On September 23, 2013, the JOBS Act rules that roll back the 80 year old ban on the use of general advertising and public solicitation by issuers of unregistered securities will be a reality. At least it will be a reality for fund managers that do not rely on an exemption from the Commodity Futures Trading Commission. Private funds managers will decide over time whether they would like to avail themselves of the new rules, which will allow them to post performance numbers on their websites, talk openly about their funds on CNBC and Bloomberg, sponsor NASCAR events, and just generally be more open and transparent about their businesses. The responsibilities associated with these new rights are the requirements that the fund manager verify the accredited status of each investor, refrain from committing financial fraud, and file a revised Form D to indicate that the fund is following the new rules. Whether to use these new rules will be a tough call for many fund managers as they consider whether greater transparency provides a benefit for their specific business model. Hedge funds have often avoided the glare of public scrutiny, but the trade-off of building a more recognizable brand and more easily reaching potential investors could provide motivation for some fund managers to give these new rules a try.
But what happens if a fund manager is initially enamored of the new rules and decides to advertise generally, but later changes his mind? Can a fund manager go back to the old “pre-existing, substantial relationship” days, and how do you do that once the fund has been “generally offered” to the public? This could happen for any number of reasons. Perhaps the most prevalent would be that the manager reaches capacity in the fund in either assets, such as a quant fund, or investor slots, which would more likely be the case for a fund that relies on Section 3(c)(1) for its exemption from investment company registration. A fund manager in one of these situations may have originally liked the idea of generally advertising, but subsequently finds public solicitation of limited utility and not worth the potential added scrutiny from regulators and market participants.
If a fund commences an offering pursuant to Rule 506(c) using general solicitation, and later wants to go back and use the old rules, (i.e., rule 506(b)), the issue is one of integration. Rule 506(b) prohibits general solicitation; accordingly, the only way to stop using the public offering rules once a fund manager has done so, would be to wait a period of time so the rule 506(c) offering is not integrated with the rule 506(b) offering. Rule 502(a) of Regulation D provides for a safe harbor from integration so long as the selling effort of the earlier offering ceases for six months, and the fund does not commence a subsequent offering for 6 months after completion of the earlier offering. Therefore, a fund manager would need to cease the offering, file the Form D to indicate that the offering is over, and wait six months before commencing the “private” offering. A new Form D would need to be filed for the private offering under Rule 506(b) once that offering commences.
There is another way whereby fund managers could go straight from the public offering to the private offering without the six month cooling off period. It is possible that a fund manager could use the five factor test safe harbor of Rule 502(a) to avoid integration and commence a new private offering immediately. For most hedge fund managers, this would be fairly tough test to meet. The five factors that a fund would need to consider are as follows:
- Whether the sales are part of a single plan of financing;
- Whether the sales involve issuance of the same class of securities;
- Whether the sales have been made at or about the same time;
- Whether the same type of consideration is being received; and
- Whether the sales are made for the same general purpose.
In order to meet the requirements of the five factor test, the fund seeking to avoid integration would need to offer a different class of shares/interests, for a different investment purposes, with different terms and conditions. For many hedge fund managers, this will be a difficult standard to meet. So the bottom line here appears to be that you can put Humpty Dumpty back together again, he will just need six months in intensive care.