The Securities Act of 1933

Overview:

Any fund that brings on third-party investors is generally considered to be offering a security to those investors implicitly by the act of bringing them into the fund, regardless of the specific construction of the fund, the strategy or assets in which it invests, or the offering terms of the fund.  Anytime a security is offering in the United States, whether from within or outside, it must be offered in compliance with the Securities Act of 1933 (the “Securities Act” or “Act“).

Alongside the Investment Company Act of 1940 and the Investment Advisers Act of 1940, the Securities Act is one of the three most common considerations for hedge funds, and uniquely, it applies to funds of all asset classes, including those which do not invest in securities.

Key provisions of the Act:

A practical summary of the Act is as follows: whenever an investment opportunity is being offered, generally of any kind and in any form, the offering must either become a registered securities offering or fall within an exemption from registration.

For hedge funds, the two most pertinent sections of the Act are generally Regulation D and Section 4(a)(2).  Both of these pieces of the Act provide for exemption frameworks for securities offerings, which impose restrictions on how an offering may be conducted but in so satisfying such critera may avoid registration.

Section 4(a)(2) vs Reg D

4(a)(2) allows offerings that are not public or widely distributed (also known as “private placements“) to be exempt from registration.  4(a)(2) can quickly become a rabbithole, as whether or not a private placement is acceptable or not is per-offering facts and circumstances based, with general guidelines and case law precedents, rather than absolute science.  For example, while the Act says that public offerings must be registered, exactly when an offering is considered a public offering is not explicitly defined. Despite the lack of absolute definition, there is a sense of “you know it when you see it” that regulators tend to apply.  Generally, though, the intent is that placements are limited in number of investors, non-public, and given to investors that are suitable, knowledgable, and appropriately aware of risk.

If the above seems a bit vague to you, you’re not alone, and Regulation D was introduced to provide for some absolute clarity.  Regulation D provides “safe harbor” private placement types that definitely qualify as acceptable, non-public, private placements under Section 4(a)(2).

Put another way, while 4(a)(2) as a standalone doesn’t clearly define an acceptable private placement, Regulation D does define several.

As such, most hedge funds seek to follow a well-established “safe harbor Reg D offering under 4(a)(2).”

Regulation D Safe Harbor offerings:

The two most common Reg D safe harbor offerings are known as Rule 506(b) and Rule 506(c). See the more detailed, dedicated articles linked herein for more detailed information about each.

To briefly summarize, 506(b) generally restricts investors to being at minimum accredited investors and restricts the offering from any general solicitation.  506(c) also generally restricts investors to being accredited investors, but does allow for general solicitation, at the cost of an much higher burden of verifying the accreditation and financial status of each investor coming into the fund, which can be costly and undesirable for either or both the fund and prospective investors.  Both these offerings generally pair with the restrictions of the Investment Company Act – and even funds which do not participate in trading securities tend to follow the investor count guidelines of that act – and are therefore further capped at either 100 investors or 2000 investors, depending on whether the 3(c)(1) or 3(c)(7) exemption is utilized.

Lastly, note that private placements are self-executing, which is to say that there is no application or approval process.  Similar to driving under the speed limit in a car, there is no process associated; however, failure to offer a suitable private placement can subject a fund to severe adverse regulatory action upon inspection.

Summary:

The Securities Act is extremely important, but also relatively straightforward.  For most funds, the fund must simply comply with one of Regulation D’s safe harbor frameworks when they conduct their offerings to investors, and the most common offering type is a 506(b) offering in conjunction with the investor count restrictions from the Invesment Company Act’s Section 3(c)(1), which caps the number of investors at 100.