The Securities and Exchange Commission (SEC) has gotten a tremendous amount of publicity recently for changing its rules to allow fund managers and other issuers to advertise and use general solicitations to raise capital. The discussion of the new rule has generally focused on “private funds” – hedge funds and other funds trading securities – but the new rules also will apply to commodity pools. Here we’ll explain what the SEC did, the current and proposed regulatory hurdles associated with the new advertising rules and whether commodity pool operators (CPOs) can take advantage of those changes (or not).
To summarize, in July 2013, the SEC:
1) adopted final rules required by the Jumpstart Our Business Startups Act (the JOBS Act) to eliminate the ban on general solicitations and advertising by private offerings under Rule 506 of Reg D (which is the exemption relied on by substantially all private funds and commodity pools)
2) prohibited certain felons and other “bad actors” from making offerings under Reg D
3) proposed various new rules which, if adopted, would impose new burdens on persons who wish to advertise their funds.
To be clear, the SEC didn’t want to make these changes, but was compelled to do so by the JOBS Act.
Because Reg D is an SEC rule, why is it important for commodity pool operators (CPO) to understand how it works? Every CPO is selling a security when it sells an interest in a pool to an investor; the interests, shares or units of the pool are themselves securities even if the pool only trades futures. The offer and sale of those pool interests are regulated by the SEC. Generally speaking, offerings of securities have to be registered with the SEC (for example, an IPO) or exempt from this registration. For many decades, SEC rules have exempted “private offerings” from the registration requirement and CPOs and private fund managers have relied on these exemptions to sell their funds. Prior to the recent SEC action, the most basic concept of private offerings had been that the manner of the offering must be “private.” General solicitations, including advertising, were not allowed. The general solicitation ban also restricted the ability of CPOs and private fund managers to discuss their funds in the press or any widely distributed forum – including the manager’s website and websites of third parties.
As required by the JOBS Act, new SEC Rule 506(c) lifts the advertising ban for CPOs and private fund managers willing to comply with its terms. CPOs and private fund managers who do NOT want to publicly solicit or advertise simply have to continue to comply with the “old” Reg D and will not be subject to the provisions of the new Rule 506(c). To advertise, new Rule 506(c) requires:
- All investors in the fund must be accredited investors; and
- The fund manager must take reasonable steps to verify that the investors are accredited.
Rule 506(c) adopts a principles-based “facts and circumstances” approach to determine whether reasonable steps were taken to verify that the purchasers are accredited. It also adds four non-exclusive “safe harbor” methods for determining that a natural person is accredited. Under the principles-based approach, a fund manager can reasonably determine that an investor is accredited based on the facts, e.g., the nature of the investor, the size of the investment, etc.
The challenge is verifying annual income or net worth of “natural person” investors. Natural persons are accredited if they meet either an annual income test or a net worth test. The SEC has listed four non-exclusive “safe harbors” for determining that a natural person is accredited. If a fund manager fits within any of these safe harbors, it will have satisfied the SEC’s standard of verification unless it has actual knowledge that an investor is not accredited. It is not necessary to fit within one of the safe harbors, but the fund manager will then have the burden of demonstrating, if asked by the SEC, that it used reasonable steps to verify that the investor was accredited.
The four safe harbors involve:
1.Reviewing copies of IRS forms that report an investor’s income and getting the investor’s representation that he or she expects to meet the income requirement for the current year;
2. Reviewing recent financial documents that report an investor’s net worth (such as bank/brokerage statements and a credit report) and getting the investor’s representation that all liabilities have been disclosed;
3. Obtaining a written confirmation from a registered broker-dealer, SEC registered investment adviser, licensed attorney or certified public accountant that such person has determined the investor is accredited; or
4. For existing investors in a fund when the new rule becomes effective, obtaining a certification that he or she still qualifies as an accredited investor.
Downsides to using the New Rule 506(c)
As discussed more fully below, while Rule 506(c) may open the door for advertising, each manager must still determine if the benefits of advertising outweigh the costs. Additionally, while most funds rely on Rule 506 of Reg D, a fund may have the fallback option of relying on the statutory exemption in Section 4(a)(2) of the Securities Act of 1933 for “transactions by an issuer not involving any public offering.” Reg D is safe harbor for complying with the statutory exemption in Section 4(a)(2). Previously, if a fund made an offering that failed to meet the requirements of the Rule 506 safe harbor, the fund could potentially still fall back on the statutory exemption because there was no public offering. This remains the case for funds who do not publicly solicit or advertise. However, if a fund advertises its offering in reliance on new Rule 506(c), the fallback option of Section 4(a)(2) will not be available if the requirements of Rule 506(c) are not met.
