General Solicitation and General Advertising in Regulation D

Joseph W. Bartlett, Founder of VC

Changing Rules; defacto if not yet de jure

An article last Summer in The Daily Deal contains a piece by Ron Oral, [1] pointing out a set of facts which have been well known to experienced practitioners in private equity ... but have rarely surfaced in the public press or, for that matter, the trade papers. The phenomenon noted is the de facto relaxation by the Securities and Exchange Commission of the ban on 'general solicitation' and 'general advertising' in Regulation D, the most prominent and (almost) exclusively relied-on exception from the registration requirements of Section 5 of the `33 Act. The SEC's silent move ... exemplified by the notable absence of enforcement proceedings brought by the Agency, despite the myriad examples in recent years of private placements which are clearly "generally solicited" ... dates back a number of years. I first noted the issue in 1988, when I began remarking that, given the ban on general solicitation, we were in the midst of what I called overdramatically called a 'crime wave:' [2]

The Oral piece in The Deal carries forward the central thesis ... that there is some sort of entente cordiale between the industry (the professional advisers, the issuers, the investors and their agents) and the SEC to the effect that, in the absence of fraud, general solicitation either is now, or is on its way to becoming, a dead letter. As The Deal article states:

"Enter the SEC's corporate finance division, which is set to start developing new rules easing these restrictions, although an agency spokesman says the commission has not yet begun drafting a proposal.

"This effort at deregulation, which includes other revisions making it easier for corporations to tap the capital markets, is part of the SEC's broader move to relax landmark securities rules adopted during the 1930s. But this campaign has been afoot for years. In the late 1990s the agency tried to overhaul securities law with a rules package so massive it was dubbed the 'aircraft carrier.' It sank like an overloaded vessel.

"Former corporate finance division chief Brian Lane, who devised the proposals borne by the aircraft carrier, says its time to update the 60-year-old private placement rules. He says there is no harm in permitting 'general solicitations,' which might disclose a placement to investors who do not meet the financial requirements to participate in the transaction.

"'As long as you only sold to sophisticated investors, who cares if a hot dog vendor sees the advertisement,' he says."

The problem, of course, is that the law has not officially changed; therefore, for those of us who read the rules as written on the books (versus how we think they ought to be ... or indeed even how we think they are being interpreted by the Agency Staff), it is difficult to give Securities Act opinions in instances where general solicitation has clearly been violated and the Section 4(2) exemption is (as one party to a recent transaction in which I was involved stated), "not opinable."

In fact, according to the most experienced SEC practitioner I have ever known, Ed Fleischman, the SEC is allowing the ban on general solicitation to be "regulated by opinion," meaning that whatever restraints exist, such as they are, are enforced by the opinion practices of the major law firms refusing, in egregious cases at least, to opine that the offering is an exempt placement. This is not, of course, a desirable state of the law ... counsel compelled, if punctilious, to give advice without business logic in the sense, that, if the client were to act contrary to the advice, the chances of adverse consequences are remote.

Does a "Cooling Off" Period Work?

Parenthetically, Ed gave me an extremely valuable tip on the question whether, if a press release or speech at a seminar amounts to "general solicitation," and the opinion was in doubt, a cooling off period (suspending the offering) could rehabilitate the same. My views, as helped by Ed, are as follows:

As the Gerstenfeld No-Action Letter [3] phrased, the primary issue of "general solicitation" in terms of whether "the syndication expects in the near future to offer and sell securities." (Emphasis supplied.) See also H.B. Shaine [4] ("sufficient time" between the all-comers screening ... allowed as a preliminary step ... and the submission of the investment opportunity to those screened). In connection with the "cooling off period," it is relevant (although not decisive) that administrative attitudes towards "cooling off" have themselves, "cooled off" (pardon the pun) significantly in recent years. In the 1962 Release on integration, the "cooling off period" was ... and is, as adopted in 1982 in Reg. D, Rule 502(a) ... six months; [5] the generally accepted "cooling off period" between solicitation by the broker by virtue of "screening" before sending a placement to prospects with whom the backer has a "pre-existing substantial relationship" was, in my view, 45 days and now appears to be 30 days; [6] the conventional cooling off period between a busted public placement and the resumption of a private placement [7] was, pre Rule 155(c), 60 days, a period cooked up (as far as I am aware) by Stanley Keller of Palmer Dodge ... it has now has been reduced by Commission Rule 155(c) to 30 calendar days; the cooling off period between "testing the waters" in Regulation A and beginning the solicitation is 20 days. In short, there has clearly been, over time, a loosening of the timing restrictions, by custom and administrative rule, driven by re-evaluations by the administrative agency in charge, the SEC, of changing circumstances. None of the SEC's pronouncements, to be sure, directly pertain to a placement contaminated by "general solicitation" and not otherwise covered by the protective shield of a rule or no-action positions arguably amounting to a Rule. But, as evidence of the Agency's general attitudes on the issue of "conditioning the market," the consistent trend cannot be ignored.

