Happy Friday, Funds Family!

This is the first in a three-part series about the holy trifecta 👼 of investment fund law:

1. The Securities Act of 1933

2. The Investment Company Act of 1940

3. The Investment Advisers Act of 1940

⚖️ Who does the Securities Act apply to?

The Securities Act applies to anyone selling securities. Big surprise.

But what is a security really?

Well, the Securities Act defines “Security” as follows:

To help refine the statutory definition, there are a couple of common tests.

Howey Test

The famous Howey Test lays out the four main factors of an “investment contract” (which is a common type of security):

1. An investment of money

2. In a common enterprise

3. With the expectation of profit

4. To be derived from the efforts of others

There are other tests for other types of securities.

Reves Test

For example, the Reves Test includes a test to determine whether a promissory note counts as a security.

✅ The Practical Bottom Line

I’ve discussed these tests for completeness.

However, in practice, you can safely assume that if you are soliciting passive investors (publicly or privately) to invest in your fund, syndication, SPV, or other pooled investment vehicle, you are selling securities.

If you are merely seeking a business partner (or seeking to do a JV where both parties have control), you’re likely not selling securities. But double check with your lawyer.

🤔 What do you need to do if you’re selling securities?

As a general rule, if you are selling securities, you must either:

1. Register: Register the securities with the Securities and Exchange Commission (SEC)

   or

2. Exemption: Sell the securities pursuant to an exemption from SEC registration.

Registering the securities means doing an IPO (or another take-public transaction) for your fund or SPV.

⛔️ Unless you are raising an utterly massive investment vehicle, you do not want to go public. Way too burdensome and expensive. Too much lawyer time for your own good.

You want an exemption. 100% of our clients use an exemption.

🏦 What exemptions from securities registration are there?

Common exemptions to SEC registration include:

• Regulation A: A public/private hybrid that has two tiers (Tier 1 for simpler raises of up to $20 million in a 12-month period and Tier 2 for more complex raises of up to $75 million in a 12-month period. This requires significant disclosure.

• Regulation S: An exemption for sales of securities outside the US.

• Regulation CF: The “crowdfunding” exemption that allows you to raise up to $5 million in a 12-month period. This has investment limits and other technical requirements.

• 4(a)(2): An exemption for transactions by an issuer of securities not involving a public offering.

While these exemptions are all well and good, most investment funds and SPVs rely on the golden child: Regulation D.

💪 What is Regulation D?

Regulation D is a magnificent law that provides a “safe harbor” for certain securities offerings.

There are multiple flavors to Regulation D. The two most typical options for investment funds and SPVs are Rule 506(b) and Rule 506(c).

They are easy to use, do not limit the amount of money you can raise, and require less lawyer time than the other options. 🕰️ 

Rule 506(b) - “506 Be Quiet!”

This is a true private placement. What does that mean?

👍️ The upside of 506(b)

The beauty of 506(b) is that you can have investors self-certify whether they are an accredited investor. All you have to do is ask (assuming you don’t have reason to believe they’re lying.

This is very simple and low friction.

Side Quest: What is an accredited investor?

There are many ways to be accredited, but the most common are:

• Individual with $200k annual income (or $300k joint income with spouse) for the last two years with an expectation to continue earning income above the threshold.

• Individual with $1 million net worth (excluding the value of your primary residence).

• Entity with at least $5 million in assets.

• Entity in which all equity owners are accredited.

👎️ The downside of 506(b)

You must have a preexisting relationship with each investor. Friends, family, etc.

Ways you cannot fundraise:

• Podcasts

• Tweets

• LinkedIn

• Fund-related speeches at conferences

• Blasting an email to a bunch of people you don’t know

• General advertising

So…what can you talk about?

In general, it’s best to avoid all mention of the fund or fundraising. You can potentially mention that you make investments, and you can talk about your views on the market, but don’t solicit investors or even suggest you’re raising money. It’s a gray, murky analysis.

We counsel clients that it’s better to be safe than sorry and advise erring on the side of saying less rather than more. 🦺 

When in doubt, ask your lawyer.

⚠️ Non-Accredited Investors in 506(b)

506(b) technically allows you to have up to 35 nonaccredited investors.

