Hedge funds are typically structured as private placements in order to avoid registering their interests under the Securities Act of 1933 (“Securities Act”). In particular, Section 4(2) of the Securities Act exempts from registration transactions not involving any public offering. However, the availability of the Section 4(2) exemption is subjective and, at times, ambiguous. To better clarify the availability of the Section 4(2) exemption, the Securities and Exchange Commission (“SEC”) adopted Regulation D (“Reg D”), a collection of certain safe harbor exemptions from registration of private offerings that effectively serve as the backbone of the “private placement exemption.”
Reg D provides three alternative safe harbors in Rules 504, 505, and 506; however, Rule 506 is generally the most relevant exemption for private funds, as it allows funds to offer securities without regard to the dollar amount of the offering. Below is a brief description of Rules 501 through 506.
Rule 501 – Definitions and Terms Used in Regulation D
Rule 501 provides definitions of certain terms found in Rules 502 to 508, most notably the definition of an “accredited investor.”
Rule 502 – General Conditions to Be Met
Rule 502 details the conditions private funds must meet to qualify for a Reg D exemption, including integration issues, information requirements and limitations on resale. However, the most relevant condition for fund managers is typically the limitation on the manner of the offering, which prohibits any form of general solicitation or general advertising of the underlying securities. The solicitation and advertising restrictions are an integral aspect of all Reg D offerings, and should be discussed in detail with a qualified hedge fund attorney prior to marketing the fund.
Rule 503 – Filing of Notice of Sales
Rule 503 requires a private fund relying on Reg D to file a notice of sale on Form D with the SEC within fifteen days after the first sale of an interest in the fund. Although states cannot require a private fund to register its Rule 506 offering with them, states can require notice filings (typically a copy of Form D) and associated filing fees under applicable Blue Sky laws.
Rule 504 – Exemption for Limited Offers and Sales of Securities Not Exceeding $1,000,000
Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities over any 12-month period. Rule 504 applies primarily to certain intrastate offerings.
Rule 505 – Exemption for Limited Offers and Sales of Securities Not Exceeding $5,000,000
Rule 505 provides an exemption for the offer and sale of up to $5,000,000 of securities over any 12-month period. Issuers may sell securities to an unlimited number of accredited investors plus no more than 35 non-accredited investors.
Rule 506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering
Rule 506 provides an exemption for the offer and sale of securities without regard to the dollar amount of the offering. For this reason, the vast majority of hedge funds and private equity funds rely on the Rule 506 exemption from registration. Rule 506 is similar to Rule 505 in that funds may issue securities to an unlimited number of accredited investors and up to 35 non-accredited investors. Often referred to as the “sophistication” element, Rule 506 requires non-accredited investors to have “such knowledge and experience in financial and business matters that [they are] capable of evaluating the merits and risks of the prospective investment.”
Please contact us for a free consultation if you have any questions regarding Regulation D or starting a fund in general.