The Proposed Rules
As mentioned earlier, the SEC also proposed various new rules under Reg D and asked for public comments. Specifically, the Proposed Rules would have the following effects if enacted as proposed:
1. Written general solicitation materials used in a Rule 506(c) offering would temporarily need to be filed with the SEC.
2. Form D would have to be pre-filed in any Rule 506(c) offerings 15 days before the first advertisement and an amended Form D would be required 15 days after the first investor buys an interest in the fund. Currently, Form D filings are only required within 15 days after the first sale.
3. All funds (even those not advertising) would have to file a closing amendment to Form D at the end of the offering.
4. Advertisements would require certain legends and other disclosures.
5. All funds (even those not advertising) would be banned from using the current or new exemption if they failed to comply with the Form D filing requirements.
6. All funds (even those not advertising) would need to provide additional information on Form D, including: a) the fund’s website (if any); b) the percentage of purchasers who accredited investors and natural persons; c) the use of proceeds and d) the names and SEC file numbers of any SEC registered investment advisers providing advice. Additionally, those issuers relying on Rule 506(c) would be required to disclose: a) information regarding the issuer’s control persons; b) the types of general solicitation used and c) the methods of verifying that all investors are accredited.
7. Finally, the SEC is proposing to apply its current rule that regulates sales literature used by mutual funds to Reg D offerings.
Can CPOs advertise their pools?
So how can a CPO take advantage of new and proposed SEC rules? Currently, CFTC rules still restrict many CPOs from advertising certain pools.
Commodity pools fall into two categories: Either “filed” or “exempt.” The offering documents for filed pools have to contain all of the disclosures required by Part 4 of the CFTC rules and be filed with and reviewed by NFA before distributed to investors. Filed pools have no NFA/CFTC restriction from using the new SEC rule permitting public solicitations and advertising, so long as the CPO complies with Rule 506(c) and NFA’s advertising rule (which is essentially an anti-fraud rule). One interesting question is whether the CFTC will want filed pools relying on Rule 506(c) to list their offering as “private” or “public” as required in their offering documents.
Most exempt pools claim exemptive relief under either Rule 4.7 or Rule 4.13(a)(3). To claim the relief, a CPO must meet each condition of the exemption. Rule 4.7 requires that the offering be exempt under Section 4(a)(2) (the statutory exemption for Reg D discussed above). Public solicitations and advertising can only occur in private offerings that rely on new SEC Rule 506(c), which is the safe harbor regulation, but not the exemption in Section 4(a)(2). Therefore, at the current time, a CPO relying on Rule 4.7 cannot publicly solicit or advertise.
The other popular exemption for pools is Rule 4.13(a)(3). This often is called the “de minimis” exemption because the rule limits the pool’s use of, or exposure to, futures. This rule is only available to pools whose interests “are exempt from registration under the Securities Act of 1933, and such interests are offered and sold without marketing to the public in the United States.” If a CPO complies with new Rule 506(c), it would be entitled to the Reg D exemption from registration of the offering under the Securities Act of 1933. However, the second part of Rule 4.13(a)(3) prohibits marketing to the public in the U.S. Most forms of public solicitations and advertising would constitute marketing to the public, so, at the current time, a CPO relying on Rule 4.13(a)(3) cannot publicly solicit or advertise.
The CFTC has been formally petitioned (and informally lobbied) to issue guidance or relief so that CPOs that operate exempt pools can take advantage of new SEC Rule 506(c). The SEC and CFTC are currently working together to harmonize the new CFTC Rule 4.5, which will regulate certain mutual funds as commodity pools. It is hoped that the CFTC also will harmonize its rules for exempt pools with new Rule 506(c) so that CPOs will be able to use public solicitations and advertising to the same extent, and subject to the same constraints, as hedge fund managers not trading futures.
Importantly, the determination of whether a fund relies on the new Rule 506(c) or the old Rule 506(b) is done on a case by case basis. Accordingly, a CPO can choose to advertise certain funds under Rule 506(c) and stick with Rule 506(b) for its other funds.
With the passage of Rule 506(c), most hedge fund managers and some CPOs now have the ability to widely advertise their products if they choose to jump over the additional regulatory hurdles imposed by Rule 506(c) and the final version of the Proposed Rules. It remains to be seen if the CFTC will act to extend that choice to CPOs relying on a 4.7 or 4.13(a)(3) exemption. The ultimate impact of the JOBS Act on the commodity pool industry will depend on 1) what action the CFTC determines to take for exempt pools and 2) whether CPOs view the SEC’s additional hurdles as too high or too numerous to offset the benefit of advertising their pools.