Strictly Business is a business law blog for entrepreneurs, startups, venture capital, and the private fund industry. The author is Alexander J. Davie, an attorney at Riggs Davie PLC based in Nashville, Tennessee. His practice focuses on corporate, securities, and business law.
The vast majority of private companies raising capital use Rule 506 of Regulation D, which, if complied with, ensures the securities being sold are exempt from registration with the Securities and Exchange Commission (SEC) because the offering of these securities does not involve “any public offering.” One of the primary advantages of a Rule 506 offering is that it is considered an offering of “covered securities,” which means that individual states cannot require issuers who meet the conditions of Rule 506 to register their offerings at the state level. By granting covered security status to Rule 506 offerings, Congress greatly reduced the compliance costs of companies raising private capital who would otherwise have to comply with the unique registration or exemption requirements of each state where one of their investors happened to live.
Although states are not permitted to require issuers in Rule 506 offerings to register with state authorities, states can require notice filings substantially similar to the Form D notice filing required to be filed with the SEC within 15 days after the first sale of securities within the state. Some states do not require a filing but most require a copy of Form D, a consent to service of process, and a fee. However, New York takes a different approach.
New York’s state securities statute, also known as the “Martin Act,” is unique among all other state securities statutes in that it generally does not regulate securities offerings but instead requires some issuers to be registered as “dealers” in their own securities. For issuers using Rule 506, in addition to filing a copy of Form D, New York requires Rule 506 issuers to file a state-specific form called “Form 99” with the Investor Protection Bureau of the Attorney General’s office before selling its securities to New York investors. Additionally, whereas most states require a $200-300 fee in connection with the notice filing or no fee at all, New York requires private companies to pay $1,200 if the proposed offering could exceed $500,000. The form is also more complicated than the notice filings required by other states, thus causing the issuer to incur more legal costs.
Given that Congress created the “covered security” status to prevent states from “reconstruct[ing] in a different form the regulatory regime for covered securities that Section 18 has preempted,” many securities law practitioners and the issuers they advise take the position that New York’s Form 99 requirement conflicts with federal law and is thus preempted. In fact, the New York State Bar Association has published a position paper advancing this view. The position paper also made other legal arguments that the Martin Act itself would exclude any offerings that are exempt under Rule 506 because the Martin Act only covers offerings of securities “to the public.” Many securities law practitioners advise their clients that it is acceptable to take the positions advanced in the position paper when you have New York investors; however, the arguments have never been tested in court and the New York Attorney General’s office declined to amend its filing requirements in response to the position paper.
Another big difference between the Martin Act and the securities laws of all of the other states is the inability of investors to bring private lawsuits for securities law violations. In most states, investors can sue the company and its management to enforce its state securities laws. This is one of the reasons advisors to securities issuers encourage strict adherence to state requirements. Disgruntled investors can use lack of compliance to bring a claim for rescission (i.e. receive their money back) against the issuer and its officers, directors, and owners personally. Investors in New York, on the other hand, do not have a private right of action under the Martin Act, so failing to file Form 99 alone would not, in itself, allow investors to bring a claim. Therefore, the risk to a company that fails to adhere to New York’s unique – and arguably invalid – filing requirements is lower.
Under the Martin Act, New York’s Attorney General has the power to conduct investigations, seek injunctive relief (i.e. stop an offering from moving forward) or restitution, or even to criminally indict persons for securities violations. To my knowledge, New York has never brought criminal charges for failing to file a Form 99 in New York, and, in my view, it is extremely unlikely it would do so given the arguments for federal preemption of the Form 99 requirement.
In the end, each issuer must make its own calculation whether it wants to go through the added expense of complying with New York’s filing requirements. There are strong legal arguments that the filing requirements are invalid. Failing to file Form 99 alone should not result in liability to your New York investors. There is also a very low possibility that New York’s Attorney General will bring an enforcement action against you solely for opting not to file the form, although if there are other circumstances placing you on the state’s radar, they may require these filings as part of an ongoing enforcement action. Many issuers decide that the low risk of adverse consequences combined with the strong argument that New York’s filing requirements are preempted by federal law are enough for them to forgo the filings. Others, out of an abundance of caution, take the opposite view and file because even the possibility of having to litigate against the attorney-general outweighs the cost of filing.
Companies considering conducting an offering in New York should make their decision on the best approach for them only after consulting their securities counsel.
At some point while raising capital for a private fund, you will likely be asked by one or more potential investors to enter into a side letter. A side letter is an agreement between the fund and one particular investor to vary the terms of the limited partnership agreement with respect to that particular investor (almost always to the benefit of the investor).
