Private Placements In The United States Of Interests In Unregistered Investment Funds

Wednesday, March 1, 2006 - 01:00
Stephen Culhane
Alexander A. Gendzier


This article provides a general overview of the requirements of, and the
related documentation for, a private placement of securities in the United
States by investment funds. It focuses on exemptions from the registration
requirements for sales under the Securities Act of 1933, as amended (the
"Securities Act") and does not cover other statutes and regulations that may
apply to investment funds, such as the Investment Company Act of 1940.
Specifically, this memorandum summarizes the following:

  • the background of the federal securities laws and the main,
    applicable private placement exemption from registration

  • the requirements for a valid private placement under the federal
    securities laws; and

  • typical documentation for private placement by a private
  • This article provides only a brief summary of the topics discussed and
    does not constitute legal advice regarding a particular offering or other


    In the United States, any offer to sell or sale of securities must be
    either registered under the Securities Act or qualify for an exemption from the
    registration requirements. For investment funds, the most commonly relied upon
    exemption from the registration requirements is Section 4(2) of the Securities
    Act and, more specifically, the safe harbor for private placements found in
    Sections 501 through 508 of the General Rules and Regulations under the
    Securities Act (referred to as Regulation D). Together, Section 4(2) and
    Regulation D serve as one of the primary private placement exemptions from the
    registration requirements. In addition, we note here, but do not discuss in this
    memorandum, that the offer to sell and sale of securities outside the United
    States is generally exempt from the registration requirements provided the
    conditions to Regulation S of the Securities Act are satisfied. The availability
    of any of these exemptions from the registration requirements depends on an
    analysis of all relevant facts and circumstances.

    Section 4(2)

    Section 4(2) provides a general exemption from registration for any
    transaction by an issuer "not involving a public offering." Section 4(2) does
    not provide specific guidelines regarding how a private placement avoids
    involving a public offering. Through caselaw and practice, procedures for
    conducting these types of private placements have developed over time. Many of
    these procedures are incorporated in the safe harbor for private placements
    contained in Regulation D.

    Regulation D

    Regulation D, and in particular Rule 506 under Regulation D, provides
    specific guidelines for conducting private placements. Regulation D is viewed as
    a "safe harbor" because, if its requirements are satisfied, the offering will be
    considered exempt from U.S. registration requirements under the Securities Act.
    Regulation D is considered a "non-exclusive safe harbor" for effecting private
    placements because failure to comply with all the terms of Regulation D does not
    necessarily preclude the availability of an exemption under Section 4(2).
    Because it is a non-exclusive safe harbor, issuers and practitioners often rely
    on Section 4(2) and/or Regulation D together to effect a valid private

    Effect Of Noncompliance

    If an offering of securities attempts to rely upon, but fails to satisfy,
    an applicable private placement exemption, the issuer will violate Section 5 of
    the Securities Act and may be subject to enforcement action by the Securities
    and Exchange Commission (the "SEC"). One of the possible consequences of
    violating Section 5 of the Securities Act is that investors may have a
    rescission, or put, right to the issuer based on the original purchase price of
    the securities. As a result, care must be taken in structuring and conducting a
    private placement to ensure that the offering complies with the requirements of
    the exemption being relied upon.

    Rule 506 Requirements

    To comply with Rule 506 under Regulation D, the issuer and any placement
    agent or underwriter acting on behalf of the issuer must comply with
    requirements relating to the following:

  • the number and nature of the offerees;

  • disclosure and information requirements;

  • prohibition on general solicitation and advertising;

  • limitations on the resale of the securities;

  • possible integration with other securities offerings;

  • SEC notice requirements.
  • Number And Nature Of Offerees

    There is no per se dollar limit on the amount of securities which
    may be offered under Rule 506. In order to qualify for the exemption, however,
    there must be no more than, or the issuer must reasonably believe that there are
    no more than, 35 purchasers (other than excluded purchasers). Section 501(e)
    sets forth certain rules for calculating the number of purchasers and excludes
    from the count, among others, accredited investors.

    "[A]ccredited investors" include the following categories:

  • individuals with a net worth (or joint net worth with such person's
    spouse) of $1 million;

  • individuals with an annual income in excess of $200,000 or joint
    annual income with a spouse in excess of $300,000 in each of the two most recent
    years and a reasonable expectation of reaching the same income level in the
    current year;

  • corporations, partnerships and certain trusts with $5,000,000 in

  • entities whose owners are all accredited investors; and

  • additional categories of accredited investors that are specified in
    Regulation D.
  • Non-accredited investors (either on their own or together with a purchaser
    representative) must be "sophisticated" purchasers who have sufficient
    experience in business and financial matters to be capable of evaluating the
    merits and risks of the prospective investment. If non-accredited investors are
    included in the offering, the issuer must provide those non-accredited investors
    with certain information specified in Rule 502. Although not strictly required,
    the issuer should consider providing such information to accredited investors as
    well, in light of the anti-fraud provisions of the federal securities laws.

    Disclosure And Information Requirements

    To comply with Regulation D, the issuer must ensure that investors are
    provided, at a reasonable time prior to the sale of the securities, with all
    information that is material to an investment decision and that they be provided
    a meaningful opportunity to conduct due diligence about the issuer and the
    offering. While there are no specific requirements for what must be provided to
    prospective investors in a Rule 506 offering, over time practice and convention
    have developed in response to the Securities Act and caselaw regarding the
    contents of such an offering document. In general, private investment funds that
    offer their securities prepare with counsel and distribute to offerees a private
    placement or confidential offering memorandum. The preparation of such an
    offering document serves several purposes, including protecting the issuer from
    claims that it has provided incorrect information or omitted to include all
    material information regarding the investment. We describe in more detail below
    the typical contents of such a private placement memorandum.

