Basic Securities Law for Fund Sponsors

As an attorney in the private fund space, I get a lot of questions about the basic securities laws that impact funds, fund sponsors, and investors. I spend a lot of time discussing some basic principles and ideas over email and phone calls. If you are considering raising money through a fund, the following are some some basics on the federal securities laws you need to be aware of. I’ll start off by discussing the basic regulatory framework and then I’ll discuss four federal Acts you should know about. Keep in mind, this is by no means a comprehensive list of everything fund organizers should be aware of. There are many other legal requirements that could arise given the specifics of a deal. As always, consult your own legal counsel, because your situation is unique.

Basic Regulatory Framework

There is an interplay between the federal securities laws and state securities laws. Funds and fund organizers are often required to deal with a combination of federal and state laws. I won’t be going into much detail on state law, but know that state law may be implicated by what you’re doing.

The following is a brief overview of 4 basic federal securities laws that impact most private funds and their organizers. It’s important to understand that each Act regulates different things and different people. They are:

The threshold question that generally must be answered is whether the thing being sold or purchased is a security. The answer to this question can be straight-forward, but there are situations where the thing being bought or sold is not a security. In these cases, the above acts are often not applicable. I’m not going into detail on the Howie test here, but you should be aware that, depending on the situation, these laws may not apply.

Securities Act of 1933

Section 5 of the Securities Act of 1933 (“Securities Act“) makes it unlawful to use interstate commerce to sell a security unless a registration statement has been filed. Section 3 of the act exempts from the registration requirement certain securities, and Sections 4 and 4A of the act exempt certain transactions. So every sale of securities falls into one of three categories:

Registration

Registration is a time-consuming, onerous, expensive process, which is why most companies are not public. The cost outweighs the benefits of going public. Registration requires that the issuer of securities disclose information to investors including a description of the company’s business and property, a description of the security to be offered for sale, information about the management of the company, and financial statements that are certified by independent accountants. Basically, any “material” information investors would want to make a decision must be disclosed. The information becomes public and the issuer then has ongoing reporting requirements. Most offerings are not registered because of the cost. Instead, private companies rely on one or more exemptions from registration to sell securities.

Exemptions

Here is a summary of the federal exemptions. Many states also have similar tables for state exemptions. In addition to the exemptions in the linked table, there are some other exemptions that issuers may be able to rely upon such as Regulation S or Rule 144.

4(a)(2) and Regulation D

The most common exemption is found under Section 4(a)(2) of the 33 Act. Section 4(a)(2) says:

The provisions of section 5 shall not apply to transactions by an issuer not involving any public offering.

The statutory language above is not very helpful, because it doesn’t define a “public offering.” For this, we have to turn to case law. The supreme court has basically interpreted a non-public offering to be one in which the investors being offered securities are able to “fend for themselves,” which means the investors should have have sufficient access to information of the type that would be available in a registration statement and be sophisticated. It’s not easy to stay within these two requirements as these two criteria are vague. So, most private raises are done pursuant to a safe-harbor rule that the SEC has promulgated with its rule-making authority.

The most common safe-harbor exemption is Rule 506, part of Regulation D. There are now two parts to rule 506: Rule 506(b) and Rule 506(c). Rule 506(c) was added with the JOBS Act, which now allows private issuers to engage in general solicitation. Rule 506(b) requires that the issuer have a substantive pre-existing relationship of the type that the issuer, or the issuer’s agent, has a reasonable basis to believe the person is sufficiently sophisticated to participate in a non-public offering. Under Rule 506(b), an issuer may sell to up to 35 non-accredited investors, but if the issuer does so the issuer must provide additional information to the non-accredited investors, which often makes allowing non-accredited investors impractical. Rule 506(c) allows issuers to engage in “general solicitation,” does not allow for non-accredited investors, and places a requirement on the issuer to take “reasonable steps” to verify that each investor meets the definition of an “accredited investor.”

Here’s additional information showing the distinctions between Rule 506(b) and Rule 506(c):

Accredited Investor

I’ve mentioned accredited investors several times now. For a natural person, an accredited investor is one who either: (1) has a net worth of $1 million, either alone or together with a spouse, excluding the primary residence; or (2) has earned over the two most recently completed years at least $200,000 (or $300,000 together with a spouse) and has a reasonable expectation to meet the income requirement in the current year. The complete definition can be found under Rule 501 of Regulation D.

Preemption and Form D

A major reason issuers like to rely on Rule 506 is that it preempts state law, which means issuers do not need to find both a federal exemption and state exemptions in each state in which a sale is made. However, to qualify for this exemption, issuers must file Form D with the SEC and the states can require notice filing in their states. Form D must be filed within 15 days of an investor becoming bound to purchase securities and may also be filed preemptively.

Exchange Act of 1934

The Securities Exchange Act of 1934 (“Exchange Act“) regulates securities exchanges and other market participants. With respect to fund organizers, the main issue that comes up has to do with whether a fund organizer needs to register as a broker dealer. Broker dealer is broadly defined in the act as

any person engaged in the business of effecting transactions in securities [for the account of others or for the person’s own account.]

Once again, we have an unhelpful definition, so we have to look to other sources of law such as SEC no-action letters and court rulings. Whether someone is a broker dealer is a factor test. The factors typically include whether a person:

• Is employed by the issuer;
• Receives commission rather than a salary (transaction-based compensation);
• Sells or has sold the securities of other issuers;
• Negotiates between the issuer and the investor;
• Provides investment or tax advice; and
• Actively, rather than passively, finds investors.

