The SEC proposed to require private funds making Rule 506(c) offerings to file written general solicitation materials with the SEC on a temporary basis. The filings would be required to apply for a period of two years, and would not be available to the public. The SEC also proposed to amend Rule 156 under the Securities Act of 1933, the anti-fraud rule that applies to sales literature of registered investment companies. The rule amendments would apply the guidance to sales literature of private funds making general solicitations under Rule 506.

Rule 156 prevents registered investment companies from using sales literature that is materially misleading in connection with the offer and sale of securities. The rule provides that sales literature is considered misleading if it (i) contains an untrue statement of a material fact; or (ii) it omits to state a material fact necessary in order to make a statement, in light of the circumstances of its use, not misleading.

Rule 156 provides specific examples of regarding the types of statements in sales literature that the SEC would consider to be misleading. Generally, whether a statement involving a material fact would be misleading depends on the context in which it is made, in light of all pertinent factors, including:

  • Other statements being made in connection with the offer or sale of the securities in question;
  • The absence of explanations, qualifications limitations or other statements necessary or appropriate to make the statement not misleading; or
  • General economic or financial conditions or circumstances.

Rule 156 provides a non-exclusive list of factors concerning representations of past or future investment performance that could be misleading. It also contains examples of when statements about possible benefits connected with or resulting from the services to be provided that do not give equal prominence to discussion of any associated risks.

Rule 156 broadly defines “sales literature,” which generally means any communication (whether in writing, by radio or by television) used to sell or induce the sale of securities of any investment company.  Communications between issuers, underwriters and dealers are included in this definition of sales literature if the communication (or the information it contains) can be “reasonably expected” to be communicated to prospective investors in the offer or sale of securities, or are designed to be employed either in written or oral form in the offer or sale of securities, such as in sales scripts.  The definition likely would apply to communications contained in social media.

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.

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.

Until now.

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.