Exemptions from requirement to register fund interests
To ensure that a private equity fund offering securities in the US will satisfy the requirements necessary to avoid registration of the interests in the fund with the SEC, a private equity fund sponsor will customarily conduct the offering and sale of interests in the private equity fund to meet a private placement exemption under the Securities Act. The most reliable way to do this is to comply with the safe harbour criteria established by Rule 506 under Regulation D under the Securities Act. Offers and sales of securities that comply with Regulation D will not be deemed to be a transaction that involves a public offering. The applicability of the exemptions will depend on the manner of the offering. Under the Rule 506(b) exemption, the private equity fund sponsor must not make any offers or sales by means of general solicitation or general advertising. In addition, the private equity fund cannot have more than 35 non-accredited investors. Each such non-accredited investor, either individually or with a representative, must also be sophisticated (ie, must have sufficient knowledge and experience in financial or business matters to make them capable of evaluating the merits and risks of the potential investment).
Under the Rule 506(c) exemption, the private equity sponsor may broadly solicit and generally advertise the offering, so long as, among other requirements, ‘reasonable steps’ are implemented to ensure that each investor in the private equity fund is an accredited investor at the time of the sale of securities to that investor.
An ‘accredited investor’, as defined in Rule 501 under Regulation D, generally includes a natural person with a net worth (either individually or jointly with a spouse) of more than US$1 million or income above US$200,000 in the past two years (or US$300,000 in joint income with a spouse for those two years and a reasonable expectation of reaching the same income level in the current year), and certain entities with more than US$5 million in total assets. For purposes of the US$1 million net-worth test described above, the value of the investor’s primary residence is excluded from the calculation of the investor’s total assets and the amount of any mortgage or other indebtedness secured by an investor’s primary residence is similarly excluded from the calculation of the investor’s total liabilities, except to the extent the estimated fair market value of the residence is less than the amount of such mortgage or other indebtedness. There is also a timing provision in the net-worth test designed to prevent investors from artificially inflating their net worth by incurring incremental indebtedness secured by their primary residence to acquire assets that would be included in the net worth calculation. Under the timing provision, if a borrowing occurs in the 60 days preceding the purchase of securities in an exempt offering and is not in connection with the purchase of the primary residence, the amount of such incremental indebtedness must be treated as a liability for the net worth calculation. The SEC is authorised to adjust the ‘accredited investor’ definition for individuals every four years as may be appropriate to protect investors, further the public interest or otherwise reflect changes in the prevailing economy.
Rule 506(c) provides some non-exclusive, non-mandatory methods of verifying that a natural person is accredited (eg, reviewing tax returns or bank account statements) and, to the extent these methods are not used, or a sponsor is verifying the accredited investor status of an entity, in determining whether the steps taken by an issuer to verify eligibility are objectively reasonable, sponsors should consider the particular facts and circumstances of each offering and each purchaser, including the following:
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- the amount and type of information that the issuer has about the purchaser; and
- the nature, terms and manner of the offering.
Given that these increased verification measures with respect to sales under Rule 506(c) generally result in increased compliance burdens and costs for issuers, and in some cases investors are reluctant to provide or are sensitive about providing the additional information required as part of the enhanced verification procedures, private equity firms are not yet widely relying on the Rule 506(c) exemption, and this exemption is not expected to play a significant role in private equity fundraising in the future.
Another factor impeding utilisation of the Rule 506(c) exemption by private equity firms is that the use of general solicitation in reliance on Rule 506(c) may affect other aspects of a private equity sponsor’s regulatory compliance regime. For example, it is possible that the use of general solicitation or general advertising by a private equity fund under Rule 506(c) could have an adverse impact on its private placement under the securities laws of other jurisdictions in which it conducts its offering as the securities laws thereof may not permit general solicitation in their current form.
The potential impact of pending SEC proposed amendments to Rule 506 would also create additional burdens for reliance on Rule 506(c). A private equity fund relying on a private placement exemption contained in Regulation D under the Securities Act must file electronically with the SEC a notice on Form D within 15 calendar days after the date of first sale of securities. Form D sets forth certain basic information about the offering, including the amount of securities offered and sold as well as whether any sales commissions were paid to any broker-dealers and, if so, the states in which purchases were solicited by such broker-dealer. For purposes of the Form D filing deadline, the SEC considers the first date of sale to occur on the date on which the first investor is irrevocably contractually committed to invest. Therefore, depending on the terms and conditions of the contract, such date could be deemed to be the date on which a private equity fund receives its first investor subscription agreement and not necessarily the typically later closing date. The SEC has proposed amendments to Regulation D, which would impose additional procedural requirements on issuers seeking to rely on Rule 506(c) to engage in a general solicitation by requiring that an initial Form D (with heightened disclosure requirements) be filed at least 15 days before commencing any such general solicitation and that a final amendment to Form D be filed within 30 days of the termination of any such offering. Under other proposed amendments, failure to comply with the Form D filing requirements (whether or not involving a general solicitation) would result in an automatic one-year disqualification from relying on a Rule 506 exemption.
