Introduction
This article provides a general overview of the requirements of, and the
related documentation for, a private placement of securities in the United
States by investment funds. It focuses on exemptions from the registration
requirements for sales under the Securities Act of 1933, as amended (the
"Securities Act") and does not cover other statutes and regulations that may
apply to investment funds, such as the Investment Company Act of 1940.
Specifically, this memorandum summarizes the following:
the background of the federal securities laws and the main,
applicable private placement exemption from registration
requirements;
the requirements for a valid private placement under the federal
securities laws; and
typical documentation for private placement by a private
fund.
This article provides only a brief summary of the topics discussed and
does not constitute legal advice regarding a particular offering or other
matters.
Background
In the United States, any offer to sell or sale of securities must be
either registered under the Securities Act or qualify for an exemption from the
registration requirements. For investment funds, the most commonly relied upon
exemption from the registration requirements is Section 4(2) of the Securities
Act and, more specifically, the safe harbor for private placements found in
Sections 501 through 508 of the General Rules and Regulations under the
Securities Act (referred to as Regulation D). Together, Section 4(2) and
Regulation D serve as one of the primary private placement exemptions from the
registration requirements. In addition, we note here, but do not discuss in this
memorandum, that the offer to sell and sale of securities outside the United
States is generally exempt from the registration requirements provided the
conditions to Regulation S of the Securities Act are satisfied. The availability
of any of these exemptions from the registration requirements depends on an
analysis of all relevant facts and circumstances.
Section 4(2)
Section 4(2) provides a general exemption from registration for any
transaction by an issuer "not involving a public offering." Section 4(2) does
not provide specific guidelines regarding how a private placement avoids
involving a public offering. Through caselaw and practice, procedures for
conducting these types of private placements have developed over time. Many of
these procedures are incorporated in the safe harbor for private placements
contained in Regulation D.
Regulation D
Regulation D, and in particular Rule 506 under Regulation D, provides
specific guidelines for conducting private placements. Regulation D is viewed as
a "safe harbor" because, if its requirements are satisfied, the offering will be
considered exempt from U.S. registration requirements under the Securities Act.
Regulation D is considered a "non-exclusive safe harbor" for effecting private
placements because failure to comply with all the terms of Regulation D does not
necessarily preclude the availability of an exemption under Section 4(2).
Because it is a non-exclusive safe harbor, issuers and practitioners often rely
on Section 4(2) and/or Regulation D together to effect a valid private
placement.
Effect Of Noncompliance
If an offering of securities attempts to rely upon, but fails to satisfy,
an applicable private placement exemption, the issuer will violate Section 5 of
the Securities Act and may be subject to enforcement action by the Securities
and Exchange Commission (the "SEC"). One of the possible consequences of
violating Section 5 of the Securities Act is that investors may have a
rescission, or put, right to the issuer based on the original purchase price of
the securities. As a result, care must be taken in structuring and conducting a
private placement to ensure that the offering complies with the requirements of
the exemption being relied upon.
Rule 506 Requirements
To comply with Rule 506 under Regulation D, the issuer and any placement
agent or underwriter acting on behalf of the issuer must comply with
requirements relating to the following:
the number and nature of the offerees;
disclosure and information requirements;
prohibition on general solicitation and advertising;
limitations on the resale of the securities;
possible integration with other securities offerings;
and
SEC notice requirements.
Number And Nature Of Offerees
There is no per se dollar limit on the amount of securities which
may be offered under Rule 506. In order to qualify for the exemption, however,
there must be no more than, or the issuer must reasonably believe that there are
no more than, 35 purchasers (other than excluded purchasers). Section 501(e)
sets forth certain rules for calculating the number of purchasers and excludes
from the count, among others, accredited investors.
"[A]ccredited investors" include the following categories:
individuals with a net worth (or joint net worth with such person's
spouse) of $1 million;
individuals with an annual income in excess of $200,000 or joint
annual income with a spouse in excess of $300,000 in each of the two most recent
years and a reasonable expectation of reaching the same income level in the
current year;
corporations, partnerships and certain trusts with $5,000,000 in
assets;
entities whose owners are all accredited investors; and
additional categories of accredited investors that are specified in
Regulation D.
Non-accredited investors (either on their own or together with a purchaser
representative) must be "sophisticated" purchasers who have sufficient
experience in business and financial matters to be capable of evaluating the
merits and risks of the prospective investment. If non-accredited investors are
included in the offering, the issuer must provide those non-accredited investors
with certain information specified in Rule 502. Although not strictly required,
the issuer should consider providing such information to accredited investors as
well, in light of the anti-fraud provisions of the federal securities laws.
Disclosure And Information Requirements
To comply with Regulation D, the issuer must ensure that investors are
provided, at a reasonable time prior to the sale of the securities, with all
information that is material to an investment decision and that they be provided
a meaningful opportunity to conduct due diligence about the issuer and the
offering. While there are no specific requirements for what must be provided to
prospective investors in a Rule 506 offering, over time practice and convention
have developed in response to the Securities Act and caselaw regarding the
contents of such an offering document. In general, private investment funds that
offer their securities prepare with counsel and distribute to offerees a private
placement or confidential offering memorandum. The preparation of such an
offering document serves several purposes, including protecting the issuer from
claims that it has provided incorrect information or omitted to include all
material information regarding the investment. We describe in more detail below
the typical contents of such a private placement memorandum.