Many lawyers will tell you that.

What many lawyers will forget is that, pursuant to Section 502(b), if you accept even one nonaccredited investor, you must do a bunch of extra disclosure.

Below are some of the requirements:

Basically, you need a mountain of disclosure, similar to what you would need to disclose if using Regulation A. 🗻 

For this reason, many funds/SPVs accept only accredited investors even if they use Rule 506(b).

Rule 506(c) - “Come See Our Fund!”

506(c) is a newer creature that is becoming increasingly popular. It allows for public solicitation.

👍️ The upside of 506(c)

You don’t need to worry about speaking publicly. Go ahead and talk about your fund or SPV wherever you want.

You can post about fundraising on the internet.

You can go on podcasts.

You can even advertise.

👎️ The downside of 506(c)

Unlike 506(b), you must “take reasonable steps to verify” that 100% of investors are accredited.

You can do this by getting a letter from each investor’s attorney, CPA, or financial advisor verifying accreditation.

You can also hire a third party to verify the investor for you. Common providers include VerifyInvestor, InvestReady, and Parallel Markets. ☑️ 

In a pinch, you can also review their tax returns. We try to avoid this whenever possible though.

🤷‍♂️ Which is better – 506(b) or (c)? 

In short, the benefit of 506(c) is that you can raise money publicly.

The benefit of 506(b) is that investors can self-certify that they are accredited.

If you’re not sure which you prefer, you can change from 506(b) to 506(c) if you change your mind mid-fundraise. ♻️ 

However, you cannot go from 506(c) back to 506(b). No putting the genie back in the bottle, toothpaste back in the tube, rabbit back in the hat, etc. You’re locked in.

Anything you have to change in the legal documents if you switch from 506(b) to 506(c)? 

Most of your legal documents will be the same whether you use 506(b) or 506(c).

The only real difference is that you should make it clear in the subscription documents that each investor must be accredited.

You can also include a form accredited investor verification letter the investor can send to their financial professional.

📜 What government filings are required for Regulation D?

If you use 506(b) or 506(c), you need to file a Form D with the SEC within 15 days of the fund’s initial closing date.

This is a simple notice filing and isn’t difficult.

Some funds/SPVs file the Form D just before their initial closing, as pre-filing allows you to disclose less information (mostly about dollars raised and number of investors).

Many states also require “blue sky” notice filings within 15 days of the initial close. This is basically just a tax you pay in each state where you sold securities to investors. 🤑 

🦹‍♂️Bad Actor Disqualification

Regulation D (where both 506(b) and 506(c) live) is not available to “bad actors” as set forth in 506(d).

Examples of “bad acts” include:

• Financial crimes

• Being restricted from being a financial professional

• Generally getting in trouble with the SEC

If you have been subject to a “disqualifying event” prohibiting you from using Regulation D, you can still sell securities, it’s just more difficult.

One common route is to use 4(a)(2). However, unlike Regulation D, 4(a)(2) doesn’t “preempt” state law. 👨‍⚖️ 

In normal person terms:

• If you use Regulation D, you generally don’t need to deal with state-specific versions of the Securities Act (other than making the Blue Sky filings discussed above).

• If you use 4(a)(2), you need to research and comply with the state-specific version of the Securities Act in each state where one of your investors is based.

Reg D is much easier than 4(a)(2).

🤡 No Bamboozling the Public 

No matter how you sell securities, Regulation D or otherwise, you can’t lie.

More specifically, Rule 10b-5 prohibits fraud, material misstatements and/or omissions, and other methods of deceit.

Court cases have held that private citizens (as well as the SEC) can go after issuers of securities (including fund/SPV managers) for these actions, which are generally referred to as securities fraud.

Please don’t commit fraud.

To avoid fraud, don’t overpromise in your marketing materials.

And, for the love of funds, 🚨never “guarantee” returns🚨 

⏩️ Next up

Next week, we’re going to move on to the Investment Company Act.

It will be nothing short of a dazzling adventure ✨ (hopefully this isn’t overpromising, but luckily this sentence isn’t subject to 10b-5).

Have a great weekend!

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.