The recent economic downturn has caused a number of investors in private equity funds to experience liquidity crunches and to either default or consider defaulting on their capital commitment to the funds. Among other options, a fund manager[1] may consider providing assistance to such investors in selling their interests because doing so may reduce the loss of committed capital, or prevent delays in calling capital, while at the same time preserving goodwill and the manager’s continued relationship with such investors. 

This article examines certain fiduciary, regulatory, legal, tax and other issues that a manager of a private equity fund should consider in connection with providing such assistance to a defaulting or near-defaulting investor seeking to transfer its interest in the fund.[2]

Fiduciary and Compliance Considerations

In considering whether to assist investors that have already defaulted and investors that are in the “zone” of default but have not yet defaulted, a manager needs to take into account the fiduciary duties that it owes to all the investors in the fund. Although Delaware (often the preferred jurisdiction of organization for private funds) allows a contractual modification or waiver of fiduciary obligations, a manager cannot opt out of the fiduciary duties of good faith and fair dealing. Consequently, a manager must act fairly and may not put its interests, or the interests of certain investors, before that of all investors.

With respect to an investor that has already defaulted, it is important that, at the outset, the manager examine the fund documents, including any side letters, to determine whether the manager is obligated to take certain actions vis-à-vis a defaulting investor, or whether the manager has the right, but not the obligation, to enforce one or more specified or other remedies against such defaulting investor. Oftentimes, the fund documents afford the manager great flexibility in deciding which remedies to apply, and provide that such remedies are cumulative and non-exclusive, in which case the manager should be able to assist a defaulting investor in selling its interest.

With respect to an investor that is in the “zone” of default but has not yet defaulted, although the manager need not be concerned with the applicability of default remedies, the manager nonetheless should ensure that assisting such investor in selling its interest is not prohibited under the fund documents. The manager must, in either case, conclude that its course of action is consistent with the proper discharge of its fiduciary duties and that assisting an investor with selling its interest is neither self-interested nor against the overall interest of the investors.[3]

The manager should understand that whatever actions or measures it takes will likely set a precedent against which the application of future remedies may be assessed. Although the manager has the ability to treat investors differently, it has a responsibility to do so on a reasonable basis that is consistent with its fiduciary duties. Moreover, the manager should be mindful of the most-favored-nation clauses often found in side letters, in respect of which the beneficiary may assert a claim in connection with its own default. Finally, the manager should confirm that its actions do not contravene the confidentiality provisions of the fund documents, particularly as they relate to disclosure of fund information to potential buyers.

Securities Act of 1933

A secondary sale must be registered under Section 5 of the Securities Act of 1933, as amended (the “Securities Act”), unless an exemption applies.[4] Under Section 4(1), a prospective seller is exempt from the registration requirements of Section 5 where the seller is not an issuer, dealer or underwriter.[5] Assuming that the seller is not an issuer or dealer, in order to be exempt from registration under Section 4(1), the seller must also not fall under the Section 2(a)(11) definition of underwriter,[6] or generally, the seller must not be deemed to have purchased the securities with a view to distribute them. 

Accordingly, the question is under what circumstances can a seller involved in a secondary sale avoid underwriter status. Rule 144 under the Securities Act provides protection from underwriter status where the seller, based on its affiliation with the issuer, complies with certain conditions, including a holding period. However, even where such holding period and other conditions are not met, a secondary sale to a purchaser to whom the issuer could have made a direct sale under Section 4(2) (issuer transactions not involving any public offering) may not require registration. Some courts have argued that, because the term “distribution” is generally considered synonymous to a public offering, a private resale is not a “distribution” and, as such, the seller involved is not an “underwriter.” 

