Should Private Funds Be Exempt from the Ban on General Solicitation?

Alexander Davie

The Managed Funds Association recently submitted a comment letter to the Securities and Exchange Commission dated January 6, 2012 requesting the SEC to amend Rule 502(c) of Regulation D to exempt private funds, such as hedge funds, private equity funds, and venture capital funds, from the ban on general solicitation and advertising under Regulation D.

Currently under existing law, private funds cannot engage in any "general solicitation" or "general advertising" in connection with offers and sales of interests in their funds.  This prohibits funds from engaging in any public advertising and communications about their securities offerings and requires a "substantial pre-existing relationship" between the issuer and any offeree.  In its letter, the MFA makes the case that changes in the securities markets and technology have rendered the general solicitation restrictions of Regulation D, enacted 30 years ago, outdated.  In addition, the MFA argues that the vagueness over what constitutes a general solicitation, combined with the severe penalties for even an inadvertent violation creates legal uncertainly for private funds, which inhibits capital formation.  It also makes the argument that allowing general solicitations for private fund offerings will increase transparency of funds, because they will be able to publicly publish their returns.

If the MFA proposal were to be adopted, private funds would be able to engage in public communications and offering activity while remaining in compliance with Regulation D and corresponding sections of the Investment Company Act that exempt private funds from investment company registration if they do not engage in a public offering.  This would certainly ease some of the compliance burdens on private funds.

One question that must be asked is why should this exemption from the general solicitation requirement apply only to private funds?  Why shouldn't it apply to any Regulation D offering?  The MFA's letter doesn't really answer this point, though it does make a few arguments in favor of the change that would generally only apply to private funds.  For instance, it argues that the restriction creates an aura of secrecy that causes people not familiar with securities laws to make negative inferences about the hedge fund industry.  This is certainly true; though how much harm this actually causes the hedge fund industry is up for debate.   It seems to me that if we've decided that the ban on general solicitation is outdated, then it should be repealed outright, rather than just repealed for certain industries.[1]

Another thought I had while reviewing the letter is that the MFA makes a much better case for exempting so-called "3(c)(7)" funds rather than "3(c)(1) funds."  3(c)(7) funds are limited to qualified purchasers who must have over $5 million in investment assets (if an individual) or $25 million in investment (if an institution).  Given that there are relatively few qualified purchasers, repealing the ban on general solicitation only for offerings targeted towards qualified purchasers would not likely cause the inundation of investment offers we are likely to see if this was opened up to all accredited investors.

Therefore, in my view, the best reform that could be instituted right now would be to allow general solicitation for any private offering that is offered solely to qualified purchasers (regardless of whether the offering is for a private fund or some other kind of entity).  I also propose that one additional condition on being exempt from the general solicitation ban would be that the issuer would be required to document proof of the qualified purchaser's status by obtaining financial records (rather than now where the investor can simply represent that he or she is a qualified purchaser).  Such an approach, in my view, may be the best way to balance the needs of capital formation with investor protection.

Footnotes

[1] In fact there is a bill circulating through Congress right now that does repeal the ban on general solicitation for Regulation D private placements.  What comes of it remains to be seen.

Read more articles by Alexander Davie at Strictly Business, a business law blog for entrepreneurs, emerging companies, and the investment management industry.

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