Thursday, October 11, 2012

While Supporting SEC Proposed Implementation of JOBS Act Ending of Regulation D General Solicitation Ban, Hedge Fund Industry Asks for Safe Harbor

The hedge fund industry generally believes that SEC proposals implementing the JOBS Act termination of the Regulation D ban on general advertising represent an effective approach but asks the SEC to include a safe harbor in the final regulations. In a letter to the SEC, the Managed Funds Association said that it is important that issuers are able to verify the status of purchasers in a practical, efficient manner, particularly in contexts where investors are often large institutions or individuals with substantial assets.  An overly prescriptive approach to verification would undermine the clear intent of the JOBS Act to modernize private offerings and enhance capital formation.

The MFA commended the SEC for proposing a framework to implement Section 201 of the Act that permits issuers to use a variety of methods to verify the status of purchasers.  The proposed facts and circumstances analysis fulfills the SEC’s statutory mandate to determine the methods that an issuer should use in taking steps to verify the status of investors, said the group, and provides appropriate investor protection. A one-size-fits-all approach to verification would be inappropriate for the many different types of institutions and individuals who will seek to invest in offerings conducted pursuant to new Rule 506(c).

However, the hedge fund association urged the SEC to provide issuers with additional legal certainty when an investment amount is sufficiently high and the purchaser certifies that it is in fact an accredited investor.  In general, an individual is an accredited investor if he or she has a net worth that exceeds $1,000,000, and an entity is an accredited investor if it has total assets that exceed $5,000,000.  The MFA asked the SEC to adopt a safe harbor in the final version of Rule 506(c) deeming an issuer to have complied with the verification requirement if a purchaser, in addition to providing certifications that it is an accredited investor and has not obtained financing for the transaction, meets a certain minimum investment level that the SEC determines based on these thresholds.

The MFA recommends a minimum investment level of 50 per cent of the accredited investor net worth or total asset thresholds, currently $500,000 for an individual, and $2,500,000 for an entity.  This recommendation is based on an analogous approach to investor qualification that the SEC has used for many years in the definition of “qualified client” in Rule 205-3 under the Investment Advisers Act. Under this standard, an investor who has assets under management with an adviser that are at least half of the value of the net worth threshold is deemed to meet the qualification requirement.  A similar approach is appropriate for the verification of an accredited investor.

In the alternative, the SEC should adopt a safe harbor in Rule 506(c) where a purchaser certifies that it is an accredited investor and did not obtain financing for the transaction, and invests some minimum amount up to the net worth and total asset thresholds in the definition of accredited investor.  Any minimum investment amount included in a safe harbor should be adjusted proportionally in accordance with any future changes to the accredited investor net worth and total asset thresholds.

If the SEC decides not to include a safe harbor for a minimum investment, the MFA urged the Commission to describe in the adopting release how an issuer should incorporate a purchaser’s investment amount into its analysis of the facts and circumstances of a transaction.  While recognizing that the proposing release indicates that an issuer conducting an offering with a high minimum investment may not need to take additional verification steps other than to confirm that the investment is not being financed by the issuer or by a third party, the MFA noted that an issuer would not be able to determine independently whether an investment is financed by a third party.

Rather, an issuer could confirm that the issuer itself has not financed the transaction, and obtain a certification from the purchaser that it has not obtained financing for the transaction. Such a process, posited the MFA, together with a sufficiently high investment minimum and a certification from the purchaser that it is an accredited investor should fulfill the requirement that an issuer take reasonable steps to verify the status of the purchaser.

The hedge fund association also asked the SEC to confirm that private funds and other issuers with existing investors who are not accredited investors will be able to rely on new Rule 506(c) by complying with the applicable requirements with respect to future investments in the private fund. This approach is consistent with the language and underlying policy of the JOBS Act. 

Section 201(a) instructs the SEC to eliminate the ban on general solicitation for offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors.  Thus, reasoned the MFA, the requirement that all purchasers are accredited investors should apply only to future sales made pursuant to Rule 506(c) and should not require an issuer to either redeem or buy out existing investors, or incur the burdens of organizing an entirely new private fund.

Including a “grandfathering” provision for existing investors is also consistent with the goal of Section 201(a) to ensure that any investor who may have learned about the issuer through general solicitation or advertising is an accredited investor.  Issuers that currently conduct offerings under Rule 506, such as private funds, are prohibited from engaging in general solicitation.  As a result, existing investors have not been subject to any general solicitation activities, and should be able to maintain their investments in private funds that rely on Rule 506(c) in future offerings. 

Finally, while the MFA supports the SEC proposal that an issuer indicate on Form D whether it is relying on Rule 506(b) or Rule 506(c), the group believes that such an indication may be of limited use to the SEC in monitoring general solicitation by private funds.  Given the uncertainty about what activities may be deemed a general solicitation, the MFA expects that many private funds will indicate on Form D, based on the advice
of outside counsel, that they are relying on Rule 506(c) even if they do not intend to engage in actual solicitation activities.  Some fund managers, for example, may rely on Rule 506(c) in order to respond to media inquiries or correct inaccurate information about a private fund, which may or may not be deemed a general solicitation, depending on the facts and circumstances.