Ultimately, although some of the pronouncements of the Securities and Exchange Commission (“SEC”) have been inconsistent (on some occasions, indicating that such private resales are exempt from registration in reliance upon the Section 4(2) exemption, and, on other occasions, supporting the Section 4(1) basis for such private resales, stating that Section 4(2) provides an exemption only for the issuer[7]), most SEC staff letters permit private resales based on the intent and theories of both Securities Act sections, now commonly referred to as the Section 4(1 1/2) exemption.[8]

Under the Section 4(1 1/2) exemption, private sales by persons other than issuers can be exempt from the registration requirements of Section 5, so long as the sales are similar to the private sales by issuers allowed pursuant to Section 4(2). Although the SEC has recognized this exemption, it has not provided specifics as to the extent and manner of similarity required. However, the general view is that no registration is required where the prospective seller ensures that there is no general solicitation or advertising, the sale is targeted at only a small number of sophisticated prospective buyers, and the prospective buyers are provided with a proper disclosure statement that sets forth the material facts and risks associated with an investment in the fund, including disclosure as to the restricted nature of the securities offered. It is good practice for the manager to require that the secondary purchaser provide the same representations as the initial investor in the fund (e.g., that it is an accredited investor, and, with respect to a 3(c)(7) fund, that it is a qualified purchaser). 

In addition, pursuant to Rule 502(d), an issuer of securities must exercise reasonable care to ensure that the purchasers of its interests are not underwriters.[9] Rule 502 provides examples of certain actions that would demonstrate such reasonable care (reasonable inquiry that the purchaser is acquiring the interests for his own account, written disclosure to each purchaser prior to sale that the securities have not been registered under the Securities Act and cannot be resold unless they are registered under the Securities Act or unless an exemption from registration is available, and a legend on the fund documents stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities).[10] Although this provision is less relevant with respect to private equity funds for which the organizational documents generally provide that no transfers can be made without the consent of the manager, it is still advisable that managers ensure that purchasers, including any secondary purchasers, provide written assurances that they have obtained the interests for their own account and the fund documents should provide that the interests have not been registered under the Securities Act and cannot be resold unless an exemption is available. 

Note also that because most blue sky laws require that offered securities be registered or exempt from registration, managers that wish to assist investors with secondary sales should consult their counsel as to the specific exemptions available in the states in which the securities are to be privately offered.

Securities Exchange Act of 1934

Pursuant to Section 15(a)(1) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), broker-dealers may be required to register with the SEC and become subject to a variety of regulatory requirements.[11] In order to avoid these requirements, a manager needs to ensure that, in the course of assisting with any secondary sale, its actions do not cause it to fall under the definition of broker.[12] In determining whether a person can be deemed a broker, the SEC looks at a variety of factors, including whether the person received compensation for the transaction, whether the person is or has been associated with a broker or dealer[13] within the preceding 12 months, whether the person participated in important parts of the transaction, whether the person regularly engages in the business of a broker, and whether the person holds himself out as a broker. Accordingly, a manager who provides assistance to an investor in a secondary sale should take certain precautions in order to minimize the likelihood that it will be required to register as a broker.

Foremost, a manager should not receive any compensation for assisting an investor with the secondary sale. Although, arguably, the manager may receive an indirect benefit for its services (i.e., avoidance of loss from the default of an investor), such benefit is less likely to cause the manager to gain broker status where the manager does not receive direct compensation. In addition, although the manager should be able to introduce the defaulting or near-defaulting investor to prospective buyers, the manager should not participate in the negotiations or advise the prospective buyers or sellers on the related sale. Moreover, the fund documents should not provide that the manager will offer any assistance with secondary sales. Finally, the manager should keep in mind that, although a manager that provides assistance on an ad hoc basis to its investors to deal with specific situations (and at the same time, allows the fund to avoid an investor default) may fall outside the definition of broker, where it provides such services regularly, the manager will be more likely viewed as engaged in the brokerage business and, as such, required to register.

As with securities registration, managers should consult their counsel as to the relevant blue sky laws to ensure that they comply with the required broker or issuer registration requirements.

