Many comment letters relating to the SEC’s proposed rules relaxing the ban on general solicitation suggest that the JOBS Act mandate was not well thought through and that relaxing the ban on general solicitation requires careful thought. While it is true that any change that would affect investor protections should require careful thought, it seems like writers of these comment letters have neglected their history. Discussion related to relaxing the ban on general solicitation has been ongoing since the early 1990s. Various speeches and statements by SEC Staff members over the years have commented on, and acknowledged, the need to revisit private placement exemptions in light of changes in communications patterns. The legal community also has given close consideration to these questions going as far back as the late 1990s and early 2000s. In 2001, the American Bar Association’s Committee on the Federal Regulation of Securities submitted a comment letter to the SEC that suggested relaxation of the ban on general solicitation. At around the same time, the ABA Task Force for the Review of the Federal Securities Laws also proposed that a private offering would qualify for an exemption from registration based on the eligibility of the purchasers of the securities and the restrictions on resales, and not on the number of offerees. The Advisory Committee on Smaller Public Companies, formed in 2004, advocated a relaxation of the ban on general solicitation. Is it possible that over a decade of consideration, and discussion of proposals, would not be considered careful consideration?
The SEC’s Investment Advisory Committee has recommended that the SEC should require issuers relying on the exemption from the ban on general solicitation and advertising to file a form as a precondition for claiming the exemption, and also file with the SEC general solicitation and general advertising material they use in private offerings that rely on the exemption.
The committee published its recommendations on October 15, 2012 in its report, “Recommendations of the Investment Advisory Committee Regarding SEC Rulemaking to Lift the Ban on General Solicitation and Advertising in Rule 506 Offerings: Efficiency Balancing Investor Protection, Capital Formation and Market Integrity.”
The committee’s recommendations follow the SEC’s action on August 29, 2012 to propose rules implementing the JOBS Act mandate to eliminate the ban on general solicitation and general advertising in Rule 506 private placements. Lifting the ban, the committee said, can and should be done “in a manner that simultaneously promotes investor protection, facilitates efficient capital formation, and provides regulators with the tools they need to police the market effectively.”
The committee suggested that the SEC “give strong consideration” to its recommendations, including:
- Require issuers intending to rely on the new JOBS Act general solicitation exemption to file either a new “Form GS” or a revised version of Form D as a precondition for claiming the exemption.
- Require that issuers file with the SEC all solicitation material prepared or disseminated on its behalf in a general solicitation or advertising campaign in reliance on the exemption through an online electronic “drop box.”
- Adopt a safe harbor that “provides clear and enforceable standards” for verification, as opposed to reasonable belief, of accredited investor standards to promote reliance on reliable third parties, including broker-dealers, banks and licensed accountants.
- Make the filing of Form D a condition for relying on the Regulation D exemption (currently, the filing is not a condition for relying on the Regulation D exemption).
- The SEC should take steps to ensure that performance claims in general solicitation materials “are based on appropriate performance reporting standards.”
- Amend the definition of “accredited investor” to better reflect the financial sophistication of “natural persons.”
- The SEC should promptly adopt a “bad actors” rule to disqualify felons, as required by Section 926 of the Dodd-Frank Act.
Section 911 of the Dodd-Frank Act established the Investment Advisory Committee to advise the SEC on regulatory priorities, the regulation of securities products, trading strategies, fee structures, and the effectiveness of disclosure and the integrity of the securities marketplace. The Dodd-Frank Act authorizes the committee to submit its findings and recommendations for review and consideration by the SEC.
Senator Carl Levin of Michigan also weighed in on the SEC’s proposed rule. In a letter dated October 5, 2012 to the SEC, he cited two “significant flaws.” The first is that the proposed rule fails to adequately outline “reasonable steps” necessary to be taken by the issuer to ensure that all investors are accredited. The second is that the proposed rule fails to meaningfully regulate permissible solicitation and advertising so as to protect investors from deceptive advertising, inappropriate or unfair sales tactics and investment fraud.
Among the many distinctive aspects of the JOBS Act is that we could end up seeing more Congressional hearings on the JOBS Act after it was enacted than before it was enacted. The focus has now shifted from merits of the JOBS Act’s provisions to the pace at which those provisions are going into effect, as well as the manner in which the SEC is seeking to implement the provisions.