The short of the matter is that there appears to be little doubt that an appropriate "cooling off" period has now been recognized as a therapeutic; in every context in which timing has been addressed, "general solicitation" fades to non-'general solicitation" after some period of time ... it is not a permanent blemish. To be sure, Reg. D has not been formally amended. And the 1963 Release can be read, technically, as suggesting that only two disparate placements can be disaggregated ... not one continuous placement. Thus, one can argue that one instance of "general solicitation" during an extended placement period taints the placement indefinitely; it (if the same placement) can never be resuscitated. To accept that contention, however, one would have to ignore the latest pronouncement (more official than a "no action" letter) of the SEC Staff on the subject. Let me quote from the Staff Report to the Commission, September 2003. Implications of the Growth of Hedge Funds (herein the "Staff Report"):

"We also have concerns about the proliferation of public information about hedge funds that has accompanied the growth of the hedge fund industry. We believe that questions exist whether some participants in the hedge fund industry may not be complying with the prohibition on general solicitation and general advertising in privately offering and selling the hedge fund securities. As discussed above, as a condition to the availability of the safe harbor of Rule 506, hedge funds may not engage in any form of general solicitation or general advertising in finding investors. [8] The hedge fund has the burden of proving the availability of the exemption from registration. If the hedge fund, its adviser or other persons acting on its behalf uses general solicitation or general advertising to sell the hedge fund interests, the hedge fund will not be able to rely on the safe harbor.

"Current marketing practices by some hedge fund advisers raise questions as to whether the hedge fund is engaging in general solicitation or general advertising. For example, information contained in newsletter, press articles , and even institutional reporting services about specific hedge fund raises concerns about whether the hedge fund is engaged in a general solicitation or general advertising if that information is provided by the hedge fund's adviser or at their behest." [9] .

The staff, after considering whether to exempt Section 3(c)(7) funds entirely from the "general solicitation" prohibition (and answering 'yes' on Section 3(c)(7) and 'no' on Section 3(c)(1)), went on to say:

"The Commission has requested comment in various rulemakings as to whether the restrictions on general solicitation should be relaxed as to certain types of offerings or certain types of investors. See, e.g., The Regulation of Securities Offerings, Securities Act Release No. 7606A (Nov.13, 1998); Securities Act Concepts and their Effects on Capital Formation , Securities Act Release No. 7314 (July 25, 1996); Exception for Certain California Limited Issues, Securities Act Release No. 7285 (May 1, 1996); Exemptions for Certain California Limited Issues, Securities Act Release No. 7185). To date, the Commission has not adopted proposals to relax general solicitation or general advertising restrictions. The Commission and the staff have, however, recognized that a shorter time frame, 30 days, between the end of activities that may be considered general solicitation or general advertising and the commencement of an offering may be sufficient to eliminate a concern that investors in the subsequently commenced private offering were found by means of general solicitation or general advertising. See e.g., Integration of Abandoned Offerings , Securities Act Release No. 7943 (Jan. 26, 2001)." .

To be sure, one might say, " may be sufficient ..." and , one might argue that the formal subject of the Release cited deals with a different set of facts and a different context (a busted public placement, followed by a private placement). However, note the context of the remarks in the Staff Report: (i) continuous placements by hedge funds ... all one placement; and (ii) use of "press articles ... media reports," which amount to "general solicitation" ... i.e. a very common fact pattern. And, note, that this report purports to reflect a Commission and staff point of view. [10] Thus, on "cooling off," absent fraud or other special facts, I believe the case is closed.

