Bipartisan congressional actions may encourage capital raising and smaller investment funds

May 29, 2018

Securities Law Alert

Author(s): Kelly D. Babson, John C. Partigan

The Economic Growth, Regulatory Relief, and Consumer Protection Act was recently signed into law by President Trump. This alert discusses key securities and fund-related provisions that businesses and investment fund managers need to know.

On May 22, 2018, the U.S. Congress passed Senate bill S.2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Act”), which largely centered on various measures and reforms intended to reduce a number of the regulatory burdens on financial institutions imposed under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). The Act was signed into law by President Trump on May 24. In addition to the banking-related provisions, the Act amends, or directs the Securities and Exchange Commission (the “SEC”) to amend, various rules and regulations to broaden the scope of exemptions to the registration requirements of the Securities Act of 1933 (the “Securities Act”) provided for certain types of securities offerings. Section V of the Act also amends the Investment Company Act of 1940 (the “Investment Company Act”) to expand certain exemptions under the Investment Company Act and to close a loophole for U.S. overseas territories. The Act also loosens certain restrictions under the Volcker Rule. Key securities and fund-related provisions are highlighted below:

Expansion of Rule 701 exemption for employer securities

Section 507 of the Act directs the SEC to amend Rule 701(e) to increase the threshold for requiring additional disclosures under Rule 701 from $5 million to $10 million and to index that amount for inflation every five years thereafter. The additional disclosures required for certain offerings under Rule 701(e) include the delivery of (i) a summary plan description if the employer plan under which the shares are issued is an ERISA plan, (ii) risk factors associated with the investment and (iii) financial statements that must be audited, if available, and of a date not more than 180 days before the sale of securities in reliance on the exemption. Under the amended Rule 701(e), private companies offering employer securities for compensatory purposes to their employees, directors, officers, consultants and other qualified participants would not be required to provide as a condition to the exemption the additional disclosures unless the aggregate sales price or amount of securities sold during any 12-month consecutive period were in excess of $10 million. We note that the antifraud rules would continue to apply to the sale of securities that do not exceed the threshold under the amended Rule 701(e). The SEC was directed to amend Rule 701(e) within 60 days after the date of enactment of the Act.

Expansion of the definition of “Covered Securities” to all NMS securities

Under Section 501 of the Act, Section 18(b)(1) of the Securities Act was amended to more equitably apply the exemption from state regulation of securities offerings to all national securities exchanges. Covered securities, which are exempt from state law securities regulation requirements under Section 18, now include all securities designated as qualified for trading on the National Market System.

Expansion of Regulation A/A+ eligibility to Exchange Act reporting issuers

Section 508 of the Act directs the SEC to amend Regulation A under the Securities Act to (i) remove the requirement that the issuer in an offering of eligible securities under the registration exemption provided under Regulation A not be subject to the reporting requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), immediately prior to the offering and (ii) provide that such an Exchange Act reporting issuer that satisfies the reporting requirements of Section 13 will be deemed to have satisfied the periodic and current reporting requirements of Regulation A.

Regulation A eligible issuers must be organized and have their principal place of business in the United States or Canada, and may not be “blank check” companies, investment companies or entities issuing fractional undivided interests in oil and gas rights or similar interests in other mineral rights. Additionally, issuers that have failed to file the reports required to be filed under Regulation A with the SEC during the two years preceding filing of an offering statement (or such shorter period as the issuer has been required to file such reports); issuers that have been subject to an SEC order suspending, denying or revoking registration pursuant to Section 12(j) of the Exchange Act within the five years preceding the current offering; and “bad actors” are also ineligible to use the exemption. Additional information about Regulation A, as amended in March 2015, is available here. These other eligibility requirements under Regulation A continue to apply.

Upon adoption of these amendments to Regulation A, Exchange Act reporting companies thus will be eligible to conduct offerings under the Regulation A safe harbor, subject to the conditions and limitations specified under that exemption, but would not as a result be required to separately prepare and file additional periodic reports otherwise required of issuers that have issued and sold securities under Regulation A.