Sometimes these side letters are borne of necessity for the investor to enter into the fund, either due to regulatory requirements or to commitments it has to other parties (such as its own investors). Other times these side letters are the result of the investor trying to negotiate a better deal for itself. Not all investors are created equal and some have the leverage to demand side letters with certain terms, while others do not.
Whether it makes financial sense for a fund to consent to a request for a side letter is ultimately a business decision, but it is important to understand the legal considerations that arise in connection with such a request. Agreeing to some types of side letters carry the risk of litigation from the other investors or enforcement actions by securities regulators.
Common Side Letter Requests
The most common side letter request is for a partial or complete waiver of the fund manager’s fees (either the management fee, performance fee/carried interest, or both) for the investor requesting the side letter. Another common request is for a relaxation of the lock-up requirements for the investor, which give that investor the right to withdraw his or her funds at an earlier date than other investors. Other side letter requests might include granting more access to the investor to information about the fund. Finally, some investors may want “Most Favored Nation” (MFN) clauses which essentially give those investors the right to obtain any benefit bestowed on other investors via a side letter.
Legal Risks of Side Letters for Fund Managers
For many fund managers, especially those early in their careers, obtaining capital and new investors is the biggest challenge, and so the temptation is great to accede to side letter requests from investors that are willing make a large investment in the fund. This can be especially true when the investor is demanding the side letter just prior to closing and may have the fund managers over a proverbial barrel. There are several risks that should be kept in mind when negotiating and drawing up such agreements.
First, it is important to understand that, once a side letter has been entered into, the fund manager now has two potentially competing sets of obligations: its obligations to all limited partners under the limited partnership agreement and its obligations to the particular limited partner via the side letter. Generally, in the case of a conflict, the provisions of the side letter govern. Often, a fund manager is perfectly able to balance these concerns. For example, in the case where a manager waives its fee with respect to a particular investor, there is generally no significant issue, because that fee waiver doesn’t negatively impact the other investors. The fund manager can charge the fee disclosed in the private placement memorandum and limited partnership agreement to the other investors, while also waiving that fee with respect to the investor that requested the waiver.
However, other common side letter arrangements do cause potential legal issues for fund managers. For example, allowing an investor with a side letter to exit the fund early could cause the fund manager to face a claim for breach of its fiduciary duty to the other investors, because they could claim that they were harmed by the side letter. In a situation where the fund is unable to meet all of the requested redemptions, the investors that do not have a side letter allowing for an early withdrawal are at a disadvantage, because the investors that do have such a side letter may have drained the liquidity from the fund by the time the other investors are eligible to request a redemption.
Likewise, side letters that grant a particular investor additional information the other investors are not privy to may be appropriate in certain circumstances. However, if the additional access to information can be used by the investor to determine when they should make a redemption request, then such rights may disadvantage the other investors, leading to litigation by those other investors later.
In addition, the Securities Exchange Commission and state securities regulators could and often do bring claims against fund managers based on the same concerns. They may argue that the fund manager failed to fulfill disclosure and transparency requirements by not adequately notifying prospective and existing investors of the side letter obligations or that fiduciary duties owed to the investors were violated when the fund manager agreed to a side letter with an investor that disadvantaged the other investors.
Best Practices in Entering into Side Letters
While fund managers may face an enormous temptation to grant side letter requests, they should exercise due consideration and care in what requests they grant and how they grant them.
The fund’s limited partnership agreement and private placement memorandum should include language that alerts investors to the possibility that the fund many grant side letter requests to particular investors.
Fund managers should also make sure that they don’t enter into any oral side letters. All agreements to vary the terms of the limited partnership agreement should be in writing. Often the investors requesting the side letter will insist on this anyway, but it’s important for fund managers not to make promises loosely.
When assessing each side letter request, the most important concern for fund managers is to determine whether the terms of the proposed side letter impact their fiduciary duties to other investors. This determination should be made in consultation with the fund’s legal counsel. When the terms of the side letter do not impact other investors, they may often be entered into without disclosing the terms to other investors. When other investors are impacted, it’s possible that the disclosure of the terms of the side letter to the other investors may be sufficient to address such concerns. More often, the fund manager should seek the consent of the other investors to the arrangement or not enter into such arrangement at all.
In addition, careful attention must be given to fund managers to what other obligations are triggered by entering into side letters. For example, those other investors with MFN status may need to be promptly informed of a side letter and offered the same benefits.
By working with fund legal counsel to draft and negotiate side letters that are in accordance with the limited partnership agreement, fiduciary duties, disclosure requirements, and other legal concerns, a fund manager can limit the potential for a side letter to cause problems later down the road.