Many buyout professionals aren’t quite sure what “general solicitation” means. And frankly, the Securities and Exchange Commission doesn’t want them to know.
When it comes to private placement, it seems every buyout firm has its own ideas about what constitutes “private.” Some firms speak openly to the press about fund raising, leave names and phone numbers in industry publications and even fax out press releases when they hit a first closing. Others dare not publicly utter the word “fund” until every dollar is accounted for and every contract signed, fearing retribution from the SEC.
A Failure to Define the Law
On the subject of discretion and fund raising, the SEC claims it is being deliberately vague. So how is a private equity group to know when it is crossing the line that separates a private placement from a public offering? “We’ll let you know when we sue you,” says John Heine, a spokesperson for the SEC.
The vagueness has caused some anxiety among those in the private equity world, particularly now that private placement memorandums are beginning to be displayed via new vehicles of communication, such as the Internet. And the expansion of interest in private equity among wealthy individuals has led some observers to wonder whether clearer guidelines are needed to protect potential investors who may be less than sophisticated.
Legal advisers to buyout groups say the SEC is unlikely to go after them for anything short of out-and-out fraud but nevertheless continue to tell their clients to err on the side of caution.
No Enforcement in Sight … For Now
Of course, no one really knows what circumstances would prompt the SEC to go after a private equity group for improper capital soliciting, because it has never happened before.
Mr. Heine confirmed that, at least in the recent history of private equity, no action has ever been taken against a firm for violating the rules that govern a private placement. “That’s not to say we won’t,” he adds.
According to Joseph Bartlett, a partner at New York law firm Morrison & Foerster, LLP, which specializes in private equity, the SEC has more pressing things to do than go after private placement violations. “The SEC enforcement capability is almost totally taken up with things like penny stock fraud,” he says. “The risk of enforcement is close to zero.”
Mr. Bartlett says he has joked with officers he knows at the SEC about this very topic and says the SEC admits that it doesn’t have the resources or the will to draw a sharper line between private placements and public offerings. “If they were to pick on one [private equity group], they’d have to pick on thousands of groups,” he says.
The accessibility of the World Wide Web increasingly is being seen by buyout firms as a useful tool, but some legal advisers see it as cause for concern.
At issue is an amendment to the U.S. Securities Act of 1933 called Regulation D, which provides a “safe harbor” for private placement and includes the stipulation that “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising.” The rule goes on to state that this includes advertisements, articles or notices in any form of media.
Reg D’s Safe Harbor Proves Confusing
The SEC also mandates that in a legitimate private placement, the relationship between the party offering the security and the potential investor will have been established prior to the launch of the offering.
This rule, say legal experts, is meant to restrict fund-raising efforts to accredited investors only. The intent is noble, they say, because it protects Aunt Mildred from the guy who wants her to invest her retirement money in a race horse. But when applied to the world of private equity, where the minimums can be $10 million and where each interest position is heavily negotiated, it’s hard to imagine an unsophisticated investor accidentally wandering into the fray.
Playing by the Rules or with Fire?
Accordingly, many in the buyout world don’t have much of a problem with entering the gray area of Reg D. Thomas Bagley, a senior managing director at Pfingsten Partners, which recently raised $100 million for its second fund, says mentioning fund raising in the trade press doesn’t necessarily equal soliciting. “The industry has a right to know,” he says, adding that he would not consider talking to a mainstream publication about his firm’s fund raising.
The problem with the SEC’s regulation, Mr. Bagley says, is “you really don’t know what’s right or wrong unless someone decides to sue.”
The SEC, for its part, is in no hurry to set guidelines for fund raisers about what is right and wrong. “We won’t give you a recipe for staying out of trouble because, if we do, people will certainly be out there pushing the envelope,” Mr. Heine says. “And when they do, they’ll point to our recipe.”
Another official at the SEC, who declined to speak on the record, says that in the past, a firm could get clarification on a rule through a “no action” letter, which essentially gives an official response to a hypothetical situation. The source says he didn’t think the SEC “really did that anymore.”
Stiff Penalties Surround Gray Legalities
A partner at a law firm that specializes in private equity says penalties for violating Reg D could range anywhere from a six-month suspension of fund raising activities to the firm being required to return all committed capital to investors.
According to Rufus King, a partner at Boston law firm Testa, Hurwitz & Thibeault, LLP, if a penalty did get handed down, the general partners and even the limited partners to the fund could hold their legal council liable for calling a bad private placement good. “That’s the reason law firms are all over this issue,” Mr. King says.
The fear of penalties unknown leads many attorneys to warn their clients to keep any mention of fund raising out of media outlets, even industry publications with restricted circulations. One source, whose firm is currently raising a fund-of-funds, was unaware that conversations with reporters about the effort might get him into trouble until he heard an ultimatum from his lawyers. “I was shell-shocked by their response,” he says.
“The SEC enforcement capability is almost totally taken up with things like penny stock fraud. The risk of enforcement is close to zero.”
Legal council told him not to comment on the firm’s fund-of-funds until the private placement memorandum was “widely dispersed.” The source says he believes one mention of the word “fund” in a publication could end his career in private equity. “Maybe our lawyers are over sensitized,” he adds.
The Internet Raises New Concerns
Just how to interpret Reg D is being given a closer look by general partners now that the Internet is beginning to play a role in private equity fund raising. The accessibility of the World Wide Web is increasingly being seen by buyout firms as a useful tool, but some legal advisers see it as cause for concern.
When Mr. Bagley told his legal council that Pfingsten Partners was considering putting its private placement memorandum on a Web site, the lawyers were shocked. “They almost had a heart attack,” Mr. Bagley says.
Only after Mr. Bagley explained that the PPM would be in a secure site, accessible only by a password supplied by the firm, did the legal council agree that it might be a good idea.
Pfingsten Partners’ Web site was constructed by Envista, a company that maintains Internet sites to help manage investor relations for private equity firms. Clarke Simmons, Envista’s president, says his firm is taking no chances with running afoul of the SEC and its rules governing private placements.
When a firm is in the process of raising a fund, he says, there is no mention of it on the firm’s home page except for a link that says “fund documents.” Any interested party would need to contact the private equity firm and request a password, which would require proof that the interested party is an accredited investor.
“We won’t give you a recipe for staying out of trouble because, if we do, people will certainly be out there pushing the envelope. And when they do, they’ll point to our recipe.”
Mr. Simmons says investors learn about his clients’ funds through standard private placement means, and the Web site is by no means a public notice. However, in spite of the safeguards that have been put in place to avoid attracting the general public’s attention, Mr. Simmons says, when first hearing about the services offered by his company, “the initial reaction of most law firms is to be skittish.”
Rise of the Wealthy and Unsophisticated?
At least one law partner, who declined to be named, feels there may be a chance that the SEC will eventually find it necessary to further define private placement discretion rules.
As more high-net-worth individuals grow interested in private equity funds and funds-of-funds, the law partners says, the SEC may decide that the possibility of unaccredited investors being lured into private equity investment vehicles is increasing. If that happens, the partner says, the private equity community may finally have the chance to know exactly what general solicitation means.