Circular 230; Another Nuisance Regulation.

I continue to be concerned about creeping and witless overregulation, at least in my view, of U.S. financial transactions, including, of course, private equity. Many of the new Regs are of the 'nuisance' variety; but the cost continues to mount up. Although not a major item, the Internal Revenue Service's Circular 230 Regulations, which took effect June 21, 2005, are a typical example. According to the Circular, when a law firm provides written advice to its clients regarding federal tax issues, then depending on the nature of the advice given, written advice either (a) can be rendered in a full formal opinion based on due diligence review which discusses all the relevant tax matters or (b) contain cautionary language that the advice cannot be relied on by the taxpayer to avoid penalties. Certain types of advice ("covered opinions") must comply with the full-blown due diligence rules, such as advice in respect of listed transactions, advice the principal purpose of which is tax avoidance, or certain other advice involving tax avoidance. This latter category includes advice considered a "marketed opinion," which is an opinion written to support the marketing of transaction; certain "reliance opinions" (involving the more likely than not standard); advice subject to confidentiality agreements; and advice subject to contractual protection. However, marketed and reliance opinion status may be avoided by attaching an appropriate disclaimer (a bit like a warning on a cigarette packet).The thrust of the commentary by the tax bar is that firms, unless specifically required by clients to go through the due diligence review of all the facts and a discussion of all the relevant tax issues, or unless giving advice which is unavoidably a covered opinion, will simply add the required disclaimer language ( e.g. , in the case of what would otherwise be a reliance opinion, a disclaimer that the advice cannot be relied to avoid penalties). Frankly, what this bureaucratic annoyance accomplishes is approximately just that ... a annoyance. Moreover, the more serious question has to do with the Hobson's Choice affecting clients. Does one pay ... and it is likely to be expensive ... for the full blown opinion? And, if not, is the client getting any meaningful protection, given the disclaimer?

[1] Oral, "Tongue Untied," The Deal , Jul.25-Aug.7, 2005, p. 17.

[2] Bartlett, Venture Capital (Wiley, 1988).

[3] SEC No-Action Letter (Dec. 3, 1985).

[4] SEC No-Action Letter (March 31, 1987).

[5] The 6 months period is not decisive if one is dealing with one complete offering and not two.

[6] To be sure, the purpose stated of a "cooling off" period in this context is to confirm that the investor/broker relationship is "pre-existing."

[7] Again, usually an offering on different terms, although for the same purpose.

[8] See supra , Part III.B (discussing hedge funds and the Securities Act). See also Roundtable Transcript, May 14 (statement of Alan Beller) ("You can't put up a billboard on Times Square and say, 'We have a new hedge fund but please understand that unless you are an accredited investor, don't call.'").

[9] The Staff has found numerous media reports quoting hedge fund advisory personnel discussing the "rollout" of new hedge funds.

[10] `33 Act Rel. No. 7943 (Jan. 26, 2001) is the Release adopting Rule 155. The only material I find of relevance in that Release is the following comment:

"The 30-day waiting period is designed to reduce concerns regarding the validity of the issuer's claimed reliance on a private offering exemption. The 30-day waiting period, together with the disclosure applicable to offerees in the private offering, should assure that investors do not confuse the investment decision they are making in the private offering with the decision that they previously considered in the registered offering."

In this article, references to private equity funds means buyout and venture, not hedge, funds; hedge funds will be separately identified.

Mike Halloran, who writes on these subjects as prolifically as I, was good enough to comment that, in his view, the SEC intervention is far off. Given the slow down (driven by Enronitis preoccupation) by the SEC in other areas ... "general solicitation" and "finders" as broker/dealers, I will not quarrel with Mike's thesis.

The term MFN ("most favored nation") is used, variously, to describe an LP/investor which negotiates a genuine MFN letter ... "I get as much as anyone else" ... or simply to refer to the beneficiary of a side letter.

See Dec. 2004 Private Equity Bulletin: "The GP's Fiduciary Duty Can Now Be Eliminated in Delaware Limited Partnerships, We Think." If the penalty is a forced secondary sale at a discounted price, maybe to an MFN LP, there may be no disclosure.