On September 13, 2012, two key House subcommittees held a joint hearing on the implementation of the JOBS Act. The Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs of the House Committee on Oversight and Government Reform, chaired by Representative Patrick McHenry (R-NC), and the Subcommittee on Capital Markets and Government Sponsored Enterprises of the House Committee on Financial Services, chaired by Representative Scott Garrett (R-NJ), questioned a panel consisting of an academic, a small business representative and potential beneficiaries of the JOBS Act. In addition to Robert Thompson, a professor at the Georgetown University Law Center and Jeffrey Van Winkle of the National Small Business Association, the panelists included Alison Bailey Vercruyesse, founder and CEO of 18 Rabbits, a producer of granola and granola products, Rory Eakin, co-founder and COO of CircleUp, and Naval Ravikant, CEO of AngelList. The panel evaluated the progress of the SEC’s implementation of the JOBS Act, and in particular the removal of the ban on general solicitation in Rule 506 offerings under Title II and the crowdfunding exemption under Title III.
While the panelists were largely supportive of the JOBS Act and the flexibility that it will bring to capital-raising efforts, there was an underlying concern that, particularly with respect to the crowdfunding exemption, the SEC’s implementation through rulemaking could make the costs and burdens too onerous for the types of companies who would find the exemption attractive. The panelists, perhaps to the consternation of certain of the members of the subcommittees, did not seem too concerned with the pace of the SEC’s rulemaking, with some panelists expressing the view that the SEC should take an approach which ensures that they get the rulemaking right, so that the JOBS Act provisions are workable and achieve the objectives of promoting capital formation.
The members themselves touted the bipartisan effort which brought about the JOBS Act, and then devolved into partisan bickering about the pace of the SEC’s efforts to implement the Act. In this regard, much focus was placed on the SEC’s shift toward adopting Title II rules through a traditional notice and comment process, rather than going straight to interim final rules. Further, there was some debate among the members regarding the extent to which the SEC should be prioritizing JOBS Act rules over rules required under the Dodd-Frank Act, including the extent to which the majority members were seeking to delay Dodd-Frank Act implementation while at the same time pushing forward with the JOBS Act.
Perhaps the most insightful commentary of the hearing came from Representative Waters (D-CA), who expressed some concern that Ms. Vercruyesse, the founder of 18 Rabbits, was taking time away from running her business to testify on the implementation of the JOBS Act. Representative Waters stated “you don’t need to be sitting up here in Congress for hours talking about whether or not they’re moving fast enough.”
No SEC officials were present at the hearing, and it is unlikely that we will see any change in course at the SEC or any legislative initiatives coming out of this hearing.
When the SEC finalizes proposed rules that eliminate the prohibition on general solicitation and general advertising, private funds will be free to jump in and publicly offer their securities, right?
Not so fast, especially if the private fund is a commodity pool under the Commodity Exchange Act.
Among other things, Section 201(a)(1) of the JOBS Act mandated the SEC to revise Rule 506 of Regulation D under the Securities Act to eliminate the prohibition against general solicitation and general advertising for offerings to accredited investors. Section 201(b) of the JOBS Act amends Section 4 of the Securities Act of 1933 to clarify that offerings made under Rule 506 won’t be considered public offerings under the federal securities laws if they rely on the exemption.
Private funds, including hedge funds that are also commodity pools, typically rely on Section 4(a)(2) and Rule 506 to offer their interests without registration under the 1933 Act. Private funds also generally rely on exclusions from the definition of an investment company provided by either Section 3(c)(1) or 3(c)(7) of the Investment Company Act. But, as a condition to rely on either of these exclusions, the issuer must be one that is not making and does not propose to “make a public offering” of its securities.
The SEC’s long-awaited rule proposals implementing Section 201(a) recognize the issue. The SEC unambiguously stated that it believes that Congress, in adopting Section 201(b) of the JOBS Act, intended to let privately offered funds make a general solicitation under amended Rule 506 “without losing either of the exclusions under the Investment Company Act.”
While the JOBS Act addresses private offerings for purposes of the federal securities laws, it does not specifically address how the Section 201(a) would apply to regulation of commodity pools that are exempt from registration under the CEA.
In particular, consider CFTC rule 4.7 and rule 4.13(a)(3), which exempt certain hedge funds and other commodity pools from the CEA’s registration requirements. A fund can rely on rule 4.7(b) only if it “offers or sells participations in a pool solely to qualified eligible persons.” It is not clear whether this condition prohibits marketing to the public, as contemplated in the proposed amendments to Rule 506. Similarly, a fund can rely on the de minimis exception, rule 4.13(a)(3), only if the pool interests are exempt from registration under the 1933 Act “and may not be marketed in public in the United States.”
