The phone rings. On the other end of the line is a business reporter from a trade publication who is working on a story about the outlook for VC fund-raising activity. She is curious to hear your thoughts and observations based on your firm’s recent experience. Her questions seem innocuous enough and it’s nice to be recognized as a knowledgeable source. You start talking, generally at first, then more specifically as her follow-up questions become more probing.
“It sounds as if your firm is optimistic about the future and is doing very well,” she says. “Do you have plans for a new fund?” You gladly confirm the rosy outlook, and acknowledge that your firm is looking to raise a $200 million fund that will maintain its predecessor’s early-stage investment focus. She thanks you for your time and proceeds to write an upbeat article that prominently features your quotes, including your impending private placement.
The phone rings again. It is your lawyer. He has seen the story and is considerably less enthusiastic than your colleagues. You have just undermined your private placement’s exemption from registration, he maintains. He suggests that, in order to protect the legal status of the private placement, it is necessary to have a cooling-off period.
This advice, if given, is not likely to be followed in the real world. However, in an environment where investment returns are frequently disappointing and there are disagreements with limited partners about whether capital commitments or management fees should be adjusted, it is worth reexamining the law governing private placement publicity, and whether current practices should be continued or adjusted.
All offers, sales and issuance of securities – including interests in private equity funds – are governed by both federal and state securities law. The general rule in federal securities law is that unless an applicable exemption is available, registration of the offering with the SEC is required. Given the costly and time-consuming nature of the registration process (not to mention the complications occasioned by becoming subject to ongoing compliance obligations as a public company), finding an exemption is vital for a private equity firm that wants to raise a new fund.
There are a variety of exemptions available, but the private offering exemption is the most relevant to private equity firms. To qualify for this exemption, a private equity firm must satisfy a number of requirements and abide by several limitations, including restrictions on the way it solicits investors. Such safe harbor falls under Regulation D of the Securities Act of 1933, because firms operating within its parameters can be assured that they will get the benefit of the exemption. Compliance with this safe harbor is especially important since it enlarges, rather than restricts, the scope of offering activity that will not require registration. It permits a number of offerees and investors that otherwise would be deemed to be a public offering.
General Solicitation and Advertising
While operating within the safe harbor of Regulation D, a private equity firm must not use any form of “general solicitation or general advertising” to offer or sell its securities. This limitation extends both to the issuer of the securities and to anyone acting on its behalf. Although a legal term of art, the concept of “general solicitation or general advertising” is fairly straightforward: When conducting a private offering, you should preserve the private nature of the offering by not encouraging the public to participate. Prohibited activities include any advertisement, article, notice or other communication published in any newspaper, magazine or similar media or broadcast over television or radio, as well as any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. Mass mailings, including email, also are prohibited.
Given these limitations, do the practices of private equity funds in dealing with industry-focused publications and while attending industry conferences comply with the prohibitions against general solicitation and general advertising? The answer would appear to be: Not entirely.
It has become relatively common for private equity funds to discuss ongoing fund-raising with trade publications and to mention such activity at trade conferences. In some instances, tombstone type notices even are published following an initial closing, even though the offering period for subsequent closings is ongoing.
Does this activity comply with the requirements of Regulation D? If the issuers were public entities, the answer would be yes, because Regulation D features a provision that information permitted by Rule 135(c) would not be considered general solicitation or general advertising. Rule 135(c) permits a notice or announcement that contains no more than the name of the issuer, the title, amount, basic terms, time of offering, amount being offered by selling shareholders (if any), a brief statement of the manner and purpose of the offering without naming the underwriters and any statement or legend required by state or foreign law or administrative authority. The notice or announcement also must state that the securities being offered are not registered and cannot be sold in the United States absent registration or an available exemption.
However, there is no analogous protection in Regulation D for private issuers, and operating companies engaged in private placements are routinely advised to avoid the same kind of disclosures being made by the private equity funds. Furthermore, the SEC has not sanctioned a different approach for private equity funds. The general goal of preventing an issuer from conditioning the market for its offering still applies.
So was that phone call with the trade publication reporter dangerous? Maybe.
The SEC has not demonstrated any inclination to pursue enforcement actions against funds that provide this limited information during a fund-raising period. Given the other issues preoccupying SEC dockets right now, this is not surprising. Also, the nature of investors in most private equity funds – usually very sophisticated institutions such as pension funds, insurance companies and university endowments – have less need for the assistance of the SEC and the registration process to protect their interests. There is no reason to expect the SEC’s level of interest in these practices to result in a different approach to enforcement absent more flagrant abuses.
Private invest-ors, however, are not engaged in a similar balancing of priorities. If they decide to look for legal shortcomings in order to pursue a claim against a fund, early publicity might provide suitable material. After all, the remedy for conducting an unregistered public offering is rescission, which means a return of the investment amount with interest. One helpful fact is that remedies of this type must be pursued more quickly than disclosure-oriented claims, generally within one year. However, clever counsel may find ways to extend this period by postponing when it begins.
How then should a private equity fund behave? The simplest answer is to promote your fund-raising after it has been completed. Before deviating from this strategy, ask yourself whether there is something important to be gained by earlier publicity. If you cannot accept this limitation, buy your counsel some Advil and try one of the following:
* Delay the announcement until all investors have submitted subscription materials.
* Limit your offerees to parties that have invested with you previously.
* Limit your offerees to parties that have already received your placement memorandum.
These techniques do not provide technical compliance, but they do try to insulate the offering activity from pre-closing publicity. If you are a first-time fund or your marketing is focused on individuals, though your need may be greater to obtain the benefits of publicity, it is that need which makes the publicity more troublesome, and it would be better to stick closer to the rules. The SEC has also provided guidance in no-action letters that an issuer or its agent should have a preexisting relationship with all offerees at the time that the marketing of a fund begins. This would make contacts developed through general publicity during the fund-raising especially troublesome.
The relationship between fund managers and investors has generally been very polite in the world of private equity, but it may be wise to assume that this won’t always be the case.
Doug Zingale is chairman of Business Practice/Boston and a shareholder in the international law firm Greenberg Traurig LLP. His practice focuses on venture-backed technology companies, private equity, M&A and strategic alliances. DJ Sardella is a senior associate in the Boston office of Greenberg Traurig LLP. His practice concentrates on corporate and securities matters, including M&A, public offerings, venture capital transactions.