Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News January 16, 2012 Issue

MFA Petitions SEC to Lift Private Offering Prohibitions

A year ago, President Barack Obama launched an initiative that charged the federal government with finding outmoded regulations to jettison. The goal was to promote "economic growth, innovation, competitiveness, and job creation by using the best, most innovative, and least burdensome tools for achieving regulatory ends."

In the summer, the executive order was extended to the independent federal agencies. The SEC instructed its staff to ferret out dysfunctional rules that may be ripe for recission. Staff scrambled in thoughtful earnest to comply.

Now comes the first fruit of the SEC’s labors.

Helped along by industry participants that have long struggled with the interpretation of and compliance with certain private offering rules, the prohibitions on general solicitation and advertising in private offerings to sophisticated investors have been targeted for repeal and may soon go by the wayside.

In November and December, Congressional hearings on small business capital formation fanned the flames of private offering reform. In testimony before the Senate Banking Committee on December 1, Division of Corporation Finance director Meredith Cross said good arguments existed for allowing the general solicitation of accredited investors. The rules as they exist now have been cited by some as a significant impediment to capital raising, she said.

Last week, the Managed Funds Association (MFA) officially petitioned the SEC for a rulemaking that would amend the private offering rules to remove the prohibitions on general solicitation and advertising for private fund sales to accredited investors.

Urging elimination of the two prohibitions, the MFA observed that the framework of private offering regulation under Regulation D dates back almost 30 years. Since then, securities markets, issuers, investors and securities regulation have all undergone significant changes.

"Private funds and regulatory oversight of the industry, in particular, would be unrecognizable to the original drafters of Regulation D," said MFA president and CEO Richard Baker.

Lifting the private offering prohibitions would increase transparency of the hedge fund industry, said Baker. It would also reduce the legal uncertainty that is part of the current regulation of private fund offerings. Lifting the private offering prohibitions would also facilitate capital formation and reduce investor costs by easing access to information about private fund offerings and reduce regulatory oversight costs. This would allow the SEC staff to reallocate resources to other aspects of investor protection.

What about the Investment Company Act restrictions on public offering contained in Sections 3(c)(1) and 3(c)(7)?

Private funds have other statutory restrictions on public offerings, namely certain restrictions in the Investment Company Act (ICA) related to private funds. Those restrictions, embedded in ICA Sections 3(c)(1) and 3(c)(7), permit funds to avoid registration as an investment company provided that, among other things, they are not making and do not propose to make a public offering of their securities. These sections of the ICA are the two provisions commonly relied upon by private funds to avoid registration.

With respect to Section 3(c)(7) funds, the MFA believes that the SEC has interpreted such private fund offerings to be "non-public" as long as they comply with the Regulation D requirements of Rule 506 and Rule 502. This would continue to be the case even after recission of the general solicitation and advertising prohibitions, provided the SEC maintains its long-held position that sophisticated investors can fend for themselves, said MFA’s Baker.

Section 3(c)(1) offerings should receive similar treatment, too, said Baker. The recent amendments to the accredited investor standard exclude the value of an investor’s primary residence and "substantially" raise the qualification thresholds. The SEC has proposed similar amendments to the qualified client standard in the Rule 205-3 performance fee rule. "We believe it would also be appropriate for the SEC to reconsider the policy justification for subjecting funds that rely on Section 3(c)(1) to the ban, in light of the significant investor protection enhancements in the Dodd-Frank Act," he said.

For all these reasons, Rule 502 should be amended to exempt private funds from the ban on general solicitation and advertising in Regulation D, said Baker. The amendment would serve investor protections because private funds would continue to generally be prohibited from selling interests to persons other than either qualified purchasers in the case of 3(c)(7) funds, or qualified clients in the case of 3(c)(1) funds managed by registered investment advisers."

Baker urged that the SEC staff "confirm its existing guidance that private offerings that comply with Rule 506 and the amended Rule 502 of Regulation D would continue to be non-public offerings for purposes of Section 3(c)(1) and Section 3 (c)(7)."

In the alternative, Baker asked that at least some of the uncertainty of the current regulatory environment be removed.

Say that an "offering" begins when offering materials are delivered, so that general communications prior to the offering are not considered an "offering" of securities, he said.

Either path will reduce uncertainty, facilitate capital formation, and enhance transparency of the private fund industry, while maintaining appropriate investor protection, said Baker.