In early April 2012, President Obama signed into law two separate acts that will have a profound effect on hedge funds. The implications of these two new laws, the JOBS Act and the STOCK Act, are discussed below.
The JOBS Act: allows advertising in hedge fund offerings and increases the permitted number of investors in certain funds
On April 5, 2012, President Obama signed the Jumpstart Our Business Startups Act (JOBS Act). In addition to crowdfunding and emerging company IPO rules that have little if any relevance to private fund advisors, the JOBS Act (i) removes the general solicitation and general advertising prohibition for offerings made pursuant to Rule 506 of Regulation D of the Securities Act of 1933 (Securities Act); and (ii) raises the equity holder threshold in the Securities Exchange Act of 1934 (Exchange Act) that triggers public company reporting from 500 to 2,000 persons. These amendments represent significant changes to the regulations governing the offering process for private funds and the manner in which issuers may conduct these offerings.
Rule 506 is the safe harbour for private placements on which most hedge funds rely to avoid Securities and Exchange Commission (SEC) registration as a public offering.
The JOBS Act directs the SEC, within 90 days of enactment, to revise Rule 506 to eliminate its current prohibition on general solicitation and general advertising provided that the only purchasers in the private fund are ‘accredited investors’. The SEC’s rules must require an issuer offering securities pursuant to Rule 506 to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods to be determined by the SEC.
What does this mean?
Practically speaking, sponsors of private funds under Rule 506 will have a much broader array of marketing tools at their disposal. Pending the enactment of the SEC’s rules, which could contain further restrictions, a sponsor may be able to use advertising, newspaper or magazine articles, public Internet websites, media broadcasts and interviews, social media, mass email campaigns, and public seminars or meetings to solicit investors and sell interests in the private fund - as long as all of the actual investors are accredited. The use of advertising eliminates the method in place today, where a sponsor must have or establish via narrow protocols a substantive pre-existing business relationship with a prospective investor.
These developments add flexibility but may not represent unmitigated positives for fund managers. The removal of the ban on general solicitation does not refer directly to Securities Act Section 4(2). Thus, sponsors of private funds should be aware that if they broadly advertise as they are now allowed, they may not be allowed to fall back on the exemption from registration under Section 4(2) if they fail to satisfy the exemption under Rule 506. Also, the duty to verify accredited status is a departure from current law that allows a fund to rely on a representation from an investor in the absence of a reason to doubt it. Finally, antifraud rules and specific advertisement content rules, especially for registered advisors, may be a trap for the unwary advertiser.
The JOBS Act may have unintended consequences on other various laws that currently do not permit general advertising and with which sponsors of private funds must comply. For instance, one exemption from registration as a commodity pool operator requires that the fund interests are sold ‘without marketing to the public’, and the federal ‘foreign private adviser’ exemption and certain state laws prohibit unregistered investment advisers from ‘holding themselves out’ as advisers to the public. At this time, it is uncertain how engaging in general advertising will implicate these laws.
Important note: Because the JOBS Act does not directly amend Rule 506, there may be some questions as to the precise extent of the relief from the general solicitation and general advertising prohibition, if any, until the SEC promulgates its rules on the topic. It is also possible that the 90-day deadline for adoption of such rules could be extended.
Headcount limit raised to 1,999
The JOBS Act amends the Exchange Act to provide that an issuer is not required to register its securities with the SEC (and thus become subject to public company reporting requirements) unless it has a class of equity security (other than an exempted security) that is ‘held of record’ by either (i) 2,000 persons or (ii) 500 persons who are not ‘accredited investors’. The JOBS Act would thus significantly increase the 499-record holder limit with which private funds relying on the exemption from registration under Section 3(c)(7) of the Investment Company Act of 1940 must currently comply. Funds exempt under Section 3(c)(1) of the Investment Company Act are limited to 100 beneficial owners, so this change has no impact on them.
What does this mean?
It appears that 3(c)(7) funds will no longer be limited to 499 investors but may have up to 1,999 accredited investors.
The STOCK Act: prohibits trading based on material nonpublic information
On April 4, 2012, President Obama signed the Stop Trading on Congressional Knowledge Act (STOCK Act). This law prohibits members of Congress and other federal government officials and employees from trading on material nonpublic information they obtain based on their position or responsibilities. The STOCK Act specifically imposes a fiduciary duty on Congress owed to the U.S. government and U.S. citizens for purposes of the federal securities laws. The existence of such a duty previously had been subject to scholarly debate.
Information obtained indirectly may be considered insider trading
By explicitly imposing such a fiduciary duty on governmental persons, the STOCK Act makes clear that trading on information obtained through government channels can serve as the basis for a federal securities law violation. As a result, hedge funds that obtain material nonpublic information from lawmakers or other public officials can be exposed to potential liability.
This is true even if the fund obtains the information indirectly, e.g., from a ‘political intelligence’ firm. The law prohibits ‘tipping’, that is, when a person who obtains material nonpublic information in violation of a fiduciary duty provides the information to another person who trades on it. The tipper and tippee can both be liable for insider trading. Liability can also extend beyond the first recipient and apply to other recipients further down the chain. The ‘misappropriation theory’ extends liability for insider trading to outsiders who trade while in possession of material nonpublic information in violation of a fiduciary duty.
What does this mean?
Where a public official passes prohibited information directly or indirectly to a hedge fund that in turn trades on it, the fund and its managers can be held liable for insider trading if they were aware the information was material and nonpublic.
As demonstrated by the recent wave of prosecutions involving the use of expert network firms by hedge funds, the government has aggressively pursued insider-trading cases based on this theory of liability.
The final version of the STOCK Act did not contain reforms targeted at political intelligence firms but rather requires a study of the industry by the comptroller general.
Sponsors of hedge funds must be aware of the ramifications these two new laws will have on their ability to solicit new investors and their ability to trade based on nonpublic information received from governmental officials.
Scott R. MacLeod has spent 100 percent of his practice over the last 22 years forming and representing investment funds, investment advisers and related investment management clients. He has formed and represented a wide spectrum of investment funds and investment advisers including hedge funds, mutual funds, private equity and venture capital funds, offshore funds, group trusts, and bank collective and common trust funds. Mr. MacLeod has also represented investment advisers, banks and their trust and investment departments, and pension plans as institutional investors.
James S. Crenshaw practices exclusively in the area of investment management, primarily forming and advising hedge funds and investment advisers.
Christopher P. McHugh is an associate in the firm's Public Companies and Securities Practice. He concentrates practice on the formation and representation of investment funds, including hedge funds and private equity funds. He also advises institutional investors with respect to their fund investments.
Amy R. Rigdon practices in the area of corporate and securities law. Her practice includes investment management, mergers and acquisitions, general corporate law, and litigation. Specifically, her experience includes forming and providing counsel to investment advisers and onshore and offshore hedge funds. Ms. Rigdon advises clients on a range of matters, including federal and state registration and exemptions, compliance with state blue sky laws, fund offering documents, commodities registration and exemptions, legal fiduciary obligations of investment advisers and broker-dealers, and various compliance and regulatory issues. Additionally, Ms. Rigdon's practice includes drafting private placement memoranda for funds, drafting fund contracts with service providers, and drafting registration statements, amendments and withdrawals for investment advisers. She also has experience with derivative transactions and civil litigation. Ms. Rigdon is a member of the firm's Investment Management team.
This article first appeared on Holland & Knight’s website in April 2012. For more information, please visit www.hklaw.com.