In addition to federal securities law compliance, most states have similar notice-filing requirements. While state registration of securities is pre-empted under the Securities Act, private equity sponsors should be cognisant of the state law notice-filing requirements in the various jurisdictions in which they will or have offered or sold limited partnership interests to investors. Many states require a notice filing, consisting of a copy of a Form D and a filing fee, to be made within 15 calendar days after the date of first sale in the state. Anti-fraud provisions under applicable state laws apply despite the pre-emption described above.
Under Rule 506(d), issuers are prohibited from relying on the Rule 506 exemptions (whether or not the proposed offering involves a general solicitation), if the issuer or any other ‘covered person’ was subject to a ‘disqualifying event’. Covered persons include the issuer and its predecessors, affiliated issuers (ie, issuers that issue securities in the same offering, such as parallel funds and related feeder funds), directors and certain officers, general partners and managing members of the issuer, beneficial owners of 20 per cent or more of an issuer’s outstanding voting equity securities calculated on the basis of voting power (which could include limited partners in related private equity funds if the issuer and such related fund vote together), any investment manager to a pooled investment fund issuer, any ‘promoter’ connected with the issuer in any capacity at the time of the sale and any persons compensated (directly or indirectly) for soliciting investors (eg, placement agents), as well as the general partners, directors, officers and managing members of any such investment manager or compensated solicitor. For purposes of these ‘bad actor’ rules, disqualifying events include certain criminal convictions, court injunctions and restraining orders, final orders of state and federal regulators, SEC disciplinary orders, stop orders and cease-and-desist orders, suspension or expulsion from a securities self-regulatory organisation and US Postal Service false representation orders. A number of these disqualifying events are required to occur in connection with the purchase or sale of securities and include a look-back period of five to 10 years depending on the particular facts surrounding the disqualifying event. Disqualification is not triggered by actions taken in jurisdictions other than the US. While only disqualifying events that occur after the rule’s effective date (23 September 2013) will disqualify an issuer from relying on a Rule 506 exemption, Rule 506(e) provides that disqualifying events that occurred prior to such date but within the applicable look-back period would nonetheless be required to be disclosed to investors in connection with any sales of securities under Rule 506 within a reasonable time prior to such sale. Under Rule 506(e), a failure to provide this disclosure will not prevent an issuer from relying on a Rule 506 exemption if an issuer can show that it did not know and, in the exercise of reasonable care could not have known, that the issuer or any other covered person was subject to a disqualifying event, although this reasonable care exception requires factual inquiry into whether any disqualifications exist. This factual inquiry will depend on the facts and circumstances concerning, among other things, the issuer and the other offering participants. Additionally, the SEC may grant waivers from disqualification under certain circumstances, including if the issuer has undergone a change of control subsequent to the disqualifying event.
Exemptions from requirement to register funds
To ensure that a private equity fund will satisfy the requirements necessary to avoid regulation as an ‘investment company’ under the Investment Company Act, the fund must be excluded from the definition of investment company. Under section 3(c)(7) of the Investment Company Act, each investor in the fund will typically be required to represent that it is a qualified purchaser. In the event that not all of a private equity fund’s investors are qualified purchasers, the fund may still be excluded from the definition of an ‘investment company’ under section 3(c)(1) of the Investment Company Act by limiting the number of investors to not more than 100 (all of which must still be accredited investors for Regulation D purposes and with respect to which certain ‘look through’ attribution rules apply). A qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act generally includes a natural person (or a company owned directly or indirectly by two or more natural, related persons) who owns not less than US$5 million in investments, a company acting for its own account or the accounts of other qualified purchasers that in the aggregate owns and invests on a discretionary basis not less than US$25 million in investments and certain trusts. In order to rely on section 3(c)(1) or 3(c)(7), a private equity fund sponsor must not be making or presently proposing to make a public offering. One way that a sponsor can meet this requirement is by complying with Regulation D, as described above.
Certain rules under the Investment Company Act provide additional clarification for the above requirements. Rule 3c-5 under the Investment Company Act provides that ‘knowledgeable employees’ (namely, executive officers and directors of the sponsor and most investment professionals who, as part of their regular functions or duties, have been participating in the private equity fund’s investment activities, or substantially similar functions or duties for another fund, for at least 12 months) are ignored for the purposes of the 100-person limit for purposes of section 3(c)(1) and the qualified purchaser requirement for purposes of section 3(c)(7). Similarly, for funds organised outside the US, the SEC staff has taken the position that non-US investors are generally ignored for purposes of the 100-person limit of section 3(c)(1) and the qualified purchaser requirement of section 3(c)(7).
For real estate funds, section 3(c)(5)(C) of the Investment Company Act provides another exclusion from the definition of ‘investment company’ for any issuer who is primarily engaged in purchasing and acquiring mortgages or other liens in real estate.
If the sponsor of a private equity fund is a registered investment adviser under the Advisers Act, then in certain circumstances each investor may need to represent that it is a ‘qualified client’ as defined in Rule 205-3 under the Advisers Act. A qualified client generally includes a natural person or company with a net worth exceeding US$2.1 million or that has US$1 million under management with the investment adviser, although the SEC is required every five years to adjust these dollar amounts for inflation, excluding the value attributable to such person’s primary residence (as further described above). A qualified client also includes both qualified purchasers as defined in the Investment Company Act and nearly all persons that fall under the ‘knowledgeable employee’ definition above (with the exception of an advisory board member, who is not included in the definition of ‘qualified client’).
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