The result is that the CFTC’s rules are not in harmony with the federal securities regulations. That is, private funds that invest only in securities and security-based swaps, may engage in general solicitation and advertising, while private commodity pools, including those that rely on the rule 4.13(a)(3) de minimis exception, would not be able to engage in general solicitation and advertising.
The Managed Funds Association makes a cogent argument in its July 17, 2012 comment letter to the CFTC concerning harmonization of compliance obligations under JOBS Act and CFTC regulations.
We hope the CFTC gives serious consideration to the MFA’s comment.
Over the last few weeks, many commentators have written about the potential for widespread fraud and abuse in connection with Rule 506 offerings in which general solicitation is used. Some of these commentators have noted that if general solicitation is permitted, additional safeguards should be implemented in order to protect accredited investors. The argument seems to go more or less as follows: the securities laws prevented general solicitation from being used in connection with private offerings made to sophisticated purchasers and mandated that where general solicitation was permitted (i.e., public offerings), certain disclosure standards had to be met in order to ensure that investors had adequate information on which to base their investment decision. And, the argument continues: if general solicitation is permitted in connection with certain exempt offerings, then the accredited investor standard should be revisited and certain disclosures should be mandated in order to protect investors.
We have a little trouble following these arguments. Indeed, an exemption from registration has always been available in the case of certain private offerings made to a limited number of financially sophisticated investors that have some relationship to each other and to the issuer, have access to information about the issuer, and no general solicitation is used. It was determined that in the case of such offerings, financially sophisticated investors could fend for themselves. Was their ability to fend for themselves dependent on the fact that no general solicitation was used? If general solicitation is used, would it render otherwise financially sophisticated investors unable to fend for themselves? We’ll come back to this question.
A bit of history first: the notion of deregulating offers (relaxing the ban against general solicitation) is not a new idea that was rashly suggested and was not given careful consideration. Relaxing the prohibition against general solicitation and general advertising has been suggested and considered for the better part of twenty years. Not sure we would say that taking two decades to effect this change is “rushed.”
The proposed rules regarding Rule 506 offerings using general solicitation do require that additional steps be taken to verify the status of those investors that are actually purchasing securities. This is intended to address the concerns raised by certain legislators in connection with their consideration of the JOBS Act. Issuers (or the broker-dealers acting on their behalf) will be required to evidence the steps they took to verify the status of investors. On this basis, it is difficult to understand how investors that are subjected to general advertising or solicitation efforts but do not participate in offerings are harmed. One might be able to understand that certain classes of TV viewers might be harmed by watching advertisements for sugary cereals or “jumbo-sized” meal deals (although someone, presumably older and more nutritionally-aware, still has to make the decision to visit a store and make the purchase decision) or by being exposed to excessively violent television programs. However, it is a little harder to draw parallels with investing. Is the point that listeners will be de-sensitized to hearing about investment opportunities? Or, that merely listening will do harm? Not everyone that listens to a compelling or aggressive sales pitch for a security will qualify as an accredited investor, or will be deemed to be a customer for which the investment is appropriate based on investment objectives and other criteria.
A couple of commentators have also noted that it is the “accredited investor” standard that may be deficient. For some time now, we have relied on the utility of the “accredited investor” threshold as one that is useful in identifying a class of investors that has the financial wherewithal to make certain investments and that possess, either on their own or with the assistance of a purchaser representative, the ability to make investment decisions. It is true that the “accredited investor” definition uses financial tests as a proxy for assessing sophistication, and, perhaps, that’s a crude and imprecise test. We have never implemented investor standards that require testing or screening for financial literacy. Does the fact that general solicitation will be permitted really require revisiting of all of our investor standards? And, if we were to revisit the “accredited investor” test, then should we revisit the other investor standards contained in the securities laws? If we don’t believe that accredited investor self-certification is reliable, would it be reasonable to rely on the accuracy and reliability of any “financial literacy” test? Don’t the know-your-customer and suitability obligations mitigate any potential risks that securities would be recommended to customers for which such purchases would be inappropriate?
Some have suggested that it may be useful to require a “warning label” on the offered securities, or impose a “cooling off” period during which investors who were generally solicited (and presumably vetted and determined to be accredited) could re-consider their investment decision. This is not the first time that a “cooling off” period has been suggested in connection with securities offerings. In fact, we’ve seen this suggested in connection with mortgage-backed and asset-backed offerings, as well as with accelerated book build transactions marketed principally to institutional investors. The rationale given is that the marketing of transactions moves too quickly to permit careful consideration of investment opportunities—so, we should slow down the pace of the market, but facilitate capital formation? Interesting.
