Jumpstart Our Business Startups Act – Implications for Sponsors of Venture Capital, Private Equity and Hedge Funds

On April 5, 2012, the Jumpstart Our Business Startups Act (the "JOBS Act") was enacted into law.  This bipartisan legislation is intended to stimulate economic growth by improving access to the U.S. capital markets for U.S. and non-U.S. startup and emerging companies. 

This Client Alert focuses on those provisions of the JOBS Act that most directly affect sponsors of "venture capital funds," "private equity funds" and "hedge funds." [1]  These funds customarily are organized under exclusions from the provisions of the Investment Company Act of 1940 (the "Company Act") provided by Section 3(c)(1) or Section 3(c)(7) thereof ("Section 3(c)(1)" and "Section 3(c)(7)," respectively) and are referred to herein, collectively, as "Private Funds."

In particular, the JOBS Act: (i) eliminates the prohibition on "general solicitation" and "general advertising" in connection with the private placement of Private Fund securities, provided the securities are purchased solely by "Accredited Investors;" [2]  and (ii) provides a new safe-harbor exemption from broker-dealer registration for persons who take certain actions or perform certain services in connection with such transactions. 

For an overview of all of the provisions of the JOBS Act, please refer to the "JOBS Act Alert."

I.          Private Placement Offerings of Securities to Accredited Investors.

A.        Background.  Section 3(c)(1) excludes from the definition of "investment company" a fund that, among other things, limits to 100 the number of beneficial owners of its securities.  Section 3(c)(7) excludes from the definition of an "investment company" a fund, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are "Qualified Purchasers," if certain other conditions are met. [3]  The exclusion provided by each requires that the fund is not making and does not propose to make a "public offering of its securities."  In other words, a fund that seeks to rely upon either of these exclusions must offer and sell its securities in a transaction that qualifies as a "private placement" under the Securities Act of 1933 (the "Securities Act").

Customarily, Private Funds issuing interests to investors rely upon Section 4(2) of the Securities Act [4] and Regulation D thereunder ("Regulation D"), which provides a "safe harbor" exclusion from the registration requirements of the Securities Act.  The broadest exclusion available under Regulation D is provided by Rule 506 thereof ("Rule 506") which does not limit the dollar amount of the offering or the number of Accredited Investors who can participate.  However, Rule 506 requires, among other things, that:

neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following: (1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and (2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising . . . .

Accordingly, since its adoption in 1982, the prohibition on "general solicitation" or "general advertising" under Regulation D has severely limited the number of prospective investors to which a Private Fund, or any person acting on its behalf, can offer interests in the fund without relying upon the assistance of a properly authorized placement agent, such as a broker-dealer registered under the Securities Exchange Act of 1934 ("Exchange Act").  Effectively, Regulation D has regulated both the "offer" and "sale" of securities to Accredited Investors.

B.        The JOBS Act Eliminates the Prohibition on General Solicitation and General
Advertising in Connection with Certain Private Placements.  Section 201(a)(1) of the JOBS Act mandates that no later than 90 days after its enactment the Securities and Exchange Commission ("SEC") shall revise Rule 506 to provide that the prohibition against "general solicitation" or "general advertising" not apply to offers and sales of securities "provided that all purchasers of the securities are accredited investors." (Emphasis added.)  Such rules must "require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the [SEC]." 

Section 201(a) also confirms that offers and sales that are exempt under revised Rule 506 "shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation."  Accordingly, the "no public offering" condition of Section 3(c)(1) and Section 3(c)(7) should not be violated as a result of such offers.

C.        The JOBS Act Provides a New Safe-Harbor Exemption from Broker-Dealer Registration for Certain Persons Engaged in the Offer and Sale of Securities in Compliance with Rule 506.  Section 201(b) of the JOBS Act provides that with respect to securities offered and sold in compliance with Rule 506, no person who meets certain conditions shall be subject to registration as a broker or dealer under the Exchange Act solely because they take certain actions or perform certain services, most notably, maintaining "a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means."  Other "Ancillary Services" that can be provided include "the provision of due diligence services, in connection with the offer, sale, purchase, or negotiation of such security," provided that these services do not constitute advisory services for which the person is separately compensated.  The most notable condition of this exclusion is that "such person and each person associated with that person receives no compensation in connection with the purchase or sale of such security." 

D.        Potential Impact of the JOBS Act on Existing Private Placement Practices. 

1.         Direct Marketing by Fund Managers.  The JOBS Act, when fully implemented, should enhance the ability of Private Funds to engage in direct marketing and reduce the cost of fund raising.  Private Fund managers would also be permitted to respond to media inquiries and provide information that, under existing regulatory standards, might be deemed to be "conditioning the market" or the commencement of an offering.  Examples of marketing activities that have been problematic, but may now be permissible, include:  public statements or advertisements concerning a fund offering, including, in particular, the investment strategy of the fund and its range of targeted returns; placing advertisements in newspapers or trade publications; posting information on non-password protected websites, or making presentations at conferences whose attendees were invited by means of a "general solicitation."

