in general solicitations. As enacted, the JOBS Act does not specifically amend Section 4(2) of the 1933 Act. The new provisions permitting general solicitation do not, by their terms, apply to private placements that are conducted in reliance upon Section 4(2) but not in accordance with Rule 506 or Rule 144A as revised by the JOBS Act. Thus, it is unclear what effect, if any, these provisions will have on the exemption provided by Section 4(2).
The removal of these restrictions will likely have a significant impact on the capital-raising methods used by Private Funds and the placement agents who serve them. In theory, Private Funds will be permitted to approach a wider audience when seeking investors using a variety of media, including print and electronic communications, that previously had not been permissible. The foregoing notwithstanding, it is reasonable to expect that, as part of the rulemaking implementing the JOBS Act, the SEC will impose certain content-based standards and restrictions on advertisements and other forms of solicitation by Private Funds.
In addition to eliminating the ban on general solicitation, the JOBS Act provides an exemption from broker-dealer registration for platforms that permit participants to advertise, solicit, negotiate and enter into transactions in Regulation D offerings. However, such platforms may neither receive transaction-based compensation for these services nor have possession of customer funds or securities in connection with transactions over the platform. Although largely geared toward EGCs, such exchange platforms also could facilitate capital-raising efforts, as well as provide an alternate means of liquidity for investors in Private Funds.
Registration Triggers Under Section 12(g) of the Exchange Act
For 3(c)(7) Funds, the JOBS Act greatly increases the number of investors that such a fund is permitted to have without becoming subject to the registration and reporting obligations of the Exchange Act. The JOBS Act increases the holders of record threshold, at or above which an issuer is required to register such securities under Section 12(g) of the Exchange Act (and thus become subject to public company reporting requirements), from 500 persons to either of the following thresholds: (a) 2,000 persons or (b) 500 persons who are not accredited investors. The JOBS Act also increases the total assets threshold under Section 12(g) from $1 million to $10 million; however, the SEC has previously exempted the equity securities of issuers having less than $10 million in total assets from registration. Thus, as a practical matter, the asset threshold remains unchanged.
Section 3(c)(7), unlike Section 3(c)(1), contains no explicit limit on the number of beneficial owners that a Private Fund relying on such exemption may have. Currently, 3(c)(7) Funds, like most other issuers, are limited to having no more than 499 record holders before having to register under the Exchange Act. Thus, the amendments to Section 12(g) under the JOBS Act are likely to allow 3(c)(7) Funds to greatly increase the number of investors that may invest in such a fund at any one time.
On the other hand, 3(c)(1) Funds generally are limited to having no more than 100 beneficial owners at any one time. Thus, unless Section 3(c)(1) is amended, the amendments to Section 12(g) of the Exchange Act will have little impact on 3(c)(1) Funds.
Although subject to final rulemaking by the SEC, the JOBS Act has the potential of redefining the manner in which Private Funds raise capital and market themselves to investors. In theory, the JOBS Act will allow Private Funds to be marketed to a much broader range of investors.
The JOBS Act also includes certain provisions that are of less relevance to Private Funds and have not been addressed in this bulletin, including provisions that would ease the IPO process and certain reporting requirements for EGCs. For more information regarding these provisions please refer to our bulletin The JOBS Act: Impact on Capital-Raising for Startup Companies.
1For complete details, see the final version of the JOBS Act that was sent to the president for his signature.
2In connection with Private Funds relying on the exemption set forth in Section 3(c)(7) of the 1940 Act, all purchasers of the securities of such funds must be "qualified purchasers" as defined in Section 2(a)(51) of the 1940 Act. As noted above, the JOBS Act does not amend Section 3(c)(7) of the 1940 Act.
3See, e.g., STARS & STRIPES GNMA Funding Corp., SEC No-Action Letter (Apr. 17, 1986); see also Advisers Act Release No. 22597 (Apr. 3, 1997).