Join us for a JOBS Act Update. The seminar will be held at The Michelangelo in New York on Friday, September 21st, from 8:15am-10:00am. Want to attend? Click here.
We invite you to join us for the first of our fall CLE series (note: new location). Our session will focus on developments related to the JOBS Act and the IPO market. We will discuss the SEC Staff’s guidance on various interpretative questions relating to Title I of the JOBS Act. We also will discuss the SEC Staff’s Frequently Asked Questions on research issues, and the proposal relaxing the ban on general solicitation in connection with certain private offerings. Our speakers will cover the following topics:
- SEC views on emerging growth company (EGC) status;
- Research guidance, research safe harbors, and liability issues;
- Using Title I benefits in connection with mergers and exchange offers;
- The general solicitation proposal and investor verification;
- The IPO process and investor communications; and
- Practical considerations for various offering formats, including PIPE transactions, 4(a)(1-1/2) transactions and 4(a)(2) exempt offerings.
Partner, Morrison & Foerster LLP
Partner, Morrison & Foerster LLP
Assistant General Counsel, Bank of America Merrill Lynch
NY and CA CLE credit is pending.
Now that the SEC has proposed rules to eliminate the general solicitation and general advertising restrictions for certain offerings of securities, can advertisements for private funds on bus shelters and billboards be far behind?
Not so fast.
Private funds, including hedge funds, venture capital funds and private equity funds, often rely on Section 4(a)(2) and Rule 506 safe harbors to offer interests without registering under the Securities Act of 1933. Private funds typically rely on the exemptions from the definition of “investment company” provided by Section 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940. As a condition to relying on these exemptions, funds cannot publicly offer their securities, which includes a prohibition on advertising. When the JOBS Act ordered the SEC to lift this ban, it opened a Pandora’s Box.
Private funds have never been able to publically advertise, so they never had to worry about standards for general advertising in newspapers, radio, TV, the internet, billboards, buses and bus shelters, or milk box cartons.
Once the SEC fulfills the JOBS Act mandate to unshackle the advertising chains, what will private funds do? Will there be a rush to spend thousands, or millions, of dollars on advertising? What rules will apply?
The JOBS Act mandate to the SEC does not refer specifically to private funds. The SEC clarified that the when Congress directed it to allow private fund general solicitations and general advertisements, the private funds won’t lose either of the exemptions under the Investment Company Act. That’s one compliance headache avoided. But there’s more.
Private funds advised by registered investment advisers. We won’t be shocked if the SEC insists that the private funds managed by registered advisers must comply with Rule 206(4)-1 under the Investment Advisers Act. This rule regulates advertisements by registered advisers. Among other things, it prohibits testimonials (broadly interpreted); advertisements of cherry-picked investment returns, charts or graphs soliciting investors on statistics alone, and the catch-all misleading statements or material omissions. But if the hedge fund, not the adviser, is running the advertisement, can the SEC really force a private fund to comply with the prohibitions of Rule 206(4)-1? We will leave that discussion for another day.
Private funds advised by unregistered advisers. This gets a bit more complicated. The SEC’s advertising rules apply only to registered investment advisers (and those required to be registered). What about advisers that rely on any of the Dodd-Frank exemptions from registration, such as the adviser solely to venture capital funds, advisers solely to private funds with less than $150 million under management, and foreign private advisers? What about investment advisers registered with a state? While these advisers are exempt from the substantive rules of the Investment Advisers Act, some must still report to the SEC certain information on Form ADV.
On its face, these exempt advisers, and state registered advisers, do not have to comply with the substantive provisions Rule 206(4)-1. Of course, the anti-fraud laws of the Investment Advisers Act apply to all advisers, exempt or not. And, state laws concerning advertisements may apply.
Will the SEC adopt rules for private fund advertisements, similar to those that apply to mutual funds? Time will tell.
To be sure, when the shackles are lifted, hedge fund advisers are advised to tread carefully, because there may be some land mines planted in the wide-open field of private fund advertising. And remember, past results do not guarantee future performance.
Following this morning’s meeting, the Commission has published its proposed rules:
The SEC published its guidance today as a proposed rule, with a comment period, and not as an interim final rule.
The SEC proposes to amend Rule 506 to provide that the prohibition against general solicitation contained in Rule 502(c) shall not apply to offers and sales of securities made pursuant to Rule 506 provided that all purchasers are accredited investors and the issuer takes reasonable steps to verify their status.
