The Top 10 Legal and Regulatory Issues in Fundraising: The issues that keep us up at night! –

We are often asked what keeps us up at night with respect to the fundraising process. There are a myriad of salient issues facing private equity funds, companies and placement agents in these transactions. This article presents our current top 10 issues in legal and regulatory compliance in the fundraising process. The offering and sale of securities of any kind is regulated under the Securities Act of 1933 (“Securities Act”). Any offering and sale of securities must either be registered or qualify for an exemption under the Securities Act. The exemption from registration may either be as a result of the fact that the specific security being offered and sold is exempt from registration under the Securities Act or the particular offer and sale of the securities qualifies for a transactional exemption under the Securities Act. A private equity fund or company selling securities will likely seek to qualify for an exemption from registration under Regulation D Rule 506 of the Securities Act.

1. Presentation Materials and the Offering. The presentation materials typically consist of a Private Placement Memorandum (“PPM”) and a road show presentation and flip charts. These materials would be considered an “offering document” under the Securities Act. The offering and sale of securities should be made only via the PPM and any issuer-provided supplements. The PPM should contain specific legends that caution the potential investor that they are authorized to rely only on the PPM in making an investment decision. Potential investors should not be permitted to rely on statements made in other presentations. This limitation does not permit the issuer or its representatives from escaping liability for fraudulent or misleading statements in those other materials as the parties are still subject to the anti-fraud provisions of the Securities Act and other securities laws.

A private placement under Regulation D may not be made through a “general solicitation” of investors. A general solicitation includes any advertisement, article, notice or communication published or broadcast in the media and includes inviting potential investors to attend a seminar, meeting or conference through this media. Information on web sites, press releases and statements to the media offering the securities for sale are also prohibited. Finally, the issuer should keep a detailed log with identifying information of each recipient, including state of residence, and require that any potential investor who did not invest in the offering return the materials.

2. Characteristics of Investors. Accredited Investors only, please! In order to meet the requirements under Regulation D of the Securities Act, it is highly advisable to offer for sale securities only to “accredited investors”. The term “accredited investor” is defined in Regulation D of the Securities Act and provides a bright line rule based upon a net worth/net income test. The accredited investor only rule is often tested when friends and family eager to support management in their endeavors wish to invest with the issuer but do not meet the standard. By selling to non-accredited investors, an issuer’s disclosure obligations and potential legal exposure are increased.

3. Confidentiality. There are certain steps an issuer should take in order to ensure that it has adequately put on notice the outside world of its rights in the confidential information. The issuer should place a confidentiality notice on every page of the PPM and on all presentation materials. The issuer should require the potential investor to return all materials if they determine not to invest in the issuer. The main concern is that information may become outdated and stale. In addition, there is a potential that the issuer may have a legal obligation to continuously update a recipient if they have not officially passed on the investment and returned the offering materials.

4. Publicity. The simple rule is: Avoid it. This flies in the face of the old adage that any publicity is good publicity. Publicity may be seen as a sales campaign to condition the market for the issuer’s offering or as part of a general solicitation that blows the Regulation D exemption. We recommend that issuers and their representatives avoid the general press with respect to the offering. Concerning the trade press, issuers should limit their discussions. A typical response to the trade press would be to acknowledge the fund raising process and, as all good soldiers, supply only name, rank and serial number (i.e., anticipated close and funding goals, etc.). For the issuer it makes sense to designate one manager who is responsible for all inquiries so as to ensure a consistent response. Finally, Google yourself early and often as a self check.

5. Avoid the 3 Ps (Predictions, Promises and Projections). Although this appears to be a simple rule on its face, in practice there are some concerning issues for fundraisers. Issuers should avoid predictions and never make promises regarding future performance. The disclosure materials should contain appropriate “safe harbor” legends, including the forward looking statements qualifications. Issuers may discuss management team background and their substantive experience. Management must strike the proper balance between selling one’s background and experience versus promising future performance, which should clearly be avoided.

6. Track Record Disclosure. In particular with respect to fund performance data, disclose all valuation criteria and underlying assumptions and principles. Be conservative. Consistent disclosure in your fund performance (both as to form and substance) is paramount. Finally, don’t hide the ballreport your investments that are performing and underperforming in a balanced presentation. These disclosure items are equally important and analogous to disclosure of performance indicators by private companies to their shareholders.

7. Blue Sky Filings and the Federal Form D. Issuers must be very cautious to ensure compliance with applicable state blue sky and Federal filings. Certain states, such as New York, require a pre-offering filing of information about the offering and the issuer. It is advisable to have a member of management charged with ensuring pre-offering compliance with state and federal filings. Each potential investor should be pre-qualified and all requisite filings should be made or updated for each state based upon the residence of each potential investor.

8. Side Letters and Special Arrangements. The main concern for private equity funds in this context is whether there is a breach of the general partner’s fiduciary duties to the partnership as a whole if special rights are negotiated with only a certain investor. The authority to enter into side letter agreements or special arrangements, however, is widely accepted, and side letters are widely used. General partners may negotiate enhanced terms for certain investors provided the terms are disclosed to other investors. As a general rule these agreements must not change the basic economics of the fund or the fund focus. The trend is to include terms and conditions that change the basic economics of the fund or the fund focus into the partnership agreement.

9. Regulatory Compliance. With the advent of the Sarbanes-Oxley Act of 2002 (SOX) and Anti-Money Laundering Regulations, the regulatory landscape has dramatically changed for all issuers. The general overall effect of SOX and these other regulations has been for issuers and their advisors to be more conservative and focused on compliance. This “tightening up” or more formal approach to compliance has also been seen in the Asset-Backed Issuer and Hedge Fund rules promulgated by the Securities and Exchange Commission. Another facet of this regulatory compliance is that issuers must clearly know their investors. Anti-Money Laundering regulations and Treasury regulations prohibit an issuer from doing business with specifically designated nationals. The Department of Treasury through the Office of Foreign Assets Control publishes this lengthy list of individuals and organizations. The Subscription Agreement must directly address these issues by containing representations and warranties designed to assure compliance with these regulations. Issuers should have a designated compliance officer who is charged with pre-investment due diligence on all potential investors.

10. Public Entity Disclosure. Perhaps one of the most dynamic issues related to private equity funds is whether disclosure of confidential information would be required by public fund limited partners. Public fund investors are subject to open-record laws and have historically been some of the largest private equity investors in the market. Over the last year, there has been an increase in the litigation associated with requests for confidential information related to these private equity funds held by public entities. Managers of private equity funds have a legitimate concern that disclosure of fund level information and portfolio confidential information may adversely affect underperforming companies in a fund’s portfolio. Some states are dealing directly with this issue by limiting open record disclosure of private equity fund confidential information (e.g., Michigan, Colorado, Massachusetts and Virginia). Private equity funds raising capital are assessing whether they should continue to include public entity investors as limited partners. At a minimum, disclosure limiting strategies such as having password- protected web sites and requiring review of trade secret information only at the fund offices are examples of strategies that managers are employing to address such public disclosure concerns.

The formula almost seems simplistic. Build a quality management team. Develop a strong business model. Finance your dreams. Achieve success. Along the way there is one thing you can count on-the fund raising process requires adherence to a web of legal and regulatory requirements. We have identified, for our money, the Top 10 legal and regulatory requirements that issuers must be concerned with in the fund raising process.

For further information, please contact Richard F. Langan, Jr., Chair, Business & Finance Department, Nixon Peabody LLP. Email: or Tel: 212-940-3140.

The foregoing article is for educational and informational purposes only. It is not a full analysis of the matters summarized and is not intended and should not be construed as legal advice.