May 31, 2012

The Effect of the JOBS Act on Private Investment Companies: Foreseen Consequences?

Martin E. Lybecker

The JOBS Act makes a number of changes to traditional understandings and practices regarding what is a "public offering" that have been discussed in detail elsewhere. While most of the attention has been devoted to the direct implications of the JOBS Act to operating companies, the phrase "public offering" also appears in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the Investment Company Act), which exclude those two types of private investment companies from the definition of "investment company." Private investment companies, like venture capital funds, hedge funds, and private equity funds, can usually rely on one of those two exclusions, and thus are not required to be registered with the Securities and Exchange Commission (SEC) as an investment company. Section 3(c)(1) of the Investment Company Act excludes an issuer that is not making or planning to make a public offering and has fewer than 100 beneficial owners. Section 3(c)(7) of the Investment Company Act excludes an issuer that offers its shares exclusively to qualified purchasers and is not making or planning to make a public offering. Since 1940, the SEC's Division of Investment Management (and its predecessors) has taken the position that the concept of "public offering" in the Investment Company Act and the Securities Act of 1933 (Securities Act) were co-terminus. Section 201(b) of the JOBS Act provides that offers and sales exempt under Rule 506 are not deemed public offerings under the federal securities laws as a result of general solicitation or general advertising. Because Section 201(b) applies to all of the federal securities laws, the SEC will be faced with an interpretive dilemma. The SEC will have to decide whether it wants to: maintain its traditional co-terminus position (which would have the effect of significantly liberalizing the notion of "public offering" for private invetment companies that elect to rely on new Rule 506), or maintain its position that the term "public offering" still also includes a traditional private placement that relies on new Section 4(a)(2) of the 1933 Act, or argue that the words "public offering" in the Investment Company Act mean something altogether different than what they are now going to mean in new Rule 506 (notwithstanding Section 201(b)) or new Section 4(a)(2). It seems more likely than not that the SEC will decide to give the term "public offering" the two different meanings that this term will now have in the Securities Act, and sponsors will be allowed to choose which path they wish to follow. Note that new Rule 506 offerings utilizing general solicitation or general advertising must be made only to "accredited investors." Some important points: Previously one could always rely on old Section 4(2) if someone were to allege that a Regulation D offering somehow failed to comply with the particulars of Regulation D, but that will no longer be true if the sponsor of the private investment company has engaged in permissible general solicitation activities pursuant to new Rule 506. Guidance from the Division of Investment Management as to Section 3(c)(7) regarding testing to determine that an existing investor is still a "qualified purchaser" each time a new investment is made, for example pursuant to a non-mandatory capital call with respect to an existing investment, may be extended to "accredited creditors," too. While it is highly unlikely that new Rule 506 will be given any kind of retroactive effect, for those private investment companies that previously made their private offering pursuant to old Rule 506, included capital calls, and sold to "non-accredited investors," it is an open question whether the requirements of new Rule 506--only "accredited investors"--will apply to any ongoing non-mandatory capital calls from the prior offering(s). Sponsors of private investment companies will have to be ultra-careful in testing whether a person is an "accredited investor" since one mistake could lead to an allegation that the offering cannot rely on new Rule 506, won't be able to rely on new Section 4(a)(2) because of the general solicitation conducted by the sponsor pursuant to new Rule 506, and thus should have been conducted through an offering registered with the SEC under the Securities Act. At present, Rule 501 under the Securities Act defines an accredited investor to be a person who comes within one of the specified categories of the Rule or "who the issuer reasonably believes comes within any of the" categories at the time of the sale. Guidance regarding the expected scope of "accredited investor" due diligence from the SEC in the process of implementing new Rule 506 would be welcomed by sponsors of private investment companies. The SEC was given 90 days to adopt regulations implementing new Rule 506, so it is hoped that these and other questions will be addressed during the rulemaking exercise. The provisions in the JOBS Act that change the threshold for registration in Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act) from the old 500 holders of record test to the new test of either 2,000 holders of record or 500 holders of record who are not "accredited investors" also have implications for private investment companies. As noted above, Section 3(c)(7) has just two requirements: no public offering, and offers and sales only to "qualified purchasers." In short, there is no limitation in the Investment Company Act as to the number of persons who can be shareholders in a Section 3(c)(7) fund. But such a private investment company could unintentionally have backed into registration under the Exchange Act if it had 500 holders of record, so most issuers have been very careful to observe a ceiling of 500 shareholders. Changing the threshold for registration to 2,000 holders of record or 500 holders who are not "accredited investors" will increase the potential number of shareholders which a Section 3(c)(7) fund can have before becoming subject to Section 12(g) registration. This change to Section 12(g) went into effective immediately.

Martin E. Lybecker

Martin E. Lybecker is a partner at Perkins Coie LLP in Washington, D.C.