Form D will be amended so that an issuer will be required to indicate whether it has used general solicitation.
The SEC is not proposing to amend the Section 4(a)(2) exemption.
Rule 506 offerings
Release implements a bifurcated approach—that is an issuer can conduct a Rule 506 offering without general solicitation, or a Rule 506(c) offering using general solicitation
A new Rule 506(c) is introduced, which would permit general solicitation provided: issuer takes reasonable steps to verify investor status; purchasers are accredited investors; and other conditions of Rule 501 and 502(a) and 502(d) are satisfied.
The Staff is not prescribing a verification approach, but recognizing that the reasonableness of the steps taken to verify status will be based on particular facts and circumstances. The Staff sets out a number of measures (in the form of a non-exclusive list) that could be used in order to assess investor status.
Rule 144A will be amended to remove the reference to “offer” and “offeree” from Rule 144A(d)(1), requiring only that securities be sold only to a QIB or person reasonably believed to be a QIB.
Rule 144A/Rule 506 offerings will not be integrated with contemporaneous Regulation S offerings—however, the language used in the release may not be as clear as market participants would like.
At a meeting this morning, the SEC voted to propose rules relaxing the ban on general solicitation for certain offerings conducted pursuant to Rule 506 and resales under Rule 144A. In a meeting that lasted approximately 45 minutes, the Staff outlined the principal aspects of the proposed rules. The Staff indicated that it was proposing rules for comment, and not proposing an interim final rule. As a result, market participants will have an opportunity to comment on the proposal and the Staff will have an opportunity to consider these comments prior to the adoption of final rules. As anticipated, close attention will be required in relation to the Staff’s proposals regarding the “reasonable steps” to be taken to verify accredited investor status for offerings in which general solicitation is used. The Staff discussed generally the verification process. The Staff also discussed proposed changes to Form D. The Staff also noted that the proposal would address the “directed selling effort” prong of Regulation S. We will provide a detailed analysis of the proposal shortly.
The Commissioners provided interesting perspectives on the proposed rules and on the rulemaking process.
Commissioner Walter noted her support for modification of the communications rules in order to make these rules more contemporary. She noted that allowing general solicitation is “a profound change,” which likely will have “unintended consequences.” Commissioner Walter noted that comments on the proposal should help to identify these potential unintended consequences. She also suggested that the Staff consider updating Form D in order to make it a source for more information regarding the types of offerings in which general solicitation is used and that the Staff should study the uses of general solicitation. Commissioner Walter asked how the Staff intended to monitor the use of Rule 506 offerings involving general solicitation. Meredith Cross noted that a multi-divisional task force would be formed in order to identify offerings in which general solicitation was used and to understand the verification processes used in these offerings.
Commissioner Aguilar noted he did not support the proposal and he would issue a separate statement which would be forthcoming. He expressed concerns about investor protection.
Both Commissioners Paredes and Gallagher expressed their support for the proposal, while noting their significant concerns with the rulemaking process itself. The two Commissioners noted that the original rulemaking course, which had been to release an interim final rule (not a proposal), had been changed in midstream. This change had been occasioned after significant concerns had been expressed by various groups, including state regulators. Both Commissioners Paredes and Gallagher noted their concern regarding the change in course and the resulting delays.
We’ve been thinking about whether the changes to Rule 506 offerings are likely to have any effect on the PIPE market. Our preliminary conclusion is that the ability to use general solicitation is unlikely to have much effect on PIPE transactions. An already public company generally turns to a PIPE transaction for financing because the company wants to ensure that it will be able to obtain definitive commitments from PIPE purchasers before announcing the financing. In order to address Regulation FD concerns and avoid a premature disclosure regarding the potential private financing, the company and its financial intermediary will obtain confidentiality undertakings from potential purchasers. It would be inconsistent with this approach to rely on general solicitation. Moreover, there often are special circumstances, such as an acquisition, that compel the company to rely on a PIPE transaction instead of a shelf takedown. To the extent that a company shares material non-public information with potential PIPE purchasers (which information will later be made public through a cleansing release), using general solicitation in connection with the PIPE transaction also would not be possible. However, the practices relating to PIPE press releases may change going forward. Now, the press release announcing the entry into definitive PIPE purchase agreements does not name the PIPE placement agent since that would not comport with the strict requirements of Rule 135c. Given the additional flexibility relating to general solicitation, counsel may be more comfortable with naming the financial intermediary in a Rule 135c release.