No single factors is sufficient nor necessary for a finding that a person is a broker dealer, so fund organizers wishing to not register as a broker dealer should stay as far away from engaging in the above activity as possible. While no factor is dispositive, the most important factor is whether a person receives transaction-based compensation. The underlying issue is that transaction-based compensation creates a “salesman’s stake” in a transaction. If someone has incentive to sell securities, they have an incentive to act badly, and should therefore, be subject to regulation. Any time compensation is tied to an amount raised or the volume of transactions completed, there is an increased risk that the person receiving compensation needs to register as a broker dealer.

It’s not enough for a fund organizer to only ensure they do not engage in broker activity. There have been situations where fund organizers were held liable for assisting others who were not registered but engaged in the above activity. Ranieri Partners.

The Investment Advisers Act

The Investment Advisers Act of 1940 (“Advisers Act“) regulates individuals who are (1) in the business (2) of giving investment advice (3) for compensation. Typical general partners or investment managers of a fund are considered investment advisers if they receive compensation. Compensation is defined broadly to include “any economic benefit,” so even carried interest counts.

Regulatory Framework

Advisers are regulated by either the SEC or the states in which they operate or where their clients reside. Advisers with at least $100 million ($25 million if the adviser is in or regulated by the state of New York) in assets under management are regulated by the SEC. Advisers with less than that are regulated by the states.

National De Minimis Standard. Questions may arise about which states have jurisdiction over an adviser. There is a national de minimis standard that prohibits a state from requiring registration of an adviser if the adviser (1) has no place of business in the state AND (2) has fewer than 6 clients (up to 5). Most fund advisers with less than $100 million in assets under management only look to the state they operate from.

Exemptions

Advisers that meet the definition of an investment adviser under the act generally must register as investment advisers. This requires obtaining securities licenses, hiring a Chief Compliance Officer, and a number of other requirements that must be met. Additionally, there is a prohibition on registered investment advisers receiving performance-based compensation, because they may be incentivized to take unnecessary risks. Performance-based compensation is only allowed if the client is a “qualified client” ($2.1 M in net worth). Carried interest is a form of performance-based compensation. For these reasons, private fund advisers typically look for any rely on exemptions from registration.

SEC Advisers

Most SEC advisers rely on one of two exemptions from registration: (1) the private fund adviser exemption and (2) the venture capital fund exemption.

Private Fund Exemption

There are two basic requirements: (1) the adviser can only advise private funds (I’ll discuss those in the Investment Company Act section below) and (2) the fund adviser can only have assets under management of no more than $150 million.

Venture Capital Fund Exemption

To qualify for this exemption, the adviser must solely advise qualifying venture capital funds, which means all funds must satisfy the following:

1. The fund must represent to investors that it pursues a venture strategy. This should be part of the PPM and Partnership or Operating Agreement;
2. The fund must meet the holding limitation of no more than 20% of the fund’s aggregate capital contributions and uncalled committed capital in non-qualifying investments (basically the investments need to be in operating companies);
3. The fund must meet certain borrowing and debt limitations;
4. The fund must not grant its investors certain redemption rights; and
5. The fund must not be a registered investment company or a business development company.

In either case, these advisers must file truncated Form ADV with the SEC as Exempt Reporting Advisers. The substantive provisions of becoming a Registered Investment Adviser do not apply. The requirement here is primarily a disclosure requirement, and making this filing is relatively straight forward if you can navigate FINRA’s process.

State Advisers

State regulated advisers must look to the state or states that regulate them for any exemptions.

State requirements vary but generally fall into one of three categories: no exemption, an Exempt Reporting Adviser type exemption, or full exemption where no filing is required.

STATE INVESTMENT ADVISERS

THE INVESTMENT COMPANY ACT OF 1940

An Investment Company is one that is set up with the purpose of investing in securities. Mutual and index funds, for example, are investment companies, and they must register as such. The registration process of an investment company is not unlike the registration process of a public company. It is onerous, time-consuming, and expensive, so most private funds try to avoid registration by relying on the exemptions in the Investment Company Act. The two most common exemptions are found under Sections 3(c)(1) and 3(c)(7).

3(C)(1) Exemption

There are two requirements for the exemption under 3(c)(1): (1) the company cannot make a public offering (Regulation D, for example); and (2) the company must limit the number of investors (beneficial owners) to no more than 100 (or 250 if the company is a qualifying venture fund).

3(c)(7) Exemption

Again, there are two main requirements for the exemption under 3(c)(7): (1) the company cannot make a public offering; and (2) sales must be limited to qualified purchasers. Qualified purchasers is a higher standard than accredited investor. For individuals, they must have at least $5 million in investments.

Securities Requirement

The Investment Company Act applies to companies that invest in Securities. If the fund invests directly into real estate, for example, the fund is likely not invested in a security, so the Investment Company Act would not apply to such a fund.

Recap & Fraud

One of the tricky things about dealing with private funds is it’s easy to get lost in each of the securities acts, especially without having a legal background. The basic framework generally works like this: you must register (the sale, as an adviser, or as an investment company) unless there is an available exemption.

There are no exemptions for fraud. The fraud provisions still apply even if an exemption is found. If you tell investors something, it must be true.