Prohibitions On General Solicitation And Advertising
To ensure the validity of a private placement, neither the issuer nor
anyone acting on its behalf (such as an investment bank or other placement
agent) may engage in any general solicitation or general advertising about the
offering. A general solicitation includes any effort directly or indirectly to
sell the securities or to condition the market for their sale. It covers many
different kinds of communications, including those contained in any newspaper,
magazine or other traditional media, on any website, in any widely disseminated
email distribution and at widely advertised seminars or meetings. In addition,
there may be a general solicitation if too many parties are invited to consider
making the investment, although we note that this is an inherently unclear
aspect of the requirements.
In conducting a private placement, the issuer should develop, in
consultation with counsel, a process designed to identify potential investors
and solicit their interest to ensure that the requirements regarding the number
and nature of the offerees and the prohibitions on general solicitation and
advertising are satisfied. This process will generally require the issuer or its
agent(s) to:
gather information on a potential investor, including by means of an
investor questionnaire;
consider using a confidentiality, or non-disclosure, agreement prior
to making an offer of the securities and distributing a private placement
memorandum;
contact offerees, receive confirmation that they are accredited
investors or are otherwise permitted non-accredited investors, and provide
offerees with a private placement memorandum and any other offering
materials;
receive subscriptions from qualifying offerees; and
retain detailed records of all offers made, including if relevant;
the basis of each relationship with offerees, including investor questionnaires
and subscription agreements received from potential investors.
Limitations On Resale
Securities sold in a private placement are not freely transferable,
meaning they are subject to restrictions on their resale for a period of time
(typically two years), subject to specified exceptions. There are four general
implications to this limitation as follows:
When identifying offerees, the issuer must ensure that such
investors are purchasing the securities for their own account and not with the
intent to distribute the securities to other parties. If an investor were to
purchase securities with a view to distribution, the validity of the offering as
a private placement would be jeopardized and the investor would likely have
potential liability under federal securities laws as an underwriter. If the
validity of the offering as a private placement were questioned, there could be
an SEC enforcement action and investors might be entitled to a rescission, or
put, right based on the original purchase price of the securities.
In the subscription documents for the offering, the issuer typically
receives a representation from the investor regarding the matters described
above.
Any subsequent resales of privately placed securities must either be
registered under the Securities Act or qualify for an exemption from the
registration requirements.
The offering documents must disclose the private placement nature of
the offering and the limitations on resale.
Although not required by securities laws, additional transfer restrictions
such as a right of first refusal or co-sale rights also may be incorporated into
the issuer's offering documents in a private placement (such as a partnership
agreement or operating agreement) to reflect the terms of an issuer's business
arrangements with its investors.
Integration Issues
Integration is a doctrine applied under the Securities Act pursuant to
which two or more ostensibly separate securities offerings are viewed as a
single offering for purposes of determining whether an exemption from the
registration requirements is available. Thus, a private placement that otherwise
would be exempt from registration could cease to meet the requirements for such
exemption when integrated with another private placement or a registered public
offering, which would result in a violation of Section 5 of the Securities Act.
A safe harbor exists under Rule 502 of the Securities Act for Regulation D
offerings that are conducted at least six months apart, meaning they will not be
viewed as integrated. An issuer considering multiple offerings within a six
month period, however, should discuss with counsel the implications of such an
arrangement to ensure that a valid private placement is achieved and
maintained.
SEC Notice Requirements
The issuer must also make a filing with the SEC within 15 days following
the first sale of securities that rely on the Regulation D exemption from the
registration.
Typical Documentation
We summarize below the typical documents used by a private fund in a
private placement of its own securities.
Subscription Documents
investor questionnaire - provides the issuer with information about
the investor to ensure both a valid private placement and compliance with other
relevant laws and regulations; and
subscription agreement - constitutes a binding agreement of the
offeree to purchase a certain amount of securities from the issuer and contains
representations and warranties to, among other things, ensure a valid private
placement and compliance with other relevant laws and regulations.
Private Placement Memorandum
Typically includes the following types of disclosure:
business description - business plan and use of proceeds from the
offering;
issuer/management background - information regarding experience,
track record and prior performance;
risk factors - details all material risks of the investment;
terms of the offering - details costs of investing, size of
offering, rights of investors, etc.;
a summary of the tax and other legal and regulatory implications for
investors;
related party transactions - summary of any possible conflicts of
interest between the issuers, management and other affiliates; and
legends and other disclosure - includes language regarding transfer
restrictions and other disclaimers necessary for a valid private placement.
Partnership Agreement or Operating Agreement
Governs the terms of the relationship between the issuer and investors
including, to the extent applicable:
capital calls and capital contributions;
distributions;
fees and expenses;
restrictions on transfer of interests;
allocations of profits and losses for tax purposes;
events of default; and
authority and liability of general partner or sponsor.
Management, Advisory or Other Ancillary Documents
management or advisory agreements - used when third parties advise
the issuer or manage the issuer's assets or investments; and
side letters - used when significant investors negotiate specific
terms with the issuer which are, or may be, different from those applicable to
other investors.
Published March 1, 2006.