At the same time, it must be borne in mind that the JOBS Act does not modify in any way the anti-fraud provisions of the securities laws, including disclosure obligations that are applicable to issuers and third-parties engaged in a securities offering and sale, such as full and fair disclosure of the risks presented in connection with an investment in a particular fund or its trading strategies, etc.

Moreover, at this time there is no reason to believe that other conditions of Regulation D will be modified, such as the requirement that all sales that are deemed to be part of the same Regulation D offering must meet all of its requirements, i.e., sales that are deemed to be "integrated" for purposes of determining whether the conditions of Regulation D have been satisfied.  For example, if shortly after having completed an offering of interests in a Private Fund in compliance with the requirements of revised Rule 506 that:  (i) involved the use of "general solicitation" or "general advertising"; and (ii) did not include any non-Accredited Investors as purchasers,  a Private Fund conducts another offering of interests of the same class to fund the same investment program under revised Rule 506 that:  (i) does not involve the use of "general solicitation" or "general advertising"; but (ii) includes non-Accredited Investors as purchasers, the two offerings might be "integrated" under the standards set forth in Regulation D with the risk that the second offering would not satisfy its requirements.

2.         Employment of Non-Registered Sales Personnel.  It has been a concern of investment managers of Private Funds that are engaged in an ongoing offering of interests in their funds that an employee who devotes substantially all of his/her time to client relations and marketing might be deemed to be acting as a broker-dealer and subject to the registration requirements of the Exchange Act.  It has also been a concern of these investment managers that third-party referral agents or service providers might be subject to these requirements.  The safe-harbor of Section 201(c) of the JOBS Act may substantially reduce those concerns, although the scope of the relief granted will be highly dependent on how the permitted activities and the prohibition on compensation "in connection with the purchase and sale of [a] security" are interpreted in any implementing rules adopted by the SEC.

For example, would the activity of acting in the traditional role of a referral agent come within the safe harbor of "maintain[ing] a platform or mechanism that permits the offer, sale, purchase, sale or negotiation of or with respect to securities . . ." ?  Might the prohibition on compensation to persons "in connection with the purchase or sale of such security" be interpreted to preclude only "transaction based compensation," generally regarded by the SEC and the Financial Industry Regulatory Authority ("FINRA") as a "red flag" connoting broker-dealer status, or would the prohibition extend to any compensation that clearly is not attributable to marketing activities or investment advice?

3.         Re-examination of Access to, and Content of, Websites of Investment Managers to Private Funds.  Under the regulatory guidance provided by the Staff of the SEC, investment managers of Private Funds have developed procedures under which investors have been able to access Private Fund offering materials.  These procedures, generally, entail a two-stage process under which a prospective investor first will provide sufficient information that allows the investment manager to make a reasonable determination that the prospective investor is an Accredited Investor and then the prospective investor must wait at least 30 days before being granted full access to the website in order that a "pre-existing relationship" be established with the issuer, so as to satisfy the offering requirements of Regulation D. 

As noted above, implementation of Section 201(a) of the JOBS Act is subject to the adoption by the SEC of rules that "require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the [SEC]."  Hopefully, these rules will be modeled upon existing Staff guidance.

4 .        Better Alignment of U.S. and U.K. Marketing Standards.  Prior to the enactment of the JOBS Act, the U.S. private placement regulatory regime was significantly more restrictive than its counterpart in the U.K.  The JOBS Act should broadly bring the U.S. and U.K. regulatory regimes into closer alignment and facilitate cross-border offerings of interests in Private Funds.

In the U.K., under Section 21 of the Financial Services and Markets Act 2000 (the "FSMA"), an unauthorized person is prohibited from communicating a financial promotion unless the content of the promotion is approved by an authorized person or is exempt.  The exemptions are set out in the FSMA (Financial Promotion Order) 2005 (the "FPO").  These include promotions made publicly to "Investment Professionals," [5] "Certified High Net Worth Individuals" [6] and "Sophisticated Investors." [7]  Recent guidance of the Financial Services Authority has confirmed that promotions made publicly can be targeted at Investment Professionals, provided that they must be effectively targeted through the publication or medium used, be fair, clear and not misleading and clearly state the target audience.  For example, to take advantage of the investment professionals exemption, the promotion should be accompanied by an indication that it is directed at persons having professional experience in matters relating to investments, that persons who do not have professional experience in matters relating to investments should not rely on it, and that there are proper systems and procedures in place to prevent recipients other than Investment Professionals from engaging in the investment activity.