    Prohibitions On General Solicitation And Advertising

    To ensure the validity of a private placement, neither the issuer nor
    anyone acting on its behalf (such as an investment bank or other placement
    agent) may engage in any general solicitation or general advertising about the
    offering. A general solicitation includes any effort directly or indirectly to
    sell the securities or to condition the market for their sale. It covers many
    different kinds of communications, including those contained in any newspaper,
    magazine or other traditional media, on any website, in any widely disseminated
    email distribution and at widely advertised seminars or meetings. In addition,
    there may be a general solicitation if too many parties are invited to consider
    making the investment, although we note that this is an inherently unclear
    aspect of the requirements.

    In conducting a private placement, the issuer should develop, in
    consultation with counsel, a process designed to identify potential investors
    and solicit their interest to ensure that the requirements regarding the number
    and nature of the offerees and the prohibitions on general solicitation and
    advertising are satisfied. This process will generally require the issuer or its
    agent(s) to:

  • gather information on a potential investor, including by means of an
    investor questionnaire;

  • consider using a confidentiality, or non-disclosure, agreement prior
    to making an offer of the securities and distributing a private placement

  • contact offerees, receive confirmation that they are accredited
    investors or are otherwise permitted non-accredited investors, and provide
    offerees with a private placement memorandum and any other offering

  • receive subscriptions from qualifying offerees; and

  • retain detailed records of all offers made, including if relevant;
    the basis of each relationship with offerees, including investor questionnaires
    and subscription agreements received from potential investors.
  • Limitations On Resale

    Securities sold in a private placement are not freely transferable,
    meaning they are subject to restrictions on their resale for a period of time
    (typically two years), subject to specified exceptions. There are four general
    implications to this limitation as follows:

  • When identifying offerees, the issuer must ensure that such
    investors are purchasing the securities for their own account and not with the
    intent to distribute the securities to other parties. If an investor were to
    purchase securities with a view to distribution, the validity of the offering as
    a private placement would be jeopardized and the investor would likely have
    potential liability under federal securities laws as an underwriter. If the
    validity of the offering as a private placement were questioned, there could be
    an SEC enforcement action and investors might be entitled to a rescission, or
    put, right based on the original purchase price of the securities.

  • In the subscription documents for the offering, the issuer typically
    receives a representation from the investor regarding the matters described

  • Any subsequent resales of privately placed securities must either be
    registered under the Securities Act or qualify for an exemption from the
    registration requirements.

  • The offering documents must disclose the private placement nature of
    the offering and the limitations on resale.
  • Although not required by securities laws, additional transfer restrictions
    such as a right of first refusal or co-sale rights also may be incorporated into
    the issuer's offering documents in a private placement (such as a partnership
    agreement or operating agreement) to reflect the terms of an issuer's business
    arrangements with its investors.

    Integration Issues

    Integration is a doctrine applied under the Securities Act pursuant to
    which two or more ostensibly separate securities offerings are viewed as a
    single offering for purposes of determining whether an exemption from the
    registration requirements is available. Thus, a private placement that otherwise
    would be exempt from registration could cease to meet the requirements for such
    exemption when integrated with another private placement or a registered public
    offering, which would result in a violation of Section 5 of the Securities Act.
    A safe harbor exists under Rule 502 of the Securities Act for Regulation D
    offerings that are conducted at least six months apart, meaning they will not be
    viewed as integrated. An issuer considering multiple offerings within a six
    month period, however, should discuss with counsel the implications of such an
    arrangement to ensure that a valid private placement is achieved and

    SEC Notice Requirements

    The issuer must also make a filing with the SEC within 15 days following
    the first sale of securities that rely on the Regulation D exemption from the

    Typical Documentation

    We summarize below the typical documents used by a private fund in a
    private placement of its own securities.

    Subscription Documents

  • investor questionnaire - provides the issuer with information about
    the investor to ensure both a valid private placement and compliance with other
    relevant laws and regulations; and

  • subscription agreement - constitutes a binding agreement of the
    offeree to purchase a certain amount of securities from the issuer and contains
    representations and warranties to, among other things, ensure a valid private
    placement and compliance with other relevant laws and regulations.
  • Private Placement Memorandum

    Typically includes the following types of disclosure:

  • business description - business plan and use of proceeds from the

  • issuer/management background - information regarding experience,
    track record and prior performance;

  • risk factors - details all material risks of the investment;

  • terms of the offering - details costs of investing, size of
    offering, rights of investors, etc.;

  • a summary of the tax and other legal and regulatory implications for

  • related party transactions - summary of any possible conflicts of
    interest between the issuers, management and other affiliates; and

  • legends and other disclosure - includes language regarding transfer
    restrictions and other disclaimers necessary for a valid private placement.
  • Partnership Agreement or Operating Agreement

    Governs the terms of the relationship between the issuer and investors
    including, to the extent applicable:

  • capital calls and capital contributions;

  • distributions;

  • fees and expenses;

  • restrictions on transfer of interests;

  • allocations of profits and losses for tax purposes;

  • events of default; and

  • authority and liability of general partner or sponsor.
  • Management, Advisory or Other Ancillary Documents

  • management or advisory agreements - used when third parties advise
    the issuer or manage the issuer's assets or investments; and

  • side letters - used when significant investors negotiate specific
    terms with the issuer which are, or may be, different from those applicable to
    other investors.
  • Stephen Culhane is a Partner in the Private Equity &
    Investment Funds practice group of King & Spalding's New York Office. He can
    be reached at (212) 827-4361. Alexander A. Gendzier is a Partner in the
    Corporate Finance practice group of King & Spalding's New York Office. He
    can be reached at (212) 556-2325.

    Please email the authors at or with
    questions about this