On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the “JOBS Act”), a law which is intended to facilitate fundraising and ease regulatory burdens for small companies. Certain provisions of the JOBS Act became effective immediately while others await future implementation by SEC final rules and guidance. While the JOBS Act will have a significant impact on U.S. securities practices as a whole, the extent of this impact on private investment funds and their business model is not as clear. In any event, this article focuses on three aspects that should generally benefit private investment funds: (i) greater flexibility on private placements; (ii) increased investor thresholds; and (iii) the simplification of the IPO process and public reporting requirements.
Greater Flexibility in Private Placements for Private Investment Funds
One of the most notable aspects of the JOBS Act is its relaxation of long-standing rules prohibiting marketing and advertising of private placements of securities under Rule 506 of Regulation D.
Many private investment funds rely on Rule 506 for exemption from the SEC registration requirements of Section 5 of the Securities Act of 1933. Traditionally, these private investment funds have been restricted from advertising or marketing the securities to the general public. While SEC rules on this issue will not be finalized until July 4, 2012, the new rules are expected to permit private investment funds to solicit investors using public advertising campaigns, media interviews, seminars, and other marketing channels as long as all ultimate purchasers of the securities are accredited investors. The SEC rules must also require private investment funds to take “reasonable steps” to verify that purchasers of its securities are in fact “accredited investors.” It is common practice for private investment funds to receive representations from investors as to their “accredited investor” status, and ideally this practice would satisfy the requirement. It is important to note, however, that an issuer’s advertisements and other marketing communications and actions will continue to be subject to anti-fraud provisions under the various federal securities laws. Additionally, managers of private investments funds will need to consider advertising restrictions that apply to fund offering materials under the Investment Advisers Act and other federal and state laws and regulations applicable to the private investment funds.
Once the SEC implements the mandated changes, managers of private investment funds will be able to employ new strategies and use new modes of communication to reach new investors. It is unclear whether these changes will have a significant impact on fundraising for private investment funds. In any event, private investment funds are likely to have greater flexibility in their marketing efforts.
Increased Investor Thresholds for Private Investment Funds and Private Companies
The JOBS Act also increases the number of investors permitted to hold securities of a private company or private investment fund before such company or fund is required to register its securities with the SEC and abide by certain public company reporting requirements under the Securities Exchange Act of 1934 (the “Exchange Act”).
Previously, the Exchange Act required an issuer with assets exceeding $10 million and 500 or more shareholders of record to register its securities with the SEC and abide by certain public reporting requirements. As amended by the JOBS Act, an issuer is required to register its securities and meet the reporting requirements only when its assets exceed $10 million and its securities are held of record by either 2,000 persons or 500 persons who are non-accredited investors. While certain details of this change require further SEC rulemaking, the revised thresholds for registration were effective as of April 5, 2012.
The increased investor threshold will benefit certain private investment funds by permitting them to accept a greater number of investors. Specifically, many private investment funds rely on Section 3(c)(7) of the Investment Company Act of 1940 for exemption from registration under the act. Prior to the JOBS Act, these funds were limited to accepting 499 qualified investors if they wished to avoid registration under the Exchange Act. The JOBS Act will permit the “3(c)(7) funds” to expand and accept an unlimited number of certain qualified investors into the fund under this exemption.
Simplifying the IPO Process and Reporting Requirements
The JOBS Act amends the federal securities laws to improve access to public capital markets, largely by reducing the costs associated with conducting an IPO and being a public company. The JOBS Act creates a streamlined IPO process and reduces the regulatory burden for a new category of company known as an “emerging growth company” (“EGC”). EGCs include companies that conducted an IPO after December 9, 2011 and have total annual gross revenues of less than $1 billion during their most recently completed fiscal year. A company may generally remain an EGC until the earliest of (i) the first fiscal year after its annual revenues reach $1 billion, (ii) the first fiscal year following the five-year anniversary of its IPO, (iii) any date on which the company has, in the prior three years, issued more than $1 billion of non-convertible debt, and (iv) the date on which it becomes a “large accelerated filer.”
The JOBS Act eases the IPO process for EGCs, in part, by:
- allowing an EGC to “test the waters” by communicating before or after the filing of a registration statement with potential investors that are qualified institutional buyers or institutions that are accredited investors;
- permitting an EGC to confidentially submit to the SEC a draft registration statement for non-public review; and
- requiring two years (rather than three) of audited financial statements and only selected financial data for periods after an EGC’s earliest audited period presented in a registration statement.
“[The JOBS ACT is] a fundamental change to the U.S. securities practice that should benefit private investment funds and their portfolio companies”
Further, the JOBS Act relaxes the public reporting requirements of an EGC. EGCs are exempt from many of the Dodd-Frank Act requirements, such as say-onpay and pay-versus-performance disclosures, and the expensive “internal controls” requirements of Section 404 of the Sarbanes-Oxley Act of 2002. Importantly, these companies are subject to reduced Management Discussion & Analysis disclosure requirements and are permitted to provide executive compensation disclosures in accordance with the rules applicable to smaller reporting companies, which eliminates the need to provide a Compensation Discussion and Analysis section in offering documents and proxies.
These provisions of the JOBS Act became effective upon signing of the law on April 5, 2012.
This area of the JOBS Act could have the most meaningful impact on the private equity market, as the JOBS Act clearly incentivizes an IPO exit by streamlining the process and lessening the regulatory burden on this new category of company.
It is our belief that, until the SEC clarifies many of the important provisions of the JOBS Act, issuers and Wall Street will proceed cautiously when relying on the new law. There is no question that, in the mediumto- long run, the JOBS Act will represent a fundamental change to the U.S. securities practice that should benefit private investment funds and their portfolio companies; however, time will tell the extent of these benefits and whether they will represent a meaningful change to market practice for private investment funds.