II.        Other Relevant Provisions of the JOBS Act.

A.        Easier Communications with Accredited Investors and "Qualified Institutional Buyers."  As more fully discussed in the JOBS Act Alert, a possible benefit to a sponsor of a Private Fund, particularly a venture capital fund, is that an "Emerging Growth Company," [8] or its authorized representatives, can communicate orally or in writing with institutions that are Accredited Investors and "Qualified Institutional Buyers" [9] to determine whether these investors would have an interest in a proposed securities offering.  Such communications could take place before or after the filing of a registration statement under the Securities Act. 

B.        "Crowdfunding" – Unavailability to Private Funds.  As discussed in detail in the JOBS Act Alert, the JOBS Act provides a new exemption from the registration requirements of the Securities Act for capital raising by issuers using on-line internet services in compliance with certain requirements (the "Crowdfunding Exemption").  The Crowdfunding Exemption is not available to an issuer that is:  "an investment company, as defined in section 3 of the Investment Company Act of 1940, or is excluded from the definition of investment company by section 3(b) or section 3(c) of that Act." [11] Accordingly, a Private Fund would not be eligible to raise capital through the Crowdfunding Exemption.

C.        Increase in Limit on the Number of Holders of Record an Issuer May Have Before Being Required to Register Securities Under the Exchange Act.  Section 501 of the JOBS Act amends Section 12(g) of the Exchange Act to change the limit on the number of holders of record of a class of equity securities an issuer may have before it is required to register such securities under the Exchange Act from 500 to either:  (i) 2,000 persons; or (ii) 500 persons who are not Accredited Investors, excluding persons:  (i) who received securities pursuant to employee compensation plans in transactions exempted from the registration requirements of the Securities Act; and (ii) investors who acquired securities in an offering under the Crowdfunding Exemption.  This change will allow managers of large Private Funds to expand their investor base and more efficiently raise funds for particular investment programs without being subject to the reporting burdens of the Exchange Act.

III.       Concluding Observation.   The JOBS Act provisions discussed above raise a number of interpretative issues and the lifting of the prohibition on "general solicitation" and "general advertising" for offers and sales of securities under Rule 506 (provided that the securities are purchased solely by Accredited Investors) is subject to the adoption of rules by the SEC.   Against this background, it should be anticipated that other regulatory bodies, such as FINRA and the North American Securities Administrators Association (which has expressed concerns about the legislation), will be carefully considering the potential impact of the JOBS Act and SEC rulemakings.  Therefore, the impact of the legislation on the private funds industry will not be fully known until the rulemaking process has run its course.  Orrick will be closely monitoring these developments and will provide timely updates as warranted.

Please do not hesitate to contact the authors of this Alert, any of the members of the Private Investment Funds Group, or other Orrick attorneys with whom you work to discuss any questions that arise. 

* Only admitted in New Jersey

[1] Each of these terms is defined in the Glossary of Terms contained in Form PF adopted under the Investment Advisers Act of 1940.

The definition of "Accredited Investor" is set forth in Rule 501(a) promulgated under the Securities Act.

[3] Section 3(c)(1) and Section 3(c)(7) of the Company Act provide in relevant part:

(c)  Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title:  (1) Any issuer whose outstanding securities (other than short- term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities.          

(7)(A) Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities

The definition of "Qualified Purchaser" is set forth in Section 2(a)(51) of the Company Act.

[4] Section 4(2) of the Securities Act provides:

4.  The provisions of [the registration requirements of the Securities Act]shall not apply to—  

(2) transactions by an issuer not involving any public offering.

[5] The definition of "Investment Professionals" is set forth in Article 19(5) of the FPO.

[6] The definition of "Certified High Net Worth Individuals" is set forth in Article 48(2) of the FPO.

[7] The definition of "Sophisticated Investors" is set forth in Article 50(1) and the definition of "Self-Certifying Sophisticated Investors" is found in Article 50A(1) of the FPO.

[8] The term "Emerging Growth Company" is defined in Section 101 of the JOBS Act to mean, generally, a company that had total annual gross revenues of less than $1 billion during its most recently completed fiscal year.

[9] The definition of "Qualified Institutional Buyer" is set forth in Rule 144A promulgated under the Securities Act.

[10] Generally, in order for an issuer to rely upon the Crowdfunding Exemption it must either not be an "investment company" as defined in the Company Act or it must satisfy the requirements of one of the exceptions from investment company status under the Company Act available under Rule 3a-1 ("certain prima facie investment companies"),  Rule 3a-2 ("transient investment companies"), Rule 3a-3 ("certain investment companies owned by companies which are not investment companies"),  Rule 3a-5 ("finance subsidiaries"), Rule 3a-6 ("foreign banks and foreign insurance companies"), Rule 3a-7 ("issuers of asset backed securities"), or Rule 3a-8 ("certain research and development companies").