Monday, December 12, 2011

Proposed FINRA Rule on Private Placement Disclosure Would Conflict with the Federal Securities Laws Maintains Hedge Fund Industry

Proposed FINRA Rule 5123 would conflict with the federal securities laws by mandating that particular information be disclosed in connection with a private offering, said the hedge fund industry association. In a letter to the SEC, the MFA noted that, under Section 4(2) of the Securities Act, a transaction by an issuer that does not involve a public offering is exempt from registration. As a result, private offerings are not required to be sold by means of a registration statement, and are not subject to the disclosure requirements applicable to public offerings. In the view of the MFA, the private offering exemption in Section 4(2) reflects the intent of Congress to exempt transactions where there is no practical need for the Act’s application or where the public benefits are too remote. Thus, the MFA recommend that FINRA modify proposed Rule 5123 to include exemptions for an offering made by a private fund, as defined in the Investment Advisers Act.

The MFA believes that proposed Rule 5123 would conflict with the long-standing framework for the regulation of offerings by private funds. By requiring that particular information be disclosed in connection with a private offering, the Rule would be inconsistent with both Section 4(2) and Regulation D, which provides a safe harbor for issuers to comply with Section 4(2).

Hedge funds comply with Section 4(2) and Regulation D by providing investors with offering documents, memoranda and other materials that include extensive information about the activities of the fund and its investment manager. Hedge funds and their investors have operated effectively under these provisions for many years, said the MFA, and this continues to be the appropriate framework to ensure that sophisticated investors in private offerings have access to the type of information necessary to make their investment decisions.

Congress has established a regulatory framework for private placements that excludes a mandatory disclosure regime, posited the MFA, and FINRA would substitute its judgment for the Congress. While FINRA may plausibly argue that additional disclosure regarding private placements may be helpful to investors, Congress has enacted and repeatedly reaffirmed a statutory framework for private placements generally and for offerings by private funds specifically that leave matters of disclosure to issuers and the sophisticated investors who are eligible purchasers.

In the MFA’s view, FINRA seeks to institute its own disclosure regime for private placements, including offerings by private funds to sophisticated investors. FINRA is thus seeking to do what the SEC itself cannot do, establish a disclosure regime for private placements to sophisticated investors. The MFA believes that such requirements are inconsistent with the statutory scheme in the Investment Company Act, the Securities Act and the Exchange Act.

The MFA also maintained that the proposal is inconsistent with Section 3(f) of the Exchange Act, which requires the Commission as part of its review of an SRO rule to consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation, because it is inconsistent with the framework that Congress established for raising capital in private placements. By requiring a FINRA member that offers or sells private placements to provide disclosures to each investor prior to sale, said the MFA, the proposed Rule would make private offerings more costly and less efficient, thereby imposing an unnecessary burden on capital formation.

A private fund engaged in an offering would need to prepare the disclosure, and then coordinate with each FINRA member involved with the offering to arrange for delivery of the information, leading to a potentially lengthy review process, difficulties in ensuring that appropriate disclosures were made, and liability concerns. These burdens and delays associated with the disclosure and review process would inhibit private funds from conducting offerings efficiently and obtaining needed capital to invest throughout the economy.

The requirement that the information be disclosed in a private placement memorandum or term sheet, as opposed to a separate disclosure document, would be particularly disruptive and harmful to capital formation. For example, managers may provide an investor with a term sheet or other document prior to a private placement memorandum, and the Rule would create unnecessary confusion in these situations regarding how and when the required information should be disclosed to the investor and filed with FINRA.

In addition, under the Rule as proposed, a FINRA member would need to file any material amendments to the documents with FINRA. It is not clear to the MFA what policy objective would be served by filing amendments to a term sheet or private placement memorandum with FINRA, particularly where such amendments are unrelated to the specific disclosures that would be required by the Rule.