Investment Advisers Act of 1940

Section 203(b)(3) provides an exemption from registration under the Investment Advisers Act of 1940, as amended (“Advisers Act”) for an adviser who had fewer than 15 clients in the preceding 12 months, so long as the adviser does not hold itself out to the public as an investment adviser.[14] Rule 203(b)(3)-1 under the Advisers Act provides that legal entities can generally be deemed a single client if the individual investors do not receive individualized investment advice.[15] Accordingly, a non-registered investment adviser relying on the 15 client exemption must ensure that, in the course of assisting an investor with a secondary sale, it is not viewed as providing individualized investment advice, thereby requiring it to count such individual investor as a “client.” Although there is a lack of guidance on this issue, the adviser should provide assistance and take actions, if any, only in respect of the investors’ collective interests. 

It should also be noted that all advisers are subject to the anti-fraud provisions of Section 206 of the Advisers Act[16] and that Rule 206(4)-1 provides additional specific prohibitions for registered investment advisers.[17] Accordingly, to the extent a manager provides any materials to potential secondary buyers, it should confirm that the materials are not untrue or misleading.

Tax - Publicly Traded Partnerships

Private funds often are organized so they can be taxed as partnerships for U.S. income tax purposes and flow through their income and loss to their investors, without incurring an extra layer of U.S. tax.[18]   With respect to secondary sales, a general partner that desires to preserve such tax treatment needs to ensure that any transfer does not cause the fund to be treated as a publicly traded partnership (a “PTP”) taxed as a corporation, under Section 7704 of the Internal Revenue Code of 1986, as amended (the “Code”). A PTP will not be taxed as a corporation if, during each taxable year of its existence as a PTP, 90% or more of its income can be deemed “qualifying income.”[19] Qualifying income generally includes interest, dividends, real property rents, gain from the disposition of real property and other similar types of passive income and gain.

Where the income of a private fund does not qualify for the 90% exemption, in order to avoid taxation as a corporation, the fund must monitor secondary sales so that they do not cause the partnership to be treated as a PTP. A partnership will be treated as a PTP if interests in the partnership are (i) traded on an established securities market or (ii) “readily tradable” on a secondary market or substantial equivalent thereof.[20]

Because interests in private funds generally are not traded on established securities markets, the focus is whether such interests would be treated as readily tradable on a secondary or equivalent market. The relevant tax regulations promulgated under the Code (the “Treasury Regulations”) identify certain situations in which interests would be deemed “readily tradable.”[21] However, this determination generally is based on a facts-and-circumstances test – assessing whether partners are able to buy, sell or exchange their interests in the fund in a manner “comparable economically” to trading on an established securities exchange.[22]

Although the determination of “readily tradable” is based on the overall nature and magnitude of trading in a fund, the Treasury Regulations describe several safe harbors under which certain transfers are ignored.[23] The most relevant safe harbor in the secondary sale context relates to “private transfers.”[24] In addition, the Treasury Regulations provide that interests in a partnership are not deemed to be readily tradable if they are issued in a qualified private placement (“private placement”),[25] or if no more than 2% of the total interests in partnership profits or capital are transferred during a taxable year (“de minimis trading”).[26]

Private transfers consist of transfers at death, among family members, and otherwise not involving trading (including certain closed-end redemptions).[27] More importantly for purposes of this discussion, they include so-called “block transfers.” A block transfer is a transfer by an investor of interests aggregating more than 2% of the total interests in the partnership capital or profits, and may occur in one or more transactions spanning any 30 consecutive-day period.[28] Accordingly, so long as the 2% threshold is met in each case, a fund can theoretically permit unlimited transfers without running afoul of the PTP restrictions.[29]

