§ 5.08 Offering of Fund Interests
| Jurisdiction | United States |
| Publication year | 2022 |
§ 5.08 Offering of Fund Interests
[1]—Private Placement Exemptions from U.S. Securities Registration
[a]—Private Placement Provisions Generally
As a hedge fund begins to raise capital, it issues interests or shares depending on its entity type (most commonly, a limited partnership or limited liability company). Just as a myriad of federal and state laws govern the sponsors or managers of hedge funds, a fund manager must consider the principal federal laws and regulations that have the potential to affect the securities offered by the fund itself, specifically, the Securities Act.459 The Securities Act regulates the offering of securities, including the offering of interests and shares by hedge funds. As a general rule, issuers must register their securities pursuant to Section 5 of the Securities Act460 unless an exemption applies. Additionally, issuers must comply with the periodic reporting obligations under the Securities Act. However, Section 4(a)(2) (formerly codified as 4(2)) of the Securities Act provides that "transactions by an issuer not involving any public offering" are exempt from registration.461 This so-called "private placement" exemption allows hedge funds offering securities in the United States to avoid the heavy regulatory and economic burdens of registration.
Though heavily relied on, Section 4(a)(2) offers little guidance in its short text about the distinction between public and private offerings, leaving those distinctions to the SEC and the courts, which have looked to factors such as (i) the manner of the offering and contact between the issuer and the offerees, (ii) the number of shares or interests offered, and (iii) the sophistication of the offerees with regard to financial markets and investment experience. Given the lack of any bright line test and uncertainty concerning the definition of a "private offering," funds typically rely on two safe harbors to ensure that the offering will be considered private: Regulation D462 for U.S. investors and Regulation S for non-U.S. investors. Funds may rely on both regulations simultaneously for their domestic and offshore offerings.
[b]—State Law Preemption
Prior to the enactment of the National Securities Markets Improvement Act of 1996 ("NSMIA"),463 states were able to impose merit or disclosure reviews on private offerings offered pursuant to Rule 506 of Regulation D, as discussed below. Since the enactment of NSMIA, which amended Section 18 of the Securities Act, state securities registration requirements with respect to offers and sales of certain securities, including those offered pursuant to Rule 506 of Regulation D, are preempted by federal law.464 Despite the preemption, states are still entitled to receive notice filings. Accordingly, fund sponsors should take care to determine the specific filing requirements of each state in which their funds issue securities. Preemption also does not affect various state broker-dealer registration laws, which may require that employees of an issuer register as broker-dealers.
[c]—Regulation D
Offers and sales of securities by private funds are typically made under Rule 506 of Regulation D as a "safe harbor" from registration under the Securities Act.465 As discussed previously, Regulation D is typically relied upon by hedge funds for offerings made in the United States because the regulation offers more guidance and definitive criteria to determine the definition of a private offering. Regulation D offers three exemptions from the Section 5 registration requirements. Under Rule 504,466 offerings are exempt if the dollar amount of the private offering is less than $10 million (and other conditions are satisfied).467 Rule 506,468 however, does not limit the offering amount. As hedge funds typically raise capital well in excess of the Rule 504 offering limits, they rely mainly on Rule 506.
Rule 506 itself is comprised of two separate exemptions, Rule 506(b) and Rule 506(c). Rule 506(b) offerings are exempt if, among other things, offers and sales are not made using general solicitation or general advertising and all purchases (except for up to thirty-five purchasers) are "accredited investors," as described below. Similar to Rule 506(b), Rule 506(c) offerings are exempt if all purchasers are accredited investors (there is no exception for non-accredited investors) and the issuer has taken reasonable steps to verify each purchaser's accredited investor status. Rule 506(c) does not prohibit the use of general solicitation or general advertising.469
[i]—Accredited Investors
Rule 501(a) defines an "accredited investor" for the purposes of the exemption in Rule 506.470 Specifically, Rule 501(a) defines an "accredited investor" as any person who comes within any of the following categories, or whom the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:
1. Any bank as defined in Section 3(a)(2) of the Securities Act, or any savings and loan association or other institution as defined in Section 3(a)(5)(A) of the Securities Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to Section 15 of the Exchange Act; any investment adviser registered pursuant to Section 203 of the Advisers Act or registered pursuant to the laws of a state; any investment adviser relying on the exemption from registering with the SEC under Section 203(l) or (m) of the Advisers Act; any insurance company as defined in Section 2(a)(13) of the Securities Act; any investment company registered under the Investment Company Act or a business development company as defined in Section 2(a)(48) of the Securities Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under Section 301(c) or (d) of the Small Business Investment Act of 1958471 ; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of ERISA if the investment decision is made by a plan fiduciary, as defined in Section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
2. Any private business development company as defined in Section 202(a)(22) of the Advisers Act;
3. Any organization described in Section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, partnership, or limited liability company not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
5. Any natural person whose individual net worth,472 or joint net worth with that person's spouse or spousal equivalent (meaning a cohabitant occupying a relationship generally equivalent to that of a spouse), at the time of his purchase exceeds $1,000,000;473
6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse or spousal equivalent in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii);
8. Any entity in which all of the equity owners are accredited investors;
9. Any entity, of a type not listed in paragraph (1), (2), (3), (7), or (8), not formed for the specific purpose of acquiring the securities offered, owning investments in excess of $5,000,000;
10. Any natural person holding in good standing one or more professional certifications or designations or credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status. In determining whether to designate a professional certification or designation or credential from an accredited educational institution for purposes of this paragraph (10), the SEC will consider, among others, the following attributes:
...(ii) The examination or series of examinations is designed to reliably and validly demonstrate an individual's comprehension and sophistication in the areas of securities and investing;
(iii) Persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and
(iv) An indication that an individual holds the certification or designation is either made publicly available by the relevant self-regulatory organization or other industry body or is otherwise independently verifiable;
11. Any natural person who is a "knowledgeable employee," as defined in Rule 3c-5(a)(4) under the Investment Company Act, of the issuer of the securities being offered or sold where the issuer would be an investment company, as defined in Section 3 of such act, but for the exclusion provided by either Section 3(c)(1) or Section 3(c)(7) of such act;
12. Any "family office," as defined in Rule
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