It is not often that Congress passes a forward thinking, revolutionary new law with little debate or rancor. But that is exactly what happened with the JOBS Act, which was signed into law by President Obama on April 5, 2012. The gift from Congress is a little-noticed section of the new law that will allow private funds (such as commodity pools) to advertise and use the Internet to find investors.
Just about all CPOs and fund managers rely on a private offering exemption from registering the offering of interests in their funds under the Securities Act of 1933. Without this exemption, the sale of interests in the fund would be a public offering of securities under the Securities Act, which is expensive and time consuming.
Although it seems too obvious to even mention, the most basic concept of private offerings of funds has been that the offering be “private.” This has been interpreted to mean that general solicitation, including advertising, was not allowed. The prohibition on general solicitation and advertising is a major roadblock to finding investors for private pools. Fund sponsors had to have a pre-existing relationship with their investors or be introduced to them one-by-one. And, if the press wanted to write an article on the manager, the article could mention only the manager’s trading strategy generally and not the manager’s private fund, or risk “blowing” the fund’s private offering exemption. If the exemption was blown, the offering would become a public offering and the manager’s costs and compliance burdens would skyrocket. In early 2012, perhaps feeling frustrated by the slow recovery of the U.S. economy, Congress introduced a new piece of legislation called the “Jumpstart Our Business Startups Act,” or the JOBS Act. The bill contained a wide variety of provisions designed to stimulate small business, including entrepreneurs, and to relieve the burdens of federal securities regulation, including capital formation, on those small businesses.
Importantly for CPOs and fund managers, the JOBS Act directs the Securities and Exchange Commission (SEC) to revise Rule 506 of Regulation D to provide that the prohibition against general solicitations and general advertising (set forth in Rule 502) shall not apply to offers and sales of securities under Rule 506 so long as all the purchasers of such securities are “accredited investors.” The law also requires the SEC to adopt rules requiring the issuer of the securities (the CPO or fund manager) to take reasonable steps to verify that the purchasers are accredited. The JOBS Act requires the SEC to revise its rules within 90 days of enactment (July 5, 2012).
Ordinarily, a change in the law this dramatic and far reaching would be the subject of numerous SEC studies, hearings, industry input, proposed SEC rules, industry comment to such proposed rules, revised proposed rules, etc. The legislative record of the JOBS Act does not show any involvement by the SEC, which is highly unusual because the Act directs the SEC to amend drastically its private offering regime. Did Congress intend to keep the SEC in the dark? Was the SEC asleep? Or, did the SEC, in fact, know about this legislation but lack the political muscle to stop it from being passed?
Here, we attempt to answer some of the likely questions fund managers will have regarding the change.
What about the Investment Company Act?
The Investment Company Act of 1940 (often called the 1940 Act) requires every private fund (including commodity pools) that meets the definition of an investment company (generally a fund that trades, owns or invests in securities) to register with the SEC as a mutual fund unless an exemption applies. The two primary exemptions that fund managers rely on, Sections 3(c)(1) and 3(c)(7) of the 1940 Act, also prohibit a “public offering” of fund interests. So do the restrictions of the 1940 Act effectively nullify the JOBS Act’s loosening of advertising prohibitions in the Securities Act? Probably not.
First, the SEC has stated previously that any offering that is a private offering under Rule 506 under the Securities Act also is a private offering for 3(c)(1) and 3(c)(7) of the 1940 Act. Second, the JOBS Act provides that an offering under Rule 506 will not be deemed to be a public offering for purposes of “other federal securities laws” because of the advertising now allowed under the JOBS Act. The 1940 Act clearly is one of the federal securities laws. Funds relying on Section 3(c)(1) or Section 3(c)(7) therefore should be permitted to engage in solicitation and advertising to the extent permitted by the revised Rule 506 without jeopardizing their 1940 Act exemption. Nevertheless, the SEC is certain to address managers relying on 3(c)(1) or 3(c)(7) in its JOBS Act rules; it is premature to say with any certainty how these rules will treat the “public offering” prohibition in 3(c)(1) and 3(c)(7).
What will the SEC’s rules look like?