Unlike the private transfer exceptions, which exclude certain transfers in assessing PTP status, interests in a partnership are by definition not readily tradable if they fall under the “private placement” or “de minimis trading” exemption. The “private placement” exemption applies where all the interests in a partnership are issued in a transaction that is not required to be registered under the Securities Act [30] and the partnership does not have more than 100 partners at any time during the taxable year.[31] Managers wishing to rely on this exemption should be aware that, in determining the number of partners in a partnership, the Treasury Regulations provide that a beneficial owner that owns an interest in a partnership through one or more flow-through entities will be treated as a partner in the underlying partnership if (i) substantially all the value of the beneficial owner's interest in the flow-through entity is attributable to its interest in the underlying partnership and (ii) the principal purpose of the use of the tiered arrangement is to permit the partnership to satisfy this 100-partner limitation.[32] In addition, while the Treasury Regulations do not expressly discuss parallel entities, where a fund creates multiple parallel entities for the principal purpose of satisfying the 100-partner limitation, it is possible the entities will be integrated for purposes of determining the number of partners in a partnership.  A fund manager should therefore require representations from its investors as to their status and intent. 

The “de minimis trading” exemption is applied in conjunction with the exceptions for “private transfers” described above. Accordingly, even if a partnership experiences several block transfers of more than 2% each, the partnership can still qualify for the “de minimis trading” exemption, so long as the total transfers of other interests do not exceed 2% of the total interests in the partnership capital or profits in the aggregate during the relevant taxable year.[33]

Note also that where a defaulting or near-defaulting investor wishes to engage in a secondary sale prior to any drawdown of capital, it is possible that such investor will not yet be considered a partner for tax purposes, and as such, the transfer of such investor’s commitment may not be taken into account for purpose of the PTP determination. 

Conclusion

Assisting defaulting or near-defaulting investors in selling their interests in a secondary market may be beneficial to the manager, the investor and the fund. However, a manager needs to consider the issues discussed above, along with additional issues based on the nature of the fund and the specific circumstances surrounding the potential sale. For example, the manager should ensure that the acquisition of the transferred interest will not cause, or potentially cause, the fund to exceed the so-called 25% benefit plan investor limit where the fund is operated in reliance thereon, or to become subject to the Bank Holding Company Act. 

The manager should also be mindful of certain tax and accounting considerations in connection with a secondary sale. For example, to the extent a partnership has made a “754 election” or the partnership’s property has depreciated by more than a prescribed threshold, the fund may be required to separately track the basis of the buyer in a secondary sale;[34] and to the extent more than 50% of the ownership of a partnership changes during a period of 12 months, partnership termination issues may arise.[35]

Although this article provides a summary of some of the issues that are likely to arise, any manager considering assisting a defaulting or near-defaulting investor with a secondary sale should consult with its legal counsel prior to, and in the course of, doing so.

To ensure compliance with requirements imposed by the United States Treasury Department in Circular 230, we inform you that any tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

[1] As used herein, the term “manager” may refer to the general partner, investment adviser or other relevant managing entity of a fund.

[2] The considerations discussed in this article may also apply to real estate and infrastructure funds. Note that there may be different and additional considerations for hedge funds, and/or for managers that are seeking to force a sale of a defaulting investor’s interest as a remedy to default. This article does not address those considerations. 

[3] In this regard, when fund documents are being drafted, it is advisable for the manager to provide that decisions involving a determination of the best interest of the fund will be made by the manager in its discretion, so that the decision of the manager, unless grossly negligent or otherwise made in bad faith, is more likely to withstand a challenge by a disgruntled investor.

[4] 15 U.S.C. § 77e.

[5] 15 U.S.C. § 77d(1).

[6] 15 U.S.C. § 77(a)(11). The term “underwriter” means any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking; but such term shall not include a person whose interest is limited to a commission from an underwriter or dealer not in excess of the usual and customary distributors' or sellers' commission. As used in this paragraph the term "issuer" shall include, in addition to an issuer, any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control with the issuer.

[7] See, inter alia, 17 C.F.R. §230.144(e)(3)(G).