Investment Company Act exemption for small venture capital funds

The Investment Company Act requires certain entities, including investment funds, to register with the SEC and file periodic reports unless an exception from the definition of investment company applies. The vast majority of private investment funds are excepted under one of two exceptions—the “3(c)(1)” exception, which excepts funds with 100 or fewer beneficial owners, and the “3(c)(7)” exception, which excepts funds that sell their securities only to qualified purchasers. The Act expands the 3(c)(1) exemption to permit a “qualifying venture capital fund” to have up to 250 beneficial owners, which may encourage investments in incubators and angel funds. This exemption is effective immediately.

For these purposes, a qualifying venture capital fund is a venture capital fund, as defined under the Investment Advisers Act of 1940 (the “Advisers Act”), with $10 million or less of capital contributions and uncalled capital commitments. A venture capital fund is a private investment fund that:

  • holds itself out to have a venture capital strategy;
  • holds no more than 20% of its capital contributions and uncalled capital commitments in assets that are not “qualifying investments,” which generally includes equity securities issued directly by the portfolio company to the fund;
  • does not borrow or incur leverage in excess of 15% of the fund’s aggregate capital contributions and uncalled capital commitments, subject to limited exceptions;
  • only issues securities that do not permit redemptions, repurchases or withdrawals except under extraordinary circumstances; and
  • are not registered under the Investment Company Act and has not elected to be treated as a business development company, or BDC.

Furthermore, we note that while qualifying venture capital funds are now exempted from the Investment Company Act, its manager would still be subject to investment adviser laws. At the federal level, a manager that advises only venture capital funds may qualify for the “venture capital fund adviser” exemption, which exempts the adviser from many provisions of the Advisers Act but still requires the adviser to file portions of Form ADV to perfect the exemption. Smaller venture capital managers, however, may be subject to state registration regimes rather than the federal registration regime, and not all states have an exemption similar to the venture capital fund adviser exemption. Further, while some states with the exemption merely cross-reference the federal exemption, others do not and would need to revise their own laws to increase the investor limit from 100 to 250 to harmonize with federal law.

Expansion of Investment Company Act to companies from overseas territories

The Investment Company Act previously exempted companies organized under, and having a principal place of business in, Puerto Rico or any other U.S. overseas territory, so long as its securities are not sold in any other state. The Act eliminates this exemption and gives companies that relied on this exemption three years to become compliant. This could have an impact on a number of entities. For example, investment funds (other than qualifying venture capital funds) and certain CLO issuers with over 100 beneficial owners may need to liquidate or find other solutions to get down to the 100 beneficial owner limit under 3(c)(1).

Where this could be particularly problematic, however, is for inadvertent investment companies. Any company, even if its primary stated business is not making investments, is an investment company for purposes of the Investment Company Act if it owns or proposes to acquire investment securities having a value exceeding 40% of its total assets, net of government securities and cash items, on a consolidated basis. “Investment securities” includes nearly all securities except government securities and majority-owned subsidiaries that are not themselves investment companies. Puerto Rican holding companies that have 40% of their assets tied up in non-majority owned companies may need to plan ahead to either divest or acquire assets to avoid investment company registration requirements.

Loosening of Volcker Rule restrictions

The Act made two small but important changes to Section 619 of Dodd-Frank, more commonly known as the Volcker Rule, which prohibits banks and certain other financial institutions from most proprietary trading and ownership of interests in most private investment funds. First, the Act exempts community banks from the Volcker Rule entirely. For these purposes, a community bank is an institution with less than $10,000,000,000 in total consolidated assets and whose total trading assets and trading liabilities, as reported on the most recent applicable regulatory filing filed by the institution, are not more than five percent of total consolidated assets. Such an institution would not be a community bank if it is controlled by an institution that does not meet those qualifications. Second, the Act revises the naming requirements of the Volcker Rule. An investment adviser owned by an institution subject to the Volcker Rule has not been permitted to include its name in the name of a fund it advises. These advisers are now permitted to do so for hedge funds and private equity funds, so long as (a) the adviser itself is not an insured depository institution, a company that controls an insured depository institution or a company that is treated as a bank holding company; (b) the investment adviser does not share the same name or a variation thereof with an insured depository institution, any company that controls an insured depository institution or any company that is treated as a bank holding company; and (c) the name of the fund does not include the word “bank.” While the changes to the Volcker Rule do not go nearly as far as many had hoped (such as carving out strategies that are less subject to systematic risk, such as private equity), it is still a step in the right direction.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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