The SEC is required to adopt rules for verifying the accredited status of investors, and we will need to wait until its rules are published to know how onerous those procedures will be. Because the JOBS Act is a statute, the SEC cannot adopt rules that are contrary to its terms. Thus, even though the SEC likely is not in agreement with the changes to Regulation D, it must follow the new law. If the SEC issues rules that are not consistent with the JOBS Act, those rules likely would be challenged in court as being in conflict with the statute.
Still, the SEC’s rulemaking process could throw a wrench into the movement toward CPO and private fund advertising. For example, the SEC could rescind its previous position that a private offering under Rule 506 also is a private offering under the 1940 Act and determine that Congress did not intend to include the 1940 Act among the “securities laws” modified by the JOBS Act. If that were to happen, there likely would be a legal challenge to the rule, resulting in further delays to implementation.
What about CPOs and fund managers relying on CFTC Rules 4.13(a)(3) or 4.13(a)(4)?
Much like Sections 3(c)(1) and 3(c)(7) of the 1940 Act, Rules 4.13(a)(3) or 4.13(a)(4) of the Commodity Futures Trading Commission’s (CFTC’s) Part 4 regulations require CPOs relying on the exemption to offer and sell the interests in the fund without marketing to the public in the United States. However, unlike Sections 3(c)(1) and 3(c)(7) of the 1940 Act, Sections 4.13(a)(3) or 4.13(a)(4) never have been tied to Rule 506 and are not part of the “other federal securities laws” modified by the JOBS Act. Absent regulatory relief from the CFTC to harmonize with the changes to Regulation D, CPOs and fund managers relying on 4.13(a)(3) or 4.13(a)(4) likely will have to 1) continue to refrain from advertising, 2) drop the exemption and register with the CFTC or 3) drop the exemption and refrain from trading futures. (Note that the CFTC recently rescinded the exemption under 4.13(a)(4). No new 4.13(a)(4) exemptions may be filed and the exemption will disappear altogether at the end of 2012.)
How will the JOBS Act affect CPOs and fund managers?
The final impact of the JOBS Act won’t be known until the SEC completes its rulemaking process and those rules pass any challenges in court. Nevertheless, the likely consequences on CPOs and fund managers can be broken down by the type of manager:
- Pure CPOs (i.e., no securities) and other managers who do not rely on 3(c)(1) or 3(c)(7) (such as certain real estate fund managers) should expect to be able to advertise their funds freely.
- Mangers who do rely on 3(c)(1) or 3(c)(7) likely also will be able to advertise, but should be on the lookout for any roadblocks imposed by the SEC’s rulemaking process.
- Additionally, any managers who rely on 4.13(a)(3) or 4.13(a)(4) should plan either to drop their CFTC exemption or refrain from advertising unless the CFTC grants regulatory relief.
What other effects will the JOBS Act have on CPOs and private fund managers?
Another JOBS Act benefit for CPOs and private fund managers is an increase in the number of investors a fund may have without registering as a public reporting company under the Securities Exchange Act of 1934. This number has been increased from 500 to 2,000. Pure CPOs and fund managers relying on 3(c)(7) may now have up to 2,000 investors in each fund without additional regulation. The 100-investor limit for 3(c)(1) funds remains in place.
Additionally, CPOs and private fund managers who advertise based on the JOBS Act changes to Rule 506 must not allow any non-accredited investors into their funds. Some will allow a few non-accredited investors into their funds under certain circumstances (such as for employees, friends and family members).
Finally, mailing lists or “lead” lists may become more valuable because they now will be allowed to be used to solicit investors. Ads in trade journals or the popular press will be able to be used to find investors. Web sites can be re-done specifically to attract potential investors. All solicitations and sales can be done on-line, rendering hard copy offering materials obsolete.
If a CPO or private fund manager takes advantage of the new rules and advertises its funds, what should he or she be worried about?
Once a fund’s marketing materials are available on the Internet, it means the SEC and National Futures Association (NFA) can view them as well. Thus, sponsors of private funds that decide to use the Internet to solicit investors should be very cautious about the text of their materials. The SEC and NFA have rules governing marketing or promotional material, and CPOs and other private fund managers should assume that their materials will be scrutinized carefully.
David Matteson is a partner with Drinker Biddle & Reath LLP in its Chicago office and heads its managed futures practice.