[8] See e.g., 7A J. William Hicks, Securities Laws Series, Exempted Transactions Under the Securities Act § 9:109 et seq. (2009); The Section “4(1-1/2)” Phenomenon: Private Resales of “Restricted” Securities, A Report to the ABA Comm. on Fed. Reg. of Sec. from the Study Group on 4(1-1/2) of the Subcomm. on the 1933 Act, 34 Bus. Law 1961 (1979); Securities Act Release No. 6188, 1980 WL 29482 (Feb. 1, 1980); SEC v. Ralston Purina Co., 346 U.S. 119 (1953); Cambridge Ltd. Partnership, SEC No-Action Letter, 1984 WL 45265 (Apr. 24, 1984); and Optelecom, Inc., SEC No-Action Letter, 1982 WL 30378 (Mar. 5, 1982).

[9] 17 C.F.R. § 230.502(d).

[10] 17 C.F.R. § 230.502.

[11] 15 U.S.C. § 78o(a)(1).

[12] See 15 U.S.C. § 78c(a)(4), which provides that the term “broker” means “any person engaged in the business of effecting transactions in securities for the account of others.” 

     In addition, many managers rely on Rule 3a4-1, which provides a safe harbor for managers who meet certain conditions. See 17 C.F.R. § 240.3a4-1.

[13] See 15 U.S.C. § 78c(a)(18), which provides that the term “person associated with a broker or dealer” or “associated person of a broker or dealer” means “any partner, officer, director, or branch manager of such broker or dealer (or any person occupying a similar status or performing similar functions), any person directly or indirectly controlling, controlled by, or under common control with such broker or dealer, or any employee of such broker or dealer, except that any person associated with a broker or dealer whose functions are solely clerical or ministerial shall not be included in the meaning of such term for purposes of section 15(b) (other than paragraph (6) thereof).”

[14] 15 U.S.C. § 80b-3.

[15] 17 C.F.R. § 275.203(b)(3)-1.

[16] 15 U.S.C. § 80b-6.

[17] 17 C.F.R. 275.206(4)-1.

[18] Where a fund is comprised of multiple entities, unless those entities are integrated for tax purposes, the following analysis generally applies separately to each partnership.

[19] I.R.C. § 7704(c).

[20] I.R.C. § 7704(a).

[21] See Treas. Reg. § 1.7704(c)(2).

[22] Treas. Reg. § 1.7704(c)(1).

[23] See Treas. Reg. § 1.7704(e) through -(j).

[24] Treas. Reg. § 1.7704(e). In addition, though strictly regulated, the Treasury Regulations provide an additional safe harbor for transfers under a “qualified matching service.” A “qualified matching service” is a service which generally meets the following requirements: (i) the service must be a computerized or printed listing system that lists customers’ bid/ask quotes, (ii) the matching occurs by matching the lists of buyers/sellers or through bids by interested buyers on the listed interests, (iii) binding agreements to sell the interests cannot be entered into until at least 15 days following the date the information offering the sale of interests is made available, (iv) the closing of the sale does not occur prior to 45 days after the date the information offering the sale of interests is made available, (v) the matching service does not display firm price quotes, (vi) the information is removed within 120 days following the date it is made available and no sales are made for at least 60 days thereafter; and (vii) the sum of the partnership interests in profits and capital transferred during the taxable year (other than in “private transfers”) does not exceed 10% of the total such interests. See Treas. Reg. § 1.7704(g).

[25] Treas. Reg. § 1.7704(h).

[26] Treas. Reg. § 1.7704(j).

[27] See Treas. Reg. § 1.7704(e)(1)(i) through -(x).

[28] Treas. Reg. § 1.7704(e)(2).

[29] Note that there may be other issues involved in a partnership permitting a change in ownership of more than 50% of its interest in a 12-month period, including partnership termination issues.

[30] Partnership interests that are exempt from registration under the Securities Act pursuant to Regulation S will not be deemed readily tradable only if the offering of the interests would have been exempt from registration had the interests been offered and sold within the U.S. See Treas. Reg. § 1.7704(h)(2).

[31] Treas. Reg. § 1.7704(h)(1).

[32] Treas. Reg. § 1.7704(h)(3).

[33] Treas. Reg. § 1.7704(j).

[34] See I.R.C. §§ 743(a), 743(d) and 754.

[35] I.R.C. § 708(b)(1)(B).