Eric A. Brill
ATTORNEY AT LAW
235 MONTGOMERY STREET, 17TH FLOOR
SAN FRANCISCO, CALIFORNIA 94104
DIRECT DIAL (415) 954-4474
FACSIMILE (415) 954-4480
June 7, 2012
JOBS Act Authorizes “General Solicitation and General Advertising” in Private Offerings
Most private investment funds offer ownership interests to investors in reliance on the private-offering registration exemption available under Rule 506, part of Regulation D under the Securities Act of 1933. Ever since Rule 506 was adopted three decades ago, the exemption has prohibited any “general solicitation or general advertising.” Generally this has limited issuers to private communications with prospective investors with whom the issuer or its representative has a pre-existing relationship that satisfies certain criteria.
The prohibition against “general solicitation or general advertising” soon will disappear.
The Jumpstart Our Business Startups (JOBS) Act became law on April 5, 2012. It requires the Securities and Exchange Commission (SEC) to amend Rule 506 within 90 days (July 4, 2012) to permit “general solicitation or general advertising” in a Rule 506 exempt offering, provided that all investors are “accredited investors” as defined in Rule 501(a). No longer will a pre-existing relationship with an offeree be required. Though “general solicitation or general advertising” may take many forms, predictable examples include fund marketing materials posted on a manager’s non-password protected website, open-to-the-public marketing presentations by fund managers, and advertisements in the financial or general press.
Several related changes made by the JOBS Act are not discussed here, and some important questions remain unanswered. While the imminent broadening of Rule 506 has been hailed by many (for example, see comments of the Managed Funds Association on the SEC’s anticipated rule-making at http://www.sec.gov/comments/jobs-title-ii/jobs-title-ii.shtml), some SEC officials have expressed dismay (see http://www.sec.gov/news/speech/2012/spch031612laa.htm), and powerful critics have recommended severe restrictions on this new freedom of private funds to advertise (see, for example, comments of the Investment Company Institute, the principal lobbying group for registered mutual funds, at the first link above).
Perhaps most immediately important for private funds, the JOBS Act directs the SEC to adopt a rule requiring issuers to take “reasonable steps to verify” that all investors are accredited in an offering that relies on revised Rule 506. In light of the displeasure expressed by some SEC officials with this JOBS Act provision (see the second link above), the SEC may prescribe verification procedures that investors find unduly intrusive or burdensome, and that issuers are reluctant to follow for that reason or others. For example, the SEC may declare it unreasonable for an issuer to rely solely on an investor’s representation of accredited investor status in subscription documents.
Private fund offerings under revised Rule 506 are likely to receive closer scrutiny.
Under the pre-JOBS Act version of Rule 506, an offering may have up to 35 non-accredited investors. Revised Rule 506 will permit none at all if general solicitation or general advertising is used. This may not matter to private funds that charge performance-based compensation (most do), since investors in such funds generally must satisfy an even stricter “qualified client” standard. But it may adversely affect funds that do not charge performance-based compensation.
Important to private funds generally, various parties – for example, regulators, disgruntled investors, even competitors – may find it both tempting and relatively easy to determine whether a private fund offering was eligible for the revised Rule 506 registration exemption. A single non-accredited investor – not 36 of them – will be sufficient to disqualify the offering if general solicitation or general advertising was used. On this point, fund managers should bear in mind that accredited-investor standards recently have become more stringent, and soon may become even more so. For example, the “net worth” test now excludes equity in an investor’s principal residence, and the SEC soon may increase the $1,000,000 net worth threshold and make additional changes in the definition of “accredited investor.”
It is beyond the scope of this notice to describe the legal consequences of an offering’s failure to satisfy revised Rule 506. It is sufficient here to note that there are several and each may be quite severe. The pre-JOBS Act version of Rule 506 (permitting up to 35 non-accredited investors) will remain available to issuers, but only if no “general solicitation or general advertising” is used in the offering. Once an issuer has commenced an offering in reliance on revised Rule 506, using general solicitation or general advertising, it will be impossible to rely on the earlier version.
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This notice is not intended as specific legal advice to any person, even if the reader is a client of the writer. Before acting on this or any other legal information, a reader should consult an attorney experienced in the subject matter. The attorney properly will evaluate a client’s particular circumstances and may recommend a course of action different from what the reader may have considered advisable before consulting the attorney.