Wednesday, January 11, 2012

Hedge Fund Industry Petitions SEC to End Regulation D Ban on General Solicitation

In a public rulemaking petition, the Managed Funds Association asked the SEC to amend Rule 502(c) of Regulation D to eliminate the prohibition on offers or sales securities by general solicitation or general advertising with respect to private funds. The petition is part of the broader effort by executive and regulatory policy makers and the SEC to modernize the securities laws in response to technological innovations and the evolving manner in which investors, issuers and other market participants interact. The framework for issuers to raise capital through private offerings under Regulation D dates back almost thirty years, noted the MFA, during which time the securities markets, issuers, and investors have undergone extensive change. The MFA posited that private funds and regulatory oversight of the industry, in particular, would be unrecognizable to the original drafters of Regulation D

In the petition, the MFA said that eliminating the prohibition would reduce the legal uncertainty resulting from the current regulation of private fund offerings conducted in reliance on Regulation D and increase transparency of the hedge fund industry in a manner consistent with the Dodd-Frank Act and recent regulatory initiatives. The change would also facilitate capital formation and reduce administrative costs by allowing investors to more easily obtain information about private funds, while at the same time maintaining strong investor protections and ensuring that only sophisticated investors are able to purchase interests in private funds.

Moreover, the requested amendment would reduce regulatory oversight costs and allow the SEC staff to reallocate resources to other aspects of investor protection, including products offered and sold to retail investors. The MFA emphasized that the petition is not proposing that anyone other than sophisticated investors be permitted to invest in hedge funds; and further emphasized that the activities of hedge fund managers in connection with an offering or sale of securities would continue to be subject to the broad anti-fraud provisions of the securities laws.

The MFA noted that the terms “general solicitation” and “general advertising” are not defined in Regulation D or elsewhere in the federal securities laws, and therefore have an uncertain and potentially broad application. The SEC has indicated that an issuer seeking to comply with these limitations should determine whether a particular manner of securities offering constitutes a general solicitation or general advertising based on relevant facts and circumstances.

As a result of this framework, Rule 502(c) subjects hedge funds to a sweeping prohibition on a range of activities and communications, noted the MFA, and as a practical matter fund managers only engage in activities which the SEC staff has identified as permissible. Guidance issued by the staff, however, such as no-action letters, is dependent on the specific facts and circumstances of the entity making a request, and therefore generally offers only narrow, limited relief upon which other issuers may rely.

Despite the best of intentions by the SEC staff to provide clear, workable guidance, by its nature this approach leads to uncertainty for hedge fund managers in assessing whether the facts associated with a range of communications, including discussions with potential investors, participation at industry events, and making public statements, would comply with the terms of previous guidance issued to another entity in a distinct set of circumstances. According to the MFA, this uncertainty is exacerbated by the potentially severe consequences to a hedge fund that would threaten its survival if it engages in conduct that is deemed to violate Regulation D.

For example, the SEC staff has indicated that an important factor in assessing if an offering is in compliance with Regulation D is whether an issuer, or a selling agent or other person acting on its behalf, has a pre-existing substantive relationship with an offeree so that the issuer or agent could form a reasonable belief that it meets the investor eligibility requirements. This condition is particularly difficult for hedge fund managers to interpret and apply to their businesses, said the MFA, because they generally conduct continuous offerings of securities. As a result, managers must carefully analyze whether they, or a selling agent acting on behalf of a fund, have established a substantive relationship with an offeree prior to, or in the course of, an offering.

The hedge fund industry group also noted that eliminating the ban would allow the SEC staff to reallocate resources to other important aspects of investor protection, including oversight of products that are offered and sold to retail investors. The current framework requires the SEC staff to determine whether activity constitutes a general solicitation or general advertising on a case-by-case basis. This approach requires the staff to expend scarce resources to evaluate an issuer’s conduct in connection with a broad range of activity.

In addition, eliminating the ban would reduce the cost of capital for private funds and lead to greater efficiency in private offerings, said the MFA, which in turn would facilitate the allocation of capital and investment by private funds throughout the financial markets. Private fund managers face significant costs in seeking to comply with the ban due to its broad application, the limited scope of existing guidance, and the severe consequences of an inadvertent violation. Managers expend considerable time and resources when making any sort of communications or participating in industry events, and often take a conservative approach and refrain from such activity. These effects impose administrative burdens for managers and unnecessarily limit communications with potential investors, increasing the cost of obtaining capital for private funds.

In the First Session of the 112th Congress, the House passed by an overwhelming 413-11 vote the Access to Capital for Job Creators Act, H.R. 2940, to instruct the SEC to amend Regulation D to eliminate the ban on general solicitation and advertising. There is a companion bill in the Senate.

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